SCHOOL OF BUSINESS

COURSE: FINANCIAL MANAGEMENT

Dr. P. MATHURASWAMY
ASSOCIATE PROFESSOR

KOTHURD, PUNE – 411038.

 Dr. P. Mathuraswamy, Associate Professor, School of Business

FINANCIAL MANAGEMENT

STUDY MATERIAL

INTRODUCTION
Financial Management is concerned with planning, directing, monitoring, organizing and
controlling monetary resources of an organization. Financial Management simply deals with
management of money matters. Management of funds is a critical aspect of financial
management. The process of financial management takes place: at the individual as well as
organization levels. Our area of dealing is from the view- point of organization.
‘Financial Management’ is a combination of two words, ‘Finance’ and ‘Management’. Finance is
the lifeblood of any business enterprise. No business activity can be imagined, without finance. It
has been rightly said that business needs money to make more money. However, money begets
money, when it is properly managed. Efficient management of business is closely linked with
efficient management of its finances. Financial Management is that specialized function of
general management, which is related to the procurement of finance and its effective utilization
for the achievement of common goal of the organization.
MEANING OF FINANCE
Finance is defined as the provision of money at the time, it is required. Finance is the art
and science of managing money. There is no human being, without blood. Similarly, there is no
organization that does not require finance, irrespective of the activity, it is engaged in. The
way blood is needed for a person to live, so is the requirement of finance to any firm for its
survival and growth. Without adequate finance, no organization can possibly achieve its
objectives.
Ray G. Jones and Dean Dudley observe that the word ‘finance’ comes directly from the Latin
word ‘finis. As a management function, finance has special meaning. Finance function may be
defined as the procurement of funds and their effective utilization.
Howard and Uption (1952) defined finance as “the administrative area or set of administrative
function in an organization which have to do with the management of flow of cash so that the
organization will have the means to carry out its objectives as satisfactory as possible and, at the
same time, meet its obligations as they become due.”
Distinction between Money and Finance: Money is expressed in currency. Money can be any
country’s currency, which is in the hands of any person or organization. Finance is also money,
any country’s currency, which is owned by any person or organization, but lent to others, used to
buy an asset or make investment opportunities. The distinction between money and finance can
be explained in another way.
If you hold currency, it is money, while you lend it over to others for buying or investing
in investment opportunities, it becomes finance.

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It is curious to find that the same currency changes its role from ‘Money’ to ‘Finance’, with the
change of hands. Let us illustrate. Money raised by a bank, in the form of deposits from public,
becomes finance when it is lent to borrowers. If it is granted to buy/ construct a home, it becomes
a home loan. It is a vehicle loan, when the amount is lent for buying a car. The amount becomes
‘Project Finance’, if lent to entrepreneur to start or expand a project.
If you hold money, it does not give any return. You part money in the form of finance,
either by way of loan or investment, it starts getting return. Is it not interesting?

MEANING AND DEFINITION—FINANCIAL MANAGEMENT:

The general meaning of finance refers to the provision of funds, as and when needed.
However, as management function, the term ‘Financial Management’ has a distinct meaning.
Financial management deals with the study of procuring funds and its effective and judicious
utilization, in terms of the overall objectives of the firm, and expectations of the providers of
funds. The basic objective is to maximize the value of the firm. The purpose is to achieve
maximization of share value to the owners, i.e. equity shareholders.
The objective of every company is to create value for its shareholders. Market price of equity
share is the barometer for showing the real ‘Value’. The basic objective of financial management
is to maximize the shareholders’ wealth, represented by the market value of equity shares.
Financial Management is concerned with three activities:
• Anticipating financial needs, which means estimating requirements of the firm in terms of long-
term and short-term needs or investment in fixed and current assets.
• Acquiring financial resources from different sources to meet the financial needs.
• Allocating funds to maximize shareholders’ wealth.
The term financial management has been defined differently by various authors. Some of the
authoritative definitions are given below:
1. “Financial Management is concerned with the efficient use of an important Economic
resource, namely, Capital Funds.” – Solomon
2. “Financial Management is concerned with the managerial decisions that result in the
acquisition and financing of short-term and long-term credits for the firm.” – Phillioppatus
3. “Financial Management i s concerned with t h e acquisition o n , financing and
Management of assets with some overall goal in mind.”– James C. Van Horne
4. “Financial Management deals with procurement of funds and their effective utilization in the
business.” – S.C. Kuchhal From the above definitions, two basic aspects of financial
management emerge.
Functions of financial management:
Functions of financial management can be broadly divided into two groups.
1. Executive functions of financial management, and
2. Routine functions of financial management.
This division of functions of financial management is depicted below.

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Executive Functions of Financial Management:

The executive functions of financial management are depicted & listed below.
Eight executive functions of financial management (FM) are:-
1. Estimating capital requirements: The Company must estimate its capital requirements
(needs) very carefully. This must be done at the promotion stage. The company must
estimate its fixed capital needs and working capital need. If not, the company will
become over-capitalized or under-capitalized.
2. Determining capital structure: Capital structure is the ratio between owned capital and
borrowed capital. There must be a balance between owned capital and borrowed capital.
If the company has too much owned capital, then the shareholders will get fewer
dividends. Whereas, if the company has too much of borrowed capital, it has to pay a lot
of interest. It also has to repay the borrowed capital after some time. So the finance
managers must prepare a balanced capital structure.
3. Estimating cash flow: Cash flow refers to the cash which comes in and the cash which
goes out of the business. The cash comes in mostly from sales. The cash goes out for
business expenses. So, the finance manager must estimate the future sales of the business.
This is called Sales forecasting. He also has to estimate the future business expenses.
4. Investment Decisions: The business gets cash, mainly from sales. It also gets cash from
other sources. It gets long-term cash from equity shares, debentures, term loans from
financial institutions, etc. It gets short-term loans from banks, fixed deposits, dealer
deposits, etc. The finance manager must invest the cash properly. Long-term cash must
be used for purchasing fixed assets. Short-term cash must be used as a working capital.
5. Allocation of surplus: Surplus means profits earned by the company. When the company
has a surplus, it has three options, viz.,
1. It can pay dividend to shareholders.
2. It can save the surplus. That is, it can have retained earnings.
3. It can give bonus to the employees.
6. Deciding Additional finance: Sometimes, a company needs additional finance for
modernization, expansion, diversification, etc. The finance manager has to decide on
following questions.
1. When the additional finance will be needed?
2. For how long will this finance be needed?
3. From which sources to collect this finance?
4. How to repay this finance?
Additional finance can be collected from shares, debentures, loans from financial
institutions, fixed deposits from public, etc.
7. Negotiating for additional finance: The finance manager has to negotiate for additional
finance. That is, he has to speak to many bank managers. He has to persuade and
convince them to give loans to his company. There are two types of loans, viz., short-

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term loans and long-term loans. It is easy to get short-term loans from banks. However, it
is very difficult to get long-term loans.
8. Checking the financial performance: The finance manager has to check the financial
performance of the company. This is a very important finance function. It must be done
regularly. This will improve the financial performance of the company. Investors will
invest their money in the company only if the financial performance is good. The finance
manager must compare the financial performance of the company with the established
standards. He must find ways for improving the financial performance of the company.
Routine Functions of Financial Management:
The routine functions are also called as incidental functions. Routine functions are clerical
functions. They help to perform the Executive functions of financial management. The routine
functions of financial management are briefly listed below. Six routine functions of financial
management (FM) are:-
1. Supervision of cash receipts and payments.
2. Safeguarding of cash balances.
3. Safeguarding of securities, insurance policies and other valuable papers.
4. Taking proper care of mechanical details of financing.
5. Record keeping and reporting.
6. Credit Management.
• Understanding Capital Markets
Objectives of Financial Management:
• Profit maximization: The main objective of financial management is profit
maximization. The finance manager tries to earn maximum profits for the company in the
short-term and the long-term. He cannot guarantee profits in the long term because of
business uncertainties. However, a company can earn maximum profits even in the long-
term, if:-
• The Finance manager takes proper financial decisions. He uses the finance of the
company properly.
• Wealth maximization: Wealth maximization (shareholders' value maximization) is also
a main objective of financial management. Wealth maximization means to earn
maximum wealth for the shareholders. So, the finance manager tries to give a maximum
dividend to the shareholders. He also tries to increase the market value of the shares. The
market value of the shares is directly related to the performance of the company. Better
the performance, higher is the market value of shares and vice-versa. So, the finance
manager must try to maximize shareholder's value.
• Proper estimation of total financial requirements: Proper estimation of total financial
requirements is a very important objective of financial management. The finance
manager must estimate the total financial requirements of the company. He must find out
how much finance is required to start and run the company. He must find out the fixed
capital and working capital requirements of the company. His estimation must be correct.

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If not, there will be shortage or surplus of finance. Estimating the financial requirements
is a very difficult job. The finance manager must consider many factors, such as the type
of technology used by company, number of employees employed, scale of operations,
legal requirements, etc.
• Proper mobilization: Mobilization (collection) of finance is an important objective of
financial management. After estimating the financial requirements, the finance manager
must decide about the sources of finance. He can collect finance from many sources such
as shares, debentures, bank loans, etc. There must be a proper balance between owned
finance and borrowed finance. The company must borrow money at a low rate of interest.
• Proper utilization of finance: Proper utilization of finance is an important objective of
financial management. The finance manager must make optimum utilization of finance.
He must use the finance profitable. He must not waste the finance of the company. He
must not invest the company's finance in unprofitable projects. He must not block the
company's finance in inventories. He must have a short credit period.
• Maintaining proper cash flow: Maintaining proper cash flow is a short-term objective
of financial management. The company must have a proper cash flow to pay the day-to-
day expenses such as purchase of raw materials, payment of wages and salaries, rent,
electricity bills, etc. If the company has a good cash flow, it can take advantage of many
opportunities such as getting cash discounts on purchases, large-scale purchasing, giving
credit to customers, etc. A healthy cash flow improves the chances of survival and
success of the company.
• Survival of company: Survival is the most important objective of financial management.
The company must survive in this competitive business world. The finance manager must
be very careful while making financial decisions. One wrong decision can make the
company sick, and it will close down.
• Creating reserves: One of the objectives of financial management is to create reserves.
The company must not distribute the full profit as a dividend to the shareholders. It must
keep a part of it profit as reserves. Reserves can be used for future growth and expansion.
It can also be used to face contingencies in the future.
• Proper coordination: Financial management must try to have proper coordination
between the finance department and other departments of the company.
• Create goodwill: Financial management must try to create goodwill for the company. It
must improve the image and reputation of the company. Goodwill helps the company to
survive in the short-term and succeed in the long-term. It also helps the company during
bad times.
• Increase efficiency: Financial management also tries to increase the efficiency of all the
departments of the company. Proper distribution of finance to all the departments will
increase the efficiency of the entire company.
• Financial discipline: Financial management also tries to create a financial discipline.
Financial discipline means:-

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• To invest finance only in productive areas. This will bring high returns (profits) to the
company.
• To avoid wastage and misuse of finance.
• Reduce cost of capital: Financial management tries to reduce the cost of capital. That is,
it tries to borrow money at a low rate of interest. The finance manager must plan the
capital structure in such a way that the cost of capital it minimized.
• Reduce operating risks: Financial management also tries to reduce the operating risks.
There are many risks and uncertainties in a business. The finance manager must take
steps to reduce these risks. He must avoid high-risk projects. He must also take proper
insurance.
• Prepare capital structure: Financial management also prepares the capital structure. It
decides the ratio between owned finance and borrowed finance. It brings a proper balance
between the different sources of Capital. This balance is necessary for liquidity,
economy, flexibility and stability.

Features of Financial Management:

 According to Solomon, “Financial management is concerned with the efficient use of an
important economic resource, namely, capital funds.”
 According to J. L. Massie, “Financial management is the operational activity of a
business that is responsible for obtaining and effectively utilizing the funds necessary for
efficient operation.”
 According to Weston & Brigham, “Financial management is an area of financial
decision making harmonizing individual motives & enterprise goals.”
 According to Howard & Upton, “Financial management is the application of the
planning & control functions of the finance function.”
 According to J. F. Bradley, “Financial management is the area of business management
devoted to the judicious use of capital & careful selection of sources of capital in order to
enable a spending unit to move in the direction of reaching its goals.”
Main features of financial management:
On the basis of the above definitions, the following are the main characteristics of the financial
management-
 Analytical Thinking-Under financial management financial problems are analyzed and
considered. Study of trend of actual figures is made and ratio analysis is done.
 Continuous Process-previously financial management was required rarely but now the
financial manager remains busy throughout the year.
 Basis of Managerial Decisions- All managerial decisions relating to finance are taken
after considering the report prepared by the finance manager. The financial management
is the base of managerial decisions.

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 Maintaining Balance between Risk and Profitability-Larger the risk in the business
larger is the expectation of profits. Financial management maintains balance between the
risk and profitability.
 Coordination between Process- There is always a coordination between various
processed of the business.
 Centralized Nature- Financial management is of a centralized nature. Other activities
can be decentralized but there is only one department for financial management.

Responsibility of Financial Management:

The responsibilities of financial management or financial manager vary widely from one
business unit to another, depending upon the size and the nature of the business.
In the light of this wide diversity of organizational practices, it is not surprising to find that in
most of the company, financial officer is responsible for the routine finance functions. The main
responsibilities of the financial officer are as follows:
1. Financial Planning
The main responsibility of the chief financial officer in a large concern is to forecast the needs
and sources of finance and ensure the adequate supply cash at proper time for the smooth
running of the business. He is to see that cash inflow and outflow must be uninterrupted and
continuous. For this purpose, financial planning is necessary, i.e., he must decide the time when
he needs money, the sources of supply of money and the investments patters so that the company
may meet its obligations properly and maintain its goodwill in the market. The financial manager
is also to see that there is no surplus money in the business which earns nothing.
2. Raising of Necessary Funds
The second main responsibility of the financial officer is to see the nature of the need, i.e.,
whether finances are required for long-term or for short-term. He must assess the alternative
sources of supply of finance taking into view the cost of raising funds, its effect on various
concerned parties, i.e. shareholders, creditors, employees and the society, control and risk in
financing and elasticity in capital structure etc.
3. Controlling the Use of Funds
The financial manager is also responsible for the proper utilization of funds. Assets must be
used effectively so as to earn higher profits; inflow and outflow of cash must be controlled in a
manner so as to meet the current as well as future obligations; unnecessary expenditure should be
curtailed and there should be left no possibility for misappropriation of money.
4. Disposition of profits
Appropriation of profits is one of the main responsibilities of the financial manager. He is to
advise to the top executives as how much of the profits should be retained in the business as
reserves for future expansion; how much to be used in repaying the debts; and how much to be
distributed to the shareholders as dividend. On the basis of the advice given by the financial
manage, the resolutions regarding deprecations, reserves, general reserves and distribution of
dividends are carried out in the meeting of board of directors of the company.

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5. Other Responsibilities
Over and above, the responsibilities sated above, there are certain other responsibilities of the
financial manager. These are:
a) Responsibility to owners
Shareholders or stock-holders are the real owners of the concern. Financial manager has the
prime responsibility to those who have committed funds to the enterprise. He should not only
maintain the financial health of the enterprise, but should also help to produce a rate of earning
that will reward the owners adequately for the risk capital they provide.
b) Legal obligations
Financial manager is also under an obligation to consider the enterprise in the light of its
legal obligations. A host of laws, taxes and rules and regulations cover neatly every move and
policy. Good financial management help to develop a sound legal framework
c) Responsibilities of Employees
The financial management must try to produce a healthy going concern capable of
maintaining regular employment at satisfactory rate of pay under favorable working conditions.
The long term financial interests of management, employee’s, owners are common.
d) Responsibilities to customers
In order to make the payments of its customers’ bill, the effective financial management is
necessary. Sound financial management ensures the creditors continued supply of raw material
e) Wealth Maximization
Prof. Soloman of Standford University has argued that the main goal of the finance function
is wealth maximization. The other goals may be achieved automatically
In the light of the above discussion, we can conclude that the main responsibility of the
financial manager is not only to maintain the financial health of the organization but also to
increase the economic welfare of the shareholders by utilizing the funds in an effective manner.
Scope of financial management in any organization of your choice:
Scope of Financial Management:
Financial management has a wide scope. According to Dr. S. C. Saxena, the scope of financial
management includes the following five 'A's.
Anticipation : Financial management estimates the financial needs of the company. That is, it finds
out how much finance is required by the company.
Acquisition : It collects finance for the company from different sources.
Allocation : It uses this collected finance to purchase fixed and current assets for the company.
Appropriation : It divides the company's profits among the shareholders, debenture holders, etc. It
keeps a part of the profits as reserves.
Assessment : It also controls all the financial activities of the company. Financial management is
the most important functional area of management. All other functional areas such as production
management, marketing management, personnel management, etc. depends on Financial

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management. Efficient financial management is required for survival, growth and success of the
company or firm.

“The goal of profit maximization does not provide an operationally useful criterion” –
Explain:
Profit maximization refers to the maximization of income or earnings of a firm. The arguments
in favour of profit maximization as the objectives of financial management are
1. Nature Goal: Profit is the aim of any business. Naturally, the goal of financial
management should be profit maximization.
2. Measure of Efficiency: Profit is a measure of efficiency. Higher profits imply greater
efficiently. Hence, the objective of profit maximization is quite rational.
3. Internal Generation of Funds Profit lead to internal generation of funds. It helps to
finance the growth of the business.
4. Protection against Risks: Profits provide protection against risks when a company is
faced with unfavourable conditions, (such as fall in prices, increase n costs and severe
competition). Accumulated profits serve as a cushion to absorb the shocks.
5. Fulfillment of Social Obligations: Profits are essential for fulfilling social obligations of
the business. The goal or profit maximization helps to maximize social welfare.
1. Vague: The term profit is vague. It has different meanings. For instance, profit may refer
to long-term profits or short-term profits. It may refer to profit before tax or profit after tax or
short-term profits. It may refer to profit before tax or profit after tax or even operating profits.
2. Neglects Time Value of Money: The objective of profit maximization neglects time
value of money. Profits of today are more valuable than profits to be earned after five years. But
profit maximization objective treats all profits as equal, irrespective of the timing.
3. Ignores Risk Factor. Some projects are more risky than the others though the expected
earnings may be equal. But, the risk factor is not considered by the profit maximization goal.
4. Taint of Immorality: Profit maximization implies exploitation of consumers, workers
and the society. Hence, it is regarded as immoral.
5. Invalid: Profit maximization may be a valid objective under conditions of perfect
competition. As the markets are not perfect, it cannot be a valid objective.
6. Inadequate: In company form of a organization, there is separation of ownership and
control. Share holders are the owners. But, control is in the hands of professional managers.
Creditors, financial institutions, workers, consumers and the society are concerned with the
company’s operations. The management has to reconcile the conflicting interests of these stake
holders. Profit maximization goal is inadequate for the purpose.
IMPORTANCE OF FINANCIAL MANAGEMENT:
Finance is the lifeblood of business organization. It needs to meet the requirement of the
business concern. Each and every business concern must maintain adequate amount of finance
for their smooth running of the business concern and also maintain the business carefully to
achieve the goal of the business concern. The business goal can be achieved only with the help of

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effective management of finance. We can’t neglect the importance of finance at any time at and
at any situation. Some of the importance of the financial management is as follows:
Financial Planning
Financial management helps to determine the financial requirement of the business concern and
leads to take financial planning of the concern. Financial planning is an important part of the
business concern, which helps to promotion of an enterprise.
Acquisition of Funds
Financial management involves the acquisition of required finance to the business concern.
Acquiring needed funds play a major part of the financial management, which involve possible
source of finance at minimum cost.
Proper Use of Funds
Proper use and allocation of funds leads to improve the operational efficiency of the business
concern. When the finance manager uses the funds properly, they can reduce the cost of capital
and increase the value of the firm.
Financial Decision
Financial management helps to take sound financial decision in the business concern. Financial
decision will affect the entire business operation of the concern. Because there is a direct
relationship with various department functions such as marketing, production personnel, etc.
Improve Profitability
Profitability of the concern purely depends on the effectiveness and proper utilization of funds by
the business concern. Financial management helps to improve the profitability position of the
concern with the help of strong financial control devices such as budgetary control, ratio analysis
and cost volume profit analysis.
Increase the Value of the Firm
Financial management is very important in the field of increasing the wealth of the investors and
the business concern. Ultimate aim of any business concern will achieve the maximum profit and
higher profitability leads to maximize the wealth of the investors as well as the nation.
Promoting Savings
Savings are possible only when the business concern earns higher profitability and maximizing
wealth. Effective financial management helps to promoting and mobilizing individual and
corporate savings.
Nowadays financial management is also popularly known as business finance or corporate
finances. The business concern or corporate sectors cannot function without the importance of
the financial management.
The variants of profit maximization goal are :
To overcome the problem of vagueness, the term profit may be defined specifically as profit after
taxes. But this objective is also not sound as it will not maximize the economic welfare of the
share holders.
For example, A Ltd has 10,000 equity and earns a profit of Rs.50,000. The earnings per share
(EPS) are Rs.5. The company issues 5000 additional shares and invests the proceeds in the

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business. If profit after tax increases to Rs.60,000 the EPS will decline to Rs.4 (Rs.60,000
divided by 15,000). It is clear that maximizing profit after tax is not necessarily advantageous to
the share holders.
ii) Maximizing the EPS
The objective of maximization of earnings per share also suffers from draw backs. It ignores
time value of money and the risk element. Because of the drawbacks profit maximization, as an
objective of financial management has been rejected.

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CAPITAL STRUCTURE:
The term ‘capital structure’ represents the total long-term investment in a business firm:
It includes funds raised through ordinary and preference shares, bonds, debentures, term loans
from financial institutions, etc. Any earned revenue and capital surpluses are included.
CAPITAL STRUCTURE DEFINITION:
According to Gerstenberg, Capital structure refers to ‘the makeup of a firm’s
capitalization’. In other words, it represents the mix of different sources of long term funds
(such as equity shares, preference shares, long term loans, retained earnings, etc).
Optional Capital Structure may be defined as that of Capital structure or Combination of debt
and equity that leads to the maximum value of the firm.
Capital structure planning aims at maximization of profits and the wealth of the shareholders
ensures the maximum value of a firm or minimum Cost of capital.
ESSENTIAL FEATURES OF A SOUND CAPITAL MIX
→ Maximum possible use of leverage
→ Capital structure should be flexible
→ To avoid undue financial/business risk with the increase of debt
→ The use of debt should be within the capacity of a firm. The firm should be in a position
to meet its obligations in paying the loan and interest charges as and when due.
→ It should involve minimum possible risk of loss of control
→ It must avoid undue restrictions in agreement of debt
FACTORS INFLUENCING CAPITAL STRUCTURE:
1. Financial leverage (or) Trading on equity
It is the use of long term fixed interest bearing debt and Preference shares along with equity
share capital. The use of long-term debt increases and magnifies the EPS if the firm yields a
return higher than the cost of debt. This is positive leverage. However, if the firm yields a lower
return than the cost of debt, it is adverse leverage. EPS also increases with the use of preference
share capital also, but due to the fact that interest is allowed to be deducted while computing the
tax, the leverage impact of debt is more.
2. Growth & Stability of Sales
If the sales of a firm are expected to remain fairly stable, it can raise a higher level of debt, as the
firm may not face any difficulty in meeting its fixed commitments of interest repayment of debt.
Usually, greater the rate of growth of sales, greater can be the use of debt in the financing of a
firm.
3. Cost of Capital
The capital structure should provide for minimum overall cost of capital depending upon the risk
involved, out of the three sources of capital (equity, preference and debt capital), debt usually is
a cheaper source because of (1) fixed rate of interest (2) legal obligation to pay interest (3)
priority in payment at the time of winding up of the company and (4) tax advantage. Preference
capital is also cheaper than equity because of lesser risk involved and fixed rate of dividend.
4. Cash flow ability to service debt

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A firm which can generate higher and stable cash inflows can employ more debt in its capital
structure as compared to one which has unstable and lesser ability to generate cash inflows.
5. Nature and size of firm
Public utility concerns may employ more of debt due to their regular earnings. Small companies
due to their inability to raise long-term loans at reasonable rate of interest depend on own capital.
A large company can arrange for long-term loans and also can issue equity or preference shares
to be public.
6. Control
Issue of equity shares implies dilution of control of existing equity shareholders. Hence either
debt or preference capital is issued.
7. Flexibility
Capital structure of the firm should be flexible and must be able to substitute one form of
financing by another.
8. Requirement of Investors
The risk profile of the investors – institutional as well as private (risk averse, indifferent and
adventurous investors) should be matched with the risk characteristics of the capital instruments
i.e. issue of equity shares to adventurous investors, issue of preference shares to indifferent
investors and issue of debt to risk averse investors.
9. Capital market conditions
If the share market is depressed the company should not issue equity shares. If there is boom
period, it should issue equity shares.
10. Assets structure
If major portion of the total assets of a company comprises of fixed assets, the company can
borrow long-term debts.
COST OF CAPITAL
A project’s Cost of Capital is the minimum acceptable rate of return/required rate of
return on funds committed to the project. It is a compensation for time and risk in the use of
capital by the project. Since the investment projects may differ in risk, each one of them will
have its own unique cost of capital.
The Firm represents the aggregate of investment projects undertaken by it. Therefore, the firm’s
Cost of Capital will be the overall or average, required rate of return on the aggregate of the
investment projects.
 In NPV method, the Cost of Capital is the discount rate used for evaluating the
desirability of an investment project.
 In IRR method, Cost of Capital is the minimum required rate of return on an
investment project. It is also known as the cut off or target rate or the hurdle rate.
 The Cost of Capital is the minimum required rate of return on the investment
project. It is also known as the cut off or target rate or the hurdle rate.
 The Cost of Capital is the minimum required rate of return on the investment
project that keeps the present wealth of shareholders unchanged.

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Basic Assumptions of Cost of Capital

The Cost of Capital is a dynamic concept affected by a variety of economic and firm factors and
assumes the following assumptions relating to risk and taxes:
1) Business Risk: It refers to the risk of the inability of the firm to cover its operating
costs. This cost is assumed to be unchanged i.e. the firm’s acceptance of a given
project does not affect its ability to meet operating costs.
2) Financial Risk: It refers to the risk of the inability of the firm to cover the required
financial obligations (interests, lease payments or preference dividend) – is assumed
to be unchanged.
3) After Tax Costs: They are considered relevant. The Cost of Capital is measured on
an after tax basis.
4) Capital Structure: The firm’s financial structure is assumed to remain fixed.
Concepts of Cost of Capital
1. Explicit Cost And Implicit Cost
The explicit cost of any source of finance may be defined as the discount rate that equates
the present value of the funds received by the firm net of underwriting costs, with the
present value of expected cash outflows. These outflows may be interest payments,
dividend, or repayment of principal.
The implicit cost is the rate of return on the best investment opportunity for the firm and
its shareholders which will be foregone if the project presently under consideration by the
firm is accepted.
2. Future Cost And Historical Cost
Future cost refers to the expected cost of funds to finance the proposed project whereas
Historical cost refers to the cost already incurred for financing a particular project.
3. Specific Cost And Combined Cost
The Cost of each component of capital (i.e. equity shares/preference
shares/debentures/loans/etc) is known as Specific Cost of Capital.
The Composite/Combined Cost of Capital is the total cost of capital from all sources (i.e.
equity shares/preference shares/debentures/loans/etc).
4. Average Cost And Marginal Cost
The average cost of capital refers to the weighted average of the cost of each component
of funds employed by the firm. The weights are in proportion of the share of each
component of the share in the total capital structure.
Marginal Cost of Capital is the weighted average cost of new funds raised by the firm.
Factors affecting the cost of capital of a firm
1. The capital structure of a firm
2. The demand supply forces existing in the market for debt or equity
3. The existing and potential growth prospects of the firm
4. The risk profile of the majority shareholders
5. The stage of the firm’s lifecycle etc

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

LEVERAGES
INTRODUCTION
Leverage has been defined as ‘the action of a lever, and the mechanical advantage gained
by it’ - A lever is a rigid piece that transmits and modifies force or motion where forces are
applied at two points and it turns around a third. The physical principle of the lever is intuitively
appealing to most. It is the principle that permits the magnification of force when a lever is
applied to a fulcrum. The term leverage refers to an increased means of accomplishing some
purpose. With leverage, it is possible to lift objects, which is otherwise impossible. The term
refers generally to circumstances which bring about an increase in income volatility. In business,
leverage is the means of increasing profits. It may be favourable or unfavorable. The former
reduces profit, while the latter increases it. The leverage of a firm is essentially related to a
measure, which may be a return on investment or on earnings before taxes. It is an important tool
of financial planning because it is related to profits.
Christy and Rodent define leverage as the tendency for profits to change at a faster rate than
sales. Leverage is an advantage or disadvantage which is derived from earning a return on total
investment (total assets) and which is different from the return on owner’s equity. It is a
relationship between equity share capital and securities, and creates fixed interest and dividend
charges. It is also known as gearing. The term capital gearing is used to describe the ratio
between the ordinary share capital and the fixed interest bearing securities of a company. Capital
gearing reveals the suitability or otherwise of a company’s capitalization. Capital gears up the
effect on earnings of any change at the trading profit level. However, it is a double-edged
weapon, and emphasizes the effects of deterioration as well as of improvement.
Master Table for Leverage Calculations
Sales
Less: Variable Cost
Contribution
Less: Fixed Cost
Earnings before Interest and Taxes (OP) (EBIT)
Less: Interest
Earnings before Tax (EBT)
Less: Tax
Earnings after Tax (EAT)
Less: Preference shareholders’ dividend
Earnings Available to Equity Shareholders
1. OPERATING LEVERAGE
The operating leverage takes place when a change in revenue produces a greater change
in EBIT. It indicates the impact of changes in sales on operating income. A firm with a high
operating leverage has a relatively greater effect on EBIT for small changes in sales. A small rise
in sales may enhance profits considerably, while a small decline in sales may reduce and even

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

wipe out the EBIT. Naturally, no firm likes to operate under conditions of a high operating
leverage because that creates a high-risk situation. It is always safe for a firm to operate
sufficiently above the break-even point to avoid dangerous fluctuations in sales and profits. The
operating leverage is related to fixed costs. A firm with relatively high fixed costs uses much of
its marginal contribution to cover fixed costs. It is interesting to note that beyond the break-even
point, the marginal contribution is converted into EBIT. The operating leverage is the highest
near the break-even point. After a firm reaches this point, even a small increase in sales results in
a big increase in EBIT.
The extent of the operating leverage at any single sales volume is calculated as follows:

The change in the rate of earnings is based on the operating leverage resulting from the
fact that some costs do not move proportionally with changes in production. This leverage
operates both positively and negatively, increasing profits at a rapid rate when sales are
expanding and reducing them or causing losses when operations decline. If all the costs are
variable, the rate of profit would show fewer changes at different operating levels. The operating
leverage, then, is the process by which profits are raised or lowered in greater proportion than the
changes in the volume of production because of the inflexibility of some costs. The higher the
fixed costs, the greater the leverage and the more frequent the changes in the rate of profit (or
loss) with alternations in the volume of activity.

2. FINANCIAL LEVERAGE
It is generally accepted that investors seek to maximize their return on investments,
subject to given risk constraints, and that they demand a higher return for the greater risk
involved in an investment. The proportion of debt in the capital structure of a company is limited
by two factors:
 Investors risk preference
 Business risk associated with the nature of a company’s operations.
The determination of this limit, which is known as the corporate debt capacity, is an
important aspect of the financial policy of a company to get the maximum benefit from debt
financing. While the investors’ risk preference is difficult to assess because it varies from
individual to individual, business risk can be determined objectively.
D.F.L=EBIT/EBIT-I or EBIT/EBT
3. COMBINED LEVERAGE
Combined leverage compares changes in revenues with changes in EBT. It is so called
because II combines the operating and fixed charges leverages, as can be seen below:
Combined Leverage — Operating Leverage x Fixed Charges Leverage

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

A combined leverage may thus be described as a ratio of marginal contribution to EBT,

or as operating leverage multiplied by fixed charges leverage. If operating leverage is 2.1/1 and
fixed charges leverage 2.7/1, the combined leverage is

APPROACH OF WEIGHTED AVERAGE COST OF CAPITAL AND LIMITATIONS:

The weighted average cost of capital (WACC) is the rate that a company is expected to pay
on average to all its security holders to finance its assets. The WACC is the minimum return
that a company must earn on an existing asset base to satisfy its creditors, owners, and other
providers of capital, or they will invest elsewhere. Companies raise money from a number of
sources: common equity, preferred equity, straight debt, convertible debt, exchangeable
debt, warrants, and options, pension liabilities, executive stock options, governmental subsidies,
and so on. Different securities, which represent different sources of finance, are expected to
generate different returns. The WACC is calculated taking into account the relative weights of
each component of the capital structure.

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

Capital budgeting:
Capital Budgeting: Capital budgeting is the process of making investment decision in
long-term assets or courses of action. Capital expenditure incurred today is expected to bring its
benefits over a period of time. These expenditures are related to the acquisition & improvement
of fixes assets.

Capital budgeting is the planning of expenditure and the benefit, which spread over a
number of years. It is the process of deciding whether or not to invest in a particular project, as
the investment possibilities may not be rewarding. The manager has to choose a project, which
gives a rate of return, which is more than the cost of financing the project. For this the manager
has to evaluate the worth of the projects in-terms of cost and benefits. The benefits are the
expected cash inflows from the project, which are discounted against a standard, generally the
cost of capital.
Capital budgeting Techniques: The capital budgeting appraisal methods are techniques of
evaluation of investment proposal will help the company to decide upon the desirability of an
investment proposal depending upon their; relative income generating capacity and rank them in
order of their desirability. These methods provide the company a set of norms on the basis of
which either it has to accept or reject the investment proposal. The most widely accepted
techniques used in estimating the cost-returns of investment projects can be grouped under two
categories.

Objectives of capital budgeting:

(1) To ensure the selection of the possible profitable capital projects.
(2) To ensure the effective control of capital expenditure in order to achieve by forecasting
the long-term financial requirements.
(3) To make estimation of capital expenditure during the budget period and to see that the
benefits and costs may be measured in terms of cash flow.
(4) Determining the required quantum takes place as per authorization and sanctions.
(5) To facilitate co-ordination of inter-departmental project funds among the competing
capital projects.
(6) To ensure maximization of profit by allocating the available investible.

Traditional Techniques: These techniques are generally very simple and easily understandable.
But the main drawback of these techniques is that they don’t consider the time value of money.
But in many industries where an instant decision is to be taken, these methods offer the quicker
way out. There are mainly two techniques under this category of methods. They are –
Accounting rate of return and Payback period.

Accounting rate of return (ARR):

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

This method relies on the rate of return each project will earn over its life. It takes the help of
accounting profit while calculating the returns. There are 2 methods of calculating ARR
(i) On the basis of original investment,
ARR = average after tax annual net profit
Original investment
This method of calculation was rejected on the ground that the original outlay is gradually
recovered over the project life because of depreciation charge.
(ii) On the basis of average investment,
ARR = average annual net profit
Original investment / 2
When depreciation is to be taken on a straight line basis and no salvage value is assumed, the
average investment is always equal to one-half of the original investment, and the resulting rate
of return is always twice the rate determined on the basis of original investment.
Advantages of ARR:
 It is easy to understand and simple to calculate
 With the help of this method, direct comparisons among proposed projected of
varying lives without a built-in-prejudice in favor of short-term ventures can be
made.
Disadvantages of ARR:
 This method ignores time value of money.
 It fails to shed light on yearly rate if return of the project. It may be possible for
the project producing higher earnings in the early years to show a lower average
rate of return and be rejected in favor of other projects.
 Serious errors can occur in selection of projects if corporate managers accept
projects whose accounting rates are equal to or above some arbitrarily selected
cut-off rate, and they reject projects whose accounting rates fall short of the cut-
off rate.
 Accounting information is not suitable for investment decision because if fails to
distinguish between cash flowing in and out of the company and book keeping
transactions.
 There is no full agreement on the proper measure of the term investment. Thus,
different managers have different meanings when they refer to ARR.
Payback period (PBP):
This is the most popular method employed by industrial practitioners for ranking
investment projects. This is defined as the “period required for a proposal’s initial cash outlay to
be recovered by future additional cash savings generated from the proposal”. The cash flow
(after tax & depreciation) is used in calculating the payback period.
PBP = CO/CF
Where CO = cash outflow of the project and CF = cash inflow

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

When the cash gains generated by the project are unevenly distributed, cumulative cash gains
resulting from the project are to be calculated until the year in which the running total is equal to
the amount of investment outlay.
Accept-Reject Rule:
The decision rule is to accept the project if the computed payback period is less than the
standard. Otherwise, reject it. While ranking the projects, project with shortest payback period
is assigned the highest rank.
Advantages:
 It is easy to understand and calculate
 With the help of this method, projects can be ranked in terms of their economic
merits without much of complication.
 It indirectly considers factors like obsolescence and liquidity of investments
because project with shortest payback period is exposed to fewer risks.
 This method is useful to the company experiencing shortage of cash because it
helps in choosing a project that will yield a quick return of cash fund regardless of
its long-term profitability.
Disadvantages:
 It does not measure the profitability of the projects.
 It fails to consider any receipts after the pay-back period, no matter how great
they might be. As a result, a project with shorter payback period may be selected
against a project with a longer pay back period but longer income producing life
and greater return on investment.
 It ignores time value of money.
A survey conducted by the Machinery and Allied Products Institute disclosed that about 2/3 rd of
the American companies employ pay back approach to appraise merit of projects. This is
because, in countries where technological changes are rapid, companies are usually exposed to
greater obsolescence risks and where uncertainty surrounding the outcome estimates is great,
prime consideration is the speed of capital investment recovery.
Modern / Discounting Cash Flow Techniques: These techniques usually are of more use to
businesses in their investment decisions. They take into account the time value of money and
adjust their cash flows accordingly before taking a decision. That is the reason why they are
considered superior to the traditional techniques. There are four techniques under this category
of methods. They are –
 Net present value (NPV)
 Internal rate of return (IRR)
 Profitability index (PI)
 Discounted Payback Period (DPBP)
Net Present Value (NPV):
In this method, future cash flows are discounted to the present and then compared with the
investment outlay. The basic discount rate is usually the cost of capital to the enterprise. For

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

ranking the projects according to this method, the NPVs of various alternative projects are
compared. Project with highest positive NPV or a project with highest NPV is given highest
rank.
Accept-Reject Rule:
In the case of independent projects, if the present value of cash inflows of a project is higher than
the present value of investment outlay of the project, it should be accepted. Otherwise, it should
be rejected. In the case of mutually exclusive projects, a project with highest NPV should be
accepted.
Advantages:
 It is simple to understand
 Where a company has several mutually exclusive projects in hand, this method
helps the management to choose the most profitable one.
Disadvantages:
 It does not take into consideration the magnitude of the investment outlay and net
cash benefits together.
Internal Rate of Return (IRR):
This rate tries to find the earnings rate which equates the present value of the streams of earnings
to the investment outlay. IRR is defined as the rate of return which discounts all the future cash
inflows to exactly equal the outlay.
Accept-Reject Rule:
The project with IRR higher than the cut-off rate will be accepted. Otherwise, it will be rejected.
The management will be indifferent if the IRR = cut-off rate.
Advantages:
 It is useful and has many positive points
 It recognizes the time value of money
 It helps the management in selecting the most profitable project
Disadvantages:
 It is complicated to calculate by trial and error method
 It assumes that the funds received at the end of each year can be invested at the
same rate of return.
 It does not provide weight age of the volume of funds committed in the project.
 Under certain conditions it becomes very difficult to take any decisions like –
under conditions of irregular cash flows, IRR may give 2 or more answers.
Profitability Index (PI):
It is a ratio of the present value of the net cash benefits to the present value of the net cash outlay.
The higher the PI, the greater the return. Any project with a PI higher than ONE is acceptable
since benefits exceed outlay. Projects with PI less than ONE are rejected.
Advantages:
 It places the present value of each investment project on a relative basis so that projects
of different sizes of capital outlays can be compared.

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

Discounted Payback Period (DPBP):

The discounted payback period is the no of periods taken in recovering the investment outlay on
the present value basis? Discounted payback period will always be higher than simple payback
period for a project because its calculation is based on the discounted cash flows. It differs from
the simple pay period in that it takes into account the time value of money. But still, it does not
account for post pay back profitability of the project.
Factors influencing capital expenditure decisions:
1. Availability of funds
Generally, capital expenditure projects require large funds. A project, however profitable, may
not be taken for want of funds. So, projects with a lesser profitability may be sometimes
preferred due to lesser payback period for want of liquidity.
2. Urgency
Sometimes an investment is to be made on the grounds of urgency for the firm’s survival or to
avoid heavy losses. In such circumstances, proper evaluation of proposal cannot be made
through profitability test. E.g. break down of machinery, fire accident etc.
3. Legal Compulsion
When statutory compulsion arises, investment has to be made in a project though it may not be
profitable one. For example, waste disposal plants have to be installed to satisfy environmental
laws.
4. Degree of uncertainty
Profitability is directly related to risk. Normally, higher the profits, greater is the risk or
uncertainty. Sometimes, a project with lower profitability may be selected due to constant flow
of income as compared to another project with an irregular and uncertain flow of income.
5. Intangible factors:
Sometimes, a capital expenditure has to be made due to certain emotional and intangible factors
such as safety and welfare of workers, prestigious project, social welfare, goodwill of the firm
etc., though such investments are not profitable.
6. Obsolescence:
If obsolete plant and machinery exist in a firm, their replacement becomes necessary.
7. Research and Development
It is necessary for the long term survival of the business to invest in research and development
projects though it may not loom to be a profitable investment.
8. Competitors’ activities
When competitors perform certain activities, they may compel a firm to undertake similar
activates to withstand competition.
9. Future Earnings
A project may not be profitable today when compared to another one, but it may promise better
future earnings. In such cases, it may be preferred to increase earnings.
Capital budgeting process / Phases of capital budgeting:
The entire Capital budgeting process can be divided into following steps:

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

1) Identification of potential investment opportunities: the process of Capital budgeting

begins with identifying potential investment opportunities. An individual or a planning
committee is responsible for developing estimates of future sales, which form the basis
for setting future production targets. Based on such information, estimates of required
investment can be made
For imaginative identification of investment ideas it is helpful to
i) monitor external environment (PEST analysis) regularly to scout investment
opportunities
ii) formulate a well defined corporate strategy based on a thorough analysis of strength
weakness opportunities and threats
iii) share corporate strategy and perspective with persons who are involved in process of
Capital budgeting
iv) motivate employees to make suggestions
2) Assembling of investment proposals: various investment proposals identified by
departments of a company are submitted in a standardized capital investment proposal
form. These proposals are routed through various persons in order to evaluate the capital
investment decision from different angles. Projects can be classified as expansion
replacement new product diversification or welfare projects.
3) Decision Making: the projects then undergo a preliminary screening to obtain those
which merit further consideration. Different executives are vested with the authority to
approve investment proposals to certain limits. For e.g. consider a manufacturing
concern. The plant superintendent can approve investment outlays up to Rs 20,00,000.
Any investment above the mentioned level needs the approval of the board of directors.
Such a decision making process breaks up the investment approval process. Different
appraisal criteria are used for the project selection such as payback, NPV etc.
4) Preparation of capital budget and appropriations: Projects involving smaller outlays,
decided at the lower levels of the management are covered by a blanket appropriation.
While those involving large cash outlays are included in the budget after getting
necessary approvals. A proper appropriation of expenses ensures adequacy of resources
during implementation of the capital expenditure decisions.
5) Implementation: translating an investment decision into a concrete project is a time
consuming process. Delay in implementation can lead to substantial cost and time
overruns. To ensure proper implementation, the following points must be kept in mind:
 Adequate formulation of projects- this involves, conducting preliminary studies
and a comprehensive and detailed formulation. It brings to light any difficulties
likely to be faced in future. Therefore adequate formulation is necessary to ensure
right implementation
 Use of the principle of responsibility accounting- assigning specific
responsibilities to project managers for completing the project within the defined
time frame and cost limit is helpful for the correct implementation of projects

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

 Use of network techniques- using techniques like CPM, PERT, help easy
implementation and monitoring of projects
6) Performance review: post completion audit is used as a feedback device. It compares
the actual performance with the projected performance. Based on the review corrective
steps can be taken. It is useful in following ways
i) it throws light on how realistic were the assumptions underlying the project
ii) it provides a documented log of experience that is highly valuable for decision
making
iii) it helps in uncovering judgment biases
iv) It includes a desired caution among project investors.
Capital budgeting decisions/Project classification:
a) Accept- reject decision- this is the fundamental decision in capital budgeting. If the
project is accepted then the firm invests in it, or else rejects it. In general all projects
which yield returns higher than the required rate of return (cost of capital in most cases)
are accepted and the rest are rejected. By these criteria all independent projects that
satisfy the minimum investment criteria are accepted. An independent Project is a project
whose cash flows are not affected by the accept- reject decision for the projects and the
selection of one is not dependent on any other project
b) Mutually exclusive projects: are set of projects from which at the most one will be
accepted. They are set of projects which are to accomplish the same task. The acceptance
of one excludes the acceptance of other projects. For e.g. deciding between a capital
intensive or labor intensive machine. Thus when choosing between mutually exclusive
projects more than one project may satisfy the Capital Budgeting criterion. However only
one i.e. the best project can be accepted.
c) Capital rationing: Capital rationing is a situation where a constraint or budget is placed
on the total size of capital expenditures during a particular period. Often firms draw up
their capital budget under the assumption that the availability of financial resources is
limited. Capital rationing refers to a situation where a company cannot take all acceptable
projects it has identified because of shortage of capital. Under this situation a decision
maker is compelled to reject some of the viable projects because of shortage of funds.

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

WORKING CAPITAL:
Working capital refers to the capital required for day-to-day operations of a business enterprise.
The need for Working Capital is omnipresent for all types and sizes of businesses, and as such
cannot be overstressed.
CONCEPTS OF WORKING CAPITAL
There are two concepts of Working Capital – Gross Working capital and Net Working capital.
1. Gross Working Capital
Gross Working capital refers to the firm’s investment in current assets (Cash, Short Term
Securities, Debtors, Bills Receivable and Inventory). Current assets are those assets which can
be converted into cash within a period of one year. This concept focuses on – how to optimize
investment in current assets and how should they be financed? In this instance, both excessive
and inadequate investment in current assets should be avoided.
2. Net Working Capital
Net Working capital refers to the difference between current assets and current liabilities. It may
be positive or negative. This concept is a qualitative concept. It indicates the liquidity position
of the firm and suggests the extent to which working capital needs may be financed by
permanent sources of capital. Current assets should be sufficiently in excess of current liabilities
to constitute a margin for maturing obligations within the ordinary operating cycle of a business.
This concept also covers the question of judicious mix of long-term and short-term funds for
financing current assets.
The two concepts of Working Capital are not exclusive; rather, they have equal significance
from management’s view point.
TYPES OF WORKING CAPITAL
Working capital can be divided into two categories on the basis of time. They are – Permanent
Working Capital and Temporary or Variable Working capital
Permanent Working Capital refers to that minimum amount of investment in current assets
which is required at all times to carry on minimum level of business activities. It represents the
current assets required on a continuing basis over the entire year, and hence should be financed
out of long term funds. Tandon Committee has referred to this type of Working capital as ‘Core
Current Assets’.
Temporary Working capital represents the additional current assets required at different times
during the operating year.
FACTORS AFFECTING WORKING CAPITAL:
1. Nature of business:
In the case of public utility concern like railways, electricity etc most of the transactions are on
cash basis. Further they do not require large inventories. Hence working capital requirements are
low. On the hand, manufacturing and trading concerns require more working capital since they
have to invest heavily in inventories and debtors. Example cotton or sugar mil

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

2. Size of business
Generally large business concerns are required to maintain huge inventories are required. Hence
bigger the size, the large will be the working capital requirements.
3. Time consumed in manufacture
To run a long production process more inventories is required. Hence the longer the period of
manufacture, the higher will the requirements of working capital and vice-versa.
4. Seasonal fluctuations
A number of industries manufacture and sell goods only during certain seasons. For example the
sugar industry produces practically all sugar between December and April. Their working capital
requirements will be higher during this session. It is reduced as the sales are made and cash is
realized.
5. Fluctuations in supply
If the supply of raw materials is irregular companies, are forced to maintain huge stocks to avoid
stoppage of production. In such case, working capital requirement will be high.
6. Speed of turnover
A concern say hotel which affects sales quickly needs comparatively low working capital. This is
because of the quick conversion of stock into cash. But if the sales are slow, more working
capital will be required.
7. Terms of sales
Liberal credit sales will result in locking up of funds in sundry debtors. Hence a company, which
allows liberal credit, will need more working capital than companies, which observe strict credit
norms.
8. Terms of purchase
Working capital requirements are also affected by the credit facilities enjoyed by the company. A
company enjoying liberal credit facilities from its suppliers will need lower amount working
capital. (For example book shops). But a company that has to purchase only for cash will need
more working capital.
9. Labour intensive Vs. Capital intensive industries
In labour intensive industries, large working capital is required because of heavy wage bill and
more time taken for production. But the capitals intensive industries require lesser amount of
working capital because of have investment in fixed assets and shorter time taken for production.
10. Growth and expansion of business
A growing concern needs more working capital to finance its increasing activities and expansion.
But working capital requirements are low in the case static concerns.
11. Price level changes
Changes in price level also affect the working capital requirements. Generally the rising prices
will require the firm to maintain large amount of working capital. This is because more funds
will be required to maintain the same amount of working capital to maintain the same level of
activity.

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

ESTIMATING WORKING CAPITAL REQUIREMENTS:

In order to estimate the extent of working capital requirement of a firm, several factors are to be
considered. There are several methods / techniques for estimating the working capital
requirements of a firm. They include – i) Estimation of components of working capital method,
ii) Percent of sales method and iii) Operating cycle method
1. Estimation of components of working capital method
As the concept of net working capital refers to the difference between current assets and current
liabilities, estimation of both may give the potential working capital requirement of the firm.
2. Percent of sales method
According to this method, based on the past data, the relationship between sales and working
capital are found out and are expressed as a ratio. The application and calculation of this ratio on
estimated future sales will give the extent of working capital needs of the firm.
3. Operating cycle method
Operating cycle is the time duration required to convert sales, after the conversion of resources
into inventories and cash. The operating cycle of a manufacturing co involves 3 phases – i)
acquisition of resources such as raw material, labor, power and fuel etc, ii) manufacture of the
product that includes conversion of raw material into work in process and into finished goods,
and iii) sales of the product either for cash or credit. Credit sales create book debts for
collection (debtors).
The length of the operating cycle of a manufacturing co is the sum of – i) inventory conversion
period (ICP) and ii) Book debts conversion period (BDCP). Together, they are sometimes
called as gross operating cycle (GOC).
GOC = ICP + DCP
The Inventory conversion period is the total time needed for producing and selling the product
and includes – (a) raw material conversion time (RMCP), (b) work in process conversion period
(WIPCP) and (c) Finished good conversion period (FGCP)
ICP = RMCP + WIPCP + FGCP
The payables deferral period (PDP) is the length of time the firm is able to defer payments on
various resource purchases. The difference between the gross operating cycle and payables
deferrals period is the net operating cycle (NOC).
NOC = GOC- Payables deferral period

SOURCES OF WORKING CAPITAL

Sources of working capital are many. There are both external and internal sources. The
external sources are both short-term and long-term. Trade credit, commercial banks, finance
companies, indigenous bankers, public deposits, advances from customers, accrual accounts,
loans and advances from directors and group companies etc. are external short-term sources.
Companies can also issue debentures and invite public deposits for working capital which re
external long term sources. Equity funds may also be used for working capital. A brief
discussion of each source is attempted below.

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

Trade credit is a short term credit facility extended by suppliers of raw materials and
other suppliers. It is a common source. It is an important source. Either open account credit or
acceptance credit may be adopted. In the former as per business custom credit is extended to the
buyer, the buyer is not goring any debt instrument as such. The invoice is the basic document. In
the credit system a bill of exchange is drawn on the buyer who accepts and returns the same. The
bill of exchange evidences the debt. Trade credit is an informal and readily available credit
facility. It is unsecured. It is flexible too; that is advance retirement or extension of credit period
can be negotiated. Trade credit might be costlier as the supplier may inflate the price to account
for the loss of interest for delayed payment.
Commercial banks are the next important source of working capital finance commercial
banking system in the country is broad based and fairly developed. Straight loans, cash credits,
hypothecation loans, pledge loans, overdrafts and bill purchase and discounting are the principal
forms of working capital finance provided by commercial banks. Straight loans are given with or
without security. A onetime lump-sum payment is made, while repayments may be periodical or
one time. Cash credit is an arrangement by which the customers (business concerns) are given
borrowing facility up to certain limit, the limit being subjected to examination and revision year
after year. Interest is charged on actual borrowings, though a commitment charge for utilization
may be charged. Hypothecation advance is granted on the hypothecation of stock or other asset.
It is a secured loan. The borrower can deal with the goods. Pledge loans are made against
physical deposit of security in the bank’s custody. Here the borrower cannot deal with the goods
until the loan is settled. Overdraft facility is given to current account holding customers tn
overdraw the account upto certain limit. It is a very common form of extending working capital
assistance. Bill financing by purchasing or discounting bills of exchange is another common
form of financing. Here, the seller of goods on credit draws a bill on the buyer and the latter
accepts the same. The bill is discounted per cash will the banker. This is a popular form.
Finance companies abound in the country. About 50000 companies exist at present.
They provide services almost similar to banks, though not they are banks. They provide need
based loans and sometimes arrange loans from others for customers. Interest rate is higher. But
timely assistance may be obtained.
Indigenous bankers also abound and provide financial assistance. to small business and
trades. They change exorbitant rates of interest by very much understanding.
Public deposits are unsecured deposits raised by businesses for periods exceeding a year
but not more than 3 years by manufacturing concerns and not more than S years by non-banking
finance companies. The RB! is regulating deposit taking by these companies in order to protect
the depositors. Quantity restriction is placed at 25% of paid up capital + free services for deposits
solicited from public is prescribed for non-banking manufacturing concerns. The rate of interest
ceiling is also fixed. This form of working capital financing is resorted to by well established
companies.
Advances from customers are normally demanded by producers of costly goods at the
time of accepting orders for supply of goods. Contractors might also demand advance from

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

customers. Where sellers’ market prevail advances from customers may be insisted. In certain
cases to ensure performance of contract in advance may be insisted.
Accrual accounts are simply outstanding suppliers of overhead service requirements and
the like taxes due, dividend provision, etc.
Loans from directors, loans from group companies etc. constitute another source of
working capital. Cash rich companies lend to liquidity crunch companies of the group.
Commercial papers are usance promissory notes negotiable by endorsement and
delivery. Since 1990 CPs came to be introduced. There are restrictive conditions as to issue of
commercial paper& CPs are privately placed after RBI’s approval with any firm, incorporated or
not, any bank or financial institution. Big and sound companies generally float CPs.
Debentures and equity fund can be issued to finance working capital so that the
permanent working capital can be matching financed through long term funds.
Significance of working capital:
The problem of managing working capital has got a separate entity as against different
decision making issues concerning current assets individually. Working capital has to be regarded as
one of the conditioning factors in the long run operation of a firm which is inclined to treat it as no
issues of short term analysis and decision making. The skills for working capital management are
somewhat unique, though the goals are the same as in managing current assets individually, viz to
make on efficient use of funds for minimizing the risk of loss to attain profit objectives.
Working capital may be regarded as the life blood of a business. It is a capital which is required to
look after the day to day operation of the business. Its effective provision can do much more to
ensure the success of a business. There are two concept of working capital gross concept and net
concept.
Significance of working capital:
Modern business enterprises produce goods in anticipation of demand. Goods produced are not sold
immediately. Cash for sales is also not realized immediately. From the time of purchases of raw
materials to the time of realizations of cash for sales made, an operating cycle is involved. The
following stages are usually found in the operating cycle of a manufacturing firm :
1) Conversion of cash in to raw material
2) Conversion of raw material into work in progress
3) Conversion of work in progress into finished goods
4) Conversion of finished goods into debtors through sales
5) Conversion of debtors into cash
There are time gap between purchase or raw materials and production, production and sales and
sales and realization of cash thus the need for working capital arises due to the time gap between
purchases of raw materials and realization of cash from sales. Working capital is need for the
following purposes.
1) To purchases raw materials spares and component parts
2) To incur day to day expenses
3) To meet selling cost such as packing advertising

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

4) To provide credit facilities to customers

5) To maintain inventories of raw materials work in progress and finished stock
Advantages of adequate working capital:
Working capital is the life blood and never center of a business. No business can be run successfully
without adequate of working capital. The advantages of working capital are:
1) Continuous production : Adequate working capital ensures regular supply of raw materials and
continuous production
2) Solvency and good will: Adequate working capital enables promote to creditors this helps in
creating and maintaining good will.
3) Easy Loans: A concern having sufficient working capital enjoys liquidity and good credit
standing. Hence, it can secure loans from banks and other on easy and favourable terms.
4) Cash discount: Adequate working capital enables a concern to avail cash discounts on the
purchases, leading to a reduction in costs.
5) Regular payment of expenses: A company, which has ample working capital, can make regular
payment of salaries, wages and other day to day commitments. Such prompt payments raise the
morale of employees and increase their efficiency. As a result, costs are minimized and profit
increases.
6) Exploitation of market conditions: A concern with adequate working capital can exploit
favourable market conditions. It can buy its requirements of raw materials in bulk when the market
price is lower. Similarly, it can hold stock of finished goods to realize better prices.
7) Ability to face: Adequate working capital enables a concern to face business crises such as
depression, because during such period there is much pressure on working capital.
8) High return on investment: Adequate of working capital facilities continuous production and
effective utilization of fixed assets. Because of this, the concern is able to generate more profits and
ensure higher returns on investment.
Disadvantages of redundant working capital:
 Redundant or excessive working capital means the funds which earn no profit for the
business. Hence, the business cannot earn a proper rate of return on its investments.
 Due to low rate or return on investments, the value of shares may also fall.
 Redundant working capital may lead to unnecessary purchasing and accumulation of
inventories. As a result, chances of theft, waste and losses will increase.
 Excessive working capital is an indication of excessive debtors and defective credit policy.
Consequently, there may be delay in collection and higher incidence of bad debts.
 Excessive working capital makes management co placement. It leads to overall inefficiency
in the organization.

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

PROBLEMS

Weighted average cost of capital (or) overall cost of capital (Ko)

1. From the following particulars relating to the capital structure of Blue Ltd, calculate the
overall cost of capital, using (a) book value weights and (b). Market value weights.
Sources of funds Book value Market value
Equity share capital 45,000 90,000
Retained earnings 15,000 Nil
Preference share capital 10,000 10,000
Debentures 30,000 30,000
The after-tax cost different sources of finance are as follows; Equity share capital 14% Retained
earnings 13% Preference share capital 10% Debentures 8 %.
2. A firm has the following capital structure and after-tax cost.
Source Amount After tax cost %
Debt 8,75,000 6
Preference capital 6,25,000 12
Equity capital 10,00,000 15
Calculate the weighted average cost of capital using book value weights.
3. A firm has the following capital structure and after-tax costs for the different sources of funds
used:
Sources Amount Proportion After-tax cost
Rs. % %
Debt 15,00,000 25 5
Preference shares 12,00,000 20 10
Equity shares 18,00,000 30 12
Retained earnings 15,00,000 25 11
60,00,000 100
You are required to compute the weighted average cost of capital.
4. The following is the Capital structure of M/S Kurukshetra Earning Works Ltd.,
Source of Finance Amount (Rs) Projections
Equity share Capital (45,000 shares
of Rs. 10 each fully paid) 4,50,000 45%
Retained Earnings 1,50,000 15%
Preference share capital 1,00,000 10%
Debentures 3,00,000 30%
_______________________
10,00,000 100%
_______________________
The firm’s after-tax component costs of the various sources of funds are as follows:
Equity capital 14%
Preferences share capital 10%
Retained earnings 14%
Debt 4.5%
Calculate the weighted cost of capital
1). By assigning the book-value as weight and
2). Market values as weight. Assume the market price of equity shares is Rs. 20 per share.

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

Working Capital Management

1. Peerless Ltd. is engaged in customer retailing. You are required to forecast their working
capital requirements form the following information.
Projected annual sales Rs. 6, 50,000
% N.P. to cost of sales 25%
Average credit allowed to debtors 10 weeks
Average credit allowed by creditors 4 weeks
Average stock carrying (in terms of sales Requirement) 8 weeks
Add 20% to allow for contingencies.
Solution:
Projected Annual Sales = 6, 50,000
Less: NP to cost of sales
(25% on cost, that is – 20% on sales) = 1, 30,000
Cost of sales = 5, 20,000
Statement of working capital requirements
Current Assets Rs
Debtors 5,20,000*10/52 1,00,000
Stock 5,20,000*8/52 80,000
Total Current Assets 1,80,000
Current Liabilities
Creditors 5,20,000*4/52 40,000
Total current liabilities 40,000
Working capital (CA-CL) 1,40,000
Add: 20% Contingencies 28,000
Working capital required 1,68,000

Leverage
1. A firm has sales of Rs.75,00,000 variable cost of Rs.42,00,000 and fixed cost of Rs.6,00,000.
It has a debt of Rs.45,00,000 at 9% and equity of Rs. 55,00,000. Calculate operating, financial
and combined leverage of them. Also calculate the new EBIT, if the sales drop to Rs. 50,00,000.
Particulars Existing Sales Revised Sales drop
Sales Rs.75,00,000 Rs 50,00,000
variable cost Rs.42,00,000 Rs.42,00,000
Contribution Rs.33,00,000 Rs.8,00,000
Fixed cost Rs.6,00,000 Rs.6,00,000
EBIT Rs.27,00,000 Rs.2,00,000
Interest Rs. 4,05,000 Rs. 4,05,000
EBT Rs. 22,95,000 (Rs.2,05,000)

Capital Budgeting
1. A Ltd., Company is considering investing in a project requiring a capital outlay of
Rs.2,00,000. Forecast of annual income after depreciation but before tax is as follows:
Year Rs.
1 1,00,000

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

2 1,00,000
3 80,000
4 80,000
5 40,000
Depreciation may be taken as 20% on original cost and taxation at 50% of net income.
You are required to evaluate the project according to each of the following methods.
(a) Pay-back method
(b) Rate of return on original investment
(c) Rate of return on average investment
(d) Discounted cash flow method taking cost of capital at 10%
(e) Excess present value index.

2. ABC Limited is proposing to invest in a project requiring a capital outlay of Rs.50,000. Cost
for annual income after depreciation but before tax is as follows:
Year 1 2 3 4 5
Rs.20,000 20,000 16,000 16,000 8,000
Depreciation may be taken at 20% on original cost and taxation at 50% of net income. You are
required to evaluate the project according to each of the following method.
i) Pay-back method.
ii) Rate of return on original investment method
iii) Rate of return on average investment method
iv) Discount cash flow method taking cost of capital at 10%
v) Excess present value index.
Working capital
1. Tom & Co. Ltd. desires to purchases a business and has consulted you, and one point
on which you are asked to advise them is the average amount of working capital which
will be required in the first year’s working.
You are given the following estimates and are instructed to add 10% to your computed
figure to allow for contingencies.
Figures for the year
Rs.
1. Average amount locked up in stock:
Stock of finished product 5,000
Stock of stores, materials, etc., 8,000
2. Average credit given:
Inland sales 6 weeks credit 2,60,000
Exports sales 1½ weeks credit 78,000
3. Lag in payment of wages and other outstanding:
Wages - 1½ weeks 2,60,000
Stores, materials, etc., - 1½ months 48,000
Rent, Royalties, etc., - 6 months 10,000
Clerical staff - ½ months 62,400
Manager - ½ months 4,800
Miscellaneous expenses- 1½ months 48,000
4. Payments in advance:
Sundry expenses (paid quarterly in advance) 8,000

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

5. Undrawn profits on an average throughout the year 11,000

Calculate the average amount of working capital required.
2. From the following estimates, calculate the average amount of working capital
required.
Per annum
Rs.
1. Average amount locked up in stock
Stock of finished goods and work-in-progress 10,000
Stock of stores, materials etc., 8,000
Average credit given:
Local sales 2 week’s credit 1,04,000
Outside the state 6 weeks’ credit 3,12,000
2. Time available for payment:
For purchases 4 weeks 78,000
For wages 2 weeks 2,60,000
Add 10% to allow for contingencies
3. The Board of directors of Aravind mills Ltd., request you to prepare a statement showing
the working capital requirements for a level of activity of 30,000 units of outputs for the year.
The cost structure for the company’s product for the above-mentioned activity level is given
below:
Cost per unit
Rs.
Raw materials 20
Direct labour 5
Overheads 15
-------
Total 40
Profit 10
-------
Selling price 50
-------
a. Past experience indicates that raw materials are held in stock, on an average for 2 months
b. Work-in progress (100% complete in regard to materials and 50% for labour and
overheads) will be half a month’s production.
c. Finished goods are in stock on an average for 1 months
d. Credit allowed by suppliers: 1 month
e. Credit allowed to debtors: 2 months
f. A minimum cash balance of Rs.25,000 is expected to be maintained.
Prepare a statement of working capital requirements.
4. Cost sheet of a company provides the following particulars.
Raw materials 40%; Labour 10%; Overheads 30%.
The following details are also available.
a. Raw materials remain in stores for 6 weeks.
b. Processing time - 4 weeks
c. Finished goods are in stock for 5 weeks
d. Period of credit allowed to debtors 10 weeks

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 Dr. P. Mathuraswamy, Associate Professor, School of Business

e. Lag in payment of wages 2 weeks

f. Period of credit allowed by creditors 4 weeks
g. Selling price Rs. 50 per unit.
Production in units 13,000 per annum. Prepare an estimate of working capital.
Earning Pers share
1. The capital structure of Hindustan Corporation Ltd., consists of equity share capital
ofRs.10,00,000 (shares of Rs.100 each) and Rs.10,00,000 of 10% debentures. Sales have
increased From 1,00,000 to 1,20,000 units, the selling price is Rs.10 per unit and fixed expenses
amount Rs.2,00,000. The income tax rate is assumed to be 50%
You are required to calculate the following:
a).Percentage increase in EPS
b).Operating leverage at 1,00,000 units and 1,20,000 units
c).Financial leverage at 1,00,000 units and 1,20,000 units.

Theory
1. Discuss the factors that determine working capital requirements.
2. What are the various factors influencing Dividend Policy? Explain.
3. What are the various types of Leverages explain in detail.
4. What is capital structure? Explain the various theories of capital structure.
5. What are the Methods of Capital Budgeting, Enumerate?
6. Discuss the various functions of finance manager in an organization.
7. What are the various factors determining cost of capital?
8. What are the various types of shares explain in details?
9. What are the several of capital explain?

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