BASICS OF FINANCIAL MANAGEMENT

Q1. ‘Financial Management is the management of funds’. Elaborate

 Finance is called as the science of money. It studies the principles and the methods of obtaining funds,
investments of funds and management of surplus money.
 Finance may be defined as a set of functions in an organization which relate to the management of money so that
the organization may carry out its objectives in an effective and efficient manner.
 In simple words finance is defined as the activity concerned with the planning, raising, controlling and
administering of the fund used in the business.

Scope – ‘Financial Management deals with procurement of funds and effective utilisation of funds in a business.’
 Financial management is that managerial activity which is concerned with the planning and controlling of the
firm's financial resources.
 It is an integrated decision making process concerned with acquiring, financing and managing assets to
accomplish the overall goal of a business organisation.
 Financial managers have a major role in cash management, acquisition of funds and in all aspects of raising and
allocating capital. As far as business organisations are concerned, the objective of financial management is to
maximise the value of business.
 “Financial management comprises the forecasting, planning, organising, directing, co-ordinating and controlling
of all activities relating to acquisition and application of the financial resources of an undertaking in keeping with
its financial objective.”

Procurement Utilization

Owners
Borrowings
Funds Venture ADR, GDR, Fixed Current
(Debenture, Capital FCCB, ECB Assets Assets
(Share
Bonds)
Capital)

Meaning of Finance

 Finance may be defined as an art or a science of managing money. It includes financial service and financial
instruments. Basically, finance function is the procurement of funds and their effective utilization in a business.
 Webster’s Ninth New Collegiate Dictionary defines finance as ‘the science on study of the management of funds’
and the management of fund as the system that includes the circulation of money, the granting of credit, the
making of investments, and the provision of banking facilities.

Meaning of Business Finance

 According to Wheeler, “Business finance is that business activity which concerns with the acquisition and
conversion of capital funds in meeting financial needs and overall objectives of a business enterprise”.
 Basics of Financial Mgt.
 According to Guthumann and Dougall, “Business finance can broadly be defined as the activity concerned with
planning, raising, controlling, administering of the funds used in the business”.
 In the words of Parhter and Wert, “Business finance deals primarily with raising, administering and disbursing
funds by privately owned business units operating in nonfinancial fields of industry”.

Definition of Financial Management

 “It is concerned with the efficient use of an important economic resource namely, capital funds”. – Solomon
 Financial management “as an application of general managerial principles to the area of financial decision-
making. – Howard and Upton
 Financial management “is an area of financial decision-making, harmonizing individual motives and enterprise
goals”. – Weston and Brigham
 Financial management “is the operational activity of a business that is responsible for obtaining and effectively
utilizing the funds necessary for efficient operations. – Joseph and Massie
 Thus, financial management is broadly concerned with raising of funds, creating value to the assets of the
business enterprise by efficient allocation of funds. It is the study of integration of the flow of funds in the most
optimal manner to maximize the returns of a firm by taking proper decisions in utilizing the funds. In other words,
raising of funds should involve minimum cost and to bring maximum returns.

Q2. Short Notes on Objectives of Financial Management

a) Profit Maximisation:
The finance manager has to make his decisions to maximise the profits of the concern. It ensures that a firm utilizes
its available resources most efficiently under conditions of competitive markets.

Advantages Disadvantages / Limitations

Profits are vital for survival of business. The term “Profit” is vague.
Essential for the growth and development of business. Higher the profits, higher the risks involved. It
may ignore the risk or uncertainty element.
Impact on society through payment to factors of Ignores time pattern of return, difficult to sustain
production. in the long run.
Profit-making firms only can pursue social obligations Ignores social and moral obligations of business.

b) Wealth Maximisation:
The objective of a firm should be to maximise its value or wealth. Wealth or Value of a firm is represented by the
market price of its shares. This value is a function of two factors:
 The expected rate of Earnings Per Share (EPS) of the company; and
 The Capitalisation Rate.
Value of a Firm = Earnings per Share (EPS)
Capitalization Rate (%)
EPS: Earnings per Share (EPS) depends upon the assessment as to how profitably a company is going to operate in
the future or what it is likely to earn against each of its ordinary shares.

Capitalisation Rate: It is the cumulative result of the assessment of the various shareholders regarding the risk and
other qualitative factors of a company. This rate reflects the liking of the investors for a company. Wealth
maximization is a better objective for a business since it represents both return and risk.
 Basics of Financial Mgt.

Advantages Disadvantages
i) Emphasizes the long term i) Offers no clear relationship between
ii) Recognises risk or uncertainty financial decisions and share price,
iii) Recognises the timing of returns ii) Can lead to management anxiety and
iv) Considers shareholders' return. frustration.

Q3. ‘There is a conflict between Profit Maximization and Wealth Maximization function’. Discuss
 Basically, profit maximization is a short-term goal. It is usually interpreted to mean the maximization of profits
within a given period of time. A firm may maximize its short-term profits at the expense of its long-term profitability
and still realize this goal. In any company, the management (Board of Directors) is the decision taking authority.
Normally, the basic tendency of any management is to maximize enterprise profits (i.e. profit maximization).
 However, in an organization where there is a significant outside participation (through shareholding, lenders etc.),
the management is under constant supervision of the various stakeholders of the company – employees,
creditors, customers, government, etc. Every entity associated with the company will evaluate the performance of
the management for the fulfilment of its own objective. The success of the enterprise shall depend on satisfaction
of the stakeholders. Shareholder wealth maximization is a long-term goal shareholders are interested in future as
well as present profits.
 Thus, the wealth maximization objective is wider and it covers the interests of the various groups such as owners,
employees, creditors and society, and thus, it may be consistent with the management objective of survival.
Hence, in today’s world, wealth maximization is a better objective.
 Wealth maximization is generally preferred because it considers – (a) wealth for the long-term, (b) risk or
uncertainty, (c) the timing of returns, and (d) the shareholders’ return.

Objects of Financial 
Management

1. Wealth Maximization  2. Profit Maximization 
of Shareholders of Company

Q4. Distinguish between profit maximization and wealth maximization.

Sr. Profit Maximization Wealth Maximization
1 Focus on the short term Focus on the long term
2 Profits are vital for survival of business Wealth incudes shareholders' return.
3 Narrow approach (BOD/ shareholders) Broad approach (all stakeholders)
4 Higher the risk, high the profits Risk is considered, but no emphasized upon
5 Ignores the time value of money Recognizes the timing of returns
6 Linked to annual profits Linked to share prices and dividends
7 Profits can be manipulated through Wealth is a real concept and difficult to
window dressing manipulate easily.
 Basics of Financial Mgt.

Q5. What are the Roles / Functions of a Finance Manager?

1. Fund Requirement Estimation:
 The requirements of funds have to be carefully estimated.
 The purpose of funds (investment in fixed assets or working capital) & timing of funds should be determined.
 This involves the use of techniques like budgetary control and long range planning.
 This calls for forecasting all physical activities of the organisation and translating them into monetary terms.

2. Determining Sources of Finance

 Identify the various sources of finance – long, medium and short term.
 Select the sources of funds which are most suitable for the company. Such choice should be exercised with
great care and caution.

3. Capital Structure / Financial Decisions:

 Decisions regarding capital structure (called financing decisions) should be taken to provide proper balance
between (a) long-term and short-term funds (b) loan funds and own funds.
 Long-term funds are required to (a) finance fixed assets and long-term investments and (b) provide for
permanent needs of working capital. Short Term Funds are required for Working Capital purposes.
 A proper mix of various sources has to be worked out by the Finance Manager.

4. Investment decisions:
 Funds procured should be invested / utilised effectively.
 Long Term Funds should be invested (a) in Fixed Assets / Projects after Capital Budgeting and (b) in
Permanent Working Capital after estimating the requirements carefully.
 Asset management policies should be laid down, for Fixed Assets and Current Assets.

5. Dividend decisions:
 The Finance Manager assists the top management in deciding as to (a) what amount of dividend should be
paid to shareholders and (b) what amount should be retained in the business itself.
 Dividend Decisions depend upon numerous factors like (a) earnings, (b) trend of share market prices, (c)
requirement of funds for future growth, (d) cash flow situation, (e) tax position of shareholders

6. Cost Control:
Financial Manager is responsible for monitoring and analyzing cost over-runs. He can make recommendations to
the top management for controlling the costs relating to purchases, production, distribution etc.

7. Cost-Volume-Profit (CVP) Analysis / Profit Planning

 In-depth study of fixed costs, variable costs and semi-variable costs is needed
 Ensure that the income / revenues are sufficient to cover the variable costs, i.e. a positive contribution.
 To determine the BEP of the business and take key decisions to improve profitability of the enterprise.

8. Taxation
 Corporate taxation is an important function of the financial management.
 Taxation includes direct taxes such as Income Tax as well as indirect taxes such as Excise, Service Tax, etc.
 Taxation functions include periodical compliances as well as tax management techniques.
 Proper tax planning and management is vital for the wealth maximization function of the enterprise.
 Basics of Financial Mgt.
9. Cash Management Decisions (Working Capital):
 The Finance Manager has to ensure that all sections/ branches/ factories/ departments and units of the
organisation are supplied with adequate funds (cash), to facilitate smooth flow of business operations.
 He should also ensure that there is no excessive cash (idle funds) in any division at any point of time.
 For this purpose, cash management and cash disbursement/ transfer policies should be laid down.

10. Performance Evaluation / Financial Analysis:

 The Finance Manager has to evaluate financial performance of various units of the organisation. There are
various tools of financial analysis viz. Budgetary Control, Ratio Analysis, Cash Flow and Fund Flow Analysis,
Common Size Statement analysis, Intra-Firm Comparison etc.
 Financial Analysis helps management to assess how effectively funds are utilised & identify improvements

11. Financial negotiations:

The Finance Manager is required to interact and carry out negotiations with financial institutions, banks and public
depositors. Negotiations with outside financiers require specialised skills.

12. Market Impact Analysis:

 The Finance Manager has to keep in touch with stock exchange quotations and behaviour of share prices.
 It involves analysis of trends in stock market and judging their impact of the share price of the Company.

13. Product / Services Pricing:

The Financial Manager can supply important information about cost at varying levels of production and the profit
margins needed to carry on the business successfully. In fact, financial manager analyses information for pricing
decisions and contribute to the formulation of pricing policies jointly with the marketing manager.

14. Corporate Restructuring (M & A deals)

 Corporate restructuring includes external growth through mergers and acquisitions.
 Valuation and financing M & A deals is an important aspect of corporate restructuring. The process of valuing
a firm and its securities is difficult, complex and prone to errors. The financial manager should, therefore, go
through a valuation process very carefully.

Sources 
M & A  of Funds Invt. 
Deals Decision

Pricing  Cost 
Decision Control

Stock 
Financial 
Exch. 
Analysis
Mgt. Financing 
Decision

Profit  Dividend 
Planning Decision
Internal 
Tax Mgt.
Control
 Basics of Financial Mgt.

Q6. What are the major decisions of a finance manager

OR
The major decisions of a finance manager are inter-related. Comment.

A) Investment Decisions
 Investment ordinarily means utilization of money for profits or returns. These decisions determine how scarce
resources in terms of funds available are committed to projects.
 Basically, it implies creating or purchasing physical assets and carrying on business or purchasing shares or
debentures of a company or even acquisition of another company.
 The investment of funds in a project has to be made after careful assessment of the various projects through
capital budgeting exercise as well as financing the working capital requirements.
 Investment decisions are commitments of monetary resources, in expectation of economic returns in future.
Choice is required to be made amongst available resources and avenues for investment.
 Thus, investment decisions have become the most important area in the decision making process. Such
decisions are essentially made after evaluating the different proposals with reference to growth and profitability
projections of the company. The choice helps achieve the long term objectives of the company i.e. survival and
growth, preserving market share of its products and retaining leadership in its production activity.
 Investment decisions include expansion, replacement of assets or modernization etc.

B) Financing Decisions
 Financing decisions relate to acquiring the optimum finance to meet funds requirement and seeing that fixed and
working capital are effectively managed.
 The financial manager needs to possess a good knowledge of the sources of available funds and their respective
costs, and needs to ensure that the company has a sound capital structure, i.e. a proper balance between equity
(own) capital and debt (borrowing).
 Financing decisions also need a good knowledge of risk evaluation e.g. excessive debt carries higher risk than
equity because of the priority rights of the lenders.

C) Dividend Decisions
 Dividend decisions relate to the determination as to how much and how frequently cash can be paid out of the
profits of an organization as income for its owners / shareholders.
 The dividend decisions thus has two elements – the amount to be paid out and the amount to be retained to
support the growth of the organisation, the latter being also a financing decision; the level and regular growth of
dividends represent a significant factor in determining a profit-making company's market value.
 Theoretically, this decision should depend on whether the company or its shareholders are in the position to
better utilize the funds, and to earn a higher rate of return on funds.
 However, in practice, a number of other factors like the market price of shares, the trend of earning, the tax
position of the shareholders, cash flow position, requirement of funds for future growth, and restrictions under the
Companies Act, etc. play an important role in the determination of dividend policy of business enterprise.
 Basics of Financial Mgt.
D) Liquidity Decision (Ability to meet current obligations)
 Liquidity can be defined as the ability of a business to meet its short-term obligations.
 It shows the speed (efficiency) with which a business can convert its assets into cash to pay what it owes in the
near future.
 It also focuses attention on the availability of funds. Enhancement of liquidity enable to corporate body to have
more funds from the market.
 A company will need to maintain liquidity for transaction purposes, precautionary measures and for speculative
opportunities.
 Liquidity is assessed through the use of ratio analysis. Liquidity ratios provide an insight into the present cash
solvency of a firm and its ability to remain solvent in the event of calamities. Ratios such as current ratio, quick
ratio, cash ratio etc. show the liquidity position of a company at a given point of time.
 Further, liquidity is affected by the credit policy of the company. The same can be seen through average
collection and payment period. A higher inventory turnover ratio also facilitates faster conversion of stock into
sales and in-turn into cash.
 Liquidity is a vital decision for a business to ensure timely payment of current obligations. A poor liquidity position
may affect the goodwill of a business. The firm may lose lucrative opportunities, affecting its wealth maximization
function.

Investment  Financing  Dividend  Liquidity (W. Cap)

Decision Decision Decision

•Expansion •Debt‐Equity •Payout vs.  •Stock

•Modernization •Mix of Own &  Retention, i.e.  •Debtors
•Diversification Borrow funds re‐invest •Cash Mgt.

Q7. Factors affecting Decision Criteria

Decision criteria depends upon the objective to be achieved through the decision making process. The main
objectives which a business organisation pursues are maximisation of return and minimization of costs. A fair
decision criterion should consider various proposals and select the best alternative.

A fair decision criterion should follow the following two fundamental principles i.e.
(1) the “Bigger and Better” principle which implies bigger benefits as compared to smaller ones; and
(2) “A Bird in Hand is Better than Two in the Bush” principle, which implies early benefits are better to later benefits.

Further, factors such as urgency of matter, recovery of funds, rate of return and profitability etc. shall be considered.

Short Notes
a) Profitability

 Profitability is an important tool in financial management for decision-making.

 It is used to measure and compare performance of a business. Profitability can be related to sales or to total
capital employed or to net worth of the company.
 Profit to sales ratio reflects the company’s ability to generate profits per unit of sales. Absence of adequate
profitability ratio on sales reflects the company’s inability to utilise assets effectively.
 From investors point of view profits are compared as percentage to the capital employed in the business.
Another important profitability ratio is Profits on Equity, i.e. PAT in relation to shareholders’ funds. This is an
indicator of profits earned on funds invested by the owners. It is an indicator of actual returns received by them.
 Basics of Financial Mgt.
 For assessment of profitability as a decision criterion return on investment (ROI) is a frequently used ratio.
Return on Investment: This is an important profitability ratio from the angle of shareholders and reflects on the
ability of management to earn a return on resources put in by the shareholders.
 Inadequacy of profit margin is an evidence of company’s inability to achieve satisfactory results.

b) Costing and Risk

 In financial management, costing relates to the system adopted for assessing cost of capital from various
sources viz., equity and preference shares, debentures, long-term borrowings from financial institutions, etc.
 Equity capital is owner’s money employed in the business whereas borrowed funds are creditors’ funds carrying
an interest obligation and repayment schedule.
 Thus risks are involved if interest is not paid or on account of default in repayment of principal.
 It is ensured that the rate of interest on borrowed funds is usually lower than the returns expected by the
investors or risk-takers in the business. Moreover, interest paid is deductible for tax purposes.
 But if the company is unable to earn sufficient returns, the returns for owners are reduced and risk increases.
Using borrowed funds or fixed cost funds in the capital structure of a company is called financial gearing.
 High financial gearing will increase the earnings per share of a company if earnings before interest and taxes
are rising, as compared to the earnings per share of a company with low or no financial gearing.
 Risk is associated with fixed interest on debt capital. Higher the interest, the greater the chance that it will not be
covered by earnings and so greater the risk. Any internal disturbance or external constraint that may hamper the
company’s production and sales will reduce inflow of funds but fixed interest charges have to be paid.

c) Value of Firm – Risk and Return

A Financial Manager tries to achieve the proper balance between considerations of ‘risk and return’ associated with
various financial management decisions to maximize the market value of the firm. It is well known that ‘higher the
return, other things being equal, higher the market value, higher the risk and vice versa’. In fact, risk and return go
together. This implies that a decision alternative with high risk tends to promise higher return and reverse is true.

d) Distinguish between Business Risk and Financial Risk

Sr. Business Risk Financial Risk

1 Business risk is associated with the Financial risk is associated with the
variation in operating profits (EBIT) variation in net profits (PAT)

2 Business risk occurs due to excessive Financial risk occurs due to excessive
fixed cost in the company. fixed interest in the company.

3 Higher business risk results in higher Higher financial risk leads to inability to
break-even point pay bank interest (EMIs)

4 Also known as operating risk and Measured by financial leverage

measured by operating leverage

5 Business risk is not affected by the capital Financial risk is due to the debt-equity
structure of company, i.e. debt-equity ratio of a company, i.e. capital structure

6 Result of Investment Decision Result of Financing Decision

 Basics of Financial Mgt.
e) Financial Management – Art or Science
 Financial Management is a social science as it deals with people. Also, it is applied in practical affairs and solving
business problems. But, there is a wide scope for application of value judgement in financial decisions-making.
 Most practical problems of finance have no fixed answers that can be worked out mathematically or programmed
on a computer. They must be solved by judgement, intuition and experience.
 Theory of financial management is based on certain systematic principles, some of which can be tested in
mathematical equations (as natural science). The use of computers, operations research, statistical techniques
and econometric models find wide application in financial management as tools for solving corporate financial
problems like budgeting, choice of investments, acquisition or mergers etc.
 This takes the financial management nearer to treatment as a subject of real science.
 Hence, knowledge of facts, principles and concepts is necessary for making decisions but personal involvement
of the manager through his intuitive capacities and power of judgement becomes essential.

f) Financial Distress & Insolvency

 Generally, a business should be managed to reduce the risk and maximize the returns of the shareholders.
 Business risk includes variability of demand for its products, their prices, input prices etc.
 Financial risk is due to high proportion of debt in the capital structure requires a high level of interest payments.
If cash inflows are inadequate, the firm will face difficulties in payment of interest and repayment of principal.
 If such a situation continues for a long time, the firm would face pressure from creditors. Reduced sales can
also cause difficulties in carrying out production operations.
 In such a scenario, the firm would face a lot of difficulties – investors would not invest further, creditors and
lenders would recall their loans, market share price would fall heavily etc. Thus, the firm would find itself in a
situation called as ‘financial distress’.
 It may have to sell its values i.e. resort to distress sale. So, when sale proceeds are inadequate to meet outside
liabilities, the firm is said to have become bankrupt or insolvent (after legal proceedings).
 Failure of a firm to meet its current obligations could be temporary and might be corrected.
 When liabilities exceed assets i.e. the net worth becomes negative, bankruptcy / insolvency arises.
 Bankruptcy can be ascertained by comparing current assets and current liabilities, i.e. the ability of the firm to
discharge its short term liabilities.
 Examples of solvency ratios are Debt to Equity ratio, Debt to total Funds Ratios, and Interest coverage ratio.
Trend analysis should be made for the past three to five years to pick up signals of bankruptcy, if any.

g) Economic Value- Added (EVA)

 Economic value added (EVA) is the after tax cash flow generated by a business over and above the cost of the
capital it has deployed to generate that cash flow. EVA represents the real profits versus paper profits.
 EVA stresses on measuring shareholders value. Practically, shareholders provide funds to a firm so that they
gain a return on that capital.
 EVA concept is related to the wealth maximization function, since the ‘value addition’ is the surplus returns
earned by the shareholders. EVA represents the surplus earned after meeting all obligations, i.e. wealth creation.
 There are two key components to EVA. The Net Operating Profit After Tax (NOPAT) and the capital charge,
which is the amount of capital multiplied by its cost of capital.
 Basics of Financial Mgt.
 The cost of capital is the minimum rate of return on capital required to compensate debt and equity investors for
bearing risk-a-cut-off rate to create value and Capital is the amount of cash invested in the business. In formula
form –
EVA = (Operating Profit) – (The Capital Charge)
EVA = NOPAT – (Cost of Capital x Capital)
 However, to compute EVA, certain adjustments should be made to the NOPAT as well as the capital employed in
business.
 Implementing EVA in a company is a kind of change process which should be given some management effort.
However, if right actions are taken straight from the beginning then implementing EVA should be one of the
easiest change processes that a company goes through. The actions might include e.g. gaining commitment of all
members of the management group through training and discussing, training of the other employees, especially
all the key persons and adopting EVA in all levels of organizations
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 RATIO ANALYSIS NUMERICAL
Q1. Given below is balance sheet and income statement of Alpha Co. Ltd.

Liabilities Amt. Rs. Assets Amt. Rs.

Creditors 300 Cash 400
Accrued expenses 200 Debtors 1,600
Short Term advances 1,000 Inventory 2,000
Long term loans 2,000
Share Capital 4,000 Fixed Assets 3,500
(Face value Rs.10)
Total 7,500 Total 7,500

Particulars Rs.
Sales (all credit) 13,000
(-) Cost of Goods Sold 9,000
Gross Profit 4,000
(-) Admin, selling, general expenses 2,000
Profit before interest and tax 2,000
(-) Interest 500
Profit before tax 1,500
(-) Income Tax 500
Profit after tax 1,000

Calculate the following ratios –

a) Current ratio b) Debtors Turnover Ratio
c) Inventory Turnover period d) Return on Equity
e) Acid test ratio f) Return on Capital Employed
g) Capital turnover ratio h) Earnings per share

Q2. Given below is balance sheet of Primary Co. Ltd. Compute the ratios and comment.

Liabilities Amt. Rs. Assets Amt. Rs.

Equity Capital 100,000 Fixed Assets 162,000
6 % Preference Capital 50,000 Stock 22,000
7 % Debentures 20,000 Debtors 51,000
Creditors 64,000 Bills Receivables 2,000
Tax provision 15,000 Bank 12,000
Total 249,000 Total 2,49,000

▪ Current ratio
▪ Absolute Cash ratio
▪ Proprietary ratio
▪ Liquid ratio
▪ Debt Equity ratio

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 1

 Ratio Analysis
Q3. Given below is balance sheet of Tertiary Ltd.

Liabilities Amt. Rs. Assets Amt. Rs.

Equity Capital 2,50,000 Fixed Assets 2,60,000
Reserves 1,16,000 Long Term Investment 40,000
Bank Loan 1,00,000 Stock 1,20,000
Creditors 1,34,000 Debtors 70,000
Prepaid expenses 20,000
Bank 90,000
Total 6,00,000 Total 6,00,000

Given – Sales Value Rs. 6,00,000 and Profit before Interest and Tax Rs. 1,50,000
Calculate the following ratios and comment on the same -
▪ Current Ratio
▪ Stock Turnover Ratio
▪ Return on Capital Employed
▪ Liquid ratio
▪ Return on Net-worth

Q4. Given below is balance sheet of HP Compaq Ltd.

Liabilities Amt. Rs. Assets Amt. Rs.

Equity Capital 6,00,000 Fixed Assets 30,00,000
(Face Value Rs. 10 each)
Reserves 4,00,000 Stock 6,00,000
Profit & Loss Account 5,00,000 Debtors 5,00,000
Long Term Loans 20,00,000 Bank balance 1,00,000
Other Current Liabilities 2,50,000
Creditors 4,50,000
Total 42,00,000 Total 42,00,000

Given – Net Profit Rs. 4,50,000 and Market price per share Rs. 500
Calculate the following ratios and comment on the same -
▪ Debt-Equity Ratio
▪ Acid Test Ratio
▪ Earnings per share
▪ Current ratio
▪ Price Earnings Ratio

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 2

 Ratio Analysis
Q5. Following data is available for two companies Amar Ltd. and Prem Ltd. Prepare a statement of comparative ratios
showing liquidity, profitability, activity and financial position of the two companies.

Particulars Amar Ltd. (Rs.) Prem Ltd. (Rs.)

Sales / Revenue 32,00,000 30,00,000
Net Profit after Tax 1,25,000 1,60,000
Equity Share Capital
10,00,000 8,00,000
(Face Value Rs. 10 per share)
General Reserves 2,30,000 6,40,000
Long Term Debt 8,00,000 6,00,000
Creditors 3,80,000 5,50,000
Bank Overdraft 60,000 200,000
Fixed Assets 16,00,000 16,00,000
Inventories / Stock 3,30,000 8,00,000
Bank Balances 5,40,000 4,50,000

Q6. Given below are the financial statements of a company.

Balance Sheet as on 31st March 2011

Liabilities Rs. Assets Rs.

Equity Share Capital 5,50,000 Net Fixed Assets 15,00,000
Reserves & Surplus 3,50,000
Long Term Loans 4,50,000 Cash & Bank 50,000
Sundry Creditors 4,00,000 Receivables 3,25,000
Bills Payable 2,50,000 Inventory 1,25,000
Total 20,00,000 Total 20,00,000

Income Statement for the year ended 31st March 2011

Particulars Rs.
Sales 30,00,000
COGS 22,00,000
Operating Expenses 4,00,000
Depreciation 1,00,000
EBIT 3,00,000
Interest 50,000
Taxable Income 2,50,000
Income Tax (30%) 75,000
Profit After Tax 1,75,000

Compute the following Ratios –

Current Ratio Debt-Equity Ratio Return on Equity

Quick Ratio Interest Coverage Ratio Debtors Turnover Ratio
Total Asset Turnover Ratio Net Profit Margin Debt-Assets Ratio
Inventory Turnover Ratio Return on Capital Employed Gross Profit margin

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 3

 Ratio Analysis
Q7. Given below are financial statements of Mukesh Ltd. and Anil Ltd. Answer the following questions.

Liabilities Mukesh Rs. Anil Rs. Assets Mukesh Rs. Anil Rs.
Creditors 9,00,000 10,50,000 Cash 2,10,000 3,20,000
8 % Debentures 5,00,000 10,00,000 Debtors 3,30,000 6,30,000
Equity Capital (FV 10) 11,00,000 17,50,000 Stock 12,30,000 9,50,000
Reserves Surplus 9,65,000 5,00,000 Machinery 16,95,000 24,00,000
Total 34,65,000 43,00,000 Total 34,65,000 43,00,000

Net Sales 56,00,000 82,00,000

COGS 40,00,000 64,80,000
Operating exp 8,00,000 8,60,000
Interest 40,000 80,000
Income Tax 3,80,000 3,90,000
Dividends 1,00,000 1,80,000

a) Which company is using the equity shareholders' money more profitably?

b) Which company is better able to meet its current debts?
c) If you were a Bank and want to give long term loan, which company would you chose?
d) Which company collects its receivables faster, assuming all sales are on credit?
e) How long does it take for each company to convert its stock to money?
f) Which company retains larger proportion of income in the business?
g) Whether the fixed assets being used efficiently? By which company?

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 4

 LONG TERM FINANCE & COST OF CAPITAL
1. LONG TERM FINANCE

The primary goal of financial management is ‘maximization of shareholders’ wealth’. Hence, all decisions of
management are directed towards such wealth maximization. There are three basic functions of financial
management, viz. investment decisions, financing decisions and dividend decisions.

A business requires funds to purchase fixed assets like land and building, plant and machinery, furniture etc. These
assets may be regarded as the foundation of a business. The capital required for these assets is called fixed
capital. Funds required for long term fixed capital is called long term finance.

2. FEATURES OF LONG TERM FINANCE

 It involves financing for fixed capital required for investment in fixed assets

 It is obtained from Capital Market

 Long term sources of finance have a long term impact on the business

 Generally used for financing big projects, expansion plans, increasing production, funding operations.

3. PURPOSES OF LONG TERM FINANCE

1. To finance Fixed Assets – Business requires fixed assets like machines, building, furniture etc. Finance
required to buy these assets is for a long period, because such assets are used for long period.

2. To finance the Permanent Working Capital – Business is a continuing activity. It must have a certain
amount of working capital which would be needed again and again. This part of working capital is of a fixed
or permanent nature. This requirement is also met from long term funds.

3. To finance Growth and Expansion of business – Expansion of business requires investment of a huge
amount of capital permanently or for a long period.

4. FACTORS DETERMINING LONG TERM FINANCE

a) Nature of Business – The nature of a business determines the amount of fixed capital. A manufacturing
company requires land, building, machines etc. So it has to invest a large amount of capital for a long
period. But a trading firm will require a smaller amount of long term fund as it does not have to buy building
or machines. Also, a service oriented firm will not require much long term funds.

b) Nature of goods produced – If a business is engaged in manufacturing small and simple articles it will
require a smaller amount of fixed capital as compared to one manufacturing heavy machines or heavy
consumer items like cars, refrigerators etc. which will require more fixed capital.

c) Technology used – In heavy industries like steel the fixed capital investment is larger than in the case of a
business producing plastic jars using simple technology or using labour intensive technique.
 Cost of Capital

5. SOURCES OF LONG TERM FINANCE

 Shareholders’ Funds (Equity Capital)

o Equity Share Capital
o Preference Share Capital
o Retained Earnings

 Borrowed Funds (Loan Funds)

o Debentures Issues
o Loans from Financial Institutions
o Deposits / Bonds etc.

6. COST OF CAPITAL

 Cost of Capital can be defined as the minimum rate of return that a firm must earn on its investments, so
that the market value of the firm is constant.

 It is the cut-off rate for determining future benefits (cash flows) against current investments.

 The decision regarding feasibility of a project is taken on the basis of cost of capital.

 Hence, cost of capital is the cost of obtaining funds from various sources.

 Thus, cost incurred by a company for obtaining funds is the minimum rate of return that it must earn.

 It can be stated as the opportunity cost of an investment, i.e. the rate of return that a company would
otherwise be able to earn at the same risk level as the investment that has been selected.

 John J. Hampton defined “Cost of capital is the rate of return the firm required from investment in order to
increase the value of the firm in the market place”

 According to Ezra Solomon “Cost of capital is the minimum required rate of earnings or the cut-off rate of
capital expenditure”.

 James C. Van Horne defined it as “a cut-off rate for the allocation of capital to investment of projects. It is
the rate of return on a project that will leave unchanged the market price of the stock”.

 According to William and Donaldson, “Cost of capital may be defined as the rate that must be earned on
the net proceeds to provide the cost elements of the burden at the time they are due”.

7. IMPORTANCE OF COST OF CAPITAL

 Securities analysts use Cost of Capital in valuation and selection of investments.

 In discounted cash flow analysis, Cost of Capital is used as the discount rate applied to future cash flows
for deriving a business’s net present value. It is an important constituent in Capital Budgeting decisions.

 It also plays a key role in Economic Value Added (EVA) calculations. Used for deciding debt-equity mix.

 Investors use Cost of Capital as a tool to decide whether or not to invest. It is known as ‘Hurdle Rate’

 Cost of Capital represents the minimum rate of return at which a company produces value for its investors.

 Cost of Capital is used for evaluating investments plans, discounting cash flows, compare with ROI.

 Weighted Average Cost of Capital is the outcome of the relative proportions of different sources of finance.
 Cost of Capital

8. TYPES OF COST OF CAPITAL

a) Explicit and Implicit Cost

Explicit cost is the rate that the firm pays to procure financing. Implicit cost is the rate of return associated with
the best investment opportunity for the firm and its shareholders that will be forgone if the projects presently
under consideration by the firm were accepted. In other words, implicit costs refer to the opportunity cost.

b) Average and Marginal Cost

Average cost of capital is the weighted average cost of each component of capital employed by the company. It
considers weighted average cost of all kinds of financing such as equity, debt, retained earnings etc. Marginal
cost is the weighted average cost of new finance raised by the company. It is the additional cost of capital when
the company goes for further raising of finance.

c) Historical and Future Cost

Historical cost is the cost which has already been incurred for financing a particular project. It is based on the
actual cost incurred in the previous project. Future cost is the expected cost of financing in the proposed project.
Expected cost is calculated on the basis of previous experience.

d) Specific and Combine Cost

The cost of each sources of capital such as equity, debt, retained earnings and loans is called as specific cost of
capital. It is very useful to determine the each and every specific source of capital. The composite or combined
cost of capital is the combination of all sources of capital. It is also called as overall cost of capital. It is used to
understand the total cost associated with the total finance of the firm.

9. FACTORS DETERMINING COST OF CAPITAL

1. General Economic Conditions – Economic conditions determine the demand and supply of funds within the
economy, as well as expected inflation. Any change in demand and supply of money in the economy changes
the interest rates. Thus, if demand for money increases without much increase in supply, there will be rise in
interest rate and vice versa.

2. Market Conditions – Where risk increases, an investor requires a higher rate of return. Such increase is
called a risk premium. When investors increase their required rate of return, the cost of capital rises
simultaneously. The rate of return also depends on the ease of marketability of securities.

3. Operating and Financing Decisions – Various decisions of a company creates different levels of risk. Such
risk is divided into two types: business risk and financial risk. As business risk and financial risk increase or
decrease, the investor’s required rate of return (and the cost of capital) will move in the same direction.

4. Amount of Financing – Cost of funds depends on the level of financing that the firm requires. As the fund
requirements is higher, the cost of capital increases due to additional flotation costs, legal compliances,
underwriting commission, brokerage etc.
 Cost of Capital
5. Controllable Factors

a. Capital Structure Policy (Debt-Equity ratio) – A firm can control its debt-equity ratio, and it targets an
optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued,
the cost of equity increases.

b. Dividend Policy – A company can control its dividend payout ratio. For example, as the payout ratio of the
company increases, more the cash outflow and additional need for funds is created.

c. Investment Policy – Generally, while taking investment decisions, a company is making investments with
similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt
and cost of equity change.

6. Uncontrollable Factors

a. Interest Rates – The level of interest rates will affect the cost of debt and, potentially, the cost of equity.
For example, when interest rates increase the cost of debt increases, which increases the cost of capital.

b. Tax Rates – Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases,
decreasing the cost of capital.

c. Inflation Rates – The rate of inflation affects purchasing power, and thus affects cost of capital.

10. MEASUREMENT OF COST OF CAPITAL

a) Cost of Debt Capital (‘Kd’)

 Basically, debt capital represents long term borrowing of a company.
 Borrowings include Debentures and funds obtained from financial institutions, banks, Government etc.
 The period of borrowing is fixed and the rate of interest is also fixed. Interest payment is mandatory i.e.
payable even in case of losses.
 However, interest is tax deductible, i.e. tax shield is available on interest payments.

Cost of Term Loans (Kd) = Interest (1 – tax rate) * 100

Net Proceeds
Debentures:
 Debentures are issued by companies to the public and financial institutions.
 Debentures can be classified as irredeemable & redeemable. Irredeemable debentures are not redeemable
during life of company, whereas redeemable debentures are redeemed at maturity.
 The rate of interest is fixed, and it is paid on its face value.
 Interest attracts tax benefits and it is payable even in case of losses.
 Debentures can be issued at par, premium or discount as well as redeemed at par, premium or discount.
 Based on issue and redemption value, the net proceeds received at maturity value paid will changes
accordingly.

Cost of Irredeemable Debentures (Kd) = Interest (1 – tax rate) * 100

Net Proceeds
 Cost of Capital
Cost of Redeemable Debentures (Kd) = Interest (1 – tax rate) + (RV – NP) / N * 100
(RV + NP) / 2
Where,
RV = Redeemable value on maturity
NP = Net Proceeds on issue N = Life of redeemable debt.

b) Value of Bonds
In case of bonds, cash flows and the discount rate can be determined easily. They are issued by Govt. and
hence there is no risk of default and there is no difficulty in calculating the cash flows associated with a bond.
The expected cash flows consist of annual interest payments plus repayment of principal. The appropriate
capitalisation or discount rate would depend upon the risk of the bond. The risk in holding a government bond is
less than the risk associated with a debenture issued by a company. Therefore, a lower discount rate would be
applied to the cash flows of the government bond and a higher rate to the cash flows of the company debenture.

Value of Bonds = Annual Coupon * PVIFA (R %, N years) + Maturity Value * PVIF (R %, Nth year)

c) Cost of Preference Share Capital (‘Kp’)

 Preference shares are issued to promoters, venture capitalist who invest in the company in its initial stages.
 Earlier preference shares could be issued with an irredeemable feature. However, after the amendment of
Companies Act, preference shares can be issued for a maximum period of 20 years.
 The rate of dividend on preference shares is fixed and dividend payment is mandatory in cases of sufficient
profits. The dividend is paid as a percent of face value of the shares.
 However, dividends paid on preference shares is a non-tax deductible expense and the company doesn’t
get any tax benefits on payment of preference dividends.
 Preference shares can be issued at par or premium, thus net proceeds changes accordingly.
 Also, redemption of preference capital may be done at par or premium, according to agreement with
preference shareholders.

Cost of Irredeemable Preference Shares (Kp) = Dividends * 100 OR Dividend * 100

Net Proceeds Mkt. Price

Cost of Redeemable Preference Shares (Kp) = Dividend + (RV – NP) / N * 100

(RV + NP) / 2
Where,
RV = Redeemable value on maturity
NP = Net Proceeds on issue
N = Life of redeemable preference shares
 Cost of Capital
d) Cost of Equity Share Capital (‘Ke’)
 Cost of equity shares can be defined as the rate of return expected by equity shareholders.
 Equity shares are issued to promoters, financial institutions and general public.
 Such shares can be issued at par or premium.
 Equity shares of public company are freely transferable.
 The dividend payout is not fixed, as well as rate of dividend not fixed.
 Also, dividend is a non-tax deductible expense and no tax shield is available to the company.
 The cost of equity depends purely upon the expectations of the shareholders. Shareholders’ expectations
and returns are reflected in market price per share.
 Any decline in returns results in adverse share price and vice versa. Since the dividend payment is not
mandatory cost of equity shares cannot be wholly based on dividends.
 The earnings of the company also influence the share price and hence the shareholders’ expectations.
 Thus there are manly two approaches used for computation of cost of equity, based on shareholders’
expectations, i.e. dividends and earnings, coupled with expected growth rate.

i. Dividend Price Approach: Here, cost of equity capital is computed by dividing the current dividend by the
market price per share. This dividend price ratio expresses the cost of equity capital in relation to what
dividend the company should pay to attract investors. However, this method cannot for units suffering
losses.
Cost of Equity (Ke) = DPS1 * 100
MP0
Ke = Cost of equity
DPS1 = Annual dividend
MP0 = Current Market Price per equity share

ii. Dividend Price Growth Approach: Earnings and dividends do not remain constant and the price of equity
shares is also directly influenced by the growth rate in dividends. Where earnings, dividends and equity
share price all grow at the same rate, the cost of equity capital may be computed as follows:

Cost of Equity (Ke) = (DPS1 * 100) + g

MP0
Where, g = annual growth rate of earnings of dividend

iii. Earning / Price Approach: According to this approach, the earnings of the company have a direct impact
on the market price of its share. Accordingly, the cost of equity share capital would be based upon the
expected rate of earnings of a company. The argument is that each investor expects a certain amount of
earnings, whether distributed or not from the company in whose shares he invests.

Cost of Equity (Ke) = EPS1 * 100

MP0
Where,
Ke = Cost of equity EPS1 = Earnings per share MP0 = Current Market price / equity share
 Cost of Capital
iv. Earnings Price Growth Approach: When earnings increase every year, it influences the market price per
share, and the same is considered in this approach. Since, dividends are recommended by the Board of
Directors and shareholders cannot change it. Thus, this approach concentrates on the actual strength of the
company, i.e. its earnings. So, cost of equity will be given by:

Cost of Equity (Ke) = (EPS1 * 100) + g

MP0

v. Realized Yield Approach: According to this approach, the average rate of return realized in the past few
years is historically regarded as ‘expected return’ in the future. The yield of equity for the year is:

Cost of Equity (Ke) = DPS1 + (MP1 – MP0) * 100

MP0
Ke = Actual yield for the year
DPS1 = Dividend per share expected at end of the year
MP1 = Market Price per share expected at the end of the year
MPo = Market Price per share at the beginning of year

vi. Capital Asset Pricing Model Approach (CAPM): This model describes the linear relationship between risk
and return for securities. The risk a security is exposed to, are diversifiable and non-diversifiable. The
diversifiable risk can be eliminated through a portfolio consisting of large number of well diversified
securities. The non-diversifiable risk is assessed in terms of beta coefficient through fitting regression
equation between return of a security and the return on a market portfolio. Thus, the cost of equity capital
can be calculated under this approach as:

Ke = E(r) = Rf + b x (Rm – Rf)

Where,
Ke = Cost of equity capital
Rf = Rate of return on security
b = Beta coefficient of systematic risk
Rm = Rate of return on market portfolio

Therefore, required rate of return = risk free rate + risk premium. The idea behind CAPM is that investors
need to be compensated in two ways - time value of money and risk. The CAPM says that the expected
return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected
return does not meet or beat the required return, then the investment should not be undertaken. The capital
asset pricing approach is useful in calculating cost of equity, even when the firm is suffering losses.

vii. Bond Yield plus Risk Premium Approach: This approach is a subjective procedure to estimate the cost of
equity. In this approach, a judgmental risk premium to the observed yield on the long-term bonds of the firm
is added to get the cost of equity. Generally, the risk premium is 5% over the before tax cost of debt.

Ke = Yield on long-term bonds + Risk Premium.

 Cost of Capital
e) Cost of Retained Earnings (‘Kr’)
Cost of Retained Earnings or Reserves & Surplus are generally taken as the same as Cost of Equity. This is
because reserves and surplus is the opportunity cost of dividends foregone by the shareholders. It is the rate of
return, which the existing shareholders can obtain by investing the dividends in alternative options.
Cost of Retained Earnings (Kr) = (DPS1 * 100) + g
MP0

Cost of Retained Earnings (Kr) = Opportunity Loss * (1 – brokerage rate) * (1 – tax rate)

f) Weighted Average Cost of Capital (WACC)

 WACC denotes the Weighted Average Cost of Capital. It is defined as the Overall Cost of Capital computed
by reference to the proportion of each component of capital as weights. It is denoted by Ko.
 WACC is the average cost of various sources of financing, i.e. cost of its capital structure.
 The proportion of the sources of finance forms the weights. The weights can be allotted using the book
value or market value. After-tax cost of the sources of finance is considered.
 Hence WACC = Sum of [Cost of Individual Components X Proportion i.e. Capital]

The following format may be adopted for computation of WACC:

Component Amount Proportion (%) Individual Cost Multiplication (Ki * Wi)

Debt Wl Kd Kd * W1
Preference Capital W2 Kp Kp * W2
Retained Earnings W3 Ke Kr * W3
Equity Capital W4 Ke Ke * W4
Total Ko = WACC = Total of above

Advantages of market values as weights:

a. Market values represent the opportunity cost.
b. It represents the present economic value of various sources of finance.
c. It is consistent with the definition of cost of capital i.e. the cost of capital is the minimum rate of return
needed to maintain the market value of the firm
d. Market value is the true reflection of the firm’s capital structure.

Disadvantages of market values as weight

a. Market values are not available in case of unlisted companies.
b. It is not reliable when shares are not actively traded (no purchase or sale of share)
c. Market price fluctuates frequently and is affected by speculations. (Manipulation of share prices)

Advantages of using book values as weight

a. The data is easily available i.e. the Balance Sheet data.
b. Calculations are simple
c. Fewer fluctuations in Book Value.
d. Useful when Mkt. price is not available, (unlisted company) or when the shares are not actively traded,
 Cost of Capital
Disadvantages of Book values as weights
a. Affected by accounting policies.
b. Does not truly represent the opportunity cost of capital.
c. Does not represent the present economic values of various sources of finance.

11. MARGINAL COST OF CAPITAL

 Marginal Cost of Capital (MCC) is the cost of additional capital introduced in the capital structure.
 MCC is the differential cost of capital between original capital structure and revised capital structure.
 It is derived when the average cost of capital is computed with marginal weights. The weights represent the
proportion of funds the firm intends to employ.
 When funds are raised in the same proportion as at present and if the component costs remain unchanged,
there will be no difference between average cost of capital and marginal cost of capital
 As the level of capital employed increases, the component costs may start increasing. In such a case both
the WACC and marginal cost of capital will increase. But marginal cost of capital will rise at a faster rate.
 
 
12. LIMITATIONS OF COST OF CAPITAL (WACC)

The determination of cost of capital suffers with a number of problems. Conditions are continuous changing in the
modern world, i.e. present conditions today may not remain static in future. Therefore, cost of capital which is
determined today, is dependent on certain conditions or situations which are subject to change. A form shall
continuous (annually) re-examine its cost of capital before determining annual capital budget.

Following are reasons for monitoring cost of capital –

 The firms’ internal structure and character change. For instance, as the firm grows and matures, its
business risk may decline resulting in new structure and cost of capital.
 Capital market conditions may change, making either debt or equity more favourable than the other.
 Demand-Supply funds may vary from time to time leading to change in cost of different capital components.
 The company may experience subtle change in capital structure because of retained earnings unless its
growth rate is sufficient to call for employment of debt on a continuous basis.

13.COST OF CAPITAL & ITS IMPLICATIONS IN BUDGETING DECISIONS

Investment decisions are directly related to financial decisions influenced by cost of capital. A company is always
eager to maximise return on investments. A company wants to reduce its cost of capital and yield highest returns.
Management needs to expands or diversify due to reasons such as –
 technological change requiring replacements,
 necessitating expansion or taking up new activities;
 competition strategies to avail of economic opportunities;
 short-term and long-term market forecasts with reference to sales, revenue proceeds, net profits etc.;
 incentives offered by the Govt. to promote investment in particular areas
 Cost of Capital
The management computes capital investments and correlates with the expected receipts (cash inflows) generated
from the activity through such investment. The optimum decision covers cost of financing such fund requirement.
Capital budgeting decisions are directly linked with the cost of capital. Before dealing with investment decision, it is
necessary to finalize the sources of capital and the cost of capital.

Cost of capital is used as the basis to evaluate investments whose cash flows are perfectly correlated with the cash
flows from the company’s present assets. Weighted average cost of capital represents an averaging of all risks of
the company and can be used to evaluate investments. Present value of an investment can be computed using a
weighted average cost of capital and this can be compared with present values calculated using the other discount
rates. Evaluation of capital investment projects requires some basis which could serve as the minimum rate of
return which a project should generate. In such cases, weighted cost of capital could serve as an accepted
discounting rate for evaluating investment decisions as no project will be acceptable which does not generate funds
equal or greater to the cut-off rate represented by weighted cost.
 COST OF CAPITAL – NUMERICAL
1) Expert Ltd. issued 12% irredeemable debentures. The par value is Rs. 100 and premium of 5% on issue. The
rate of tax is 30%. Find Kd.

2) Last year a company paid dividend per share of Rs. 1.855. The current market price of the company’s equity
share is Rs. 20. Generally, dividends grow at 8% p.a. The company follows dividend model to estimate the cost
of equity. Tax rate is 35%. Find cost of equity.

3) Calculate the cost of equity capital of Himesh Ltd., whose risk free rate of return equals 10%. The firm’s beta
equals 1.75 and the return on the market portfolio equals to 15%.

4) Compute WACC from the following data. Explain the importance of WACC in decision making.

Source of Finance Cost % in Capital Structure

Equity Share Capital 16 % 15 %
Preference Capital 13 % 10 %
Debentures 12 % 35 %
Term Loan 14 % 15 %
Retained Earnings 16 % 25 %

5) A company paid dividend of Rs. 3.00 in previous year. Current market price of equity share is Rs. 30. Dividends
are expected to grow at 10% p.a. The company has 10% Bank Loan (10 years tenure). Tax rate is 25%. Find
cost of equity, cost of debt and overall cost of capital. The debt component is same as equity component.

6) A company wants to raise debt capital of Rs. 10 lakhs. The cost of debt (before tax) is 12% up to Rs. 2 lakhs,
15% for 2 lakhs to 5 lakhs and 18% beyond that limit. Compute after tax cost of debt.

7) Gamma Ltd. has furnished the following information:

Earnings per share (EPS) Rs. 6.00 Dividend payout ratio 20%
Market price per share Rs. 40 Rate of tax 30%
Growth rate of dividend 8% Compute Cost of Equity (Ke)

8) Sunshine Ltd., has Equity Capital Rs. 50,00,000. Equity shares of the company are sold at Rs. 25 per share in
the market. It is expected that the company will pay next year a dividend of Rs. 4 per share which will grow at
8% forever. Assume a tax-rate of 30%. Compute Ke

9) YZ Ltd. retains Rs. 750,000 of its current earning. The expected rate of return to shareholders if they invested
the funds elsewhere is 10%. The brokerage is 3% and shareholders came in 30% tax bracket. Calculate Kr.

10) The existing WACC of a company is 12.50%. The company has decided to raise additional funds which shall
increase its WACC to 14.30%. How much shall be the incremental profits so that the investors stay invested in
the company. What is such term known as ?
 Cost of Capital Numerical
11) Anarchy Ltd. provides the following capital structure. Compute the marginal cost of capital.

Particulars Rs. in Lakhs Cost %

Existing structure:
Equity 3,000 15 %
Retained earnings 500 18 %
Preference capital 500 10 %
Debt 2,000 12 %
Additional demand:
Equity 2,000 18 %
Retained earnings 500 18 %
Preference capital 1,000 12 %
Debt 1,500 16 %

12) The prevailing risk-free rate of interest in 10-Year GOI Treasury Bonds is 5.5%. The average risk premium is
8%. The beta of the company is 1.1875. The company now wants to take up a project requiring an investment
of Rs. 75 crores with a debt-equity ratio of 20%. The beta of this project is 1.4375. The debt can be raised at an
interest rate of 9.50% upto first Rs. 10 crores and at 10% for the rest of the amount. Find out WACC, if the tax
rate is 35%.

13) Supreme Ltd. has Equity Rs. 400,000, Retained Earnings Rs. 100,000. Equity face value is Rs. 100. The EPS
of the company is Rs. 15 and the current market price is equal to its book value per share. The corporate tax
rate is 30%, while shareholders’ personal tax liability is 10%. Find Ke and Kr.

14) Compute the EVA from the date given below –

Particulars Year 2011 Year 2012 Year 2013
Equity capital 10,00,000 15,00,000 17,00,000
10% Debt 500,000 700,000 700,000
NOPAT 200,000 400,000 800,000

The risk free rate of return is 7%, Beta 0.90. Market rate of return 15%. Tax rate 30%

15) Calculate the WACC using Book values given below. The tax rate applicable is 30%.

Source of Finance Book Value (Rs) Cost %

Equity Capital 100,000 16.0%
14 % Preference Capital 50,000 14.0%
Retained Earnings 50,000 16.0%
14 % Debentures 100,000 14.0%
12% Term Loan 100,000 12.0 %
 Cost of Capital Numerical
16) Calculate the Ko using Market value proportions. Following data is available –

Source of Finance Mkt. Value (Rs) Cost %

Equity Capital 60,00,000 18.0%
11% Preference Capital 2,00,000 14.5%
13.5% Debentures 8,00,000 12.7%
18% Term Loan 10,00,000 12.6 %
Total 80,00,000

17) Widely Held Ltd. has the following capital structure on 31st March 2013:
Particulars Amount Rs.
Equity shares (150,000 shares) 30,00,000
10% Preference shares 500,000
14% Debentures 15,00,000
Total 50,00,000

The market price of share is Rs. 20 each. It is expected that company will pay next year a dividend of Rs. 2 per
share which will grow at 5% forever. Tax rate is 30%. You are required to:
i. Compute weighted average cost of capital based on existing capital structure
ii. Compute the new weighted average cost of capital if the company raised an additional Rs. 10 lakhs
debt by issuing 15% Debentures. This would result in increasing the expected DPS to Rs. 3 and leave
the growth rate unchanged, but the price of share will fall to Rs. 15 per share
 CAPITAL STRUCTURE & LEVERAGES
1. INTRODUCTION

 Financing decision relates to the composition of relative proportion of various sources of finance. A Financial
Manager compares the merits and demerits of different sources of finance while taking the financing decision.

 A business can be financed from either the shareholders’ funds or borrowings from outside agencies.

 Shareholders’ funds include equity share capital, preference share capital and accumulated profits. Equity
has no fixed commitment regarding payment of dividend or principal amount and therefore, no risk is involved.

 Borrowings include borrowed funds like debentures and loans from financial institutions. The borrowed funds
have to be paid back with interest and some amount of risk is involved if the principal and interest is not paid.

 Finally, it is the decision of the business to decide the ratio of borrowed funds and owned funds. However,
most of the companies use a combination of both the shareholders’ funds and borrowed funds.

 Whether the companies choose shareholders’ funds or borrowed funds, each type of fund carries a cost.
Borrowed funds involve interest payment whereas equities, as such do not have any fixed obligation but
definitely they involve a cost. Both types of funds incur cost and this is the cost of capital to the company.

Meaning – Capital Structure refers to the mix of sources from where the long-term funds required in a business
may be raised. In other words, it refers to the proportion of debt, preference capital and equity capital.

According to Gerstenberg, “Capital Structure of a company refers to composition or make up of its capitalization
and it includes all long-term capital resources”.

James C. Van Horne defines capital structure as “The mix of a firm’s permanent long-term financing represented
by debt, preferred stock and common stock equity”.

Optimum Capital Structure

One of the basic objectives of financial management is to maximise the value or wealth of the firm. Capital Structure
is optimum when the firm has a combination of equity and debt so that the wealth of the firm is maximised. At this
level, cost of capital is minimum and market price per share is maximum. Hence, factors considered in determining
capital structure include nature of industry, risk element, dilution of control, cost factor, earnings capability, Govt.
policies etc.

2. FEATURES OF APPROPRIATE CAPITAL STRUCTURE

The following are the major features of an appropriate capital structure:

1. Profitability. It should minimize the cost of financing and maximise earning per equity share.

2. Flexibility: The capital structure should be such that company can raise funds whenever needed.

3. Conservation: The debt content should not exceed the maximum which the company can bear.

4. Solvency: The capital structure should be such that the firm does not run the risk of becoming insolvent.

5. Control: There should be minimum risk of loss or dilution of control of the company.
 Capital Structure & Leverages

3. PRIMARY CONSIDERATIONS IN CAPITAL STRUCTURE PLANNING

The three major considerations in Capital Structure Planning are: Risk, Cost and Control. A comparative analysis is
given:

Cost of Capital

Capital Structure Decision Risk Involved

Dilution of Control
        

Type of fund Risk Cost Control

Equity Capital Low Risk - no question of Most expensive - dividend Dilution of control - Since the
repayment of capital except expectations of shareholders Capital base might be
when the company is under are higher than interest expanded and new
liquidation - Hence best from rates. Dividends are not tax- shareholders/ public are
viewpoint of risk. deductible. involved.
Preference Slightly higher risk when Cheaper cost than Equity but No dilution of control since
Capital compared to Equity Capital - higher than Interest rate on voting rights is restricted.
Principal is redeemable after loan funds. Further,
a certain period even if preference dividends are not
dividend payment is based tax-deductible.
on profits.
Loan Funds High risk - Capital should be Comparatively Cheaper - No dilution of control - but
repaid as per agreement; prevailing interest rates are some financial institutions
Interest should be paid considered only to the extent may insist on nomination of
irrespective of performance of after tax impact. their representatives in the
or profits. Board of Directors.

4. FACTORS AFFECTING STRUCTURE PLANNING

In addition to Risk, Cost and Control, the other considerations in Capital Structure Planning are as under:

1. Profitability (Valuation): A degree of profitability is conducive to higher borrowings. If an organization is

confident about its profit stability they may prefer debt capital. It helps in increasing EPS and hence positive
impact on the market price per share, thereby maximizing shareholders’ wealth.

2. Corporate Taxation: Interest on borrowed capital is a tax-deductible expense, but dividend is not. Also, the
cost of raising finance through borrowing is deductible in the year in which it is incurred. If it is incurred
during the pre-commencement period, it is to be capitalized. Due to the tax saving advantage, debt has a
cheaper effective cost than preference or equity capital. The impact of taxation should be carefully analysed.
 Capital Structure & Leverages
3. Trading on equity: When the Return on Total Capital Employed (ROCE) is more than the rate of interest on
borrowed funds or the rate of dividend on preference shares, financial leverage can be used favourably to
maximise EPS. In such a case, the company is said to be “trading on equity”. Loans or Preference Shares
may be preferred in such situations. The effect of financing decision on EPS and ROE should be analysed.

4. Cash Flow policy: While making a choice of the capital structure the future cash flow position should be
kept in mind. Debt capital should be used only if the cash flow position is really good because a lot of cash
is needed in order to make payment of interest and refund of capital.

5. Government policies: Raising finance by way of borrowing or issue of equity is subject to policies of the
Government and its regulatory bodies like SEBI, RBI etc. The monetary, fiscal and lending policies, as well
as rules and regulations stipulated from time to time by these bodies have to be complied with for acquiring
funds through the particular mode.

6. Legal requirements: The applicable legal provisions should be considered while deciding the capital
structure. Provisions relate to maximum borrowings, approvals required for foreign direct investment etc.

7. Marketability: The mode of obtaining finance depends on the marketability of the company’s shares or debt
instruments (debentures / bonds). In case of restrictions in marketability, it is difficult to obtain public
subscription. Hence, the company has to consider its ability to market corporate securities.

8. Size of the Company: Small companies rely heavily on owner’s funds, while large and widely held
companies are generally considered to be less risky by the investors.

9. Flexibility: Flexibility is required to have as many alternatives as possible at the time of expanding or
contracting the requirement of funds. It enables use of proper type of funds available at a given time and
also enhances the bargaining power when dealing with prospective suppliers of funds. It also implies the
capacity of business to adjust to expected and unexpected changes in the business environment.

10. Timing: Proper timing of a security issue often brings substantial savings because of the dynamic nature of
the capital market. Hence the issue should be made at the right time so as to minimise effective cost of
capital. The management should constantly study the trend in the capital market and time its issue carefully.

11. Purpose of financing: Funds required for long term productive purposes like manufacturing, setting up new
plant etc. may be raised through long term sources. But if funds are required for non-productive purposes,
like welfare facilities to employees such as schools, hospitals etc., internal financing may be used.

12. Period of finance: Funds required for medium and long-term periods say 8 to 10 years may be raised by
way of borrowings. But if the funds are for permanent requirement, it will be better to issue of equity shares.

13. Nature of investors: Enterprises which enjoy stable earnings and dividend with a proven, track record may
go for borrowings, since they are having adequate profits to pay fixed interest charges. But companies,
without assured income should prefer internal resources to a large extent since it may be difficult to attract
investors towards the issue.

14. Floatation Costs: Floatation costs are expenses incurred while issuing securities (e.g. shares, debentures).
These include commission of underwriters, brokerage, stationery expenses, etc. Generally, the cost of
issuing debt capital is less than the share capital. This attracts the company towards debt capital.
 Capital Structure & Leverages

5. BUSINESS RISK AND FINANCIAL RISK

a) Business Risk – Business risk is the variation from the expected operating profit (EBIT) or earning capacity
of a company. Internal business risk due to drop in sales, labour strikes, high fixed cost etc. External
business risk includes cyclical variations, social factors, high competition etc. Business risk is also known as
‘Operating Risk’.

b) Financial Risk – Financial risk depends on capital structure of the company, i.e. its debt-equity ratio. It is
the risk associated with high interest obligations. Higher debt increases the uncertainty in returns (PAT) for
the shareholders. Earnings must always be higher than cost of borrowings. The financial risk is due to two
reasons viz. higher interest payable, even in years of insufficient profits and secondly, principal repayment
even if sufficient cash not available. Thus, financial risk increases the chances of cash insolvency and
financial distress.

Sr. Business Risk Financial Risk

1 Business risk is associated with the Financial risk is associated with the
variation in operating profits (EBIT) variation in net profits (PAT)
2 Business risk occurs due to excessive Financial risk occurs due to excessive
fixed cost in the company. fixed interest in the company.
3 Higher business risk results in higher Higher financial risk leads to inability to
break-even point pay bank interest (EMIs)
4 Also known as operating risk and Measured by financial leverage
measured by operating leverage
5 Business risk is not affected by the Financial risk is due to the debt-equity
capital structure of company, i.e. debt- ratio of a company, i.e. capital structure
equity

6. EBIT – EPS ANALYSIS

 Generally, there is a definite relationship between the firm’s earnings before interest and tax (EBIT) vis-a-vis
EPS.
 Hence, EBIT – EPS analysis facilitates the management to take decisions on different financing plans and
its effect on the EPS of the company.
 Financial Break-even Point is that level of EBIT of which EPS is zero. Thus, every firm would be interested
in knowing the level of earnings (EBIT) which will influence the EPS, i.e. what is the desirable level to EBIT
to be maintained to have a positive EPS and in the long run – a growing EPS.
 Alternative modes of financing have different impact on EPS. A firm is said to be indifferent between two
modes of financing if the EPS under both options is the same. This level of EBIT that results in equal EPS is
called EPS Equivalency Point or Indifference Point.
 The level of EBIT at which EPS remains the same for two options of debt-equity mix, is called Indifference
Point.
 Capital Structure & Leverages
 Indifference Point is computed by solving the following equation for EBIT –

EPS = (EBIT – Interest) * (1 – tax rate) – Pref. Dividend

Number of equity shares

The equation will give that level of EBIT where the EPS would be equal, i.e. indifference point.

Interpretation of the Indifference Point:

Situation Option to be chosen Reason

EBIT is below Option with lower debt When rate of earnings and operating
Indifference Point (less interest burden) profits (EBIT) are low, more interest and
debt burden is not advisable.
EBIT is equal to Any alternative can be Same EPS due to indifference point.
Indifference point chosen.
EBIT is above Option with higher debt When EBIT is high, financial leverage
Indifference Point (high interest burden) works favourably and EPS is maximized.

7. FINANCIAL BREAK-EVEN POINT

Financial break-even point is the minimum level of EBIT needed to satisfy all the fixed financial charges i.e. interest
and preference dividends. It denotes the level of EBIT for which the firm’s EPS equals zero. If the EBIT is less than
the financial breakeven point, then the EPS will be negative but if the expected level of EBIT is more than the
breakeven point, then more fixed costs financing instruments can be taken in the capital structure, otherwise, equity
would be preferred. EBIT-EPS breakeven analysis is used for determining the appropriate amount of debt a firm
might carry.

8. DISTINGUISH BETWEEN

Sr. Capital Structure Financial Structure

1. Capital structure is a mix of various long Financial structure is a mix of long term
term funds used in the business and short term sources of funds.
2. It consists of Equity & Preference It consists of capital structure elements
Capital, Reserves, Long-term loans, as well as Current Liabilities
Debentures
3. Capital structure is a core element of the Financial structure is the entire source of
financial structure. funds.
4. It is possible that there are long term It is unlikely that there are only current
funds but no current liabilities. liabilities and no long term funds.
5. Long term funds may be used for Short term funds should not be used for
servicing short-term (current) assets servicing long-term (fixed) assets.
 Capital Structure & Leverages

Sr. Pyramid Capital Structure Inverted Pyramid Capital Structure

1. A pyramid shaped capital structure has a Such capital structure has small
large proportion consisting of equity component of equity capital and retained
capital and retained earnings earnings but an ever increasing debt
component.
2. The cost of share capital and the retained All increases in capital structure are
earnings of the firm is usually higher than made through debt only.
the cost of debt
3. This structure is indicative of risk averse Such a capital structure is highly
conservative firms vulnerable to collapse, i.e. very risky

Sr. Vertical Capital Structure Horizontal Capital Structure

1. Very less equity capital and high proportion All funds (100%) are through equity
of debt capital and preference capital. capital, i.e. zero debt component
2. Any addition is through debt capital Any addition is through equity capital
3. Very high financial risk, insolvency risk No financial risk as no interest payment

9. CAPITAL STRUCTURE THEORIES

Capital Structure theories seek to explain the relationship between the following variables:
 Proportions of Components of capital (debt, equity etc.);
 Costs of each component of capital;
 Overall Cost of Capital (WACC); and
 Value of the Firm.

These theories explaining Capital Structure and Cost of Capital are:

A. Net Income (NI) Approach
B. Net Operating Income (NOI) Approach
C. Traditional Theory
D. Modigliani and Miller (MM) Approach

General Assumptions in Capital Structure Theories:

a) There are only two sources of funds viz., debt and equity (i.e. no preference share capital)
b) The total assets of a firm and its capital employed are fixed (i.e. no change in capital employed)
c) All earnings are distributed to equity shareholders. (i.e. no retained earnings)
d) The firm earns operating profits and it is not expected to grow. (i.e. no losses)
e) The business risk is assumed to be constant and is not affected by the financing mix decision.
f) There are no corporate or personal taxes. (i.e. no taxation)
g) There is no difference in investors’ expectations, due to changes in the capital structure.
 Capital Structure & Leverages
A. Net Income Approach

Assumptions: Apart from the general assumptions, the following additional assumptions are made:

i. There are no Corporate Taxes.

ii. Kd = Cost of Debt and Ke = Cost of Equity.
iii. The Cost of Debt (Kd) is always less than Cost of Equity (Ke).
iv. Kd and Ke remain constant at all levels of debt-equity mix. This is because the use of debt content does
not change the risk perception of investors.

Ke
Cost
Ko
Kd

Degree of borrowing

Theory / Proposition:

 Debt is a cheaper source of finance than equity due to investor’s risk expectations.
 Use of cheaper debt funds in total capital structure will reduce the Overall or Weighted Cost of Capital since
debt percentage increases in the total capital structure.
 Hence, the WACC will decline with every increase in the debt content in total funds employed.
 Since Value of Firm = EBIT / WACC, the value of firm will increase for every decline in WACC.
 Where debt content is reduced, reverse will happen, i.e. WACC will increase thereby reducing the value of
firm.
 A firm can increase its value and lower its overall cost of capital by increasing the proportion of debt in
capital structure
 The Value of the Firm will be maximised at a point where WACC is minimum
 Thus, the theory suggests total or maximum possible debt financing for minimising the cost of capital.

B. Net Operating Income (NOI) Approach

Assumptions: The following additional assumptions are made:

i. The Cost of Debt (Kd) is always less than Cost of Equity (Ke).
ii. Kd (Cost of Debt) remains constant at various levels of debt-equity mix.
iii. Ke increases as debt increases due to higher financial risk and higher expectations of equity investors.
iv. The market (investors in debt as well as equity) capitalises the value of the firm as a whole, without giving
importance to the debt-equity mix. Hence Overall Cost of Capital is constant.

Diagram –
 Capital Structure & Leverages
Theory / Proposition:

 Debt may be cheaper than equity. But the risk perception of equity investors increases with the use of
additional debt in the capital employed.

 Increase in financial risk causes the equity capitalisation rate to increase, i.e. Ke increases.

 Thus, the advantage of using low-cost debt is set off exactly by increase in equity capitalisation rate.

 Therefore, the overall cost of capital remains constant for all degrees of debt-equity mix.

 The market capitalizes the value of firm as a whole. Thus, the proportion between debt and equity is not
important.

 The market value of the firm is ascertained by capitalizing the net operating income at the overall cost of
capital, which is constant. Hence, the market value of firm is not affected by a change in the debt-equity mix.

 Since WACC is constant at all levels, every debt-equity mix is as good as any other mix. There is no
optimum capital structure. Every capital structure is optimal one.

C. Traditional Approach (Optimal Capital Structure)

Assumptions: Apart from the general assumptions, the following additional assumptions are made:

i. The Cost of Debt (Kd) is always less than Cost of Equity (Ke).
ii. Kd and Ke vary with change in debt-equity mix. As debt content increases, financial risk increases,
causing increase in the expectations of equity investors and rise in the cost of equity. Also additional loans
can be taken only at a higher rate of interest. So Cost of Debt also rises beyond a certain level of debt
content.
iii. Increase in Cost of Equity is steeper and higher than increase in cost of debt.

Ke
Cost
Ko

Kd

Degree of borrowing

Theory / Proposition:

 Debt is a cheaper source of finance than equity due to tax saving effect and investor’s risk expectations.

 Use of cheaper debt funds in total capital structure will reduce the Overall or Weighted Cost of Capital since
debt percentage increases in the total capital structure. This is because the benefits of cheaper debt may be
so large that even in offsetting the effect of increase in cost of equity, the WACC may go down.

 Hence, the WACC will decline with every increase in the debt content in total funds employed.

 However, if borrowing increases beyond an acceptable limit (called the optimal point); the cost of debt and
cost of equity start rising. This is because of the high financial risk associated with the firm.
 Capital Structure & Leverages
 The increasing cost of equity owing to increased financial risk and increasing cost of debt makes the overall
cost of capital to increase.

 The firm should strive to reach the optimal capital structure and maximise its total value through a proper
use of both debt and equity in the capital structure. At the optimal capital structure the overall cost of capital
will be minimised and the value of the firm is maximum.

 Thus, as per Traditional Theory, the firm should try to achieve the optimal Capital Structure by minimizing
WACC and maximising its value.

D. Modigliani and Miller Approach

This Approach is a refinement of the Net Operating Income Approach. The basic theory is essentially the same,
but some additional propositions are made. The following additional assumptions are made:

i. Kd less than Ke – the Cost of Debt (Kd) is always less than Cost of Equity (Ke)
ii. Constant Kd – the cost of debt remains constant at various levels of debt equity mix.
iii. Increasing Ke – cost of equity increases as debt increases due to high risk and high expectations of equity.
iv. Constant WACC – the market (investors in debt as well as equity) capitalises the value of the firm as a
whole, without giving importance to the debt-equity mix. Hence Overall Cost of Capital is constant.
v. Perfect Market – the capital markets are perfect. Investors are free to buy and sell securities. They are
well informed about the risk and return on all type of securities. There are no transaction costs. The
investors behave rationally. They can borrow without restrictions on the same terms as the firms do.

Theory / Proposition:

 Debt may be cheaper than equity. But the risk perception of equity investors increases with the use of
additional debt in the capital employed.

 Increase in financial risk causes the equity capitalisation rate to increase.

 Thus, the advantage of using low-cost debt is set off exactly by the increase in equity capitalisation rate.

 Therefore, the overall cost of capital remains constant for all degrees of debt-equity mix.

 The market capitalizes the value of firm as a whole. Thus the proportion between debt and equity is not
important.

 The market value of the firm is ascertained by capitalising the net operating income at the overall cost of
capital, which is constant. The market value is not affected by changes in debt-equity mix.

 Since WACC is constant at all levels, every debt-equity mix is as good as any other mix. There is no
optimum capital structure. Every capital structure is an optimal one. The total cost of capital of a firm is
independent of its methods and level of financing.

 Since WACC is constant, WACC at 0% debt (i.e. 100% equity) should be the same as WACC at any other
percentage of debt. Hence WACC = Ke when the firm is financed purely by equity. WACC of a firm equals
the capitalisation rate of pure equity stream of its class of risk.
 Capital Structure & Leverages
Concept of Arbitrage under MM Approach

Modigliani and Miller argue that there is no difference in the market values of different firms in the same risk
class. They consider that use of debt in capital structure has no impact on market values. Their reasoning is as
under:
 Companies in different industries may have different risks, which will result in their earnings being
capitalised at different rates.
 If the market values (as represented by market price per share) of different companies were to be different,
investors in the high market price company will sell their holding and the shares of low market price
company will be bought. This is because, in the capital market, the rational movement should be “buy at
low prices and sell at high prices”.
 The buying and selling spree will lead to increase in demand of the low market price company’s shares
causing its share price to increase. Similarly, due to sale of holdings, price of high market price company’s
share will fall.
 This movement in share prices will continue till both companies’ share prices settle at a constant.
 Through the above procedure, investors will move from leveraged firm to unleveraged firm and vice-versa
through the process of arbitrage. This will cease only when total market values of both firms are the same.
 The arbitrage effect nullifies the effect of leverage that the companies may possess.
 Hence, it is not possible for the companies in the same risk class, to affect their market values and therefore
their overall capitalisation rate by use of leverage.
 Thus, for a company in a particular risk class, the total market value must be same irrespective of debt in
company’s capital structure.

Criticism of Modigliani and Miller Theory

1. The assumption of perfect market is not practical. In the real world, various imperfections exist, such as
transaction costs for purchase and sale of securities, differential rates of interest etc.
2. The argument that arbitrage nullifies the effect of leverage is not valid. Investors do not behave in such a
calculated and rational way in switching from leveraged to unleveraged firm or vice-versa.
3. The theory presumes the availability of free and upto date information on all aspects of the company’s
functioning. In practice, investors have little or no knowledge about the company’s operations. Their dealing
in shares is not based only upon the information on hand, but on other considerations also.

10. OVER CAPITALIZATION

It is a situation where a firm has more capital than its requirements. In other words, value of assets is less than its
issued share capital, and earnings (profits) are insufficient to pay dividend and interest. This situation mainly arises
when the existing capital is not effectively utilized due to fall in earning capacity of the company and the company
has raised funds more than its requirements. The chief sign of over-capitalisation is the fall in payment of dividend
and interest leading to fall in value of the shares of the company.
 Capital Structure & Leverages
Causes of Over Capitalization:

 Raising more money through issue of shares or debentures than company can employ profitably.
 Borrowing huge amount at higher rate than rate at which company can earn.
 Excessive payment for the acquisition of fictitious assets such as goodwill etc.
 Improper provision for depreciation, replacement of assets and distribution of dividends at a higher rate.
 Wrong estimation of earnings and capitalization.

Consequences of Over-Capitalisation

 Considerable reduction in the rate of dividend and interest payments.

 Reduction in the market price of shares.
 Resorting to “window dressing”.
 Some companies may opt for reorganization. However, sometimes the matter gets worse and the company
may go into liquidation.

Remedies for Over-Capitalisation

 Company should go for thorough reorganization.

 Buyback of shares.
 Reduction in claims of debenture-holders and creditors.
 Value of shares may be reduced. This will result in sufficient funds for the company to carry out replacement
of assets.

11. UNDER CAPITALIZATION

It is opposite of over-capitalisation. It is a state, where actual funds available are lower than required warranted by
its earning capacity. This situation normally happens with companies which have insufficient capital but large secret
reserves in the form of considerable inflation in the values of the fixed assets not brought into the books.

Consequences of Under Capitalization

 The dividend rate will be higher in comparison to similarly situated companies.

 Market value of shares will be higher than value of shares of other similar companies because their earning
rate being considerably more than the prevailing rate on such securities.
 Real value of shares will be higher than their book value.

Effects of Under Capitalization

 It encourages acute competition. High profitability encourages new entrepreneurs’ entry in same type of
business.
 High rate of dividend encourages the workers’ union to demand high wages.
 Normally common people (consumers) start feeling that they are being exploited.
 Management may resort to manipulation of share values.
 Invite more government control and regulation on the company and higher taxation also.
 Capital Structure & Leverages
Remedies

 Stock-split will reduce dividend per share, though EPS shall remain unchanged.
 Issue Bonus Shares as it reduces both dividend per share and the average rate of earning.
 By revising upward the par value of shares in exchange of the existing shares held by them.

Over Capitalization vis-à-vis Under Capitalization

From the above discussion it can be said that both over capitalization and under capitalisation are not good.
However, over capitalisation is more dangerous to the company, shareholders and the society than under
capitalization. Under capitalization can be handled more easily than the situation of overcapitalisation. Moreover,
under capitalization is not an economic problem but a problem of adjusting capital structure. Thus, under
capitalization should be considered less dangerous but both situations are bad and every company should strive to
have a proper capitalization.

12. EBITDA ANALYSIS

EBITDA stands for “Earnings Before Interest, Taxes, Depreciation and Amortization”. It is used to measure
cash operating profits of a business, and hence the value of a business. EBITDA is used to analyze a company’s
operating profitability before non-cash charges (depreciation and amortization) and finance costs (interest and
dividends).

EBITDA enables analysts to focus on the quality and result of operating decisions. Non-operating activities include
interest expenses, tax rates, and non-cash items such as depreciation and amortization. By removing the non-
operating effects, EBITDA gives investors the ability to focus on the core profitability of company’s operations. This
type of analysis is particularly important when comparing similar companies.

Advantages EBITDA analysis –

1) EBITDA can be used to estimate the cash flow available to pay debt on long-term assets. Dividing EBITDA by
the amount of required debt payments yields a debt coverage ratio.
2) It helps to evaluate the relative profitability of a company.
3) It can also be used to compare companies against each other and against industry averages. In addition,
EBITDA is a good measure of core profit.

Limitations of EBITDA

Comparison of EBITDA does not reflect the ultimate profitability of a company. It does not show the profits earned
for the shareholders (owners of the company). Further, EBITDA numbers can be manipulated, through fraudulent
accounting techniques to inflate revenues.
 Capital Structure & Leverages

13. SIGNIFICANCE OF CAPITAL STRUCTURE

Capital structure is important for a firm because the long term profitability and solvency of the firm is sustained by
an optimal capital structure consisting of an appropriate mix of debt and equity. The capital structure also is
significant for the overall ranking of the firm in the industry group. The significance of the capital structure is
discussed below –

1. It reflects the firm’s strategy

The capital structure reflects the overall strategy of the firm. The strategy includes the pace of growth of the
firm. In case the firm wants to grow at a faster pace, it would be required to incorporate debt in its capital
structure to a greater extent. In case of growth through M&A, (i.e. inorganic mode), the firm would need
higher borrowings.

2. It is an indicator of the risk profile of the firm

One can get a broad idea about the risk profile of the firm from its capital structure. If the debt component in
the capital structure is higher, the fixed interest cost of the firm increases thereby increasing its risk. If the
firm has no long term debt in its capital structure, it means that it is risk averse.

3. It acts as a tax management tool

The capital structure acts as a tax management tool. Since interest on borrowings is tax deductible, a firm
having healthy operating profits would find it appropriate to incorporate debt in the capital structure in a
greater measure.

4. It helps to brighten the image of the firm

A firm can build on the retained earnings component of the capital structure by issuing equity capital at a
premium to a larger base of small investors. Such an act has two benefits – it helps the firm to improve its
image in the eyes of the investors and it reduces chances of hostile take-over of the firm.

14. PLANNING & DESIGNING CAPITAL STRUCTURE

An effective capital structure ensures that prime goal of the firm, i.e. maximisation of the shareholder wealth.
Planning of the capital structure is a preliminary activity. For meeting the cost of the project, the means of finance
are to be arranged. Hence the need for timely and early planning of the capital structure.

Attributes of a well-planned and designed Capital Structure –

a) Return: The capital structure of the company should generate maximum returns to the shareholders without
adding additional cost to them.

b) Risk: The use of excessive debt threatens the solvency of a company. To the point debt does not add
significant risk. It should be used, otherwise its use should be avoided.

c) Flexibility: The capital structure should be flexible. It should be possible for a company to adapt its capital
structure with a minimum cost and delay if needed by a changed situation. There shall be flexibility in order
to allow for temporary expansion or contraction of funds whenever needed.
 Capital Structure & Leverages
d) Capacity: The capital structure should be determined within the debt capacity of the company and this
capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future
cash flows. It should have enough cash to pay creditors’ fixed charges and principal sum.

e) Control: The capital structure should involve minimum risk of loss of control of the company. The owners of
closely-held companies are particularly concerned about dilution of control.

f) Functional: The capital structure design should create synergy with the long term strategy of the firm. It
should facilitate the day to day working of the firm and not create obstacles.

g) Conform to statutory guidelines: The design should conform to the statutory guidelines, if any, regarding
the proportion and amount of each component. The limits imposed by lenders regarding the minimum level
of owners’ equity required in the firm should be complied with.

15. OPTIMAL CAPITAL STRUCTURE

Optimal capital structure means a particular arrangement of various components of the structure which is perfect for
both the long term and short term objectives of the firm. For designing such a structure, a firm needs exact
information of –

– The requirement of capital of the firm

– Availability of different components
– Cost of these components
– Rate of return from investment

In reality, it is not possible to have the exact information on all the above parameters. Secondly whatever
information is available is for a particular period. Thus, we have to design the structure in a static. However, the real
business world is a dynamic with ever changing demand and supply of various components of the capital structure.
Therefore, optimal capital structure is only an ideal situation which can function as the benchmark of performance
for a firm.

16. CAPITAL STRUCTURE & VALUATION

Capital structure should be conducive to increase in valuation of a firm. Valuation implies the market value. This can
happen in case value of both components of the shareholders’ equity, i.e. share capital and retained earnings
increases.

In case of listed companies, the value of the share capital is reflected in the market price of the firm. This market
value, under ideal conditions, is indicative of the inherent value and is different from both the face value and the
book value. The capital structure should be such as maximises the inherent value of the firm.

Retained earnings also have a book value, i.e. the value at which these earnings are shown in the books of the firm.
The inherent value of the retained earnings depends upon the future returns which these earnings can generate for
the firm. As earnings of the firm increase, its valuation also increases. Earnings can increase either through
increased level of operations or through decrease in cost of capital. Direct increase in earnings depends upon the
investment decisions and the reducing cost of capital depends on optimal capital structure.
 Capital Structure & Leverages

17. LEVERAGES

 The term leverage in general, refers to advantage gained for any purpose.
 Leverage is the relationship between two inter-related financial variables. These may be cost, output, sales,
EBIT, EBT, EPS etc.
 Leverage effect implies the responsiveness or influence of one financial variable over other financial variable.
 Leverage can be defined as a percent (%) change in dependent variable as compared to the percent change
in independent variable. Magnification impact on the dependent variable is the leverage effect. Higher the
leverage, higher the risk => higher the risk, higher the return.
 Leverage means a more than proportionate outcome against a given proportionate cause. In financial
analysis, leverage is used by business firms to quantify the risk-return relationship to different alternative
capital structures. Study of leverage is essential to define the risk undertaken by the shareholders.
 Earnings available to shareholders fluctuate on account of two risks –
o Variability of EBIT - Operating Risk arises due to variability of sales and variability of expenses.
o Variability of EPS or ROE - Financial Risk arises due to the impact of interest charges.

 James Horne has defined leverage as, “the employment of an asset or fund for which the firm pays a fixed
cost or fixed return.

 There are three commonly used measures of leverage in financial analysis. These are:

o Operating Leverage
o Financial Leverage
o Combined Leverage

18. OPERATING LEVERAGE

 Operating leverage is defined as the ‘firm’s ability to use fixed operating costs to magnify effects of changes in
sales on its earnings before interest and taxes.

 Operating Leverage is the relationship between contribution and EBIT, i.e. effect of change in contribution on
change in EBIT.

 A change in sales will lead to a change in profit i.e. Earnings before Interest and Taxes (EBIT).

 The effect of change in sales on EBIT is measured by operating leverage.

 Since fixed costs remain the same irrespective of level of output, percentage increase in EBIT will be higher
than increase in Sales.

Operating Leverage = Contribution

EBIT

Degree of Operating Leverage = % change in EBIT

% change in Contribution
 Capital Structure & Leverages
Significance of Operating Leverage –

 Degree of Operating Leverage (DOL) measures the impact of change in sales on operating income.
Suppose the operating leverage of a firm is 2 times, it implies that 1 % change in sales will lead to 2 %
change in EBIT. Hence, if sales rises by 20%, EBIT rises by 20% X 2 = 40 %. Also, if sales decreases by
say 40%, EBIT fails by 80 %.

 The DOL depends on fixed costs, i.e. if fixed costs are higher, operating leverage is higher and vice-versa.

 If operating leverage is high, it implies that fixed costs are high. Hence, the Break-Even Point (no profit-no
loss situation) would be reached at a higher level of sales.

Due to the high Break-Even Point, the Margin of Safety and profits would be low. This means that the
operating risks are higher. Hence, a low operating leverage is preferred.

 A high operating leverage means that profits (EBIT) may be wiped off, even for a marginal reduction in
sales. Hence, it is preferred to operate sufficiently above Operating BEP to avoid the danger of fluctuations
in sales and profits. Operating BEP is the level of Sales where EBIT becomes ‘zero’.

19. FINANCIAL LEVERAGE

Financial Leverage is defined as the ability of a firm to use fixed financial charges (interest) to magnify the effects of
changes in EBIT (Operating profits), on the firm’s Earning per Share (EPS). Financial Leverage occurs when a
company has debt content in its capital structure and fixed financial charges e.g. interest on debentures. These
fixed financial charges do not vary with the EBIT. They are fixed and are to be paid irrespective of level of EBIT.
Hence an increase in EBIT will lead to a higher percentage increase in Earnings per Share (EPS). This is measured
by the Financial Leverage, sometimes also known as ‘Financial Gearing’

Financial Leverage = EBIT

EBT

Degree of Financial Leverage = % change in EBT

% change in EBIT

Significance of Financial Leverage:

 Degree of Financial Leverage measures the impact of change in EBIT (Operating Income) on EPS
(earnings per share). Suppose, financial leverage of a firm is 4 times, it implies that 1 % change in EBIT will
lead to 4 % change in EPS. Hence, if EBT increases by 10%, EPS increases by 10% X 4 = 40 %. Also, if
EBIT decreases by say 5%, EPS fall by 20 %.

 Degree of Financial Leverage depends on the magnitude of interest and fixed financial charges. If these
costs are higher, financial leverage is higher and vice-versa.
 If Degree of Financial Leverage is high, it implies that fixed interest charges are high. This means that the
financial risks are higher. The financial leverage is considered to be favourable or advantageous to the firm,
when it earns more on its total investment that what it pays towards debt capital. In other words, financial
leverage is advantageous only if Return on Capital Employed (ROCE) is greater than Interest rate on Debt.
 Financial BEP is the level of EBIT which covers all fixed financing costs of the company. Financial BEP is
the level of EBIT at which EPS is zero.
 Capital Structure & Leverages
What is favourable financial leverage?

 Degree of financial leverage is considered to be favourable or advantageous to the firm, when it earns more
on its total investment than what is pays towards debt capital. In other words, DFL is advantageous only if
Return on Capital Employed (ROCE) is greater than Rate of Interest on Debt.

 This is because shareholders gain in a situation where the company earns a high rate of return and pays a
lower rate of return to the supplier of long term debt funds. Here, Financial Leverage is also called ‘Trading
on Equity’.

 The difference, between EBIT and the cost of debt funds would enhance the earnings of shareholders.
Further, in case of debt funds the interest cost is also tax deductible. Hence gain from DFL arises due to:

o Excess of return on investment over effective cost (cost after considering taxation effect) of debt funds
o Reduction in the number of shares issued due to the use of debt funds.
 Where the rate of return on investment falls below the rate of interest, the shareholders suffer, because their
earnings fall more sharply than the fall in the return on investment. This is because fixed interest costs have
to be met, irrespective of the level of EBIT. In such cases, a high financial leverage is harmful. In fact, the
use of debt funds involving fixed commitment of interest payment and principal repayment is not justified.

 Degree of Financial Leverage should be high when Return on Capital Employed (ROCE) is greater than
Interest Rate on Debt. If ROCE is less than Interest Rate on Debt, DFL should be maintained low.

20. COMBINED LEVERAGE

Combined Leverage is used to measure the total risk of a firm i.e. Operating Risk and Financial Risk. The effect of
fixed operating costs (i.e. operating risks) is measured by operating leverage. The effect of fixed interest charges
(i.e. financial risks) is measured by financial leverage. The combined effect of these is measured by combined
leverage.

Combined Leverage = Contribution

EBT

Combined Leverage = Operating Leverage (x) Financial Leverage

Degree of Combined Leverage = % change in EBT

% change in Contribution

Significance: Operating leverage measures impact of change in Sales on EBIT, Financial leverage measures the
impact of change in EBIT on EPS. Combined leverage measures the combined impact, i.e. effect of change in
Sales on EPS.
 Capital Structure & Leverages
Ideal Combination

Operating Financial Effect Reason and Significance

leverage leverage

High operating risk due to high fixed cost & high BEP. High
High High Risky
financial risk, so small fall in EBIT to greater fall EBT.

High operating risk impact is set off with low financial risk. Hence
High Low Careful
equity shareholders’ interest is safeguarded.

Very Cautious Low operating risks since low fixed costs, low BEP. But equity
Low Low
Conservative shareholders’ gains not maximised as financial leverage is low.

Low operating risks since low fixed costs, low BEP. Due to high
Low High Preferable financial risk, a small rise in EBIT leads to greater rise in EBT and
EPS. Hence Equity Shareholders’ gains are maximised.

21. DISTINGUISH

Sr. Operating Leverage Financial Leverage

1. Operating Leverage is associated with Financial Leverage is associated with

investment activities of a company. financing activities of a company.

2. It consists of fixed operating expenses It consists of fixed interest cost of

company

3. It measures business risk It measures financial risk

4. It shows relationship between sales and It shows relationship between EBIT and
EBIT EBT

5. Operating leverage doesn’t involve Financial leverage results in trading on

trading on equity. equity.

22. RISK AND LEVERAGE

Risk is the probability that the future revenue streams of a firm shall show a variation from the expected figures. The
variation is normally on the negative or the lower side because a positive variation reduces the investment risk and
a reduction of risk is always welcome.

For linkage with leverage, we can divide risk into two broad categories, i.e. business risk and financial risk.
Business risk pertains to risks associated with day to day operations of the firm. For example, decisions made
regarding purchase of raw materials, manufacturing expenses and administrative expenses change the business
risk profile of the firm. These decisions have an impact upon the operational profitability of the firm, i.e. the profits
before interest and taxes. Financial risk, on the other hand, is associated with introduction of fixed interest bearing
debt obligations in the capital structure of the firm. These obligations create a prior charge on EBIT before
distribution of post-tax profits among the owners.
 Capital Structure & Leverages

23. WORKING CAPITAL LEVERAGE

One of the new models of leverage is working capital leverage which is used to locate the investment in working
capital or current assets in the company. Working capital leverage measures the sensitivity of return in investment
of changes in the level of current assets.

Working Capital Leverage = Percentage Change in ROI

Percentage Change in Working Capital

OR

Working Capital Leverage = Current Assets

Total Assets + Change in Current Assets
 CAPITAL STRUCTURE & LEVERAGES – NUMERICAL
1) Best of Luck Ltd., a profit making company, has a paid-up capital of Rs. 100 lakhs consisting of 10 lakhs
ordinary shares of Rs. 10 each. Currently, it is earning an annual pre-tax operating profit of Rs. 60 lakhs. The
company's shares are listed and are quoted in the range of Rs. 50 to Rs. 80. The management wants to
diversify production and has approved a project which will cost Rs. 50 lakhs and the new project is expected to
yield a pre-tax operating profit of Rs. 40 lakhs per annum. Compute the EBIT for evaluation purposes.

2) From following data of Abhishek Ltd. as on 30th Sept, 2006, compute the operating leverage, financial leverage,
combined leverage and percentage change in earnings per share (EPS), if sales are expected to rise by 5%:
Earnings before interest and tax (EBIT) Rs. 10 lakhs,
Profit before Tax (PBT) Rs. 4 lakhs and Fixed Costs Rs. 6 lakhs.

3) Monark Ltd. is considering two alternative financial plans to start a new project. In Plan-I, it is likely to issue
equity shares of Rs. 16 lakhs and 13% preference capital of Rs. 4 lakhs. In Plan-II, the company will issue
equity shares of Rs. 8 lakhs, 13% preference capital of Rs. 4 lakhs, and 15% debentures of Rs. 8 lakhs.
Expected EBIT is Rs. 400,000. The face value of equity shares in both plans is Rs. 10. Tax rate is 30%.
Required –

 Which Plan is most suitable for the company?

 Determine level of EBIT where EPS would be same under both the plans. What is such level known as?

4) Flat-screen Limited needs Rs. 10,00,000 for expansion. It is considering the possibility of raising debt capital of
Rs. 100,000 or Rs. 400,000 or Rs. 600,000. Compute annual interest cost from the given interest rates –
(a) 8% p.a. upto Rs. 1,00,000;
(b) 12% p.a. over Rs. 1,00,000 up to Rs. 5,00,000;
(c) 18% p.a. over Rs. 5,00,000.

5) A company needs Rs. 800,000 for modernization. The company is planning to use borrowed capital of either
Rs. 200,000 or Rs. 350,000 or Rs. 500,000. The current market price per share is Rs. 25 and is expected to
drop to Rs. 20 if the funds are borrowed in excess of Rs. 400,000. Compute the number of equity shares to be
issued to finance the project. Equity shares are issued at market price

6) Calculate indifference point between the following financing alternatives. Assume 35% tax and FV Rs. 10.
 Equity share capital of Rs. 600,000 and 12% debentures of Rs. 400,000.
 Equity capital Rs. 400,000, 14% preference share capital Rs. 200,000 and 12% Debentures Rs. 400,000.

7) EML Ltd. has operating profit Rs. 40 lakhs; Tax rate = 30%; Total 10% Bank Loan = Rs. 20 lakhs; (Ke) = 16%;
No. of equity shares 500000; and FV Rs. 10. Compute the company’s EPS and its market price per share?

EML plans to buy-back 1 lakh equity shares at Rs. 35 per share. For buy-back purposes, EML shall raise funds
through issue of 8% Preference Capital of Rs. 35 lakhs. After buyback, if Ke is expected to rise to 18%, whether
EML shall change its capital structure?
 Capital Structure Numerical

8) Financial data of A, B and C companies are given below. Prepare Statement of Income for the three companies

Particulars A B C
Var. Cost as % of sales 66.67% 75.00% 50.00%
Interest expenses Rs. 200 Rs. 300 Rs. 1000
O. L 05:01 06:01 02:01
F. L 03:01 04:01 02:01
Income tax rate 50 % 50 % 50 %

9) Gamma Ltd. have a P/E ratio of 7.50 times, retained earnings are 37.50%, i.e. Rs. 6 per share.

 Compute Cost of Equity, if investors’ expected annual growth rate is 8%,

 Compute market price, if company’s cost of capital is as computed above and growth rate is 10% p.a.
 Compute market price, if company’s cost of capital is 15% and anticipated growth rate is 11% p.a.

10) Don Ltd. wishes to raise total finance of Rs. 20 lakhs for meeting its investments plans. Desired Debt-Equity
ratio shall be 25:75. Interest rate is 10 % upto Rs 200,000 and 13% beyond that. The EPS is Rs. 12 and
Dividend payout 50% of earnings. Expected growth rate in dividend 10%. Current market price is Rs. 60 per
share and tax rate is 30%. Calculate WACC.

11) The following details of Alpha Ltd. for the year ended 2012 are furnished:

Financial leverage 2:1 Operating leverage 3:1

Interest charges per annum Rs. 20 lakhs Corporate tax rate 40%
Variable cost as percentage of sales 60%
Prepare the income statement of the company.

12) Prepare income statements of the two companies from the data given below (tax rate 30%) –

Particulars Dhoom Dhoom II

Variable cost 56,000 60% of sales
Fixed cost 20,000 ??
Finance charges 12,000 9,000
Operating leverage ?? 4 times
Financial leverage 5:1 ??
Sales ?? 1,05,000

13) Sales of Max Ltd. are Rs. 30 crores and EBIT is 15% of sales. The Equity Capital is Rs. 12 crores, 13%
Preference Capital Rs. 5 crores and 15% Debentures Rs. 6 crores. Combined leverage is 3 times. Compute
Operating leverage.

14) Shubham Textiles Ltd. earns a profit of Rs. 300,000 p.a. after meeting its interest liability of Rs. 120,000 on
12% debentures. Tax rate is 50%. The number of equity shares are 80000 having FV Rs. 10 each and the
retained earnings are Rs. 1,200,000. Compute existing EBIT and Return on Capital Employed.
 Capital Structure Numerical

15) Beta-Dine Ltd. has provided following Balance Sheet as on 31st March 2012.

Liabilities Rs. Assets Rs.

Equity Capital (FV Rs. 10) 10,00,000 Fixed Assets 30,00,000
General Reserve 2,00,000 Current Assets 18,00,000
15% Debentures 28,00,000
Current Liabilities 8,00,000
Total 48,00,000 Total 48,00,000

Additional information:
 Annual fixed cost (except interest) Rs. 28,00,000
 Variable cost ratio 60%
 Total assets turnover ratio 2.50 times
 Tax rate 30%
Compute EPS & Combined Leverage

16) The following information is available for Aishwarya Ltd.

Particulars Rs.
Sales 400,000
(-) Variable Cost 140,000
Contribution 260,000
(-) Fixed Cost 180,000
EBIT 80,000
(-) Interest 10,000
PBT 70,000

Compute the following using the concept of Leverages:

 What percent will taxable income increase, if the sales increase by 6%?
 What percent will EBIT increase, if the sales increase by 10%?
 What percent will taxable income increase, if the EBIT increase by 6%?
 What shall be the rise in Sales where EPS rises by 50%
 What shall be the fall in EBIT where taxable profit becomes zero?
 What shall be the rise in Sales where EBIT is doubled?

17) Maxwell Ltd. generated sales of Rs. 70 lakhs and operating profits of Rs. 18 lakhs. During the year, finance
charges were Rs. 16,000 and preference dividends Rs. 20,000, the same shall continue in next year. As a per
of diversification plan, the company needs Rs. 7 lakhs, which will augment the operating profits by Rs. 4 lakhs.
Following options are available:

a) Issue 10000 ordinary shares at Rs. 70 per share. The company has existing 80000 shares outstanding, or
b) Issue 15% Debentures of Rs. 7 lakhs with maturity of 15 years, or
c) Issue 14% Preference shares of Rs. 7 lakhs.

Assuming 30% tax rate, compute the EPS at the expected level of profits, for each financing option
 Capital Structure Numerical

18) Following two financial plans of Damn Ltd., with two financial situations. Compute all leverages for both plans.

Installed capacity 10,000 units

Actual production and sales 60% of installed capacity
Selling price per unit Rs. 30
Variable cost per unit Rs. 20
Fixed cost: Situation A = Rs. 20,000 & Situation B = Rs. 25,000. Capital structure of company under two plans:

Particulars Plan I Plan II

Equity Shares 10,000 40,000
12% Debt 40,000 10,000
Total 50,000 50,000

19) The following information related to XL Company Ltd. for the year ended 31st March, 2013 are available to you:

Equity share capital of Rs. 10 each Rs. 25 lakh 11% Bonds of Rs. 1000 each Rs. 18.50 lakh
Sales Rs. 42 lakh, Fixed cost (excluding Interest) Rs. 3.48 lakh,
Financial leverage 1.39, Profit-Volume Ratio 25.55%
Income Tax Rate Applicable 35%.
You are required to calculate: Operating Leverage; Combined Leverage; and Earning per Share.

20) Given below is the Balance Sheet of Honey Ltd.

Liabilities Rs. Assets Rs.

Equity Capital (FV Rs. 10) 180,000 Fixed Assets 450,000
10% Debentures 240,000
Retained Earnings 60,000 Current Assets 150,000
Current Liabilities 120,000
Total 600,000 Total 600,000

The total assets turnover ratio is 2.50 times, fixed operating costs are Rs. 200,000, variable cost ratio is 40%
and income tax rate is 30%.

a) Compute Operating leverage, Financial leverage and Combined leverage

b) Determine the level of EBIT if the EPS is Rs. 6

21) The existing capital structure of Polly Ltd., is as under –

Equity shares of Rs. 100 each Rs. 40,00,000

Retained Earnings Rs. 10,00,000
9 % Preference shares Rs. 25,00,000
7 % Debentures Rs. 25,00,000

The existing rate of return on the company’s capital employed is 12 % and the income tax rate is 30%. The
company needs additional Rs. 25,00,000 to finance its expansion programme. Compute the expected EBIT of
the company after expansion?
 CAPITAL STRUCTURE, COST OF CAPITAL & LEVERAGES

Capital Structure

▪ Financing decision relates to the composition of the various sources of long-term funds.
▪ A Finance Manager compares the merits and demerits of different sources of finance while taking
the financing decision.
▪ A business can be financed from either shareholders’ funds (i.e., owned funds) or borrowed
funds from outside sources.
▪ Owned funds have no fixed commitment regarding payment of dividend or principal amount and
therefore, no risk is involved.
▪ Borrowed funds have to be paid back with interest and some amount of risk is involved if the
principal and interest is not paid.
▪ Finally, it is the decision of the business to decide the ratio of borrowed funds and owned funds.
However, most companies use a combination of both owned funds and borrowed funds.
▪ Meaning – Capital Structure refers to the mix of sources from where the long-term funds required
in a business may be raised. It refers to the proportion of debt capital and equity capital.

Sources of Long-Term Funds:

▪ Owned Funds
o Equity Share Capital
o Preference Share Capital
o Retained Earnings / General Reserve
o Profit & Loss credit balance
o Security Premium
o Global Depository Receipts (GDR)
o American Depository Receipts (ADR)

▪ Borrowed Funds
o Bank Loans
o Debentures
o Deposits
o Bonds
o Loans from Financial Institutions
o External Commercial Borrowings (ECB)
o Foreign Currency Convertible Bonds (FCCB)

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 1

 Capital Structure

Factors Affecting Capital Structure Planning / Design:

1. Cost of Capital – generally, interest rate is lower than equity dividend rate, hence cost of
borrowed funds is lower than cost of equity funds.

2. Risk of Company – borrowed funds require mandatory interest commitment and repayment
obligation at maturity. However, dividend on equity capital is optional and there is no repayment
obligation. Hence, borrowed funds create higher risk for the company.

Trading on equity: Where the borrowed funds are more than the equity funds, it creates higher
risk element. However, if the company earns higher profits than the rate of interest, it is beneficial
for the company. Such phenomenon is known as ‘trading on equity’.

3. Stability of Profits – generally, a company having higher profitability shall prefer borrowed funds
and vice versa.

4. Income tax benefits – interest payment on borrowed funds provide income tax savings, but
dividends on share capital do not provide any tax benefits.

5. Dilution Control – equity share capital has voting rights and the members can interfere in the
management decisions, resulting in reduction in management control. However, borrowed funds
do not cause dilution of control as long as interest / EMI payment are regular and without default.

6. Duration of Funds: Funds required for short-term or medium-term may be raised by borrowings.
But if the funds are for permanent requirement, it will be better to issue of equity shares.

7. Amount of Funds: Huge fund requirement is generally met through own sources, whereas small
fund requirements are financed through borrowings.

8. Administrative Convenience – borrowed funds are preferred due to convenience as compared

to owned funds.

9. Cost of Raising Funds - borrowed funds are preferred due to lower costs as compared to owned
funds. Costs include underwriters’ commission, brokerage, stationery etc.

10. Age of Company – generally, newer / smaller companies prefer owned funds, whereas mature
companies use borrowed funds

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 2

 Capital Structure

Practical Illustrations:

1) Monark Ltd. needs ₹ 20 lakhs for new project and it is considering following two alternative plans:
Plan-I: Equity shares ₹ 16 lakhs and 13% preference capital of ₹ 4 lakhs.
Plan-II: Equity shares ₹ 8 lakhs, 13% Preference Shares ₹ 4 lakhs, 15% Debentures ₹ 8 lakhs.
Expected EBIT is ₹ 400,000. Face value per equity shares ₹ 10. Tax rate is 30%.
Evaluate the two plans and advice the company about the best plan to maximize EPS.

2) Maple Ltd. has existing equity share capital of ₹ 40 lakhs with current operating profit ₹ 10 lakhs.
The company needs ₹ 10 lakhs for expansion plan and following alternatives are available:
1) Entirely through Equity shares of ₹ 10 lakhs
2) Entirely 10% Preference capital of ₹ 10 lakhs.
3) Entirely 12% Bank Loan of ₹ 10 lakhs.
4) Equity Share Capital ₹ 2 lakhs and 11% Debentures ₹ 8 lakhs
5) 8% Preference Capital ₹ 4 lakhs and 14% Bank Loan ₹ 6 lakhs
Post expansion, the EBIT is expected to increase by ₹ 2 lakhs. FV per equity share ₹ 10 and
Tax rate is 20%. Evaluate the given alternative plans and advice the company about the best
plan to maximize EPS.

3) Maxwell Ltd. has existing operating profits of ₹ 16 lakhs. Existing finance charges are ₹ 76,000
and current preference dividends ₹ 80,000, and same shall continue. As per diversification plan,
the company needs ₹ 7 lakhs, which will increase operating profits by ₹ 4 lakhs. The company
has existing 70000 equity shares. Following options are available:
a) Issue 10000 ordinary shares at ₹ 70 per share, or
b) Issue 15% Debentures of ₹ 7 lakhs with maturity of 15 years, or
c) Issue 14% Preference shares of ₹ 7 lakhs.
Assuming 30% tax rate, compute the EPS and decide the best plan for the company.

4) Minion Ltd. has provided following details: Expected EBIT ₹ 20 lakhs. Existing Equity ₹ 20 lakh
(FV ₹ 10) and 8% Debentures of ₹ 50 lakhs. Tax 30%. Additional funds needed ₹ 30 lakhs with
following options –
Plan A) Issue Equity Capital ₹ 30 lakhs (Face Value ₹ 10 per share)
Plan B) Issue 14% Debentures of ₹ 30 lakhs.
Expected P/E ratio for Plan A is 15 times and Plan B is 12 times. Determine the best plan to
maximize shareholders’ wealth.

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 3

 Capital Structure

Cost of Capital

▪ Cost of Capital can be defined as the minimum rate of return that a firm must earn on its
investments, so that the market value of the firm is constant.
▪ It is the cut-off rate for determining future benefits (cash flows) against current investments.
▪ The decision regarding feasibility of a project is taken on the basis of cost of capital.
▪ Hence, cost of capital is the cost of obtaining funds from various sources.
▪ Cost incurred by a company for obtaining funds is the minimum rate of return that it must earn.
▪ It can be stated as the opportunity cost of an investment, i.e. the rate of return that a company
would otherwise be able to earn at the same risk level as the investment that has been selected.

Importance of Cost of Capital:

▪ Securities analysts use Cost of Capital in valuation and selection of investments.

▪ In discounted cash flow analysis, Cost of Capital is used as the discount rate applied to future
cash flows for deriving a business’s net present value. It is an important constituent in Capital
Budgeting decisions.
▪ Investors use Cost of Capital to decide whether or not to invest. It is known as ‘Hurdle Rate’
▪ Cost of Capital represents the minimum rate of return at which a company produces value for its
investors. Weighted Average Cost of Capital is the outcome of the relative proportions of different
sources of finance.

Factors Determining Cost of Capital:

1. General Economic Conditions – Economic conditions determine the demand and supply of
funds within the economy, as well as expected inflation. Any change in demand and supply of
money in the economy changes the interest rates. Thus, if demand for money increases without
much increase in supply, there will be rise in interest rate and vice versa.

2. Market Conditions – Where risk increases, an investor requires a higher rate of return. Such
increase is called a risk premium. When investors increase their required rate of return, the cost
of capital rises simultaneously. The rate of return also depends on the ease of marketability of
securities.

3. Operating and Financing Decisions – Various decisions of a company creates different levels
of risk. Such risk is divided into two types: business risk and financial risk. As business risk and
financial risk increase or decrease, the investor’s required rate of return (and the cost of capital)
will move in the same direction.

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 4

 Capital Structure
4. Amount of Financing – Cost of funds depends on the level of financing that the firm requires.
As the fund requirements is higher, the cost of capital increases due to additional flotation costs,
legal compliances, underwriting commission, brokerage etc.

5. Controllable Factors
a. Capital Structure Policy (Debt-Equity ratio) – A firm can control its debt-equity ratio,
and it targets an optimal capital structure. As more debt is issued, the cost of debt
increases, and as more equity is issued, the cost of equity increases.
b. Dividend Policy – A company can control its dividend payout ratio. For example, as the
payout ratio of the company increases, more the cash outflow and additional need for
funds is created.
c. Investment Policy – Generally, while taking investment decisions, a company is making
investments with similar degrees of risk. If a company changes its investment policy
relative to its risk, both the cost of debt and cost of equity change.

6. Uncontrollable Factors
a. Interest Rates – The level of interest rates will affect the cost of debt and, potentially, the
cost of equity. For example, when interest rates increase the cost of debt increases, which
increases the cost of capital.
b. Tax Rates – Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of
debt decreases, decreasing the cost of capital.
c. Inflation Rates – The rate of inflation affects purchasing power, and thus affects cost of
capital.

Weighted Average Cost of Capital (WACC)

▪ WACC is defined as the Overall Cost of Capital computed by reference to the proportion of each
component of capital as weights. It is denoted by Ko.
▪ WACC is the average cost of various sources of financing, i.e. cost of its capital structure.
▪ The proportion of the sources of finance forms the weights. The weights can be allotted using
the book value or market value. After-tax cost of the sources of finance is considered.
▪ Hence WACC = Sum of [Cost of Individual Components X Proportion i.e. Capital]

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 5

 Capital Structure
▪ The following format may be adopted for computation of WACC:
Component Amount Proportion Individual Multiplication
(%) Cost (Ki * Wi)
Debt Funds Wl Kd Kd * W1
Preference Capital W2 Kp Kp * W2
Retained Earnings W3 Ke Kr * W3
Equity Capital W4 Ke Ke * W4
Total Ko = WACC = Total of above

Advantages of market values as weights:

a. Market values represent the opportunity cost.
b. It represents the present economic value of various sources of finance.
c. It is consistent with the definition of cost of capital i.e. the cost of capital is the minimum rate of
return needed to maintain the market value of the firm
d. Market value is the true reflection of the firm’s capital structure.

Disadvantages of market values as weight

a. Market values are not available in case of unlisted companies.
b. It is not reliable when shares are not actively traded (no purchase or sale of share)
c. Market price fluctuates frequently and is affected by speculations. (Manipulation of share prices)

Advantages of using book values as weight

a. The data is easily available i.e. the Balance Sheet data.
b. Calculations are simple
c. Fewer fluctuations in Book Value.
d. Useful when Mkt. price is not available, (unlisted company) or when the shares are not actively
traded,

Disadvantages of Book values as weights

a. Affected by accounting policies.
b. Does not truly represent the opportunity cost of capital.
c. Does not represent the present economic values of various sources of finance.

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 6

 Capital Structure

Marginal Cost of Capital:

▪ Marginal Cost of Capital (MCC) is the cost of additional capital introduced in the capital structure.
▪ MCC is the differential cost of capital between original capital structure and revised capital
structure.
▪ It is derived when the average cost of capital is computed with marginal weights. The weights
represent the proportion of funds the firm intends to employ.
▪ When funds are raised in the same proportion as at present and if the component costs remain
unchanged, there will be no difference between average cost of capital and marginal cost of
capital
▪ As the level of capital employed increases, the component costs may start increasing. In such a
case both the WACC and marginal cost of capital will increase. But marginal cost of capital will
rise at a faster rate.

Practical Illustrations

1) Compute WACC from the following data:

Source of Finance Cost % in Capital Structure
Equity Share Capital 16 % 15 %
Preference Capital 13 % 10 %
Debentures 12 % 35 %
Term Loan 14 % 15 %
Retained Earnings 16 % 25 %

2) Calculate the WACC (after tax) using Book values given below. Following are cost before tax.
The tax rate applicable is 30%.

Source of Finance Book Value (Rs) Cost %

Equity Capital 100,000 16.0%
14 % Preference Capital 50,000 14.0%
Retained Earnings 50,000 16.0%
14 % Debentures 100,000 14.0%
12% Term Loan 100,000 12.0 %

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 7

 Capital Structure
3) Anarchy Ltd. provides the following capital structure. Compute the overall cost of capital.
Particulars Rs. in Lakhs Cost %
Equity 3,000 15 %
Retained earnings 500 18 %
Preference capital 500 10 %
Debt 2,000 12 %

4) Calculate the WACC using Market value proportions. Following data is available –
Source of Finance Mkt. Value (Rs) Cost after tax %
Equity Capital 60,00,000 18.0%
11% Preference Capital 2,00,000 14.5%
13.5% Debentures 8,00,000 12.7%
18% Term Loan 10,00,000 12.6 %
Total 80,00,000

5) Minerva Ltd. provides the following capital structure. Compute the overall cost of capital.
Particulars Rs. in Lakhs Tax adjusted Cost %
12% Debentures 30,00,000 8.00 %
9% Preference Capital 20,00,000 9.00%
Equity Share Capital 50,00,000 14.00 %

6) Calculate the WACC (before tax and after tax) using values given below. Tax rate is 40%.
Source of Finance Book Value (Rs)
Equity Capital (dividend rate 12%) 5,00,000
10 % Preference Capital 2,50,000
9 % Debentures 2,50,000
8% Term Loan 5,00,000

7) Calculate the WACC (after tax) using values given below. Tax rate is 20%.
Source of Finance Book Value (Rs)
Equity Capital (dividend rate 11%) 15,00,000
8 % Preference Capital 10,00,000
9 % Debentures 20,00,000

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 8

 Capital Structure

LEVERAGES

▪ The term leverage in general, refers to advantage gained for any purpose.
▪ Leverage is the relationship between two inter-related financial variables. These may be cost,
output, sales, EBIT, EBT, EPS etc.
▪ Leverage effect implies the responsiveness or influence of one financial variable over other
financial variable.
▪ Leverage can be defined as a percent (%) change in dependent variable as compared to the
percent change in independent variable. Magnification impact on the dependent variable is the
leverage effect. Higher the leverage, higher the risk => higher the risk, higher the return.
▪ Leverage means a more than proportionate outcome against a given proportionate cause. In
financial analysis, leverage is used by business firms to quantify the risk-return relationship to
different alternative capital structures. Study of leverage is essential to define the risk undertaken
by the shareholders.

Operating leverage

▪ Operating leverage is defined as the ‘firm’s ability to use fixed operating costs to magnify effects
of changes in sales on its earnings before interest and taxes.
▪ Operating Leverage is the relationship between contribution and EBIT, i.e. effect of change in
contribution on change in EBIT.
▪ A change in sales will lead to a change in profit i.e. Earnings before Interest and Taxes (EBIT).
▪ The effect of change in sales on EBIT is measured by operating leverage.
▪ Since fixed costs remain the same irrespective of level of output, percentage increase in EBIT
will be higher than increase in Sales.

Operating Leverage = Contribution

EBIT

Degree of Operating Leverage = % change in EBIT

% change in Contribution

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 9

 Capital Structure

Financial leverage

Financial Leverage is defined as the ability of a firm to use fixed financial charges (interest) to
magnify the effects of changes in EBIT (Operating profits), on the firm’s Earning per Share (EPS).
Financial Leverage occurs when a company has debt content in its capital structure and fixed
financial charges e.g. interest on debentures. These fixed financial charges do not vary with the
EBIT. They are fixed and are to be paid irrespective of level of EBIT. Hence an increase in EBIT will
lead to a higher percentage increase in Earnings per Share (EPS). This is measured by the Financial
Leverage, sometimes also known as ‘Financial Gearing’

Financial Leverage = EBIT

EBT

Degree of Financial Leverage = % change in EBT

% change in EBIT

Combined leverage

Combined Leverage is used to measure the total risk of a firm i.e. Operating Risk and Financial
Risk. The effect of fixed operating costs (i.e. operating risks) is measured by operating leverage.
The effect of fixed interest charges (i.e. financial risks) is measured by financial leverage. The
combined effect of these is measured by combined leverage.

Combined Leverage = Contribution

EBT

Combined Leverage = Operating Leverage (x) Financial Leverage

Degree of Combined Leverage = % change in EBT

% change in Contribution

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 10

 Capital Structure

Distinction

Sr. Operating Leverage Financial Leverage

1. Operating Leverage is associated with Financial Leverage is associated with
investment activities of a company. financing activities of a company.
2. It consists of fixed operating expenses It consists of fixed interest cost of
company
3. It measures business risk It measures financial risk
4. It shows relationship between sales It shows relationship between EBIT
and EBIT and EBT
5. Operating leverage doesn’t involve Financial leverage results in trading on
trading on equity. equity.

Practical Illustrations

1) Following data of Abhishek Ltd. as on 30th Sept, 2022,

Earnings before interest and tax (EBIT) Rs. 10 lakhs,
Profit before Tax (PBT) Rs. 4 lakhs and Fixed Costs Rs. 6 lakhs.
Compute –
a) operating leverage,
b) financial leverage,
c) combined leverage and
d) percentage change in earnings per share (EPS), if sales are expected to rise by 5%:

2) The following information is available for Aishwarya Ltd.

Particulars Rs.
Sales 400,000
(-) Variable Cost 140,000
Contribution 260,000
(-) Fixed Cost 180,000
EBIT 80,000
(-) Interest 10,000
PBT 70,000

Compute all the leverages

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 11

 Capital Structure
3) Given below is the Balance Sheet of Honey Ltd.
Liabilities Rs. Assets Rs.
Equity Capital (FV Rs. 10) 180,000 Fixed Assets 450,000
10% Debentures 240,000
Retained Earnings 60,000 Current Assets 150,000
Current Liabilities 120,000
Total 600,000 Total 600,000

The total assets turnover ratio is 2.50 times, fixed operating costs are Rs. 200,000, variable cost
ratio is 40% and income tax rate is 30%. Compute Operating leverage, Financial leverage and
Combined leverage.

4) Following details were extracted from Gama Ltd.

Financial leverage 2:1, Operating leverage 3:1,
Interest charges p.a. Rs. 20 lakhs, Tax rate 40%,
Variable cost 60% of sales.
Prepare the income statement of the company

5) Sales of Max Ltd. are Rs. 30 crores and EBIT is 15% of sales. The Equity Capital is Rs. 12
crores, 13% Preference Capital Rs. 5 crores and 15% Debentures Rs. 6 crores. Combined
leverage is 3 times. Compute Operating leverage

6) The following information is available for Sush Ltd. Compute all the leverages.
Particulars Rs.
Sales 500,000
(-) Variable Cost 100,000
Contribution 400,000
(-) Fixed Cost 200,000
EBIT 200,000
(-) Interest 120,000
PBT 80,000

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 12

 CAPITAL BUDGETING
1. INTRODUCTION

Investment decisions are the most important function of a Finance Manager. This function involves investment in
long term assets/ projects for maximization of shareholders’ wealth. Capital investment involves a cash outflow in
the immediate future in anticipation of returns at future date. The investment of funds requires a number of
decisions to be taken in which funds are invested and benefits are expected over a long period. A capital
investment decision involves largely irreversible commitment of resources that is generally subject to significant
degree of risk. The finance manager therefore is required to do proper planning of project to know in advance
technical and financial feasibility of the project.

Efficient allocation of funds involves an organisation’s decision to invest its resources in long-term assets like land,
building facilities, equipment, vehicles, etc. Basically, profits are derived from the use of capital investments.
Investments in fixed assets involve a large amount of funds, and these funds remain invested over a long period of
time. The success of an organization depends on the quality of such capital investment decisions.

2. CONCEPT OF CAPITAL BUDGETING

 Capital budgeting refers to long term planning of expenditure whose returns are attained over a future period.

 It is the process of deciding whether or not to commit resources to a project whose benefits would be spread
over several time periods.

 It considers proposed capital outlay, i.e. planning for the utilisation of long term funds.

 The exercise involved in capital budgeting is to co-relate the future benefits to current / future costs in some
reasonable manner which would be consistent with the profit maximising objectives of the business.

 Capital Budgeting is a managerial decision, since it involves future estimation, prediction, requiring high order
of intellectual ability.

 The economic justification for a capital expenditure programme requires a long term estimates of profits,
which in turn involves projection of sales and cost of operation over a period of years in the future.

3. DEFINITIONS OF CAPITAL BUDGETING

 According to Charles T. Horngreen, “Capital budgeting is a long-term planning for making and financing
proposed capital outlays”.

 G. C. Philippatos has defined as “Capital budgeting is concerned with the allocation of the firms source
financial resources among the available opportunities. The consideration of investment opportunities involves
the comparison of the expected future, streams of earnings from a project with the immediate and subsequent
streams of earning from a project, with the immediate and subsequent streams of expenditure”.

 According to Richard and Green Law, “Capital budgeting is acquiring inputs with long-term return”.

 According to the definition of Lyrich, “Capital budgeting consists of planning development of available capital
for the purpose of maximizing the long-term profitability of the concern”.
 Capital Budgeting

4. NEED FOR CAPITAL INVESTMENT

a. Increase revenues

b. Cost reduction proposals

c. Replacement of machinery with new modern equipment

d. Plant re-arrangement programmes, change of site

e. Mechanisation of process

f. Expansion proposal through extensions to plant and machinery for having additional volume of production

g. Installation of new plant and machinery for taking up a new product or product lines.

h. Research and Development proposal

i. Product improvement

j. New product line or diversification proposal

k. Strategic investment proposal

l. Contractual investment proposal

5. IMPORTANCE OF CAPITAL BUDGETING DECISIONS

Capital Budgeting is the process of making investment decisions in capital assets. It is a process of planning,
analyzing and implementation of capital expenditure. These are very crucial decisions since heavy funds outlay and
uncertain future. Thus, capital budgeting decisions should be taken after careful analysis and review.

The importance of Capital Budgeting can be understood from the following points:

a) Huge Investment: Initial Investment in huge / substantial. Hence, commitment of monetary resources
should be made properly. There shall be thoughtful, wise and correct decisions. An incorrect decision would
not only result in losses but affect the survival of the firm.

b) Long Term Implications: The effect of today’s decision is known only in the future and not immediately.
Hence, capital budgeting decisions have long term implications on the company’s growth and existence. A
capital budgeting decision affects the company’s future growth. A wrong decision can prove disastrous for
the long-term survival of firm. Hence, capital budgeting decisions determine future destiny of a company.

c) Irreversible decision: Decisions are irreversible and commitment should be made on proper evaluation.
Where the decision does wrong, it is very difficult to resell such fixed assets, unless at heavy losses.

d) Risk & uncertainty: Investments decisions are based on future expectation. But, the future is uncertain and
hence there is a lot of risk involved. Longer the period, higher the risk. Future estimates may go wrong.

e) Complexity: Decisions are based on future events. Quantification of future events involves application of
statistical and probabilistic techniques. Careful judgement and application is needed. These decisions
require an overall assessment of future events which are uncertain. It is really a tough job to estimate the
future benefits correctly in quantitative terms due to the uncertainties caused by economic-political social
and technological factors.
 Capital Budgeting

6. CAPITAL BUDGETING PROCESS

i. Planning: The capital budgeting process begins with the identification of potential investment opportunities.
The feasible opportunities are put forward for discussion and planning. Their potential effect on the firm’s
profitability is assessed. Also, the practical implementation of the opportunity is tested.

ii. Establish criteria: The decision making criteria are determined, such as minimum acceptable rate of return,
social obligations, legal bottlenecks etc.

iii. Evaluation: This phase involves analysis of investments opportunities by combining the factors such as
cash inflows, cash outflows, expected rate of return and time horizon. Investment appraisal techniques such
as payback method and accounting rate of return, discounted cash flow techniques etc. are used to
evaluate the proposals.

iv. Selection: Considering the associated risk-returns with the individual projects as well as the cost of capital
to the organisation, the organisation will choose among projects so as to maximise shareholders’ wealth.

v. Implementation: When the final selection has been made, the firm must acquire the necessary funds,
purchase the assets, and begin the implementation of the project.

vi. Control: The progress of the project is monitored with the aid of feedback reports.

vii. Review: When a project terminates, or even before, the organisation should review the entire project to
explain its success or failure. This phase may have implication for firms planning and evaluation procedures.

7. FACTORS INFLUENCING INVESTMENT DECISIONS

 Initial Investment: This refers to the cash outflows at the initial stage. Initial investments would include cost
of new assets purchased, working capital required, installation and commissioning of assets, tax
implications sale of old assets etc. The cash outflows would be computed after deducting the salvage value
of old machinery, if any. Hence, Initial Investment = Cost of Assets purchased (-) Sale Value of old assets.

 Cash Flow After Taxes (CFAT): This refers to the cash inflows generated by the projects at various points
of time. Cash flows would be based on income sources, cash receipts, variable cost of operations,
disbursements, interest on borrowings, tax implications, depreciation etc. CFAT = PAT + Deprn + Amortzn.

 Project Life: The time period during which the project generates positive CFAT is called Project Life.

 Time Value of Money: The value of money differs at different point of time. So the present value of future
cash flows will be computed by discounting the same at the appropriate discount rate.

 Minimum expected rate of return: It represents the cut-off rate for capital investment evaluation. A project
which does not earn atleast the cut-off rate should not be accepted. Generally, the rate used for discounting
is the WACC of the enterprise. It is the minimum rate of return which a project should earn.

 Management attitude: If the management is progressive and has a growth outlook, they would encourage
new investments for higher productivity and profitability.
 Capital Budgeting
 Risk and Uncertainty: Evaluation of capital expenditure proposal involves projections of the future. Future
is always uncertain. There are too many unknown and uncertain factors which influence cash flows and
hence risk element should be considered in decision-making.

 Competitors’ strategy: The competitors’ strategies regarding capital investments have a significant
influence on the investment decisions of the company. If the competitor is expanding, then the company
also tends to go for capital investments etc.

 Market forecasts: If the management perceives a rise in demand for their product and services, they would
go for an expansion project. Hence, the market forecasts affect the decision making of company.

 Tax benefits: The govt. offers various tax incentives based on capital investments in specified sector or
geographical area. Hence, companies may start a new project of wind energy in a backward area for tax
benefits.

 Social Corporate Responsibility (CSR): Certain projects may be undertaken to fulfil CSR commitments.

Initial Invt.
(Outflow)

Social CFAT
Impact (Inflow)

Project
Competition
Life

Capital
Budgeting
Factors
Business Time Value
Attitude of Money

Expected
Risk Mgt.
Returns

Tax Mgt.
 Capital Budgeting

8. TIME VALUE OF MONEY

Re. 1 today is worth more than Re. 1 received after one year!
One of the most fundamental concepts in finance is that money has a “time value.” Money in hand today is worth
more than money that is expected to be received in the future. The reason is simple – a rupee that you receive
today can be invested such that you will have more than a rupee at some future time. The time value of money
serves as the basis for all other concepts in finance. It impacts business finance, consumer finance, and
government finance. Time value of money results from the concept of interest.

Primary reasons why a rupees to be received in the future is worth less than a rupees to be received immediately –

1. Inflation reduces the purchasing power of rupees through time. Suppose rate of petrol about one year back
was Rs. 65 per litre and now it is Rs. 72 per litre, thereby reducing purchasing power of money.

2. A rupee today is worth more today than in the future because of the opportunity cost of lost earnings — that
is, it could have been invested and earned a return between today and a point in time in the future.

3. All future values contain some uncertainty about their occurrence. As a result of the risk of default or non-
performance of an investment, a rupee in hand today is worth more than an expected rupee in the future.

4. Finally, human preferences typically involve impatience, or the preference to consume goods and services
now rather than in the future. The satisfaction of today is better than future.

Important Concepts related to Time Value of Money

 Future value of a lump sum amount refers to the value of money invested today, at a given rate of interest.

 Compounding is the method used to compute the future value of money invested today, as a certain rate.
The additional funds received over and above the amount invested is known as ‘compound interest’

 Present Value of future cash flow (inflow or outflow) means the current value of a future sum of money or
stream of future cash flows, using a given rate of return.

 Discounting is the method used to compute the present values of series of future cash flows, using a certain
rate of return. Such rate of return is known as ‘discount rate’

 Annuity is a stream of regular periodic payment made or received for a specified period of time. Normally,
payments or receipts occur at the end of each period.

 Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed date and continue
indefinitely or perpetually.

 Sinking Fund is the fund which is created for a specified purpose by way of sequence of periodic payments
over a time period at a specified interest rate.

 Net Present Value is the difference between the total present values of all future cash inflows and outflows.
 Capital Budgeting

9. CLASSIFICATION OF PROPOSALS

A firm may have several proposals for its consideration. It may adopt one of them, some of them or all of them
depending upon whether they are independent, contingent or dependent or mutually exclusive.

a) Independent proposals: These are the proposals, which do not compete with one another. In case of such
proposals the firm may straightway accept or reject on the basis of a minimum return on investment required.

b) Contingent or dependent proposals: These are the proposals, whose acceptance depends on the
acceptance of one or more other proposal. When a contingent investment proposal is made, it should also
contain the proposal on which it is dependent in order to have better perspective of the situation.

c) Mutually Exclusive Proposals: These are proposals which compete with each other in way a way the
acceptance of one project automatically means rejection of other projects. Thus, in case of two or more mutually
exclusive proposals, only one of the proposals can be accepted.

d) Capital Rationing Proposal – discussed later

10.CAPITAL BUDGETING EVALUATION TECHNIQUES

There are several methods / techniques for evaluation and ranking of the capital investment proposals. In case of all
these methods the main emphasis is the return which will be derived on the capital investment in the project.

Capital Budgeting Techniques

Traditional or Time-adjusted or
Non-Discounting Discounted Cash Flows

Payback Period Net Present Value

Profitability Index
Accounting Rate
of Return

Internal Rate of
Return

Modified Internal
Rate of Return

Discounted
Payback
 Capital Budgeting
A) Payback Period Method

Payback period refers to the period in which the project will generate the necessary cash to recover the initial
investment. In case of even cash flows,

Payback period = Initial Investment

Annual Cash Inflows

In case of differential cash inflows, the payback period can be computed through proportionate calculations of cash
inflows with respect to the initial investment.
Annual cash flows = Estimated cash inflow (i.e. net income from investments before depreciation but after taxation)

Decision Making – A project whose actual payback period is less than the predetermined period, the project will be
accepted by the management. The fixation of maximum acceptable pay-back period is generally done by taking into
account the reciprocal of the cost of capital (i.e. maximum acceptable pay-back period = 100 divided by desired rate
of return).
In case of comparison of projects, the lower payback is selected. It may be said that pay-back period is measure of
liquidity of investments rather than their profitability. Sometimes payback period is calculated after discounting the
cash flows by a predetermined rate. The payback period so calculated is called “Discounted Payback Period”.

Merits / Advantages of Payback Method:

 This method is simple to understand and easy to operate.
 Surplus arises only if the initial investment is fully recovered. Hence, there is no profit on any project unless
the payback period is over.
 When funds are limited, projects having shorter payback periods should be selected, since they can be
rotated more number of times.
 This method is suitable in the case of industries where the risk of technological obsolescence is very high
and hence only those projects which have a shorter payback period should be financed.
 This method focuses on projects which generates cash inflows in earlier years, thereby reducing the risk
element.
 This method promotes liquidity by stressing on projects with earlier cash Inflows. This is a very useful
evaluation tool in case of liquidity crunch and high cost of capital.

Demerits / Limitations of Payback Method:

 It stresses on capital recovery rather than profitability.
 It does not consider the post-payback cash flows, i.e. returns from the project after its payback period.
 This method becomes an inadequate measure of evaluating two projects where the cash inflows are
uneven.
 This method ignores time value of money. Cash flows occurring at all points of time are treated equally. This
goes against the basic principle of financial analysis which gives high importance to time value of money.
 Capital Budgeting
B) Discounted Payback Period Method

When the payback period is computed after discounting the cash flows by a predetermined rate, it is called as the
‘Discounted payback period’. Discounted Payback Period refers to the period where the project will generate
necessary ‘discounted cash flows’ to recover its initial investment.

The payback period is computed after discounting the cash flows. A pre-determined rate (generally WACC) is used
for discounting the cash flows. This method is an improvement over the simple payback period, since it recognizes
the time value of money.

Payback period = Initial Investment (where cash inflows are same p.a.)
Annual discounted Cash Inflows

C) Accounting or Average Rate of Return (ARR)

According to this method, the capital investment proposals are judged on the basis of their relative profitability. For
this purpose, capital employed and expected incomes are determined according to commonly accepted accounting
principles over the entire economic life of the project and then the average yield is calculated. Such a rate is termed
as ‘Accounting Rate of Return.’

It may be calculated, according to either of the following formula –

ARR = Average net profit * 100 OR ARR = Average net profit * 100
Original Investment Average Investment

The term “Average net profit” is the average of earnings (after depreciation and tax) over the whole of the economic
life. One may calculate “Average annual net earnings” before tax. Such rate is known as pre-tax accounting rate of
return. Average investment it estimated by dividing the total of original investment and investment at end of project
life by two. It takes into consideration the current cash outlays, scrap value of existing equipment, working capital
employed and residual value of assets at end of project life.

Decision Making – Any project expected to give a return below minimum desired rate of return will be straightway
rejected. In case of several comparable projects, the project with highest ARR is selected.

Merits:
 The method is superior to pay-back period as it takes into account savings over the entire economic life,
even though estimates of distant future may be subject to wide margin of errors.
 The projects differing widely in character can be compared property.
 The method embodies the concept of ‘net profits’ after allowing for depreciation as it is of vital importance in
the appraisal of a proposal.

Demerits:
 The method suffers from the fundamental weakness as that of pay-back method i.e. it ignores the fact that
receipts occur at different time intervals i.e. it ignores time value of money.
 The method has different formulae, each of which gives different rate of return for the same proposal.
 Some analyst are of the opinion that as the, method takes into account earnings after depreciation, it is
gross error because it is only the cash flows, that are relevant for the decision making purpose.
 Capital Budgeting
Discounted Cash Flow (DCF)
An investment is essentially an outlay of funds in anticipation of future returns. Time is a fundamental factor in
investment for the purpose of evaluation of investments. Time is always crucial for the investor, so that a sum
received today is worth more than the same sum to be received tomorrow. Thus, in evaluating investment projects,
it is important to consider the timings of return on investments.
Based on the concept of time value, following investment evaluation techniques are used –
1. Net Present Value (NPV)
2. Profitability Index (PI)
3. Internal Rate of Return (IRR)

D) Net Present Value Method (NPV)

The net present value is the difference between present value of benefits and present value of costs.

‘NPV = Total Discounted Cash Inflows (-) Total Discounted Cash Outflows’

Cash outflows and inflows are forecasted / calculated and these are discounted using a suitable rate of return. The
discounted cash flows are compared and decision is taken accordingly. A positive NPV (i.e. NPV > 0) indicates a
favourable position and the project should be approved. If NPV < 0, project is rejected. The discount rate is the cut-
off rate / rate of return (WACC) which is expected by the management. In case of mutually exclusive projects, the
project with the highest NPV should be selected. A negative NPV indicates that the returns earned by the projects
are less than management expectation, and hence such project is rejected. A project with negative NPV may not be
a loss making project. It simply does not meet expectations.

Decision Making –
 NPV > Zero, accept the proposal, since earning more than expectation
 NPV = Zero, accept the proposal, since earning same as expectation
 NPV < Zero, reject the proposal, since earning less than expectation

Important Terms –

 Cash Outflows: Generally, Cash Outflows consist of the initial investment at start of project along with other
payments such as working capital, tax paid on capital gain on sale of old asset, if any etc.

 Cash Inflows: Generally cash Inflows are after tax cash inflows generated by a project. (CFAT = PAT +
Depreciation). Other cash inflows include salvage value of old assets as well as new assets, recovery of
working capital at the end of the project, tax savings etc. The general assumption is that all cash inflows
occur at the end of each year.

 Discounting cash inflows and outflows: Each item of cash inflows and outflow is discounted to ascertain
its present value. For this purpose, the discounting rate is generally taken as the Cost of Capital (WACC)
since the project must earn a return atleast equal to its cost of capital.

 Use of Discounting Rate: The relevant discount factor can be computed as where k = cost of capital and n
= year in which the inflow or outflow takes place. Hence, PV factor at 10% after 1st year =1/1.10 = 0.9090
and PV factor at end of 2nd year = 1/(1.10)2 = 0.8264 …
 Capital Budgeting
Merits:
 It considers the time value of money. Hence, it satisfies the basic criterion for project evaluation.
 The entire cash flows are considered over the life of the project.
 NPV constitutes addition to wealth of shareholders and thus focuses on the basic objective of financial mgt.,
 Since all cash flows are converted into present value, different and unrelated projects can be compared on
NPV basis. Thus, each project can be evaluated independent of others on its own merit.

Demerits:
 It involves complex calculations.
 It involves forecasting cash flows and application of discount rate. Thus accuracy of NPV depends on
accurate estimation of these two factors which may be quite difficult in practice.
 NPV and ranking of project may differ at different discount rates, causing inconsistency in decision making.
 It ignores the difference in initial outflows, size of different proposals etc., while evaluating mutually
exclusive projects.

E) Profitability Index (P.I)

Profitability Index (P.I) is the ratio of the present value of discounted cash inflows to the discounted cash outflows of
an investment. If the present value method is used, the present value of the earnings of one project cannot be
compared directly with the present value of earnings of another, unless the investments are of the same size. It is
also known as Benefit-Cost Ratio. In order to compare proposals of different size, the flows to investment must be
related. This is done by dividing the present value of earnings by the amount of investment, to give a ratio i.e. called
the profitability index / ratio or desirability factor. P.I method is most useful when the NPV of mutually exclusive
projects is equal. P.I measures profitability as well as maximization of shareholders’ wealth.

Profitability Index = Total Discounted Cash Inflow

Total Discounted Cash Outflow

Decision Making – Higher the profitability index, the better is the project. This is called benefit cost ratio.
Where, PI > 1 accept the proposal
PI = 1 accept the proposal
PI < 1 reject the proposal

Advantages:

 This method considers the time value of money.

 It is a better project evaluation technique than NPV and helps in ranking projects where NPV is positive.
 It focuses on maximum return per rupee of investment and hence is useful in case of investment in divisible
projects, when funds are not fully available.

Disadvantages:

 It fails as a guide in resolving capital rationing when projects are indivisible.

 It involves complex calculations.
 Capital Budgeting
F) Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is the rate of return at which present value of cash outflows and present value of cash
inflows is equal. IRR is the rate which brings the sum of the future cash flows to the same level as the original
investment. Hence, IRR is the rate of return at which NPV = ‘0’, i.e. investments are equal to the earnings. At the
rate of IRR, discounted cash inflows = discounted cash outflows. The acceptance or rejection of a project depends
on the relationship between IRR and the expected rate of return (discounting rate). If IRR is higher than the
discounting rate, accept the proposal and vice versa. In case of mutually exclusive proposals, higher the IRR,
better. It is presumed that the company re-invests its cash inflows at the rate of IRR, to earn profits.

Decision Making –
Where IRR > Cut-off-rate, accept the proposal
IRR = Cut-off-rate, accept the proposal
IRR < Cut-off-rate, reject the proposal

Advantages:
 Time value of money is taken into account.
 All cash inflows of the project, arising at different points of time are considered,
 Decisions are immediately taken by comparing IRR with the cost of capital,
 It helps in achieving the basic objective of maximisation of shareholders wealth.

Disadvantages:
 It is very tedious to compute IRR in case of multiple cash outflows.
 Multiple IRR’s may result, leading to difficulty in interpretation.
 It may conflict with NPV in case Inflow / outflow patterns are different in alternative proposals,
 The presumption that all the future cash inflows of a proposal are reinvested at a rate equal to the IRR may
not be practically valid.

Comparison:

a) NPV vs. IRR

Higher the NPV, higher will be IRR. However, NPV and IRR may give conflicting results in certain these cases:
i. Interest Rate – Under the NPV method, rate of interest is assumed as the known factor whereas it is
unknown in case of IRR method.
ii. Timing difference – The NPV method considers the timing differences at the appropriate discount rate.
iii. Objective – NPV is actual surplus amount leading to wealth maximization, whereas IRR is just a rate
iv. Reinvestment assumption – There is a presumption in IRR that intermediate cash inflows will be re-invested
at that rate (IRR); whereas in the case of NPV method, intermediate cash inflows are presumed to be re-
invested at the cut-off rate. However, re-investment at the cut-off rate is more realistic than the re-
investment at IRR.

Hence, in case of conflicting decisions based on NPV and IRR, the NPV method should be selected.
 Capital Budgeting
b) NPV vs. PI

All three techniques viz. NPV, PI and IRR use the time value of money. The discount rate used in NPV and PI
methods is the same. Hence, for a given project, NPV and PI method give the same result, i.e. Accept or Reject.
However, if we have to select one project out of two mutually exclusive projects, the NPV method should be
preferred. This is because the NPV indicates the economic contribution or cash surplus of the project in
absolute terms. Higher the NPV, better the project.

11. OTHER ASPECTS IN CAPITAL BUDGETING

a) Capital Rationing

Generally, a firm decides the maximum amount that can be invested in capital projects for a given period of
time. Else, firms may suffer from inadequate funding. In such cases, the firm attempts to select a best
combination of investment proposals that will provide maximum profitability, within the fund constraint. Such a
situation is called ‘Capital Rationing’. Hence, capital rationing is required where a firm cannot implement all the
projects due to shortage of funds. Hard capital rationing is due to external conditions (sources of funds) and Soft
capital rationing is due to internal conditions (policy).

Classification of Capital Rationing Proposals –

i. Indivisible Projects – in case of indivisible projects, the investment amount cannot be partial or
proportionate. Thus, investment should be made in full, i.e. either accept the project in full or reject it. In
such cases, decision is taken on the basis of maximum NPV and the best combination of projects is
selected, to utilise available amount.

ii. Divisible Projects – in case of divisible projects, the investment amount can be pro-rata. Thus, investment
may be made to the extent funds are available i.e. the project can be accepted partially. In such cases,
decision is taken on the basis of P.I and the best combination of projects is selected, to utilise available
amount.

Capital Rationing

Multiple Investment Opportunities

Limited (Insufficient) Funds
(Projects)

Internal External
Indivisible Divisible
Shortage Shortage
Projects Projects
(Budgets) (Funds)

NPV
PI Method
Method
 Capital Budgeting
The situation may arise due to financing capital expenditure only by way of retained earnings, allocation of
specified departmental limits or restricted availability of own funds and thereby restrictions on borrowings. The
whole purpose of capital rationing is selection of best combination with maximum profits and maximum
utilization of available funds. Hence, a single method may not be useful for decision-making. Also, it is possible
that instead of one big project, few small projects are selected utilize of funds in full. Further, a situation may
arise whereby entire funds are not utilized, resulting in idle (non-productive) funds. Hence, it can be said that
capital rationing may not give the best results each time.

b) Capital Budgeting and Inflation

Inflation is the general rise in prices of goods and services in an economy. Inflation results in erosion (reduction)
of the purchasing power of money over a period of time. Thus, the finance manager has to measure the impact
of inflation on his decisions so as to adjust various financial policies.

Generally, Income Statement and Balance Sheet are prepared according to historical accounting system. Thus,
financial performance of a firm reflected in conventionally prepared financial statements is not exposed to the
effect of inflation. However, the management decisions are affected by inflation to a great extent. Due to
different rates of inflation, the financial ratios based on financial statements become invalid. Inflation may lead to
distortion in inter-firm comparison as well. Hence, in an inflationary environment, when historical data are used,
a firm with older assets will show a higher return on assets.

A project is subjected to inflationary pressures from time to time ranging from six months to more than one or
two years. During this period, it will be difficult to predict the trade and economic cycles. In such a situation,
inflation is bound to affect the project appraisal and implementation process.

Following guidelines should be observed while doing project appraisal:

 Provide for escalation for all cost heads, keeping in view likely inflation rate during project implementation.
 The various sources of finance should be scrutinized with reference to probable revision in the interest rate
by the lenders.
 Adjustment should be made in profitability and cash flow projection to take care of inflationary pressures.
 Assess the financial viability of the project at the revised rate and assess the same with reference to
economic justification of the project (i.e. NPV > 0). The rate of return should include the rate of inflation p.a.
 Projects having early payback period should be preferred being less risky.

Real cash flow refers to expression of future cash flows in terms of rupees of today’s purchasing power.
Nominal Cash flow means the number of rupees which are forecasted to be paid and received at various future
times. It is also called ‘money cash flow’. For capital budgeting purposes, real cash flows should be discounted
using real discount rate and nominal cash flows should be discounted using nominal discount rate. Generally,
interest rates are usually quoted in nominal terms rather than real times. Thus, an inflationary economy distorts
capital budgeting decision. In inflationary situation, the real rate of return on a security will be less than its
nominal rate of return.
 Capital Budgeting
c) Capital Expenditure Control

Planning and control are inter-linked and consecutive steps for the successful implementation of any
programme. Planning done for incurring capital expenditure is followed by control devices to assess the
deviations between the expected and achieved results. Capital expenditure is classified into three main forms:

(1) expenditure made to reduce costs;

(2) expenditure made to increase revenue;
(3) expenditure which is justified on non-economic grounds.

Based on capital expenditure control, the capital investment analysis should concentrate on three types of
capital outlays viz.:

1) Major Projects involve strategic investments for expansion of productive capacity, achieving product
innovation

2) Routine expenditure includes working condition improvement, maintenance expenditure, competition

oriented expenditure etc.

3) Replacement projects are undertaken to avoid capital wastage for existing equipment to check its disposal
value or it may be obsolescence replacement.

An important aspect of capital expenditure control is to match the demand for funds with the supply of funds.
Demand for capital comes from all departments while supply of capital is a scarce. This requires the Finance
Manager to exercise economy in capital expenditure so that optimum benefit could be obtained with the use of
scarce capital sources. This establishes the need for capital rationing to impose constraints on capital
expenditure under prevailing market conditions and place self-imposed constraints to check the funds being
raised from outside agencies like borrowings. Thus, capital rationing is adopted to control capital expenditure.

d) Projects with Different Lives

The decision-making based on NPV or IRR assumes that the life / duration of the project are equal. In mutually
exclusive projects, decisions based on NPV would provide correct results. However, decision making based on
NPV may not provide right conclusions in cases of different lives. Thus, differential lives of projects require a
separate evaluation methodology.

This problem can be handled by annualising the respective cash flows of the alternative projects under study. In
other words, we need to compute ‘Annual Equivalent Value’ or ‘AEV’ to take the right decisions. The process of
annualising the net present values of the cash inflow or outflow of an investment proposal involves conversion
of the present value into an annuity over the economic life of the proposal at suitable opportunity. Thus, the
present values are divided by the annuity factors to arrive at AEV.

Annualised Equivalent Value = NPV

PV Annuity factor over the project life

The annualising net benefit can be compared directly with similar results for projects with entirely different lives
and cash flow patterns. Projects with equal annual benefit but varying cash outflows can be ranked on the basis
of annualised cost, i.e. Annual Equivalent Cost.
 Capital Budgeting

12. CAPITAL BUDGETING UNDER RISK & UNCERTAINTY

Risk can be defined as a diversion from expectations. Uncertainty is the knowledge of the unknown / variance.
However, it is said that risk is always certain. Capital budgeting is the process of making investment decisions for
the future. Mostly, future is uncertain and hence risk and uncertainty arise due to the futuristic nature of projects.
Higher the uncertainty, higher the risk associated with the project. Risk cannot be avoided, but it can be, and must
be managed.

There are three different types of project risk to be considered:

1) Stand-alone risk: This is the risk of the project itself as measured in isolation from any effect it may have
on the firm’s overall corporate risk.

2) Corporate or within-firm risk: This is the total or overall risk of the firm when it is viewed as a collection or
portfolio of investment projects.

3) Market or systematic risk: This defines the view taken from well-diversified shareholders. Market risk is
essentially the stock market’s assessment of a firm’s risk, its beta, and its effect on share price.

There are various methods of risk measurement and risk management. Few of the methods are given below –

i. Payback Period – Payback period is the oldest and commonly used method for recognizing risk
associated with investment projects. Payback criteria are primarily used for mitigating risk rather than
measure profitability. This method is suitable for companies with capital deficiency, conservative mgt. etc.
Firms prefer shorter payback to reduce the risk of long duration projects. Payback ensures liquidity by
quick recovery of capital. It helps in reduction of risk element by eliminating longer projects.

ii. Risk Adjusted Discount Rate – Under this method, a higher rate of discount is adopted for projects which
are considered more risky and, lower discount rate is adopted for less risky projects. The discount rate to
be applied taken into consideration the risk profile of the project.
Risk adjusted discounted rate = Risk free rate
+ Risk premium for normal risk of the firm
+ Risk premium for covering additional risk.
Such a composite rate is known as Risk-adjusted Discount Rate and it reflects the management’s attitude
towards risk involved in projects. The approach is simple to understand, recognizes risk and uncertainty.
However, no concrete way of deriving risk premium, i.e. computation of the higher rate of discount.

iii. Certainty Equivalent Approach – According to Certainty Equivalent approach, adjustments for risk are
made to the cash flows itself, arising in the future. Cash flows are reduced to conservative level by
applying a correction factor termed as Certainty Equivalent Co-efficient (CEC). This correction factor is
the ratio of risk-less (certain) cash flows to risky cash flows, i.e. CEC = Certain cash flows / Risky cash
flow. CEC assumes a value between 0 and 1, and varies inversely with risk.

CEC are subjectively / objectively established by the decision maker and multiplied by the cash flows to
arrive at adjusted cash flows. These adjusted cash flows are further used for project evaluation through
payback, NPV, IRR or any other method. This approach clearly recognizes risk involved in investment
projects. But, process of reducing cash flows is subjective and can be inconsistent for different projects.
 Capital Budgeting

iv. Probability of Cash Flows – The most crucial information for capital budgeting decision is the forecast of
future cash flows. However, future is uncertain and hence we need to provide a range of probabilities
associated with the cash flow estimates. Probability can be described as a measure of one’s opinion about
the likelihood of occurrence of an event (optimistic, normal, and pessimistic). Under this approach,
probabilities are assigned to future cash flows and further analysis is carried out for payback, NPV, IRR
etc. This approach recognizes the risk associated with estimation of future cash flows and provides for
reduction in the same via probabilities. But, assigning probabilities is subjective and may lack consistency.

v. Sensitivity Analysis – Sensitivity analysis helps in assessing the information as to how sensitive/
responsive are the estimated parameters of the project. In other words, it measures the responsiveness of
parameters such as cash flows, discount rate, and project life to the estimation errors or uncertainly. Since
the future is always uncertain and estimations are always subject to error, sensitivity analysis takes care of
estimation errors by using a number of possible outcomes in evaluating a project.

Sensitivity Analysis is a way of analysing the changes in project’s NPV (or IRR) for a given change in any
one of the variables, i.e. estimated parameters. Higher sensitive the NPV, more critical is the variable.
Thus, it is a technique of risk analysis which studies the responsiveness of a criterion of merit like NPV or
IRR to variation in underlying factors like selling price, quantity sold, returns from an investment etc.

Sensitivity analysis answers questions like,

 What happens to the NPV if cash flows are, say Rs. 50,000 than the expected Rs. 80,000, or
 What will happen to NPV if the economic life of project is only 3 years than expected 5 years? etc.

Hence, wherever there is an uncertainty, of whatever type, the sensitivity analysis plays a crucial role.
However, sensitivity analysis is not a method to remove the risk or uncertainty, but it is only a tool to
analyze and measure the risk and uncertainty. In terms of capital budgeting, the possible cash flows are
based on three assumptions:

a) Cash flows may be worst (pessimistic)

b) Cash flows may be most likely (realistic).
c) Cash flows may be the best (optimistic).

The decision maker, in sensitivity analysis always asks himself the question – what if ?

vi. Standard Deviation & Coefficient of Variation – Assigning probabilities to cash flows exhibits the risk
element in capital budgeting decisions. However, a better approach to risk analysis is to measure the
spread / dispersion of the cash flows, through Standard Deviation or Variance. Standard Deviation is the
deviation from the mean (expected) cash flows. The general rule is ‘higher the std. deviation, higher the
risk and vice versa’.

Coefficient of Variation is a relative measure of risk. It is useful for comparing projects with same std.
deviation but different values or same values but different std. deviations etc. ↑ CV implies ↑ risk. Final
selection of project depends on investors’ attitude towards risk.

Coefficient of Variation (CV) = Std. deviation

Expected value (mean)
 Capital Budgeting

vii. Simulation – The decision tree approach is not suitable when different estimates of cash flows are
involved in the analysis. Simulation facilitates solution to such problem. Simulation is a quantitative
procedure whereby a series of organized experiments to predict the probable outcome of that process in a
given period of time. Simulation means construction of a model (usually with the aid of computer and
spreadsheets) to represent a real-life situation, which facilities substitution of critical variables within the
model. Simulation makes use of probabilities and random number series to predict the uncertain events
and its influence on the final outcome of the project.

viii. Decision Tree Analysis – When doing capital budgeting, the decision maker has to identify and evaluate
the various alternative courses of action leading to the investment decision. However, present investment
decisions may have implications on future decisions, and may affect future events. Hence, a series of
decisions should be judged, ranging from present to the future. Decision Tree is a technique to evaluate
such sequential decisions.

When a sequential series of conditional decisions are required to be taken under uncertainty, a decision
tree model facilitates visualization and evaluation of all possible options for action.

A decision tree is a graphic display of the relationship between a present decision vis-à-vis future events,
decisions & its consequences. A decision tree captures these in the form of a diagram and is useful for
clarifying the range of alternative courses of action and their possible outcomes. The basic steps for
decision tree are –

 clearly identify investment proposal,

 clearly identify decision alternatives,
 decision tree should be drawn indicating the decision points, events and other data such as
projected cash flows, probabilities.
 Analyse the results and select the best alternative.

Decision tree clearly brings out the implicit assumptions, calculations for all to check and revise
accordingly. Also, visualization of alternatives in graphic form is easier to comprehend. This approach not
suitable when the variables and alternatives are increased to a great extent.

ix. Linear Programming – Linear programming is a mathematical technique concerned with optimal solution
to problems of business world. This method is frequently used in areas such as product lines, production
processes, transportation, routing, and meeting product specifications. Most profitable use of scarce
resources could be planned through the technique in production lines and processes. Similarly, substantial
savings can be affected by using the technique in movement of goods and planning the routes which entail
minimum payments towards cost. In meeting product specifications least cost combinations could easily
be sorted out through this technique. The technique is useful in sorting out allocation problems as the
resources are limited and cannot be used beyond a fixed quantity. Choice is to be made for allocation for
best use to maximize contribution or to minimize cost. The area of application of programming techniques
in investment decision making is that of capital rationing where the approach has been fixed for seeking
solution to the problem when there are more desirable investments than there are funds available for such
investment and a solution of the best choice is involved.
 Capital Budgeting
 CAPITAL BUDGETING NUMERICAL
1) Khurana Industries Ltd. is considering investing in a project for which the capital outlay is Rs. 200,000. The
depreciation is to be provided on Straight Line Method basis. The corporate tax rate is 30%. Using Net Present
Value method you are required to evaluate the project. WACC is 15% and annual operating profits before
charging depreciation is as follows –

Year 1 2 3 4 5
PBDT 1,00,000 1,00,000 80,000 80,000 40,000

2) Amar Ltd. is considering investment in one of the mutually exclusive projects. Project P – initial investment Rs.
10 lakhs and will generate annual CFAT Rs. 3.50 lakhs for 5 years. Project Q - initial investment Rs. 12.50
lakhs and will generate CFAT Rs. 3 lakhs p.a. for 8 years. Which project should Amar Ltd. undertake assuming
a cost of capital of 10 %

40,000
3) Shubham Ltd. wants to install a large forging machine. Machine Yuva costs Rs. 50,000 and will generate
22,000
annual cash inflows of Rs. 20,000. Yuva has a useful life of 6 years and is expected to yield Rs. 2,000 scrap
80,000
value at the end of its life. Machine Guru costs Rs. 65,000 and generates cash inflows of Rs. 25,000 p.a. The
machine is expected to be useful for 10 years, with salvage value of Rs. 5,000. Both machines are depreciated
on straight line basis and tax rate is 40 % and hurdle rate is 10 %. Which machine should be purchased?

4) Aaron Ltd. is planning investment in fixed assets of Rs. 10 lakhs having useful life of 5 years. The project shall
generate sales of Rs. 15 lakhs in the 1st year and increase by 20% upto year 3 and thereafter by 10%. The
variable costs are 60% of sales and annual fixed costs Rs. 2 lakhs. Depreciation is charged on SLM basis with
salvage value Rs. 2 lakhs. Income Tax rate 30%. WACC 11%. Compute Simple payback period, Discounted
Payback period, NPV and PI.

5) Compute NPV, Internal Rate of Return and Profitability Index from the following cash-flows. Discount rate 13%

Year Cash flows Rs.

0 (7,00,000)
1 1,10,000
2 2,10,000
3 3,10,000
4 2,50,000
5 1,70,000

6) A new machine costs Rs. 100,000. The life of the machine is 10 years and has an expected salvage value of
Rs. 10,000 at the end of life. The annual operating cost of the machine is Rs. 10,000. It is expected to generate
revenues of Rs. 50,000 p.a. Cost of capital is 10%. Tax rate 30%. Compute simple payback period and advice
whether to purchase the machine? A similar machine is available with a simple payback of 4 years.
 Capital Budgeting
7) Kymera Ltd. has Rs. 10,00,000 allocated for investment purposes. The following indivisible proposals and
associated profitability indexes have been determined:

Project Investment Rs. Profitability Index

A 3,00,000 1.22
B 1,50,000 0.95
C 3,50,000 1.20
D 4,50,000 1.18
E 2,00,000 1.20
F 4,00,000 1.05

Which of the above investments should be undertaken? Assume opportunity cost of idle money is 10%.

8) Chamko Ltd. has Rs. 7 lakhs available for investment. It has four feasible investment opportunities. All these
investments are divisible, with cost of idle funds at 15%. Advice the management which projects be selected?

Project Initial Investment NPV

P 300,000 60,000
Q 200,000 50,000
R 250,000 150,000
S 600,000 180,000

9) Beta Ltd. is considering the acquisition of a computer system costing Rs. 50,000. The effective life of the
computer is expected to be 5 years. The company plans to acquire the same either by borrowing Rs. 50,000
from its bankers at 15% interest p.a. or by lease at Rs. 15,000 p.a.
The following further information is provided to you:
 The Principal amount of the loan will be paid in five (5) annual equal instalments.
 Interest, lease rentals, principal repayment are to be paid on the last day of each year.
 The computer will be depreciated on 25% WDV method and the same will be allowed for tax purposes.
 The company’s effective tax rate is 40% and the after tax cost of capital is 9%.
 The computer will be sold for Rs. 1,700 at the end of the 5th year. The commission on such sales is 9%
on the sale value and the same will be paid.
You are required to analyse the two proposals and decide the best alternative.

10) To reduce cost, a company has proposed to install a new machine for manufacturing useful component.

 Option-1 - Installation of semi-automatic machine involving annual fixed expenses of Rs. 22 lakhs and a
variable cost of Rs.18 per component manufactured.
 Option-2 - Installation of automatic machine involving an annual fixed cost of Rs. 40 lakh and variable cost
of Rs. 15 per component manufactured.
a) Find indifference point.
b) If annual requirement is 800,000 units, which machine would you advise the company to install?
 Capital Budgeting
11) Following are the data on a capital project being evaluated by the management of Xanadu Ltd.:

Particulars Project M Particulars Project M

Annual cost saving Rs. 40,000 Cost of capital ???
Useful life 4 years Cost of project ???
I.R.R. 15% Payback ???
Profitability Index (PI) 1.064 Salvage value Nil
NPV ???

Find the missing values considering the following table of discount factor only:

Discount factor 15% 14% 13% 12%

1st year 0.869 0.877 0.885 0.893
2nd year 0.756 0.769 0.783 0.797
3rd year 0.658 0.675 0.693 0.712
4th year 0.572 0.592 0.613 0.636
PVIFA (R %, 4 years) 2.855 2.913 2.974 3.038

12) A company is considering three methods of attracting customers to expand its business by undertaking - (A)
advertising campaign: (B) display of neon signs; (C) direct delivery service. The initial outlays are:

Project A B C
Investments (Rs.) 100,000 150,000 150,000

If A is carried out, but not B, it has an NPV of Rs. 125,000. If B is done, but not A, B has an NPV of Rs. 45,000.
However, if both are done, then NPV is Rs. 200,000. The NPV of the delivery system C is Rs. 90,000. Its NPV
is not dependent on whether A or B is adapted and the NPV of A or B does not depend on whether C is
adopted. Which of the investments should be made by the company if –

a) Firm has no budget constraint, and

b) The budgeted amount is only Rs. 250,000?

13) Database Ltd. has the following estimates of the present values of the future cash flows after tax associated
with the investment proposal, concerned with expanding the plant capacity. The plant expansion expects cost
of Rs. 300,000. Using probability approach, advice the company regarding feasibility of the project. The present
value of future CFAT:

With expansion Without expansion Probability

3,00,000 2,00,000 0.2
5,00,000 2,50,000 0.4
9,00,000 3,50,000 0.4
 Capital Budgeting
14) Prithvi Ltd. is a manufacturer of variety of electrical equipment. The existing machine is based on old
technology. In order to improve the quality of the product and bring down operating cost, the management is
planning to replace the existing machine with a new one based on latest technology. Following information:

Existing machine: New replacement machine:

Purchased 5 years ago Capital cost Rs. 10,00,000
Remaining life 5 years Estimated useful life 5 years
Salvage value at end of life Rs. 20,000 Estimated salvage value Rs. 100,000
Current book value Rs. 300,000
Realisable market value Rs. 350,000
Annual depreciation: Rs. 28,000

Due to replacement sales shall increase by Rs. 100,000 p.a., operating expenses would fall by Rs. 200,000 per
year. It would require additional inventory Rs. 200,000 and additional payables by Rs. 50,000. Tax rate is 30%
(including capital gains) and cost of capital of 12%. Depreciation is SLM method. Advice the company

15) A hospital wishes to purchase a diagnostic machine costing Rs. 80,000. The projected life of the machine is 8
years and has an expected salvage value of Rs. 6,000 at the end of 8 years. The annual operating cost of the
machine is Rs. 7,500. It is expected to generate revenues of Rs. 40,000 p.a. for 8 years. Presently, the hospital
is outsourcing the diagnostic work and is earning commission income is Rs. 12,000 p.a. Cost of capital is 10%.
Tax rate 30%. Advise - Whether the hospital should purchase the machine? Use NPV and P. I. method.

16) Tikdam Ltd. is considering investment in one of the two proposals. Project A involves investment Rs. 150,000
and project B needs Rs. 170,000. The probability approach is used for evaluation. The current yield on treasury
bills is 5%. Which project should be accepted? Expected values of net cash flows with their probability are:

Year Project A Project B

Cash Flow Prob. Cash Flow Prob.
1 90,000 0.8 90,000 0.9
2 1,00,000 0.7 90,000 0.8
3 1,10,000 0.5 1,00,000 0.6

17) Sydney Ltd. is considering two mutually exclusive projects, following are three possibilities for cash inflows –

Situation Prob. CFAT Rs. (A) CFAT Rs. (B)

Good 0.30 600 500
Normal 0.40 400 400
Bad 0.30 200 200

Which project should be accepted, considering risk parameter for decision making.
 Capital Budgeting
18) Elite Cooker Company is evaluating three investment situations: (1) produce a new line of aluminium skillets,
(2) expand its existing cooker line to include several new sizes, and (3) develop a new, higher-quality line of
cookers. If only the project in question is undertaken, the expected present values and the amounts of
investment required are:

Project Investment required Present value of Future Cash-Flows

1 200,000 290,000
2 115,000 185,000
3 270,000 400,000

If projects 1 and 2 are jointly undertaken, there will be no economies; the investments required and present
values will simply be the sum of the parts. With projects 1 and 3, economies are possible in investment
because one of the machines acquired can be used in both production processes. The total investment
required for projects 1 and 3 combined is Rs. 440,000. If projects 2 and 3 are undertaken, there are economies
to be achieved in marketing and producing the products but not in investment. The expected present value of
future cash flows for projects 2 and 3 is Rs. 620,000. If all three projects are undertaken simultaneously, the
economies noted will still hold. However, Rs. 125,000 extension on the plant will be necessary, as space is not
available for all three projects. Which project or projects should be chosen?

19) The management of a firm is considering an investment project costing Rs. 15,00,000 and it will have a scrap
value of Rs. 100,000 at the end of the its 5 years life. Machine transportation charges are Rs. 50,000 and
installation charges are expected to be Rs. 250,000. Annual revenue is expected to be Rs. 17,00,000 and
annual operating expenses are estimated to be material Rs. 700,000. Depreciation at 25% WDV and income
taxes at 30%. Calculate CFAT and NPV and decide feasibility of the project. (Discount Factor = 12%)

20) Rajan Electronics wishes to start new plant. A detailed feasibility analysis provided the following information -

Land Cost (incurred at the start of year 1) Rs. 2 lakhs

Buildings (to be acquired at the end of year 1) Rs. 3 lakhs
Machinery (installed at the end of year 2) Rs. 10 lakhs
Working capital (needed at the start of year 3) Rs. 5 lakhs

Actual production shall commence at start of year 3 and will continue for 5 years.
Estimated Sales Rs. 24 lakhs
Estimated Variable Costs Rs. 8 lakhs
Fixed costs (excl. depreciation) Rs. 5 lakhs
Depreciation on assets p.a. Rs. 2 lakhs
Salvage value of Fixed assets (at end of life) Rs. 5 lakhs

Cost of capital 10% and Tax rate applicable 30%.

Advice whether the project should be accepted? Use NPV method.

 Capital Budgeting
21) Fixed assets required for a capital project is Rs. 100 lakhs with working capital Rs. 40 lakhs. Other details are –
 Production and sale quantity – 100000 units p.a. for 5 years
 Selling price Rs. 150 per unit, P/V ratio 50%, Fixed Costs (excl. depreciation) Rs. 15 lakhs p.a.
 Depreciation 20 % WDV. Salvage value equal to WDV after 5 years
 Tax rate 40%, Life 5 years, Cut-off rate 12%

Compute NPV and evaluate feasibility of the project.

22) Chandu Ltd. is considering the possibility of manufacturing a particular component which is being imported.
The manufacture of this component would call for an investment of Rs. 750,000 in a new machine besides an
additional investment of Rs. 50,000 in working capital. The life of the machine would be 10 years with a salvage
value of Rs. 50,000. The estimated PBDT would be Rs. 180,000 p.a. The income-tax rate is 35%. The
company’s expected ROI is 10%. Depreciation is considered on straight line system. Whether investment
feasible?

23) Robin-Hood Ltd. wants to replace its old machine with a new automatic machine. Two models X and Y are
available at the same cost of Rs. 5 lakhs each. Salvage value of the old machine is Rs. 1 lakh. The utilities of
the existing machine can be used if the company purchases X. Additional cost of utilities to be purchased in
that case are Rs. 1 lakh. If the company purchases Y then all the existing utilities will have to be replaced with
new utilities costing Rs. 2 lakhs. The salvage value of the old utilities will be Rs. 0.20 lakhs. Compute the cash
outflows at the start of the project.

24) An oil company proposes to install a pipeline for transport of crude from wells to refinery. Investments and
operating costs of pipelines vary for different sizes of pipelines. The following details have been conducted:

Pipeline diameter (in inches) 3 4 5 6 7

Investment required (Rs. lakhs) 16 24 36 64 150
Gross savings in operating costs before depreciation (Rs. lakhs) 5 8 15 30 50

The estimated life of the installation is 10 years. The oil company's tax rate is 50%. There is no salvage value
and straight line rate of depreciation is followed. Calculate the net savings after tax and cash flow generation
and recommend there from, the largest pipeline to be installed, if the company desires a 15% post-tax return.
Also indicate which pipeline will have the shortest payback.
 CAPITAL BUDGETING

Capital Budgeting

▪ Capital budgeting is the process of capital investment planning, i.e. capital expenditure for long
term purposes. It refers to long term expenditure whose returns are attained over a future period.
▪ It considers proposed capital outlay, i.e., planning for the utilisation of long-term funds. Capital
investment includes acquiring fixed assets for the purpose of –
o New business
o Expansion of existing business
o Diversification
o Modernization etc.
▪ Capital budgeting decision answers the question - whether business should be started or not?
which business to be done? how big should be the scale of business? Etc. Etc.

Need for Capital Investments

a. Higher revenues
b. Cost reduction proposals
c. Replacement of machinery with new modern equipment
d. Plant re-arrangement programmes, change of site
e. Mechanisation of process
f. Extensions to plant and machinery for having additional volume of production
g. Installation of new plant and machinery for taking up a new product or product lines.
h. Research and Development proposal
i. New product line or diversification proposal
j. Strategic investment proposal

Factors affecting Capital Investment Decision

a) Huge initial cash investment (cash outflows) – today

b) Cash profits in the future (cash inflows)
c) Time Value of Money (TVM) – generally, value of money reduces as time passes
d) Minimum expected Rate of Return (ROI)
e) Life of the fixed assets / project – affects depreciation
f) Uncertainty and Risk – since the project benefits in the future
g) All pervasive analysis – intensive and extensive – e.g. PESTEL, SWOT, Porter 5-forces model.

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 1

 Capital Budgeting

Evaluation Techniques for Capital Projects

1) Simple Payback Period

2) Discounted Payback Period
3) Accounting / Average Rate of Return (ARR)
4) Net Present Value (NPV)
5) Profitability Index (P.I)
6) Internal Rate of Return (IRR)

Cash Flow After Tax (CFAT)

▪ CFAT represents the liquidity generated by a project for the year.

▪ it is useful for measuring the cash profits earned by a project
▪ Cash Flow After Tax (CFAT) = PAT (+) Depreciation (+) Amortization

Time Value of Money (TVM)

▪ The concept of time value of money is highly important in capital budgeting process, since there
is a time difference between cash outflows and cash inflows.
▪ The value of money changes as time passes in the future. Hence, to compare the cash flows,
we need to convert the future cash flows into present values
▪ The process of converting future cash flows in present value is known as ‘Discounting’ process

Simple Payback Period Method

▪ Simple payback period method computes the duration in which the initial investment of the
project shall be recovered.
▪ Shorter the payback period (duration) better the project. Thus, a project whose actual payback
period is less than the predetermined period, the project will be accepted by the management.
▪ In case of comparison of projects, the lower payback is selected.
▪ Basically, pay-back period measures of liquidity of investments rather than their profitability.

Merits / Advantages of Payback Method:

▪ This method is simple to understand and easy to operate.
▪ When funds are limited, projects having shorter payback periods should be selected, since they
can be rotated a greater number of times. Thus, liquidity management is stressed upon.
▪ This method is suitable in the case of industries where the risk of technological obsolescence is
very high and hence only those projects which have a shorter payback period should be financed.
▪ Focus on projects which generates cash inflows in earlier years, thereby reducing risk
Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 2
 Capital Budgeting
Demerits / Limitations of Payback Method:
▪ It stresses on capital recovery rather than profitability.
▪ Does not consider post-payback cash flows, i.e., returns from the project after its payback period.
▪ This method ignores time value of money.

Average Rate of Return (ARR) / Accounting Rate of Return (ARR)

According to this method, the capital investment proposals are judged on the basis of their relative
profitability. For this purpose, capital employed and expected incomes are determined according to
commonly accepted accounting principles over the entire economic life of the project and then the
average yield is calculated. Such a rate is termed as ‘Accounting Rate of Return.’

ARR = Average net profit * 100 OR ARR = Average net profit * 100
Original Investment Average Investment

The term “Average net profit” is the average of earnings (after depreciation and tax) over the whole
of the economic life. Average investment it estimated by dividing the total of original investment and
investment at end of project life by 2. It takes into consideration the current cash outlays, scrap value
of existing equipment, working capital employed and residual value of assets at end of project life.
Decision Making – Any project expected to give a return below minimum desired rate of return will
be straightway rejected. In case of several comparable projects, highest ARR is selected.

Merits: ARR method considers profits over the entire economic life of the capital project., The
projects differing widely in character can be compared property.

Demerits: The method ignores time value of money. Doesn’t consider cash flows.

Discounted Payback Period Method

▪ When the payback period is computed after discounting the cash flows by a predetermined rate,
it is called as the ‘Discounted payback period’.
▪ Discounted Payback Period refers to the period where the project will generate necessary
‘discounted cash flows’ to recover its initial investment.
▪ The payback period is computed after discounting the cash flows. A pre-determined rate
(generally WACC) is used for discounting the cash flows. This method is an improvement over
the simple payback period, since it recognizes the time value of money.

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 3

 Capital Budgeting

Net Present Value (NPV)

▪ Net Present Value is the difference between present value of benefits and present value of costs.
▪ ‘NPV = Total Discounted Cash Inflows (-) Total Discounted Cash Outflows’
▪ Cash outflows and inflows are forecasted and these are discounted using an expected ROI
▪ The discounted cash flows are compared and decision is taken accordingly.
▪ A positive NPV (i.e., NPV > 0) indicates a favourable position and the project should be
approved. If NPV < 0, project is rejected.
▪ The discount rate is the cut-off rate / rate of return (WACC) which is expected by the
management.
▪ In case of mutually exclusive projects, the project with the highest NPV should be selected.
▪ A negative NPV indicates that the returns earned by the projects are less than management
expectation, and hence such project is rejected.

Decision Making –
▪ NPV > Zero, accept the proposal, since earning more than expectation
▪ NPV = Zero, accept the proposal, since earning same as expectation
▪ NPV < Zero, reject the proposal, since earning less than expectation

Merits:
▪ It considers the time value of money. Hence, it satisfies the basic criterion for project evaluation.
▪ The entire cash flows are considered over the life of the project.
▪ NPV adds to wealth of shareholders and thus focuses on the basic objective of financial mgt.

Demerits:
▪ It involves complex calculations.
▪ It involves forecasting cash flows and application of discount rate. Thus, accuracy of NPV
depends on accurate estimation of these two factors which may be quite difficult in practice.
▪ NPV and ranking of project may differ at different discount rates, causing inconsistency in
decision making.

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 4

 Capital Budgeting

Profitability Index (P.I)

▪ Profitability Index (PI) is ratio of the present value of discounted cash inflows to the discounted
cash outflows of an investment.
▪ If the present value method is used, the present value of the earnings of one project cannot be
compared directly with the present value of earnings of another, unless the investments are of
the same size. It is also known as Benefit-Cost Ratio.
▪ In order to compare proposals of different size, the flows to investment must be related. This is
done by dividing the present value of earnings by the amount of investment, to give a ratio i.e.
called the profitability index / ratio or desirability factor.
▪ P.I method is most useful when the NPV of mutually exclusive projects is equal.
▪ P.I measures profitability as well as maximization of shareholders’ wealth.

Profitability Index = Total Discounted Cash Inflow

Total Discounted Cash Outflow

Decision Making – Higher the profitability index, the better is the project.
Where, PI > 1 accept the proposal
PI = 1 accept the proposal
PI < 1 reject the proposal

Advantages:
▪ This method considers the time value of money.
▪ Better project evaluation technique and helps in ranking projects where NPV is positive.
▪ It focuses on maximum return per rupee of investment and hence is useful in case of investment
in divisible projects, when funds are not fully available.

Internal Rate of Return (IRR)

▪ Internal Rate of Return (IRR) is the rate of return at which present value of cash outflows and
present value of cash inflows is equal.
▪ IRR is the rate which brings the sum of the future cash flows to the same level as the original
investment. IRR is the rate of return at which NPV = ‘0’, i.e., investments are equal to earnings.
▪ At the rate of IRR, discounted cash inflows = discounted cash outflows.
▪ The acceptance or rejection of a project depends on the relationship between IRR and the
expected rate of return (discounting rate).
▪ If IRR is higher than the discounting rate, accept the proposal and vice versa. In case of mutually
exclusive proposals, higher the IRR, better.
Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 5
 Capital Budgeting
Decision Making –
IRR > Cut-off-rate, accept the proposal
IRR = Cut-off-rate, accept the proposal
IRR < Cut-off-rate, reject the proposal

Advantages:
▪ Time value of money is taken into account.
▪ All cash inflows of the project, arising at different points of time are considered,
▪ Decisions are immediately taken by comparing IRR with the cost of capital,
▪ It helps in achieving the basic objective of maximisation of shareholders wealth.

Disadvantages:
▪ It is very tedious to compute IRR in case of multiple cash outflows.
▪ It may conflict with NPV in case Inflow / outflow patterns are different in alternative proposals,

Practical Illustrations

Q1. A new project requires ₹ 20,000 investment and life of project is 5 years. The annual cash
inflows expected are ₹ 6,000, ₹ 5,000, ₹ 4,500, ₹ 4,000 and ₹ 3,500. Compute simple payback
period.

Q2. A project requires ₹ 50,000 investment and life of project is 6 years. The annual CFAT expected
are ₹ 13,000, ₹ 14,000, ₹ 15,000, ₹ 16,000, ₹ 10,000 and ₹ 8000. Compute simple payback
period.

Q3. A new project needs ₹ 7 lakhs initial investments and following CFAT are estimated. Compute
simple payback period and discounted payback period using 12% expected ROI.

Year Cash Inflows ₹ 12% PVF

1 1,20,000 0.8929
2 2,30,000 0.7971
3 3,50,000 0.7118
4 2,70,000 0.6355
5 1,40,000 0.5674

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 6

 Capital Budgeting
Q4. An expansion project requires ₹ 20,000 investment and life of project is 5 years. The expected
CFAT are ₹ 6,000, ₹ 5,000, ₹ 4,500, ₹ 4,000 and ₹ 3,500. Compute discounted payback period
using 10% WACC. Present Value Factors: Year 1 = 0.9090, Year 2 = 0.8264, Year 3 = 0.7513,
Year 4 = 0.6830 and Year 5 = 0.6209.

Q5. A diversification project requires ₹ 50,000 investment and life is 6 years. The annual CFAT
expected are ₹ 13,000, ₹ 14,000, ₹ 15,000, ₹ 16,000, ₹ 10,000 and ₹ 8000. Using 8% expected
WACC, compute discounted payback period. Given, Present Value Factors (PVF):

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

0.9259 0.8573 0.7938 0.7350 0.6806 0.6302

Q6. A new project requires ₹ 200,000 investment and life of project is 4 years. The expected PAT
are ₹ 45,000, ₹ 70,000, ₹ 55,000, and ₹ 30,000. Compute Average Rate of Return (ARR) using
initial investment.

Q7. A profitable clothing company has planned expansion which requires ₹ 25,00,000 investment
in new machinery and life is 5 years. Cost of capital of the company is 10%. From the following
incremental cash flows, compute net present value and decide the feasibility of the project.
Given, Present Value Factors (PVF):

Year 1 2 3 4 5
Cash Flows (₹ ‘lakhs) 2,50,000 5,00,000 8,00,000 10,00,000 12,50,000
PVF at 10% 0.909 0.826 0.751 0.683 0.621

Q8. A company has a new investment plan of ₹ 30,00,000 and following cash flows are forecasted.
Advice the management on the basis of net present value and profitability index. The estimated
cost of capital is 12%.

Year Cash Inflows ₹ 12% PVF

1 7,00,000 0.892
2 10,00,000 0.797
3 9,00,000 0.712
4 8,00,000 0.636
5 4,00,000 0.567

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 7

 Capital Budgeting
Q9. A company is planning to invest in one of two plans. Project A involves investment ₹ 150,000
and Project B needs ₹ 170,000. The cost of capital is 8%. Compute NPV and decide which
project should be accepted? Expected values of net cash flows and 8% PVF are:
Year Project A Project B 8% PVF
1 90,000 1,00,000 0.926
2 1,00,000 1,10,000 0.857
3 1,10,000 1,20,000 0.794

Q10. A company has to choose between two mutually exclusive projects, both requiring investment
of ₹ 400,000. The WACC is 10%. Compute Net Present Value (NPV) and Profitability Index
(PI) and decide which project should be accepted?
Year Project X Project Y 10% PVF
1 40,000 120,000 0.909
2 120,000 160,000 0.826
3 160,000 200,000 0.751
4 240,000 120,000 0.683
5 160,000 80,000 0.621

Q11. Compute simple payback period, net present value and profitability index for the following new
capital project worth ₹ 55,00,000. Cost of capital is 15%.
Year Cash Inflows 15% PVF
1 16,00,000 0.8696
2 18,00,000 0.7561
3 20,00,000 0.6575
4 15,00,000 0.5718
5 18,00,000 0.4972
6 15,00,000 0.4323

Q12. Compare the two projects based on simple payback period. Initial investment ₹ 300,000.

Year 1 2 3 4 5
Project R 50,000 70,000 60,000 1,20,000 80,000
Project S 60,000 90,000 80,000 60,000 40,000

Prof. Prasad Bhat (CA, CS, CMA, M. Com, NET) 8

 WORKING CAPITAL MANAGEMENT
1. INTRODUCTION

 Working Capital is the funds required for managing day-to-day operations of a business. Basically, the capital
which is required to finance current assets is called working capital. It represent short term business needs.

 Working Capital is the management of current assets and current liabilities. Working capital is also known as
Circulating Capital or Trading Capital or Short Term Capital.

 Current Assets are those assets, which are meant for conversion into cash within a short duration, i.e.
generally upto 1 year (12 months). Current assets mainly used for trading purposes. Examples of current
assets include inventories, debtors, cash and bank balances, prepaid expenses, loans and advances,
marketable investments etc.

 Current Liabilities are those liabilities which are payable within a short duration, i.e. generally upto 1 year.
Such liability is created for day-to-day trading purposes. Examples of current liabilities include creditors,
outstanding expenses, tax provision, proposed dividend, short term loans, bank overdraft, cash credit etc.

2. TYPES OF WORKING CAPITAL

a) Gross Working Capital – the aggregate of only current assets

b) Net Working Capital – the difference between current assets and current liabilities, i.e. NWC = CA - CL

c) Permanent Working Capital – it is the minimum level of investment required in the business at any point of
time and hence at all points of time, it is also called Fixed or Core Working Capital.

d) Temporary Working Capital - it represents working capital requirements over and above permanent
working capital and is dependent on factors like ‘peak season, trade cycle, boom etc. It is also called as
Fluctuating or Variable Working Capital.

e) Initial Working Capital – Funds required at the commencement of business, are called initial working
capital. These are the promotion expenses incurred at the earliest stage of formation of the enterprise which
include the incorporation fees. Attorney’s fees, office expenses and other preliminary expenses.

f) Reserve margin working capital: It represents an amount utilized at the time of contingencies. Such
unpleasant events may occur at any time in the running life of the business such as inflation, depression,
slump, flood, fire, earthquakes, strike, lay-off and unavoidable competition etc. In this case greater amount
of capital is required for maintenance of the business.

g) Negative Working Capital – It implies a situation where the current liabilities exceed the current assets, i.e.
the company is unable to honour its short-term commitments. It is a sign that the company may be facing
bankruptcy or a serious financial trouble. As a result, late payments to creditors, delay in EMI payments etc.
reduces its credit rating. Companies with negative working capital may lack the funds necessary for growth.
However, successful companies may also have negative working capital and still earn profits as long as the
transactions are timed correctly. It may be taken as a sign of extreme efficiency. E.g. Amazon, Wal-Mart
 Working Capital Mgt.

3. IMPORTANCE OF WORKING CAPITAL MANAGEMENT

Working Capital Management can be defined as the management of a firm’s sources and uses of working capital,
for maximization of shareholders’ wealth. Working capital management is a short term concept, and hence time
value of money not considered. Working capital management affects the short term liquidity. Excess working capital
implies blocking up funds that can be productively used elsewhere. Insufficient working capital affects profitability,
production interruptions, inefficiencies and results in loss of opportunity, e.g. stock-outs, delayed payments etc.

Effects of Excess Working Capital –

 Unnecessary accumulation of inventories, resulting in possibility of theft, wastage etc.
 Indication of defective credit policy, resulting in delays in collection of debtors, bad debts etc.
 Excess working capital makes management complacent, leading to inefficiencies
 Higher liquidity may result in incorrect decision making, unproductive use of resources
 Idle cash – loss of investment opportunity, risk of theft and misappropriation.

Effects of Inadequate Working Capital –

 Growth is stagnated, i.e. it becomes tough for the firm to undertake profitable projects due to non-availability
of working capital resources/ funds.
 Difficult to implement operating plans and achieve firm’s profit targets.
 Operating inefficiencies due to daily crunch situation.
 Fixed assets are not efficiently utilized, leading to decreased profitability
 Interruptions in production, stock-outs, delivery schedules not met, poor quality (i.e. loss of reputation)

4. CAPITALIZATION

Capitalization denotes the level of working capital maintained in an organization. The level of working capital shall
be commensurate with the scale of operations and business needs. Any imbalance in this respect results in under-
capitalization (over-trading) or over-capitalization (under-trading).

i. Under-Capitalization (Over-trading)

Under-Capitalization or Overtrading means expansion of scale of operations, without sufficient cash resources.
Normally, firms with a tendency of overtrading have a high turnover ratio and low current ratio. There are
immense pressures on liquidity & position is very critical resulting in low inventories, no credit to customers,
delayed payment to creditors etc. The situation is dangerous, as disproportionate increase in operations without
adequate resources, might cause sudden collapse

Causes of Under-Capitalization Consequences of Under Capitalization

Faulty financial policy like using current assets Purchase cost will go up since no bargain power, no bulk
for purchase of fixed assets purchase possible,
Over-expansion without adequate resources, Difficulty in paying salaries & taxes,
Liberal dividend policies etc. Pressure in sales, due to strict credit policies, stock outs
Inflation, rising prices, material, labour costlier, Reduction in profits – high discounts, low selling prices,
excessive taxation resulting in cash outflows  High wear-tear of fixed assets due to non-maintenance,
 Working Capital Mgt.
ii. Over-Capitalization (Under-trading)

Over-Capitalization or Under-trading is the exact opposite of overtrading. In this case, there is improper and
under-utilization of funds. In other words, cash and other resources are lying idle in the business. There are
increased levels of inventory, debtors and high cash balances. Under-trading is nothing but over-capitalization
vis-à-vis current operation levels. Reasons may be conservative policies, recession, lack of opportunities etc.
Consequences are reduction in profits, low rate of returns, falling share price, loss of reputation etc.

5. NEGATIVE WORKING CAPITAL – NOT ALWAYS BAD

Basically, current assets of a firm should be more than adequate to meet the current liabilities. A firm should always
be in a position to maintain liquidity. In order to maintain the quality of its current assets, a firm seeks to reduce their
holding period. Simultaneously, the firm tries to delay the time period available for payment of its current liabilities.
The result of this exercise is that the net working capital of the firm turns negative. Usually, the concept of negative
net working capital appears to be unfavourable for a firm. The firm may not have sufficient liquidity to pay all its
current liabilities, i.e. it could default on its obligations.

However, if the firm has maintained the level of current assets to the minimum and deployed the surplus cash in
non-working capital, yet liquid investments, then it can afford to function with a net working capital that is negative.
As long as a firm does not default on payment of its current liabilities, the fact that it has a negative net working
capital need not be a cause for concern.

6. INVESTMENT IN CURRENT ASSETS vis-à-vis FIXED ASSETS

Higher the funds invested in working capital, lesser is the return in term of profitability as well as less amount is
available for investing in long-term fixed assets. Hence, a company should minimise investment in working capital
and concentrate on investment in fixed assets. Generally, it is said that current assets should be financed by current
liabilities. But it depends upon economic conditions prevailing at particular time and opportunities available. Certain
level of current assets is maintained throughout the year and it represents permanent working capital. Additional
inventory is maintained to support peak selling period when receivables also increase and must be financed.
Current assets financing is done by raising short-term loans or cash credits limits but fixed assets financing is done
by raising long-term loans or equity.

7. ADEQUACY OF WORKING CAPITAL [WHETHER BALANCE SHEET IS TRUE]

Basically, it is believed that higher the level of current assets, higher the liquidity. Thus, a firm with high current ratio
is favourable and can easily pay its current liabilities. However, this may not be true since current assets should be
proportional to the level of turnover. If current assets are disproportionate to the turnover, it is an adverse situation,
despite a high level of current assets. It may be due to old inventory, long overdue receivables etc. Hence, it may
result in high cost of maintaining inventory, interest cost on financing current assets, obsolescence, bad-debts etc.

The Balance Sheet may not show the true picture of current assets. A Balance Sheet is prepared to show the
position at the end of a financial year. To have a better idea of current assets, we should take an average (weekly,
monthly, or quarterly) for the year. Further, the level of current assets should also be compared to the seasonal
nature of industry. Also, the quality of current assets is vital in deciding the liquidity position. Obsolete stock, over
debtors etc. only inflate the current ratio, but do not reflect the real liquidity position.
 Working Capital Mgt.

8. FACTORS AFFECTING WORKING CAPITAL REQUIREMENT

1. Nature of Business (manufacturing vs. service or construction vs. hospitality)

A company that sells primarily on cash basis have less working capital pressures. Manufacturing companies
need much more inventories and receivables as compared to service industry.

2. Size of Business (small, medium or large)

The amount of working capital needed largely depends on the size of the business. Sometimes small firms
have higher liquidity pressure due to high overhead costs, less favourable credit terms, higher interest rates.

3. Credit Policy (credit granted to customers vs. credit received from suppliers)
Where the credit granted to customers is more as compared to credit received from supplies, there is
working capital pressures and vice versa. Purchases may be on a cash basis, but the manufacturing cycle
may be longer and sales terms maybe generous, causing a wide gap between cash payments and cash
receipt and putting heavy pressure on the firm.

4. Production policy (as per customer order or general market supply)

Companies producing on bulk basis require additional working capital needs due to higher inventories and
receivables. Made-to-order policies can be better managed and liquidity pressures are less.

5. Level of Competition (discounts, schemes, higher inventories etc.)

A high degree of competition puts more pressure to stock, receivables as well as liquidity. Effort to satisfy
customers’ demands and to grant more generous credit terms, thereby causing stress on cash flows.

6. Availability of Raw Material (bulk purchases vs. regular purchases)

7. Seasonal products (air-conditioners, crackers, sweaters etc.)

Companies having strong seasonal movements face working capital problems. The level of uncertainty also
add to the management troubles. In such cases, flexible arrangements are preferable to protect against
unforeseen contingencies.

8. High Taxes and Duties (higher cash outflows in the form of taxes)

9. Age of Business (Life Cycle – introduction, growth, maturity, decline)

As a company expands, larger amounts of working capital are required to avoid interruptions in production.
In maturity phase, there are less pressures due to easy credit and goodwill.

10. Inflationary Conditions (higher cost of goods and services)

11. Level of Technology (automatic vs. manual labour)

12. Economic & Business Cycles (boom, recession, slow-down, depression)

The recurring movements of the economic and business cycles influence working capital changes. As
business goes down, companies tend to postpone capital investments. Also, reduced sales volumes
decrease receivables and modify inventory purchases. However, in a boom period, companies concentrate
on higher production and credit items. During boom, a company faces higher pressure on liquidity.
 Working Capital Mgt.
13. Goodwill of the company (better bargaining power)

14. New product or service launch (higher promotion costs)

15. Dividend policy (payout vs. retention)

A higher dividend payout may affect the working capital, since there is considerable cash outflows.

16. Interest rates (floating rates affect cash flows)

17. Foreign currency rate fluctuations (exports vs. imports)

18. Operating Cycle

9. OPERATING CYCLE

Operating Cycle is the time duration for required for conversion of raw materials into work-in-progress, thereafter
finished goods, sales and creation of debtors and thereafter back into cash, followed by payment to creditors.
Operating cycle is also known as Working Capital Cycle or Cash Cycle. Operating Cycles diagram is given below:

Raw
Material

Creditors
WIP
Payment

Cash / Finished
Bank Goods

Debtors Sales

Segments of Operating Cycle:

i. Raw Material Conversion (Holding) period – the time duration, starting from purchase of raw material till
issue to production process.

RM Holding period = Avg. RM Stock * 360 days

RM consumption
OR
RM Holding period = 360 days
RM Turnover ratio
 Working Capital Mgt.
ii. Work In Progress Conversion Period – the time required for converting the raw material into finished good
with the help of labour cost and overheads cost. Also known as processing period.

WIP Holding period = Avg. WIP Stock * 360 days

Cost of Production
OR
WIP Holding period = 360 days
WIP Turnover ratio

iii. Finished Goods Holding Period – the time required for selling the finished goods in the market. It is the time
starting from creation of finished goods till they are ultimately sold. Hence, the period for which FG are stored
in warehouse.

FG Holding period = Avg. FG Stock * 360 days

Cost of Goods Sold
OR
FG Holding period = 360 days
FG Turnover ratio

iv. Average Collection Period – the time required for collection of funds from the debtors and bills receivables.
The duration starts from selling the goods on credit till the actual collection of funds from the customers.

Avg. Collection period = Avg. Receivables * 360 days

Credit Sales
OR
Avg. Collection period = 360 days
Receivables Turnover ratio

v. Average Payment Period – the time required for payment of current liabilities to the creditors, bills payables
and including outstanding wages and overheads. The duration starts from purchasing the goods / expenses
on credit till the actual payment of funds to the suppliers.

Avg. Payment period = Avg. Payables * 360 days

Credit Purchases
OR
Avg. Payment period = 360 days
Payables Turnover ratio

Gross Operating Cycle is the total duration required for inventory and collection period, i.e. holding period for all
current assets. Net Operating Cycle is the difference between current assets holding period and current liability
payment period.
 Working Capital Mgt.
Net Operating Cycle = (Raw Material Storage Period + WIP holding Period + Finished Goods Storage Period +
Average Collection Period) Less (Average Payment Period)

Number of Operating Cycles in a year = 360 days

Net Operating Cycle (NOC)

Operating Cycle represents the activity cycle of the business, i.e. purchase, manufacture, sales and collection
thereof. Hence the operating cycle stands for the process that creates surplus or profit for the business. It indicates
the total time required for rotation of funds. The faster the funds rotate, the better it is for the company. A long cycle
indicates overstocking of inventories or delayed collection of receivables and is considered unsatisfactory.

10.ESTIMATION OF WORKING CAPITAL NEEDS

Operating cycle is one of the most reliable methods of estimation of working capital. However, other methods like
ratio of sales and ratio of fixed assets may also be used to determine Working Capital requirements. These
methods are briefly explained as follows –

a) Ratio of Sales to Current Assets: To estimate working capital needs as a ratio of sales on the assumption that
current working capital change with changes in sales.

b) Ratio of Fixed Assets to Current Assets: To estimate current assets as a percentage of fixed investments.

c) Operating Cycle: To estimate working capital needs based on the average operating cycle. Holding period of
current assets and relating them to costs based on the company’s experience in the previous year. This method
is essentially based on the Operating Cycle Concept.

Avg. Working Capital requirement = Annual Cash Expenses

No. of NOC p.a.

11. SOURCES OF WORKING CAPITAL FINANCE

Temporary Working Capital Permanent Working Capital

1 Trade Creditors 1 Equity Share Capital
2 Bills Payable 2 Preference Share Capital
3 Accrued / outstanding expenses 3 Debentures
4 Bank Overdraft 4 Deposits
5 Cash-Credit Facility 5 Bonds
6 Bill Discounting 6 Working Capital Term Loan (WCTL)
7 Pledging of Current Assets 7 Debt Securitization
8 Commercial Paper
9 Advances from Customers
10 Inter-Corporate loans
11 Depreciation
12 Factoring Services
 Working Capital Mgt.
Factoring Services: - Factoring is a mechanism of managing, financing and collecting of receivables. It is a formal
agreement between a ‘Factor’ (i.e. specialist) and client (i.e. seller). Factoring is a method of selling receivables to a
company that specializes in their collection and administration.

A factor is a financial institution (e.g. bank, financial institution) that offers the following services for management of
receivables –

 Finance the customer (loans and advances etc.)

 Maintenance of accounts (relating to receivables)
 Collection of receivables
 Protection against default in payment by debtors

Purchasing receivables is the prime function of factoring. It also provides the following basic services –
 Credit administration – a factor helps in deciding credit extension to customers. It maintains proper accounts
of all customers as per due dates, provides information for credit analysis, determining credit-worthiness,
monitoring debtors
 Credit collection and protection – a factor undertakes all the collection activities. It provides full/ partial support
against bad debts.
 Financial assistance – providing loans, advances against debtors (70-80 %) are provided to the clients.

A factor charges commission for its various services, interest on loans and advances and reserve for bad-debts.

Factoring vs. Bill Discounting

Under a bill discounting arrangement, the drawer undertakes the responsibility of collecting the bills and remitting
the proceeds to the financing agency, whereas under factoring agreement, the factor collects client's bills.
Moreover, bill discounting is always with recourse whereas factoring can be either with recourse or without
recourse. The finance house discounting bills does not offer any non-financial services unlike a factor which
finances and manages the receivables of a client.

Forfaiting vs. Export Factoring

Forfaiting is similar to cross border factoring to the extent both have common features of non-recourse and advance
payment. But they differ in several important respects:

 A forfeiter discounts the entire value of the promissory note/ bill of exchange, but the factor finances
between 75-85% and retains a factor reserve which is paid after maturity.
 The availing bank which provides an unconditional and irrevocable guarantee is a critical element in the
forfaiting arrangement whereas in a factoring deal, particularly non-recourse type, the export factor bases
his credit decision on the credit standards of the exporter.
 Forfaiting is a pure financing arrangement while factoring also includes administration, collection etc.
 Factoring is essentially a short term financing deal. Forfaiting finances notes/bills arising out of deferred
credit transaction spread over three to five years.
 A factor does not guard against exchange rate fluctuations; a forfeiter charges a premium for such risk.
 Working Capital Mgt.

12. APPROACHES TO WORKING CAPITAL MGT. / FINANCE

Every company requires working capital finance to continue regular production and smooth flow of the business
operations. However, every management has their own approach/ strategy for such financing, as given below:

 Aggressive Approach
In this approach, a company uses short term financing as a major source of funds, for its short term as well
as long term requirements. In other words, short term funds are used to purchase fixed assets and
permanent working capital etc. It is an aggressive approach since the firm depends believes on maintaining
less liquidity at all times. Hence, blockage of funds is reduced and profitability is higher. However, there
might be liquidity problems in cases of emergency situations/ contingencies, i.e. it is a high risk approach.

 Conservative Approach
In this approach, a company uses long term funds as a major source of finance, for meeting its short term
as well as long term requirements. Long term funds include equity capital, debentures and term loans. In
other words, long term funds are used to purchase fixed assets as well as maintaining working capital. It is a
conservative approach since the firm depends on high safety through long term financing and thus
maintains high liquidity at all times. Hence, blockage of funds is considerably high and return on assets is on
the lower side. There is no problem of liquidity i.e. it is a low risk approach. But, profitability is lower.

 Matching / Hedging Approach

In this approach, a company uses a balanced mechanism. Thus, long term funds are used for long term
requirement and short term funds are used for short term requirements. In other words, short term funds are
used to finance current assets whereas long term funds are used to purchase fixed assets. It is a matching
approach since there is a balance between liquidity and profitability.

13. IMPROVING WORKING CAPITAL POSITION

Working capital is an effective barometer of a company’s operational and financial efficiency and effectiveness.
Better the WC condition, the better company is positioned to focus on developing its core business. Following steps
can be taken for improving the working capital position of a company –

a) Create Awareness – A properly planned and executed improvement program will focus on optimizing each
WC component. Executives shall integrate WC management into their strategic and tactical thinking.

b) Proper Communication – Institute a system of communication to identify problems and brainstorm for the
probable solutions. Involvement of all levels of management shall make the process all-inclusive.

c) Collaborative Supplier–Customer Management – Plan working capital along with clear and honest
discussions with suppliers and customers. Identify their needs, know their operations and then plan working
capital. Such collaboration helps in aligning the procurement, production and distribution cycles.
Documentation of such process is vital for future references as well as to avoid any disputes.

d) Collection of Cash – Ensure that the cash is received and collected promptly. Confirm with customers
about receipt of invoices and dispatches of cheques or any other mode of money transfer.

e) Realistic Targets – Ensure that the staff are given realistic and practical targets to manage working capital.
The targets shall be hard enough to motivate the employees and good enough to achieve them.
 Working Capital Mgt.

14. GOVERNMENT COMMITTEES ON WORKING CAPITAL FINANCE

Banks play a vital role in working capital financing. Over a period of time, the Reserve Bank of India (RBI) has
formed various committees to decide the norms for working capital financing by commercial banks. Based on the
recommendations of these committees, RBI sets the norms for granting working capital finance to companies.
Various committees were formed such as Dahejia Committee (1968), Tandon Committee (1975), Chore Committee
(1980) and Marathe Committee (1982), Kannan Committee (1996) etc. These committees submitted their
observations, finding and recommendation to the RBI, which were converted into various policies.

Findings of Committees –

 Companies were using short term credit in excess of its requirements.

 Short-term funds were used for purchase of long-term assets, i.e. fixed assets.
 Bank finance was based on security, and not operations
 Financial position of the borrower was not assessed
 Repayment was long-term
 Borrower decides amount of borrowing, rather than the banker.
 Bank credit is treated as the first source of finance
 Sufficient credit analysis was not done by banks.

The Tandon Committee was the most suitable and highly used by banks for financing working capital requirement
of companies. The recommendations of the Tandon committee are used extensively (even today) for facilitating
working capital finance. It computes Permissible Bank Credit (PBC) also known as Maximum Permissible Bank
Finance (MPBF)

Tandon Committee Recommendations

 Borrower must provide an operating plan along with loan proposal.

 Bank to thoroughly appraise such plans.
 Bank should finance genuine production needs of a firm
 Borrower must maintain reasonable levels of stocks and accounts receivables
 Bank to finance only a part of borrower’s requirements, balance by borrower himself.
 Banks should finance only a reasonable level of current assets, as per normal industry norms. Suggested
15 industries to be covered such as paper, pharmaceuticals, engineering, cement, oil etc.

Maximum Permissible Bank Finance (MPBF) – Tandon Committee Recommendations

METHOD I Bank to finance 75% of working capital gap i.e. 75% of (CA – CL)
The borrower to maintain minimum current ratio of 1:1. This method is used for good
borrowers, and maximum bank finance available.
METHOD II Finance 75% of Current Assets and deduct Current Liabilities i.e. (75% of CA) – CL
The borrower to maintain minimum current ratio of 1.33 times. Less finance available as
compared to Method I, due to lower credit rating of borrower.
METHOD III Finance 75% of Temporary (Fluctuating) Current Assets and deduct Current Liabilities
i.e. (75% of Floating CA) – CL
Hence, the borrower to contribute 100% of permanent current assets and 25% of
balance current assets. This method results in least financing.
 Working Capital Mgt.

15. RECEIVABLES / DEBTORS MANAGEMENT

Receivables or Debtors are the amount represented by good or services sold on credit. Receivables are expected
to be realized/ collected in future. It forms a vital part of current assets of a firm. Debtors result in blockage of funds
and hence it represents investment by a firm. Hence, management of sundry debtors is an important issue and
requires proper policies and efficient execution of such policies.

15.1 Reasons for creation of Debtors:

 Marketing – credit is used as a marketing tool to attract new customers.

 Competition – higher the degree of competition, more credit granted to clients.
 Business Practice – no choice to new entrepreneurs
 Bargaining Power of Seller – stronger bargaining power implies less or no credit.
 Relationship – credit is granted due to good relations with dealers / clients
 Bargaining Power of Buyers – large buyers command easy credit due to bulk purchases
 Buyers’ Requirements – buyer is not able to pay immediately.

15.2 Costs involved in Receivables Management

1) Interest Cost – Funds are blocked in receivables. This involves cost in the form of opportunity cost on
owned funds or actual interest costs in case of loan funds.
2) Administrative Costs – Costs of record keeping, investigation of credit worthiness etc.
3) Delinquency Costs – Costs of reminders, phone calls, follow-up letters etc.
4) Collection Costs – Cost of contacting customers, collecting cheques in person, collection charges, etc.
5) Default Costs – Bad debts, legal charges in respect of suits pending against debtors etc.
6) Inflationary Costs – Under high inflation, investment in receivables should be minimized as far as
possible.

15.3 Steps in Receivables Management

Following are the steps involved in management of receivables –

1. Credit Policy – A credit policy determines the investment in sundry debtors, average collection period and bad
debt losses. Hence, credit policy of a firm should enable it to achieve the objectives of –
 Increasing sales and market share,
 Increasing profits due to higher sale and higher margins on credit sales, and
 Meeting competition

Example – if credit sales are Rs. 30,000 per day and credit period is of 60 days, firm’s average investment in
debtors (i.e. funds blocked) are Rs. 18,00,000 (Rs. 30,000 x 60 days).

Credit policy involves decisions relating to length of the credit period, credit limits, discount policy, dealer
agreements, warranty terms, interest on delayed payments, business deposits, issuance of credit notes,
debtors’ account reconciliation and any other special items etc.
 Working Capital Mgt.
Credit Period denotes the period allowed for payment by customers, in the normal course of business. It is
generally stated in terms of net days. For example, if the credit terms are “net 45”, it means that customers will
repay credit obligations not later than 45 days. The credit period depends on a number of factors such as –

 Nature of product i.e. if demand is inelastic or if product is perishable, credit period may be small.
 Quantum of Sales - Credit may not be allowed if small quantities are purchased.
 Customs and Practices - normal trade practices and those followed by competitors
 Funds available with the company
 Credit Risk i.e. possibility of bad debts

Discount Policy involves decisions relating to percentage of cash discount to be offered as incentive for early
settlement of invoice and the period within which cash discount can be availed. Discounts are offered to speed
up the collection of debts. Hence, it improves the liquidity of the seller. It also ensures prompt collection and
reduces risk of bad debts. Normally, discount terms and credit terms are expressed as “2/10 net 60” means that
a cash discount of 2% will be granted if customer pays within 10 days; if he does not avail the offer he must pay
within 60 days, being the credit period.

A lenient credit policy may result in increased sales. However, additional costs incurred must also be
considered, viz. production and selling costs, administration costs, recovery costs and bad debts. Discount
policies of firms are based on cost-benefit analysis w.r.t credit period granted and classification of customers.

2. Credit Analysis – Credit Analysis is the measurement of risk borne by a seller. It evaluates the quality of
customers. Sufficient records of clients must be available and scrutinized by the seller, such as average
collection period, default rate, references, goodwill etc. and suitable rating given. Based on such scrutiny,
customers shall be categorized as per their creditworthiness and default risk. Finally, there shall be
synchronization of credit policy and credit analysis.

Factors to be analysed before Credit is granted to a Customer:

Credit should be granted on a case–to–case basis, on the following illustrative factors:

 Nature of Product: Generally perishable items are “cash and carry” basis, while durable / non-perishable
items may be sold on credit.
 Nature of customer: A valued customer, who has long and favourable past dealings with the firm may be
given credit immediately, than a new customer. However, credit may be offered for attracting new customers
 Quantity purchased: Firms may decide to grant credit only beyond a certain lot size. For example sale upto
5 kg per invoice is made on cash basis only, while orders beyond 5 kg may be supplied on credit.
 Value of Sales: Sometimes, the invoice value (instead of quantity) may be the determinant in a credit
decision. For example, credit may be granted for amounts exceeding Rs. 15,000/-.
 Credit-worthiness of the customer: The credit-worthiness of the customer is the most crucial factor in
deciding whether credit should be granted or not. This is based on past experience (for existing customers)
and credit analysis (for existing and new customers).
 Risk of Bad Debts: The extent of risk of bad debts that a firm can bear should be determined. For
example, if there is a 1 % chance of bad debts, the firm may take the risk of credit supply, but when the
chance of bad debts is 55%, credit should not be granted.
 Working Capital Mgt.
Sources of Credit Rating Information

Credit rating of a customer is based on the ability and willingness of a customer. It is comparatively easy to
judge the financial ability than willingness of a buyer. Based on such credit rating, a seller has to decide how
much and how long can credit be extended. Credit can be granted only to a customer who is reliably sound.
This decision would involve analysis of the financial status of the party, his reputation and previous record of
meeting commitments.

Following are the important sources of credit information –

1) Trade references: The prospective customer may be required to give two/three trade references. Thus, the
customers may give a list of personal acquaintances or some other existing credit-worthy customers. The
credit manager can send a short questionnaire, seeking relevant information, to the referees.
2) Bank references: Sometimes, the customer is asked to request the banker to provide the require
information. In India, bankers do not generally give detailed and unqualified credit reference.
3) Credit bureau reports: Associations for specific industries may maintain a credit bureau, which provide
useful and authentic credit information for their members.
4) Past experience: The past experience of dealings with an existing customer is a valuable source of
essential data. The transactions should be carefully scrutinised and interpreted for finding out the credit risk
involved.
5) Published financial statements: Published financial statements of a customer, (in case of limited
companies) can be examined to determine the credit-worthiness.

3. Monitoring Receivables – Monitoring of receivables involves the following measures:

1) Average Age of Receivables: Debtors Turnover Ratio and Average Collection Period are worked out at
periodic intervals. These are compared with the industry norms or the standards set by firm. In case of high
collection period, intense collection efforts are initiated.
2) Ageing Schedule: The pattern of outstanding / receivables is determined by preparing the Ageing
Schedule. If receivables denote old outstanding due for longer periods, suitable action to be taken to collect
them immediately.
3) Collection Programme: The procedures for collection e.g. reminder letters, direct follow-up etc. should be
initiated based on the company’s policies and procedures.
4) Debtors’ Reconciliation – Periodic and regular reconciliation with customers’ accounts helps to reduce any
differences, and also avoid frictions involved in collection process.

Ageing Schedule – In an ‘Ageing Schedule’, the receivables are classified according to their age, i.e. period for
which they have been outstanding, e.g. less than’ 30 days, 30-45 days, 45-60 days, above 60 days etc. Role:
Preparation of ageing schedule helps management in analysis of quality of customers, trend Analysis of
debtors, supplement to average collection period of receivables / sales analysis and recognition of recent
increase and slump in sales.
 Working Capital Mgt.
An illustrative Ageing Schedule is given below:

Period due No. of No. of Amount % of Remarks

parties bills due Total
Less than 15 days 65 70 34,180 3.42% Less than normal credit period
16 - 30 days 12 80 46,840 4.68% Less than normal credit period
31 - 45 days 86 241 3,83,690 38.37% Normal Credit Period debts
46 - 60 days 91 196 3,59,960 36.00% Regular reminders sent
61 - 90 days 43 52 97,100 9.71% Special reminders sent
91 - 180 days 12 22 41,350 4.13% Rs. 18,150 doubtful
181 - 365 days 6 9 3,000 0.80% Legal notice sent - reply due
> 1 year 3 3 17,860 1 .79% Suit filed - decision awaited
> 2 years 2 2 11,020 1.10% Suit filed - decision awaited
Total 320 675 10,00,000 100.00%

4. Collection Policy

Average collection period and bad debt losses are reduced by efficient and timely collection of debtors. Hence, a
proper collection policy should be laid down. The following aspects should be covered in Collection Policy and
procedures.
 Timing of the collection process - when to start reminding etc.
 Despatch of reminder letters to Customers.
 Personal follow-up by Company’s representatives and telephonic calls.
 Appointment of agents for collection or follow-up.
 Dealing with default accounts, legal action to be initiated, notice to defaulting customer etc.

Cost Benefit Analysis: There are certain routine costs associated with collection from customers e.g. contacting
customers, collecting cheques in person, collection agency fees etc. If a firm spends more on collection of debts, it
is likely to have smaller bad debts. Hence the amount of collection costs to be incurred should be determined by
Cost-Benefit Analysis i.e. level of expenditure vis-à-vis decrease in bad debt losses and investment in debtors.

Collection Programme – The following are the illustrative steps in a collection programme.
a) Monitoring the state of receivables.
b) Intimation of due dates to customers.
c) Telegraphic and telephonic advice to customers on the due date.
d) Threat of legal action on overdue accounts.
e) Legal action on overdue accounts.
 Working Capital Mgt.
5. Innovations in Receivables Management

1. Centralization: Centralization of high nature transactions of accounts receivables and payable is one of the
practices for better efficiency. This focuses attention on specialized groups for speedy recovery.

2. Direct debit: i.e. authorization for the transfer of funds from the buyers’ bank account.

3. Collection by a third party: The payment can be collected by an authorized external firm. The payments
can be made by cash, cheque, credit card or Electronic fund transfer. Banks may also be acting as
collecting agents of their customers and directly depositing the collections in customers’ bank accounts.

4. Lock Box Processing: Under this system an outsourced partner captures cheques and invoice data and
transmits the file to the client firm for processing in that firm’s systems.

5. Internet Payment

6. E-commerce refers to the use of computer and electronic telecommunication technologies. It uses
technologies such as Electronic Data Inter-change (EDI), Electronic Funds Transfer (EFT) and Electronic
Clearance System (ECS) to allow buyer and seller to transact business by exchange of information between
computer systems.

7. Forfaiting is a form of financing of receivables pertaining to international trade. It denotes the purchase of
trade bills/promissory notes by a bank/financial institution without recourse to the seller. The purchase is in
the form of discounting the documents covering entire risk of non-payment in collection. All risks and
collection problems are fully the responsibility of the purchaser (forfaiter) who pays cash to seller.

16. CASH MANAGEMENT

A Finance Manager should consider the following important areas of Cash Management –
a) To ensure that sufficient cash is available at each division or section for routine operations.
b) To ensure liquidity in all divisions of the organisation.
c) To identify surplus funds in certain divisions and transfer them to other divisions requiring them.
d) To invest surplus or idle funds in marketable securities in order to optimise return on funds.

16.1 Motives of Holding Cash

a) Transaction or Operation Needs: Cash may be held sufficiently in order to meet day-to-day expenses,
repayments, commitments etc. In case the forecast receipts or inflows do not arise as planned, the reserve cash
balance will be available for meeting payment commitments.

b) Speculative or Investment Needs: Cash may be held in order to take advantage of profitable opportunities
that may crop up. E.g. purchase of materials in bulk in case of temporary fall in price. Otherwise, such
opportunities may be lost for want of ready cash.

c) Precautionary or Safety Needs: Cash may be held in order to provide safety against unexpected events and
payments. Sufficient cash holding gives a sense of security or safety to the firm.
 Working Capital Mgt.
16.2 Cash Budget

Cash Budgets are a tool for forecasting short-term cash requirements of an enterprise. They provide a blueprint of
the cash inflows and outflows that are expected to occur in the immediate future period. They assist the
management in determining the surplus or shortage of funds and to take suitable action. Cash Budgets are
generally prepared in the following format, for short periods, say month by month:

Particulars Amount
a. Opening Balance of Cash
b. Cash Inflows or Receipts:
• Cash Sales
• Receipts from Debtors
• Other Revenue Receipts
• Capital Receipts (to be specified)
c. Cash Outflows or Payments:
• To Creditors for Goods
• Expenses and To Creditors for Services
• Other periodical payments such debenture interest, advance tax,
dividend etc.
• Capital Expenditures
• Repayment of Loans
d. Surplus or Shortage = b - c = Inflows less Outflows
e. Closing Balance of Cash = a + d = Opening Balance + Surplus

16.3 Float

The term “float” denotes a delay or lag between two events. In the context of cash management, the term float is
usually used for the following delays –

(1) Dispatch of FG (2) Preparation of Invoice (3) Mailing Invoice to Customer (4) Payment by Customer

Billing Float Mailing Float Credit Period

(5) Receipt of Cheque (6) Deposit of Cheque into Bank (7) Clearing Process (8) Receipt of Amt.

Mailing Float Cheque Processing Float Bank Processing Float

To convert receivables into cash quickly, all the floats have to be reduced to the minimum. While credit period is
considered as a policy decision, all other floats can be reduced by judicious managerial action.
 Working Capital Mgt.
16.4 Methods to Expedite Collection

1. Concentration Banking: This method of collection from customers operates as under:

i. Identify locations or places where major customers are placed, i.e. a Company with Head Office at Chennai
and customers based in Delhi, Kolkata and Mumbai.
ii. Open a Local Bank Account in each of these locations i.e. Delhi, Kolkata and Mumbai.
iii. Open a local collection centre for receiving cheques from these customers at the respective places. A
Branch Office or even an Agent can perform the role of a Collection Centre.
iv. Collect remittances from customers locally, either in person or through post.
v. Deposit the cheques received in the local bank account for clearing.
vi. Transfer the funds to Head Office Bank Account, upon realisation of cheques.

Advantages:
 Reduction in Mailing Float: Since remittances from customers are collected locally either in person or by
local post / courier, mailing float is reduced substantially.
 Reduction in Banking Processing Float: Cheques are cleared locally, and the funds are made available
faster. There need not be any waiting time for clearance of outstation cheques.
 Centralised Cash Management: As surplus funds are transferred to Head Office Concentration Bank
Account idle funds in various locations are avoided. Centralised Cash Management ensures optimum use
of funds available to the company and enables payment planning,

2. Lock Box System: This method of collection from customers operates as under:
i. Identify locations or places where major customers are placed, i.e. a Company with Head Office at Chennai
and customers based in Delhi, Kolkata and Mumbai.
ii. Open a Local Bank Account in each of these locations i.e. Delhi, Kolkata and Mumbai.
iii. Instruct customers to mail their payments to the Local Bank.
iv. Authorise the Bank to pick up remittances from the post box.
v. Authorise the Bank to realise the cheques through local, collection/ clearing.
vi. Transfer the funds to Head Office Bank Account, upon realisation of cheques.

Advantages:
 Reduction in Mailing Float: Since remittances from customers are collected locally either in person or by
local post / courier, mailing float is reduced substantially
 Reduction in Cheque Processing Float: The Bank would prepare a list of remittances received and forward it
to Company as a Credit Advice. This saves cheque processing float at Company’s office, before collection
 Reduction in Banking Processing Float: Since cheques are cleared locally, the funds are made available
faster. There is no delay in collection of outstation cheques.
 Centralised Cash Management: Since surplus funds are transferred to Head Office Bank Account, idle funds
in various locations are avoided. This system ensures optimum use of funds and enables payment planning.
 Working Capital Mgt.
3. Baumol’s Model for Optimum Cash Balance: The William Baumol model on Optimum Cash Balance is
similar to raw material model of EOQ. According to this model, optimum investment size is that level of
investment where the total of carrying costs and transactions costs per annum are the minimum. At that point,
these two costs are equal and constitute half of the total costs. Formula:

Optimum Investment Size = √2 AT

I

Where A = Annual Cash Requirements

T = Costs per Transaction
I = Interest rate, i.e. Carrying Cost per rupee

Limitation of Baumol Model

The limitation of the Baumol’s model is that it does not allow the cash flows to fluctuate. Firms in practice do not
use their cash balance uniformly nor are they able to predict daily cash inflows and outflows.

4. Miller-Orr Cash Management Model: Under this model, cash payments are presumed at different amounts on
different days, i.e. stochastic. In practice, the payment flow is not uniform. For example, wage and salary
payment arises in the first week, telephone bills fall due for payment once in a month etc. With this assumption,
this model is designed to determine time and size of transfers between investment account and cash account.
This model operates as under:
a) Cash outflows are not uniform during the year.
b) Upper and lower limits are fixed for cash balances, as
outflows do not exceed a certain limit on any day.
The limits are determined based on fixed transaction
costs, interest foregone on marketable securities and
the degree of likely fluctuations in cash balances.
c) When cash balance reaches upper limit, surplus cash
is invested in marketable securities, to bring down the
cash balance to the average limit or return point.
d) When cash balance touches the lower limit, investments (marketable securities) are disposed off so that
cash balances goes up to the average limit or return point.
e) During the period when cash balance stays between high and low limits, there are no transactions between
cash and marketable securities.

5. Electronic Fund Transfer: With the developments which took place in the information technology, the present
banking system is switching over to the computerization of banks branches to offer efficient banking services
and cash management services to their customers. The network will be linked to the different branches, banks.
This will help the customers in the following ways :
 Instant updation of accounts
 The quick transfer of funds.
 Instant information about foreign exchange rates.
 Working Capital Mgt.
6. Zero Balance Account: For efficient cash management some firms employ an extensive policy of substituting
marketable securities for cash by the use of zero balance accounts. Every day the firm totals the cheques
presented for payment against the account. The firm transfers the balance amount of cash in the account if
any, for buying marketable securities. In case of shortage of cash the firm sells the marketable securities.

7. Money Market Operations: One of the tasks of ‘treasury function’ of larger companies is the investment of
surplus funds in the money market. The chief characteristic of money market banking is one of size. Banks
obtain funds by competing in the money market for the deposits by the companies, public authorities, High Net-
worth Investors (HNI), and other banks, Deposits are made for specific periods ranging from overnight to one
year, a highly competitive rates which reflect supply and demand on a daily, even hourly basis are quoted.

8. Petty Cash Imprest System: For better control on cash, generally the companies use petty cash imprest
system wherein the day-to-day petty expenses are estimated taking into account past experience and future
needs and generally a week’s requirement of cash will be separately kept.

9. Management of Temporary Cash Surplus: Temporary cash surpluses can be profitably invested in:
 Short-term deposits in Banks and financial institutions.
 Short-term debt market instruments.
 Long-term debt instruments.
 Shares of Blue chip listed companies

10. Electronic Cash Management System: Most of the cash management systems now-a-days are electronically
based, since ‘speed’ is the essence of any cash management system. Electronically, transfer of data as well as
funds play a key role in any cash management system. Various elements in the process of cash management
are linked through a satellite. Various places that are interlinked may be the place where the instrument is
collected, the place where cash is to be transferred in company’s account, the place where the payment is to be
transferred etc. Certain networked cash management system may also provide a very limited access to third
parties like parties having very regular dealings of receipts and payments with the company etc. A finance
company accepting deposits from public through sub-brokers may give a limited access to sub-brokers to verify
the collections made through him for determination of his commission among other things. Good cash
management is a conscious process of knowing :
 When, where and how a company’s cash needs will arise.
 Knowing what are the best sources of meeting at a short notice additional cash requirement.
 Maintaining good and cordial relations with bankers and other creditors.

11. Virtual Banking: The practice of banking has undergone a significant change in the nineties. While banks are
striving to strengthen customer base and relationship and move towards relationship banking, customers are
increasingly moving away from the confines of traditional branch banking and are seeking the convenience of
remote electronic banking services. And even within the broad spectrum of electronic banking the virtual
banking has gained prominence. Broadly virtual banking denotes the provision of banking and related services
through extensive use of information technology without direct recourse to the bank by the customer. The origin
of virtual banking in the developed countries can be traced back to the seventies with the installation of
Automated Teller Machines (ATMs).
 Working Capital Mgt.
Subsequently, driven by the competitive market environment as well as various technological and customer
pressures, other types of virtual banking services have grown in prominence throughout the world. The
advantages of virtual banking services are as follows:
 Lower cost of handling a transaction
 The increased speed of response to customer requirements
 The lower cost of operating branch network along with reduced staff costs leads to cost efficiency.
 Virtual banking allows the possibility of improved and a range of services being made available to the
customer rapidly, accurately and at his convenience.

17. INVENTORY MANAGEMENT

Inventory management is the systematic control, monitoring and regulations of purchases, storage and usage of
materials. The purpose of inventory management is to maintain a smooth flow of production and avoid excessive
investment in inventories, thereby reducing blockage of funds. Efficient material control reduces loses and wastages
of materials. Thus, proper planning and controlling of inventory is very importance.

Inventory control ensures that right purchases, right receipts, right storage, right issues and right accounting.
Investments in inventories are reduced to a great extent, without sacrificing the production and user dept.
requirements. Inventory Management can be defined as ‘the function of ensuring that sufficient goods are retained
in stock to meet all requirements, without carrying unnecessarily large stocks’. The main objective of inventory
control is to achieve maximum efficiency in production and sales with the minimum investment in inventory.

How cost of inventory can be lowered:

 Entering into long term arrangements for supply of raw materials at market driven prices.
 Arranging for direct supply of raw material at manufacturing locations.
 Promoting ex-factory sales of the finished goods.
 Availing quantity discounts and spot payment discounts if the carrying cost and financing cost is less than
the discounts.
 Apart from these general steps, a technique called ABC analysis is also used for monitoring inventory costs.
 Working Capital Mgt.
Techniques of Inventory Control
1. ABC Analysis

ABC analysis is based on the value of material. In ABC analysis, the material is classified into ‘A’, ‘B’ and ‘C’
category. Generally, it is observed that material covering 70-80% value include just 5-10% quantity and vice versa.
Thus, ABC analysis is a systematic approach to control the material on the basis of its money value.

 ‘A’ category items constitute the highest cost inventories, as compared to the total value of inventory.
The ‘A’ category items constitute about 5-10% of the total items while its value may be about 80% of
the total value of the inventory. Maximum control is ensured on such items such as adequate
security, periodical physical verification (quarterly or semi-annually) etc.
 ‘B’ class items constitute intermediate position, i.e. these items cover 20-25% of the total items while
the usage value may be about 15% of the total value. Control over such items is lenient as compared
to ‘A’ class items. In this case, physical verification may be conducted annually.
 ‘C’ class are the most negligible in value, about 65-75% of the total quantity but the value may be
about 5% of the total usage value of the inventory. Here, the control is based on cost-benefit
analysis. Physical verification may be conducted once in two years etc.

As per ABC plan, each material should be analyzed in term of its usage, lead time, technical or other
problems and its relative money value in the total investment in inventories. Critical i.e., high value items
deserve very close attention, and low value items require minimum efforts and expenses.

2. V.E.D Analysis

VED analysis is based on the importance of material. Control over material is based on the criticality of it
in the production process. According, material is classified into following:

 ‘V’ stands for vital or most important items and their stock analysis requires more attention. Vital
implies the material whose shortage will stop the production immediately and cause heavy losses to
the company. Thus, these items shall be stored adequately to ensure smooth operation of the plant.
E.g. main raw material.
 ‘E’ means essential items. Such items are considered essential for running of the factory. Shortage of
essential material will not affect production immediately, but it will be hampered after a short duration.
Hence, adequate care must be taken to see that they are always in stock. E.g. lubricants, gasses etc.
 ‘D’ stands for desirable items, which do not affect production but availability of these items will lead to
more efficiency and less fatigue. E.g. spares and consumables.

VED analyses material based on their importance and it can be used to plan for procurement and
storage.

3. Two-Bin system

‘Bin’ means a container for storage of goods. As per two-bin system, material is stored in two separate
bins. The first bin (of large size) stores the quantity of inventory which is sufficient to meet its normal
consumption. The second bin contains the safety stock, i.e. the material sufficient for lead time
consumption. When the material from first bin is exhausted, the second bin is used and order is placed
with the supplier. Till the replenishment of goods, second bin is used and production is uninterrupted.
 Working Capital Mgt.
4. FSND Analysis

FNSD analysis is based on the frequency of usage and storage location of material. This analysis divides
the inventory into four categories in the descending order of their consumption rate:

 ‘F’ stands for fast moving items and stocks of such items are consumed in a short span of time. Stock
of fast moving items must be observed constantly and replenishment orders be placed in time to
avoid stock out position. Such material shall be stored near the shop-floor to reduce receiving lead
time.
 ‘N’ means normal moving items and such items are consumed over a period of time, i.e. a month or a
quarter. The order levels and quantities for such items should be on the basis of a new estimate of
future demand to minimize the risks of a surplus stock.
 ‘S’ indicates slow moving items, existing stock of which would last for over a year upto two years.
These items must be reviewed carefully before eliminating them.
 ‘D’ stands for dead stock or dormant stock which will not be used further. It is necessary to identify
these items and if there cannot be any alternative use for the same, should be eliminated.

5. Just in Time (JIT) Technique

This is the latest trend in inventory management. JIT was developed by Toyota Corporation, Japan to
reduce inventory costs and wastages. The purpose of JIT is to reduce the inventory holding costs. As per
JIT principle, the material procured from the supplier should directly reach the assembly line, i.e. to the
production department. This eliminates the need for storage of goods, thus reducing carrying cost,
opportunity cost, handling wastages etc.

Inventory should be purchased at the right time, in right quantities, at the right costs and of the right
quality. Due to such strict control, non-value added services are reduced; and over production is
avoidable. Pre-inspected material is only procured to avoid inspection delays. Precise coordination is
required between the marketing, production, stores, purchase departments as well as the material
suppliers. However, JIT is not 100% practical in Indian conditions due to inadequate infrastructure;
lapses in technical support etc. The benefits of JIT are as follows:

 Right quantities are purchased or produced at right time.

 Cost effective production or operation of correct services is possible.
 Inventory carrying costs are eliminated to a great extent.
 The stores function is eliminated and hence there is a considerable saving in the stores cost.
 Losses due to breakage, wastage, pilferage etc are avoided.

6. Fixing inventory levels

One of the main aspects of material control is ordering discipline, i.e. neither purchase more nor less.
Similarly, the timing of the procurement is also important. Fixing material levels is a technique which tries
to achieve correct procurements – quantity and timing. The advantages of fixing levels are avoiding
overstocking, ensuring right order size at right time and also avoiding shortage of materials. Other factors
to be considered while fixing maximum level include storage space requirement, insurance cost, and
nature of material (perishable, seasonal, obsolete etc).
 Working Capital Mgt.
 Reorder Level (ROL) – Reorder Level is fixed for deciding the time of placing an order. If the stock of
material reaches this level, fresh order is placed. The reorder level is fixed after considering the
material receiving time, so that there is no shortage, i.e. minimum level is not breached.

Reorder Level = Maximum consumption per Period * Maximum lead time

 Maximum Level – This is the highest level beyond which the inventory of material is not allowed to
rise. The purpose of maximum level is to avoid overstocking. The maximum level is fixed after
considering consumption of material and re-order (lead time) period.

Maximum Level = Reorder Level + Reorder Quantity – [Min. consumption * Min. lead time]

 Minimum Level – This level is fixed with the objective of avoiding shortage of material. If production
is held up due to shortage of material, there will be huge loss to the company. In order to avoid such
losses, the minimum level is fixed. Adequate care is taken that the stocks do not fall below this level.

Minimum Level = Reorder Level – [Average rate of consumption * Avg. Reorder period]

 Average Level: This level is the average of the maximum and minimum level.

Average Level = (Maximum Level + Minimum Level)

2
 Danger Level – Generally, the danger level of stock is maintained below the minimum stock level.
When the danger level is reached, the procurement must be done under all circumstances.

Danger Level = Average consumption * emergency lead time

Safety stock level = Reordering level – (Avg. consumption * lead time), OR

Safety stock level = (Maximum consumption – Average rate of consumption) * Lead time.

7. Economic Order Quantity (EOQ)

Inventory management involves two important costs – procurement (ordering) cost and carrying
(storage) cost. Effective inventory management implies ordering at the right time and quantity and safe
storage of goods. Thus, these two functions are very important for the success of inventory control.
However, ordering cost and carrying cost are inversely related to each other, i.e. bulk purchase reduces
ordering costs but increases carrying costs and vice versa.

Economic Order Quantity (EOQ) can be defined as that order size which minimizes the total of ordering
and carrying costs. EOQ is an ideal order size where material is available at the right time, without
blockage of funds.

Procurement (ordering) costs include handling and transportation costs, stationery costs, postage,
telegraph and telephone charges, costs incurred for inviting quotations and tenders etc. Carrying costs
include interest on capital blocked, rent of warehouse, salaries of store-keepers, loss due to
deterioration, insurance charges etc.

E.O.Q. = √2AO Where, A = Annual consumption (units), O = Cost per order, C = carrying cost/ unit p.a.
C
 Working Capital Mgt.
8. G.O.L.F

G.O.L.F is based on the source of supply and resultant inventory levels. A company shall maintain
material levels on the basis of certainty of supply and lead time.

‘G’ stands for Govt. supplier – excess stocks to be maintained due to high uncertainty of delivery,

‘O’ stands for Ordinary / private supplier – less stocks to be maintained due to certainty of delivery,

‘L’ stands for Local supplier – less stocks to be maintained due to less lead time.

‘F’ stands for Foreign supplier – excess stocks to be maintained due to higher lead time.

9. Perpetual Inventory System

Perpetual Inventory system means continuous stock-taking. Under this system, a continuous record of
receipt and issue of materials is maintained by the stores department and the information about the stock
of materials is always available. Entries in the Bin Card and the Stores Ledger are made after every
receipt and issue and the balance is reconciled on regular basis with the physical stock. The main
advantage of this system is that it avoids disruptions in the production caused by shortages. Similarly it
helps in having a detailed and more reliable check on the stocks. The stock records are more reliable
and stock discrepancies are investigated and appropriate action is taken immediately. CIMA defines
perpetual inventory system as ‘the recording as they occur of receipts, issues and resulting balances of
individual items of stock in either quantity or quantity and value’.

10. Inventory Control Ratios

The financial statements can be used to compute certain inventory related ratios to measure the
performance of inventory functions. Identification of slow moving items, bottlenecks in production,
storage issues can be traced through these ratios. For identifying these items, it is necessary to compute
inventory turnover ratios. Inventory turnover ratio enables the management to avoid the capital being
locked in such items. This ratio indicates the efficiency or inefficiency with which inventories are
maintained.

 FG Inventory Turnover Ratio = Cost of Goods Sold

Avg. FG stock

 RM Inventory Turnover Ratio = Cost of RM consumed

Avg. RM stock

 WIP Inventory Turnover Ratio = Cost of Production

Avg. WIP stock

The reciprocal of these ratios provides the duration of inventory held in stock, i.e. holding period. The
holding period facilitates identification of slow moving material.
 WORKING CAPITAL NUMERICAL
1) TML Ltd. purchases 9000 spare parts annually, orders being placed for monthly usage. Cost of each part is Rs.
20, cost per order Rs. 15 and storage charges 15% of unit cost. Suggest the most economic purchase policy
for TML Ltd. Also, enumerate the total savings from the new purchase policy.

2) Shriram Ind. manufactures a special product 'ZED'. The following particulars were collected for the year 2002:
Monthly demand of ZED 1,000 units, Cost of placing an order Rs. 100, Annual carrying cost per unit Rs. 15,
Normal usage 50 units per week, Minimum usage 25 units per week, Maximum usage 75 units per week, Re-
order period 4 to 6 weeks. Compute: Re-order quantity; Re-order level; Minimum level; Maximum level and
Average stock level.

3) Ratan Enterprises requires 180,000 units of a certain item annually. The cost per unit and the cost per
purchase order are Rs. 6 and Rs. 600 respectively. The inventory carrying cost is Rs. 6 per unit per year.
i. What is the economic order quantity?
ii. What should the firm do if the supplier offers discount as below:

Order Quantity Discount

9,000 – 11,999 2%
12,000 and above 3%

4) Elite Ltd. manufactures a product from a raw material, which is purchased at Rs. 100 per kg. The company
incurs a handling cost of Rs. 300 plus freight of Rs. 325 per order. The incremental carrying cost of inventory of
raw material is Re 0.50 per kg per month. Also, annual cost of working capital finance on investment in raw
material inventory is Rs. 4 per kg. The annual production of finished product is 100,000 units, 2 units are
obtained from 1 kg of raw material. Compute Economic order quantity of raw materials. Advise how frequently
orders for procurement of raw materials should be placed. (360 days per year)

5) Blue Berry Ltd. carrying cost 12% and ordering cost Rs 12 per order. The annual requirement is 40000 units at
a price of Rs 5 per unit. What is EOQ? Find the total cost of inventory. If the supplier is ready to give a discount
of 5% for five deliveries in a year, should the offer be accepted?

6) Saraswati Ltd. produces auto parts with a monthly demand of 4000 units. The product requires component
which is purchased at Rs. 20 per unit. For every finished product, one unit of A-345 is required. The holding
cost per unit per annum is 10% and the order cost is Rs. 120 per order. Calculate Economic Order Quantity

7) A new customer with 10% risk of non-payment desires to establish business connections with you. He requires
1.50 month of credit period and is likely to increase your sales by 120,000 p.a., cost of sales amounted to 85%
of sales. The tax rate is 30%. Should you accept the offer if the required rate of return is 40% (after tax)?
 Working Capital Mgt.
8) Kiran Corporation is considering relaxing its present credit policy and is in the process of evaluating two
proposed policies. Currently, the firm has annual credit sales of Rs. 50 lakhs and accounts receivable turnover
ratio of 4 times a year. The current level of loss due to bad debts is Rs. 150,000. The firm is required to give a
return of 25 % on the investment in new accounts receivables. The company’s variable costs are 70 % of the
selling price. Select the best option from the following:

Particulars Present Policy Policy Option – I Policy Option –II

Annual Credit Sales Rs. 50,00,000 Rs. 60,00,000 Rs. 67,50,000
Accounts receivables turnover ratio 4 times 3 times 2.40 times
Bad debt losses Rs. 1,50,000 Rs. 3,00,000 Rs. 4,50,000

9) A firm’s product sells for Rs. 10 per unit out of which Rs. 7 is variable costs before taxes (including credit
departmental costs). Current annual sales are Rs. 12 lakhs, represented entirely by credit sales, and average
total cost per unit is Rs. 9 per unit before taxes. The firm is considering a more liberal extension of credit which
will result in slowing process of the average collection period from one to two months. This credit relaxation is
expected to increase sales by 25 %, i.e. sales would become Rs. 15 lakhs annually. Advice the management if
minimum expected rate of return is 20 %.

10) Gelcorp Ltd. provides ‘net 30 days’ credit to its customers of 600 lakhs and its average collection period is 45
days. To stimulate sales, the company may grant credit terms of ‘net 60 days’. The turnover is expected to rise
by 15% and the expected collection would be after 75 days. There would be no difference in payment habits of
old and new customers. Variable cost of 80 paise per rupee of sales. Gelcorp’s expected rate of return on
investments in receivables is 20%. Assuming 360 days in a year, advise whether credit terms be changed?

11) Shrinath Traders Ltd. currently sells on terms of ‘net 30 days’. All sales are on credit basis and average
collection period is 35 days. Currently, it sells 500,000 units at an average price of Rs. 50 per unit. The variable
cost to sales ratio is 75% and a bad debt to sales ratio is 3%. In order to expand sales, the management of the
company is considering changing the credit terms from net 30 to 2/10, net 30. Due to the change in policy,
sales are expected to go up by 10%, bad debt loss on additional sales will be 5%. Now, 40% of the customers
are expected to avail the discount and pay on the tenth day. The average collection period for the new policy is
expected to be 34 days. The company required a return of 20% on its investment in receivables. Whether
policy shall be changed? Advice.

12) The manager of Suhana Ltd. is giving a proposal to Board of Directors of company that an increase in credit
period allowed to customers from the present one month to two months will bring a 25% increase in sales. The
following operational data of the company for the current year are taken from the records of the company:
 Selling price Rs. 21, Variable cost per unit 14, Total cost per unit Rs. 18, Sales value Rs. 18,90,000
 Board has requested you to give your expert advice on new credit policy, if required rate of return is 40%.
 Also compute the actual return earned on additional investment.
 Working Capital Mgt.
13) Pawan Ltd. has total sales Rs. 30 lakhs with average collection period of 2 months. To expedite collection, the
company is thinking of offering 2% discounts. As a result 50% of existing customers are likely to avail the
discount. Also, average collection period shall reduce by 1 month. If Pawan Ltd. expects 25% return on
investments, whether the policy shall be changed? Show working notes to justify your suggestion.

14) Sadhana Ltd. currently maintains a centralized billing system at Head Office to handle the daily collections of
Rs. 450,000. The total time of mailing, processing and clearing has been estimated at 4 days. If the company’s
opportunity cost on short-term funds is 15%, what is the cost of this delay of 4 days to the company? If
management designed a lock-box system with local banks, the float would reduce by 1.50 days and Head
Office expenses would reduce by Rs. 52,000. If cost of lock-box system is Rs. 200,000 p.a., decide?

15) Universal Cables has a centralized billing system. On an average 5 days are required for customers’ mailed
payments to reach the central location. Additional 2 days are required for processing the payments and deposit
in the bank account. The daily average collection is Rs. 800,000. The company is thinking of a lock-box system
which will reduce mailing delays to 3 days. Also, processing time will reduce by one day. Determine the
reduction in cash balances that can be achieved through the use of lock box system. The opportunity cost is
7.50% on short term investments. If annual cost of lock box is Rs. 120,000, should be system be initiated?

16) Khadoos Ltd. has given following data for its product. Selling price Rs. 55 per unit. 25% of the sales are on
cash basis. RM per unit Rs. 32, Wages per unit Rs. 11, Overheads per unit Rs. 7 (including depreciation of Rs.
2), RM holding period 1.50 weeks; production process requires 1 week. The FG are sold after 4 weeks from
date of production. Debtors enjoy 3 weeks credit while the creditors give 5 weeks credit to the company. The
average cash maintained by the company is 25% of current liabilities. There is delay of 2 weeks in payment of
wages and 6 weeks delay for overheads. Annual production and sale is 156,000 units. Debtors to be
considered at cost and WIP valued at 50% (labour and overheads). Estimate W.C requirement of the company.
Contingency reserve should be maintained at 2 % of Gross Working Capital. Assume 52 weeks in a year.

17) Omega Bros. have given the following data regarding their manufacturing operations. They need to calculate
the operating cycle. Compute operating cycle.

Particulars Rs. In lakhs Particulars Rs. In lakhs

Raw material consumption 5,932 Gross Sales 8,045
Receivables 1,040 Cash Sales 1,006
Payables 642 Raw Material Inventory 986
Total Production Cost 6,961 WIP stock 498
Total Cost of Goods Sold 6,492 Finished Goods Stock 995
Credit Purchases 6,091

18) Presently, the number of operating cycles in a year for Pesto Ltd. is 5. Average annual cash outflows are Rs.
175,000. If the accounts payable is stretched (delayed) by 12 days, what would be the effect on the liquidity of
the company? Compute the savings due to the above action. The opportunity cost on investments is 10%.
Assume 360 days in a year.
 Working Capital Mgt.
19) Following information is available for Banister Ltd.
RM storage period 55 days, WIP conversion 18 days, FG storage period 22 days, Debt collection period 45
days, Creditors’ payment period 60 days, Operating Cost p.a. Rs. 21,00,000 (incl. depreciation Rs. 210,000)

 Compute Operating Cycle period.

 Number of Operating Cycle in a year. Consider 1 year = 360 days
 Amount of working capital required for the company on a cash cost basis.
 The company has monopoly position. Thus, it is planning to discontinue credit sales for reducing its working
capital requirement. What would be the reduction in working capital requirement due to such decision?

20) Compute working capital requirement from the following data –

Sales (current) Rs. 24,00,000 Collection Period 60 days

Gross profit margin 20% Inventory holding period (COGS based) 90 days
Purchases 25% of COGS Bank balance 2% of Sales
Payment Period 60 days 1 year 360 days
 WORKING CAPITAL MANAGEMENT

▪ Working Capital refers to the short-term funds which are needed for (daily) day-to-day operations
of a business.
▪ Short-term funds signify current assets and current liabilities of a business.
▪ Current assets are the assets which are supposed to converted into cash within a short period
of time (12 months). Examples –
o Inventory / stock
o Debtors
o Bills Receivables
o Cash balance
o Bank balance
o Prepaid Expenses
o Short-term investments
o Short-term loans given
o Accrued income (earned but not received)

▪ Current liabilities are the obligations which are supposed to paid within a short period of time
(within 12 months). Examples –
o Creditors
o Bills Payable
o Outstanding / accrued expenses
o Bank Overdraft
o Proposed dividend
o Provision for Taxes
o Short-term loans / advances taken

▪ Types of Working Capital:

o Gross Working Capital = sum / aggregate of all current assets
o Net Working Capital = Current Assets (-) Current Liabilities
o Fixed / Core Working Capital = funds maintained by a business irrespective of the level
of operations.
o Floating / Fluctuating Working Capital = funds maintained by a business as per the level
of operations.
o Negative Working Capital = current liabilities > current assets

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 1

 Working Capital Management
▪ Factors affecting Working Capital requirement:
1) Nature of Business
2) Size / scale of business
3) Level of Competition
4) Credit policy (debtors vis-à-vis creditors)
5) Availability of Factors of Production
6) Interest rates
7) Inflation rates
8) Foreign exchange rates
9) Nature of production process (automated vs. labour oriented)
10) Demand – Supply gap for the product
11) Geographical constraints
12) Logistics costs
13) Emergency / contingency provisions
14) Dividend policy of company
15) Operating Cycle

▪ Operating Cycle
o Operating cycle is the duration (time period) required to complete the entire process
starting from purchase of raw material, production process, selling finished goods,
collection from debtors and finally payment to creditors and expenses.
o The duration of operating cycle decides the requirement of working capital
o Higher the duration of operating cycle = more the working capital funds needed
o Hence, every company tries to reduce the operating cycle duration

Amount blocked in working capital = Quantity * Cost per unit * Operating cycle duration

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 2

 Working Capital Management

Practical Examples

Q1. Silver Coin Ltd. plans to produce and sell 18000 units p.a. The Finance manager needs working
capital requirements for next year. Following information is available –

▪ Selling price per unit is ₹ 15. Raw material ₹ 7, Wages ₹ 3 and Overheads ₹ 2
▪ RM remains in store for an average of 1.50 months before issue to production.
▪ Each unit will remain in process for 1 month (wages & overheads considered 50%)
▪ Final production will be stored in warehouse awaiting dispatch for 3 months.
▪ Credit allowed by suppliers is 1.50 months from date of delivery of raw materials.
▪ Credit permitted to customers is 2.50 months from the date of dispatch.
▪ The company maintains ₹ 50,000 as cash in hand.
▪ Wages paid in next month and overheads are paid after 1.50 months from accrual.
▪ Consider debtors at selling price.
▪ Maintain 5% emergency reserve on net working capital.

Q2. Insta-mart Ltd. is a food processing company. Compute working capital requirement based on
following information. Annual production 104000 units,

Particulars Amount
Raw material cost per unit Rs. 10.00
Direct Labour cost per unit Rs. 5.00
Overheads cost per unit Rs. 7.00
Selling price per unit Rs. 30.00

▪ Raw materials inventory held for 3 weeks,

▪ Duration of production cycle is 1 week, (assume 50% for wages and overheads)
▪ Payment for wages delayed by 2 weeks and overheads are delayed by 5 weeks.
▪ Finished goods inventory held for 4 weeks,
▪ Suppliers provide 2 weeks credit
▪ Customers enjoy 4 weeks credit period.
▪ Debtors to be considered as at sales value (80% customers on credit basis)
▪ Cash balance is Rs. 100,000
▪ Assume 52 weeks in a year

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 3

 Working Capital Management
Q3. Hume Ltd. is a pipe manufacturing company. Material is introduced at the start of production
cycle; and wages and overhead accrue evenly throughout the operating cycle period. Compute
working capital requirement based on following information –

▪ Annual production of pipes 12000 units,

▪ Raw materials inventory held for 1 month,
▪ Duration of production cycle is 1 month,
▪ Payment for wages delayed by 1 month and overheads are delayed by 2 months.
▪ Finished goods inventory held for 2 months,
▪ Suppliers provide 2.50 months credit
▪ Customers enjoy 2 months credit period.
▪ Selling price (SP) Rs. 80 per unit.
▪ Raw materials cost 60 % of SP, Direct wages 15% of SP and Overheads 10% of SP
▪ Debtors to be considered as at sales value (10% customers on cash basis)
▪ Cash balance is Rs. 100,000

Q4. From the following information, compute working capital requirement –

Particulars Amount
Raw material cost per unit Rs. 400.00
Direct Wages cost per unit Rs. 200.00
Overheads cost per unit Rs. 350.00
(incl. depreciation Rs. 50)
Selling price per unit Rs. 1000.00

▪ Annual production and sale of 52,000 units,

▪ Raw material in stock for 4 weeks
▪ Work in progress 2 weeks (consider 50% for labour, overheads and 100% for material)
▪ Finished goods stock 4 weeks
▪ Suppliers’ credit period 5 weeks
▪ Customers’ credit period 6 weeks
▪ Bank balance Rs. 100,000
▪ Delay in payment of wages 2 weeks
▪ Delay in payment of overheads 4 weeks
▪ Consider debtors at selling price (all sales are credit basis)
▪ Assume 52 weeks in a year

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 4

 Working Capital Management
Q5. Lanka Ltd. provides following information. Compute working capital requirement for annual
production of 1 lakh units –

Particulars Amount
Raw material cost per unit Rs. 40.00
Direct Wages cost per unit Rs. 15.00
Overheads cost per unit Rs. 25.00
Depreciation per unit Rs. 10.00
Selling price per unit Rs. 100.00

▪ Raw material in stock for 3 weeks

▪ Work in progress 2 weeks (assume 50% for labour, overheads & full material consumption)
▪ Finished goods stock 5 weeks
▪ Suppliers’ credit period 8 weeks
▪ Customers’ credit period 6 weeks
▪ Lag in payment of wages 2 weeks
▪ Lag in payment of overheads 4 weeks
▪ Bank balance maintained Rs. 60,000
▪ Consider debtors at cash cost basis (all sales are credit basis)
▪ Assume 50 weeks in a year

Q6. The following annual figures relate to Chameleon Ltd.:

Particulars Rs.
Credit Sales (at two month's credit) 36,00,000
Materials consumed (Suppliers extend two months credit) 9,00,000
Wages paid (monthly in arrears) 7,20,000
Total Manufacturing expenses (lag of one month) 9,60,000
Total Administrative expenses, (one month arrear) 2,40,000
Sales promotion expenses, paid quarterly in advance 1,20,000

The company keeps 1 month’s stock each of raw materials and 1 month as finished, goods
stock, cash balance of ₹ 100,000. Assuming a 2% safety margin, compute the working capital
requirements of the company. There is no work-in-progress.

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 5

 FINANCIAL MANAGEMENT – REVISION
Q1. Given below is Balance Sheet and Profit & Loss Statement of Magnum Ltd.

Liabilities Amt. Rs. Assets Amt. Rs.

Equity Share Capital 2,00,000 Fixed Assets 3,00,000
(FV = Rs. 10)
Reserves 50,000
20% Debentures 1,50,000 Inventory 1,00,000
Creditors 80,000 Receivables 60,000
Bank Overdraft 20,000 Bank balance 40,000

Total 5,00,000 Total 5,00,000

Particulars Rs.
Sales (all credit) 5,00,000
(-) Cost of Goods Sold 3,00,000
Gross Profit 2,00,000
(-) Admin, selling, general expenses 1,00,000
Profit before interest and tax (EBIT) 1,00,000
(-) Interest on Debentures 30,000
Profit before tax 70,000
(-) Income Tax 20,000
Profit after tax 50,000

Calculate the following ratios –

1) Current ratio
2) Debt-Equity Ratio
3) Acid-test Ratio
4) Return on Capital Employed
5) Net Profit Ratio
6) Debtors Turnover Ratio
7) Earnings per Share (EPS)
8) Inventory Turnover Ratio
9) Return on Equity
10) Capital turnover Ratio
11) Return on Net-Worth
12) Proprietary Ratio
13) Interest Coverage Ratio
14) Gross Profit Margin
15) Price Earnings Ratio (MP per share = Rs. 20)

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 1

 FM - Revision
Q2. Given below is Balance Sheet of Dell Ltd.

Liabilities Amt. Rs. Assets Amt. Rs.

Equity Capital 5,00,000 Fixed Assets 30,00,000
(FV Rs. 10 each)
General Reserves 4,00,000 Inventory 5,00,000
Profit & Loss Account 5,00,000 Receivables 4,00,000
Long Term Loans 20,00,000 Cash and Bank 1,00,000
Other Current Liabilities 2,00,000
Creditors 4,00,000
Total 40,00,000 Total 40,00,000

Sales Rs. 40,00,000, Net Profit Rs. 5,00,000 and Market price per share Rs. 200
Calculate the following ratios -
1) Debt-Equity Ratio
2) Liquid Ratio
3) Earnings per Share
4) Receivables Turnover Ratio
5) Current Ratio
6) Price Earnings Ratio
7) Inventory Turnover Ratio
8) Total Assets Turnover Ratio

Q3. Compute working capital requirement based on following information. Annual production 104000 units,
Particulars Amount (₹)
Raw material cost per unit 12.00
Direct Labour cost per unit 8.00
Overheads cost per unit 5.00
Total Cost 25.00
Profit per unit 5.00
Selling price per unit 30.00

▪ Raw materials inventory held for 2 weeks,

▪ Duration of production cycle is 1 week, (assume 50% for wages and overheads)
▪ Payment for wages delayed by 2 weeks and overheads are delayed by 5 weeks.
▪ Finished goods inventory held for 3 weeks,
▪ Suppliers provide 4 weeks credit
▪ Customers enjoy 5 weeks credit period.
▪ Debtors to be considered as at sales value (80% customers on credit basis)
▪ Cash balance shall be maintained at 20% of Debtors
▪ Maintain contingency reserve at 5% of Net Working Capital
▪ Assume 52 weeks in a year

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 2

 FM - Revision
Q4. Compute working capital requirement for annual production of 96,000 units –
Particulars Amount (₹)
Raw material cost per unit 50.00
Direct Wages cost per unit 30.00
Overheads cost per unit 25.00
(including depreciation ₹ 5)
Selling price per unit 120.00

▪ Raw material holding period 2 months

▪ Work in Progress processing period 1 month (assume 50% for labour, overheads & full material usage)
▪ Finished goods holding period 3 months
▪ Suppliers’ credit period 3 months
▪ Customers’ credit period 2 months
▪ Lag in payment of wages 1 month
▪ Lag in payment of overheads 2.50 months
▪ Bank balance maintained ₹ 100,000
▪ Consider debtors at cash cost basis (all sales are credit basis)

Q5. A new project requires ₹ 10 lakhs initial investments and following cash inflows are estimated. Compute simple
payback period and discounted payback period using 12% expected returns.

Year Cash Inflows ₹ 12% PVF

1 2,50,000 0.8929
2 3,50,000 0.7971
3 3,00,000 0.7118
4 3,00,000 0.6355
5 2,00,000 0.5674

Q6. A highly profitable company has planned diversification which requires ₹ 20,00,000 investment in new machinery
and life is 5 years. Cost of capital (WACC) 10%. From following incremental cash flows, decide the feasibility of the
project using NPV and P.I. Given, Present Value Factors (PVF):

Year 1 2 3 4 5
Cash Flows (₹ ‘lakhs) 3,00,000 5,00,000 8,00,000 6,00,000 4,00,000
PVF at 10% 0.909 0.826 0.751 0.683 0.621

Q7. Lenovo Ltd. provides the following capital structure.

Particulars Amount (₹) Tax adjusted Cost %

Equity Share Capital (FV ₹ 10) 40,00,000 14.00 %
10% Preference Capital 10,00,000 10.00%
12% Debentures 20,00,000 8.00 %

Compute Weighted Average Cost of Capital.

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 3

 FM - Revision
Q8. Calculate the WACC (after tax) using Market value proportions. Tax Rate 20%. Following data is available –

Source of Finance Mkt. Value (Rs)

Equity Capital (rate of dividend 16%) 20,00,000
8% Preference Capital 8,00,000
10% Debentures 10,00,000
12% Bank Loan 12,00,000
Total 50,00,000

Q9. Compaq Ltd. provides the following capital structure.

Particulars Quantity Face Value Market Price Cost post tax %

Equity Share Capital 100,000 shares ₹ 10 ₹ 70 16.00 %
8% Preference Capital 50,000 shares ₹ 100 ₹ 98 8.00 %
12% Debentures 10,000 debentures ₹ 100 ₹ 110 9.00 %

Compute Weighted Average Cost of Capital using Book Value and Market Values.

Q10. The following information is available. Compute all the leverages.

Particulars Amount (₹)

Sales 4,00,000
(-) Variable Cost 3,00,000
Contribution 1,00,000
(-) Fixed Cost 50,000
EBIT 50,000
(-) Interest 20,000
PBT 30,000

Q11. Compute Operating Leverage, Financial Leverage, Combined Leverage and EPS using the following information:
Selling Price per unit ₹ 50
No. of units sold 10000 units
Total Fixed Cost ₹ 60,000
Variable Cost 40% of Selling Price
10% Bank Loan ₹ 400,000
Tax Rate 20%
No. of Equity Shares 1 lakh shares

Prof. Prasad Bhat (CA, CS, CMA, M.Com, NET) 4