The capital of the company consists of two parts . The equity and the loans .

Say the bank savings rate is 10 % per annum for fixed deposits and the bank lends money to you at say 16 % interest . You also have shareholders who have invested for the equity capital . Though they are not going to charge you any interest they have expectations about the performance of the company and they want to be rewarded for the risk that they have taken by investing in the company instead of putting their money in the bank or in government bonds .If they were to keep the money in the bank they will be getting a return of 10 % per annum . So let us assume that your shareholders want a return of 15 % o the money they have invested .

You also get deposits from the lay public for which you pay 12 % per annum .
 

Total Investment	Capital	Interest	Total money Payment
Equity	500,000	15%	75,000
Loan	300,000	16%	48,000
Deposits	200,000	12%	24,000
Total	1,000,000		147,000

Thus in total you will have to pay out at the rate of 14.7 % on the investment . Thus the finance manager has to invest the company money in such a way that at the end of the year the company gets better return than 14.7 %.

The cost of capital has to be considered when the budgeting exercise is gone through .

Deduct the interest to depositors = 24,000

Deduct the interest to bank = 48,000
 

Deduct the interest to depositors	24000
Deduct the interest to bank	48000
	72000

 

Profit Before tax	300000
Deductions	72000
Profit after tax	228000
Less business tax 30 %	68400
Net Profit	159,600

Thus return to investors = 159600/500000 = 32 % which is almost double of what they expected .

II

Now let us consider that the whole investment was in equity only .
 

Investment	1,000,000
Profit before tax	300,000
Tax	90,000
Profit after tax	210,000
Thus return on investment	21 %

This return is much less than before and also the tax liability is much more in this case .

Let us consider a scenario when the economy is not doing so well and n the year makes a loss of 300,000.
 

Loss before tax	300,000
Interest on deposit	24,000
Interest on loans	48,000
Total loss	-372,000
Loss to shareholders	372000/500000 = 74 %
The second scenario when all is equity
Loss after tax	300,000
Loss to investors	300,000/1,000,000 = 30 %
The loss is less on percentage basis

Conclusion :

If you are making the profits , the more loans you take the better , but if you are making losses , the more equity you have the better . This is called as the principle of financial leveraging .
 
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