Unit-I

Meaning of Financial Management:-

Financial Management is such a managerial process, which is concerned with the planning and control
of Financial resources. It is being studied as a separate subject in 20 th century. Till now it was used as a
part of economics. Now, its scope has undergone some basic changes from time to time. In present time,
it analyses all financial problems of a business. Financial Manager estimates the requirements of funds,
plans the different sources of funds and performs functions of collection of funds and its effective
utilisation.

Finance is such a powerful source that it performs an important role to operate and coordinate the
various economic activities of business. Finance is of two types:-

(1) Public finance.

(2) Private finance.

1. Public Finance:-

Means government finance under which principles and practices relating to the procurement and
management of funds for central government, state government and local bodies are covered.

2. Private Finance:-

means procurement and management of funds by individuals and private institutions. Under it we
observe as to how individuals and private institution procure funds and utilise it.

Scope:-

What is finance? What are a firm’s financial activities? How are they related? Firm create manufacturing
capacities for production of goods, some provide services to customers. They sell goods or services to
earn profit and raise funds to acquire manufacturing and other facilities. Thus, the 3 most important
activities of business firm are:-

(1) Production
(2) Marketing
(3) Finance.
A firm secures whatever capital it needs and employs it (finance activity) in activities, which generate
returns on, invested capital (production and marketing activities.)

Real and financial Assets:-

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 A firm acquire real assets to carry on its business. Real assets can be tangible or intangible. Plant,
machinery, factory, furniture etc. are examples of tangible real assets, while technical know-how,
patents, copy rights are examples of intangible real assets.

The firm sells financial assets or securities such as shares and bonds or debentures, to investors
in capital market to raise necessary funds. Financial assets also include borrowings from banks, finance
institutions and other sources.

Funds applied to assets by the firm are called capital expenditure or investment. The firm expects
to receive return on investment and distribute return as dividends to investors.

EQUITY AND BORROWED FUNDS:-

There are two types of funds that a firm can raise:- Equity funds and borrowed funds.

A firm sells shares to acquire equity funds. Shares represent ownership rights of their holders.
Buyers of shares are called share holders and they are legal owners of the firm whose share they hold
share holders invest their money shares of a company in expectation of return on their invested capital.
The return on shares holder’s capital consists of dividend and capital gain by selling their shares.

Another important source of securing capital is creditors or lenders. Lenders are not the owners
of the company. They make money available to firm on a lending basis and retain title to the funds lent.
The return on loans or borrowed funds is called interest. Loans are furnished for a specified period at a
fixed rate of interest. Payment of interest is a legal obligation. The amount of interest is allowed to be
treated as expense for computing corporate income taxes. Thus the payment of interest on borrowings
provides tax shied to a firm. The firm may borrow funds from a large number of sources, such as banks,
financial institutions, public or by issuing bonds or debentures. A bond or debenture is a certificate
acknowledging the money lent by a bond holder to the company. It states the amount, the rate interest
and maturity of bonds or dentures.

Finance Functions:-

(a) Financing decisions

(b) Investment decisions
(c) Dividend policy decision
(d) Liquidity Decision

(a) Financing Decisions are decisions regarding process of raising the funds. This function of finance
is concerned with providing answers to various questions like -

(a) What should be amount of funds to be raised.

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(b) What are the various sources available to organisation for raisaing the required amount of funds? For
this purpose, the organisation can go for internal & external sources.

(c) What should be proportion in which internal & external sources should be used by organisation?

(d) If organisation, wants to raise funds from different sources, it is required to comply with various
legal & procedural formalities.

(e) What kinds of changes have taken place recently affecting capital market in the country?

(b) Investment decisions:- are decisions regarding application of funds raised by organisation. These
relate to selection of the assets in which funds should be invested.

The assets in which funds can be invested are of 2 types

(a) Fixed assets:- are the assets which bring returns to organisation over a longer span of time. The
investment decisions in these types of assets are “capital budgeting decisions.” Such decisions include

1. How fixed assets should be selected to make investment ? What are various methods available to
evaluate investment proposals in fixed assets?

2.How decisions regarding investment in fixed assets should be made in situation of risk & uncertainity?

(b) Current assets:- are assets which get generated during course of operations & are capable of getting
converted in form of cash with in a short period of one year. Such decisions include

(1) What is meaning of Working Capital management & its objectives?

(2) Why need for working capital orises?

(3) What are factors affecting requirements of working capital?

(4) How to quantity requirements of working capital?

(5) What are sources available for financing the requirement of working capital?

(c ) Dividend Policy Decisions:- Such decisions include

(1) What are forms in which dividend can be paid to share holders?

(2) What are legal & procedural formalities to be completed while paying dividend different forms?

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(d) Liquidity Decisions:- Current assets should be managed efficiently for safe guarding firm against of
liquidity & insolvency. In order to ensure that neither insufficient nor unnecessary funds are invested in
current assets, the financial manager should develop sound technique of managing current assets.

Organisation of Finance Function

The organisation of finance function implies the division and classification of functions relating
to finance because financial decisions are of utmost significance to firms. Therefore, to perform the
functions of finance, we need a sound and efficient organisation.

Although in case of companies, the main responsibility to perform finance function rests with the
top management yet the top management (Board of Directors) for convenience can delegate its powers
to any subordinate executive which is known as Director Finance, Chief Financial Controller, Financial
Manager or Vice President of Finance. Besides it is finally the duty of Board of Directors to perform the
finance functions. There are various reasons to assign the responsibility to the Board of Directors.
Financing decisions are quite significant for the survival of firm. The growth and expansion of business
is affected by financing policies. The loan paying capacity of the business depends upon the financial
operations.

The organisation of finance function is not similar in all businesses but it is different from one
business to another. The organisation of finance function for a business depends on the nature, size
financial system and other characteristics of a firm. For a small business, no separate officer is appointed
for the finance function. Owner of the business himself looks after the functions of finance including the
estimation of requirements of funds, preparation of cash budget and arrangement of the required funds,
examination of all receipts and payments, preparation of credit policy, collecting debtors etc. with the
increase in the size of business, specialists were appointed for the finance function and the
decentralisation of the finance function began. For a medium sized business, the responsibility of the
finance function is given to a separate officer who is known as financial controller, finance manager,
deputy chairman (finance), finance executive or treasurer.

In a large sized company the finance function has become more difficult and complex and the
position of financial manager has become very important. He is the member of top management of an
organisation. For such large organisations it is not possible for a finance manager to perform all the
finance functions or to co-ordinate with the various departments. Therefore, finance and financial
control are separated and allocated to two different sub-departments. For the ‘finance’ sub-department
treasurer is appointed and for the ‘financial control’ sub department, financial controller is appointed.
Each of them have various sub-units under them.

Financial planning and financial control are quite significant for a large sized organisation.
Therefore, a finance committee is established between the Board of Directors and Managing Director. It
includes the financial Manger, representatives of the directors and departmental heads of various
departments. Managing Director is the chairman of the committee. Its main function is to advise the

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Board of Directors on financial planning and financial control and co-ordinate the activities of various
departments. The following chart 1.1. explains the organisation of finance function.

From the chart 1.1. it is clear that treasurer and financial control work under finance Manager.
Financial Manager is responsible to the Managing Director for his actions.

Board of Directors

Managing Directing Finance Committee

Production Personnel Financial Marketing

Manager Manager Manager Manager

Treasurer Controller

Banking Cash Credit Assets Securities

Relations Magt. Analysis Protection Mgt.

Corporate Annual Internal Planning & Statistics

Accounting Reports Auding Budgeting
& Cost

Treasurer performs the functions of procurement of essential funds, their utilisation, investment,
banking, cash management credit management, dividend distribution, pension, management etc.
Financial, controller is responsible for general accounting, cost accounting, auditing, budget, reporting
and preparing financial statement etc. In India the function of financial manager is given to secretary in
most of the companies. He performs the functions of treasurer and financial controller along with the
routine functions of secretary. He collects necessary data and information and sends them to the
Managing Director.

Functions of the Chief Financial Manager.

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 Chief Financial manager is the top officer of finance department. In America he is known as
Vice-president finance and in India he is called Chief Financial Controller. He performs following
functions:

(1) Financial Planning :- He determines the capital structure and prepares financial plan.

(2) Procurement of Funds:- Financial manager makes the necessary funds available from
different sources.

(3) Co-ordination:- Financial manager establishes co-ordination among the financial needs of
various departments. He is a member of finance committee.

(4) Control:- Financial manager examines whether the work is being performed as per pre-
determined standards or not. He gets the reports prepared, controls the cost and analyses profits.

(5) Business Forecasting:- Financial manager evaluates the effects of all national, international,
economic, social and political events on industry and company.

(6) Miscellaneous Functions:- It includes the management of assets, management of inventory,

arrangement of data and management of bank deposits etc.

Functions of Treasurer

The following are the functions of treasurer.

(1) Provisions of finance:- It includes the estimation of funds necessary for procurement
preparing programmes and implementing them, establishing relation among various sources of funds,
issuing the securities and managing debt etc.

(2) Banking Function:- It includes opening bank accounts, depositing cash, payment of
company liabilities, accounting cash receipts & payments, responsibility for transacting actual assets etc.

(3) Custody:- The treasurer is the custodian of funds and securities.

(4) Management of credit and collection:- The treasurer determines credit risk of customers
and arranges for collection.

(5) Investments: It involves the investment of surplus funds.

(6) Insurance:- The treasurer signs the cheques, agreement and other letters of company
forecasts cash receipts and payments, pay property taxes and follows government regulations.

Functions of controller

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 The controller performs the following functions:-
(1) Planning:- The controller prepares plan for controlling the business activities which are the
main constituents of management and in which proper arrangement regarding profit planning, capital
expenditure planning, sales forecasting and expenditure budgeting is made.

(2) Accounting:- Controller determines the accounting system and arrangements for costing and
management accounting systems and prepares financial statements.

(3) Auditing:- Controller Manages internal auditing.

(4) Reports :- Controller prepares financial reports according to various needs and presents
them to the managers. He advises the management to correct the deviation between the standard
performance and actual performance.

(5) Government Reporting :- Controller sends essential information’s to the government by

obeying the legal requirement.

(6) Tax Administration :- Controller prepares statement on tax liability.

(7) Economic Appraisal :- He determines and analyses the effect of economic and social
factors on business.

OBJECTIVES OF FINANCIAL MANAGEMENT:-

It is the duty of management to clarify the objectives of business so that the departmental
objectives could be determined accordingly. Financial objectives of a firm provide a concrete framework
within which optimum financial decisions can be made. The main objective of any firm should be to
maximise the economic welfare of its shareholders. Accordingly, there are 2 approaches in this regard.

(A) Profit maximisation Approach.

(B) Wealth maximisation Approach.

(A) PROFIT MAXIMISATION APPROACH:-

According to this approach, a firm should undertake all those activities which add to its profits
and eliminate all others which reduce its profits. This objectives highlights the fact that all decisions:-
financing, dividend and investment, should result in profit maximisation. Following arguments are given
in favour of profit maximisation approach:-

(i) Profit is a yardstick of efficiency on the basis of which economic efficiency of a business can
be evaluated.

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 (ii) It helps in efficient allocation and utilisation of scarce means because only such resources are
applied which maximise the profits.
(iii) The rate of return on capital employed is considered as the best measurement of the profits.
(iv) Profit acts as motivator which helps the business organisation to be more efficient through
hard work.
(v) By maximising profits, social & economics welfare is also maximised.

However this approach has been criticised on various counts:-

(1) Ambiguity:-

Profit can be expressed in various forms i.e it can be short term or long term or it can be profit
before tax or after tax or it can be gross profit or net profit. Now the question arises, which profits can be
maximised under profit maximisation approach.

(2) Time Value of Money

This approach is also criticised because it ignores time value of money i.e. under this approach
income of different years get equal weight. But, in fact, the value of rupee today will be greater as
compared to the value of rupee receivable after one year. In the same manner, the value of income
received in the first year will be greater from that which will be received in later year e.g. the profits of 2
different projects are:-

Example:-

YEAR PROJECT1 PROJECT2

1 5,000 -
2 10,000 10,000
3 5,000 10,000

Both the projects have a total earnings of Rs 20,000 in 3 years and according to this approach
both will be considered equally profitable. But Project 1 has greater profits in the initial years of the
project & therefore, is more profitable in terms of value of income. The profits earned in initial years can
be reinvested and more profits can be earned.

(3) Risk Factor:-

This approach ignores risk factor. The certainity or uncertainity of income receivable in future
can be high or less. High uncertainity increases risk and less uncertainity reduces risk. Less income with
more certainity is considered better as compared to high income with greater uncertainity.

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 Thus, this approach was more significant for sole trader & partnership firms because at that time
when personal capital invested in business, they wanted to increase their assets by maximising profits.
Companies are now managed by professional managers and capital is provided by shareholders,
debenture holders, financial institutions etc. one of the major responsibilities of business management is
to co-ordinate the conflicting interest of all these parties. In such a situation profit maximisation
approach does not appear proper and practicable for financial decisions.

B Wealth Maximisation Approach

Value Maximisation Approach or Maximum net present worth.

According to this approach , financial management should take such decision’s which increase
net present value of the firm and should not undertake any activity which decrease net present value.
This approach eliminates all the 3 basic criticisms of the profit maximization approach.

As the value of an asset is considered from view point of profit accruing from it, in the same
manner the evaluation of an activity depends on the profits arising from it. Therefore, all 3 main
decisions of financial manager-financing decision, investment decision dividend decision affect net
present value of the firm. The greater the amount of net present value, the greater will be value of firm
and more it will be in the interest of share holders. When the value of firm increases, the market price of
equity shares also increase. Thus to maximize net present worth means to maximize the market price of
shares. Net present worth can be calculated with the help of following equation.

A1 A2 An -c
W= + + --------------------- +
2
(1+k) (1+k) (1+k)n

n At
=  -C
t
t=1 (1+k)

Where W = Net present worth.

A, A2--- An= Stream of expected cash benefits from a course of action over a period of time.

K = Discount rate to measure risk & timing.

C= Initial outlay to acquire that asset

If W is positive, the decision should be taken & vice versa.

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If W is Zero, it would mean that it does not add or reduce the present value of the asset.

This approach is considered good for the companies in present situation. This approach gives due
consideration to the time value of expected income receivable over different period of time. Under this
approach, risk and uncertainty is analyzed with the help of interest rate. If uncertainty & time period are
greater, higher rate of interest will be used to calculate present value of expected future cash benefits
where as the interest rate will be lower for the projects with low risk & uncertainty. Besides, this
approach uses cash flows instead of accounting profits which removes ambiguity associated the term
profit.

On the basis of above explanation, we can conclude that wealth maximization approach is better
to profit maximisation approach to establish mutual relation among the various data. It is possible only
through statistics. Cash and inventory management, forecast of financial needs, credit policy decision all
are based on the advanced techniques of statistics.

Finance is also related to law. Any decision regarding financial policy should be in line with the
laws of the country.

Time Value of Money:-

The evaluation of capital expenditure proposals involves the comparison between cash outflows
& cash inflows. The pecularity of evaluation of capital expenditure proposals is that it involves the
decision to be taken today where as the flow of funds, either outflow or inflow, may be spread over a
number of years. It goes without saying that for a meaningful comparison between cash outflows and
cash inflows, both the variables should be on comparable basis. As such, the question which arises is
“that is the value of flows arising in future the same in terms of today.”

For Example:- if a proposal involves cash inflow of Rs 10,000 after one year, is the value of this cash
inflow really Rs 10,000 as on today when capital expenditure proposal is to be evaluated.? The ideal
reply to this question is ‘no’. The value of Rs 10000 received after one year is less than Rs 10,000 if
received today. The reasons for this can be stated as below:-

(i) There is always an element of uncertainety attached with the future cash flows.

(ii) The purchasing power of cash inflows received after the year may be less than that of equivalent sum
if received today.

(iii) There may be investment opportunities available if the amount is received today which cannot be
exploited if equivalent sum is received after one year.

Time Value of money:

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Example:- If Mr. X is given the option that he can receive an amount of Rs 10000 either on today or
after one year, he will most obviously select the first option why? Because, if he receives Rs 10000
today he can always invest the same say in fixed deposit with the bank carrying interest of say 10% p.a
As such, if choice is given to him, he will like to receive Rs 10000 today or Rs 11000 (i.e. Rs 10000 plus
interest @ 10% p.a. on Rs 10000) after one year. If he has jto receive Rs 10,000) only after one year, the
real value of same in terms of today is not Rs 10000 but something less than that. This concept is called
time value of money.

Time value of
money

Compounding Discounting
or future or present
value value

1. Compounding or future value concept:- Under this method of compounding, the future
values of all cash inflows at the end of the time horizon at a particular rate of interest are
found. Interest is compounded when the amount earned on an initial deposit becomes part
of the principle at the end of the first compounding period. E.g. is Mr. invest Rs. 1000 in
a bank which offers him 10% interest compounded annually, he has Rs. 1100 in his
account at the end of the first year. The total of the interest & principal Rs. 1100
constitutes the principal for the next year. He thus earns Rs. 1210 for the second year.
This becomes the principal for the third year & so on.
i. Compound value of a single flow (lump sum):- The process of calculating
future value becomes very cumbersome if they have to be calculated over long
maturity periods 10 to 20 years. A generalized procedure for calculating the future
value of a single cash flow compounded annually is as follows:
FV = PV (1+i)n
Where, FV = Future Value of the initial flow in n years
PV = Initial cash flow
I = annual rate of interest
N= no. of years for which compounding is done
e.g. Mr. X invites Rs. 1000 at 10% is compounded annually for three years.
Calculate value after three years.

FV = PV (1+i)n
FV = 1000 (1+.10)3
FV = Rs. 1331

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 ii. Multi-period compounding or future value:- If the co. will compounding
interest half yearly (semi annually) instead of annually then investors will gain as
he will get interest on half yearly interest. Since interest will be compounded half
yearly for finding out the compound value.
FV = PV (1+i/m)nxm
Where, FV = Future value of the initial flow in n years
PV = Initial cash flow
i= initial rate of interest
n= no. of years for which compounding is done.
m= no. of times compounding is done during a year
e.g.:- Mr. X invests Rs. 10000 at 10% p.a. compounded semi annually. Calculate
value after three years.
FV = PV (1+i/m)nxm
FV = 10000 (1+.10/2)3X2
FV = Rs. 11025
iii. Compounded value of a series of cash flows:- We have considered only single
payment made once & its accumulation effect. An investor may be interested in
investing money in installments & wish to know the value of its saving after n
years.
FV = A (1+i)n-------------------------+A(1+i)2+A(1+i)1+A
Where FV = Future Value of the initial flow in n years
PV = Initial cash flow
i= annual rate of interest
n= no. of years for which compounding is done.
A = amount deposit or invested.
e.g. Mr. X invests Rs. 500, Rs. 1000, Rs. 1500, Rs. 2000 & Rs. 2500 at the end of each year for 5 years.
Calculate the value at the end of 5 years compounded annually if the rate if interest 5% p.a.
FV = 500(1+.05)4+1000(1+.05)3+1500(1+.05)2+2000(1+.05)1+2500
FV = Rs. 8020
iv. Compound value of an annuity:- Annuity refers to the periodic flows of equal
amounts.
FV = A{(1+i)n-1}/i
e.g. Mr. X invests Rs. 2000 at the end of each year for 5 years into his account.
Interest being 5% compounded annually. Determine the amount of money he will
have at the end of the 5th year.
FV= 2000{(1+.05)5-1}/.05
FV = 11054
2. Discounting or Present Value Concept:-as per this concept, rupee one of today is more
valuable than rupee one a year later. The reason for more value of rupee today than a
rupee of future interest. Discounting is the process of determining present value of a
series of future cash flows.
Eg. If Mr .X, depositor expects to get Rs.100 after one year at the rate of 10%. The amount he will have
to forgo at present is Rs. 90.90 at present .thus, it is present value of Rs. 100.

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i. Discounting or present Value of a Single flow(Lump sum):- We can determine the PV of a future
cash flow using the formula.
PV=FV(1+i)n
Where ,FV=Future value of the initial flow in n year.
PV=Present Value.
i=Annual rate of interest.
n=No. of year.

Eg. Mr.X, expects to have an amount of Rs.1000 after one year what should be the amount he has to
invest today if the bank if offering 10% interest rate?
PV=1000(1+.10)1
PV=Rs. 909.09

ii. Present Value of a Cash Flows:-in a Business situation, it is very natural that returns received by a
firm are spread over a number of years. To estimate the present value of each expected inflow will be
calculated.
C1 C2 Cn
PV= ------- + --------- + ----------
1
(1+i) (1+i) 2 (1+i)n
Where PV sum of individual present values of each cash flow.

C1,C2,Cn=Cash Flows after periods 1,2-----------------n

i=Discounting Rate

Eg. Given the time value of money as 10%(i.e the discounting factor).You are required to find out the
present value of future cash inflows that will be received over.
Year Cash Flows
1 1000
2 2000
3 3000
4 4000

1000 2000 3000 4000

PV= ---------- + --------- + ----------- + ----------
(1+.10)1 (1+.10)2 (1+.10)3 (1+.10)4

=909+1652+2253+2732
Rs.=7546
iii. Present Value of an Annuity:-An investor may have an opportunity to receive a constant periodic
amount for a certaion number of years. The present value of an annuity can be found out by using the
following formula.

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 A1 A2 An
PV An = -------- + ----------- +-------------+--------------
(1+i)1 (1+i)2 (1+i)n

PV An=Present Value of an annuity having a duration or ‘n’ periods.

A=Value of single installment
I =Rate of interest
Eg. Calculate the present value of annuity of Rs.500 received annually for Four years. when discounting
factor is 10%.
500 500 500 500
PVAn = --------- + ----------- + ---------- + ---------
1 2 3
(1+.10) (1+.10) (1+.10) (1+.10)4

PV An=454.50+413.50+375.50+341.50
PV An=Rs. 1585

Unit-II

Investment decisions

The investment decisions of a firm generally known as capital budgeting or capital expenditure
decisions. A capital budgeting decision may be defined as the firm’s decision to invest its current funds
most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of
year. The long term assets are those which affect the firm’s operations beyond the one year period. The
firm’s investment decision would generally include expansion, acquisition, modernisation and
replacement of long term assets. Sale of a division or business (Investment) is also analysed as an
investment decision. Activities such as changes in the methods of sales distribution or undertaking an
advertisement compaign or a research and development programme have long-term implication’s for the
firm’s expenditure and benefits and therefore, they may also be evaluated as investment decisions.

Features:-

1) The exchange of current funds for future lengths.

2) The funds are invested in long term assets.

3) The future benefits will occur to the firm over a series of year.

Importance of Investment Decisions

Investment decision require special attention because of the following reasons:

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1) They influence the firm’s growth in the long turn.

2) They affect the risk of the firm.

3) They involve commitment of large amount of funds.

4) They are irreversible or reversible at substantial loss.

5) They are among the most difficult decisions to make.

1) GROWTH:

A firm’s decision to invest in long term assets has a decisive influence on rate and direction of its
growth. A wrong decision can prove disastrous for continued survival of firm, unwanted or unprofitable
expansion of assets will result in heavy operating costs to the firm. On other hand, inadequate
investment in assets would make it difficult for the firm to complete successfully and maintain its
market share.

2) Risk:

A long-term commitment of funds may also change risk complexity of the firm. If the adoption
of an investment increases overage gain but causes frequent fluctuations in its earnings the firm will
become more risky.

3) Funding:

Investment decisions generally involve large amount of funds which make it imperative for firm
to plan its investment programmes very carefully and make an advance arrangement for procuring
finance internally or externally.

4) Irreversibility:

It is difficult to find a market for such capital items once they have been acquired. The firm will
incur heavy losses if such assets are scrapped.

5) Complexity:

Investment decisions are an assessment of future events which are difficult to predict. It is really
a complex problem to correctly estimate future cash flow of an investment. The uncertainty in cash flow
is caused by economic, political, social and technological forces.

Difficulties:-

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 1. Measurement problems:- Identifying & measuring the costs & benefits of a capital expenditure
proposals tend to be difficult. This is more so when capital expenditure has a bearing on some
other activities of the firm.
2. Uncertainty:- A capital expenditure decision involves costs & benefits that extends fat into the
future. It is impossible to predict exactly what will happen in the future. Hence, there is usually a
great deal of uncertainty characterizing the cost & benefits of a capital expenditure decision.
3. Temporal spread:- The costs & benefits associated with a capital expenditure decision are
spread out over a long period of time, usually 10-20 years for industrial projects & 20-25 years
for infrastructural projects.

Techniques of Capital Budgeting:

it may be grouped in the following two categories:-

(A) Discounted cash flow (DCF) Criteria.

(1) Net present value (NPV)

(2) Internal Rate of Return (IRR)
(3) Profitability Index (PI)
(4) Discounted Payback Period.

(B) Non-discounted Cash flow Criteria:

(1) Pay back period (PB)

(2) Accounting rate of return (ARR)

(A) Discounted Cash Flow (DCP) Criteria – These techniques are considered good because they take
into account time value of money.

(1) Net Present Value (NPV)

This method take into account time value of money. In this method present value of cash flows is
calculated for which cash flows are discounted. The rate of interest is called cost of capital and is equal
to minimum rate of return which must accrue from the project. Later, present value of cash out flows is
calculated in same manner and subtracted from present value of cash inflows. This difference is called
Net Present value or NPV. In case investment is made only in beginning of the project, it present value is
equal to the amount invested in the project. Taking this assumption, NPV can be calculated as under:

NPV = CF1 CF2 Cfn

+ +-- -C
1 2 n
(1+k) (1+k) (1+k)

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 n Cft
=  -C
t=1 (1+k)t

Where Cf1, Cf2 represent cash inflows

K = Cost of Capital

C = Cost of investment proposal

n = Expected life of Proposal

If the project has a salvage value also, it should be added in cash inflows of last year. Similarly, if some
working capital is also needed, it will be added to initial cost of project and to cash flows of last year.

Acceptance Rule:-

1) Accept if NPV >O (i.e. NPV is Positive)

2) Reject if NPV <O (i.e. NPV is Negative)
3) May accept if NPV= O

Advantage:

1) It takes into account time value of money.

2) It considers cash inflows form project throughout its life.
3) In this method variable discount rates can be used for the projects with longer life period.
4) This method is more closely related to firm’s objective of maximising wealth of shareholders.
5) True measure of profitability.

Disadvantages:

(1) Difficult to use, calculate & understand.

(2) In calculating NPV, discount rate is most significant because with different discount rates NPV will
be different. Thus comparable profitability of projects will change with the change in discount rate. To
determine required rate of return which is called cost of capital, is a difficult task. Different authors have
their different opinions regarding its calculation.

17
(3) When the initial cost of 2 projects is different, this method is not very useful because we will accept
or project whose NPV is higher and such a project may have more initial cost as compared to other. This
method evaluates absolute profitability rather than relative profitability.

(4) When life of 2 projects is dissimilar, this method does not give satisfactory results. Normally, project
with less life time is preferred. But as per this method, NPV of the project with longer life may be more,
and thus finds will be blocked for a longer period, in this project. In such cases, NPV method may not
present actual worth of alternate projects.

3) PROFITABILITY INDEX

It is Benefit –Cost ratio (B/C Ratio) or Profitability Index (P1).

It is the ratio of value of future cash benefits at required rate or return to the initial cash outflow
of the investment. PI method should be adopted when the initial costs of projects are different. NPV
method is considered good when the initial cost of different projects is the same. Thus NPV is an
absolute measure of evaluating projects and PI is an absolute measures. Pl can be calculated as under:-

Present Value of Cash Inflows

PI _________________________

Present Value of Cash outflows

Acceptance rule

 Accept if Pl>1.0
 Reject if Pl<1.0
 Project may be accepted if Pl= 1.0

MERITS

 Considers all cash flows.

 This method considers all benefits during the life time of the project.
 This method takes into account the time value of money.
 Pl method is considered better to NPV in case when the initial costs of projects are different for
eg. The NPV of two project is equal ie, Rs 5000. The initial cost of project is Rs 40,000 and that
of project B Rs 20,000. Project should be selected on the basis of profitability index, whereas
under NPV method both the projects will be considered equally profitable.
 Generally consistent with the wealth maximisation principle.

Disadvantages/ Demerits

1). It is difficult to understand and implement this method.

2). The calculations in this method are complex as compared to traditional methods.
18
3). Requires estimates of the cash flows which is a tedious task.
4). At times fails to indicate correct choice between mutually exclusive projects.

4). Discounted Pay Back Period:

This is an improvement over the pay back period method in the sense that it considers time value of
money. Thus discounted pay book period indicates that period with which the discounted cash inflows
equal to the discounted cash outflows involved in a project.

Pay Back Method:

Under this method the pay back period of each project/ investment proposal is calculated. The
investment proposal, which has the least pay back period is considered profitable. Actual pay back
period is compared with the standard one. If actual pay back period is less than the standard, the project
will be accepted and in case, actual payback period is more than the standard pay back period, the
project will be rejected. Thus, the project with the least payback period is considered profitable.

“Pay Back Period is the number of year required for the original investment to be recouped.

For eg, if the investment required for a project is Rs 20,000 and it is likely to generate cash flow of Rs
10,000 for 5 years, its payback period will be 2 years. It means that investment will be recovered in first
2 year of the project.

There are two methods of calculating payback period. First method is used when cash flows
remains the same during the life time of the project. In such a case payback (PB) is calculated as under:-

INVESTMENT CO
PB = _______________________ = ___

CONSTANT ANNUAL CASH FLOW C

For eg, if the investment for a machinery is Rs 50,000 and it will generate Rs 10,000 such year for 10
years, then its Pay Back period will be:-

Rs 50000
PB = _________ = 5 Years

Rs 10000

For the pay back period of 5 years, it can be observed that the investment of Rs 50,000 will be recovered
by the business in 5 years.

19
ACCEPTANCE RULE

 Accept if PB < standard pay back.

 Accept if PB > standard pay back.

MERITS
1. Easy to understand and compute.
2. This method follows short terms view point, as a result, the obsolescence are minimum.
3. Emphasis liquidility, therefore useful for the companies which faces the problem of liquidity.
Such companies will invest their funds in such projects in which investment can be recovered in
minimum time.
4. Used to find out internal Rate of Return.
5. Suitable for those organisations which emphasise on short-term investments rather than long
terms development.
6. Uses cash flow information.
7. Easy and crude way to cope with risk.

Demerits
1. Ignores the value of money.
2. Ignores the cash flows occurring after the pay back period. Thus does not take into account the
whole profitability of the project. For eg: investment in a project is Rs 50,000. Its life 10 years
and cash flows every year are Rs 10,000. Then its Pay back period will be 5 years. But the cash
inflows of Rs 50,000 during the last 5 years have been taken into account.
3. No objective way to determine the standard payback.
4. This method also does not take into account the time value of money. The time value of money is
the interest on investment. The payback period of two projects may be the same but a project
may get more CFAT in the initial years and less in the later years. In such a case the cash flows in
the initial years can fetch additional income of interest. Such a project may become more
profitable than the others. But this method ignores this fact.
5. This method does not take into account the total life time of the project.
6. No relation with the wealth maximisation principle.
7. not a measure of profitability.

II. Average Rate of Return Method: This method is also called Accounting Rate of Return Method.
This method is based on accounting information rather than cash flows. There are various ways of
calculating Average Rate of Return. It can be calculated as:-

Average annual Profit after Tax

ARR = ___________________________X100

Average Investment

20
Average Annual Profit = Total of after tax profit of all the year
___________________________

No. Of years

Average Investment = Original Investment + Salvage Value

________________________________

or Original Investment – Salvage Value

________________________________ + Salvage Value

If working Capital is also required in the initial year of the project, the average investment will be= Net
working Capital + Salvage value + ½ (initial cost of Machine- Salvage Value).

In another method instead of average investment original cost is used.

In this method, to evaluate the project all those projects are accepted on which average rate of return is
more than the predetermined rate. Thus, the project is given more significant on which the average rate
of return is the highest.

Acceptance Rule

 Accept if ARR > minimum rate.

 Accept if ARR < minimum rate.

Merits

1). Easy to understand. Necessary informations to calculate average rate of return are available easy.

2). This method takes into account all the profits during the life time of the project, whereas pay back
period ignores the profits accruing after the pay back period

3). Give more weightage to future receipts.

4). Easy to understand and calculate.
5). Uses accounting data with which executives are familiar.

Demerits

21
1). Ignore the time value of money.
2). Does not use cash flow.
3). No objective way to determine the minimum acceptable rate of return.
4). This method does not account for the profits arising on sale of profit on old machinery on
replacement.
5). ARR method does not consider the size of investment for each project. It may be time that the
competing ARR of two projects may be the same but they may require different average investments. It
becomes difficult for the management to decide which project should be implemented.

Risk analysis

Risk exists because of inability of decision maker to make perfect forecasts. Forecasts cannot be
made with perfection or certainty since the future events on which they depend are uncertain. An
investment is not risky if, we can specify a unique sequence of cash flows for it. But the whole trouble
is that cash flows cannot be forecast accurately, & alternative sequence of cash flows can occur
depending on future events. Thus, risk arises in investment evaluation because we cannot anticipate
occurrence of possible future events with certainty & consequently, cannot make any connect prediction
about cash flow sequence.

Techniques to handle Risk

1) Pay back
2) Risk-adjusted discount rate.
3) Certainty equivalent.

2) Risk-adjusted Discount Rate:-

To allow a risk, businessman required a premium over and above an alternative which was risk
free. Accordingly, more uncertain the returns in future, the greater the risk & greater premium required.
Based on this reasoning, it is proposed that risk premium be incorporated into capital budgeting analysis
through discount rate. That is, if time preference for money is to be recognised by discounting estimated
future cash flows, at same risk-free rate, to their present value, than, to allow for riskiness of those future
cash flows a risk premium rate may be added to risk free discount rate. Such a composite discount rate,
called risk-adjusted discount rate, will allow for both time preference & risk preference & will be a sum
of risk-free rate & risk-premium rate reflecting the investors attitude towards risk. The risk adjusted
discount rate method can be expressed as follows:

N
NPV =  NCFt
t=0 (1+k)t
Where

22
 K= Risk-adjusted rate.

That is,

Risk-adjusted discount rate= Risk free Rate+ Risk Premium

K= kf+kr
Under CAPM risk- premium is difference between market rate of return & risk free rate multiplied by
beta of the project.

The risk adjusted discount rate accounts for risk by varying discount rate depending on degree of
risk of investment projects. A higher rate will be used for riskier projects & a lower rate for less risky
projects. The net present value will decrease with increasing k, indicating that riskier a project is
perceived, the less likely it will be accepted.

In contrast to net present value method, if firm uses IRR method, then to allow for risk of an
investment project, the IRR for project should be compared with risk-adjusted minimum required rate of
return. If IRR is higher than this adjusted rate, the project would be accepted, otherwise it should be
rejected.

Evaluation:-

Advantages:-

1) Simple to understand.
2) Has a great deal of intuitive appeal for risk adverse businessman.
3) It incorporates an attitude towards uncertainty.

Disadvantages:-

1) There is no easy way of deriving a risk-adjusted discount rate.

2) It does not make any risk adjustment is numerator for cash flows that are for cast over future years.
3) It is based on assumption that investors are risk-averse. Though it is generally true, there exists a
category of risk seekers who do not demand premium for assuming risks, they are willing to pay a
premium to take risks. Accordingly, composite discount rate would be reduced, not increased, as the
level of risk increases.

 It is based on the assumption that investors are risk averse. Though it is generally true, there
exists a category or risk seekers who do not demand premium for assuming risks; they are
willing to pay a premium to take risk. Accordingly, the composite discount rate would be
reduced, not increased, as the level of risk increases.1

Certainty Equivalent
23
Yet another common procedure for dealing with risk in capital budgeting is to reduce the forecasts of
cash flows to some conservative levels. For example, if an investor, according to his ‘best estimate,’
expects a cash flow of Rs 60,000 next year, he will apply an intuitive correction factor and may work
with Rs 40,000 to be on safe side. There is a certainty-equivalent cash flow. In formal way, the certainty
equivalent approach may be expressed as:

N tNCFt
NPV = 
t=0 (1+kf)t

Where, NCFt= the forecasts of net cash flow without risk-adjustment

t = the risk-adjustment factor or the certainty equivalent coefficient
Kf = risk-free rate assumed to be constant for all periods.

The certainty- equivalent coefficient, t assumes a value between 0 and 1, and varies inversely
with risk. A lower t will be used if greater risk is perceived and a higher  t will be used if lower risk is
anticipated. The coefficients are subjectively or objectively established by the decision maker. These
coefficients reflect the decision-maker’s confidence in obtaining a particular cash flow in period t. For
example, a cash flow of Rs 20,000 may be estimated in the next year, but if the investor feels that only
80 per cent of it is a certain amount, then the certainty-equivalent coefficient will be 0.80. That is, he
considers only Rs 16000 as the certain cash flow. Thus, to obtain certain cash flows, we will multiply
estimated cash flows by the certainty-equivalent coefficients.

The certainty-equivalent coefficient can be determined as a relationship between the certain cash
flows and the risky cash flows. That is:

NCFt* Certain net cash flow

t = =
NCFt Risky net cash flow

For example, if one expected a risky cash flow of Rs 80,000 in period t and considers a certain cash flow
of Rs 60,000 equally desirable, then t will be 0.75=60,000/80,000.

ILLUSTRATION 15.2 A project costs Rs 6,000 and it has cash flows of Rs 4,000, Rs 3,000, Rs 2,000
and Rs 1,000 in year 1 through 4. Assume that the associated  t factors are estimated to be: o = 1.00,
1=0.90, 2=0.70, 3=0.50 and 4=0.30, and the risk free discount rate is 10 per cent. The net present
value will be:

0.90(4,000) 0.70(3,000) 0.50(2,000) 0.30(1,000)

NPV = 1.0(-6,000) + + + + = Rs 37
(1+0.10) (1+0.10)2 (1+0.10)3 (1+010)4

24
 The project would be rejected as it has a negative net present value.

If the internal rate of return method is used, we will calculate that rate of discount which equates
the present value of certainty-equivalent cash inflows with the present value of certainty-equivalent cash
outflows. The ratio so found will be compared with the minimum required risk-free rate. Project will be
accepted if the internal rate is higher than, the minimum rate; otherwise it will be unacceptable.

Evaluation of Certainty Equivalent

The certainty-equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts
of cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this
method suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that
will be made in his forecasts, may inflate them in anticipation. This will no longer give forecasts
according to ‘best estimate.’ Second, if forecasts have to pass through several layers of management, the
effect may be to greatly exaggerate the original forecasts or to make it ultra conservative. Third, by
focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some
good investments.

Unit III

Cost of Capital

The project’s cost of capital is minimum acceptable rate of return on funds committed to the project. The
minimum acceptable rate or required rate of return is a compensation for time and risk in use of capital
by project. Since investment projects may differ in risk, each one of them will have its own unique cost
of capital. The firm represent aggregate of investment projects under taken by it. Therefore, the firm’s
cost of capital will be overall, or average, required rate of return on aggregate of investment projects.

Determining Component Cost of Capital:-

1) Cost of Debt:-

A Company may raise debt in various ways. It may borrow funds from financial institutions or
public either in form of public deposits or debentures for a specified period of time at certain rate of
interest. A debenture or bond may be issued at per or at discount or premium.
Debt may either be irredeemable or redeemable after a certain period.

(a) Cost of irredeemable debt, before tax:-

Formula for calculating cost of debt before tax is:-

25
 Kdb = I
___ X 100
NP

Where,
Kdb= before-tax cost of debt.
I = coupan rate of interest.
NP = net proceeds from the issue of debt

(b) Cost of irredeemable debt, after tax:- When a co. uses debt as a source of finance then it saves a
considerable amount in payment of tax because the amount of interest paid on the debts is a deductible
expense in computation of tax. Formula for calculating cost of debt after tax is:-
Kda = I
___ X 100 (1-t)
NP
Where,
Kda= after-tax cost of debt.
t= Corporate tax rate.

2. Cost of redeemable debt:- Normally a co. issue a debt which is redeemable after a certain
period during its life time. Such a debt is termed as redeemable debt. Cost of redeemable debt may also
be calculated before tax & after tax.

Cost of redeemable debt, before tax:-

I + 1 (RV – NP)
n
Kdb = ------------------------- x 100
1 (RV + NP)
2
RV = redeemable value of debt
N = no. of years in which debt is to be redeemed
I = annual interest charges

Cost of redeemable debt, after tax:-

I + 1 (RV – NP)
n
Kdb = ------------------------- x 100 (1-t)
1 (RV + NP)
2

2). Cost of Preference Capital:-

26
The measurement of cost of preference capital poses some conceptual difficulty. In case of debt, there is
binding legal obligation on the firm to pay interest & interest constitutes basis to calculate cost of debt.
However, in case of preference capital, payment of dividends is not legally binding on the firm & even if
the dividends are paid, it is not a charge on earnings, rather it is a distribution or appropriation of
earnings to preference share holders.

Irre Deemable Preference share:-

The preference share may be treated as a perpetual security if it is irredeemable Thus, its cost is
given by following equation:-

D
KP= _______ X 100
NP

Where,
Kp= Cost of Preference share
D= annual preference dividend

Redeemable Preference Share:- Redeemable preference share ahs to be returned ti the preference
shareholders after a stipulated period. He cost of a redeemable preference share capital is calculated as
follows:
D + 1 (RV – NP)
n
Kpr = ------------------------- x 100
1 (RV + NP)
2

3) Cost of Equity Capital:-

Firms may raise equity capital internally by retained earnings. Alternatively, they could distribute the
entire earnings to equity share holders & raise equity capital externally by issuing new shares. In both
cases, shareholder are providing funds to the firm to finance their capital expenditures. Therefore, equity
shareholders required rate of return will be same whether they supply funds by purchasing new shares or
by for going dividends which could have been distributed to them. The cost of equity share capital can
be computed in the following ways:-
i. Dividend yield method:- This method is based on the assumption that when an investor
invests in the equity shares of a co., he expects to get a payment at least equal to the rate of
return prevailing in the market. The equation is:-
Ke = DPS
___ X 100
MP

27
Where, Ke = cost of equity capital
DPS = Dividend per share
MP = Market Price per share
ii. Dividend yield plus growth in dividend method:- This method is used to compute the cost
of equity capital when the dividend of a firm are expected to grow at a constant rate.
Ke = DPS
___ X 100 + G
MP
G = Rate of growth in dividend
iii. Earning yield method:- As per this method cost of equity capital is calculated by
establishing a relationship between earning per share & the current market price of the
share. The equation is:-
Ke = EPS
___ X 100
MP
EPS = Earning per share
iv. Earning yield plus growth in earning method:- If the EPS of a co. is expected to grow at a
constant rate of growth, the cost of equity capital can be computed as follows:-

Ke = EPS
___ X 100 + G
MP

There is, however, a difference between retained earnings & issue of equity shares from firms point of
view.

Cost of Retained Earnings:-

The opportunity cost of retained earnings (internal earnings) is the rate of return on dividends foregone
by equity shareholders. The shareholders generally expect dividend and capital gain from their
investment. The required rate of return of shareholder can be determined from dividend valuation model.

Normal Growth:- A firm whose dividend are expected to grow at a constant rate of g is as follows

Divl
Po =
Ke-g

Where
DWl= DIVo (1+g)

Super normal growth:-

28
 Dividends may grow at different rates in future. The growth rate may be very high for a few
years & after wards, it may, it may become normal indefinitely in future. The dividend valuation model
can be used to calculate cost of equity under different growth assumptions. For example, If the dividends
are expected to grow at a super normal growth rates g for n year & there after, at a normal perpetual
growth rate of In beginning in year n+1 then cost of equity can be determined by following formula.

n DIV0 (1+gs)t Pn
Po=  __________ + ________
t=1 (1+ke)t (1+ke)n

Pn= Discounted value of dividend stream, beginning in year n+1 & growing at a constant, perpetual rate
gn, at end of year n and therefore it is equal to :-

DIV n+1
Pn = ________

Ke-gn

Zero growth

DIVl
Ke =______

Po

The growth rate g will be zero if firm does not retain any of its earnings.

Weighted Average (Cost of Capital)

After calculating costs, they are multiplied by weights of various sources of capital to obtain a
weighted cost of capital (WACC). The composite, cost of capital is the weighted average of costs of
various sources of funds. It is relevant in calculating over all cost of capital.

The following steps are involved to calculate weighted average cost of capital:-

1) Calculate cost of specific sources of funds (i.e. cost of debt, cost of equity, cost of preference capital
etc).

2) Multiply cost of each sources by its proportion in capital structure.

3) Add weighed components costs to get firm’s weighted average cost of capital.

29
 In order to calculate weighted cost of capital component cost should be ofter tax costs. If we
assume that a firm has only debt & equity in its capital structure, then its weighted average cost of
capital,
(Ro) Will be:-

Ko= kd (1-T) Wd+kewe

Ko= Kd (1-T) D+ + ke S
____ ___
D+S D+S
Where Ko= Weighted average cost of capital Kd(1-t) ke are after tax cost of debt & equity D= amount of
debt, S= amount of equity.

Computation of weighted average cost of capital:-

 XW
Kw= --------
 W
KW = Weighted Average Cost Of capital
W = weight of specific source of finance
X = cost of specific source of finance

Assignment of weights:-
For computing weighted average cost of capital, it is necessary to determine the proportion of each
source of finance in the total capitalization. For this purpose weights will have to be assigned to various
source of finance. Weights may be assigned by any of the following methods:-
i. Book value weights
ii. Market value weights
i. Book value weights:- Book value weights are computed from the values taken from the
balance sheet. The weight to be assigned to each source of finance divided by the book value
of total sources of finance.
Advantages of book value weights:-
 Book values are readily available from the published records of the firm.
 Book value weights are more realistic because the forms set their capital structure targets in
terms of book values rather than market values.
 Book values are not affected by the fluctuations in the capital market.
 In the case of those companies whose securities are not listed, only book value weights can be
used.
Limitations of book value weights:-
 The costs of various sources of finance are calculated using prevailing market prices. Hence
weights should also be assigned according to the market values.
 The present economic values of various sources of capital may be totally different from their
book values.

30
 ii. Market value weights:- As per market value scheme of weighting, the weights to different
sources of finance are assigned on the basis of their market values.
Advantages of market values weights:-
 The costs of various sources of finance are calculated using prevailing market prices. Hence it is
proper to use market value weights.
 Weights assigned according to market values of the sources of finance represent the true
economic values of various sources of finance.
Limitations of market value weights:-
 Market value weights may not be available as securities of all the companies are not actively
traded.
 It is very difficult to use market value weights because the market prices of securities fluctuate
widely & frequently.
Example:- A company’s after tax specific cost of capital are as follows:-
Cost of debt 10%
Cost of preference shares 12%
Cost of equity shares 15%

The following is the capital structure:

Sources Amount
Debt 3,00,000
Preference share capital 2,00,000
Equity share capital 5,00,000
10,00,000
calculate the weighted average cost of capital, kw

computation of weighted average cost of capital using book value weights:

Sources of finance Book value Proportion or Cost(%) Weighted cost
(1) Rs. weight (4) (5) = (3 x 4)
(2) (3)
Debt 3,00,000 .3 10 3.0
Preference share capital 2,00,000 .2 12 2.4
Equity share capital 5,00,000 .5 15 7.5
total 10,00,000 1.00 12.9

The weighted average cost using book value weights is 12.9%

Theories of Capital Structure

(1) Net Income Approach:-

The essence of net income approach is that the firm can increase its value or lower the overall cost of
capital by increasing proportion of debt in capital structure.

31
The assumption of this approach are:-

1) The use of debt does not change the risk perception of investors, as a result equity capitalisation rate
(kc) & debt-capitalisation rate (kd) remain constant with changes in leverage.

2) The debt capitalisation rate is less than equity-capitalisation rate ( rate (i.e. kd < ke)

3) The corporate income taxes do not exist.

The first assumption implies that if ke & kd are constant, increased use of debt by magnifying
the shareholders earnings, will result in higher value of the firm via higher value of equity.
Consequently, overall or weighted average cost of capital, ko will decrease. The overall cost of capital is
measured by Eq-

X Noi
Ko= ___ =___

V V

Thus, with constant annual net operating income (NOI) overall cost of capital of capital would decrease
as the value of firm, V increases.

NET OPERATING INCOME APROACH

According to the net operating income (NOI) approach the market value of the firm is not
affected by the capital structure changes. The market value of the firm is found out by capitalizing the
net operating income at the over all or the weighted average cost of capital, which is constant.

The overall capitalisation rate depends on the business risk of the firm. It is independent of
financial mix. If NOI and average cost of capital are independent of financial mix, market value of firm
will be a constant are independent of capital structure changes. The critical assumptions of the NOI
approach are:

a) The market capitalizes the value of the firm as a whole. Thus the split between debt and
equity is not important.
b) The market uses an overall capitalisation rate, to capitalize the net operating income.
Overall cost of capital depends on the business risk. If the business risk is assumed to
remain unchanged, overall cost of capital is a constant.
c) The use of less costly debt funds increases the risk to shareholder. This causes the equity
capitalisation rate to increase. Thus, the advantage of debt is offset exactly by the
increase in the equity-capitalisation rate.
d) The debt capitalisation rate is constant.

32
 e) The corporate income taxes do not exist.

Thus, we find that the weighted cost of capital is constant and the cost equity increase as debt is
substituted for equity capital.

EXISTENCE OF OPTMUM CAPITAL STRUCTURE: THE TRADITIONAL VIEW

The traditional view, which is also known as an intermediate approach, is a compromise between the net
income approach and the net operating approach. According to this view, the value of the firm can be
increased or the cost of capital can be reduced by a judicious mix of debt and equity capital. This
approach very clearly implies that the cost of capital decreases within the reasonable limit of debt and
then increases with leverage. Thus, an optimum capital structure exists, and it occurs when the cost of
capital is minimum or the value of the firm is maximum. The cost of capital declines with leverage
because debt capital is cheaper than equity capital within reasonable, or acceptable, limit of debt. The
statement that debt funds are cheaper than equity funds carries the clear implication that the cost of debt,
plus the increased cost of equity, together on a weighted basis, will be less than the cost of equity which
existed on equity before debt financing.2 In other words, the weighted average cost of capital will
decrease with the use of debt.

 IRRELEVANCE OF CAPITAL STRUCTURE: THE MODIGLIANI-MILLER

HYPOTHESIS
WITHOUT TAXES

The Modigliani-Miller (M-M) hypothesis is identical with the net operating income approach. (M-M)
argue that, in the absence of taxes, a firm’s market value and the cost of capital remain invariant to the
capital structure changes. In their 1958 article, 2 they provide analytically sound and logically consistent
behavioural justification in favour of their hypothesis, and reject any other capital structure theory as
incorrect.

Leverage

The dictionary meaning of the term leverage refers to an increased means of accomplishing some
purpose. E.g. leverage helps us in lifting heavy objects which may not be otherwise possible. However
in the area of finance it is used to describe the firm’s ability to used fixed cost assets or funds to magnify
the returns to its owners. Leverage can be define as the employment of an asset or fund for which the
firms pays a fixed cost or fixed return thus according to him, leverage result as a result of the firm
employing an asset or source of funds which has a fixed cost or return. The former may be termed as
fixed operating cost while the latter may be termed as fixed financial cost. It should be noted that fixed
cost or return is the fulcrum of leverage. If a firm is not required to pay fixed cost or fixed return there
will be no leverage. A high degree of leverage implies that there will be a large change in the profits due

33
to relatively small change in sales & vice – versa. Thus the higher is the leverage, the higher is the risk
& higher is the expected return.

Types of leverage:- Leverage are of two types:-

(1) Operating leverage
(2) Financial leverage

1. Operating leverage:- The operating leverage may be defined as the tendency of the
operating profit to vary disproportional with sales. It is said to exist when a firm has to pay fixed cost
regardless of volume of output or sales. The firm is said to have a high degree of operating leverage if
it employs a greater amount of fixed cost & a smaller amount of fixed cost. Thus the degree of
operating leverage depends upon the amount of fixed element in the cost structure.
Operating leverage in the firm is a function of three factors:-
a) The amount of fixed cost
b) The contribution margin
c) The volume of sales

Formula:-
Operating leverage = Contribution or C
Operating profit OP

Utility:- The operating leverage indicates the impact of change in sales on operating income. If a firm
has a high degree of operating leverage, small changes will have large effect on operating income. In
other words, the operating profit (EBIT) of such firm will increase at a faster rate than the increase in
sales. Similarly the operating profit of such a firm will suffer a great loss as compared to reduction in its
sales.

2. Financial leverage:- The financial leverage may be defined as the tendency of the
residual net profit to vary disproportionately with operating profit. It indicates the change that take
place in the taxable income as a result of change in the operating income. It signifies the existence if
fixed interest/ fixed dividend bearing securities in the total owner capital structure of the co. thus the
use of fixed interest/dividend bearing securities such as debt & capital preference along with the
owner’s equity in the total owner capital structure of the co. is described as financial leverage. Where
in capital structure of the co., the fixed interest/ dividend bearing securities are greater as compared to
the equity capital, the leverage is said to be larger. In the reverse case the leverage will be said to be
smaller.
Favorable & unfavourable financial leverage:- Financial leverage may be favourable or unfavourble
upon whether the earning made by the use of fixed interest or dividend – bearing securities exceed or not
explicit the fixed cost, the firm has to pay for the employment of such funds. The leverage will be
considered to be favourable so long the firms earn more on assets purchased with the funds than the
fixed cost of their use. Unfavourable or negative leverage occurs when the firm does not earn as much as
the fund cost. Financial leverage is also termed as trading on equity. The co. resorts to trading on equity
with the objective of giving the equity shareholders higher rate of return than the general rate of earning

34
on capital employed in the co. to compensate them for the risk that they have to bear. E.g. if a co.
borrows Rs. 100 @10%p.a. & earns a return for 12%, the balance 4% p.a. after payment of interest
belongs to the shareholders & thus they can be paid a higher rate of return than the general rate of
earning of co. but in case co. could earn a return of only 6% on Rs. 100 employed by it, the equity
shareholders loss will be Rs. 2 p.a. thus, the financial leverage is a double – edged sword. It has the
potentiality of increasing the return to equity shareholders.

Formula:- Financial leverage = Earning before tax & interest

Profit before tax but after interest

Utility:- Financial leverage helps considerably the financial manager while devising the capital structure
of the co. A high financial leverage means a high fixed capital structure. Financial manager must plan
the capital structure in a way that the firm is in a position to meet its fixed financial costs. Increase in
fixed financial costs requires necessary increase in EBIT level. In the event of failure to do so the co.
may be technically forced into liquidation.

Unit IV

Dividend

Dividend refers to that part of net profits of a co. which is distributed among shareholders as a return on
their investment in the co. dividend is paid on preference as well as equity shares of the co. On
preference shares, dividend is paid at a predetermined fixed rate. But decision on dividend on equity
shares, dividend is taken on each year separately. A settled approach for the payment of dividend is
known as dividend policy. Thus the dividend policy divides the net profits or earnings after taxes into
two parts:
1. Earnings to be distributed as dividend
2. Earnings retained in the business

Factors determining dividend policy:-

1. Financial needs of the firm:- financial needs of a firm are directly related to the investment
opportunities available to it.
 If a firm has abundant profitable investment opportunities, it will adopt a policy of distributing
lower dividends.
 On the other hand, if the firm has little or no investment opportunities, it should retain only a
small portion of its earnings & should distribute the rest as dividends.
2. Stability of dividends:- Investor always prefer a stable dividend policy. They expect that they
should get a fixed amount as dividend which should increase gradually over the years.
3. Legal restrictions:- The firms dividend policy has to be formulated within the legal provisions
& restrictions. For instance sec. 205 of the Indian Companies Act provides the dividend shall be
paid only out of the current profits or past profits after providing depreciation.

35
 4. Restrictions in loan agreement:- Lenders, mostly the financial institution, put certain restriction
on payment of dividend to safeguard their interest. The following restrictions may be:-
 A loan agreement may prohibit the payment of any dividend as long as the firm’s current
ratio is less than, say, 2:1.
 A loan agreement may prohibit the payment of any dividend as long as the firm’s debt
equity ratio is more than, say, 1.5:1.
 They may prohibit the payment of dividend in excess of a certain percentage, say, 10%.
When such restrictions are put, the co. will have to keep a low dividend payout ratio.
5. Liquidity:- Payment of dividend causes sufficient outflow of cash. Although a firm may have
adequate profits, it may not have enough cash to pay the dividends. Thus the cash position is a
significant factor in determining the size of dividends. Higher the cash & overall liquidity of
position of a firm, higher will be its ability to pay the dividends.
6. Access to Capital Market:- A co. which is not sufficient liquid can still pay dividends if it has
easy accessibility to the capital market. In other words, if a co. is able to raise debt or equity in
the capital market, it will be able to pay dividends even his liquid position is not good.

7. Stability of earnings:- Stability of earnings also has a significant effect on the dividend policy
of a firm. Normally the greater the stability of earnings, greater will be the dividend payout ratio.

8. Objectives of maintaining control:- Sometimes the present management employs dividend

policy to retain control of the co. in its own hands. When a co. pays larger dividends, is liquidity
position adversely affected & it may have to issue new shares to raise funds to finance its
investment opportunities. If the existing shareholders do not want to purchase the new shares,
their control over the co. will be diluted.

9. Effect on EPS:- As discussed above, higher dividend payout ratio affects the liquidity position
adversely & may necessitate the issue of new equity shares in the near future, causing am
increase in the no. of equity shares & ultimately the EPS may reduce. On the other hand by
keeping a low dividend payout ratio the firm can retain earnings resulting in increase in future
earnings & thereby an increase in EPS.

10. Firm’s expected rate of return:- If the firm’s expected rate of return would be less than the rate
which could be earned by the shareholders themselves from external investment of their funds,
the firm should retain smaller part of its earnings & should opt for a higher dividend payout ratio.

11. Inflation:- Inflation may also act as a constraint on paying larger dividends. Depreciation is
charged on the original cost of the asset & as a result when there is an increase in price level,
funds generated from depreciation become inadequate to replace the obsolete assets.
Consequently companies will have to retain more of its earnings to provide funds to replace the
assets & hence their dividend payout ratio will be low during periods of inflation.

36
12. General state of economy:- Earnings of a firm are subject to general economic conditions of the
country. If the future economic conditions are uncertain, it may lead to retention of larger part of the
earnings of a firm to absorb any eventuality. Likewise in the event of depression when the level of
business activity is very low, the management may reduce the dividend payout ratio of preserve its
liquidity position. All the above factors must be carefully considered before formulating a dividend
policy.

Walter’s model

Walter’s model supports the doctrine that the dividend policy is relevant for the value of the firm.
According to Walter, the investment policy of the firm & its dividend policy are interlinked. The main
proposition of the Walter approach is the relationship between the following two factors:-
i. The return on firm’s investment or its internal rate of return (r) &
ii. Its cost of capital or the required rate of return (ke)

According to Walter approach optimum dividend policy of the firm shall be determined by the
relationship between r & ke.
i. When internal rate of return is greater than the cost of capital (r > ke):- If the firm’s return on
investment is more than the cost of capital, the firm should retain the earnings rather than
distributing it to the shareholders because of the reason that the money is earning more profits in
the hands of the firm than it would if it was paid to the shareholders.
ii. When internal rate of return is less than cost of capital ( r < ke):- On the other hand, if r is less
than ke, the firm should pay off the money to the shareholders in the form of dividends because
of the reason that the shareholders can earn higher return by investing it elsewhere.
iii. If internal rate of return is equal to cost of capital (r = ke):- Lastly, if r is equal to ke, it is a matter
of indifference whether the earnings are retained or distributed. For such firms, there is no
optimum dividend policy.

The Walter’s model thus relates the question of distributing the dividends & retaining the earnings to the
investment opportunities that are available with the firm.
i. If a firm has adequate profitable investment opportunities it will be able to earn more than what
the investors expect as r > ke i.e. return on investment is more than the cost of capital. Such firms
are called the growth firms. For growth firms, the optimum dividend policy would be given by
dividend payout ratio of zero. i.e. they would retain their earnings. The market value of the
shares will be maximized as a result.
ii. On the contrary if a firm does not have profitable investment opportunities i.e. when r is less than
ke, the shareholders will be better off if the earnings are paid out to them so that they are able to
earn a higher return by investing the funds elsewhere. In such a case the market price of shares
will be maximized by the distribution of the entire earnings as dividend. For such firms the
optimum dividend policy would be given by dividend payout ratio of 100%.

Assumptions:-

37
 1. Constant return & cost of capital:- The Walter’s model assumes that the firm’s rate of return &
its cost of capital are constant.
2. Internal financing:- All financing is done through the retained earnings that is external sources
of funds like debt or new equity capital are not used.
3. 100% payout or retention:- All earnings are either distributed as dividends or reinvested
internally immediately.
4. Constant earnings per share & constant dividends per share:- There is no change in key
variables namely beginning earnings per share & dividend per share.
5. Infinite time:- The firm has a very long life.
Walter’s formula for determining the value of a share:-
D + r (E – D)
ke
P = _______________
ke

where P = Market price per share

D = Dividend per share
E = Earning per share
r = internal rate of return
ke = cost of equity capital or capitalization rate
E.g.- The following information is available in respect of a firm:
Capitalization rate (ke) = 10%
EPS (E) = Rs. 8
Calculate the market price of share under Walter’s model by assuming rate of return
(i) 15% (ii) 10% (iii) 5% and
Dividend payout ratio
(i) 0% (ii) 25% (iii) 50% (iv) 75% (v) 100%

Solution:-
Dividend policy & the value of share (Walter’s model)

S.No. r > ke r = ke r < ke

r = 0.15 r = 0.10 r = 0.05
ke = 0.10 ke = 0.10 ke = 0.10
E = Rs. 8 E = Rs. 8 E = Rs. 8
(i) D/P Ratio = 0% D/P Ratio = 0% D/P Ratio = 0%
(Dividend per share = Rs. 0) (Dividend per share = Rs. 0) (Dividend per share = Rs. 0)
0 + 0.15 (8 – 0) 0 + 0.10 (8 – 0) 0 + 0.05 (8 – 0)
0.10 0.10 0.10
P = __________________ P = __________________ P = __________________
0.10 0.10 0.10
P = 120 P = 80 P = 40
(ii) D/P Ratio = 25% D/P Ratio = 25% D/P Ratio = 25%
(Dividend per share = Rs. 2) (Dividend per share = Rs. 2) (Dividend per share = Rs. 2)
38
 2 + 0.15 (8 – 2) 2 + 0.10 (8 – 2) 2 + 0.05 (8 – 2)
0.10 0.10 0.10
P = __________________ P = __________________ P = __________________
0.10 0.10 0.10
P = 110 P = 80 P = 50
(iii) D/P Ratio = 50% D/P Ratio = 50% D/P Ratio = 50%
(Dividend per share = Rs. 4) (Dividend per share = Rs. 4) (Dividend per share = Rs. 4)
4 + 0.15 (8 – 4) 4 + 0.10 (8 – 4) 4 + 0.05 (8 – 4)
0.10 0.10 0.10
P = __________________ P = __________________ P = __________________
0.10 0.10 0.10
P = 100 P = 80 P = 40
(iv) D/P Ratio = 75% D/P Ratio = 75% D/P Ratio = 75%
(Dividend per share = Rs. 6) (Dividend per share = Rs. 6) (Dividend per share = Rs. 6)
6 + 0.15 (8 – 6) 6 + 0.10 (8 – 6) 6 + 0.05 (8 – 6)
0.10 0.10 0.10
P = __________________ P = __________________ P = __________________
0.10 0.10 0.10
P = 90 P = 80 P = 70
(v) D/P Ratio = 100% D/P Ratio = 100% D/P Ratio = 100%
(Dividend per share = Rs. 8) (Dividend per share = Rs. 8) (Dividend per share = Rs. 8)
8 + 0.15 (8 – 8) 8 + 0.10 (8 – 8) 8 + 0.05 (8 – 8)
0.10 0.10 0.10
P = __________________ P = __________________ P = __________________
0.10 0.10 0.10
P = 80 P = 80 P = 80

Criticism of Walter’s model:-

(i) No external financing:- Walter’s model assumes that the firm’s investment are financed
exclusively by retained earnings & no external financing is used. If it was so then the model would
be applicable to only those firms in which equity was the only source of finance.
(ii) Constant rate of return:- The model assumes that r is constant. This is not a realistic
assumption because when increased investments are made by the firm, r also changes.
(iii) Constant equity capitalization rate (ke):- The model assumes that equity capitalization
rate remains constant. This is also not a realistic assumption because equity capitalization rate
changes directly with the change in risk complexion of the firm.

Gordon’s Model

Gordon’s model is another theory which contends that dividend policy is relevant for the value of the
firm. In other words, the dividend decision of the firm affects the value of the firm.

Assumptions:-
39
(i) No external financing:- Gordon’s model assumes that no external financing is available &
retained earnings are the only source of finance.
(ii) All equity firm:- This model assumes that the firm is an all equity firm & it has absolutely no
debt.
(iii) No taxes:- Corporate taxes do not exist.
(iv) Perpetual earnings:- It is assumed that the firm has perpetual life & its stream of earnings are
also perpetual.
(v) Constant internal rate of return:- The internal rate of return of the firm is assumed to be
constant.
(vi) Constant cost of capital:- The cost of capital of the firm is assumed to be constant.
(vii) Constant retention ratio:- The retention ratio once decided upon is constant.
(viii) Cost of capital greater than growth rate:- It is assumed that the firm’s cost of capital is greater
than the growth rate.

Explanation:- The implications of Gordon’s basic valuation may be as below:-

1. When the rate of return of the firm on its investment is greater than the cost of capital, then the price
per share increases as the dividend payout ratio decreases. Thus the growth firm should distribute
smaller dividends & should retain maximum earnings.
2 When the rate of return is equal to the cost of capital then the price per share remains unchanged
& is not affected by dividend policy. Thus for a normal firm there is no optimum dividend policy.
3 When the rate of return is less than the cost of capital, the price per share increases as the
dividend payout increases. Thus the shareholders of declining firm stand to gain if the firm distributes its
earnings for such firms.

Gordon’s formula for determining the value of a share:-

( 1 – b) D
P = E X -------------- or P = ----------
Ke – br ke – g
Where E = Earnings per share
r = firm’s rate of return
b = retention ratio
br = g = growth rate
( 1 – b) = D/P ratio
Ke = cost of capital

e.g. The following is the information is available is available:

rate of return:
(i) 15% (ii) 10% (iii) 8%
Cost of capital (ke) = 10% Earning per share (E) = Rs. 10

Calculate the dividend policy & the value of the firm using Gordon’s model when
D/P Ratio Retention ratio

40
 (i) 40% 60%
(ii) 60% 40%
(iii) 90% 10%
Solution:-
Dividend policy & the value of a share (Gordon’s model)
S.no. r > ke r = ke r < ke
r = 0.15
ke = 0.10
E = Rs. 8
(i) D/P Ratio (1 –b) = 40% D/P Ratio (1 –b) = 40% D/P Ratio (1 –b) = 40%
Retention ratio (b) = 60% Retention ratio (b) = 60% Retention ratio (b) = 60%
g = br = 0.6 x .15 = 0.09 g = br = 0.6 x .10 = 0.06 g = br = 0.6 x .08 = 0.048
10 (1 – 0.6) 10 (1 – 0.6) 10 (1 – 0.6)
P = ------------------------- P = ------------------------- P = -------------------------
0.10 – 0.09 0.10 – 0.06 0.10 – 0.048
P = 400 P = 100 P = 77
(ii) D/P Ratio (1 –b) = 60% D/P Ratio (1 –b) = 60% D/P Ratio (1 –b) = 60%
Retention ratio (b) = 40% Retention ratio (b) = 40% Retention ratio (b) = 40%
g = br = 0.4 x .15 = 0.06 g = br = 0.4 x .10 = 0.04 g = br = 0.4x .08 = 0.032
10 (1 – 0.4) 10 (1 – 0.4) 10 (1 – 0.4)
P = ------------------------- P = ------------------------- P = -------------------------
0.10 – 0.06 0.10 – 0.04 0.10 – 0.032
P = 150 P = 100 P = 88
(iii) D/P Ratio (1 –b) = 90% D/P Ratio (1 –b) = 90% D/P Ratio (1 –b) = 90%
Retention ratio (b) = 10% Retention ratio (b) = 10% Retention ratio (b) = 10%
g = br = 0.1 x .15 = 0.015 g = br = 0.1 x .10 = 0.01 g = br = 0.1 x .08 = 0.008
10 (1 – 0.1) 10 (1 – 0.1) 10 (1 – 0.1)
P = ------------------------- P = ------------------------- P = -------------------------
0.10 – 0.015 0.10 – 0.01 0.10 – 0.018
P = 106 P = 100 P = 98

Modigliani & Miller approach (MM Model):- The most prominent theory in support of irrelevance of
dividends & value of the firm is provided by Modigliani & Miller. The crux of the hypothesis is that the
dividend policy of a firm is a passive decision which does not affect the value of the firm. The dividend
policy is a residual decision which depends upon the availability of investment opportunities to the firm.
There are two situations:
i. If a firm has sufficient investment opportunities it will not pay dividends & retain the
earnings to finance them.
ii. On the contrary, if there are inadequate investment opportunities, dividends will be declared
to distribute the earnings.

Assumptions of MM hypothesis:-
i. There are perfect capital markets.
ii. Investors behave rationally.
41
 iii. Information about the co. is available to all without any cost.
iv. There are no floatation & transaction costs.
v. No investor is large enough to influence the market price of shares.
vi. There are no taxes.
vii. The firm has rigid investment policy.
viii. There is no risk or uncertainty in regard to the future profits of the firm.

The argument of MM:- The argument given by MM in support of their hypothesis is that whatever
increase in the value of the firm results from the payment of dividend will be exactly offset by the
decline in the market price of shares because of external financing & there will be no change in the total
wealth of the shareholders. E.g. if a co. having investment opportunities, distributes all its earnings
among the shareholders, it will have to raise additional funds from external sources. To be more specific
the market price of a share in the beginning of a period is equal to the present value of dividends paid at
the end of the period plus the market price of the shares at the end of the period.

MM hypothesis can be explained by following steps:-

Step 1: Calculation of the value of the firm.
D1 + P1
P0 = ------------
1 + ke
P0 = market price per share at the beginning of the period or prevailing market price of share.
D1 = Dividend to be received at the end of year 1
P1 = market price of shares at the end of year 1
Ke = cost of equity capital or rate of capitalization
Calculation of P1:- The value of P1 can be derived by the above equation:
P1 = P0 ( 1 + ke) – D1
Step 2: Calculation of no. of shares to be issued when firm requires additional funds:
I – ( E – n D1)
m = ----------------------
P1
m = no. of shares to be issued
I = total amount required for investment
E= earning of the firm during the year
nD1 = Total dividends to be paid
Step 3: Further calculation of the value of the firm with the help of following formula:
( n + m) P1 – I + E
nP0 = -------------------------
1 + ke
nP0 = value of the firm
n = no. of shares outstanding at the beginning of the period

E.g. MM foam co. currently has 5,000 outstanding shares selling at Rs. 100 each. The firm expects to
have a net earning of Rs. 50,000 & contemplating a dividend of Rs. 6 per share at the end of the current

42
financial year. There is a proposal for making new investment of Rs. 1,00,000. Assuming 10% cost of
capital show that under MM hypothesis, the payment of dividend does not affect the value of the firm.

Solution:
1. Calculation of the value of the firm when dividends are paid:
i. Price of the share at the end of the current financial year:
P1 = P0 ( 1 + ke ) – D1
= 100 ( 1 + .10 ) – 6
= Rs. 104
ii. No. of shares to be issued:
I – ( E – n D1)
m = ----------------------
P1
= 1,00,000 – (50,000 – 5,000 x 6)
104
= 80,000
104
iii. Value of the firm:
( n + m) P1 – I + E
nP0 = -------------------------
1 + ke
= ( 5,000 + 80,000/104) 104 – 1,00,000 + 50,000
1 + .10
= 6,00,000 – 50,000
1.10
= 5,00,000

2. Value of the firm when dividends are not paid

i. Price of the share at the ned of current financial year:
P1 = P0 ( 1 + ke ) – D1
= 100 ( 1 + .10 ) – 0
= Rs. 110
ii. No. of shares to be issued:
I – ( E – n D1)
m = ----------------------
P1
= 1,00,000 – (50,000 – 5,000 x 0)
110
= 50,000
110
iii. Value of the firm:

( n + m) P1 – I + E
nP0 = -------------------------
1 + ke
= ( 5,000 + 50,000/110) 110 – 1,00,000 + 50,000

43
 1 + .10
= 6,00,000 – 50,000
1.10
= 5,00,000

Conclusion:- Hence, whether dividends are paid or not the value of the firm remains the same Rs.
5,00,000.

Management Of Working Capital

Working capital management is an important component of overall financial management.

Management of working capital like long-term financial decisions affects the risk and profitability of
business. In business two types of assets are used.

(1) Fixed Assets

(2) Current Assets

Fixed Assets include land, building, plant and machinery, furniture and fittings etc. fixed assets are
used in the business for a long period and they are not purchased for the purpose of selling them to earn
profit.

Current Assets, on the other hand, are used for day to day operation of business. For the efficient
and effective use of fixed assets, there should be adequate working capital in the business. Current assets
include cash, bank stock debtors, bills receivable, marketable securities etc. the capital employed in
these assets is called working capital. In any business, there should be proper balance between fixed
capital and working capital.

The problem relating to management of working capital is different from that of management of
fixed assets. Fixed assets are purchased for long term use in business and the return on them is received
during their lifetime. On the other hand, current assets get converted into cash in short term. One more
significant characteristic of the current assets is that, if the amount of current assets is more in a
business, it will increases the liquidity but profitability will reduce. On the other hand, if current assets
are relatively lesser, profitability will improve but liquidity will be adversely affected. Therefore, the
main objective of working capital management is to determine optimum amount of investment in current
assets so that balance in profitability and liquidity of the business could be ascertained.

Definition of Working Capital

There is difference of opinion among different authors about the definition of working capital.
Considering the objectives and scope of working capital, it can be defined in two ways:

44
(i) Gross Concept
(ii) Net Concept

(i) Gross Concept:- According to the gross concept, working capital means total of all the
current assets of a business. It is also called gross working capital.

Gross Working Capital= Total Current Assets

(ii) Net Concept:- According to the net concept of working capital, net working capital means
the excess of current assets over current liabilities. If current assets are equal to current liabilities then
according to this concept working capital will be zero and in case current liabilities are more than
current assets, the working capital will be called negative working capital.

Net Working Capital= Current Assets-Current Liabilities

Current assets are those assets which are converted into cash within one accounting period, for
example, stock, debtors, bills receivables, prepaid expenses, cash and bank balance. Similarly, current
liabilities are those liabilities which have to be paid within an accounting year, for example, creditors
bills payables, short term loans etc.

Net working capital can also be defined in another manner. Net working capital is the part of
current assets which has been financed from long term funds. It is, therefore also called circulating
capital.

Gross concept and net concept of working capital have their own significance. When individual
current assets are to be managed, gross concept of working capital is used. Net concept of working
capital emphasizes on how much current assets have been financed out of long term funds. Under this
concept the relationship between current assets and current liabilities is established or their liquidity is
determined. The difference between gross working capital and net working capital can be understood
with the help of following illustration.

ILLUSTRATION I.

From the following balance sheet, you are required to calculate the amount of Gross Working
Capital and Net Working Capital:-

Balance Sheet
Rs Rs
Share Capital 10,00,000 Land and Building 10,00,000
Reserves 1,00,000 Plant and Machinery 2,90,000
Debentures 4,00,000 Cash and Bank Balance 10,000
45
Short-term Loan 50,000 Marketable Securities 90,000
Trade Creditors 40,000 Trade Debtors 1,00,000
Bills Payable 10,000 Bills Receivable 40,000
Inventory 70,000
16,00,000 16,00,000

Solution :

Gross Working capital= Cash and Bank Balance+ Marketable Securities+ Trade Debtors+ Bills
Receivable+ Inventory

= Rs. 10,000+Rs90,000+Rs1,00,000+Rs40,000+Rs70,000
= Rs. 3,10,000

Net Working Capital= Current Assets- Current Liabilities

= Rs10,000 + Rs 90,000 + 1,00,000 + Rs 40,000 + Rs70,000- Rs50,000 – Rs 40,000 – Rs 10,000

= Rs 3,10,000- rs 1,00,000 = Rs 2,10,000

Need For Working Capital

For the efficient operation of the business, working capital is required along with the fixed
capital. Working capital is needed for the purchase of raw material and for the payment of various day to
day expenses. There will be hardly any business which does not require working capital. The need for
working capital is different businesses. Financial management aims at maximising the wealth of
shareholders. To achieve this objective, it is necessary to earn adequate profits. The profit depends
largely on sales but sales do not result in cash immediately. To increase sales goods are to be sold on
credit, the collection of which takes place after time terms. Thus, there exists a gap between the sale of
goods and realisation of cash. During this period expenses are to be incurred to continue business
operations. For this purpose, working capital is required. The need for working capital can be explained
with the help of operating cycle or cash cycle. Operating cycle means that time period which is required
to convert raw material into cash. In a manufacturing enterprise raw material is purchased with cash,
then raw material is converted into work-in progress, which in turn gets converted into finished goods;
both receivable through sales and lastly cash is received from debtors and bills receivable.

In the operating cycle, following events are included:

Debtors and Bills Receivable
(1) Conversation of cash into raw material.
(2) Conversation of raw material into work-in-progress.
(3) Conversation of work in progress into finished goods.
(4) Conversation
Cash of finished goods into Debtors and Bills Receivable.
Finished Goods
(5) Conversation of Debtors and Bills receivable through sales into cash.

46
Raw Materials Work-in-
Progress
Management Of Cash

Management of cash is one of most important areas of overall working capital management. This
is due to the fact that cash is the most liquid type of current assets. As such, it is the responsibility of
finance function to see that various functional areas of business have sufficient cash whenever they
require the same. At the same time, it has also to be ensured that funds are not blocked in form of idle
cash, because it will effect interest cost & opportunity cost. As such, management of cash has to find a
mean between these 2 extremes of shortage of cash as well as idle cash.

Motives of holding Cash/ Need:-

1) Transactive Motive:- Business needs cash for various payments in ordinary course of its operation
which includes payment for purchase of material, wages, dividend, taxes etc. Similary business gets cash
from its selling activities & other investment. But there is no coordination between inflow and outflow
of cash. When expected cash receipt is short of required payment, cash is needed by firm so that
liabilities could be paid, if cash receipts match with cash payments business does not need cash for
transactional purpose.
2) Precautionary Motive:- Firms need cash to meet some contingencies. For example.

(2) Strikes, floods, failure of important customers.

(3) Slow rate of cash collection from debtors.
(4) Rejection of orders by customers due to their dissatisfaction.
(5) Rise in cost of raw material etc.

3) Speculative Motive:- It means to make use of profitable opportunities by firm. Sometimes, firm
wants to make use of such profitable opportunities which are outside operation of business. For this
purpose, firm retains some cash. Some of these opportunities are:-

(1) Opportunity to purchase raw material at low price by payment of cash immediately.

47
 (2) Opportunity to purchase securities at falling prices.
(3) Purchasing raw material at a time when its prices are lowest.

(4) Compensation Motive:- Bank provide number of services to its customers like clearance by
cheque, credit information about other customers, transfer of funds etc. for certain services banks charge
commission but same of services are provided by them free of cost for which they require indirect
compensation. For this purpose they wish their customer to maintain minimum cash balance.

Objective of Cash Management:-

1) To make Payment According to Payment Schedule:-

Firm needs cash to meet its routine expenses including wages, salary, taxes etc.

Following are main advantages of adequate cash-

(1) To prevent firm from being insolvent.

(2) The relation of firm with bank does not deteriorate.
(3) Contingencies can be met easily.
(4) It helps firm to maintain good relation’s with suppliers.

(2) To minimise Cash Balance:-

The second objective of cash management is to minimise cash balance. Excessive amount of
cash balance helps in quicker payments, but excessive cash may remain unused & reduces profitability
of business. Contrarily, when cash available with firm is less, firm is unable to pay its liabilities in time.
Therefore optimum level of cash should be maintain.

Managing Cash Flows:-

The main objective of managing cash flows is to accelerate collection of cash and delay
disbursement of cash without damaging credit worthiness. After preparing cash budget, management
should try that there should not be any significant difference in actual & budgeted cash flows.

Accelerating Cash Collections:-

The customers should be encouraged to make early payment by giving cash discount to fill time
gap between sale of goods and its payment by cheque. There are 2 methods of reducing these time gaps:-

(1) Concentration Banking:-

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 It is a system of collecting cash from customers of large sized firms which have large number of
branches. Some of these branches are selected for collection of cash from debtors which are called
collection centres. Firm opens its account in local banks of these collection centre. On receiving cheque,
centre sends them to local branch of bank and then they are transferred to Head office daily for
disbursements.

Thus, this method is profitable technique of realising debts at the earliest because it reduces time
gap between sending of cheque by customer and their receipts by firm.

(2) Lock box System:-

Under concentration banking, cheques or drafts received by collection centres are deposited in
local banks & therefore, sometime is wasted before cheques or drafts are sent for collection. Under the
lock box system, this time gap can be reduced.

Under this system, firm takes on rent a lock box from post office at important collection centres.

Customers are instructed to send their cheques/drafts in lock-box. Firm authorises local banks to
withdraw these cheques/drafts from lock box and credit the same to firm’s account. Bank operates this
lock-box several times a day. Local banks are also instructed to transfer funds exceeding a particular
level to Head office. This system is considered better to concentration banking because in this system,
time involving in receiving cheque, their accounting & deposit of these cheque in banks is saved.

But under this system, firm has to bear additional expenses of post office & bank.

Slowing Disbursements:-

The main objective of disbursement management is to slow down the payments without farming
goodwill & credit worthiness of firm. Following methods can be used for slowing disbursements.:-

1) Avoidance of Early Payments:-

Under this management, firm should make payment on due date only, neither early nor
afterwards. Firm is allowed some time to make payment. But firm should not bear loss of cash discount.

2) Centralised Disbursements:-

Under this system, all payments should be made from the central account by Head Office. This
system will help in delaying payments and it will increase time gap in payment before they reach
creditors. If payment is made by local branch, it will not take much time to reach to creditors by post.

In this system, firm will have to maintain lesser total cash as against deentralised disbursement.

49
Where each branch will have to maintain some cash. In this method, greater time will be involved in the
presentation & collection of cheques. Control over payments will also become easier.

3). Float-

Float is the amount which is trapped in cheques but which are yet to be collected. It means that
although cheque has been issued but actual cash will be required later when it will be actually presented
for payment.

For Example:- if the payment of wages and salaries is made by cheque on Ist of every month. It is not
necessary that all cheques would be presented on Ist day. In actual practice, some cheques will be
presented on Ist day, some on 2nd & some on 3rd. Thus firm need not deposit extra amount in bank on
very Ist day.

4) Accruals:-

Wages & other expenses can be paid after the date of actual services rendered to them.

Determining Optimum cash Balance:-

If available cash is more than operating requirements of firm, additional cash should be invested
in short-terms securities. Optimum cash balance is that level of cash at which transaction cost &
opportunity cost are minimum. If firm maintains more cash than optimum level, opportunity cost
increases and transaction decreases and vice versa.

Investing Surplus Cash:-

If nature of surplus cash is permanent, it can be invested in long term assets. While investing
cash in securities, their safety, maturity and marketability should be considered.

a) Safety:- Cash should be invested in those securities, the prices of which do not change substantially
and there is no risk in repayment of its principal & interest.

b) Maturity:- more changes take place in long term securities.

c) Marketability:- of securities means easiness in converting them into cash. Therefore, the surplus
cash should be invested in such securities which can be converted into cash with out much loss.

INVENTORY MANAGEMENT

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 Inventories constitutes the most significant part of current assets of large majority of companies
in India. On an average, inventories are approximately 60% of current assets in public limited
companies in India. Because of the large size of inventories maintained by firms, a considerable amount
of funds is required to be committed to them. It is, therefore absolutely imperative to manage inventories
efficiently in order to avoid unnecessary investment. A firm nelegecting the management of inventories
may fail ultimately. It is possible for a company to reduce its level of inventories to a considerable
degree e.g. 10 to 20% without any adverse effect on production and sales, by using simple inventory
planning and control techniques. The reduction in ‘Excessive’ inventories carries a favourable impact on
a company’s profitability.

Nature of Inventories:- Management of inventory constitutes one of the major investments in current
assets. The various forms in which a manufacturing concern may carry inventory are:

1) Raw Material: These represents inputs purchased and stored to be converted into finished products
in future by making certain manufacturing process of the same.

2) Work in Process: These represent semi-manufactured products which need further processing before
they can be treated as finished products.

3) Finished Goods: These represents the finished products ready for sale in market.

4) Stores and Supplies: These represents that part of inventory which does not become a part of final
product but are required for production process. They may be in form of cotton waste, oil and lubricants,
soaps, brooms, light bulbs etc. Normally they form a very major part of total inventory and do not
involve significant investment.

MOTIVE/NEEDS OF HOLDING INVENTORY

A Company may hold the inventory with the various motives as stated below:

1) Transaction Motive: The company may be required to hold the inventory in order to facilitate the
smooth and unintrupped production and sale operations. It may not be possible for the company to
procure the raw material whenever necessary. There may be a time lag between the demand for the
material and its supply. Hence it is needed to hold the raw material inventory. Similarly it may not be
possible to produce the goods immediately after they are demanded by the customers. Hence it is needed
to hold the finished goods inventory. They need to hold work in progress may arise due to production
cycle.

2) Precaution Motive: In addition to the requirement to hold the inventory for routine transactions, the
company may like hold them to guard against risk of unpredictable changes in demand and supply
forces. Eg. The supply of raw material may get delayed due to factors like strike, transport, disruption,
short supply, lengthy processes involved in import of raw material etc. hence the company should
maintain sufficient level of inventory to take care of such situations. Similarly, the demand for finished

51
goods may suddenly increases (especially in case of seasonal type of products) and if the company is
unable to supply them, it may mean gain of competition. Hence, company will like to maintain sufficient
supply of finished goods.

3) Speculative Motive: The Company may like to purchase and stock the inventory in the quantity
which is more than needed for production and sales purpose. This may be with the intention to get
advantage in term of quantity discounts connected with bulk purchasing or anticipating price rise.

Objectives of Inventory Management

Through the efficient Management of Inventory of the wealth of owners will be maximised. To
reduce the requirement of cash in business, inventory turnover should be maximised and management
should save itself from loss of production and sales, arising from its being out of stock. On the other
hand, management should maximise stock turnover so that investment in inventory could be minimised
and on the other hand, it should keep adequate inventory to operate the production & sales activities
efficiently. The main objective of inventory management is to maintain inventory at appropriate level so
that it is neither excessive nor short of requirement Thus, management is faced with 2 conflicting
objectives.

(1) To keep inventory at sufficiently high level to perform production and sales activities smoothly.

(2) To minimise investment in inventory at minimum level to maximise profitability.

Both in adequate & excessive quantities of inventory are undesirable for business. These mutually
conflicting objectives of inventory management can be explained is from of costs associated with
inventory and profits accruing from it low quantum of inventory reduces costs and high level of
inventory saves business from being out of stock & helps in running production & sales activities
smoothly.
The objectives of inventory management can be explained in detail as under:-

(i) To ensure that the supply of raw material & finished goods will remain continuous so that production
process is not halted and demands of customers are duly met.

(ii) To minimise carrying cost of inventory.

(iii) To keep investment in inventory at optimem level.

(iv) To reduce the losses of theft, obsolescence & wastage etc.

(v) To make arrangement for sale of slow moving items.

(vi) To minimise inventory ordering costs.

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Techniques of Inventory Management

(i) A.B.C. Analysis

A.B.C. analysis is a selective technique of controlling different items of inventory. In actual

practice, thousands of items are included in business as inventories. But all these items are not equally
important. According to this technique, only those items of inventory are paid more attention which are
significant for business. According to this technique, all items are classified into 3 categories A.B. and
C. In ‘A’ category those items are taken which are very precious and their quantity or number is small.

(ii) In ‘B’ category those items are reserved which are less costly than the items of category ‘A’ but their
number is greater.

(iii) In category ‘C’ all those items are included which are low priced but their number is highest.

The rate of use of items of category ‘A’ is the highest and that of category ‘C’ is the lowest. In a
manufacturing organisation, the items of inventory can be classified as under:-
Example:-

Class Number of items in terms of % as per their value

their %
A 15 70
0 10 20 30 40 50 60 70 80 90 100

B 30 20
C 55 10
100 100
% of Costs

Thus, the number of items of category ‘A’ are 15% but their value is 70% of total inventory.
Therefore, inventory management can be made more effective by concentrating control on this category.
Effort are made to minimise investment items of this category. The % of number of items in category ‘B’
is 30 but their value is 20%. Therefore this category will be paid less attention. The items in category ‘C’
is 55% but their value is just 10% of total. Therefore, management need not spend much time for control
of this class
Y of inventory because very little investment is made in them. These items are purchased in
bulk quantity once in 2-3 years. The management must be aware that theses items may be less important
in terms of value but their non-availabetety can break down the production process. Therefore, these
item should available in time A.B.C. analysis can be presented by following diagram also.

53
X
10 20 30
% of40 50
Units 60 70 80 90 100
Advantages of ABC Analysis
(1) A Close and strict control is facilitated on the most important items which constitute a major portion
of overall inventory valuation or overall material consumption & due to this, costs associated with
inventories maybe reduced.

(2) The investment in inventory can be regulated in proper manner & optimum utilisation of available
funds can be assured.

(3) A strict control on inventory items in this manner help in maintaining a high inventory turnover rates.

2) FIXATION OF INVENTORY LEVELS:

Fixation of various inventory levels facilitates initiating of proper action in respect of the movement of
various materials in time so that the various materials may be controlled in a proper way. However, the
following propositions should be remembered.

(i) Only the fixation of inventory levels does not facilitates the inventory control. These has to be a
constant watch on the actual stock level of various kinds of materials so that proper action can be taken
in time.

(ii) The various levels fixed are not fixed on a permanent basis and are subject to revision regularly.

The various levels which can be fixed are as below.

1) Maximum level:

It indicates the level above which the actual stock should not exceed. If it exceeds, it may involved
unnecessary blocking of funds in inventory while fixing this level, following factors are considered.

i) Maximum usage.

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ii) Lead time.

iii) Storage facilities available, cost of storage and insurance etc.

iv) Prices for material

v) Availability of funds.

vi) Nature of material eg If a certain type of material is subject to government regulation in respect of
import of goods etc maximum level may be fixed at a higher level.

vii) Economic order Quantity.

2) Minimum Level: It indicates the level below which the actual stock not reduce, If it reduces, it may
involve the risk of non-availability of material whenever it is required. While fixing this level, following
factors are considered.

i) Lead time.

ii) Rate of consemption

3). Re-order level

It indicates that level of material stock at which it is necessary to take the steps for the
procurement of further lots of material. This is the level falling in between the two existences of
maximum level and minimum level and is fixed in such a way that the requirements of production are
met properly till the new lot of material is received.

4). DANGER LEVEL:

This is the level fixed below minimum level. If the stock reaches this level, it indicates the need
to take urgent action in respect of getting the supply. At this stage, the company may not be able to make
the purchases in the systematic manner but may have to make rush purchases which may involve higher
purchase cost.

CALCULATION OF VARIOUS LEVELS:

The various levels can be decided by using the following mathematical expressions.

1). Re-Order level:-

Maximum lead time X Maximum usage.

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2). Maximum level:-
Re-order level + Re order Quantity- (Minimum Usage X Maximum lead time)

3). Minimum level:-

Re-order level- (Normal usage + Normal lead time)

4). Average level:-

Minimum level + Maximum level

2
5). Danger level:-
Normal Usage X Lead time for emergency Purchases.

3). INVENTORY TURNOVER:

Inventory turnover indicates the ratio of materials consumed to the average inventory held.
It is calculated as below:

Value of Material Consumed

_______________________
Average inventory held

Where value of material consumed can be calculated as:

Opening stock + purchases- closing stock. Average inventory held can be calculated as:

Opening stock + closing stock

__________________________
2

Inventory turnover can be indicated in terms of number of days in which average inventory is consumed.
It can be done by dividing 365 days (a year) by inventory turnover ratio.

4. EOQ:- Economic order Quantity as per notes

include bills payable, notes payable and miscellaneous accruals. Net working capital is the excess of
current assets over current liabilities here. Current assets are those assets which are normally converted
into cash within an accounting year; and current liabilities are usually paid within an accounting year.

What for is working capital required by firm very much depends on the nature of the business which the
firm is conducting. If the firm has business which deals with public utility services, obviously the
requirement will be low. It is primarily because the amount becomes available as soon as services are
sold and also the services arranged by the firm and immediately sold, without much difficulty and

56
complication. On the other hand trading concerns need heavy amounts because these require funds for
carrying goods traded. Similarly many industrial units will also need heavy amounts for carrying on
their business. Many manufacturing concerns will also need sufficiently heavy amounts, the of course
depends on the nature of commodities which are being manufactured.

MANAGEMENT OF RECEIVABLES

“Receivables are asset accounts representing amounts owned to a firm as a result of sale of goods
or services in ordinary course of business.”
Receivables are also turned as trade receivables, accounts receivables, customer receivables, sundry
debtors, bills receivable etc. Management of receivable is also called management of trade credit. The
receivable arising from credit sales contain risk element.

Purpose of Receivables

There a 3 purposes of investing or maintaining Receivables.

(1) Growth in Sales:-

In comparison to cash sales, firm can make high sales by selling on credit, because many
customers do not want to pay cash. Some of the customers may have deficit of cash. Therefore, if any
firm does not sell on credit, it sales may go down.

(2) Increased Profits:-

Due to credit sale of goods and services, the total sales of business can increases. As a result of it,
it profits also start increasing.

(3) Meeting Competition:-

Various firm sell goods on credit to their customer only because their competitors are doing so. If
a firm does not follow credit policy of it competitors, its total sales will decrease because its customers
will be attracted towards other firms.

Objectives of Receivable Management

From creation of receivables the firm gets a few advantages & it has to bear bad debts,
administrative expenses, financing costs etc. In the management of receivables financial manager should
follow such policy through which cash resources of the firm can be fully utilized. Management of
receivables is a process under which decisions to maximise returns on the investment blocked in them
are taken. Thus, the main objectives of management receivable are to maximise the returns on
investment in receivables & to minimise risk of bad debts etc. Because investment in receivables affects
liquidity and profitability, it is, therefore, significant to maintain proper level of receivables. In other

57
words, the basic objectives of receivables management are to maximise the profits. Efficient credit
management helps to increase the sales of the firm. Thus, following are the main objectives of
receivables management:-

(1) To optimise the amount of sales.

(2) To minimize cost of credit.

(3) To optimise investment in receivables.

Therefore, the main objective of receivable management is to establish a balance between

profitability and risk (cost). A business can afford to invest in its receivables unless the marginal costs
and marginal profits are the same. Although the level of receivables is affected by various external
factors like standards of industry, economic conditions, seasonal factors, rate of competition etc,
management can control its receivables. Though credit policies, credit terms, credit standards and
collection procedures.

Aspect, Areas of Receivable Management

(A) Formulation of Credit Policies:-

Credit Policy means such factors which affect the amount of investment in receivable and about
which management has to take decisions for example credit period, cash discount period etc.

Following are the main constituents of credit policy-

(1) Credit Terms:- are these terms on the basis of which credit sales are made to customers. These are
also called terms of repayment of receivable. These are 3 main constituents of credit terms. They are:

(a) Credit Period:-

It is the period for which goods are sold on credit to customers i.e. the period after which
payment is to be made by customers. For example, if customers are required to pay before the end of 30
days from date of sale, it will be written as ‘Net 30’. Credit period normally depends on the standard of
the industry. By raising credit period, not only the sales and profits of firm rise but its costs also rise.
Similarly, by reducing the credit period sales & profits decline on one hand & cost of fund & bad debt
go down on the other. Therefore, on optimum credit policy should be determined by establishing balance
in costs and profits of different credit periods.

(b) Cash Discount:-

A Firm gives cash discount to encourage its customers to pay quickly. In terms of cash
discount, we include rate of cash discount and period for cash discount. The customers who do not to

58
avail of cash discount, they have to make payment before expiry of general credit period. Due to
availability of cash discount average collection period is reduced. As a result, the amount locked up in
receivables declines. Cash discount is a loss to the firm. Therefore, decision to allow cash discount or to
change its rate should be undertaken on the basis analysis of its costs and benefits.

(c ) Cash Discount Period:-

Is the period during which cash discount is available? The period of cash discount affects
average collection period.

Thus, the terms of credit collectively include credit period, cash discount and period of cash
discount. For example, if terms of credit are expressed as ‘2/10, Net 30’ , it means that if the payment is
made with in 10 days, 2% cash discount will be paid. If this cash discount is not avaited of, the payment
has to be made with in 30 days of date of sale.

(2) Credit Standards:-

The term ‘Credit standard’s is basic yardstick of making credit sales to the customers. On
the basis of credit standard it is determined to whom goods are to be sold or not to be sold. The credit
standards followed by a firm affect sales, profits, investment in receivable & costs. If a firm follow loose
credit standards, its sales and receivables will be more as standards, its sales and receivables will be
more as compared, to firm which uses tight credit standards.

(B) Credit Analysis:-

is made to evaluate ability of the customers before making credit sales. A firm should determine
procedure to evaluate applications for credit. On the basis of credit analysis only, a firm should decide to
whom it will sell on credit & for how much amount. To sell on credit, all customers should not be
treated a like. Each customer should be examined properly before selling goods on credit to him.

1) Trade Refrences:-

Firm can ask its customers to mention such names/firms with which they are dealing at present.
This is an important source of credit information after receiving trade references, firm should get desired
informations from them. Sometimes, customer provides names of wrong persons, therefore, before
believing the informations received, the honesty and sincerity of traders should be examined.

2) Bank References:-

The bank of the customers can also provide important credit information’s about the customer.
Such information’s are obtained by the firm with the help of its bank. Sometimes, firm ask customers to
direct his bank to provide necessary information’s to it. The information’s like average bank balance of
customer, loan given to customer, experience with customer etc can be obtained from bank of customer.

59
Normally, bank does not give clear answer to firm’s question Therefore the firms should collect
information’s from other sources.

3) Financial Statements:-

This is one of easiest way to obtain information’s about credit worthiness of prospective
customers. If prospective customer is a public limited company, there may not be any difficulty in
getting financial statements, in form of profit & loss Account & balance sheet. However, getting
financial statements may be difficult in case of Private Limited companies of partnership firms.

Past Experience:-

This can be considered to be most reliable source of getting information about credit-worthiness
of customer who is dealing with company presently. If there is the question of extending further credit to
existing customer, the company should inevitable consider pas experience while dealing with that
customer.

(c ) Collection Policies:-

are needed because all customers do not pay in time. Some customers pay at slow rate and some
do not make payment at all. The objective of collection policy is to fasten the collection of debt. If the
collection from debtors is delayed, additional funds have to be procured for smooth operation of selling
and production activities. Delay in realisation from debtors also increases possibility of bad debts. Thus,
the main objectives of realisation policy is to reduce the ratio of bad debt & reduce average collection
period.

The collection policy means the steps which are taken to realise the debts from debtors for their
default in non payment with in the stipulated time.

Proper coordination in sales and accounting department should be established to determine clear
collection policy.

Another aspect of collection policy is the methods employed to realise the over dues. After the
end of credit period, firm should undertake necessary steps to make collection from debtors. Initially the
efforts should be polite but with the passage of time they can be made stringent. Among these methods
following are included:-

(1) Reminder letters

(2) Telephone
(3) Telegram
(4) Extension of Payment Period
(5) Legal Action

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 Before taking any action, difficulties of customers should be examined. Therefore, following
points must be considered for determining collection procedures:-

(1) Collection procedure must be clear.

(2) Before Starting action for collection, the nature of the customers and their business connections
should be considered.
(3) The time gap between due date and action for realisation of debts should be determined
separately for different classes of customers like regular customers, seasonal customers etc.
(4) So far as possible, legal action should be avoided.
(5) The expenses incurred on collection should not exceed the amount of collection of debt.
(6) While estimating collection cost, past experience should be considered.

(D) Evaluation of Credit Policies/ Monitering Receivable:-

The collection policy followed by firm should be optimum. It should neither be too liberal nor
too strict. Proper adjustment in credit policies should be made according to changing ciramstances. To
observe whether credit policy followed by firm is suitable or not, following method can be used.

(1) Turnover of Accounts Receivable:-

This ratio is calculated by dividing annual credit sales by average accounts of receivables. The
objective of this ratio is to measure liquidity.

Credit Sales during the Year

Turnover of Accounts Receivable = ________________________

Average Accounts Receivable.

Months or Days in a year

Average collection Period = _____________________

Turnover of Accounts Receivable

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