INTRODUCTION TO CAPITAL

Capital forms the base for the business. It is the capital that keeps any business going on.
This chapter deals with the concept of capital, its significance, the sources of raising the
different types and how to estimate the requirements of working capital.

WHAT IS CAPITAL

Capital is defined as wealth. There are different forms of capital : property, cash etc. It is
the aggregate of funds used in the short run and long run.

SIGNIFICANCE OF CAPITAL

Capital plays a very significant role in the modern production system. It is very difficult
to imagine the process of production without capital.
Capital is required at the promotion stage. Business firms also need capital for the
purpose of conducting their business operations such R&D , Adv , sales promotion,
distribution and operating expences
The firms requires a lot of capital for expansion and diversification purposes
To pay dividends and interests. The business has to replace its worn out assets.

TYPES OF CAPITAL

Capital can broadly be divided into two types : fixed capital and working capital

FIXED Capital

Is that portion of capital which is invested in acquiring long-term assets such as land
buildings plant and machinery furniture and fixtures and so on.

ESTIMATION of fixed capital

The amount of fixed capital of a company depends on a number of factors such as

Size of the company, nature of business, method of production and so on

Size of the company - Larger the size of the company higher is the amount of fixed
capital required
nature of business - A manufacturing firm requires more amount of fixed capital
whereas a retail firm requires less amount of fixed capital
method of production - If it is a capital intensive company it requires more amount
of fixed capital
WORKING Capital

It is that portion of capital that makes a company work. It is used to meet regular or
recurring needs of the business.The regular needs refer to the purchase of materials
payment of wages and salaries, expences like rent advertising and power.

FACTORS DETERMINING THE REQUIREMENTS OF WORKING Capital

1. Promotional stage – The business may require more funds

2. Position of business cycle – The economy is subject to ups and downs. The
upward swing is associated increase in sales followed increase in inventories.
During the downward swing sales volume will be low
3. Nature of business – In general manufacturing companies less working capital
when compared to the trading organizations
4. The length of manufacturing cycle – Longer the manufacturing cycle is, more is
the requirement of working capital.

PROCESS INVOLVED IN ESTIMATING WORKING CAPITAL

REQUIREMENTS

Step 1) Factors Involved

1) The level of production

2) The length of time for which raw materials are to remain in stores
3) The time taken for the conversion of raw materials into finished goods
4) The length of time taken to convert finished goods into sales
5) The average period of credit allowed to customers
6) The amount of cash required to pay day to day expenses of the business and make
advances
7) The average credit period expected to be allowed by suppliers
8) Time-lag in the payment of wages and other expenses
9) The prices of factors of production

Step 2) :

Find the amount of investment in current assets such as raw materials ,WIP , FG , debtors
and cash balance

Step 3) :

Liabilities such as creditors , lag in payment of expenses are to be deducted from the total
Current assets
METHODS AND SOURCES OF FINANCE

Method of finance is the type of finance used – such as a loan or a mortgage.

The source of finance would be where the money was obtained from.

METHODS OF FINANCE

The following are the common methods of finance :

- Long term finance

- Medium term finance
- Short term finance

Now we will discuss each of these methods identifying the sources under each method

Sources of finance

1.LONG TERM FINANCE

Long-term finance refers to the finance available for a long period say three years and
above. The long term methods outlined below are used to purchase fixed assets such as
land and buildings , plant and so on.

Own Capital

Money invested by the owners , partners or promoters is permanent and will stay with
business throughout the life of the business.

Share Capital

Normally in the case of a company , the capital is raised by issue of shares. The capital so
raised is called share capital.

Preference Share Capital

Capital raised through issue of preference shares is called preference share capital.

Preference share

A preference shareholder enjoys two rights over equity shareholders :

(a) right to receive fixed rate of dividend
(b) right to return of capital
Equity Share Capital

Capital raised through issue of equity share is called equity share capital. An equity
shareholder does not enjoy any priorities such as those enjoyed by a preference
shareholder. But an equity shareholder is entitled to voting rights as many as the number
of shares he holds. The profits after paying all claims belong to the equity shareholders.

Retained profits

These are the profits remaining after all the claims. Retained profits form a good source
of working capital.

Long term loans

There are specialized financial institutions offering long term loans.

Debentures

Are loans taken by the company. It is a certificate or letter issued by the company under
the common seal . A debenture is entitled to a fixed rate of interest on the debenture
amount.

II MEDIUM-TERM FINANCE

Refers to such sources of finance where the repayment is normally over one year and less
than three years. The sources of medium term finance are as given below:

Bank Loans

Bank loans are extended at a fixed rate of interest.

Hire-purchase

It is a facility to buy a fixed asset while paying the price over a long period of time. The
possession of the asset can be taken by making a down payment of a part of the price and
the balance will be repaid with a fixed rate of interest in agreed number of instalments.

Leasing

Where there is a need for fixed assets, the asset need not be purchased, it can be taken on
leas or rent for a specified number of years.
Venture Capital

This form of finance is available only for limited companies. It is normally provided in
such projects where there is relatively a higher degree of risk.For such projects additional
sources may not be available. Many banks offer such finance through their merchant
banking divisions which offer advice and financial assistance

III SHORT TERM FINANCE

Is that finance which is available for a period of less than one year.

Commercial Paper

It is a new money market instrument introduced in India in recent times. CP’s are issued
usually in large denominations by the leading nationally reputed, highly rated and credit
worthy, large manufacturing and finance companies in the public and private sector.

Bank Overdraft

This is a special arrangement with the banker where the customer can draw more than
what he has in his savings/current account subject to a maximum limit

Trade credit

This is a short term credit facility extended by the creditors to the debtors. It is common
for the traders to buy the materials and other supplies from the suppliers on credit basis.

Advance from customers

It is customary to collect full or part of the order amount from customers in advance

Internal Funds

Are generated by the firm by way of secret reserves namely depreciation provisions,
taxation provisions, retained profits and so on
INTRODUCTION TO CAPITAL BUDGETING

The company’s decision to invest its current funds most efficiently in long term assets in
anticipation of an expected flow of benefits over a series of years.

NATURE OF INVESTMENT DECISIONS

Capital expenditure decisions occupy a very important place in corporate finance

for the following reasons :

1) Once the decision is taken it has far reaching consequences which extend over a
considerably long period which influences the risk complexion of the firm
2) These decisions involve huge amounts of money
3) These decisions are irreversible once taken
4) These are among the most difficult decisions to make

FEATURES OF CAPITAL BUDGETING DECISIONS

1)Since the results of CB decision continue for many years , the firm looses some of its
flexibility
2) An erroneous forecast can have serious consequences
3) Capital assets must be available when they are needed
4) Effective CB can improve both the timing and the quality of asset acquisitions

SCOPE OF CAPITAL BUDGETING DECISIONS

The various decisions which can be grouped as Capital Budgeting Decisions are as
follows
1) Replacement : maintenance of business
The expenditures to replace worn-out or damaged equipment used in the production
of profitable projects

2) Replacement : Cost reduction

Expenditures to replace serviceable but obsolete equipment

3) Expansion of existing products / markets

Expenditures to increase output of existing products or to expand retail outlets in
markets now being served

4) Expansion into new products / markets

These are investments to produce a new product or to expand into a new geographic
area not currently being used
 5) Safety and environmental projects
Expenditures which comply with government orders, labor agreements or insurance
policy falls into this category

6) Research and Development

R & D constitutes the largest and most important type of capital expenditure

CAPITAL BUDGETING METHODS

Five key methods are used to rank projects and to decide whether they should be
accepted or not
(1) Pay Back
(2) Accounting Rate of Return
(3) Internal Rate of Return
(4) Net Present Value
(5) Profitability

PAY BACK METHOD

Defined as the expected number of years required to recover the original investment.

FORMULA:

(i) PB = Original cost of the project

Annual cash flow

(ii) PB = Lower year + Original Investment – Lower year

Higher year - Lower year

Decision Criteria : Lower the PB better the performance

ILLUSTRATION :

Aproject costs Rs. 50000 and yields an annual cash inflow of Rs. 10000 for 7 years. Calculate its
payback period

PB = Cash Outflow = 50000 = 5 years

Cash Inflow 10000

ACCOUNTING RATE OF RETURN

Refers to the ratio of annual profits after taxes to the average Investment .
 ARR = Average Annual profits after taxes
Average Investment

Decision Criteria : Higher the NPV better the profitability

ILLUSTRATION :

Calculate the ARR for the projects A and B from the following :

Particulars Project A Project B

Investment Rs 20000 Rs 30000

Expected Life 4 years 5 years
Period in years Projected Net Income After dep & Taxes
Project A Project B
1 2000 3000
2 1500 3000
3 1500 2000
4 1000 1000
5 - 1000
TOTAL 6000 10000

SOLUTION:

ARR = Average Earnings * 100

Average Investment

Project A B

Average Investmetn = 20000 / 2 30000 / 2

= 10000 15000

Average Earnings = 6000 / 4 10000 / 5

1500 2000

ARR = 1500 * 1002000 * 100

10000 15000

ARR = 15% 13.33 %

NET PRESENT VALUE

Is equal to the present value of future cash flows and any immediate cash outflows

NPV = CFo + CF n
( 1 + k)n

Decision Criteria : Higher the NPV better the profitability

ILLUSTRATION:

Calculate NPV of two projects and suggest which of the two projects should be accepted
assuming a discount rate of 10%

PARTICULARS Project A Project B

Initial Investment Rs. 40000 Rs.60000

Estimated Life 5 years 5 years
Scrap Value Rs. 2000 Rs.4000

CASH INFLOWS:

YEAR 1 2 3 4 5

PROJECT A 12000 18000 7000 5000 4000

PROJECT B 35000 25000 12000 4000 4000

SOLUTION:

PROJECT A:
YEAR 1 CASH INFLOWS PV of Rs 1 at 10% PV of cash Inflows

1 12000 0.909 10908

2 18000 0.826 14868
3 7000 0.751 5257
4 5000 0.683 3415
5 4000 0.621 1242
th
5 scrap 2000 TOTAL 38174

PV of all cash inflows = 38174

Less PV of initial Investment = 40000
NPV = - 1826
PROJECT B :

YEAR 1 CASH INFLOWS PV of Rs 1 at 10% PV of cash Inflows

1 35000 0.909 31815
2 25000 0.826 20650
3 12000 0.751 9012
4 4000 0.683 2732
5 4000 0.621 2484
th
5 scrap 4000 0.621 2484
TOTAL 69177

TOTAL PRESENT VALUE = 69177

LESS PV of Initial Investment = 60000
NET PRESENT VALUE = 9177

“BASED ON NPV PROJECT B IS SELECTED BECAUSE IT HAS POSITIVE NPV”

INTERNAL RATE OF RETURN

The discount rate that forces the present value of a project’s Inflows to equal the present value of
its costs

IRR = The discount that equat

Present Value of Inflows = Present Value of Investment Costs

ILLUSTRATION :

A project involves initial outlay of Rs. 1,29,600 Its working life is expected to be 3 years. The
cash inflows are likely to be as follows :

YEAR 1 2 3
CASH INFLOWS 64000 56000 24000

SOLUTION:

YEAR CASH INFLOWS 10% PVCI 5% PVCI 7% PVCI

1 64000 0.909 63360 0.952 60928 0.935 59840
2 56000 0.826 46256 0.907 50792 0.873 48888
3 24000 0.751 18024 0.864 20736 0.816 19584
TOTAL 1,27,640 1,32,456 1,28,312

PROFITABILITY INDEX

Is the ratio between the present value of cash inflows and the present value of cash outflows

PI = Sum of present value of cash inflows

 Sum of present value of cash outflows

ILLUSTRATION:

A company is considering an investment proposal to install new milling controls at a cost

of Rs. 50000. The facility has a life expectancy of 5 years and no salvage value. The tax
raten is 35 %. Assume the firm uses straight line depreciation and the same is allowed for
tax purposes. The estimated cash flows before depreciation and tax from investment
proposal are as follows:

Compute the following:

i) Pay back period

ii) Average rate of return
iii) Internal rate of return
iv) NPV at 10 % discount rate
v) PI at 10 % discount rate

Solution

Determination of cashflows after taxes CFAT

Year CFBT Depreciation Profits before tax Taxes EAT CFAT

Rs.50000/5 Col 2 – Col 3 0.35 Col 4 –
Col 5

1 2 3 4 5 6 7

1 Rs 10000 Rs.10000 Nil Nil Nil Rs.10000

2 10000 10000 Rs 672 Rs 242 Rs 450 10450
3 12760 10000 2769 969 1800 11800
4 13462 10000 3462 1212 2250 12250
5 20385 10000 10385 3635 6750 16750
11250 61250

(i) Pay back (PB) period

 Year CFAT Cumulative CFAT
1 Rs 10000 Rs 10000
2 10450 20450
3 11800 32250
4 12250 44500
5 16750 61250

The recovery of the investment falls between the fourth and fifth years. Therefore the PB
is 4 years plus a fraction of the fifth year.
The fractional value = Rs 5500 / Rs 16750 = 0.328 . Thus the PB is 4.328 years.

(ii) Average rate of return (ARR) = Average income * 100

Average investment

= Rs 2250 ( Rs 11250 / 5) * 100 = 9 %

Rs 25000 ( Rs 50000 / 2)

(iii) Internal rate of return (IRR)

Rs 50000 = Rs 10000 + Rs 10450 + Rs 11800 + Rs 12250 + Rs 16750

(1 + r)1 (1 + r)2 ( 1 + r) 3 ( 1 + r )4 ( 1 + r)5

The fake pay back period = 4.0186 (Rs 50000 / Rs 12250) . From A-4 the value
closest to the fake payback period of 4.0186 agains 5 years is 4.100 against 7 per
cent. Since the actual cash flow stream, the IRR is likely to be lower than 7 per cent.
Let us try with 6 per cent.

PV factor Total PV
Year CFAT (0.06) (0.07) (0.06) (0.07)

1 Rs 10000 0.943 0.935 Rs 9430 Rs 9350

2 10450 0.890 0.873 9300 9123
3 11800 0.840 0.816 9912 9629
4 12250 0.792 0.763 9702 9347
5 16750 0.747 0.713 12512 11942
Total PV 50856 49391
Less: Initial Outlay 50000 50000
NPV 856 (609)

The IRR is between 6 and 7 per cent. By interpolation , IRR = 6.6 per cent

(iv) Net Present value (NPV)

Year CFAT PV Factor (0.10) Total PV
 1 Rs 10000 0.909 Rs 9090
2 10450 0.826 8632
3 11800 0.751 8367
4 12250 0.683 10401
Total PV 45352
Less Initial Outlay 50000
NPV (4648)

(v) Profitability index (PI) = PV of cash inflows = Rs 45352 = 0.907

PV of cash outflows Rs 50000