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Project Report
On
COMPARATIVE ANALYSIS OF CAPITAL STRUCTURE OF SMES AT
NSIC
BY
SRAVANI DV
H.T.NO: 217013683024
DECLARATION
I hereby declare that project report on COMPARATIVE ANALYSIS OF
CAPITAL STRUCTURE OF SMES AT NSIC is an original and bonafide work
under taken by me impartial fulfillment for the award of (BACHEOLOR OF
BUSINESS ADMINISTRATION, Osmania University, Hyderabad)
I also declare that this project is the result of my own efforts and has not been submitted
to any other university or institution for the award of any Degree/Diploma.
SRAVANI DV
H.T.NO: 217013683024
ACKNOWLEDGMENT
The satisfaction and euphoria after the completion of any work would be incomplete without
the mention of the people behind the successful completion of work.
I would like to express with much sincerity, my deep sense of gratitude to Dr. P.
CHAKRAVARTHI, PRINCIPAL, VVISM, for promoting excellent academic environment.
My heart full thanks to Mrs VANI KOTLA, company guide for her guidance in completing
my project work.
2
I also extend my thanks to Mr G.SUMANTH KUMAR, H.O.D, BBA for his assistance
timely suggestions, guidance and having provided all facilities to complete this project work
successfully.
I would like to thank my project Guide and Faculty Mr CH.NARESH, for his valuable
guidance.
Finally, I would like to express my sincere thanks to all our faculty and friends for their
timely suggestions and encouragement provided for the successful completion of this
project.
SRAVANI DV
H.T.NO: 217013683024
LIST OF CONTENTS
S. No Topic Pg. no
Abstract 07
1. Chapter -1 08
Introduction 08
Objectives 11
Need for capital structure planning 11
Scope and coverage 12
Research and methodology 12
Limitations 13
2. Chapter-2
Literature review 14
3 Chapter-3
Company & Industry Profile 18,22 & 26
4 Chapter -4
3
Conceptual framework 30
5 Chapter-5
Data analysis & interpretation 44
6 Chapter -6
Findings & suggestions 52 & 53
7 Chapter-7
Conclusion 54
Bibliography
Annexures-1,2
LIST OF TABLES
LIST OF GRAPHS
s.no Graph Name Page No.
No.
1 5.1(a) Debt equity ratios between serwel and raghuvamsi companies 46
4
4 5.4(d) EPS ratio of serwel and raghuvamsi companies 50
5
ABSTRACT
One of the most critical areas of the finance function is to make decisions about the firms
capital structure. Capital is required to finance investments in plant and machinery,
inventory, accounts receivable and so on. Capital structure is the part of financial structure,
which represents long term sources. It is the permanent financing of the company
represented primarily by shareholders funds and long term debt and excluding all short-
term credit. To quote Walker, The term capital structure is generally defined to include only
long term debt and total stockholders investment (Walker).It refers to the Capitalization of
long term sources of funds such as debentures, preference share capital, long term debt and
equity share capital including reserves and surplus (retained earnings). According to Bogen,
The capital structure may consist of a single class of stock, or it may be complicated by
several issues of bonds and preferred stock, the characteristics of which may vary
considerably. In other words, capital structure refers to the composition of capitalization
i.e., to the proportion between debt and equity that make up capitalization (Philips).
Weston and Brigham have indicated the capital structure by the following equation
(Weston):
Capital Structure = Long term debt Preferred stock + Net worth (or)
Capital Structure = Total Assets Current Liabilities.
In this Project, an attempt has been made to study the Pattern of Capital Structure in
SME at NSIC. An analysis of long-term solvency, assessment of debt-equity, debt to total
fund and justification for the use of debt through the application of ratio analysis and
statistical test has been undertaken. The time period considered for evaluating the study is
four years.
Chapter-1
INTRODUCTION
1.1Introduction of capital structure
The financing decisions occupy a pivotal role in the overall finance function in a
corporate firm which mainly concerns itself with an efficient utilization of the funds
provided by the owners or obtained from external sources together with those retained or
6
ploughed back out of surplus or undistributed profits. These decisions are mainly in the
nature of planning capital structure, working capital and mechanism through which funds
can be raised from the capital market whenever required. The financing decisions explains
how to plan an appropriate mix with least count, how to raise long term funds, and how to
mobilize the funds for working capital within a short span of time. Such a financing policy
provides an appropriate backdrop for formulating effective policies for investment of funds
as well as management of earnings. It contributes to magnifying the earnings on equity as
profitability (expressed as return on equity), to a large extent, is dependent on the degree of
leverage in the capital structure. Besides, the valuation of the structure of physical assets
depends fundamentally on the financing mix. This makes it necessary for the management
of a firm to pursue a well thought out of financing policy, which ought to be framed initially,
incorporating, among other things, the proportion of the debt and equity, types of debts and
own funds to be used and volume of the funds to be raised from each source or combination
of sources, to enable the firm to have a proper capitalization. In the absence of this, the firm
may face the problem of either over-capitalization or under-capitalization impeding its
smooth financial functioning.
It is obvious that functioning decisions are extremely important for corporate firms. Such
decisions, in management parlance, are termed as capital structure decisions. The term
capital structure is used to describe the combination of various sources of finance employed
to raise funds. It implies, in other words, that when a firm chooses to use a group of sources
in certain proportions the resulting pattern is referred to as capital structure of the firm. The
sources of finance could be divided in terms of ownership of funds and duration of funds.
The former comprises owned and borrowed funds while the latter includes long, medium
and short term funds. Of the two, the duration-based classification is useful for preparing a
plan to meet long term as well as short term capital requirements while ownership-based
classification is useful for selection of specified sources, determining debt-equity ratio and
analyzing impact of capital structure decisions on the earnings on equity. As the ownership
based classification suggests that there are two types of sources of finance, namely owned
and borrowed funds, the capital structure represents the component relationship between
owned and borrowed funds. The owned funds which are also described as equity fund may
be defined as funds provided by or belonging to the share-holders. In the opinion Raj want
7
Singh and Brij Kumar, the capital structure is made up of the long term borrowings, the
preferred stock and the common stock equity including all related net worth accounts.
Similarly Morarka.R observes that the capital structure implies a degree of permanency and
normally omits short term borrowings of less than one year but would include other
intermediate and long term borrowings. The financial institutions consider only long term
sources of finance for computing the debt-equity ratio of corporate firm.
1.2 Definition
A mix of a company's long-term debt, specific short-term debt, common equity and
preferred equity, the capital structure is how a firm finances its overall operations and
growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified
as common stock, preferred stock or retained earnings. Short-term debt such as working
capital requirements is also considered to be part of the capital structure
1.3 Theories of capital structure
Different kinds of theories have been propounded by different authors to explain the
relationship between capital structure, cost of capital and the value of the firm. The main
contributors to the theories are Durand, Ezra, Solomon, Modigliani and Miller.
The important theories are discussed below:
Net Income Approach
Net Operating Income Approach.
The Traditional Approach.
Modigliani and Miller Approach.
1. Net Income Approach. According to this approach, a firm can minimize the
weighted average cost of capital and increase the value of the firm as well as market
price of equity shares by using debt financing to the maximum possible extent. The
theory propounds that a company can increase its value and decrease the overall cost
of capital by increasing the proportion of debt in its capital structure. This approach
is based upon the following assumptions:
The cost of debt is less than the cost of equity.
There are no taxes.
The risk perception of investors is not changed by the use of debt.
2. Net Operating Income Approach. This theory as suggested by Durand is another
extreme of the effect of leverage on the value of the firm. It is diametrically opposite
to the net income approach. According to this approach, change in the capital
structure if a company does not affect the market value of the firm and the overall
8
cost of capital remains constant irrespective of the method of financing. It implies
that the overall cost of capital remains the same whether the debt- equity mix is
50:50 or 20:80 or 0:100. Thus, there is nothing as an optimal capital structure and
every capital structure is the optimum capital structure. This theory presumes that:
The market capitalizes the value of the firm as a whole.
The business risk remains constant at every level of debt equity mix;
There are no corporate taxes.
3. The Traditional Approach. The traditional approach, also known as intermediate
approach, is a compromise between extremes of net income approach and net
operating income approach. According to this theory, the value of the firm can be
increased initially or the cost of capital can be decreased by using more debt as the
debt is a cheaper source of funds than equity. Thus, optimum capital structure can be
reached by a proper debt-equity mix. Beyond a particular point, the cost of equity
increases because increased debt increases the financial risk of the equity
shareholders. The advantage of cheaper debt at this point of capital structure is offset
by increased cost of equity. After this there comes a stage, when the increased cost of
equity cannot be offset by the advantage of low-cost debt. Thus, overall cost of
capital, according to this theory, decreases up to a certain point, remains more or less
unchanged for moderate increase in debt thereafter; and increases or rises beyond a
certain point. Even the cost of debt may increase at this stage due to increased
financial risk.
1.4 Objectives
The present study aims at endeavoring the following objectives:
To analyze the pattern of capital structure;
To assess of long-term solvency; and
To ascertain the justification for the use of debt.
Capital structure means the mixture of share capital and other long term liabilities. In capital
structure, we include equity share capital, preference share capital, debenture and long term
debt. Some of companies want to become smart. They slowly decrease equity share capital
and increases loan excessively which may be very risky because these company has to pay
fixed cost of interest and has to manage repayment of loan after some time. Some mistake in
it, may be risky for its solvency. So, decision relating to capital structure is very important
for company
9
1.5 Need for capital structure
For the real growth of the company the financial manager of the company should plan an
optimum capital for the company. The optimum capital structure is one that maximizes the
market value of the firm. There are significant variations among industries and companies
within an industry in terms of capital structure. Since a number of factors influence the
capital structure decision of a company, the judgment of the person making the capital
structure decisions play a crucial part. A totally theoretical model cant adequately handle all
those factors, which affects the capital structure decision in practice. These factors are
highly psychological, complex and qualitative and do not always follow accepted theory,
since capital markets are not perfect and decision has to be taken under imperfect knowledge
and risk.
An appropriate capital structure or target capital structure can be developed only when all
those factors, which are relevant to the companys capital structure decision, are properly
analyzed and balanced. The capital structure should be planed generally keeping in view the
interest of the equity shareholders and financial requirements of the company. The equity
shareholders being the owner of the company and the providers of risk capital (equity),
would be concerned about the ways of financing a companys operations. However, the
interest of other groups, such as employee, customers, creditors, society and government,
should be given reasonable consideration when the company lays down its objective in
terms of the shareholders wealth maximization, it is generally compatible with the interest
of other groups. The management of companies may fix its capital structure near the top of
this range in order to make maximum use of favorable leverage, subject to other
requirements such as flexibility, solvency, control and norms set by the financial institutions-
The Security Exchange Board of India (SEBI) and Stock Exchanges.
1.6 Scope and coverage
The present study is confined to SME. This study is restricted to assess the pattern of capital
structure in SME with the help of the ratio analysis. The time period considered for
evaluating the study is four years
1.7 Research methodology
Research Methodology is a systematic and objective process of identifying and formulating
the problem by setting objectives and methods for collecting, editing, calculating,
evaluating, analyzing, interpreting and presenting data in order to find justified solutions.
10
Research design:
The Descriptive research design has been using in this study. Descriptive research studies,
which are concerned with describing the characteristics of a particular individual or of a
group or a situation. Studies concerned with specific predictions, with narration of facts and
characteristics concerning individual, group or a situation are examples of descriptive
research studies.in this project, income and balance statements are evaluated to know the
state of affairs as it existed during the years 2010-2015. This helps to know the performance
of the schemes.
Sources of Data:
There are two sources of data namely:
1. Primary data
2. Secondary data
Primary Data:
Primary data are those which are collected for the first time and so are in crude form. They
are original in character. If an individual or an office collects the data to study a problem, the
data are the raw material of the enquiry. Primary data are always collected from the source.
It is collected either by the investigator himself or through his agents.
Secondary Data:
Secondary data are those which have already been collected by someone for the purpose and
are available for the present study. The choice to a large extent depends on the preliminaries
to data collection some of the commonly used methods are discussed below;
In this research, the various sources of secondary data, which are used, are:
Literature Reviews
Journals
Magazines
Balance sheets
1.8 Tools of analysis
The present study is confined to SME. This study is restricted to assess the pattern of capital
structure in SME with the help of the ratio analysis. The time period considered for
evaluating the study is four years
1.9 Limitations
It requires a small business to make regular monthly payments of principal and
interest.
Availability is often limited to established businesses.
Since lenders primarily seek security for their funds, it can be difficult for unproven
businesses to obtain loans.
11
Very complicate and expensive to administer.
Chapter-2
REVIEW OF LITERATURE
Study on capital structure has become one of the most significant subjects of interest in
modern finance. It has acquired lot of recognition from researchers during recent years.
There exists a vast body of literature that has examined the determinants of the capital
structure of companies in developed economies. Empirical works based on theories of
capital structure has been previously conducted for Australia (Cassar and Holmes, 2003;
Johnsen and McMahon, 2005), Spain (Sorgorb, 2005), UK (Hall et al., 2000) and the US
(Gregory et al., 2005). However studies on capital structure have been extended to the
developing economy contexts only in recent past. The level of development of a countrys
legal and financial systems has been shown to influence the capital structure of its
enterprises (Fan et al., 2006). In economies with relatively weak investor protection,
enterprises are more likely to employ short-term debt than long-term debt in their capital
structure. This is in contrast to enterprises in economies with active stock markets and large
banking sectors which have more long-term debts (Demirguc-Kunt and Maksimovic (1999).
Despite of the growing volume of literature on the determinants of capital structure in the
developing economy context is available, there has been limited work conducted on SMEs
in these countries. One possible reason for this discrepancy is that SME data is often scarce
and sometimes not reliable, since these firms are not officially required to disclose detailed
information or to have their reports audited. Some preliminary work has been carried out for
Poland (Klapper et al., 2006), Vietnam (Nguyen and Ramachandran, 2006), and Ghana
(Abor and Biekpe, 2007). All these studies implies to the fact that the that theories of capital
structure developed to explain the financing decisions of SMEs in developed economies are
not equally applicable in developing economies, due to their institutional and organizational
differences. Many authors suggested the firm size as a potential determinant of capital
structure decision.
12
Determinants of capital structure of Chinese-listed companies.
Jean J. Chen in this paper develops a preliminary study to explore the determinants of capital
structure of Chinese-listed companies using firm-level panel data. The findings reflect the
transitional nature of the Chinese corporate environment. They suggest that some of the insights
from modern finance theory of capital structure are portable to China in that certain firm-specific
factors that are relevant for explaining capital structure in developed economies are also relevant in
China. However, neither the trade-off model nor the Pecking order hypothesis derived from the
Western settings provides convincing explanations for the capital choices of the Chinese firms. The
capital choice decision of Chinese firms seems to follow a new Pecking orderretained profit,
equity, and long-term debt. This is because the fundamental institutional assumptions underpinning
the Western models are not valid in China. These significant institutional differences and financial
constraints in the banking sector in China are the factors influencing firms' leverage decision and
they are at least as important as the firm-specific factors. The study has laid some groundwork upon
which a more detailed evaluation of Chinese firms' capital structure could be based.
-Jean J. Chen
13
finance even in the absence of well-developed institutions, as can systems of credit
information sharing and a more competitive banking structure.
Small and medium-size enterprises: Access to finance as a growth constraints, June 2006
-Thorsten Beck
Sheridan Titamin and Robert wessels in this paper analyzes the explanatory power of some
of the recent theories of optimal capital structure. The study extends empirical work on
capital structure theory in three ways. First, it examines a much broader set of capital
structure theories, many of which have not previously been analyzed empirically. Second,
since the theories have different empirical implications in regard to different types of debt
instruments, the authors analyze measures of short-term, long-term, and convertible debt
rather than an aggregate measure of total debt. Third, the study uses a factor-analytic
technique that mitigates the measurement problems encountered when working with proxy
variables.
In this study, Kenny Bell and Ed Vos has described SME capital structure behavior is found
typically to follow pecking order behavior. However, the theoretical underpinnings of the
pecking order theory are doubted in the case of SMEs as SME managers highly value
financial freedom, independence, and control while the pecking order theory assumes firms
desire financial wealth and suffer from severe adverse selection costs in accessing external
finance. Alternatively, the contentment hypothesis of Vos, et al (2007) contends the reason
SMEs exhibit pecking order behavior is the aversion to loss of control to outside financiers
and the preference for financial freedom. This paper develops the capital structure
predictions of the contentment hypothesis, reviews the predictions of the tradeoff and
pecking order theories for relevant variables, reviews the findings of existing SME capital
14
structure studies, and provides original empirical support for the contentment hypothesis
using a survey of over 2,000 firms from Germany, Greece, Ireland, South Korea, Portugal,
Spain, and Vietnam.
15
Chapter-3
COMPANY &INDUSTRIAL PROFILE
3.1
16
MSMEs need to be provided with market related information, new avenues for their
products, new business practices, both domestically as well as overseas. MSMEs are
handicapped because of non availability of information pertaining to central government /
state government policies and programs, the support schemes and services of central /state
PSUs availability of new technologies, international and national tenders, opportunities
available in various countries for products and project exports. The NSIC marketing
intelligence cell will integrate the available information at one strengthen their efforts in
focused manner.
17
Information plays a vital role in the success if any business. Keeping in mind the
information needs to micro and small enterprises. NSIC has launched its infomediary
services. A one stop, one window bouquet for aids that will provide information on business,
technology, finance and also exhibit the core competence of Indian micro and small
enterprises in terms of price and quality internationally as well as domestically.
3.1.5 Some important services provided are:
Tender information in your e-mail box and web based browsing
Banner display on NSICC website
Accesses to wide range of technologies from India and abroad
Joint venture opportunities and information on of trade and events
Comprehensive information on government policies rules, regulations, schemes
and incentives.
3.1.6 Raw material assistance:
NSIC extends short term financial assistance to micro and small enterprises for procurement
of raw material on need basis.
The salient features
Financial assistance for procurement of raw material up to 90 days
MOU with NALCO, HCL, SAIL, RINL FOR supply of bulk materials
Easy and quick disbursement
Flexibility of repayment
3.1.7 Tender marketing:
The corporation participates in bulk global tender enquiries and local tenders of central &
state government and public sector enterprises on behalf of micro and small enterprises.
It is aimed to assist micro and small enterprises with ability to manufacture quality products
with brand equity & credibility or have limited financial capabilities.
3.1.8Benefits:
NSIC will provide all financial support depending upon the units individual requirements
like purchase of raw materials and financing of sale bill. Enhance business volume helps
micro and small enterprises to achieve maximum capability utilization. Micro and small
enterprises are exempted from depositing earnest money. It ensures fair margin to micro and
small enterprises for their production.
18
ICRA; ONICRA, DUN & BRAD STREET, CRISIL, FITCH, CARE and SNERA. Micro
and small enterprises has the liberty to choose among any of the rating agencies empanelled
with NSIC. The rating agencies will charge the credit rating fee according to their policies.
The benefits to small enterprises are as follows.
An in dependent trusted third party opinion on capabilities and credit-worthiness of
micro and small enterprises
Availability of credit at attractive interest
Recognition in global trade
Prompt sanctions of credit from banks financial institutions.
3.1.10 Facilitation of credit support through banks:
Any kind of financial assistance i.e., terms loan, working capital loan, bill
discounting facility and export finance can be arrange through united bank of India, UCO
bank, oriental bank of commerce, central bank of India, bank of Maharashtra, YES bank and
HSDC at the most competitive interest rates. The terms and condition of finance shall be of
individual bank. NSIC will undertake the follow up the proposals with the bank selected by
the unit for obtaining finance shall ensure timely disposal. Application forms of the
individual banks can be had from the office of the NSIC.
19
3.2.2 Quality
Sewell is an ISO 9001:2000 certified company with a commitment of well defined quality
systems that ensures quality products and services are delivered to our customers. R & D is a
continuous process in Sewell and we are committed to introduce new products which can be
customized as per customers request and configurations. All products are tested on various
parameters like safety, electricity consumption, durability, maintainability, etc. The stringent
quality check imbibed by us assures conformance of products in relation to international
quality standards.
3.2.3 Products
Electronic voltage stabilizers.
Power & Distribution Transformers.
Automatic power Factor.
LT panel boards.
Energy saver.
UPS.
3.2.4 Infrastructure
We possess a state-of-the-art manufacturing units, which are facilitated with the latest
machinery, equipment and technology. With these facilities, we are able to meet the bulk
requirements of our clients. We make sure that we upgrade our machinery from time to time
for the smooth functioning of our manufacturing process.
3.2.5 Profile
Serwell is one of the leading manufacturers of Servo Stabilizers, Distribution and Power
Transformers, Ultra Isolation Transformers, APFC Panels, Auto Transformers and Power
Savers. Sewell constantly adds new products every year to existing product line and is in
business to address electrical needs of customers from more than 16 years.
Basic Information
20
Business Type
Supplier
Manufacturer
Service provider
Company USP
Experienced R&D Good financial position
Primary competitive
Department &TQM
advantage
Statutory Profile
PAN No. AAECS3499J
Registration Authority Hyderabad
Registration No. AAECS3499JXM003
TIN No. / VAT No. 28250204177V
Packaging/Payment and Shipment Details
21
Payment Mode Cheque Credit card
DD LC
By road By sea
22
3.2.9 Production Capacity
With installed modernized machines and sophisticated tools and equipment, we are able to
furnish bulk demands of our customers with utmost ease and within the constraints of time.
Besides, machines installed aids in conduction of thorough testing as per IS: 5142 norms.
Owing to the use of modernized machines and tools, we are able to produce around 35000
units per year. Our manufactured products are safely stored in our capacious warehousing
facility. Owing to proper segregation into various sections, our warehouse aids in storing
range as per proper nomenclature and labeling, thereby ensuring quick retrieval and timed
dispatch. minimum turnover as of the eligibility criteria for MSE's.
23
comprehend their aspirations and offer products accordingly. As a result, we have acquired
the trust of maximum customers and expanded our base of satisfied clients from all across
the country.
Our company possesses team of extremely dedicated and talented professionals, who
dedicatedly perform the whole task and ensure accomplishing the specific targets
successfully. They cordially perform the whole operations and ensure to achieve the
predetermined objectives of a company successfully.
Mr. G.Vamshi Vikas is the managing director of our organization, who have helped us
growing and achieving a desired niche in industry. All these are just because of his sound
managerial qualities, business acumen, foresightedness, industrial experience and sincere
business approach.
3.3.2 Company Mission
To create value and make a difference in the field of Precision Manufacturing by using
world class machine shop, best quality methods, up to date technology - achieving consistent
delivery and zero-defect parts to our customers at competitive prices.
24
Reporting to the Managing Director, Mr.Subba rao heads the Sales & Coordination Team.
He ensures the customer requirements are met and bridges the customer with the company
to ensure 100% quality & on time delivery.
A Masters graduate in Mechanical Engineering from MIT, Chennai joined Raghu Vamshi in
2008. He has over 40 years of experience in Aerospace industry and has worked in various
senior management disciplines including Operations, Marketing, and Customer
Coordination in Hindustan Aeronautics Limited before retiring as AGM, Production in 2004.
He also Served as Secretary HAL in Indian Embassy, Moscow coordinating all aerospace
industries in Russia with all HALs in India.
Mallikarjuna Swami General Manager Mallikarjuna Swami is General Manager -
Operations of Raghu Vamsi mechanical engineer having 42 years of experience and worked
as a senior management member in HAL koraput division and in reputed automotive
component manufactures like range engine valves, range Die cart and Synergies Casting
Ltd.
3.3.5 Company Future Plans
Raghu Vamshi, in a short span of time, has evolved as a successful manufacturing partner to
its customers by providing High Precision machining and Engineering CAD/CAM
Services.
A strategically defined plan till 2015 will further enhance our current capabilities
Sheet Metal
Welding
NADCAP NDT
NADCAP Plating
Assembly Services
EMS Activity
25
ISO Certification
Click to Zoom
An ISO 9001:2008 Certified Company.
Chapter-4
CONCEPTUAL FRAMEWORK
26
profitability (expressed as return on equity), to a large extent, is dependent on the degree of
leverage in the capital structure. Besides, the valuation of the structure of physical assets
depends fundamentally on the financing mix. This makes it necessary for the management
of a firm to pursue a well thought out of financing policy, which ought to be framed initially,
incorporating, among other things, the proportion of the debt and equity, types of debts and
own funds to be used and volume of the funds to be raised from each source or combination
of sources, to enable the firm to have a proper capitalization. In the absence of this, the firm
may face the problem of either over-capitalization or under-capitalization impeding its
smooth financial functioning.
It is obvious that functioning decisions are extremely important for corporate firms. Such
decisions, in management parlance, are termed as capital structure decisions. The term
capital structure is used to describe the combination of various sources of finance employed
to raise funds. It implies, in other words, that when a firm chooses to use a group of sources
in certain proportions the resulting pattern is referred to as capital structure of the firm. The
sources of finance could be divided in terms of ownership of funds and duration of funds.
The former comprises owned and borrowed funds while the latter includes long, medium
and short term funds. Of the two, the duration-based classification is useful for preparing a
plan to meet long term as well as short term capital requirements while ownership-based
classification is useful for selection of specified sources, determining debt-equity ratio and
analyzing impact of capital structure decisions on the earnings on equity. As the ownership
based classification suggests that there are two types of sources of finance, namely owned
and borrowed funds, the capital structure represents the component relationship between
owned and borrowed funds. The owned funds which are also described as equity fund may
be defined as funds provided by or belonging to the share-holders. In the opinion Raj want
Singh and Brij Kumar, the capital structure is made up of the long term borrowings, the
preferred stock and the common stock equity including all related net worth accounts.
Similarly Morarka.R observes that the capital structure implies a degree of permanency and
normally omits short term borrowings of less than one year but would include other
intermediate and long term borrowings. The financial institutions consider only long term
sources of finance for computing the debt-equity ratio of corporate firm.
Definition
27
A mix of a company's long-term debt, specific short-term debt, common equity and
preferred equity, the capital structure is how a firm finances its overall operations and
growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified
as common stock, preferred stock or retained earnings. Short-term debt such as working
capital requirements is also considered to be part of the capital structure
Theories of capital structure
Different kinds of theories have been propounded by different authors to explain the
relationship between capital structure, cost of capital and the value of the firm. The main
contributors to the theories are Durand, Ezra, Solomon, Modigliani and Miller.
The important theories are discussed below:
Net Income Approach
Net Operating Income Approach.
The Traditional Approach.
Modigliani and Miller Approach.
1. Net Income Approach. According to this approach, a firm can minimize the
weighted average cost of capital and increase the value of the firm as well as market
price of equity shares by using debt financing to the maximum possible extent. The
theory propounds that a company can increase its value and decrease the overall cost
of capital by increasing the proportion of debt in its capital structure. This approach
is based upon the following assumptions:
The cost of debt is less than the cost of equity.
There are no taxes.
The risk perception of investors is not changed by the use of debt.
2. Net Operating Income Approach. This theory as suggested by Durand is another
extreme of the effect of leverage on the value of the firm. It is diametrically opposite
to the net income approach. According to this approach, change in the capital
structure if a company does not affect the market value of the firm and the overall
cost of capital remains constant irrespective of the method of financing. It implies
that the overall cost of capital remains the same whether the debt- equity mix is
50:50 or 20:80 or 0:100. Thus, there is nothing as an optimal capital structure and
every capital structure is the optimum capital structure. This theory presumes that:
The market capitalizes the value of the firm as a whole.
The business risk remains constant at every level of debt equity mix;
There are no corporate taxes.
28
3. The Traditional Approach. The traditional approach, also known as intermediate
approach, is a compromise between extremes of net income approach and net
operating income approach. According to this theory, the value of the firm can be
increased initially or the cost of capital can be decreased by using more debt as the
debt is a cheaper source of funds than equity. Thus, optimum capital structure can be
reached by a proper debt-equity mix. Beyond a particular point, the cost of equity
increases because increased debt increases the financial risk of the equity
shareholders. The advantage of cheaper debt at this point of capital structure is offset
by increased cost of equity. After this there comes a stage, when the increased cost of
equity cannot be offset by the advantage of low-cost debt. Thus, overall cost of
capital, according to this theory, decreases up to a certain point, remains more or less
unchanged for moderate increase in debt thereafter; and increases or rises beyond a
certain point. Even the cost of debt may increase at this stage due to increased
financial risk.
31
The expected cash flow must match with the obligation of making payments because if
company fails to make fixed payment it may face insolvency. Before including the debt in
capital structure company must analyze properly the liquidity of its working capital.
A company employs more of debt securities in its capital structure if company is sure of
generating enough cash inflow whereas if there is shortage of cash then it must employ more
of equity in its capital structure as there is no liability of company to pay its equity
shareholders.
2. Interest Coverage Ratio (ICR):
It refers to number of time companies earnings before interest and taxes (EBIT) cover the
interest payment obligation.
ICR= EBIT/ Interest
High ICR means companies can have more of borrowed fund securities whereas lower ICR
means less borrowed fund securities.
3. Debt Service Coverage Ratio (DSCR):
It is one step ahead ICR, i.e., ICR covers the obligation to pay back interest on debt but
DSCR takes care of return of interest as well as principal repayment.
If DSCR is high then company can have more debt in capital structure as high DSCR
indicates ability of company to repay its debt but if DSCR is less then company must avoid
debt and depend upon equity capital only.
4. Return on Investment:
Return on investment is another crucial factor which helps in deciding the capital structure.
If return on investment is more than rate of interest then company must prefer debt in its
capital structure whereas if return on investment is less than rate of interest to be paid on
debt, then company should avoid debt and rely on equity capital. This point is explained
earlier also in financial gearing by giving examples.
5. Cost of Debt:
If firm can arrange borrowed fund at low rate of interest then it will prefer more of debt as
compared to equity.
6. Tax Rate:
High tax rate makes debt cheaper as interest paid to debt security holders is subtracted from
income before calculating tax whereas companies have to pay tax on dividend paid to
32
shareholders. So high end tax rate means prefer debt whereas at low tax rate we can prefer
equity in capital structure.
7. Cost of Equity:
Another factor which helps in deciding capital structure is cost of equity. Owners or equity
shareholders expect a return on their investment i.e., earning per share. As far as debt is
increasing earnings per share (EPS), then we can include it in capital structure but when EPS
starts decreasing with inclusion of debt then we must depend upon equity share capital only.
8. Floatation Costs:
Floatation cost is the cost involved in the issue of shares or debentures. These costs include
the cost of advertisement, underwriting statutory fees etc. It is a major consideration for
small companies but even large companies cannot ignore this factor because along with cost
there are many legal formalities to be completed before entering into capital market. Issue of
shares, debentures requires more formalities as well as more floatation cost Whereas there is
less cost involved in raising capital by loans or advances.
9. Risk Consideration:
Financial risk refers to a position when a company is unable to meet its fixed financial
charges such as interest, preference dividend, payment to creditors etc. Apart from financial
risk business has some operating risk also. It depends upon operating cost; higher operating
cost means higher business risk. The total risk depends upon both financial as well as
business risk.
If firms business risk is low then it can raise more capital by issue of debt securities
whereas at the time of high business risk it should depend upon equity.
10. Flexibility:
Excess of debt may restrict the firms capacity to borrow further. To maintain flexibility it
must maintain some borrowing power to take care of unforeseen circumstances.
11. Control:
The equity shareholders are considered as the owners of the company and they have
complete control over the company. They take all the important decisions for managing the
company. The debenture holders have no say in the management and preference
shareholders have limited right to vote in the annual general meeting. So the total control of
the company lies in the hands of equity shareholders.
33
If the owners and existing shareholders want to have complete control over the company,
they must employ more of debt securities in the capital structure because if more of equity
shares are issued then another shareholder or a group of shareholders may purchase many
shares and gain control over the company.
Equity shareholders select the directors who constitute the Board of Directors and Board has
the responsibility and power of managing the company. So if another group of shareholders
gets more shares then chance of losing control is more.
Debt suppliers do not have voting rights but if large amount of debt is given then debt-
holders may put certain terms and conditions on the company such as restriction on payment
of dividend, undertake more loans, investment in long term funds etc. So company must
keep in mind type of debt securities to be issued. If existing shareholders want complete
control then they should prefer debt, loans of small amount, etc. If they dont mind sharing
the control then they may go for equity shares also.
12. Regulatory Framework:
Issues of shares and debentures have to be done within the SEBI guidelines and for taking
loans. Companies have to follow the regulations of monetary policies. If SEBI guidelines are
easy then companies may prefer issue of securities for additional capital whereas if
monetary policies are more flexible then they may go for more of loans.
13. Stock Market Condition:
There are two main conditions of market, i.e., Boom condition. These conditions affect the
capital structure specially when company is planning to raise additional capital. Depending
upon the market condition the investors may be more careful in their dealings.
During depression period in the market business is slow and investors also hesitate to take
risk so at this time it is advisable to issue borrowed fund securities as these are less risky and
ensure fixed
repayment and regular payment of interest but if there is Boom period, business is
flourishing and investors also take risk and prefer to invest in equity shares to earn more in
the form of dividend.
14. Capital Structure of other Companies:
Some companies frame their capital structure according to Industrial norms. But proper care
must be taken as blindly following Industrial norms may lead to financial risk. If firm cannot
afford high risk it should not raise more debt only because other firms are rising.
34
4.6 Essential features of a capital mix
A sound or an appropriate capital structure should have the following essentials features:
1. Maximum possible use of leverage.
2. The capital structure should be flexible so that it can be easily altered.
3. To avoid undue financial/business risk with the increase of debt.
4. The use of debt should be within the capacity of a firm. The firm should be in a position
to meet its obligations in paying the loan and interest charges as when due.
5. It should involve minimum possible risk of loss of control.
6. It must avoid undue restrictions in agreement of debt.
7. It should be easy to understand and simple to operate to the extent possible.
35
Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of
financial planning the objective of the firm lies in maximizing EPS. EBIT-EPS analysis
evaluates the alternatives and finds the level of EBIT that maximizes EPS.
Comparative Analysis:
EBIT-EPS analysis is useful in evaluating the relative efficiency of departments, product
lines and markets. It identifies the EBIT earned by these different departments, product lines
and from various markets, which helps financial planners rank them according to
profitability and also assess the risk associated with each.
Performance Evaluation:
This analysis is useful in comparative evaluation of performances of various sources of
funds. It evaluates whether a fund obtained from a source is used in a project that produces a
rate of return higher than its cost.
Determining Optimum Mix:
EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By
emphasizing on the relative value of EPS, this analysis determines the optimum mix of debt
and equity in the capital structure. It helps determine the alternative that gives the highest
value of EPS as the most profitable financing plan or the most profitable level of EBIT as
the case may be.
Limitations of EBIT-EPS Analysis:
Finance managers are very much interested in knowing the sensitivity of the earnings per
share with the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis
but this technique also suffers from certain limitations, as described below
No Consideration for Risk:
Leverage increases the level of risk, but this technique ignores the risk factor. When a
corporation, on its borrowed capital, earns more than the interest it has to pay on debt, any
financial planning can be accepted irrespective of risk. But in times of poor business the
reverse of this situation ariseswhich attracts high degree of risk. This aspect is not dealt in
EBIT-EPS analysis.
Contradictory Results:
It gives a contradictory result where under different alternative financing plans new equity
shares are not taken into consideration. Even the comparison becomes difficult if the number
of alternatives increase and sometimes it also gives erroneous result under such situation.
Over-capitalization:
This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain
point, additional capital cannot be employed to produce a return in excess of the payments
that must be made for its use. But this aspect is ignored in EBIT-EPS analysis.
36
4.8 Pattern of Capital Structure
The term capital structure refers to the relationship between the various long-term forms of
financing such as debenture, preference share capital and equity share capital. Financing the
firms assets is a very crucial problem in every business and as a general rule there should be
a proper mix of debt and equity capital in financing the firms assets. The use of long-term
fixed interest bearing debt and preference share capital along with equity shares is called
financial leverage or trading on equity. In case of new company the capital structure may
be of any of the following four patterns:
Capital structure with equity shares only
Capital structure with equity as well as preference shares
Capital structure with equity shares and debt capital
Capital structure with equity shares, preference shares and debt capital.
Chapter-5
DATA INTERPRETATION AND ANALYSIS
38
5.1 Ratio analysis:
Ratio analysis is one of the oldest methods of financial statements analysis. It was developed
by banks and other lenders to help them chose amongst competing companies asking for
their credit. Two sets of financial statements can be difficult to compare. The effect of time,
of being in different industries and having different styles of conducting business can make
it almost impossible to come up with a conclusion as to which company is a better
investment. Ratio analysis helps creditors solve these issues.
Ratio analysis is a tool that was developed to perform quantitative analysis on numbers
found on financial statements. Ratios help link the three financial statements together and
offer figures that are comparable between companies and across industries and sectors. Ratio
analysis is one of the most widely used fundamental analysis techniques.
However, financial ratios vary across different industries and sectors and comparisons
between completely different types of companies are often not valid. In addition, it is
important to analyze trends in company ratios instead of solely emphasizing a single
periods figures.
What is a ratio? Its a mathematical expression relating one number to another, often
providing a relative comparison. Financial ratios are no differentthey form a basis of
comparison between figures found on financial statements .As with all types of fundamental
analysis, it is often most useful to compare the financial ratios of a firm to those of other
companies.
Financial ratios fall into several categories. For the purpose of this analysis, the commonly
used ratios are grouped into four categories: activity, liquidity, solvency and profitability.
Following ratios have been used to analyze and interpret the result of the study:
Debt Equity ratio.
Solvency ratio.
Interest coverage ratio.
Earnings per share ratio.
5.2 Computation of ratio
39
which their interest is covered by owned funds. A standard debt-equity norm for all
industrial units is neither desirable nor practicable. Different standard debt-equity ratios are
used for different industry groups. However, in less developed countries, such standards
cannot be accepted. Therefore, this ratio depends upon industry, circumstances, and
prevailing practices and so on. The generally accepted standard norm of debt-equity ratio is
2:1. The ratio may be calculated in terms of the relative proportion of long term debt i.e.
borrowed funds and shareholders' equity i.e. net worth. This is a vital ratio to determine the
efficiency of the financial management of business undertakings (Roy Chowdhary).
The debt - equity ratio of Serwel private Limited and Raghuvamsi private limited is
presented in
Table -5.1
40
5.1(b) Interpretation:
Table 1 shows Debt-Equity ratio of Serwel pvt. Ltd. And Raghuvamshi pvt.Ltd. The
Debt-Equity ratio is calculated by dividing the long term debt and Net worth.
It is evident that long term debt of the company serwel decreased remarkably from
Rs.90194572 in 2009 to 87183784 in 2014 and again a rapid increase of
Rs.288095383 in 2015. Net Worth had a gradual rise of Rs.80883376 in 2010 and a
rapid fall in 2014 by Rs. 26939481 and again rose by Rs. 97369359 in 2015. In other
words Net Worth is fluctuating in the entire study in serwel electronics pvt.Ltd.
It is evident that long term debt of the company raghuvamshi increased remarkably
from Rs. 25361218 in 2010 to Rs.47741624 in 2015. Net worth is also rapidly
increasing from Rs.19017075 in 2010 to Rs.31786007 in the year 2015.
Debt-Equity ratio had varied from the higher of 1.3 times in 2010 to the lowest 2.9 in
2015. The ratio is well slight above than the standard ratio of 2:1. It means that the
debt employed by the company was slight high from the point of view as the
standard ratio. However, the interest of the debt-holders of the company was well
protected.
42
5.2(b) Interpretation:
Table 2 shows solvency ratio of Serwel pvt. Ltd. And Raghuvamshi pvt.ltd.
Solvency ratio is calculated by dividing total liabilities by total assets giving 1 as
ratio from the year 2010 to 15.
Total assets and liabilities had a gradual rise in 2011 of Rs.172610403 and a
rapid fall in 2015 by 1074191635 in serwel electronics and also it is rise from
Rs.5736776 in 2010 to Rs.110996369 in 2015 in raghuvamsi electronic Pvt.
Ltd.In other words Net Worth is fluctuating in the entire study.
5.3(a) Graph showing variation in EBIT ratios in serwel and raghuvamshi electronics
pvt.Ltd.
5.3(b)
Interpretation
Table 3
shows EBIT ratio of Serwel pt. Ltd. And Raghuvamshi pt. ltd. EBIT ratio is
calculated by dividing EBT by interest from the year 2010 to 2015.
EBIT had a gradual rise in 2011 of Rs.71508287 and increasing gradually to
Rs.951254340 in 2015 in Serwel electronics Ltd. In the same way RAGHU VAMSI
company has rise from Rs.5477108 in 2010 to Rs. 8524233.In other words EBIT
has been increasing from past few years.
Graph shows that Serwel Company has decreased EBIT ratio from year 2010 of 36.2
to 2015 of 10.3 where as raghuvamshi company has increased EBIT ratio from 2010
of 1.4 to 1.7 in 2015.
44
12-13 40278831 417370 96.5 12-13 246608 257191.4 0.9
13-14 84683957 417370 202.8 13-14 3566909 292860.5 12.1
14-15 22058556 973693.59 22.6 14-15 2544574 317860 8.05
5.4(b) Interpretation
Table 4 shows EPS ratio of Serwel pt. Ltd. And Raghuvamsi pvt. ltd. EBIT ratio is
calculated by dividing EAT by no. of shares.EPS is calculated here from the year
2010 to 2015.
EAT had a gradual rise in 2010 of Rs. 20161351 and is being increasing in 2015 by
22058556 in serwel electronics and in Raghuvamsi company Rs. 590475 in 2010
rose to Rs. 2544574 in 2015. In other words EAT has gained profits in entire study.
Earnings per share ratio is 108.2 in 2010 and has increased to 22.6 in 2015 in serwel
and 3.1 in 2010 and raised to 8.05 in 2015 in Raghuvamsi company.
Chapter-6
FINDINGS, SUGGESTIONS &CONCLUSIONS
45
6.1 FINDINGS
The average ratio of debt and equity is better in serwel as compared to raghuvamsi
electronics. It shows that serwel is more using debt financing in its capital structure
pattern as compared to raghuvamsi electronics. It implies that company is adopting
NOI approach of capital structure. The more use of debt financing in this industry is
increasing the value of the firm and minimising the cost of capital resulting in overall
wealth maximisation of shareholders.
It has been found from the study that average of debt equity ratio of serwel in 2014-
15 i.e. 2.97 where as the average of debt equity ratio in Raghu vamsi pvt.Ltd. is only
1.5 as per the standard norm of 2:1 of debt equity ratio for the industries.
It has been found from the study that the average solvency ratio is maintained as 1:1
from the last five years in both raghuvamsi and serwel electronics.
The average EBIT ratio of serwel is better compared to Raghuvamsi in past few
years and the ratio has been declined from 36.2 in 2010 to 10.6 in 2015,where as
raghuvamsi is maintained with 1.4 in 2010 to 1.7 in 2015.
The EPS of Serwel private Limited is far better compared to Raghuvamsi private
limited in the year 2014-15 is 22.6 and 8.05 respectively.
The rising overall average of trend of debt and equity in case of both the SMEs this
implies that these industries have access to market for both equity and debt
financing. Initially, companies were raising maximum debt fund to reduce the cost of
capital but which resulted in increase in financial risk. So they shifted to equity
financing also .They are maintaining a trade-off between debt and equity.
6.2 SUGGESTIONS
The SERWEL and Raghuvamsi industries should improve their debt equity ratio as it
is not as per the standard norm. These industries are not using as much debt as
expected from them.
The average ratio of debt and equity is not better in raghuvamsi industry as
compared to serwel industry. The Raghuvamsi industry should pay more attention
towards their reserves and surpluses, because due to this they are not getting higher
46
profits. They should more focus towards debt financing to maximise the wealth of
shareholders.
Both the SMEs are advised to maintain a trade off between debt and equity in
future also so as to achieve the objective of optimum capital structure.
The solvency ratio of Serwel private Limited and Raghuvamshi private limited
presented is good and if maintained in the same manner would be profitable.
The EPS of Serwel private Limited and Raghuvamsi private limited presented
shows that serwel has better yields in as profits, if Raghu vamshi shareholders
investment is to be increased in coming years then this would excellent opportunity
for raghuvamsi to maximize the profits.
The interest coverage ratio of serwel is great compared to raghuvamsi capital
structure of Raghuvamsi is to be increased for good profit returns.
Chapter-7
CONCLUSION
Results of the present empirical study revealed that long term funds had apportioned nearly
two-third of total funds when compared to short term funds in the SMEs selected for the
study. The firms had utilized more owned funds than borrowed funds. The SMEs had shown
an inclination in strengthening long term funds consisting of both shareholders funds as
well as long term borrowed funds in order to finance its assets requirement. The financial
risk of the firms is comparatively low since it mostly depended on equity financing. The
mobilization of the debt funds by the company means that it could raise the external funds to
bring the optimum capital structure i.e. minimize the cost of capital and maximize the share
value of the firm. This may due to the tax deductibility of the interest paid on debt. Thus the
benefits of financial leverage can be reaped for improving the financial performance of the
firm. The behaviour of the interest coverage ratio was unpredictable. The interest charges are
47
fully covered by the earnings before interest and taxes. A higher interest coverage ratio is
desirable, but too high ratio indicates that the firm is very conservative in using debt, and it
is not using debt to the best advantage of the shareholders. Hence, it is suggested that SMEs
shall tap the debt funds optimal to maintain a balanced capital structure. The financial
performance of a firm is greatly influenced by its capital structure. An optimal capital
structure maximizes the shareholders wealth with best combination of debt and equity mix
thereby minimizing the cost of capital
BIBLIOGRAPHY
References
1. Khan M Y., Financial Services, Tata McGraw Hill Education Private Ltd. Fifth
Edition, 2010.
2. I M Pandey., financial management, vikas publishing house Pvt Ltd.,Tenth edition,2010.
3. Gordan E ., Natrajan K., Financial markets and services, Himalaya publishing
house,2013
4. Jean J. Chen-Determinants of capital structure of Chinese-listed companies., Journal of
business research,2004
5. Thorsten Beck, Small and medium-size enterprises: Access to finance as a growth
constraints, Elsevier publications, Journal of business research.2006
6. Sheridan Titman and Roberto Wessels., The Determinants of capital structure
choice,Weily Publications,1998.
Stable URL: http://www.jstor.org/stable/2328319
7. Kenny Bell and Ed Vos., SME Capital Structure: The Dominance of Demand
Factors,SSRN,August,2009.
Stable URL: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1456725
48
WEBSITES
http://www.nsic.co.in/
http://www.raghuvamsi.com/
http://serwel.com/
http://www.moneycontrol.com/
I. Source of funds
TOTAL
49
II. Application of funds
TOTAL 172610403
INCOME
TOTAL 442723271
EXPENDITURE
6986202
Manufacturing Expenses 11
8047645
Personnel Expenses 12
390110845
Administrative Expenses 13
TOTAL 405144692
50
Profit before Finance Charges, Depreciation & 37578580
Taxation
14 9945333
Less : Finance charges
27633247
Profit before Depreciation & Taxation
1482667
Less : Depreciation
TOTAL 20161351
I. Source of funds
TOTAL 327250093
51
II. Application of funds
Provisions 13213137
TOTAL 327250093
INCOME
699429726
Turn Over
21801161
Other In come
524937
Accretion/Desertion to shock
TOTAL 721755824
EXPENDITURE
52
TOTAL 648123038
TOTAL 33191254
I. Source of funds
TOTAL 927662724
53
II. Application of funds
TOTAL 927662724
INCOME
TOTAL 1357978653
EXPENDITURE
134981853
Manufacturing Expenses
26518732
Personnel Expenses
54
TOTAL 161500585
TOTAL 57590554
55
56
57
58
Balance Sheets and Profit & Loss Statements of Raghuvamsi Pvt. Ltd.
BALANCE SHEET AS ON MARCH 31, 2010
I. Source of funds
TOTAL 57368776
TOTAL 57368776
59
PROFIT N LOSS AS ON MARCH 31, 2010
INCOME
TOTAL 61527902
EXPENDITURE
9991134
Manufacturing Expenses
2030565
Personnel Expenses
2351540
Administrative Expenses
TOTAL 12573239
TOTAL 590475
60
BALANCE SHEET AS ON MARCH 31, 2011
I. Source of funds
TOTAL 59115100
Provisions
TOTAL 59115100
61
Schedule As on march 31, 2011
INCOME
TOTAL 88741900
EXPENDITURE
10718900
Manufacturing Expenses
6606000
Personnel Expenses
3084000
Administrative Expenses
TOTAL 20408900
TOTAL 1898000
62
BALANCE SHEET AS ON MARCH 31, 2012
I. Source of funds
TOTAL 102138072
TOTAL 102138072
63
PROFIT N LOSS AS ON MARCH 31, 2012
INCOME
57176277
Turn Over
1168669
Other Income
TOTAL 58344946
EXPENDITURE
48200537
Manufacturing Expenses
5197285
Personnel Expenses
5300974
Administrative Expenses
TOTAL 58698796
TOTAL 113017
64
65
66
67
68
69
70