FINANCIAL MANAGEMENT

CONTENTS
Lessons Topic Page No
1 Finance
2 Financial Management
3 Objectives of Financial Management
4 Functions of Finance Manager
5 Time value of money
6 Cause of capital
7 EBIT – EPS analysis
8 Leverages
9 Investment and capital structure decision
10 Capital budgeting
11 Working capital management
12 Cash Management
13 Receivable Management
14 Inventory Management
15 Working capital financing and sources
16 Internal Financing
17 Dividends
Key Terms

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 UNIT - I
Lesson – 1
FINANCE
INTRODUCTION
In our present day economy, Finance is defined as the provision of money at the time when it is
required. Every enterprise, whether big, medium or small needs finance to carry on its operations
and to achieve its targets. In fact, finance is so indispensable today that it is rightly said to be the
life blood of an enterprise.
MEANING OF FINANCE
Finance is the life blood of business. Without adequate finance, no business can service and
without efficient finance management, no business can prosper and grow. Finance is required
for establishing developing and operating the business efficiently. The success of business
depends upon supply of finance and its efficient management.
DEFINITION
Finance may be defined as the provision of money at the time when it is required. Finance refers
to the management of flow of money through an organization.
According to WHEELER, business finance may be defined as “that business activity which is
concerned with the acquisition and conservation of capital funds in meeting the financial needs
and overall objectives of the business enterprise.”
According to GUTHMANN and DOUGALL, business finance may be broadly defined as “the
activity concerned with the planning, raising, controlling and administering the funds used in the
business.”
TYPES OF FINANCE
Finance is one of the important and integral part of business concerns, hence, it plays a major
role in every part of the business activities. It is used in all the area of the activities under the
different names. Finance can be classified into two major parts:

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1. Private finance

2.Public finance

Private Finance, which includes the Individual, Firms, Business or Corporate Financial
activities to meet the requirements.

Public Finance which concerns with revenue and disbursement of Government such as
Central Government, State Government and Semi-Government Financial matters.

Conclusion
The secret to a rewarding business is finance and without it, it's virtually impossible to achieve
your primary goal of profitability, not to mention the luxuries like marketing, employees and
further down the line, expansion.

Questions
1. What do you mean by finance?
2. Define finance
3. What are the types of finance?

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 Lesson – 2
FINANCIAL MANAGEMENT
INTRODUCTION
Finance is the life blood of and nerve centre of a business, just as circulation of blood is
essential in the human body for maintain life; finance is very essential for smooth running of
the business. It has been rightly termed as universal lubricant that keeps the firm dynamic. No
business, whether big, medium or small can be started without an adequate amount of
finance. Right from the very beginning i.e., conceiving an idea to business, finance is needed
to promote or establish the business, acquire fixed assets, make investigations such as market
surveys etc., develop product, keep men and machines at work, encourage management to
make progress and create values. Finance has thus become an integral part of the firm. Unless
the finance is managed in a profitable manner, the firm cannot reach its full potentials for
growth and success. In order to manage finance, a new management discipline was
conceived. Such discipline is known as financial management. This chapter is designed to
give an overall view on the concept of financial management.
MEANING OF FINANCIAL MANAGEMENT
Finance is called science of money. It is not only act of making money available, but its
administration and control so that it could be properly utilized. The world “Financial
Management” is the composition of two words ie. Financial and Management. Financial means
procuring or raising of money supply (funds) and allocating (using) those resources (funds) on
the basis of monetary requirements of the business. The word Management means planning,
organizing, coordinating and controlling human activities with reference to finance function for
achieving goals/ objectives of organization. Besides raising and utilization of funds, finance also
includes distribution of funds in the form of dividend to shareholders and retention of profit for
growth and developments.
DEFINITION OF FINANCIAL MANAGEMENT:
The term financial management has been defined differently by various authors. Some of the
authoritative definitions are as follows:
i. S.C.Kuchhal: 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.

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 ii. Weston and Brigham: Financial management is an area of financial decision
making, harmonizing and individual motives and enterprise goals.
iii. Solomon: Financial management is concerned with the efficient use of an important
economic resource, namely capital funds.
iv. 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
operations.
v. Archer and Ambrosio: Financial management is the application of the planning and
control function to the finance function.
Hence, three key areas of finance are:
I – Raisingof funds –Based on the total requirements ofcapital/funds for use in fixed assets,
current assets as well as intangible assets like goodwill, patent, trade mark, brand etc. crucial
decision are:
 When to raise (time)

 Sources from which to raise

 How much (quantum of money)

 In which form (debt or equity)

 Cost of raising funds

II – Investment of funds –Funds raised need to be allocated/invested in:

Fixed assets –also known as capital assets or
capitalbudgetingdecision.Thesedecisions are based upon cost and return analysis
through various techniques.
Current assets –also known on working capitalmanagement. These are assets for day
today running the business like cash, receivables, inventory, short form investments
etc. Decision about investment of funds is taken keeping in view two important
aspects.
 Profitability

 Liquidity

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III - Distribution of funds - Profit earned need to be distributed inthe form of dividend. Higher
the rates of dividend, higher world are the price of shares in market. Another crucial decision
under it would be the quantum of profit to be retained. The retained profit is cost free money to
the organization.
Hence in brief the financial management is management of funds which can be
explained through following chart.
SCOPE OF FINANCIAL MANAGEMENT
The main objective of financial management is to arrange sufficient finance for meeting short
term and long term needs. A financial manager will have to concentrate on the following areas of
finance function.
 Estimating financial requirements:
The first task of a financial manager is to estimate short term and long term financial
requirements of his business. For that, he will prepare a financial plan for present as well as for
future. The amount required for purchasing fixed assets as well as needs for working capital will
have to be ascertained.
 Deciding capital structure:
Capital structure refers to kind and proportion of different securities for raising funds. After
deciding the quantum of funds required it should be decided which type of securities should be
raised. It may be wise to finance fixed assets through long term debts. Even here if gestation
period is longer than share capital may be the most suitable. Long term funds should be
employed to finance working capital also, if not wholly then partially. Entirely depending on
overdrafts and cash credits for meeting working capital needs may not be suitable. A decision
about various sources for funds should be linked to the cost of raising funds.
 Selecting a source of finance:
An appropriate source of finance is selected after preparing a capital structure which includes
share capital, debentures, financial institutions, public deposits etc. If finance is needed for short
term periods then banks, public deposits and financial institutions may be the appropriate. On the
other hand, if long term finance is required then share capital and debentures may be the useful.

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  Selecting a pattern of investment:
When funds have been procured then a decision about investment pattern is to be taken. The
selection of an investment pattern is related to the use of funds. A decision will have to be taken
as to which assets are to be purchased? The funds will have to be spent first on fixed assets and
then an appropriate portion will be retained for working capital and for other requirements.
 Proper cash management:
Cash management is an important task of finance manager. He has to assess various cash needs
at different times and then make arrangements for arranging cash. Cash may be required to
purchase of raw materials, make payments to creditors, meet wage bills and meet day to day
expenses. The idle cash with the business will mean that it is not properly used.
 Implementing financial controls:
An efficient system of financial management necessitates the use of various control devices.
They are ROI, break even analysis, cost control, ratio analysis, cost and internal audit. ROI is the
best control device in order to evaluate the performance of various financial policies.
 Proper use of surpluses:
The utilization of profits or surpluses is also an important factor in financial management. A
judicious use of surpluses is essential for expansion and diversification plans and also in
protecting the interests of shareholders. The ploughing back of profits is the best policy of further
financing but it clashes with the interests of shareholders. A balance should be struck in using
funds for paying dividend and retaining earnings for financing expansion plans.
IMPORTANCE OF FINANCIAL MANAGEMENT
I – Importance to all types of organizations
i. Business organizations
Financial management isimportant to all types of business organization i.e. Small size,
medium size or a large size organization. As the size grows,financial decisions become more
and more complex as the amount involves also is large.
ii. Charitable organization / nonprofit organization / Trust
In all those organizations, finance is a crucial aspect tobe managed. A finance manager has to
concentrate more on collection of donations/ revenues etc. and has to ensure that every rupee
spent is justified and is towards achieving Goals of organization.

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 iii. Government / Govt. or public sector undertaking
In central/ state Govt. finance is a key/ important portfolio generally given to most capable or
competent person. Preparation of budget, monitoring capital /revenue receipt and expenditure
are key functions to be performed by the person in charge of finance. Similarly, in a Govt. or
public sector organization, financial controller or Chief finance officer has to play a key role
in performing/ taking all three financial decisions i.e. raising of funds, investment of funds
and distributing funds.
iv. Other organizations
In all other organizations or even in a family finance is a key area to be looked in to seriously
by a competent person so that things do not go out of gear.
II– Importance to all stake holders: - Financial Management is important to all stake
holders as explained below:
Shareholders–Share holders are interested in gettingoptimumdividend and maximizing their
wealth which is basic objective of financial management.
Investors / creditors –these stake holders are interestedin safety of their funds, timely
repayment of the principal amount as well as interest on the same. All these aspect are to be
ensured by the person managing funds/ finance.
Employees –They are interested in getting timelypayment of their salary/ wages, bonus,
incentives and their retirement benefits which are possible only if funds are managed
properly and organization is working in profit.
Customers – They are interested in quality products atreasonable rates which are possible
only through efficient management of organization including management of funds.
Public –Public at large is interested in general publicwelfare activities under corporate social
responsibility and this aspect is possible only when organization earns adequate profit.
Government –Govt. is interested in timely payment oftaxes and other revenues from
business world where again efficient finance manager has a definite role to play.
Management –Management is interested in overall image building, increase in the market share,
optimizing shareholders wealth and profit and all these aspect greatly depends upon efficient
management of financial resources.
III– Importance of financial management to all deportments of an organization.
A large size company has many departments like (besides finance dept.)

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  Production/ Manufacturing Dept.
 Marketing Dept.
 Personnel Dept.
 Material/ Inventory Dept.

All these departments look for availability of adequate funds so that they could manage their
individual responsibilities in an efficient manner. Lot of funds are required in
production/manufacturing dept. for ongoing / completing the production process as well as
maintaining adequate stock to make available goods for the marketing dept. for sale. Hence,
finance department through efficient management of funds has to ensure that adequate funds
are made available to all department and these departments at no stage starve for want of
funds. Hence, efficient financial management is of utmost importance to all other department
of the organization.
Conclusion
Performance evaluation will help a company to understand different sides of their
business operations on one hand where by analyzing performance in a certain period and help the
company to forecast their future business performances. This information obtained on business
performances can be used by number of parties, different stakeholders which include
shareholders, creditors, employees, tax authorities, government, media, etc. All the mentioned
parties can use these information of performance evaluation with an aim to assess the business
operations of the firm, future of the company and can contribute towards decision making
process of the company as evaluation will bring a clear image on the organizations’ financial
health or status, the financial feasibility, profitability and resource management. Also with the
right information investors and shareholders will be able to make the right decision in terms of
their investments where proper opportunities can be identified regarding the potential of positive
outcome of it.
Questions
1. Define Financial Management
2. What do you mean by financial management?
3. What are the key areas of finance?
4. State the scope of financial management
5. Explain the importance of financial management.

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 Lesson – 3
OBJECTIVES OF FINANCIAL MANAGEMENT
Introduction
It is an advanced goal compared to profit maximization. Survival of company is an important
consideration when the financial manager makes any financialdecisions. One incorrect
decision may lead company to be bankrupt. Maintaining proper cash flow is a short
run objective of financial management.
Objectives of Financial Management
There are two objectives of financial management viz.
 Profit maximization
 Wealth maximization
There are two schools of thought in this regard i.e. traditional and modern. While tradition
approach favours profit maximization as key objective, the modern thinker’s favours
shareholders wealth maximization as key objective of financial management. Traditional
thinkers believe that profit is appropriate yardstick to measure operational efficiency of an
enterprise. They are of the view that a firm should undertake only those activities that
increase the profit.
PROFIT MAXIMIZATION
Profit maximization is one of the basic objectives of financial management. According to this
concept, a firm should undertake all those activities which add to its profits and eliminate all
others which reduce its profits. This objective highlights the fact that all decisions-financing,
dividend and investment, should result in profit maximization. Following arguments are
given in favour of profit maximization concept.
i. Profit is a yardstick of efficiency on the basis of which economic efficiency of a
business can be evaluated.
ii. It helps in efficient allocation and utilization of scarce means because only such
resources are applied which maximize the profits.
iii. The rate of return on capital employed is considered as the best measurement of
the profits.
iv. Profits act as motivator which helps the business organization to be more efficient
through hard work.

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 v. By maximizing profits, social and economic welfare is also maximized.
Modern thinkers criticize the profit maximization objective on the following grounds:
 Profit is an ambiguous concept–Profit can be longterm or short term, profit before
Tax or after Tax, profit can be operating profit or gross profit etc. The economist’s
concept of profit is different than accountant’s concept of profit.
 Profit motto may lead to exploitation of customers, workers, employees and ignore
ethical trade practices.
 Profit motto also ignores social considerations or corporate social responsibility or
general public welfare.
 Profit always goes hand- to hand with risk. The owners of business will not like to
earn more and more profit by accepting more risk.
 The profit maximization was taken as objective when business was self-financed and
self-controlled.
Today, most of large business under taking witness a divergence between ownership and
management and business is dependent largely on loan and borrowed funds and only a small
fraction being financed out of owner’s funds. Hence, profit maximization will only act as a
narrow objective.
WEALTH MAXIMIZATION
Another basic objective of financial management is maximization of shareholders’ wealth.
This objective is also known as value maximization or net present-worth maximization.
According to this concept, finance manager should take such decisions which increase net
present value of the firm and should not undertake any activity which decrease net present
value. This concept eliminates all the three basic criticisms of the profit maximization
concept.
In view of above, modern thinkers consider wealth maximization as key objective of
financial management. This is also known as value maximization or net present worth
maximizations. This shareholders wealth maximization is evident from increase in the price
of shares in the market. They are of the view that wealth maximization is supposed to be
superior over profit maximization due to following reasons:
 This uses the concept of future expected cash flows rather than ambiguous term of
profit.

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  In takes in to accent time value of money.
 It also takes care of risk factors associated with project as the discount rate used for
calculating present value is generally a risk adjusted discount rate.
 It is consistent with the objective of maximizing owner’s welfare.
Equity shares of a company are traded in stock market and stock market quotation of a share
serves as an index of performance of the company. The wealth of equity share holders in
maximized only when market value of equity share of the company is maximized. In this
context, the term wealth maximization is redefined as value maximization.
At macro level, a firm has obligation to the society which is fulfilled by maximizing
production of goods and services at least cost, thereby maximizing wealth of society.

PROFIT MAXIMIZATION Vs WEALTH MAXIMIZATION

S.NO. PROFITMAXIMIZATION WEALTH MAXIMIZATION

1) Profits are earned Wealth is maximized, so that

maximized, so that firm wealth of share-holders can be
can over-come future risks maximized.
which are uncertain.

2) Profit maximization is a wealth maximization

yards stick for calculating Stockholder current wealth is
efficiency and economic evaluated in order to maximize
prosperity of the concern. the value of shares in the
market.
3) Profit is measured in terms Wealth is measured in terms of
of efficiency of the firm. Market price of shares.

4) Profit maximization Wealth maximization involves

Involvesproblemof problems related to
uncertainty because profits Maximizing Share holder’s
are uncertain. wealth or wealth of the firm

Conclusion
Financial management is primarily concerned with the optimal use of finance - the most notable
scarce resource in modern societies. Financial management decisions can be grouped into four

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broad categories namely, investment decision, capital structure decision, working capital
decision and dividend policy decision. All these decisions aim at maximizing the return and
minimizing the risk. To ensure this, each of the above decisions is related to the objectives of
financial management, viz., maximization of the wealth of the owners in private sector corporate
enterprises.
Question
1. Explain the objectives of financial management
2. Difference between profit maximization Vs wealth maximization

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 Lesson – 4
FUNCTIONS OF FINANCIAL MANAGER
Introduction
The role of the financial manager, particularly in business, is changing in response to
technological advances that have significantly reduced the amount of time it takes to produce
financial reports. Financial managers now perform more data analysis and use it to offer senior
managers ideas on how to maximize profits. They often work on teams, acting as business
advisors to top management. Financial managers need to keep abreast of the latest computer
technology in order to increase the efficiency of their firm's financial operations.
FUNCTIONS OF FINANCIAL MANAGER
A financial manager of a large organization has a very crucial responsibility to shoulder as he
has to take all decision about raising & utilization of resources have been taken efficiently
and at no time resources should remain idle. As the size of organization grows and volume of
financial transactions increases, his role and functions assumes greater importance. The key
functions of a financial manager can be as follows:
PRIMARY FUNCTIONS
Key management functions
Planning –A financial manager has to make financial planning in the form of short term and
long term plans and frame policies relating to sources of finance, investment of funds including
capital expenditure and distribution of profit.
Organizing –creating and monitoring properorganizational structure of finance looking to
the needs of organization.
Coordination –A financial manager has to coordinate with allother department so that no
department suffers for want of funds.
Controlling –A financial manager has to fix/ set standards ofperformance, compare actual
with standards fixed and exercise control on differences. He can apply techniques of
budgetary control and for this; he has to develop a system of collecting/ processing/analyzing
information.
Functions relating to finance:
Acquisition/raising of funds –He has to ensureadequate quantum of funds from right source,
right cost, right time, right form and at minimum cost.

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Allocation/ investment of funds –In fixed assets(long term assets) through appropriate
techniques of capital investment as well as allocation of funds in current assets like cash,
receivables, inventory short term investment keeping in view liquidity & profitability.
Distribution of income (profit) –In the form ofdividend (dividenddecision) and retained
earnings for growth and development of business.
Subsidiary functions:Besides core functions as above, a financial manager has to perform
following equally important functions such as:
Maintaining liquidity –Adequate liquidity need tobe maintained for paying obligations in
time as well as meeting day to day expenses and for this, he has to keep close eyes on cash
in-flows, cash out flows. Hence cash budget and cash for-casting becomes his important
function.
Profitability – For ensuring adequate profit andmaximizing share holders wealth a financial
manager has to look in to:
 Profit planning

 Price fixation of goods & services

 Cost of funds/capital

 Cost control

Evaluation of financial performance & reporting –AFinancial manager has to periodically

review financial performance against set standards, take corrective measures as well as report
performance to the board & management for facilitating timely decisions pertaining to finance at
top level.
Upkeep of records and other routine functions –Afinancial manager has to look in to
following aspects:
 supervision of cash receipts
 safe custody of valuables & securities
 maintenance of account
 internal audit
 compliance of govt. regulations

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FUNCTIONS OF MODERN AGE FINANCIAL MANAGER
Achieving corporate goals
Goals of different departments have to be achieved to increased market share of company’s
products.
Financial projections / fore casting
For next 5-10years consisting of cost & revenues for coming long term period keeping in
view companies long term plans.
Corporate Governance
For image building in theeyes of all stake holders of the company, transparency in systems
procedure and adherence of laws as well as rules & regulations.
Merger and acquisitions initiative
 For including new product lines
 Technological tie-up/ collaboration with foreign firms
 Financial restructuring for increasing profitability
 Tie-up arrangements for greater penetration in new markets in the country & abroad.
Risk management
 Preparing strategies forcombating risks arising out ofinternal &external factors.
 A Financial manager has to keep close eyes on risk factors as a result of policy
changes not only in the country but also due to developments taking place in foreign
countries. This has become important due to globalization effect.
Financial engineering
A Financial manager has to keep himselfabreast with new techniques of financial analysis
and new financial instruments coming in market. In financial engineering, a financial
manager has to work on finding out solutions to the problem through complex mathematical
models and high speed computer solutions.
NATURE OF FINANCE FUNCTION
The finance function is the process of acquiring and utilizing funds of a business. Finance
functions are related to overall management of an organization. Finance function is concerned
with the policy decisions such as line of business, size of firm, type of equipment used, use of
debt, liquidity position. These policy decisions determine the size of the profitability and

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riskiness of the business of the firm. Prof. K.M.Upadhyay has outlined the nature of finance
function as follows:
 In most of the organizations, financial operations are centralized. This results in
economies.Finance functions are performed in all business firms, irrespective of their
sizes /legal forms of organization.
 They contribute to the survival and growth of the firm.
 Finance function is primarily involved with the data analysis for use in decision making.
 Finance functions are concerned with the basic business activities of a firm, in addition to
external environmental factors which affect basic business activities, namely, production
and marketing.
 Finance functions comprise control functions also
 The central focus of finance function is valuation of the firm.
 Finance is something different from Accounting as well as Economics but it uses
information of accounting for making effective decisions. Accounting deals with
recording, reporting and evaluating the business transactions, whereas Finance is termed
as managerial or decision making process.
 Economics deals with evaluating the allocation of resources in economy and also related
to costs and profits, demand and supply and production and consumption. Economics
also consider those transactions which involve goods and services either in return of cash
or not.
Economics is easy to understand when divided into two parts.
Micro Economics:
It is also known as price theory or theory of the firm. Micro economics explains the behavior of
rational persons in making decisions related to pricing and production.
Macro Economics:
Macro Economics is a broad concept as it takes into consideration overall economic situation of
a nation. It uses gross national product (GNP) and useful in forecasting.In order to manage
problems related to money principles developed by financial managers, economics, accounting
are used.

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Hence, finance makes use of economic tools. From Micro economics it uses theories and
assumptions. From Macro economics it uses forecasting models. Even though finance is
concerned with individual firm and economics is concerned with forecasting of an industry.

OVERVIEW OF INDIAN FINANCIAL SYSTEM

Sources of finance Finance

 Equity shares
markets
Debentures
Commercial banks Capital

Insurances Repayments, interest and dividends

Govt.

Financial
Manager

Net cash flows

Investments

Investments in fixed
And currents assets

Due to recent trends in business environment, financial managers are identifying new ways
through which finance function can generate great value to their organization.
Current Business Environment: The progress in financial analytics is because ofdevelopment
of new business models, trends in role of traditional finance department, alternations in business
processes and progress in technology. Finance function in this vital environment emerged with
enormous opportunities and challenges.

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New Business Model: At the time when internet was introduced, three new e-business models
have evolved. They are business-to-business (B2B), business-to- customer (B2C) and business-
to-employees (B2E) future of financial analytics can be improved with the help of this new
model of business.
Traditionally, financial analytical is emphasizing on utilization of tangible assets like cash,
machinery etc, whereas some companies are mainly focused on intangible assets which are not
easy to evaluate and control. Hence financial analytics solved this problem by:
 Recognizing the complete performance of organization.

 Determining the source through which value of intangible assets can be evaluated and
increased.

 Predict the trends in market.

 The abilities of information system are encouraged.

 Minimizes the operating costs and enterprise-wide investments are effectively controlled
and upgrade the business processes.

Changing Role of the Finance Department: The role of finance function has been changing
simultaneously with the changes in economy. These changes are mainly due to Enterprise
Resource Planning (ERP), shared services and alternations in its reporting role.
 In the field of transaction processing, the role of financial staff has been widened up
because of automated financial transactions. Now financial executives are not just
processing and balancing transactions but they are focusing on decision-making
processes.
 International organizations are facilitating their customers by providing financial
information and facility to update both finance and non-finance functions from any place
around the world. It resulted in the department of decision support in the organization.
 Finance professionals are held responsible for supplying suitable analytical tools and
methods to decision makers.

Business Processes: With the evolution of business processes, queriesregarding business are
becoming more complicated. In order to solve, it requires analytics with high level of data
integration and organizational collaboration. In the last few decades, organizations are replacing

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function based legacy systems with new methods like ERP, BRP etc., in order to get accurate
and consistent financial and non-financial information.In 1990’s organizations were applying
some modern systems like supply chain management, Customer Relationship Management
(CRM) and many others to encourage their transactions. Overall organizations were building
strong relations with customers.
Technology: With the developments in technology, ERP, internet, data warehousinghave also
improved. Internet helps in increasing the sources of acquiring financial data, whereas ERP
vendors are building their own financial analytics which helps I n evaluating the performance,
planning and estimating, management and statutory reporting and financial consolidation.Till
now, data warehousing solutions used to emphasize on developing elements of analytical
infrastructure such as data stores, data marts and reporting applications but in future these data
ware housings provide advances analytical abilities to data stores.
Integrated Analytics: To survive in this competitive environment, organizationsmust have
advanced level of integrated financial analytics. Integrated financial analytics are useful for
organizations to evaluate, combine and share information inside and outside the
organization.Hence, with the progress in role of finance function, the financial analytics are used
in organizations effectively.

Conclusion
In exploring how managers in health care encounter and apply management knowledge, our
study has focused on three main aspects: management and leadership in the health-care context,
knowledge, knowledge mobilization and learning processes, and NoPs and CoPs. In this final
chapter, we summaries our main conclusions in each of these areas, preceding this with a
consideration of the effects of organizational and managerial diversity, before turning to assess
the limitations and implications for future research and, finally, drawing out the
recommendations from our study.
Questions
1. State the functions of finance manager
2. Explain the functions of modern financial manager.
3. State the nature of finance function.
4. Briefly explain the overview of Indian financial system.

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 UNIT - II
Lesson – 5
TIME VALUE OF MONEY
Introduction

The time value of money describes the greater benefit of receiving money now rather than later.
It is founded on time preference.

The principle of the time value of money explains why interest is paid or earned: Interest,
whether it is on a bank deposit or debt, compensates the depositor or lender for the time value of
money.

It also underlies investment. Investors are willing to forgo spending their money now if they
expect a favorable return on their investment in the future.

Meaning
The time value of money is one of the basic theories of financial management. The theory of
states that the value of money you have now is greater than a reliable promise to receive the
same amount of money at a future date. This may sound simple, but it underpins the concept of
interest, and can be used to compare investments, such as loans, bonds, mortgages, leases and
savings.
Uses

Calculations involving the time value of money allow people to find and compare the value of
future payments. To do this, five figures come into play: interest rate, number of periods or
number of times interest or dividend payments are made, payments, present value and future
value.

There are always five variables of Time value of money

Every time value of money problem has five variables. Present value( PV), Future value
(FV), Number of periods (N), interest rate (i), and a payment amount (PMT). In many cases, one
of these variables will be equal to zero, so the problem will effectively have only four variables.

21
Future Value

The time value of money tells us what the present value of an investment will grow to by a given
date. This is its future value. The difference between the present value and the future value
depends on how many compounding periods are involved in the investment, and on the interest
rate. Future value calculations can tell you how much money you will have in three years if you
put Rs.15,000 in a savings account today that pays 5 percent interest compounded annually.

Certain Payments

When investors buy bonds or pay money into an interest bearing account, they are exchanging
that money for a promise of more money on a certain date. The theory of the time value of
money allows investors to use a mathematical formula, called risk free rate of return, to calculate
today's value of that future money, and decide whether it is worth investing.

Uncertain Payments

Some types of investments do not guarantee a payout after a certain period of time. If a future
payment is not guaranteed, you must adjust its value based on the risk involved, as well as the
time value.

SIGNIFICANCE OF THE CONCEPT OF TIME VALUE OF MONEY

Time value of money is a widely used concept in literature of finance. Financial decision
models based on finance theories basically deal with maximization of economic welfare of
shareholders. The concept of time value of money contributes to this aspect to a greater extent.
The significance of the concept of time value of money could be stated as below:
Investment Decision
Investment decision is concerned with the allocation of capital into long-term investment
projects. The cash flow from long-term investment occurs at different point in time in the future.
They are not comparable to each other and against the cost of the project spent at present. To
make them comparable, the future cash flows are discounted back to present value.
The concept of time value of money is useful to securities investors. They use valuation models
while making investment in securities such as stock and bonds. These security valuation models
consider time value of cash flows from securities.

22
Financing Decision
Financing decision is concerned with designing optimum capital structure and raising funds from
least cost sources. The concept of time value of money is equally useful in financing decision,
especially when we deal with comparing the cost of different sources of financing. The effective
rate of interest of each source of financing is calculated based on time value of money concept.
Similarly, in leasing versus buying decision, we calculate the present value of cost of leasing and
cost of buying. The present value of costs of two alternatives are compared against each other to
decide on appropriate source of financing.
TIME VALUE MONEY
Compound value of Lumpsum
1. Mr. John deposits Rs. 50,000 for 3 years at 10%. What is the compound value of his
deposits?
Principal Investment 50000
Interest 1 year at 10% 5000
45000
II year at 10% 4500
40500
IIIyear at 10% 4050
36450
Formula Method
Fv =P (1+i)n
=50000(1+10)3
= 50000(1.331)
= 66550
2. Doubling Period
i) Rule of 72 = 72/Rate of interest If interest is 12%
ii) Rule of 69 = 0.35+69/Rate of interest If interest is 18%

72/12=6 years
0.35+69/18
If interest rate 10% = 0.35+69/10 = 7.25
If interest rate 12% = 0.35+69/12 = 6.10
3. Present value of series of payment

Calculate the present value of cash flow

Year 1 2 3
Expected cash flow 1000 2000 3000
Interest rate = 10%
Formula Method

Pv = F1 /(1+i)1 + F2 /(1+i)2 +… ........... Fn/(1+i)n

23
Pv = 1000/(1+10)1 + 2000/(1+10)2 +3000/(1+10)3
Pv = 1000/1.1 + 2000/1.21 + 3000/1.331
Pv = 909+1653+2254 = 4816

4. Multiple compounding
Calculate compound value of Rs. 10,000 at the end of 3 years. 12% rate of interest. When
interest is calculate (a) yearly basis (b) Quarterly basis
Vn= Vo(1+i/m)m*n
a). Vo = 10000, i = 0.12, m = 1, n = 3
Vn= 10000 (1+0.12/1)1*3
Vn= 10000 X 1.405
Vn = Rs. 14,050
b) m = 4
Vn= 10000 (1+0.12/4)4*3
Vn= 10000 X 1.426
Vn = Rs. 14,260
5. Effective rate of interest
EIR = (1+i/m)m– 1
i = normal interest rate
m = frequency of compounding year
A company offers 12% rate of interest on deposits. What is the effective rate of interest.
If the compounding is done (i) half yearly (ii) quarter yearly (iii) monthly
a). half yearly m = 2 , i = 0.12
EIR = (1+0.12/2)2– 1
= (1+ 0.06)2– 1
= 1.1236-1
EIR = 0.1236 (or) 12.36%
b). Quarter yearly basis m = 4
EIR = (1+0.12/4)4– 1
= (1+ 0.03)4– 1
= 1.126-1

24
 EIR = 0.126 (or) 12.6%
C). Monthly basis m = 12
EIR = (1+0.12/12)12– 1
= (1+ 0.01)12– 1
= 1.127-1
EIR = 0.127 (or) 12.7%
INSTRUMENTS OF LONG TERM & SHORT TERM FINANCING

Financing is a very important part of every business. Firms often need financing to pay for their
assets, equipment, and other important items. Financing can be either long-term or short-term.
As is obvious, long-term financing is more expensive as compared to short-term financing.

There are different vehicles through which long-term and short-term financing is made
available. This chapter deals with the major vehicles of both types of financing.

The common sources of financing are capital that is generated by the firm itself and sometimes,
it is capital from external funders, which is usually obtained after issuance of new debt and
equity.

A firm’s management is responsible for matching the long-term or short-term financing mix.
This mix is applicable to the assets that are to be financed as closely as possible, regarding
timing and cash flows.

I. Long-Term Financing
Long-term financing is usually needed for acquiring new equipment, R&D, cash flow
enhancement, and company expansion. Some of the major methods for long-term financing are
discussed below.

1. Equity Financing
Equity financing includes preferred stocks and common stocks. This method is less risky in
respect to cash flow commitments. However, equity financing often results in dissolution of
share ownership and it also decreases earnings.

25
The cost associated with equity is generally higher than the cost associated with debt, which is
again a deductible expense. Therefore, equity financing can also result in an enhanced hurdle
rate that may cancel any reduction in the cash flow risk.

2. Corporate Bond
A corporate bond is a special kind of bond issued by any corporation to collect money
effectively in an aim to expand its business. This tern is usually used for long-term debt
instruments that generally have a maturity date after one year after their issue date at the
minimum.

Some corporate bonds may have an associated call option that permits the issuer to redeem it
before it reaches the maturity. All other types of bonds that are known as convertible bonds that
offer investors the option to convert the bond to equity.

3. Capital Notes
Capital notes are a type of convertible security that are exercisable into shares. They are one
type of equity vehicle. Capital notes resemble warrants, except the fact that they usually don’t
have the expiry date or an exercise price. That is why the entire consideration the company aims
to receive, for the future issuance of the shares, is generally paid at the time of issuance of
capital notes.

Many times, capital notes are issued with a debt-for-equity swap restructuring. Instead of
offering the shares (that replace debt) in the present, the company provides its creditors with
convertible securities – the capital notes – and hence the dilution occurs later.

II. Short-Term Financing

Short-term financing with a time duration of up to one year is used to help corporations increase
inventory orders, payrolls, and daily supplies. Short-term financing can be done using the
following financial instruments −

1. Commercial Paper
Commercial Paper is an unsecured promissory note with a pre-noted maturity time of 1 to 364
days in the global money market. Originally, it is issued by large corporations to raise money to
meet the short-term debt obligations.

26
It is backed by the bank that issues it or by the corporation that promises to pay the face value
on maturity. Firms with excellent credit ratings can sell their commercial papers at a good price.

Asset-backed commercial paper (ABCP) is collateralized by other financial assets. ABCP is a

very short-term instrument with 1 and 180 days’ maturity from issuance. ACBCP is typically
issued by a bank or other financial institution.

2. Promissory Note
It is a negotiable instrument where the maker or issuer makes an issue-less promise in writing to
pay back a pre-decided sum of money to the payee at a fixed maturity date or on demand of the
payee, under specific terms.

3. Asset-based Loan
It is a type of loan, which is often short term, and is secured by a company's assets. Real estate,
accounts receivable (A/R), inventory and equipment are the most common assets used to back
the loan. The given loan is either backed by a single category of assets or by a combination of
assets.

4. Repurchase Agreements
Repurchase agreements are extremely short-term loans. They usually have a maturity of less
than two weeks and most frequently they have a maturity of just one day! Repurchase
agreements are arranged by selling securities with an agreement to purchase them back at a
fixed cost on a given date.

5. Letter of Credit
A financial institution or a similar party issues this document to a seller of goods or services.
The seller provides that the issuer will definitely pay the seller for goods or services delivered to
a third-party buyer.

The issuer then seeks reimbursement to be met by the buyer or by the buyer's bank. The
document is in fact a guarantee offered to the seller that it will be paid on time by the issuer of
the letter of credit, even if the buyer fails to pay.

27
Conclusion
Time value of money concepts are at the core of valuation and other finance and commercial real
estate topics. This article provides a solid foundation for understanding time value of money at
an intuitive level and it also gives you the tools needed to solve any time value of money
problem. The time value of money is required as a basic building block in finance and mastering
these concepts will pay dividends for years to come.
Questions:
1. Define Time value of money
2. What are the uses of Time value of money? Explain the variable of Time value of money.
3. State the significance of the concept of Time value of money
4. Calculate the compound value of Rs. 20,000 invested. Now the period of 5 years at the
time of preference value of 8%.
5. A deposit Rs. 5,000 to pay at 6% a rate of interest. How many years will be amount
double? Work out the problem using Rule 72 and 69?
6. Calculate the compounded value of Rs. 5,000 at the end of 5 years, 8% interest. When the
interest is calculated (a) yearly basis (b) half yearly basis (c) quarterly basis.
7. State the long term & short term finance

28
 Lesson – 6
COST OF CAPITAL
Introduction
The cost of capital of a firm is the minimum rate of return expected by its investors. It is the
weighted average cost of various sources of finance used by a firm. The capital used by a firm
may be in the form of debt, preference capital, retained earnings and equity shares. The concept
of cost of capital is very important in the financial management. A decision to invest in a
particular project depends upon the cost of capital of the firm or the cut off rate which is the
minimum rate of return expected by the investors.
DEFINITIONS
James C.Van Horne defines cost of capital as,”a cut-off rate for the allocation of capital to
investments of projects. It is the rate of return on a project that will leave unchanged the market
price of the stock.
According to Solomon Ezra, “Cost of capital is the minimum required rate of earning or the cut-
off rate of capital expenditures”.
Significance of Cost of Capital:
The concept of cost of capital plays a vital role in decision-making process of financial
management. The financial leverage, capital structure, dividend policy, working capital
management, financial decision, appraisal of financial performance of top management etc. are
greatly influenced by the cost of capital.

The significance or importance of cost of capital may be stated in the following ways:
1. Maximization of the Value of the Firm:
For the purpose of maximization of value of the firm, a firm tries to minimize the average cost of
capital. There should be judicious mix of debt and equity in the capital structure of a firm so that
the business does not to bear undue financial risk.

2. Capital Budgeting Decisions:

Proper estimate of cost of capital is important for a firm in taking capital budgeting decisions.
Generally cost of capital is the discount rate used in evaluating the desirability of the investment
project. In the internal rate of return method, the project will be accepted if it has a rate of return
greater than the cost of capital.

29
In calculating the net present value of the expected future cash flows from the project, the cost of
capital is used as the rate of discounting. Therefore, cost of capital acts as a standard for
allocating the firm’s investible funds in the most optimum manner. For this reason, cost of
capital is also referred to as cut-off rate, target rate, hurdle rate, minimum required rate of return
etc.

3. Decisions Regarding Leasing:

Estimation of cost of capital is necessary in taking leasing decisions of business concern.

4. Management of Working Capital:

In management of working capital the cost of capital may be used to calculate the cost of
carrying investment in receivables and to evaluate alternative policies regarding receivables. It is
also used in inventory management also.

5. Dividend Decisions:
Cost of capital is significant factor in taking dividend decisions. The dividend policy of a firm
should be formulated according to the nature of the firm— whether it is a growth firm, normal
firm or declining firm. However, the nature of the firm is determined by comparing the internal
rate of return (r) and the cost of capital (k) i.e., r > k, r = k, or r < k which indicate growth firm,
normal firm and decline firm, respectively.

6. Determination of Capital Structure:

Cost of capital influences the capital structure of a firm. In designing optimum capital structure
that is the proportion of debt and equity, due importance is given to the overall or weighted
average cost of capital of the firm. The objective of the firm should be to choose such a mix of
debt and equity so that the overall cost of capital is minimized.

7. Evaluation of Financial Performance:

The concept of cost of capital can be used to evaluate the financial performance of top
management. This can be done by comparing the actual profitability of the investment project
undertaken by the firm with the overall cost of capital.

30
Measurement of Cost of Capital:
Cost of capital is measured for different sources of capital structure of a firm. It includes cost of
debenture, cost of loan capital, cost of equity share capital, cost of preference share capital, cost
of retained earnings etc.

The measurement of cost of capital of different sources of capital structure is discussed:

A. Cost of Debentures:
The capital structure of a firm normally includes the debt capital. Debt may be in the form of
debentures bonds, term loans from financial institutions and banks etc. The amount of interest
payable for issuing debenture is considered to be the cost of debenture or debt capital (Kd). Cost
of debt capital is much cheaper than the cost of capital raised from other sources, because
interest paid on debt capital is tax deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par: Kd = r (1 – t)
whereKd = Cost of debenture
r = Fixed interest rate
t = Tax rate
(ii) When the debentures are issued at a premium or discount but redeemable at par
Kd = I/NP (1 – t)
where, Kd = Cost of debenture
I = Annual interest payment
t = Tax rate
Np = Net proceeds from the issue of debenture.
(iii) When the debentures are redeemable at a premium or discount and are redeemable
after ‘n’ period:
Kd
I(1-t)+1/N(Rv – NP) / ½ (RV – NP)
whereKd = Cost of debenture .
I = Annual interest payment
t = Tax rate
NP = Net proceeds from the issue of debentures

31
Ry = Redeemable value of debenture at the time of maturity
Example 1:
(a) A company issues Rs. 1,00,000, 15% Debentures of Rs. 100 each. The company is in 40%
tax bracket. You are required to compute the cost of debt after tax, if debentures are issued at (i)
Par, (ii) 10% discount, and (iii) 10% premium.
(b) If brokerage is paid at 5%, what will be the cost of debentures if issue is at par?

Example 2:
ZED Ltd. has issued 12% Debentures of face value of Rs. 100 for Rs. 60 lakh. The floating
charge of the issue is 5% on face value. The interest is payable annually and the debentures are
redeemable at a premium of 10% after 10 years.
What will be the cost of debentures if the tax is 50%?

B. Cost of Preference Share Capital:

For preference shares, the dividend rate can be considered as its cost, since it is this amount
which the company wants to pay against the preference shares. Like debentures, the issue
expenses or the discount/premium on issue/redemption are also to be taken into account.

32
(i) The cost of preference shares (KP) = DP / NP
Where, DP = Preference dividend per share
NP = Net proceeds from the issue of preference shares.
(ii) If the preference shares are redeemable after a period of ‘n’, the cost of preference shares
(KP) will be:

where NP = Net proceeds from the issue of preference shares

RV = Net amount required for redemption of preference shares
DP = Annual dividend amount.
There is no tax advantage for cost of preference shares, as its dividend is not allowed deduction
from income for income tax purposes. The students should note that both in the case of debt and
preference shares, the cost of capital is computed with reference to the obligations incurred and
proceeds received. The net proceeds received must be taken into account while computing cost
of capital.
Example 3:
A company issues 10% Preference shares of the face value of Rs. 100 each. Floatation costs are
estimated at 5% of the expected sale price.
What will be the cost of preference share capital (KP), if preference shares are issued (i) at par,
(ii) at 10% premium and (iii) at 5% discount? Ignore dividend tax.
Solution:
We know, cost of preference share capital (KP) = DP/P

33
Example 4:
Ruby Ltd. issues 12%. Preference Shares of Rs. 100 each at par redeemable after 10 years at
10% premium.
What will be the cost of preference share capital?

Example 5:
A company issues 12% redeemable preference shares of Rs. 100 each at 5% premium
redeemable after 15 years at 10% premium. If the floatation cost of each share is Rs. 2, what is
the value of KP(Cost of preference share) to the company?

C. Cost of Equity or Ordinary Shares:

The funds required for a project may be raised by the issue of equity shares which are of
permanent nature. These funds need not be repayable during the lifetime of the organisation.
Calculation of the cost of equity shares is complicated because, unlike debt and preference
shares, there is no fixed rate of interest or dividend payment.
Cost of equity share is calculated by considering the earnings of the company, market value of
the shares, dividend per share and the growth rate of dividend or earnings.

34
(i) Dividend/Price Ratio Method:
An investors buys equity shares of a particular company as he expects a certain return (i.e.
dividend). The expected rate of dividend per share on the current market price per share is the
cost of equity share capital. Thus the cost of equity share capital is computed on the basis of the
present value of the expected future stream of dividends.
Thus, the cost of equity share capital (Ke) is measured by:
Ke = where D = Dividend per share
P = Current market price per share.
If dividends are expected to grow at a constant rate of ‘g’ then cost of equity share capital
(Ke) will be Ke = D/P + g.
This method is suitable for those entities where growth rate in dividend is relatively stable. But
this method ignores the capital appreciation in the value of shares. A company which declares a
higher amount of dividend out of given quantum of earnings will be placed at a premium as
compared to a company which earns the same amount of profits but utilizes a major part of it in
financing its expansion programme.
Example 6:
XY Company’s share is currently quoted in market at Rs. 60. It pays a dividend of Rs. 3 per
share and investors expect a growth rate of 10% per year.
You are required to calculate:
(i) The company’s cost of equity capital.
(ii) The indicated market price per share, if anticipated growth rate is 12%.
(iii) The market price, if the company’s cost of equity capital is 12%, anticipated growth rate is
10% p.a., and dividend of Rs. 3 per share is to be maintained.

35
Example 7:
The current market price of a share is Rs. 100. The firm needs Rs. 1,00,000 for expansion and
the new shares can be sold at only Rs. 95. The expected dividend at the end of the current year is
Rs. 4.75 per share with a growth rate of 6%.
Calculate the cost of capital of new equity.
Solution:
We know, cost of Equity Capital (Ke) = D/P + g
(i) When current market price of share (P) = Rs. 100
K = Rs 4.75 / Rs. 100 + 6% = 0.0475 + 0.06 = 0.1075 or 10.75%.
(ii) Cost of new Equity Capital = Rs. 4.75 / Rs. 95 + 6% = 0.11 or, 11%.
Example 8:
A company’s share is currently quoted in the market at Rs. 20. The company pays a dividend of
Rs. 2 per share and the investors expect a growth rate of 5% per year.
You are required to calculate (a) Cost of equity capital of the company, and (b) the market price
per share, if the anticipated growth rate of dividend is 7%.
Solution:
(a) Cost of equity share capital (Ke) = D/P +g = Rs. 2/Rs. 20 + 5% = 15%
(b) Ke = D/P + g
or, 0.15 = Rs. 2 / P + 0.07 or, P = 2/0.08 = Rs. 25.
Example 9:
Green Diesel Ltd. has its equity shares of Rs. 10 each quoted in a stock exchange at a market
price of Rs. 28. A constant expected annual growth rate of 6% and a dividend of Rs. 1.80 per
share has been paid for the current year.
Calculate the cost of equity share capital.
Solution:
D0 (1 + g)/ P0 + g = 1.80 (1 + .06)/ 28 + 0.06
= 0.0681 + 0.06 = 12.81%
(ii) Earnings/Price Ratio Method:
This method takes into consideration the earnings per share (EPS) and the market price of share.
Thus, the cost of equity share capital will be based upon the expected rate of earnings of a

36
company. The argument is that each investor expects a certain amount of earnings whether
distributed or not, from the company in whose shares he invests.
If the earnings are not distributed as dividends, it is kept in the retained earnings and it causes
future growth in the earnings of the company as well as the increase in market price of the share.
Thus, the cost of equity capital (Ke) is measured by:
Ke = E/P where E = Current earnings per share
P = Market price per share.
If the future earnings per share will grow at a constant rate ‘g’ then cost of equity share capital
(Ke) will be
Ke = E/P+ g.
This method is similar to dividend/price method. But it ignores the factor of capital appreciation
or depreciation in the market value of shares. Adjustment of Floatation Cost There are costs of
floating shares in market and include brokerage, underwriting commission etc. paid to brokers,
underwriters etc.
These costs are to be adjusted with the current market price of the share at the time of computing
cost of equity share capital since the full market value per share cannot be realised. So the market
price per share will be adjusted by (1 – f) where ‘f’ stands for the rate of floatation cost.
Thus, using the Earnings growth model the cost of equity share capital will be:
Ke = E / P (1 – f) + g
Example 10:
The share capital of a company is represented by 10,000 Equity Shares of Rs. 10 each, fully paid.
The current market price of the share is Rs. 40. Earnings available to the equity shareholders
amount to Rs. 60,000 at the end of a period.
Calculate the cost of equity share capital using Earning/Price ratio.

37
Example 11:
A company plans to issue 10,000 new Equity Shares of Rs. 10 each to raise additional capital.
The cost of floatation is expected to be 5%. Its current market price per share is Rs. 40.
If the earnings per share is Rs. 7.25, find out the cost of new equity.

D. Cost of Retained Earnings:

The profits retained by a company for using in the expansion of the business also entail cost.
When earnings are retained in the business, shareholders are forced to forego dividends. The
dividends forgone by the equity shareholders are, in fact, an opportunity cost. Thus retained
earnings involve opportunity cost.
If earnings are not retained they are passed on to the equity shareholders who, in turn, invest the
same in new equity shares and earn a return on it. In such a case, the cost of retained earnings
(Kr) would be adjusted by the personal tax rate and applicable brokerage, commission etc. if any.

Many accountants consider the cost of retained earnings as the same as that of the cost of equity
share capital. However, if the cost of equity share capital i9 computed on the basis of dividend
growth model (i.e., D/P + g), a separate cost of retained earnings need not be computed since the
cost of retained earnings is automatically included in the cost of equity share capital.
Therefore, Kr = Ke = D/P + g.
Example 12:
It is given that the cost of equity of a company is 20%, marginal tax rate of the shareholders is
30% and the Broker’s Commission is 2% of the investment in share. The company proposes to
utilize its retained earnings to the extent of Rs. 6,00,000.
Find out the cost of retained earnings.

38
E. Overall or Weighted Average Cost of Capital:
A firm may procure long-term funds from various sources like equity share capital, preference
share capital, debentures, term loans, retained earnings etc. at different costs depending on the
risk perceived by the investors.
When all these costs of different forms of long-term funds are weighted by their relative
proportions to get overall cost of capital it is termed as weighted average cost of capital. It is also
known as composite cost of capital. While taking financial decisions, the weighted or composite
cost of capital is considered.
The weighted average cost of capital is used by an enterprise because of the following
reasons:
(i) It is useful in taking capital budgeting/investment decisions.
(ii) It recognizes the various sources of finance from which the investment proposal derives its
life-blood (i.e., finance).
(iii) It indicates an optimum combination of various sources of finance for the enhancement of
the market value of the firm.
(iv) It provides a basis for comparison among projects as a standard or cut-off rate.
I. Computation of Weighted Average Cost of Capital:
Computation of Weighted Average cost of capital is made in the following ways:
(i) The specific cost of each source of funds (i.e., cost of equity, preference shares, debts,
retained earnings etc.) is to be calculated.
(ii) Weights (i.e., proportion of each, source of fund in the capital structure) are to be computed
and assigned to each type of funds. This implies multiplication of each source of capital by
appropriate weights.
Generally, the-following weights are assigned:
(a) Book values of various sources of funds
(b) Market values of various sources of capital
(c) Marginal book values of various sources of capital.

39
Book values of weights are based on the values reflected by the balance sheet of a concern,
prepared under historical basis and ignoring price level changes. Most of the financial analysts
prefer to use market value as the weights to calculate the weighted average cost of capital as it
reflects the current cost of capital.
But the determination of market value involves some difficulties for which the measurement of
cost of capital becomes very difficult.
(iii) Add all the weighted component costs to obtain the firm’s weighted average cost of capital.
Therefore, weighted average cost of capital (Ko) is to be calculated by using the following
formula:
Ko = K1w1 + K2w2 + …………
where K1, K2 ……….. are component costs and W1, W2 ................... are weights.
Example 13:
Jamuna Ltd has the following capital structure and, after tax, costs for the different
sources of fund used:

Example 14:
Excel Ltd. has assets of Rs. 1,60,000 which have been financed with Rs. 52,000 of debt and Rs.
90,000 of equity and a general reserve of Rs. 18,000. The firm’s total profits after interest and
taxes for the year ended 31st March 2006 were Rs. 13,500. It pays 8% interest on borrowed

40
funds and is in the 50% tax bracket. It has 900 equity shares of Rs. 100 each selling at a market
price of Rs. 120 per share.
What is the Weighted Average Cost of Capital?

Example 15:
RIL Ltd. opts for the following capital structure:

41
Example 16:
In considering the most desirable capital structure for a company, the following estimates
of the cost Debt and Equity Capital (after tax) have been made at various levels of debt-
equity mix:

You are required to determine the optimum debt-equity mix for the company by calculating
composite cost of capital.

Optimal debt-equity mix for the company is at the point where the composite cost of capital is
minimum. Hence, the composite cost of capital is minimum (10.75%) at the debt-equity mix of
3: 7 (i.e., 30% debt and 70% equity). Therefore, 30% of debt and 70% equity mix would be an
optimal debt-equity mix for the company.

42
Conclusion
All businesses and investment projects need capital to operate. However, financial capital —
the money tied up in the business, is not free. A project’s cost of capital is the minimum
expected rate of return the project needs to offer investors to attract money. Simply put, the
cost of capital is the expected rate of return the market requires to commit capital to an
investment. Thus, the cost of financial capital to a firm is the return the firm’s investors (debt
and equity holders) receive from lending their savings to be used by the firm’s portfolio of
investment projects.
Questions:
1. Define cost of capital
2. State the significance of cost of capital
3. What is meant by preference share capital
4. What is cost of equity capital
5. What is meant by dividend price ratio?
6. Write the formulae of earning price ratio
7. What is retained earnings
8. What is weighted average capital? And what are the reasons for using an enterprises of
weighted average capital
9. A company issues 10% irredeemable debenture of Rs. 1,00,000. The com., 55% tax
bracket. Calculate to Cost of debt. Before tax . If the debenture issued (i) at par (ii) 10%
discount (iii) 10% premium.
10. The firms issues debenture of Rs. 1,00,000 at a realize Rs. 98,000. After allowing 2%
commissions to brokers. The debentures carry out interest rate of 10%. The debentures
are due for maturity at the end of the 10 years. You are require to calculate the effective
cost of debt. Before tax.
11. A co., issues preference share capital of Rs. 1,00,000 by issue of 10% preference share of
Rs. 100 each. Calculate cost of preference capital. When they are issued at (i) 10%
premium and (ii )10% discount.
12. A co., has 10% redeemable preference share of Rs. 1,00,000 at the end of the 10 th year of
their issue. The under writing cost came to 2%. Calculate the effective cost of preference
share capital.

43
13. The current market price if an equity share of A ltd is Rs. 95. The flotation cost are Rs. 5
per. Share. Dividend P.s. amounts to Rs. 4.50 and is expected to grow at a rate of 7%.
You are require to calculate the cost of equity share capital.
14. The firm is Ke( return available to share holder) is 15%. The average tax rate of share
holders is 40% and it is expected that 2% is brokerage cost that share holders will have to
pay while investing them dividends in alternative security. What is the cost of retained
earnings.
15. From the following capital structure of a company calculate the over all cost of capital
using (a) book value weights and (b) market value weight.
Sources Book Value Market value
Equity share ( 10p.s) 45,000 90,000
Retained earnings 15,000 -
Preference share capital 10,000 10,000
Debentures 30,000 30,000
The after tax cost of different shares of finance is as follows:
Equity share capital 14%, Retained earnings 13%, preference capital 10% and Debenture
5%.

44
 Lesson – 7
EBIT – EPS ANALYSIS
Introduction
EBIT-EPS analysis gives a scientific basis for comparison among various financial plans and
shows ways to maximize EPS. Hence EBIT-EPS analysis may be defined as ‘a tool of financial
planning that evaluates various alternatives of financing a project under varying levels of EBIT
and suggests the best alternative having highest EPS and determines the most profitable level of
EBIT’.
Concept of EBIT-EPS Analysis:
The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing alternative
methods of financing at different levels of EBIT. Simply put, EBIT-EPS analysis examines the
effect of financial leverage on the EPS with varying levels of EBIT or under alternative financial
plans.
Advantages of EBIT-EPS Analysis:
We have seen that EBIT-EPS analysis examines the effect of financial leverage on the behavior
of EPS under various financing plans with varying levels of EBIT. It helps a firm in determining
optimum financial planning having highest EPS.
Various advantages derived from EBIT-EPS analysis may be enumerated below:
Financial Planning:
Use of EBIT-EPS analysis is indispensable for determining sources of funds. In case of financial
planning the objective of the firm lies in maximizing EPS. EBIT-EPS analysis evaluates the
alternatives and finds the level of EBIT that maximizes EPS.
Comparative Analysis:
EBIT-EPS analysis is useful in evaluating the relative efficiency of departments, product lines
and markets. It identifies the EBIT earned by these different departments, product lines and from
various markets, which helps financial planners rank them according to profitability and also
assess the risk associated with each.
Performance Evaluation:
This analysis is useful in comparative evaluation of performances of various sources of funds. It
evaluates whether a fund obtained from a source is used in a project that produces a rate of return
higher than its cost.

45
Determining Optimum Mix:
EBIT-EPS analysis is advantageous in selecting the optimum mix of debt and equity. By
emphasizing on the relative value of EPS, this analysis determines the optimum mix of debt and
equity in the capital structure. It helps determine the alternative that gives the highest value of
EPS as the most profitable financing plan or the most profitable level of EBIT as the case may
be.
Limitations of EBIT-EPS Analysis:
Finance managers are very much interested in knowing the sensitivity of the earnings per share
with the changes in EBIT; this is clearly available with the help of EBIT-EPS analysis but this
technique also suffers from certain limitations, as described below
No Consideration for Risk:
Leverage increases the level of risk, but this technique ignores the risk factor. When a
corporation, on its borrowed capital, earns more than the interest it has to pay on debt, any
financial planning can be accepted irrespective of risk. But in times of poor business the reverse
of this situation arises—which attracts high degree of risk. This aspect is not dealt in EBIT-EPS
analysis.
Contradictory Results:
It gives a contradictory result where under different alternative financing plans new equity shares
are not taken into consideration. Even the comparison becomes difficult if the number of
alternatives increase and sometimes it also gives erroneous result under such situation.
Over-capitalization:
This analysis cannot determine the state of over-capitalization of a firm. Beyond a certain point,
additional capital cannot be employed to produce a return in excess of the payments that must be
made for its use. But this aspect is ignored in EBIT-EPS analysis.

46
Problem (1).Ankim Ltd., has an EBIT of Rs 3, 20,000. Its capital structure is given as under:

Indifference Points:
The indifference point, often called as a breakeven point, is highly important in financial
planning because, at EBIT amounts in excess of the EBIT indifference level, the more heavily
levered financing plan will generate a higher EPS. On the other hand, at EBIT amounts below
the EBIT indifference points the financing plan involving less leverage will generate a higher
EPS.
i. Concept:
Indifference points refer to the EBIT level at which the EPS is same for two alternative financial
plans. According to J. C. Van Home, ‘Indifference point refers to that EBIT level at which EPS
remains the same irrespective of debt equity mix’. The management is indifferent in choosing
any of the alternative financial plans at this level because all the financial plans are equally
desirable. The indifference point is the cut-off level of EBIT below which financial leverage is
disadvantageous. Beyond the indifference point level of EBIT the benefit of financial leverage
with respect to EPS starts operating.
The indifference level of EBIT is significant because the financial planner may decide to take the
debt advantage if the expected EBIT crosses this level. Beyond this level of EBIT the firm will
be able to magnify the effect of increase in EBIT on the EPS.

47
In other words, financial leverage will be favorable beyond the indifference level of EBIT and
will lead to an increase in the EPS. If the expected EBIT is less than the indifference point then
the financial planners will opt for equity for financing projects, because below this level, EPS
will be more for less levered firm.
ii. Computation:
We have seen that indifference point refers to the level of EBIT at which EPS is the same for two
different financial plans. So the level of that EBIT can easily be computed. There are two
approaches to calculate indifference point: Mathematical approach and graphical approach.
Mathematical Approach:
Under the mathematical approach, the indifference point may be obtained by solving equations.
Let us present the income statement given in Table 5.1 with the following symbols in Table 5.4.
We are starting from EBIT only.

Where, N represents number of equity shares.

In case of financing, three types of sources may be opted: Equity, debt and preference shares. So
we may have four possible combinations Equity, Equity-Debt, Equity- Preference Shares and
Equity- Debt-Preference Shares.
So, EPS under various alternatives will be as follows:

Note:
The symbols have their usual meaning.

48
The indifference point between any two financial plans may be obtained by equalizing the
respective equations of EPS and solving them to find the value of X.

Problem 2
Debarathi Co. Ltd., is planning an expansion programme. It requires Rs 20 lakhs of external
financing for which it is considering two alternatives. The first alternative calls for issuing
15,000 equity shares of Rs 100 each and 5,000 10% Preference Shares of Rs 100 each; the
second alternative requires 10,000 equity shares of Rs 100 each, 2,000 10% Preference Shares of
Rs 100 each and Rs 8,00,000 Debentures carrying 9% interest. The company is in the tax bracket
of 50%. You are required to calculate the indifference point for the plans and verify your answer
by calculating the EPS.
Solution:

Graphical Approach:
The indifference point may also be obtained using a graphical approach. In Figure 5.1 we have
measured EBIT along the horizontal axis and EPS along the vertical axis. Suppose we have two
financial plans before us: Financing by equity only and financing by equity and debt. Different
combinations of EBIT and EPS may be plotted against each plan. Under Plan-I the EPS will be
zero when EBIT is nil so it will start from the origin.
The curve depicting Plan I starts from the origin. For Plan-II EBIT will have some positive
figure equal to the amount of interest to make EPS zero. So the curve depicting Plan-II will start
from the positive intercept of X axis. The two lines intersect at point E where the level of EBIT

49
and EPS both are same under both the financial plans. Point E is the indifference point. The
value corresponding to X axis is EBIT and the value corresponding to 7 axis is EPS.
These can be found drawing two perpendiculars from the indifference point—one on X axis and
the other on Taxis. Similarly we can obtain the indifference point between any two financial
plans having various financing options. The area above the indifference point is the debt
advantage zone and the area below the indifference point is equity advantage zone.
Above the indifference point the Plan-II is profitable, i.e. financial leverage is advantageous.
Below the indifference point Plan I is advantageous, i.e. financial leverage is not profitable. This
can be found by observing Figure 5.1. Above the indifference point EPS will be higher for same
level of EBIT for Plan II. Below the indifference point EPS will be higher for same level of
EBIT for Plan I. The graphical approach of indifference point gives a better understanding of
EBIT-EPS analysis.

Financial Breakeven Point:

In general, the term Breakeven Point (BEP) refers to the point where the total cost line and sales
line intersect. It indicates the level of production and sales where there is no profit and no loss
because here the contribution just equals to the fixed costs. Similarly financial breakeven point is
the level of EBIT at which after paying interest, tax and preference dividend, nothing remains for
the equity shareholders.

50
In other words, financial breakeven point refers to that level of EBIT at which the firm can
satisfy all fixed financial charges. EBIT less than this level will result in negative EPS. Therefore
EPS is zero at this level of EBIT. Thus financial breakeven point refers to the level of EBIT at
which financial profit is nil.

Financial Break Even Point (FBEP) is expressed as ratio with the following equation:

Problem - 3:
A company has formulated the following financing plans to finance Rs 15, 00,000 which is
required for financing a new project.

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Problem – 4
Capital Structure Plan I Plan II Plan III Plan IV
Equity Share of 100
each 10,00,000 5,00,000 5,00,000 2,50,000
12% Preference Share ----- ----- 2,50,000 2,50,000
10% Debt ------ 5,00,000 2,50,000 5,00,000
Total Capital Employed 10,00,000 10,00,000 10,00,000 10,00,000

Particulars Plan I Plan II Plan III Plan IV

EBIT (ROI 25%) 5,00,000 5,00,000 5,00,000 5,00,000
Less: Interest -------- 50,000 25,000 50,000

EBT 5,00,000 4,50,000 4,75,000 4,50,000

Less: Tax (50%) 2,50,000 2,25,000 2,37,500 2,25,000

EAT 2,50,000 2,25,000 2,37,500 2,25,000

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Less: Preference Dividend --------- ---------- 50,000 30,000
Earnings to Equity
Shareholder 2,50,000 2,25,000 1,87,500 1,95,000
Number of shares 10,000 5,000 5,000 2,500
EPS(Rs.) 25 45 41.5 78
In the above example, alternative IV seems to be best alternative with EPS of Rs. 78. The EPS is
Rs. 25 when no debt is used in the capital structure. The EBIT of Rs. 5,00,000 on investment of
RS 10,00,000 turn out to be 50%. After tax ROI will be 25%. But the use of cheaper source of
finance such as debt at 10% cost and preference share at 12% cost will increase earnings per
share. Thus, use of more and more debt or fixed payment capital will lead to increase in EPS to
the shareholders.
Thus, we can conclude the followings:

1. Financial leverage (use of debt) has a favourable impact on the EPS only when ROI is
more than cost of debt (net of tax).
2. The EPS keeps increasing with the use of debt content in the capital structure till ROI is
more than cost of debt.
3. Financial leverage will have unfavourable impact on EPS if ROI is less than cost of debt
at any point of time.
Conclusion
The analysis of the effect of different patterns of financing or the financial leverage on
the level of returns available to the shareholders, under different assumptions of EBIT is known
as EBIT-EPS analysis. A firm has various options regarding the combinations of various sources
to finance its investment activities. The firms may opt to be an all-equity firm (and having no
borrowed funds) or equity-preference firm (having no borrowed funds) or any of the numerous
possibility of combinations of equity, preference shares and borrowed funds. However, for all
these possibilities, the sales level and the level of EBIT is irrelevant as the pattern of financing
does not have any bearing on the sales or the EBIT level. In fact, the sales and the EBIT level
are affected by the investment decisions.
Questions
1. What is meant by EBIT – EPS analysis

53
2. What are the concepts of EBIT & EPS analysis and explain the advantage and limitations
of EBIT and EPS analysis
3. A company having equity share capital of Rs. 4,00,000 divided into shares of Rs. 100
each. The company wants to raise additional fund of Rs. 2,00,000 for its diversification
programme. The company has following alternatives for raising the fund:
Plan I: Issue of 20,000 Equity Shares of 100 each
Plan II: Issue of 20,000 Preference Shares of 100 each
Plan III: Issue of 10% Debentures of Rs. 100 each
The expected current EBIT level of the company in present scenario is Rs. 1,00,000. The
EBIT will change according to general economic conditions as given below:
Good Conditions: EBIT Rs. 1,20,000
Bad Conditions: EBIT Rs. 80,000
Calculate EPS in all the cases and analyse the results.
Assume tax rate of 50%.

54
 Lesson – 8
LEVERAGES
Introduction
Leverage, as a business term, refers to debt or to the borrowing of funds to finance the purchase
of a company's assets. Business ownerscan use either debt or equity to finance or buy the
company's assets. Using debt, or leverage, increases the company's risk of bankruptcy. It also
increases the company's returns; specifically its return on equity. This is true because, if debt
financing is used rather than equity financing, then the owner's equity is not diluted by issuing
more shares of stock.
Meaning
Leverage is a practice which can help a business drive up its gains / losses. In business
language, if a firm has fixed expenses in P/L account or debt in capital structure, the firm is said
to be levered. Nowadays, almost no business is away from it but very few have struck a balance.
TYPES OF LEVERAGE
There is a different basis for classifying business expenses. For our convenience, let us classify
fixed expenses into operating fixed expenses such as depreciation on fixed expenses, salaries etc,
and financial fixed expenses such as interest and dividend on preference shares. Similar to them,
leverages are also of two types – financial and operating.
FINANCIAL LEVERAGE (FL)
It is a leverage created with the help of debt component in the capital structure of a company.
Higher the debt, higher would be the FL because with higher debt comes the higher amount of
interest that needs to be paid. It can be both good and bad for a business depending on the
situation. If a firm is able to generate a higher return on investment (ROI) than the interest rate it
is paying, leverage will have its positive effect shareholder’s return. The darker side is that if the
said situation is opposite, higher leverage can take a business to a worst situation like
bankruptcy.
OPERATING LEVERAGE (OL)
Just like the financial, it is a result of operating fixed expenses. Higher the fixed expense, higher
is the OL. Like the FL had an impact on the shareholder’s return or say earnings per share, OL
directly impacts the operating profits (Profits before Interest and Taxes (PBIT)). Under good

55
economic Conditions, an increase of 1% in sales will have more than 1% change in operating
profits.

COMBINED LEVERAGE (CL )

It means combination if operating and financial leverages. It express the effect of changes on sale
over changes in taxable profit.
Problem 1Calculate the operating financial and combined leverage from the following
information
Sales - 35000
Interest - 2500
Variable costs - 20000
Fixed cost - 10000
Solution
Sales 35000
Less: Variable cost 20000
Contribution 15000
Less: Fixed cost 10000
Operating profit (EBIT) 5000
Less: Interest 2500
Profit before tax (EBIT) 2500

a) Operating Leverage
Contribution / Operating profit (Or) Contribution / EBIT
= 15000/5000 = 3 times
b) Financial Leverage
Operating profit / Profit before tax (Or) EBIT / EBT
=5000/2500 = 2 times
c) Combined Leverage
Operating leverage X Financial Leverage
= 3X2 = 6

Problem 2.A firm has sales of Rs. 10,00,000, variable cost of Rs. 7,00,000 and fixed costs of Rs.
2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are the operating, financial and
combined leverages. If the firm wants to double its earnings before interest and tax (EBIT), how
much of a rise in sales would be needed on a percentage basis?

56
Solution:
Statement of Existing Profit
Sales Rs.10,00,000
Less Variable cost 7,00,000
Contribution 3,00,000
Less fixed cost 2,00,000
EBIT 1,00,000
Less Interest @ 10% on 5,00,000 50,000
Profit after Tax 50,000
Operating leverage Contribution/ EBIT = 3,00,000/1,00,000 = 3
Financial Leverage EBIT/PBT = 1,00,000/50,000 =2
Combined Leverage = 3x 2= 6

Statement of sales needed to double EBIT

Operating Leverage is 3 times i.e. 33 – 1/3% increase in sales volume causes a 100%
increase in operating profit or EBIT. Thus, at the sales of Rs. 13,33,333, operating profit or EBIT
will become Rs. 2,00,000 i.e. double existing one.
Verification:
Sales Rs.13,33,333
Variable cost (70%) 9,33,333
Contribution 4,00,000
Fixed Costs 2,00,000
EBIT 2,00,000

Problem 3The balance sheet of Well Established Company is as follows:

Liabilities Amount Assets Amount
Equity share capital 60,000 Fixed Assets 1,50,000
Retained Earnings 20,000 Current Assets 50,000
10% long term debt 80,000
Current Liabilities 40,000 ------------
2,00,000 2,00,000

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 The company’s total assets turnover ratio is 3, its fixed operating costs are Rs.1,00,000
and its variable operating cost ratio is 40%. The income tax rate is 50%. Calculate the different
types of leverages given that the face value of share is Rs.10.
Solution: Total Assets Turnover Ratio = Sales / Total Assets
3 = Sales/2,00,000
Sales 6,00,000
Variable Operating Cost (40%) 2,40,000
Contribution 3,60,000
Less Fixed Operating Cost 1,00,000
EBIT 2,60,000
Less interest (10% of 80,000) 8,000
PBT 2,52,000
Tax at 50% 1,26,000
PAT 1,26,000
Number of shares 6,000
EPS Rs.21
Degree of Operating Leverage = Contribution/EBIT
= 3,60,000/2,60,000 = 1.38
Degree of Financial leverage = EBIT / PBT
= 2,60,000/2,52,000 = 1.03
Degree of Combined Leverage =1.38 x 1.03 = 1.42
Problem 4: The following information is available for ABC & Co.
EBIT Rs. 11,20,000
Profit before Tax 3,20,000
Fixed Costs 7,00,000
Calculate % change in EPS if the sales are expected to increase by 5%.
Solution: In order to find out the % change in EPS as a result of % change in sales, the
combined leverage should be calculated as follows:
Operating Leverage = Contribution/ EBIT
= Rs.11,20,000 + Rs. 7,00,000/11,20,000
= 1.625

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Financial Leverage = EBIT / Profit before Tax
= Rs. 11,20,000/3,20,000
= 3.5
Combined Leverage = Contribution/ Profit before Tax = OL x FL
= 1.625 x 3.5 = 5.69
The combined leverage of 5.69 implies that for 1% change in sales level, the % change in
EPS would be 5.69% So, if the sales are expected to increase by 5%, then the % increase in EPS
would be 5 x 5.69 = 28.45%.
Problem 5: The data relating to two companies are as given below:
Company A Company B
Capital Rs.6,00,000 Rs.3,50,000
Debentures Rs. 4,00,000 6,50,000
Output (units) per annum 60,000 15,000
Selling price/unit Rs.30 250
Fixed costs per annum 7,00,000 14,00,000
Variable cost per unit 10 75
You are required to calculate the Operating leverage, Financial leverage and Combined Leverage
of two companies.
Solution: Computation of Operating leverage, Financial Leverage and Combined leverage
Company A Company B
Output (units) per annum 60,000 15,000
Selling price/unit Rs.30 250
Sales Revenue 18,00,000 37,50,000
Less variable costs
@ Rs.10 and Rs.75 6,00,000 11,25,000
Contribution 12,00,000 26,25,000
Less fixed costs 7,00,000 14,00,000
EBIT 5,00,000 12,25,000
Less Interest @ 12%
on debentures 48,000 78,000
PBT 4,52,000 11,47,000

59
DOL = Contribution/EBIT 12,00,000/5,00,000 26,25,000/12,25,000
= 2.4 = 2.14
DFL = EBIT/ PBT 5,00,000/4,52,000 12,25,000/11,47,000
1.11 =1.07
DCL = DOL x DFL 2.14 x 1.11 = 2.66 2.14 x 1.07 = 2.2

Problem – 6Following information is taken from the records of a hypothetical company:

Calculate operating leverage under the following situations:

Solution:

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Conclusion
Leverage is the key by which a firm increases its sales. A firm with high sales growth should be
able to obtain more funds initially. Because leverage increases the firm’s earning per share as
well as retained earnings. These high amounts of financial assets provide the firm with the
necessary financial capital to fund future expansionary investment projects. As a result firm’s
financial assets increase. The last result indicates a firm’s ability to obtain financial resources
provides some information about its future growth.
So, in total we can say that Leverage has a great impact on a company’s performance and
growth. But the firms should use leverage considering its capability of taking risk.
Questions
1. Distinguish between operating leverage and financial leverage. How the two leverages
can be measured?

2. Explain the concept of financial leverage. Examine the impact of financial leverage on
the EPS. Does the financial Leverage always increases the EPS?

3. From the following details calculate leverages

Production (units) - 3,00,000
Fixed cost Rs. 3,50,000
Variable cost (pu) – Rs. 1
Interest Expenses Rs. 1,50,000
Selling price (pu) Rs. 3
4. The installed capacity of a factor is 600 units. Actual capacity used is 400 units. Selling
price pu. Is Rs. 10. Variable cost is Rs. 6 pu. Calculate operating leveraged in each case
of the following
3 – situations
1. When fixed cost are Rs. 400
2. When fixed cost are Rs.1000
3. When fixed cost are Rs.1200
5. Calculate leverages under situations A, B &C and financial plans I, II, & III respectively
from the following information relating to the operating and capital structure of XYZ
co., also find out the combination of operating and financial leverages which give the

61
highest vale and least value. How are these calculations useful to financial manner in a
company?
Installed capacity 1200 units
Actual production & sales 800 units
Selling price p.u Rs. 15
Variable cost p.u Rs. 10
Fixed cost :
Situations A: Rs. 1000
Situations B : Rs. 2000
Situations C : Rs. 3,000
Financial plan
Capital structure I II III
Equity 5000 7500 2500
Debenture 5000 2500 7500
Cost of debt is 12%

62
 UNIT –III
Lesson – 9
INVESTMENT AND CAPITAL STRUCTURE DECISION

INTRODUCTION

The word Capital refers to be the total investment of a company of firm in money, tangible
and intangible assets. Whereas budgeting defined by the “Rowland and William” it may be said
to be the art of building budgets. Budgets are a blue printof aplan and action expressed in
quantities and manners. Investment decision is the process of making investment decisions in
capital expenditure. A capital expenditure may be defined as an expenditure the benefits of
which are expected to be received over period of time exceeding one year. The main
characteristic of a capital expenditure is that the expenditure is incurred at one point of time
whereas benefits of the expenditure are realized at different points of time in future. The
examples of capital expenditure:
 Purchase of fixed assets such as land and building, plant and machinery, good will, etc.
 The expenditure relating to addition, expansion, improvement and alteration to the fixed
assets.
 The replacement of fixed assets.
 Research and development project.
CAPITAL STRUCTURE
Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term sources such as equity shares,
preference shares, debentures, long-term loans and retained earnings. The term capital structure
refers to the relationship between the various long-term sources financing such as equity capital,
preference share capital and debt capital. Deciding the suitable capital structure is the important
decision of the financial management because it is closely related to the value of the firm.
Capital structure is the permanent financing of the company represented primarily by long-term
debt and equity.
DEFINITON OF CAPITAL STRUCTURE
 According to the definition of Gerestenbeg, “Capital Structure of a company refers to the
composition or make up of its capitalization and it includes all long-term capital
resources”.

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  According to the definition of James C. Van Horne, “The mix of a firm’s permanent long-
term financing represented by debt, preferred stock, and common stock equity”.
 According to the definition of Persona Chandra, “The composition of a firm’s financing
consists of equity, preference, and debt”.
FINANCIAL STRUCTURE

The term financial structure is different from the capital structure. Financial structure shows the
pattern total financing. It measures the extent to which total funds are available to finance the
total assets of the business. Financial Structure = Total liabilities
OPTIMUM CAPITAL STRUCTURE
Optimum capital structure is the capital structure at which the weighted average cost of capital is
minimum and thereby the value of the firm is maximum. Optimum capital structure may be
defined as the capital structure or combination of debt and equity that leads to the maximum
value of the firm.
Objectives of Capital Structure Decision of capital structure aims at the following two
important objectives:
 Maximize the value of the firm.
 Minimize the overall cost of capital.
Forms of Capital Structure Capital structure pattern varies from company to company and the
availability of finance.
 Equity shares only.
 Equity and preference shares only.
 Equity and Debentures only.
 Equity shares, preference shares and debentures.

CAPITAL STRUCTURE THEORIES

Capital structure is the major part of the firm’s financial decision which affects the value of the
firm and it leads to change EBIT and market value of the shares. There is a relationship among
the capital structure, cost of capital and value of the firm. The aim of effective capital structure is
to maximize the value of the firm and to reduce the cost of capital. There are two major theories
explaining the relationship between capital structure, cost of capital and value of the firm.

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NET INCOME (NI) APPROACH
Net income approach suggested by the Durand. According to this approach, the capital structure
decision is relevant to the valuation of the firm. In other words, a change in the capital structure
leads to a corresponding change in the overall cost of capital as well as the total value of the
firm. According to this approach, use more debt finance to reduce the overall cost of capital and
increase the value of firm.
Net income approach is based on the following three important assumptions:
 There are no corporate taxes.
 The cost debt is less than the cost of equity.
 The use of debt does not change the risk perception of the investor.
Where V = S+B
V = Value of firm S = Market value of equity B = Market value of debt Market value of the
equity can be ascertained by the following formula:
S = NI/K e
NI = Earnings available to equity shareholder capitalization rate
Ke = Cost of equity/equity
TRADITIONAL APPROACH
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as intermediate approach. According to the traditional approach, mix of debt and equity
capital can increase the value of the firm by reducing overall cost of capital up to certain level of
debt. Traditional approach states that the Ko decreases only within the responsible limit of
financial leverage and when reaching the minimum level, it starts increasing with financial
leverage. Assumptions Capital structure theories are based on certain assumption to analysis in a
single and convenient manner:
 There are only two sources of funds used by a firm; debt and shares.
 The firm pays 100% of its earning as dividend.
 The total assets are given and do not change.
 The total finance remains constant.
 The operating profits (EBIT) are not expected to grow.
 The business risk remains constant.
 The firm has a perpetual life.

65
  The investors behave rationally.
MODIGLIANI AND MILLER APPROACH
Modigliani and Miller approach states that the financing decision of a firm does not affect the
market value of a firm in a perfect capital market. In other words MM approach maintains that
the average cost of capital does not change with change in the debt weighted equity mix or
capital structures of the firm.
Modigliani and Miller approach is based on the following important assumptions:
 There is a perfect capital market.
 There are no retained earnings.
 There are no corporate taxes.
 The investors act rationally.

 The dividend payout ratio is 100%.

 The business consists of the same level of business risk.
Value of the firm can be calculated with the help of the following formula:
V=EBIT/ K (l-t)
NET INCOME (NI) APPROACH
Net income approach suggested by the Durand. According to this approach, the capital structure
decision is relevant to the valuation of the firm. In other words, a change in the capital structure
leads to a corresponding change in the overall cost of capital as well as the total value of the
firm. According to this approach, use more debt finance to reduce the overall cost of capital and
increase the value of firm.
Net income approach is based on the following three important assumptions:
 There are no corporate taxes.
 The cost debt is less than the cost of equity.
 The use of debt does not change the risk perception of the investor.
Where V = S+B
V = Value of firm S = Market value of equity B = Market value of debt Market value of the
equity can be ascertained by the following formula:
S = NI/K e
NI = Earnings available to equity shareholder capitalization rate
Ke = Cost of equity/equity

66
TRADITIONAL APPROACH
It is the mix of Net Income approach and Net Operating Income approach. Hence, it is also
called as intermediate approach. According to the traditional approach, mix of debt and equity
capital can increase the value of the firm by reducing overall cost of capital up to certain level of
debt. Traditional approach states that the Ko decreases only within the responsible limit of
financial leverage and when reaching the minimum level, it starts increasing with financial
leverage. Assumptions Capital structure theories are based on certain assumption to analysis in a
single and convenient manner:
 There are only two sources of funds used by a firm; debt and shares.
 The firm pays 100% of its earning as dividend.
 The total assets are given and do not change.
 The total finance remains constant.
 The operating profits (EBIT) are not expected to grow.
 The business risk remains constant.
 The firm has a perpetual life.
 The investors behave rationally.
MODIGLIANI AND MILLER APPROACH
Modigliani and Miller approach states that the financing decision of a firm does not affect the
market value of a firm in a perfect capital market. In other words MM approach maintains that
the average cost of capital does not change with change in the debt weighted equity mix or
capital structures of the firm.
Modigliani and Miller approach is based on the following important assumptions:
 There is a perfect capital market.
 There are no retained earnings.
 There are no corporate taxes.
 The investors act rationally.

 The dividend payout ratio is 100%.

 The business consists of the same level of business risk.
Value of the firm can be calculated with the help of the following formula:
V=EBIT/ K (l-t)

67
 I. NI Approaches
Problem – 1 Excellent Manufacturing Company expects to earn net operating income of Rs. 1,
50,000 annually. The Company has Rs. 6.00,000 8% debentures. The cost of equity capital of the
Company is 10%. What would be the value of Company? Also calculate overall cost of capital.
Solution:

II. NOI Approaches

Problem – 2
Canon Manufacturing Company has annual net operating income of Rs. 150000. The Company
has Rs. 6,00,000 8% debentures. The overall cost of capital of the Company is 10%. What would
be the value of the Company?
Solution:
Value of Canon Company has been computed as below:

68
 III. Traditional approaches
Problem – 3Sneh Steel Ltd. is expecting a net operating income of Rs. 3,00,000 on a total
investment of Rs. 20,00,000. The equity capitalization rate is 10 percent, the firm has no debt;
but it would increase to 11 percent when the firm substitutes equity capital by issuing debentures
of Rs. 6,00,000 and to 12.5 percent when debentures of Rs. 10,00,000 are issued to substitute
equity capital.The management expects that it will have to pay interest @ 5% to raise an
additional debt of Rs. 6,00,000 and @ 7% to raise an additional debt of Rs. 10,00,000. What
would be the overall cost of capital and market value of the firm under the Traditional
Approach?

Solution:

IV. MM Approaches
Problem 4 Two firms A and B falling in the identical risk class have net operating income of Rs.
2,00,000 each. Firm A is an unlevered concern having all equity but Firm B is levered concern as
it has Rs. 10,00,000 of 10% bonds outstanding. The equity capitalization rate of firm A is 12.5%
and of firm B is 16.0%.

69
Solution:

Conclusion
Capital structure decision is believed to play an important role in maximizing the value of a firm.
By having the most optimal capital structure, firms might be able to push its cost to the minimum
point, which then will help them in dealing with the competitive environment. Throughout this
research, the interest-bearing debt to total assets ratio was used to measure the level of leverage
of a firm. This ratio was then used to find out the relationship between leverage and several
factors that are deemed to have influence on capital structure, which are profitability, size, and
dividend payout
Questions:
1. What is capital structure?
2. Define capital structure
3. Define finance structure
4. What is optimum capital structure?
5. What are the objects of capital structure?
6. Explain the theories of capital structure.

70
7. X ltd expecting an annual EBIT of Rs. 1,00,000. The com., has Rs. 4,00,000 in 10%
debenture. The cost of equity capitalization rate is 12.5%. you are require to calculate
total value of the firm ad state overall cost of capital .
8. Z ltd., is an EBIT of Rs. 1,00,000. The cost of debt. Is 10% at outstanding debt amount to
Rs. 4,00,000. The overall cost of capital is 12.5%. Calculate total value of the firm and
equity capitalization rate.
9. The cargo co., ltd has an EBIT of Rs. 2,50,000. It has 6% Rs. 5,00,00 debenture. The
equity capitalization rate is 12.5%. you are require to calculate total market value of the
firm and overall capitalization rate and debt equity ratio.
10. In considering the most desirable capital structure for a co., the following the cost of debt
equity capital (After tax) has been made various levels of debt equity mix.
Debt as % total capital employed Cost of debt cost of equity
(%) (%)
0 5.0 12.0
10 5.0 12.0
20 5.0 12.5
30 5.5 13.0
40 6.0 14.0
50 6.5 16.0
60 7.0 20.0
You are require to determine the optimal debt equity mix for the com., by
calculating composite cost of capital.

71
 Lesson – 10
CAPITAL BUDGETING
Introduction
The process through which different projects are evaluated is known as capital budgeting.
Capital budgeting is defined “as the firm’s formal process for the acquisition and investment of
capital. It involves firm’s decisions to invest its current funds for addition, disposition,
modification and replacement of fixed assets”.
DEFINITION
Capital budgeting (investment decision) as, “Capital budgeting is long term planning for making
and financing proposed capital outlays.” - Charles T.Horngreen
“Capital budgeting consists in planning development of available capital for the purpose of
maximizing the long term profitability of the concern”– Lynch
“Capital budgeting is concerned with the allocation of the firm source financial resources among
the available opportunities. The consideration of investment opportunities involves the
comparison of the expected future streams of earnings from a project with the immediate and
subsequent streams of earning from a project, with the immediate and subsequent streams of
expenditure”. -G.C. Philippatos
NEED AND IMPORTANCE OF CAPITAL BUDGETING
 Huge investments: Capital budgeting requires huge investments of funds, but
theavailable funds are limited, therefore the firm before investing projects, plan are
control its capital expenditure.
 Long-term: Capital expenditure is long-term in nature or permanent in nature.Therefore
financial risks involved in the investment decision are more. If higher risks are involved,
it needs careful planning of capital budgeting.
 Irreversible: The capital investment decisions are irreversible, are not changed
back.Once the decision is taken for purchasing a permanent asset, it is very difficult to
dispose of those assets without involving huge losses.
 Long-term effect: Capital budgeting not only reduces the cost but also increases
therevenue in long-term and will bring significant changes in the profit of the company
by avoiding over or more investment or under investment. Over investments leads to be

72
 unable to utilize assets or over utilization of fixed assets. Therefore before making the
investment, it is required carefully planning and analysis of the project thoroughly.
CAPITAL BUDGETING PROCESS
Capital budgeting is a complex process as it involves decisions relating to the investment of
current funds for the benefit to the achieved in future and the future is always uncertain.
However the following procedure may be adopted in the process of capital budgeting:

Step 1 and 2 = Project generation

Step 3 = Project evaluation
Step 4 & 5 = Project Selection
Step 6 = Project execution

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PROJECT GENERATION
Identification of Investment Proposals:
The capital budgeting process begins with the identification of investment proposals. The
proposal or the idea about potential investment opportunities may originate from the top
management or may come from the rank and file worker of any department or from any officer
of the organization. The departmental head analyses the various proposals in the light of the
corporate strategies and submits the suitable proposals to the capital expenditure planning
committee in case of large organizations or to the officers concerned with the process of long-
term decisions.
Screening the Proposals:
The expenditure planning committee screens the various proposals received from different
departments. The committee views these proposals from various angels to ensure that these are
in accordance with the corporate strategies or a selection criterion’s of the firm and also do not
lead to departmental imbalances.
PROJECT EVALUATION
Evaluation of Various Proposals:
The next step in the capital budgeting process is to evaluate the profitability of various proposals.
There are many methods which may be used for this purpose such as payback period method,
rate of return method, net present value method, internal rate of return method etc. All these
methods of evaluating profitability of capital investment proposals have been discussed in detail
separately in the following pages of this chapter.
It should, however, be noted that the various proposals to the evaluated may be classified as:
 Independent proposals
 Contingent or dependent proposals and
 Mutually exclusive proposals.
Independent proposals are those which do not compete with one another and the same may be
either accepted or rejected on the basis of a minimum return on investment required. The
contingent proposals are those whose acceptance depends upon the acceptance of one or more
other proposals, e.g., further investment in building or machineries may have to be undertaken as
a result of expansion programmed. Mutually exclusive proposals are those which compete with
each other and one of those may have to be selected at the cost of the other.

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PROJECT SELECTION
Fixing Priorities:
After evaluating various proposals, the unprofitable or uneconomic proposals may be rejected
straight ways. But it may not be possible for the firm to invest immediately in all the acceptable
proposals due to limitation of funds. Hence, it is very essential to rank the various proposals and
to establish priorities after considering urgency, risk and profitability involved therein.
Final Approval and Preparation of Capital Expenditure Budget:
Proposals meeting the evaluation and other criteria are finally approved to be included in the
Capital expenditure budget. However, proposals involving smaller investment may be decided at
the lower levels for expeditious action. The capital expenditure budget lays down the amount of
estimated expenditure to be incurred on fixed assets during the budget period.
PROJECT EXECUTION
Implementing Proposal:
Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the
budget does not itself authorize to go ahead with the implementation of the project. A request for
authority to spend the amount should further be made to the Capital Expenditure Committee
which may like to review the profitability of the project in the changed circumstances.
Further, while implementing the project, it is better to assign responsibilities for completing the
project within the given time frame and cost limit so as to avoid unnecessary delays and cost
over runs. Network techniques used in the project management such as PERT and CPM can also
be applied to control and monitor the implementation of the projects.
Performance Review:
The last stage in the process of capital budgeting is the evaluation of the performance of the
project. The evaluation is made through post completion audit by way of comparison of actual
expenditure of the project with the budgeted one, and also by comparing the actual return from
the investment with the anticipated return. Theunfavorable variances, if any should be looked
into and the causes of the same are identified so that corrective action may be taken in future.
DEVOLOPING CAH FLOW DATA (cash inflow and cash outflow)
Before we can compute a project’s value, we must estimate the cash flows both current and
future associated with it. We therefore begin by discussing cash flow estimation, which is the
most important and perhaps the most difficult, step in the analysis of a capital project. The

75
process of cash flow estimation is problematic because it is difficult to accurately forecast the
costs and revenues associated with large, complex projects that are expected to affect operations
for long periods of time.

Calculation of cash inflow

Sales xxxx

Less: Cash expenses xxxx

PBDT xxxx

Less: Depreciation xxxx

PBT xxxx

less: Tax xxxx

PAT xxxx

Add: Depreciation xxxx

Cash inflow p.a xxxx

Calculation of cash outflow

Cost of project/asset xxxx

Transportation/installation charges xxxx

Working capital xxxx

Cash outflow xxxx

CAPITAL BUDGETING TECHNIQUES

At each point of time a business firm has a number of proposals regarding various projects in
which it can invest funds. But the funds available with the firm are always limited and it is not
possible to invest funds in all the proposals at a time. Hence, it is very essential to select from
amongst the various competing proposals, those which give the highest benefits. The crux of the
capital budgeting is the allocation of available resources to various proposals.There are many

76
methods of evaluating profitability of capital investment proposals. The various commonly used
methods are as follows:
Traditional methods:
 Pay-back Period Method or Pay out or Pay off Method.
 Improvement of Traditional Approach to pay back Period Method. (post payback
method)
 Accounting or Average Rate of Return Method.
Time-adjusted method or discounted methods:

 Net Present Value Method.

 Internal Rate of Return Method.
 Profitability Index Method.

TRADITIONAL METHODS:

PAY-BACK PERIOD METHOD

The ‘pay back’ sometimes called as pay out or pay off period method represents the period in
which the total investment in permanent assets pays back itself. This method is based on the
principle that every capital expenditure pays itself back within a certain period out of the
additional earnings generated from the capital assets Under this method, various investments are
ranked according to the length of their payback period in such a manner that the investment

77
within a shorter payback period is preferred to the one which has longer pay back period. (It is
one of the non-discounted cash flow methods of capital budgeting).
EQUAL INFLOW

UNEQUAL INFLOW=Cumulative value + Need amount x12

Next year cash inflow
MERITS
The following are the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement over the accounting rate return.
3. Pay-back method reduces the possibility of loss on account of obsolescence.

DEMERITS
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
3. It is one of the misleading evaluations of capital budgeting.

POST PAY-BACK PROFITABILITY METHOD:

One of the serious limitations of Pay-back period method is that it does not take into account the
cash inflows earned after pay-back period and hence the true profitability of the project cannot
be assessed. Hence, an, improvement over this method can be made by taking into account the
return receivable beyond the pay-back period.
Post pay-back profitability =Cash inflow (Estimated life – Pay-back period) Post pay-
back profitability index= Post pay-back profitability/original investment
AVERAGE RATE OF RETURN:
This method takes into account the earnings expected from the investment over their whole life.
It is known as accounting rate of return method for the reason that under this method, the
Accounting concept of profit (net profit after tax and depreciation) is used rather than cash
inflows. According to this method, various projects are ranked in order of the rate of earnings or
rate of return. The project with the higher rate of return is selected as compared to the one with

78
lower rate of return. This method can also be usedto make decision as to accepting or rejecting a
proposal. Average rate of return means the average rate of return or profit taken for considering.
a) Average Rate of Return Method (ARR):

Under this method average profit after tax and depreciation is calculated and then it is divided by
the total capital outlay or total investment in the project. This method is one of the traditional
methods for evaluating
The project proposals
ARR = (Total profits (after dept. & taxes))/ (Net Investment in the project X No. of
years of profits) x 100
OR
ARR = (Average Annual profits)/ (Net investment in the project) x 100

(b) Average Return on Average Investment Method:

This is the most appropriate method of rate of return on investment Under this method, average
profit after depreciation and taxes is divided by the average amount of investment; thus:

Average Return on Average Investment = (Average Annual Profit after depreciation and
taxes)/ (Average Investment) x 100
Merits
 It is easy to calculate and simple to understand.

 It is based on the accounting information rather than cash inflow.

 It is not based on the time value of money.

 It considers the total benefits associated with the project.

Demerits
 It ignores the time value of money.
 It ignores the reinvestment potential of a project.
 Different methods are used for accounting profit. So, it leads to some difficulties in the
calculation of the project.

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TIME – ADJUSTED OR DISCOUNTED CASH FLOW METHODS:
MODERN METHOD
The traditional methods of capital budgeting i.e. pay-back method as well as accounting rate of
return method, suffer from the serious limitations that give equal weight to present and future
flow of incomes. These methods do not take into consideration the time value of money, the fact
that a rupee earned today has more value than a rupee earned after five years.
NET PRESENT VALUE
Net present value method is one of the modern methods for evaluating the project proposals. In
this method cash inflows are considered with the time value of the money. Net present value
describes as the summation of the present value of cash inflow and present value of cash
outflow. Net present value is the difference between the total present values of future cash
inflows and the total present value of future cash outflows.

NPV = Total Present value of cash inflows – Net Investment

If offered an investment that costs Rs.5,000 today and promises to pay you Rs.7,000 two years
from today and if your opportunity cost for projects of similar risk is 10%, would you make this
investment? You
Need to compare your Rs.5,000 investment with the Rs.7,000 cash flow you expect in two years.
Because you feel that a discount rate of 10% reflects the degree of uncertainty associated with
the Rs.7,000 expected in two years, today it is worth:

By investing Rs.5,000 today, you are getting in return a promise of a cash flow in the future that
is worth Rs.5,785.12 today. You increase your wealth by Rs.785.12 when you make this
investment.

Merits
 It recognizes the time value of money.
 It considers the total benefits arising out of the proposal.
 It is the best method for the selection of mutually exclusive projects.
 It helps to achieve the maximization of shareholders’ wealth.

Demerits

80
  It is difficult to understand and calculate.
 It needs the discount factors for calculation of present values.
 It is not suitable for the projects having different effective lives.
PROFITABILITY INDEX METHOD
The profitability index (PI) is the ratio of the present value of change in operating cash inflows to
the present value of investment cash outflows:

Instead of the difference between the two present values, as in equation PI is the ratio of the two
present values. Hence, PI is a variation of NPV. By construction, if the NPV is zero, PI is one.

INTERNAL RATE OF RETURN METHOD

This method is popularly known as time adjusted rate of return method/discounted rate of return
method also. The internal rate of return is defined as the interest rate that equates the present
value of expected future receipts to the cost of the investment outlay. This internal rate of return
is found by trial and error. First we compute the present value of the cash-flows from an
investment, using an arbitrarily elected interest rate. Then we compare the present value so
obtained with the investment cost. If the present value is higher than the cost figure, we try a
higher rate of interest and go through the procedure again. Conversely, if the present value is
lower than the cost, lower the interest rate and repeat the process. The interest rate that brings
about this equality is defined as the internal rate of return. This rate of return is compared to the
cost of capital and the project having higher difference, if they are mutually exclusive, is adopted
and other one is rejected. As the determination of internal rate of return involves a number of
attempts to make the present value of earnings equal to the investment, this approach is also
called the Trial and Error Method. Internal rate of return is time adjusted technique and covers
the disadvantages of the Traditional techniques. In other words it is a rate at which discount cash
flows to zero. It is expected by the following ratio

Base factor = Positive discount rate

DP = Difference in percentage

Merits
 It considers the time value of money.

81
  It takes into account the total cash inflow and outflow.
 It does not use the concept of the required rate of return.
 It gives the approximate/nearest rate of return.

Demerits
 It involves complicated computational method.
 It produces multiple rates which may be confusing for taking decisions.

 It is assume that all intermediate cash flows are reinvested at the internal rate of return.

NPV is calculated in terms of currency while IRR is expressed in terms of the

percentage return a firm expects the capital project to return;
 Academic evidence suggests that the NPV Method is preferred over other methods
since it calculates additional wealth and the IRR Method does not
 The IRR Method cannot be used to evaluate projects where there are changing cashflows
(e.g., an initial outflow followed by in-flows and a later out-flow, such as may berequired
in the case of land reclamation by a mining firm)
 However, the IRR Method does have one significant advantage -- managers tend to
better understand the concept of returns stated in percentages and find it easy to compare
to the required cost of capital; and, finally,
 While both the NPV Method and the IRR Method are both DCF models and can even
reach similar conclusions about a single project, the use of the IRR Method can lead to
the belief that a smaller project with a shorter life and earlier cash inflows is preferable
to a larger project that will generate more cash.
 Applying NPV using different discount rates will result in different
recommendations. The IRR method always gives the same recommendation.
 The Adjusted Present Value (APV)Method is a flexible DCF method that takes into
account interest related tax shields; it is designed for firms with active debt and a
consistent market value leverage ratio.
 The Profitability Index (PI) Method, which is modeled after the NPV Method, is
measured as the total present value of future net cash inflows divided by the initial
investment; this method tends to favor smaller projects and is best used by firms with
limited resources and high costs of capital.

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 The Bailout Payback Method, which is a variation of the Payback Method, includes the salvage
value of any equipment purchased in its calculations
The Real Options Approach allows for flexibility, encourages constant reassessment based on
the riskiness of the project's cash flows and is based on the concept of creating a list of value-
maximizing options to choose projects from; management can, and is encouraged, to react to
changes that might affect the assumptions that were made about each project being considered
prior to its commencement, including postponing the project if necessary; it is noteworthy that
there is not a lot of support for this method among financial managers at this time.

PAYBACK PERIOD
S. Advantages S. Disadvantages
No No
1. Simple to compute 1. No concrete decision criteria to tell us
whether an investment increases the
firm’s value
2. Provides some information on the risk of the 2. Ignores cash flows beyond the payback
investment period
3. Provides a crude measure of liquidity 3. Ignores the time value of money
4. 4. Ignores the riskiness of future cash
flows

DISCOUNT PAY BACK PERIOD

S.No Advantages S.No Disadvantages

1. 1.
Considers the time value of money No concrete decision criteria that tell us
whether the investment increases the firm’s
value
2. 2.
Considers the riskiness of the cash flows Calls for a cost of capital
involved in the payback
3. Ignores cash flow beyond the payback period.

Payback period method

1. If the annual cash inflows are uniform. The payback period can be computed by dividing
cash outlay by annual cash inflows. A project costs Rs. 200000 and yields annual cash
inflow of Rs. 40000 for 7 years.

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Solution
Payback Period = Initial investment / Annual cash inflow
= 200000 / 40000
= 5 year.

2. Calculate payback period for a project which requires a cash outlay Rs. 50000 and
generates cash inflows of 20000 Rs. 10000, Rs. 30000 and 10000.

Year Cash inflows Cumulative cash

inflow
1 20000 20000
2 10000 30000
3 30000 60000
4 10000 70000
Payback period = 2 years 8 months
Time required = 20000 x 12 / 30000
= 8 month
Payback period = 2 years 8 months.
3. A project cost Rs. 100000 and yields annually a profit Rs. 20000 after depreciation at
10% p.a but before tax of 50. Calculate payback period.
Pay back period = Initial investment / Annual cash inflow
Initial investment = 100000
Annual cash inflow = Profit after tax plus depreciation

Profit before tax = 20000

Less: Tax 50% = 10000

Profit after tax = 10000

Add: Depreciation
(100000 x 10 /100) = 10000

20000

Payback period = 100000 / 20000 = 5 years.

II Net present value method

1. Project X initially costs Rs.25,000. It generates the following cash inflows

Year Cash in flows Present value of Rs.1/- @ 10%
1 9000 0.909
2 8000 0.826
3 7000 0.751
4 6000 0.683
5 5000 0.621

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Solution:
Year Cash in flows Present value of Rs.1/- @ 10% Present value of Cash in flow
1 9,000 0.909 8181
2 8,000 0.826 6608
3 7,000 0.751 5257
4 6,000 0.683 4098
5 5,000 0.621 3105
Total present value of cash inflow 27,249
(-) Total present value or cash outflow 25,000
Net Present Value (NPV) 2,249
This project is accepted

2. The following are the cash inflows and outflows of a certain project
Year Out flows Inflows
0 1,50,000 -
1 30,000 30,000
2 - 30,000
3 - 50,000
4 - 60,000
5 - 40,000

The step value at the end of 5 years is Rs.40,000. Taking the cut off rate as 10%.
Calculate Net Present Value
Year 1 2 3 4 5
P.r of @ rate 0.909 0.826 0.751 0.683 0.621
10%

Solution:
Year Inflows P.Vl.F @ 10% Present value of
cash inflows
0 - 0.909 27,270
1 30,000 0.826 24,780
2 30,000 0.751 37,550
3 50,000 03683 40,980
4 60,000 0.621 24,840
5 40,000 0.621 24,840
Total Present Value of Cash inflows 1,80,260
(-) Total Present Value of cash outflow 1,77,270
(1,50,000+(30,000 X 0.909)
(1,50,000+27,270)
Net Present Value 2,990

This project is recommended

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 3. A limited company is considering investing in a project requiring a capital outlay of Rs.
2,00,000.. forecast of annual income after depreciation but befor tax is as follows:
Year Rs.
1 1,00,000
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.
Calculate:
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
Solution
a. Pay back method
Statement of cash inflow (Rs. In ‘000)

Year Profit Tax at Profit Depreciation Cash Cumulative

50% after tax inflows cash
inflows
1 100 50 50 40 90 90
2 100 50 50 40 90 180
3 80 40 40 40 80 260
4 80 40 40 40 80 340
5 40 20 20 40 60 400
Pay backperiod Rs. 1,80,000 is recovered in 2 years. The balance of Rs. 20,000 will be
recovered in 20,000/80,000 X 1 = 0.25 year. Hence, pay back period is 2.25 years or 2
years and 3 months.

b. Rate of return on Original investment method

Year Net profit after tax and depreciation
1 50,000
2 50,000
3 40,000
4 40,000
5 20,000
Total profits 2,00,000
Average Annual profits = 2,00,000 /5 = 40,000
Rate of return = 40,000/2,00,000 X 100 = 20%
c. Rate of return on average investment method
= 40,000/1,00,000 X 100 = 40%
d. Discounted cash flow method

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 Year Cash inflows Discount factor @ Present value
10% Rs.
1 Rs. 90,000 0.909 81,810
2 90,000 0.826 74,340
3 80,000 0.751 60,080
4 80,000 0.683 54,640
5 60,000 0.621 37,260
Present value of cash inflows 3,08,130
Less: Initial investment 2,00,000
Net present value 1,08,130

e. Excess present value index

= Total present value of cash inflows / Total present value of cash outflows X 100
= 3,08,130 /2,00,000 X 100 = 154%

4. Internal rate of return

1. Initial outlay Rs. 50,000
Life of the asset 5 Years
Estimated cash flow Rs. 12,500
Calculate Internal Rate of Return
Solution
Present value factor = Initial investment / Annual cash inflow = 50,000/12,500 = 4
The present value factor is to be located in the present value annuity table in the column
of 5 years ( life of the asset). The figure 3.9927 (nearest to 4) is found in the row of 8%. Hence
Internal Rate of return is 8%.

Conclusion
All businesses need to maintain a safe level of cash to enable them to carry on business activities.
The managers of a business need to determine that safe level. The cash budget is then prepared
by taking into consideration, that safe level of cash. Thus, if a cash shortage is expected during a
period, a plan is made to borrow cash.
Questions:
1. Define capital budgeting
2. State the need and importance if capital budgeting.
3. What are the process of capital budgeting
4. Explain the techniques of capital budgeting
5. What is NPV?
6. What is payback period? State the advantages and limitations
7. Explain profitability index method?

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8. What is IRR?
9. Does the following project have a positive or negative rate of return? Show how this is
known to be true. Investment Cost Rs.2,500 Net Benefits Rs 300 in Year 1, increasing by
Rs 200 per year Salvage Rs. 50 Useful Life 4 year
10. ABC and Co. is considering a proposal to replace one of its plants costing Rs. 60,000 and having a written
down value of Rs. 24,000. The remaining economic life of the plant is 4 years after which it will have no
salvage value. However, if sold today, it has a salvage value of Rs. 20,000. The new machine costing Rs.
1,30,000 is also expected to have a life of 4 years with a scrap value of Rs. 18,000. The new machine, due
to its technological superiority, is expected to contribute additional annual benefit (before depreciation and
tax) of Rs. 60,000. Find out the cash flows associated with this decision given that the tax rate applicable
to the firm is 40%. (The capital gain or loss may be taken as not subject to tax).
11.AA firm whose cost of capital is 10% is considering two mutually exclusive projects X and Y, the
details of which are:
Year Project X Project Y
Cost 0 Rs. 70,000 Rs. 70,000
Cash inflows 1 10,000 50,000
2 20,000 40,000
3 30,000 20,000
4 45,000 10,000
5 60,000 10,000
Compute the Net Present Value at 10%, Profitability Index, and Internal Rate of Return
of the twoprojects.

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 UNIT – IV
Lesson – 11
WORKING CAPITAL MANAGEMENT
Introduction
The present research seeks to study in depth the Working Capital Management of selected paper
companies in India, with special emphasis on an examination of the management performance in
regard to financial management. It hardly needs mentioning that inventory, accounts receivables
and cash and its alert administration can go a long way in solving the problem of the efficient
working capital management. In fact, the present research of working capital management needs
special attention for the efficient working and the business. It has been often observed that the
shortage of working capital leads to the failure of a business. The proper management of working
capital may bring about the success of a business firm. The management of working capital
includes the management of current assets and current liabilities. The present research
undertakes to deal with the net concept of working capital: excess of current assets over current
liabilities.
MEANING OF WORKING CAPITAL
Capital required for a business can be classified under two main categories
 Fixed Capital
 Working Capital
Every business needs funds for two purposes for its establishment and to carry out its day-to-day
operations. Long-term funds are required to create production faculties through purchase of fixed
assets such as plant and machinery, land, building, furniture etc. Investments in these assets
represent that part of firm’s capital which is blocked on a permanent or fixed basis and is called
fixed capital. Funds are also needed for short-term purposes for the purchase of raw materials,
payment of wages and other day-to-day expenses, etc. These funds are known as working
capital.
Definition
In the words of Shubin, “Working capital is the amount of funds necessary to cover the cost of
operating the enterprise”.

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According to Genestenberg, “Circulating capital means current assets of a company that are
changed in the ordinary course of business from one form to another, as for example, from cash
to inventories, inventories to receivables, receivables into cash”.
TYPES OF WORKING CAPITAL
1. Gross working capital –Refers to firms investments in current assetswhich are
converted in to cash during an accounting year such as cash, bank balance, short
term investments, debtors, bills receivable, inventory, short term loans and
advances etc.
2. Net working capital –Refers to difference between current assets andcurrent
liabilities or excess of total current assets over total current liabilities.
3. Operating cycle concept –Refers to capital/ amount required in differentforms at
successive stages of manufacturing operation/ process. It represents cycle during
which cash is reconverted in to cash again. In manufacturing process, cash is
required for purchasing raw material- raw material is converted in to work in
progress – which is converted in to finished product – finished products are sold
on credit- than cash is realized out of credit sale. Total time taken in completing
one cycle helps in ascertaining working capital requirements.
4. Regular or permanent working capital –Refers to minimum amountwhich
permanently remain blocked and cannot be converted in to cash such as minimum
amount blocked in raw material, finished product debtors etc.
5. Variable or temporary working capital –Refers to amount over andabove
permanent working capital i e difference between total working capital less
permanent working capital.
6. Seasonal working capital - Refers to capital required to meet seasonaldemand
e.g. extra capital required for manufacturing coolers in summer, woolen garments
in winter. It can be arranged through short term loans.
7. Specific working capital –Refers to part of capital required for
meetingunforeseen contingencies such as strike, flood, war, slump etc.

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CONCEPTS OF WORKING CAPITAL
There are two concepts of working capital:
Balance Sheet Concept
Operating Cycle or Circular Flow Concept
Balance Sheet Concept: There are two interpretations of working capital under thebalance sheet
concept:
(i) Gross Working Capital
(ii) Net Working capital

In the broad sense, the term working capital refers to the gross working capital and represents the
amount of funds invested in current assets. Thus, the gross working capital is the capital invested
in total current assets of the enterprise; current assets are those assets which in the ordinary
course of business can be converted into cash within a short period of normally one accounting
year.
CONSTITUENTS OF CURRENT ASSETS

1. Cash in hand and bank balances.

2. Bills Receivables.

3. Sundry Debtors (less provision for bad debts.)

4. Short-term loans and advances.

5. Inventories of stocks, as:

(a) Raw Materials,

(b) Work-in-Process,

(c) Stores and spares,

(d) Finished Goods.

6. Temporary Investments of surplus funds.

7. Prepaid Expenses.
8. Accrued Incomes.

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In a narrow sense, the term working capital refers to the new working capital.
Net working capital is the excess of current assets over current liabilities or say:
Net Working Capital = Current Assets – Current Liabilities.
Net Working Capital may be positive or negative. When the current assets exceed the current
liabilities the working capital is positive and the negative working capital results when the
current liabilities are more than the current assets. Current liabilities are those liabilities which
are intended to be paid in the ordinary course of business within a short period of normally one
accounting year out of the current assets or the income of the business.

CONSTITUENTS OF CURRENT LIABILITIES

1. Bills Payable.

2. Sundry creditors or accounts payable.

3. Accrued or outstanding expenses.

4. Short-term loans, advances and deposits.

5. Dividends payable.

6. Bank overdraft.

7. Provision for taxation, if it does not amount to appropriation of profits.

The gross working capital concept is financial or going concern concept whereas net working
capital is an accounting concept of working capital. These two concepts of working capital are
not exclusive; rather both have their own merits.

(B) Operating Cycle or Circular Flow Concept

As discussed earlier, working capital refers to that part of firm’s capital which is required for
financing short-term or current assets such as cash, marketable securities, debtors and
inventories. Funds, thus, invested in current assets such as cash, marketable securities, debtors
and inventories. Funds, thus, invested again in exchange for other current assets.

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The gross operating cycle of a firm is equal to the length of the inventories and receivables
conversion periods. Thus,

Gross Operating Cycle = RMCP + WIPCP + RCP

Where, RMCP = Raw Material Conversion Period

WIPCP = Work-in-Process Conversion Period

FGCP = Finished Goods Conversion Period
RCP = Receivables Conversion Period
However, a firm may acquire some resources on credit and thus defer payments for certain
period. In that case, net operating cycle period can be calculated as below:

Net Operating Cycle Period = Gross Operating Cycle Period – Payable Deferral Period

Further, following formula can be used to determine the conversion periods.

1. Raw Material Conversion Period =

2. Work-in-Process Conversion Period = −−

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 3. Finished Goods Conversion Period = ℎ

4. Receivables Conversion Period =

5. Payables Deferral Period = ℎ

CHARACTERISTICS OF WORKING CAPITAL

1. Short –term Requirements: Working capital is utilized to purchase current
assetswhich can be easily converted into cash in short period of time. The length of
production process decides the duration of working capital; it is the time period
between sale and cash receipts.
2. Circular Movement: Working capital is continuously transformed into cash but
itagain turns into working capital. This process is on continuous basis. When cash is
utilized to purchase current assets and with the help of current assets goods are
produced and sold then therefore working capital is also termed as circulating
capital.
3. Permanence: Working capital is a short-term capital but in order to continue
theproduction process it is always required by the firm. Hence working capital is
also termed as permanence or regular working capital.
4. Instability: Though working capital is required permanently in a firm but
theamount of working capital required frequently changes with the changes in
production level, changes in purchase, sale policy, price level and demand level.
The amount of working capital that changes due to changes in other factors is called
variable working capital.
5. Liquidity: Working capital can be easily converted into cash, hence it is
moreliquid. Firms which maintain adequate amount or working capital finds easy to
convert it into cash in time when cash is required.
6. Less Risky: Working capital is the investment in current assets which is for a
shortperiod of time. Hence it involves less risk. Working capital does not involve
any risk related to technological changes. It involves a very less amount of physical
risk only.
7. Special Accounting System not Required: As working capital is for short-
termusually for one year. Hence, there is no need to adopt special accounting
system for it.

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FACTORS DETERMINING THE WORKING CAPITAL REQUIREMENTS
The Working capital requirements of a concern depend upon a large number of factors such as
nature and size of business, the character of their operations, the length of production cycles, the
rate of stock turnover and the state of economic situation. It is not possible to rank them because
all such factors are of different importance and the influence of individual factors changes for a
firm over time. However the following are important factors generally influencing the working
capital requirements.
 Nature or Character of Business: The Working capital requirements of a firmbasically
depend upon the nature of its business. Public utility undertakings like Electricity. Water
supply and Railways need very limited working capital because they offer cash sales only
and supply services, not products, and as such no funds are tied up in inventories and
receivables. On the other hand trading and financial firms require less investment in fixed
assets but have to invest large amount in current assets like inventories, receivables and
cash; as such they need large amount of working capital. The manufacturing undertakings
also require sizable working capital along with fixed investments. Generally speaking it
may be said that public utility undertaking require small amount of working capital,
trading and financial firms require relatively very large amount, whereas manufacturing
undertakings require sizable working capital between these two extremes.
 Size Business/Scale of Operations: The working capital requirements of aconcern are
directly influenced by the size of its business which may be measured in terms of scale of
operations. Greater the size of business unit, generally larger will be the requirements of
working capital. However, in some cases even a smaller concern may need more working
capital due to high overhead charges, inefficient use of available resources and other
economic disadvantages of small size.
 Production Policy: In certain industries the demand is subject to widefluctuations due to
seasonal variations. The requirements of working capital in such cases depend upon the
production policy. The production could be kept either steady by accumulating
inventories during slack periods with a view to meet high demand during the peak season
or the production could be curtailed during the slack season and increased during the
peak season. If the policy is to keep production steady by accumulating inventories it will
require higher working capital.

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  Manufacturing Process/Length of Production Cycle: In manufacturingbusiness, the
requirements of working capital increase in direct proportion to length of manufacturing
process. Longer the process period of manufacture, larger is the amount of working
capital required. The longer the manufacturing time, the raw material and other supplies
have to be carried for a longer period in the process with progressive increment of labor
and service costs before the finished product is finally obtained. Therefore, if there are
alternative processes of production, the process with the shortest production period
should be chosen.
 Seasonal Variations: In certain industries raw material is not availablethroughout the
year. They have to buy raw materials in bulk during the season to ensure an uninterrupted
flow and process them during which gives rise to more working capital requirements.
Generally, during the busy season, a firm requires larger working capital than in the slack
season.
 Working Capital Cycle: In a manufacturing concern, the working capital cyclestarts
with the purchase of raw material and ends with the realization of cash from the sale of
finished products. This cycle involves purchase of raw materials and stores, its
conversion into stocks of finished goods through work-in-progress with progressive
increment of labor and service costs, conversion of finished stock into sales, debtors and
receivables and ultimately realization of cash and this cycle continues again from cash to
purchase of raw material and so on.
Rate of Stock Turnover: There is a high degree of inverse co-relationshipbetween the quantum
of working capital and the velocity or speed with which the sales are affected. A firm having a
high rate of stock turnover will need lower amount of working capital as compared to a firm
having a low rate of turnover
 Credit Policy: The credit policy of a concern in its dealing with debtors andcreditors
influence considerably the requirements of working capital. A concern that purchases its
requirements on credit and sells its products/services on cash requires lesser amount of
working capital. On the other hand a concern buying its requirements for cash and
allowing credit to its customers, shall need larger amount of working capital as very huge
amount of funds are bound to be tied up in debtors or bills receivables.

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  Business Cycles: Business cycle refers to alternate expansion and contraction ingeneral
business activity. In a period of boom i.e., when the business is prosperous, there is a
need for larger amount of working capital due to increase in sales, rise in prices,
optimistic expansion of business, etc.
 Rate of Growth of Business: The working capital requirements of a concernincrease
with the growth and expansion of its business activities. Although, it is difficult to
determine the relationship between the growth in the volume of business and the growth
in the working capital of a business, yet it may be concluded that for normal rate of
expansion in the volume of business, we may have retained profits to provide for more
working capital but in fast growing concerns, we shall require larger amount of working
capital.
 Earning Capacity and Dividend Policy: Some firms have more earningcapacity than
others due to quality of their products, monopoly conditions, etc. Such firms with high
earning capacity may generate cash profits from operations and contribute to their
working capital. The dividend policy of a concern also influences the requirements of its
working capital. A firm that maintains a steady high rate of cash dividend irrespective of
its generation of profits needs more working capital than the firm that retains larger part
of its profits and does not pay so high rate of cash dividend.
 Price Level Changes: Changes in the price level also affect the working
capitalrequirements. Generally, the rising prices will require the firm to maintain larger
amount of working capital as more funds will be required to maintain the same current
assets. The affect of rising prices may be different for different firms. Some firms may be
affected much while some others may not be affected at all by the rise in prices.
 Other Factors: Certain other factors such as operating efficiency, managementability,
irregularities of supply, import policy, asset structure, importance of labor, banking
facilities, etc., also influence the requirements of working capital

FORECASTING WORKING CAPITAL REQUIREMENTS

“Working capital is the life-blood and controlling nerve centre of a business”. No business can
be successfully run without an adequate amount of working capital. To avoid the shortage of

97
working capital at once, an estimate of working capital requirements should be made in advance
so that arrangements can be made to procure adequate working capital.
Methods of Estimating Working Capital Requirements
The following method are usually followed in forecasting working capital requirements of a firm

1. Percentage of Sales Method

2. Regression Analysis Method
3. Cash Forecasting Method
4. Operating Cycle Method
5. Projected Balance Sheet Method

1. Percentage of Sales Method: This method of estimating working capitalrequirements

is based in the assumption that the level of working capital for any firm is directly
related to it sales value. If past experience indicates a stable relationship between the
amount of sales and working capital, then this basis may be used to determine the
requirements of working capital for future period. Thus, if sales for the year 2007
amounted to Rs.30,00,000 and working capital required was Rs.60,00,000; the
requirement of working capital for the year 2008 on an estimated sales liabilities can
also be estimated on the basis of the past experience as a percentage of sales. This
method is simple to understand and easy to operate but it cannot be applied in all cases
because the direct relationship between sales and working capital may not be
established.

2. Regression Analysis Method (Average Relationship between Sales and Working

Capital): This method of forecasting working capital requirements is based upon
thestatistical technique of estimating or predicting the unknown value of a dependent
variable from the known value of an independent variable. It is the measure of the
average relationship between two or more variables, i.e., sales and working capital, in
terms of the original units of the data.

The relationships between sales and working capital are represented by the equation:

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 Y = a + bx

Where, y = Working Capital (dependent variable)

a = Intercept of the least square
b = Slope of the regression line
x = Sales (independent variable)
For determining the values ‘a’ and ‘b’ two normal equations are used which can
be solved simultaneously:
∑= + ∑
∑ = ∑ + ∑

3. Cash Forecasting Method: This method of estimating working capital

requirementsinvolves forecasting of cash receipts and disbursements during a future
period of time. Cash forecast will include all possible sources from which cash will be
received and the channels in which payments are to be made so that a consolidated cash
position is determined. This method is similar to the preparation of a cash budget. The
excess of receipts over payments represents surplus of cash and the excess of payments
over receipts causes deficit of cash or the amount of working capital required. The
following illustration explains the cash forecasting method of estimating working capital
requirements.
4. Operating Cycle Method: This method of estimating working capital requirementsis
based upon the operating cycle concept of working capital. We have discussed earlier, in
this chapter, the concept and determination of duration or operating cycle. The cycle
starts with the purchase of raw material and other resources and ends with the realization
of cash from the sale of finished goods. It involves purchase of raw materials and stores,
its conversion into stock of finished goods through work-in-process with progressive
increment of labor and service costs, conversion of finished stock into sales, debtors and
receivables, realization of cash and this cycle continues again from cash to purchase of
raw material and so on. The speed/time duration required to complete one cycle
determines the requirement of working capital – longer the period of cycle, larger is the
requirement of working capital and vice-versa.

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 5. Projected Balance Sheet Method: Under this method, projected balance sheet
forfuture date is prepared by forecasting of assets and liabilities by following any of the
methods sated above. The excess of estimated total current assets over estimated current
liabilities, as shown in the projected balance sheet, is computed to indicate the estimated
amount of working capital required.
WORKING CAPITAL POLICY
Working capital policy can also be known as working capital management. Working capital
management refers to a strategy which mainly focuses on maintaining adequate level of current
assets and current liabilities in a firm, so that appropriate level of working capital can be
maintained.
The ratio helps to examine the following alternative working capital policies:
 Conservative Policies: Assuming a constant level of fixed assets, a higher currentassets
to fixed assets ratio, refers to conservative policies. It indicates the firm’s sound liquidity
position and lower risk to meet its current obligations and investments. This policy is also
termed as flexible policy. It also indicates that the current assets are efficiently utilized at
every levels or output.
Conservative Policy Indicates
(i) Sound liquidity
(ii) Lower risk
(iii) Current assets are efficiently utilized in production
(iv) No bottlenecks in production, because of the maintenance of huge stock
(v) Prompt payment of accounts payable, because of huge liquid cash in hand
 Moderate Policies: Moderate policy is otherwise termed as average current
assetspolicy. This ratio occurs between higher and lower ratio of current assets to fixed
assets ratio. In other words, the current assets policy of most firms may fall between the
conservative policies and aggressive policies. This indicates moderate risk and average
liquidity position of a firm.
Moderate Policy Indicates:
(i) Moderate risk
(ii) Average liquidity position
(iii) Current assets are used in production

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 (iv) Maintenance of stock of raw materials, work-in-progress and
finished goods are at an average level.
 Aggressive Policies: Lower level of current assets to fixed assets ratio
representsaggressive policy. This aggressive policy indicates higher risk and poor
liquidity position of a firm. It also indicates that the current assets are inefficiently
utilized at all levels of output. This policy is also termed as restrictive policy.
Aggressive Policy Indicates
(i) Poor liquidity position
(ii) Higher risk
(iii) Current assets are utilized at lowest in all levels of output
(iv) Maintenance of small stock levels
(v) Declining size of sales because of rare credit sales facilities
(vi) Stoppage and bottlenecks in production, due to lack of stock
(vii) Slower accounts payable payments, because of low cash balance in hand
Problems
Problem 1. From the following information, prepare a statement in column form showing · the
working capital requirements. (i) In total and (ii) As regards each constituent part of working
capital.
Budgeted sales ( Rs. 10 per unit) Rs. 2,60,000 p.a.
Analysis of Costs Rs.
Raw Materials 3.00
Direct Labour 4.00
Overheads 2.00
Total Cost 9.00
Profit 1.00
Sales 10.00

It is estimated that
(i) Raw materials are carried in stock for three weeks and finished goods for two
weeks.
(ii) Factory processing will take three weeks.

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(iii) Suppliers will give full five weeks credit.
(iv) Customers will require eight weeks credit.
It may be assumed that production and overheads accrue evenly throughout the year.

Solution : Statement of Working Capital Requirement

Current Assets Rs.
Raw Materials 78,000 x 3/52 = 4,500
Work in Progress (Note) = 9,000
Finished Goods 2,34,000 x 2/52 = 9,000
Debtors 2,60,000 x 8/52 = 40,000

Less : Current Liabilities = 62,000

Trade Creditors (5 weeks) 5/52 x 78,000 = 7,500
Working Capital Required 55,000

Working Notes:
(i) Number of Units = 26,000
(ii) Finished Goods
Raw Materials 26,000 x 3 = 78,000
Direct Labour 26,000 x 4 = 1,04,000
Overheads 26,000 x 2 = 52,000
Finished Goods 2,34,000

(iii) Work in Progress

Raw Material 78,000 x 3/52 = 4,500
Labour 1,04,000 x 3/52 x 112 = 3,000
Overhead 52,000 x 3/52 x 112 = 1,500
Work in Progress 9,000
NOTE : (i) Normally finished goods and work in progress are taken as same value. Suppose
wages and overheads accrue evenly throughout the year given in the problem, we have to find

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out the work in progress value separately. At that time of computing work in progress labour,
overhead value is reduced to half.
(ii) At the time of calculating working capital, debtor value will be taken as either
including profit element or excluding profit element.
Problem 2. Prepare a working capital forecast from the following information :
Issued share capital 4,00,000
12% Debentures 1,50,000
The fixed assets are valued at Rs. 3. 00 lakhs. Production during the previous year is
1.00 lakh units. The same level of activity is intended to be maintained during the current
year.

The expected ratios of cost to selling price are

Raw materials 50%
Direct Wages 10%
Overheads 25%
The raw materials ordinarily remain in stores for 2 months before production. Every unit
of production remains in process for 2 months. Finished goods remain in the warehouse for 4
months. Credit allowed by creditors is 3 months from the date of delivery of raw materials and
credit given to debtors is 3 months from the date of dispatch.
Selling price is Rs. 6 per unit. Both the production and sales are in a regular cycle.
Solution: Working Capital Statement
Rs.
Raw Materials 50,000
Work in Progress 67,500
Finished Goods 1,70,000
Debtors 1,27,500
4,15,000
Less : Creditors 75,000
Working capital required 3,40,000

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Working Notes :
Number of units = 1,00,000
Sales Value = 1,00,00 = 6,00,000
Material = 6,00,000 x 50/100 = 3,00,000
Labour= 6,00,000 x 10 /100 = 60,000
Overheads = 6,00,000 x 25 /100 = 1,50,000
(i) Finished Goods
Raw Materials =
Direct Labour = 3,00,000
Overheads = 60,000
i.e., 5,10,000 x 4/12 = 1,50,000
5,10,000
(ii) Work in Progress 1,70,000
Raw Materials = 3,00,000 x 2/12 = 50,000
Direct Labour= 60,000 x2/12 x 1/2 = 5,000
Overheads = 1,50,000 x 2 / 12x 1/2 = 12,500
67,500
(iii) Debtors = 5,10,000 x 3/12 = 1,27,500
(iv) Creditors = 3,00,000 x 3/12 = 75,000

Problem 3. The management of G Ltd has called for a statement showing the working capital
needed to finance a level of 3,00,000 units of output for the year. The cost structure for the
company’s product, for the above mentioned activity level is detailed below.
Cost Element Cost per unit (Rs. )
Raw Materials 20
Direct Labour 5
Overheads 15
Total Cost 40
Profit 10
Selling Price 50

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  Past trends indicate that raw materials are held in stock on an average for two months.
 Work in progress will approximate to half a month’s production.
 Finished goods remain in warehouse on an average for a month.
 Suppliers of materials extend a month’s credit.
 Two months’ credit is normally allowed to debtors.
 A minimum. cash balance of Rs. 25,000 is expected to be maintained.
The production pattern is assumed to be even during the year. Prepare the statement of working
capital determination.

Solution : Working Capital Statement (or)

Statement of Working Capital Requirement

Current Assets
Raw Materials60,00,000 x 2/12 = 10,00,000
Work in Progress = 3,75,000
Finished goods 1,20,00,000 x 1/12 = 10,00,000
Debtors 1,50,00,000 x 2/12 = 25,00,000
48,75,000
Less : Current Liabilities
Sundry Creditors 60,00,000 x 1/ 2 5,00,000
43,75,000
Add : Minimum Cash Balance 25,000
Working Capital 44,00,000
Workings :
(i) Finished Goods
Raw Materials 3,00,000 x 20 60,00,000
Direct Labour 3,00,000 x 5 15,00,000
Overheads 3,00,000 x 15 45,00,000
Finished Goods 1,20,00,000

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Problem 4
From the following estimates of Sethal Ltd you are required to prepare a forecast of working
capital requirements.

(i) Expected level of production for the year 15,600 units

(ii) Cost per unit : Raw Materials Rs. 90, Direct labourRs. 40, overheads Rs. 75.

(iii) Selling Price per unit Rs. 265

(iv) Raw Materials in stock on an average for 1 month

(v) Materials are in process on an average for 2 weeks.

(vi) Finished goods in stock on an average for 1 month.

(vii) Credit allowed by suppliers is one month.

(viii) Time lag in payment from debtors is 2 months.

(ix) Lag in payment of wages 11/2 weeks.

(x) Lag in payment of overheads is one month. All sales are on credit.

(xi) Cash in hand and at Bank is expected to be Rs. 60,000.

It is assumed that production is carried on evenly throughout the year. Wages and overheads
accrued evenly and a period of 4 weeks is equivalent to a month.

Solution : Statement of working capital Requirement

Current Assets
Raw materials 1,08,000 x 1 = 1,08,000

Finished goods 2,46,000 x 1 2,46,000

Debtors 2 months 2,46,000 X 2 4,92,000

Work in progress 88,500

Cash in hand and at Bank 60,000

9,94,500

Less : Current Liabilities

Creditors 1,08,000 x 1 1,08,000

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Lag in payment of wages 1112 weeks

48 000 X 3/2 x 1/4

Lag in payment of overheads (90,000 x 1) 18,000

90,000

Working capital required 2,16,000

[9,94,500 – 2,16,000] 7,78,500

Working notes :
Estimated sales = 15,600 units
A period of 4 weeks is taken as equivalent to one month.

Therefore, sales per month = 15,600 x 52 1200 units

Estimated sales per month = 265 x 1,200 = 3,18,000

Raw Materials p.m. 1,200 x 90 = 1,08,000

Direct Labour p.m. 1,200 x 40 = 48,000

Overheads p.m. 1,200 x 75 = 90,000

Cost of Sales/Finished Goods = 2,46,000

Work in progress

Raw materials (2 weeks) 1,08,000 x 1/2 = 54,000

Labour (2 weeks) 48,000 x 1/2 = 12,000
Overhead (2 weeks) 90,000 x1/2 x 1/2 = 22,500

88,500

NOTE : Labour and overheads are reduced to one half as they accrue evenly during the year.

Problem 5
Prepare an estimate of working capital and projected Balance Sheet for the year ended on
31.12.2002 from the following information.

(i) Share capital Rs. 5,00,000, 15% Debentures of Rs. 2,00,000, Fixed assets at cost of Rs.
3,00,000.

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(ii) The expected ratios of cost to selling price are Raw materials 60%, Labour 10%,Overheads
20%.

(iii) Raw materials are in stores for an average of 2 months.

(iv) Finished goods are kept in warehouse for 3 months.

(v) Expected level of production 1,20,000 units per year.

(vi) Each unit of production is expected to be in process for 1 month.

(vii) Credit given by suppliers is 2 months.

(viii) 20% of the output is sold against cash. Time lag in payment from debtors is 3 months.

(ix) Selling price is Rs. 5 per unit

(x) Labour and overheads will accrue evenly during the year.

Solution : Statement of Working Capital requirement

Current Assets
Raw Materials (2 months) 60,000

Work in progress 37,500

Stock of finished goods (3 months) 1,35,000

Debtors 3 months 1,08,000

Total Current Assets 3,40,500

Less : Current Liability

Creditors 2 months 60,000

Working Capital required [3,40,500 – 60,000] 2,80,500

Working Notes:

Estimated production units 1,20,000 / 12 = 10,000 units

Sales p.m. 10,000 units x Rs. 5 = 50,000

(i) Finished goods :

Raw Materials 60% = 50,000 x 60/100 = 30,000

Direct Labour 10% = 50,000 x 10/100 = 5,000

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Overheads 20% = 50,000 x 20/100 = 10,000

Finished goods/Cost of sales = 45,000

(ii) Work in progress (1 month)

Raw materials =30,000

Labour 5000 x 1/2 = 2,500

Overheads 10,000 x 1/2 = 5,000

W.I.P = 37,500

(iii) Debtors (3months) at cost equivalent

Cost of sales pm = 45,000

Less : Cash sales 20% = 9,000

Cost of sales (credit) pm = 36,000
Debtors (3 months) at cost equivalent

= 36,000 x 3 = 1,08,000

Projected Balance Sheet as on 31.12.2002

Liabilities Rs. Assets Rs.

Share Capital 2,00,000 5,00,000 Fixed Assets at cost 3,00,000

15% Debentures 30,000 2,30,000 Current Assets :

Creditors 60,000 Raw Materials 60,000

Work in progress 37,500

Stock of Finished Goods 1,35,000

Debtors 1,20,000

Profit & Loss A/c 30,000

Cash (BF) 1,07,500

7,90,000 7,90,000

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Conclusion
The relative liquidity of the firm’s assets structure is measured by the current assets to fixed
assets ratio. The greater this ratio, the less risky as well as less profitable will be the firm and
vice versa. Similarly, the relative liquidity of the firm’s financial structure can be measured by
the short-term financing to total financing ratio. The lower this ratio, the less risky as well as less
profitable will be the firm and vice versa. In shaping its working capital policy, the firm should
keep in mind these two dimensions – relative asset liquidity and relative financing liquidity of
the working capital management. A firm will be following a very conservative working policy if
it combines a high level of current assets with a high level of long-term financing. Such a policy
will not be risky at all and would be less profitable. An aggressive firm, on the other hand, would
combine low level of current assets with ahigh level of long-term financing. .This will have high
profitability and high risk. Infact, the firm may follow a conservative financing policy to counter
its relativelyilliquid assets structure in practice. The conclusion of all this it that the
considerationsof assets and financing mixes are crucial to the working capital management.
Questions:
1. What do you mean by working capital management?
2. Define working capital management
3. What are the types of working capital management?
4. Explain the concepts of working capital management
5. State the constituents of current liability
6. What id operating cycle?
7. State the characteristics of working capital management
8. What are the factors determining the working capital requirements?
9. How do you forecast the working capital requirements?
10. What id working capital policy
11. Ram Ltd decided to purchase a business and has consulted you and one point on which
you are asked to advice them is the average amount of working capital which will be
required in the first year workings.
You are given the following estimates and are instructed to add 10% to your computed
figure to allow for contingencies.

(i) Average amount locked up for the stocks Rs.

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Stock of finished products 5,000

Stock of stores materials etc. 8,000

(ii) Average credit given

Inland sales-6 weeks credit

Export sales-11/2 h weeks credit 3,12,000

(iii) Lag in payment of wages and other outgoing 78,000

Wages-11 /2 h weeks

Stores, Materials etc. 11/2h months 2,60,000

Rent Royalties etc. 6 months 48,000

Clerical Staff-l 1/2 month 10,000

Manager-1/2 month 62,400

Miscellaneous Expenses-1h month 4,800

(iv) Payment in advance 48,000

Sundry Expenses (Paid Quarterly in advance) 8,000

(v) Undrawn profits on the average throughout the year 11,000

Set up your calculations for the average amount of working capital required.
12. A proforma cost sheet of a company provides the following particulars:
Elements of Cost
Material 40%
Direct Labour 20%
Overheads 20%
The following further particulars are available:
(a) It is proposed to maintain a level of activity of 2,00,000 units.
(b) Selling price is Rs.12/- per unit.
(c) Raw materials are expected to remain in stores for an average period of one month.
(d) Materials will be in process, on averages half a month.
(e) Finished goods are required to be in stock for an average period of one month.
(f) Credit allowed to debtors is two months.

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(g) Creditor allowed by suppliers is one month.
You may assume that sales and production follow a consistent pattern.
You are required to prepare a statement of working capital requirements, a forecast Profit
and Loss Account and Balance Sheet of the company assuming that:
Rs.
Share Capital 15,00,000
8% Debentures 2,00,000
Fixed Assets 13,00,000
13. From the following information you are required to estimate the net working capital:
Cost per unit
Rs.
Raw Materials 400
Direct labour 150
Overheads (excluding depreciation) 300
Total Cost 850
Additional Information: 30
Selling-Price Rs.1,000 per unit
Output 52,000 units per annum
Raw Material in stock average 4 weeks
Work-in-process:
(assume 50% completion stage with
full material consumption) average 2 weeks
Finished goods in stock average 4 weeks
Credit allowed by suppliers average 4 weeks
Credit allowed to debtors average 8 weeks
Cash at bank is expected to be Rs.50,000
Assume that production is sustained at an even pace during the 52 weeks of the year. All
sales are on credit basis. State any other assumption that you might have made while
computing.

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 Lesson – 12
CASH MANAGEMENT
Introduction
"Cash, like the blood stream in the human body, gives vitality and strength to a business
enterprises. Though cash hold the smallest portion of total current assets. However, "Cash is both
the beginning and end of working capital cycle - cash, inventories, receivables and cash. it is the
cash, which keeps the business going. Hence, every enterprises has to hold necessary cash for its
existence.‖ Moreover, "Steady and healthy circulation of cash throughout the entire business
operations is the basis of business solvency." A Now-a-days non-availability and high cost of
money have created a serious problem for industry. Nevertheless, cash like any other asset of a
company is treated as a tool of profit." Further, "today the emphasis is on the right amount of
cash, at the right time, at the right place and at the right cost." In the words of R.R. Bari,
"Maintenance of surplus cash by a company unless there are special reasons for doing so, is
regarded as a bad sigh of cash management." As, "holding of cash balance has an implicit cost in
the form of its opportunity cost."
Meaning of cash management
The term cash management refers to the management of cash resource in such a way that
generally accepted business objectives could be achieved. In this context, the objectives of a firm
can be unified as bringing about consistency between maximum possible profitability and
liquidity of a firm. Cash management may be defined as the ability of a management in
recognizing the problems related with cash which may come across in future course of action,
finding appropriate solution to curb such problems if they arise, and finally delegating these
solutions to the competent authority for carrying them out The choice between liquidity and it
profitability creates a state of confusion. It is cash management that can provide solution to this
dilemma.Cash management may be regarded as an art that assists in establishing equilibrium
between liquidity and profitability to ensure undisturbed functioning of a firm towards attaining
its business objectives. Cash management has assumed importance because it is the most
significant of all the current assets. It is required to meet business obligations and it is productive
when not used.
Cash management deals with the following:
(i) Cash inflows and outflows

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 (ii) Cash balances held by the firm at a point of time
(iii) Cash balances held y the fire at a point of time
Cash management need strategies to deal with various facets of cash. Following are some of its
facets:
(a) Cash Planning: Cash Planning is technique to plan and control the use of cash.
Aprojected cash flow statement may be prepared, based on the present business
operations and anticipated future activities. The cash inflows from various sources may
be anticipated and cash outflows will determine the possible uses of cash;
(b) Cash Forecasts and Budgeting: A cash budget is the most important device for
thecontrol of receipts and payments of cash. A cash budget is an estimate of cash
receipts and disbursements during a future period of time. It is an analysis of flow of
cash in a business over a future, short or long period of time. It is a forecast of expected
cash intake and outlay.
Both Short-term and long-term cash forecasts may be made with the help of following methods:
(i) Receipts and disbursements method
(ii) Adjusted net income method
(i) Receipts and Disbursements Method: In this method the receipts and payments
ofcash are estimated. The receipts and disbursements are to be equaled over a short as
well as long periods. Any shortfall in receipts will have to be met from banks or other
sources. Similarly, surplus cash may be invested in risk free marketable securities. It
may be easy to make estimates for payments but cash receipts may not be accurately
made. The payments are to be made by outsiders, so there may be some problem in
finding out the exact receipts at a particular period. Because of uncertainty, the
reliability of this method may be reduced.
(ii) Adjusted Net Income Method: This method may also be known as sources anduses
approach. It generally has three sections: sources of cash, uses of cash and adjusted cash
balance. The adjusted net income method helps in projecting the company’s need for
cash at some future date and to see whether the shares, etc. In preparing its statement the
items like net income, depreciation, dividends, taxes, etc.

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GENERAL PRINCIPLES OF CASH MANAGEMENT:
Harry Gross has suggested certain general principles of cash management that,essentially add
efficiency to cash management. These principles reflecting cause and effectrelationship having
universal applications give a scientific outlook to the subject of cashmanagement. While, the
application of these principles in accordance with the changingconditions and business
environment requiring high degree of skill and tact which places cashmanagement in the
category of art. Thus, we can say that cash management like any othersubject of management is
both science and art for it has well-established principles capable ofbeing skillfully modified as
per the requirements. The principles of management are followsas –
1. Determinable Variations of Cash Needs
A reasonable portion of funds, in the form of cash is required to be kept aside toovercome the
period anticipated as the period of cash deficit. This period may either be shortand temporary or
last for a longer duration of time. Normal and regular payment of cash leadsto small reductions
in the cash balance at periodic intervals. Making this payment to differentemployees on different
days of a week can equalize these reductions. Another technique forbalancing the level of cash is
to schedule i cash disbursements to creditors during thatperiod when accounts receivables
collected amounts to a large sum but without putting thegoodwill at stake.
2. Contingency Cash Requirement
There may arise certain instances, which fall beyond the forecast of the management.These
constitute unforeseen calamities, which are too difficult to be provided for in thenormal course of
the business. Such contingencies always demand for special cashrequirements that was not
estimated and provided for in the cash budget. Rejections ofwholesale product, large amount of
bad debts, strikes, lockouts etc. are a few among thesecontingencies. Only a prior experience and
investigation of other similar companies provehelpful as a customary practice. A practical
procedure is to protect the business from suchcalamities like bad-debt losses, fire etc. by way of
insurance coverage.
3. Availability of External Cash
Another factor that is of great importance to the cash management is the availabilityof funds
from outside sources. There resources aid in providing credit facility to the firm,which
materialized the firm's objectives of holding minimum cash balance. As such if a firmsucceeds in

115
acquiring sufficient funds from external sources like banks or private financers,shareholders,
government agencies etc., the need for maintaining cash reserves diminishes.
4. Maximizing Cash Receipts
Every financial manager aims at making the best possible use of cash receipts. Again,cash
receipts if tackled prudently results in minimizing cash requirements of a concern. Forthis
purpose, the comparative cost of granting cash discount to customer and the policy ofcharging
interest expense for borrowing must be evaluated on continuous basis to determinethe futility of
either of the alternative or both of them during that particular period formaximizing cash
receipts. Yet, the under mentioned techniques proved helpful in thiscontext: -
(A) Concentration Banking: Under this system, a company establishes banking centers
forcollection of cash in different areas. Thereby, the company instructs its customers ofadjoining
areas to send their payments to those centers. The collection amount is thendeposited with the
local bank by these centers as early as possible. Whereby, the collectedfunds are transferred to
the company's central bank accounts operated by the head office.
(B) Local Box System: Under this system, a company rents out the local post offices boxes
ofdifferent cities and the customers are asked to \ forward their remittances to it.
Theseremittances are picked by the authorized lock bank from these boxes to be transferred to
thecompany's central bank operated by the head office.
(C) Reviewing Credit Procedures: It aids in determining the impact of slow payers and
baddebtorson cash. The accounts of slow paying customers should be reviewed to determine
thevolume of cash tied up. Besides this, evaluation of credit policy must also be conducted
forintroducing essential amendments. As a matter of fact, too strict a credit policy
involvesrejections of sales. Thus, curtailing the cash in flow. On the other hand, too lenient, a
creditpolicy would increase the number of slow payments and bad debts again decreasing the
cashinflows.
(D) Minimizing Credit Period: Shortening the terms allowed to the customers woulddefinitely
accelerate the cash inflow side-by-side revising the discount offered would preventthe customers
from using the credit for financing their own operations profitably.
(E) Others: Introducing various procedures for special handling of large to very largeremittances
or foreign remittances such as, persona! pick up of large sum of cash usingairmail, special
delivery and similar techniques to accelerate such collections.

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5. Minimizing Cash Disbursements
The motive of minimizing cash payments is the ultimate benefit derived frommaximizing cash
receipts. Cash disbursement can be brought under control by preventingfraudulent practices,
serving time draft to creditors of large sum, making staggered paymentsto creditors and for
payrolls etc.
6. Maximizing Cash Utilization
Although a surplus of cash is a luxury, yet money is costly. Moreover, proper andoptimum
utilization of cash always makes way for achievement of the motive of maximizingcash receipts
and minimizing cash payments. At times, a concern finds itself with funds inexcess of its
requirement, which lay idle without bringing any return to it. At the same time,the concern finds
it unwise to dispose it, as the concern shall soon need it. In such conditions,efforts should be
made in investing these funds in some interest bearing securities.There are certain basic
strategies suggested by Gitman, which prove evidently helpful in managing cashif employed by
the cash management. They are:
"Pay accounts payables as late as possible without damaging the firm's credit rating,but take
advantage of the favourable cash discount, if any.
Turnover, the inventories as quickly as possible, avoiding stock outs that might resultin shutting
down the productions line or loss of sales.
Collect accounts receivables as early as possible without losing future loss salesbecause of high-
pressure collections techniques. Cash discounts, if they are economicallyjustifiable, may be used
to accomplish this objective."
FUNCTION OF CASH MANAGEMENT:
"Cash management is concerned with minimizing unproductive cash balances,investing
temporarily excess cash advantageously and to make the best possible arrangementsfor meeting
planned and unexpected demands on the firm's cash." Cash Management mustaim to reduce the
required level of cash but minimize the risk of being unable to dischargeclaims against the
company as they arise. All these aims and motives of cash managementlargely depend upon the
efficient and effective functioning of cash management. Cashmanagement functions can be
studied under five heads, namely, cash planning, managingcash flow, controlling cash flow,
optimizing the cash level and investing idle cash. All thesefunctions are discussed below in
details:

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1. Cash Planning
Good planning is the very foundation of attaining success. For any managementdecision,
planning is the foremost requirement. "Planning is basically an intellectual process,a mental pre-
disposition to do things in an orderly way, to think before acting and to act inthe light of facts
rather than of a guess." 16 Cash planning is a technique, which comprises ofplanning for and
controlling of cash. It is a management process of forecasting the futureneed of cash, its
available resources and various uses for a specified period. Cash planning,thus, deals at length
with formulation of necessary cash policies and procedures in order tocarry on business
continuously and on sound lines. A good cash planning aims at providingcash, not only for
regular but also for irregular and abnormal requirements.
2.Managing Cash Flows
The heading simply suggests an idea of managing properly the flow of cash cominginside the
business i.e. cash inflow and cash moving out of the business i.e. cash outflow.These two are
said to be properly managed only, if a firm succeeds in accelerating the rate ofcash inflow
together with minimizing the cash outflow. As observed expediting collections,avoiding
unnecessary inventories, improving control over payments etc. contribute to bettermanagement
of cash. Whereby, a business can conserve cash and thereof would require lessercash balance for
its operations.
3. Controlling the Cash Flows
As forecasting is not an exact science because it is based on certain assumptions.Therefore, cash
planning will inevitably be at variance with the results actually obtained. Forthis reason, control
becomes an unavoidable function of cash management. Moreover, cashcontrolling becomes
essential as it increases the availability of usable cash from within theenterprise. As it is obvious
that greater the speed of cash flow cycle, I greater would be thenumber of times a firm can
convert its goods and ' services into cash and so lesser will be thecash requirement to finance the
desired volume of business during that period. Furthermore,every enterprise is in possession of
some hidden cash, which if traced out substantiallydecreases the cash requirement of the
enterprise.
4. Optimizing the Cash Level
A financial manager should concentrate on maintaining sound liquidity position i.e.cash level.
All his efforts relating to planning, managing and controlling cash should bediverted towards

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maintaining an optimum level of cash. The foremost need of maintainingoptimum level of cash
is to meet the necessary requirements and to settle the obligations wellin time. Optimization of
cash level may be related to establishing equilibrium between riskand the related profit expected
to be earned by the company.
5.Investing Idle Cash
Idle cash or surplus cash refers to the excess of cash inflows over cash outflows,which do not
have any specific operations or any other purpose to solve currently. Generally,a firm is required
to hold cash for meeting working needs facing contingencies and tomaintain as well as develop
goodwill of bankers.The problem of investing this excess amount of cash arise simply because it
contributes nothing towards profitability of the firm as idle cash precisely earns no
returns.Further permanent disposal of such cash is not possible, as the concern may again need
thiscash after a short while. But, if such cash is deposited with the bank, it definitely would earna
nominal rate of interest paid by the bank. A much better returns than the bank interest canbe
expected if a company deploys idle cash in marketable securities. There are yet anothergroup of
enterprise that neither invest in marketable securities nor willing to get interestinstead they prefer
to deposit excess cash for improving relations with banks by helping themin meeting bank
requirements for compensating balances for services and loans
Problems
Illustration 1
United Industries Ltd. projects that cash outlays of Rs.37,50,000 will occur uniformly throughout
the coming year. Unitedplans to meet its cash requirements by periodically sellingmarketable
securities from its portfolio. The firm’s marketablesecurities are invested to earn 12% and the
cost per transaction ofconverting securities to cash is Rs. 40.
a. Use the Baumol Model to determine the optimal transaction sizeof marketable securities to
cash.
b. What will be the company’s average cash balance?
c. How many transfers per year will be required?
d. What will be the total annual cost of maintaining cash balances?
Solution:
a) Optimal size = “2TA/ I = “(2 X 40 X 37,50,000)/0.12 = 50000
b) average cash balance = Rs 25000

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c) No of transactions per year = 3750000/50000 = 75
d) Total annual cost
Transaction cost 75×40 = 3000
Opportunity cost 50000×1/2×12% = 3000
6000

Illustration 2
A Ltd. has just established a small manufacturing unit tomanufacture a new product which is
expected to have a highmargin. The company has made the following estimates ofproduction,
sales and costs:
Production and Sales (both in units)
Year 2010 Production Sales
April 2,000 --
May 3,000 --
June 4,000 1,000
July 5,000 2,000
August 5,000 4,000
September 5,000 5,000
Note : Both production and sales will stabilize at 5,000 units fromSeptember, 2010 onwards.
Selling price and cost
Selling price per unit 50
Less: Variable Cost:
Materials 12
Labour 5
Overheads 5 22
Contribution per unit 28
Note: Fixed costs are expected to be Rs. 10,000 per month.
The following additional information is also given:
 An initial stock of materials to meet three months requirements will be purchased during
April, 2010. Further purchases will be made at the beginning of each month to have
sufficient stock of materials for three months.

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  Suppliers of materials have agreed to give one month’s credit.
 Labour is to be paid half a month in arrears.
 Variable overheard will be paid during the month following the month in which it is
incurred.
 Fixed overheads will be incurred in advance at the beginning of every quarter.
 Sales will be 50% cash and the balance will be on two months credit.
 There will be an opening cash balance of Rs. 3, 00,000 (in hand and bank).
Prepare a cash budget of A Ltd. for the six months ending30th September, 2010. Figures should
be given monthly and themonths, if any, during which additional funds are required, should
be clearly indicated.
Solution:
Purchases Budget (Units)
Particulars April May June July August September
Opening
Balance -- 7,000 9,000 10,000 10,000 10,000
Add:
Purchases 9,000 5,000 5,000 5,000 5,000 5,000
9,000 12,000 14,000 15,000 15,000 15,000
Less:
Consumption2,000 3,000 4,000 5,000 5,000 5,000
Closing
Balance 7,000 9,000 10,000 10,000 10,000 10,000
Payment for Creditors
(Rs.)
Particulars April May June July August September
Purchases
(Units) 9,000 5,000 5,000 5,000 5,000 5,000
Purchases
(@Rs. 12 p.u.) 1,08,000 60,000 60,000 60,000 60,000 60,000
Payment
Made(1 Month

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Credit) -- 1,08,000 60,000 60,000 60,000 60,000
Collection from debtors
(Rs.)
Particulars April May June July August September
Sales Unit -- -- 1,000 2,000 4,000 5,000
Sales (@50 p.u.) -- -- 50,000 1,00,000 2,00,000 2,50,000
Cash Sales
(50%) -- -- 25,000 50,000 1,00,000 1,25,000
Credit Sales
(50%) (2 Months
Credit) -- -- -- -- 25,000 50,000
Receipts from
Sales -- -- 25,000 50,000 1,25,000 1,75,000
Labour and Overheads
(Rs.)
Particulars April May June July August September
Wages 10,000 15,000 20,000 25,000 25,000 25,000
Wages Paid (1/2
Month Arrears) 5,000 12,500 17,500 22,500 25,000 25,000
Variable
Overheads 10,000 15,00020,000 25,000 25,000 25,000
Variable
Overheads paid
(1 Month Lag ) -- 10,000 15,000 20,000 25,000 25,000
Cash Budget
For the year ending 30th September, 2010 (Rs.)
Particulars April May June July August September
Opening
Balance 3,00,0002,65,000 1,34,000 67,000 (15,500) (500)
Budgeted

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Receipts:
Cash Sales -- -- 25,000 50,000 1,00,000 1,25,000
Collection
From
Debtors -- -- -- -- 25,000 50,000
(i) 3,00,000 2,65,000 1,59,500 1,17,000 1,09,500 1,74,500
Budgeted
Payments:
Payment to
Creditors -- 1,08,00060,000 60,000 60,000 60,000
Wages 5,000 12,500 17,500 22,500 25,000 25,000
Variable
Overheads -- 10,000 15,000 20,000 25,000 25,000
Fixed
Overheads 30,000 -- -- 30,000 -- --
(ii) 35,000 1,30,50092,500 1,32,500 1,10,000 1,10,000
Closing
Balance
(i)– (ii)2,65,000 1,34,500 67,000 (15,500) (500) 64,500
Conclusion
The cash management is very faulty as a result of which cash ratio to total current assets and to
sales are very high for the cement industry. With the above general observations one can draw
number of conclusion about the economic health of the industry and various aspects of working
capital. The industry at present is passing through buyers phase of the market. This state of
cement industry is expected to continue in near future too because new capacity is being created
faster than growth in demand. This has increased competition and working capital management
has become more difficult. On the one side customers have to be accommodated to compete in
the market but at the same time all possible economies must be achieved in management of cash,
receivables and inventory to maintain and improve profitability.

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Questions:
1. What do you mean by Cash management?
2. What are the general principles of cash management?
3. Explain the functions of cash management.

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 Lesson – 13
RECEIVABLE MANAGEMENT
Introduction
A sound managerial control requires proper management of liquid assets and inventory.
These assets are a part of working capital of the business. An efficient use of financial resources
is necessary to avoid financial distress. Receivables result from credit sales. A concern is
required to allow credit sales in order to expand its sales volume. It is not always possible to sell
goods on cash basis only. Sometimes, other concerns in that line might have established a
practice of selling goods on credit basis. Under these circumstances, it is not possible to avoid
credit sales without adversely affecting sales. The increase in sales is also essential to increase
profitability. After a certain level of sales the increase in sales will not proportionately increase
production costs. The increase in sales will bring in more profits.
Thus, receivables constitute a significant portion of current assets of a firm. But, for
investment in receivables, a firm has to incur certain costs. Further, there is a risk of bad debts
also. It is, therefore, very necessary to have a proper control and management of receivables.
Meaning
The term receivable is defined as debt owed to the concern by customers arising from sale of
goods or services in the ordinary course of business. Receivables are also one of the major parts
of the current assets of the business concerns. It arises only due to credit sales to customers,
hence, it is also known as Account Receivables or Bills Receivables. Management of account
receivable is defined as the process of making decision resulting to the investment of funds in
these assets which will result in maximizing the overall return on the investment of the firm.
The objective of receivable management is to promote sales and profit until that point is reached
where the return on investment in further funding receivables is less than the cost of funds raised
to finance that additional credit. The costs associated with the extension of credit and accounts
receivables are identified as follows:
A. Collection Cost
B. Capital Cost
C. Administrative Cost
D. Default Cost.

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  Collection Cost
These costs incurred in collecting the receivables from the customers, to who credit sales
have been made.
This is the cost on the use of additional capital to support credit sales which alternatively
could have been employed elsewhere.
 Administrative Cost
This is an additional administrative cost for maintaining account receivable in the form of
salaries to the staff kept for maintaining accounting records relating to customers, cost of
investigation etc.
 Default Cost
Default costs are the over dues that cannot be recovered. Business concern may not be
able to recover the over dues because of the inability of the customers.
FACTORS CONSIDERING THE RECEIVABLE SIZE
Receivables size of the business concern depends upon various factors. Some of the
importantfactors are as follows:
 Sales Level
Sales level is one of the important factors which determine the size of receivable of the firm. If
the firm wants to increase the sales level, they have to liberalize their credit policy and terms and
conditions. When the firms maintain more sales, there will be a possibility of large size of
receivable.
 Credit Policy
Credit policy is the determination of credit standards and analysis. It may vary from firm to firm
or even some times product to product in the same industry. Liberal credit policy leads to
increase the sales volume and also increases the size of receivable. Stringent credit policy
reduces the size of the receivable.
 Credit Terms
Credit terms specify the repayment terms required of credit receivables, depend upon the credit
terms, size of the receivables may increase or decrease. Hence, credit term is one of the factors
which affect the size of receivable.

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  Credit Period
It is the time for which trade credit is extended to customer in the case of credit sales. Normally
it is expressed in terms of ‘Net days’.
 Cash Discount
Cash discount is the incentive to the customers to make early payment of the due date. A special
discount will be provided to the customer for his payment before the due date.
 Management of Receivable
It is also one of the factors which affects the size of receivable in the firm. When the
management involves systematic approaches to the receivable, the firm can reduce the size of
receivable.
Problems
Illustration 1
The following are the details regarding the operations of a firmduring a period of 12 months.
Sales Rs.12,00,000
Selling price per unit Rs.10
Variable cost price per unit Rs. 7
Total cost per unit Rs. 9
Credit period allowed to customers one month. The firm isconsidering a proposal for a more
liberal extension of credit whichwill result in in-creasing the average collection period from one
month to two months. This relaxation is expected to increase thesales by 25% from its existing
level.
You are required to advise the firm regarding adoptionof the new credit policy, presuming that
the firm’s requiredreturn on investment is 25%.
Solution:
Appraisal of Credit policy
Present Proposed Incremental
Credit period (ACP) 1 month 2 months
Sales (units) 120000 150000
(-) Sales @ 10 (in Rs) 1200000 1500000 300000
Total Cost 1080000 1290000 210000
Profit 120000 210000 90000

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Investment in receivables 1080000 / 12 = 90000
1290000 / 6 = 215000 125000
Required return on Incremental Investment (125000@ 25%) = 31250
Actual return on Investment = 90000
(or)(90000 / 125000) x 100 = 72%
Since the Incremental return is greater than required return onIncremental investment advised to
adopt new credit policy
Illustration 2
Trinadh Traders Ltd. currently sells on terms of net 30 days.All the sales are on credit basis and
average collection period is 35days. Currently, it sells 500,000 units at an average price of Rs.
50per unit. The variable cost to sales ratio is 75% and a bad debt tosales ratio is 3%. In order to
expand sales, the management of the company is considering changing the credit terms from net
30 to2/10, net 30. Due to the change in policy, sales are expected to goup by 10%, bad debt loss
on additional sales will be 5% and baddebt loss on existing sales will remain unchanged at 3%.
40% ofthe customers are expected to avail the discount and pay on thetenth day. The average
collection period for the new policy isexpected to be 34 day’s: The Company required a return
of’20% onits investment in receivables.
You are required to find out the impact of the change in creditpolicy on the profit of the
company. Ignore taxes.
Solution:
Trinadh TradersAppraisal of Credit policy:
Present Proposed Gain/(loss)
Credit terms Net 30 (2 / 10) Net 30
ACP 35 days 34 days
Discount sales - 40%
Bad debts 3% 3 % + 5%
Sales 500000 550000
Incremental Profit [50000 x 50 x 25%] 625000
Incremental bad debts [50000 x 50 x 5%] (125000)
Discount [550000 x 40% x 50x 2%] (220000)
Investment [500000 x 50 x (35/360)] = 2430555

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 [500000 x 50 x (37/365)] + [50000 x 50 x 75% x 34/360]
= 2538194
107629
Finance cost (107629 x 20%) (21528) 258472
By implementing new credit policy, the profit is increased byRs258472. So the new credit policy
is advised to implement.
Illustration 3
Star Limited manufacturers of Colour TV Sets, are considering theliberalization of existing
credit terms to three of their largecustomers A, B and C. the credit period and likely quantity of
TVsets that will be lifted by the customers are as follows:
Credit period
(Days) A B C
0 1,000 1,000 --
30 1,000 1,500 --
60 1,000 2,000 1,000
90 1,000 2,500 1,500
The selling price per TV set is Rs. 9,000. The expectedcontribution is 20% of the selling price.
The cost of carting debtorsaverages 20% per annum.
You are required:
(a) Determine the credit period to be allowed to each customer.(Assume 360 days in a year for
calculation purposes).
(b) What other problems the company might face in allowing thecredit period as determined in
(a) above?
Solution:
(a) Determination of Credit period to be allowed to customers A,B and C.
In case of Customer A there will be constant salesirrespective of the credit period
allowed. Hence, it is suggested notto extend any credit period to Customer A. The only analysis
to bemade about the profitability of extending different credit period withdifferent sales levels.
Credit Period (Days) Customers B Customers C
Sales (Units) 0 30 60 90 0 30 60 90
1,0001,5002,0002,500----1,0001,500

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 Sales 90 135 180 225 90 135
Contribution (20%
of Sales) 18 27 36 45 18 27
Incremental
Contribution (A) 9 9 9 - - 18 9
Debtors
(Credit Period X
sales / 360) 11.25 30 56.25 -- -- 15 33.75
Incremental
Debtors 11.25 18.75 26.25 -- -- 15 18.75
Cost of
Incremental
Debtors at 80% 9 15 21 -- -- 12 15
Cost of Carrying
Incremental
Debtors at 20% (B) 1.8 3 4.2 -- -- 2.4 3
Net Margin (A) –
(B) 7.2 6 4.8 -- -- 15.6 6
Conciliation:
(a) It is observed from the above table that incremental contributionon sales exceeds
incremental cost carrying additional debtors ateach successive credit period. Hence it is
suggested to allowcredit period upto 90 days to both customers B and C.
(b) By giving credit period of 90 days to Customer B and C and nocredit allowed to
Customer A may cause to stop purchase T.V.sets from the company by Customer A.
Conclusion
Taking into consideration the current economic situation as well as the fact that banksgranting
loans is increasingly difficult and the capital market moves with difficulty, in thiscontext, on the
national and international transactions market, and financing, factoring becomes the most
available tool,representing the only financing source through which the financing increases at the
same timewith the sales, being also the cheapest form of short-term financing.Given the fact that
factoring is a financial product of financing without guarantees butalso a highly complex

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commercial management product, this type of contract can represent the saving solution for the
companies that cannot support themselves from the financial pointof view, but that have a well-
developed business plan.
Questions:
1. What is receivable management?
2. What are the factors considering receivable management?

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 Lesson – 14
INVENTORY MANAGEMENT
Introduction
Inventories constitute the most significant part of current assets of the business concern. It is also
essential for smooth running of the business activities. A proper planning of purchasing of raw
material, handling, storing and recording is to be considered as a part of inventory management.
Inventory management means, management of raw materials and related items. Inventory
management considers what to purchase, how to purchase, how much to purchase, from where to
purchase, where to store and When to use for production etc.
MEANING
The dictionary meaning of the inventory is stock of goods or a list of goods. In accounting
language, inventory means stock of finished goods. In a manufacturing point of view, inventory
includes, raw material, work in process, stores, etc.
KINDS OF INVENTORIES
Inventories can be classified into five major categories.
o Raw Material: It is basic and important part of inventories. These are goods
whichhave not yet been committed to production in a manufacturing business
concern.
o Work in Progress: These include those materials which have been committed
toproduction process but have not yet been completed.
o Consumables: These are the materials which are needed to smooth running of
themanufacturing process.
o Finished Goods: These are the final output of the production process of the
businessconcern. It is ready for consumers.
o Spares: It is also a part of inventories, which includes small spares and parts.
OBJECTIVES OF INVENTORY MANAGEMENT
Inventory occupies 30–80% of the total current assets of the business concern. It is also very
essential part not only in the field of Financial Management but also it is closely associated with
production management. Hence, in any working capital decision regarding the inventories, it will
affect both financial and production function of the concern. Hence, efficient management of

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inventories is an essential part of any kind of manufacturing process concern. The major
objectives of the inventory management are as follows:
 To efficient and smooth production process.
 To maintain optimum inventory to maximize the profitability.
 To meet the seasonal demand of the products.
 To ensure the level and site of inventories required.
 To plan when to purchase and where to purchase
 To avoid both over stock and under stock of inventory.
 To avoid price increase in future.
TECHNIQUES OF INVENTORY MANAGEMENT
Inventory management consists of effective control and administration of inventories. Inventory
control refers to a system which ensures supply of required quantity and quality of inventories at
the required time and at the same time prevents unnecessary investment in inventories. It needs
the following important techniques.

Techniques based on the order quantity of Inventories

Order quantity of inventories can be determined with the help of the following techniques:
STOCK LEVEL
Stock level is the level of stock which is maintained by the business concern at all times.
Therefore, the business concern must maintain optimum level of stock to smooth running of the
business process. Different level of stock can be determined based on the volume of the stock.

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Minimum Level
The business concern must maintain minimum level of stock at all times. If the stocks are less
than the minimum level, then the work will stop due to shortage of material.

Re-order Level
Re-ordering level is fixed between minimum level and maximum level. Re-order level is the
level when the business concern makes fresh order at this level. Re-order level=maximum
consumption × maximum Re-order period.
Maximum Level
It is the maximum limit of the quantity of inventories, the business concern must maintain. If the
quantity exceeds maximum level limit then it will be overstocking. Maximum level = Re-order
level + Re-order quantity – (Minimum consumption × Minimum delivery period
Danger Level
It is the level below the minimum level. It leads to stoppage of the production process. Danger
level=Average consumption × Maximum re-order period for emergency purchase
Average Stock Level
It is calculated such as, Average stock level= Minimum stock level + ½ of re-order quantity.
Lead Time
Lead time is the time normally taken in receiving delivery after placing order s with suppliers.
The time taken in processing the order and then executing it is known as lead time.

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Safety Stock
Safety stock implies extra inventories that can be drawn down when actual lead time and/ or
usage rates are greater than expected. Safety stocks are determined by opportunity cost and
carrying cost of inventories. If the business concerns maintain low level of safety stock, it will
lead to larger opportunity cost and the larger quantity of safety stock involves higher carrying
costs.
ECONOMIC ORDER QUANTITY (EOQ)
EOQ refers to the level of inventory at which the total cost of inventory comprising ordering cost
and carrying cost. Determining an optimum level involves two types of cost such as ordering
cost and carrying cost. The EOQ is that inventory level that minimizes the total of ordering of
carrying cost. EOQ can be calculated with the help of the mathematical formula: EOQ = 2ab/c

TECHNIQUES BASED ON THE CLASSIFICATION OF INVENTORIES

A-B-C analysis
It is the inventory management techniques that divide inventory into three categories based on
the value and volume of the inventories; 10% of the inventory’s item contributes to 70% of value
of consumption and this category is known as a category. About 20% of the inventory item
contributes about 20% of value of consumption and this category is called category B and 70%

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of inventory item contributes only 10% of value of consumption and this category is called C
category.
Aging Schedule of Inventories
Inventories are classified according to the period of their holding and also this method helps to
identify the movement of the inventories. Hence, it is also called as,

FNSD analysis—
Where,
F = Fast moving inventories
N = Normal moving inventories
S = Slow moving inventories
D = Dead moving inventories
This analysis is mainly calculated for the purpose of taking disposal decision of the inventories.
VED Analysis
This technique is ideally suited for spare parts in the inventory management like ABC analysis.
Inventories are classified into three categories on the basis of usage of the inventories.
V = Vital item of inventories
E = Essential item of inventories
D = Desirable item of inventories
HML Analysis
Under this analysis, inventories are classified into three categories on the basis of the value of the
inventories.
H = High value of inventories
M = Medium value of inventories
L = Low value of inventories
Valuation of Inventories
Inventories are valued at different methods depending upon the situation and nature of
manufacturing process. Some of the major methods of inventory valuation are mentioned as
follows:
 First in First out Method (FIFO)
 Last in First out Method (LIFO)

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  Highest in First out Method (HIFO)
 Nearest in First out Method (NIFO)
 Average Price Method

FINANCING WORKING CAPITAL THROUGH SHORT-TERM SOURCES

Funds available for a period of one year or less are called short-term sources of finance. They are
raised from sources, which can provide funds only for short period quickly, and its cost is less
than the funds raised from long-term sources. These funds are usually met by taking short-term
loans or getting the bills discounting from the commercial banks. Spontaneous sources and bank
loans are important sources of short-term funds. They are explained in detail below.

Spontaneous Sources Some sources of funds, which are created during the course ofnormal
business activity have zero cost and are termed as spontaneous sources. For example suppliers
supply goods; employees provide services where the payment is made at a later stage.
Trade Credit The credit extended in connection with the goods purchased for resale bya retailer
or a wholesaler for materials used by manufacturers in producing its products is called the trade
credit. Trade credit is a form of short-term financing common is almost all types of business
firm. As a matter of fact, it is the largest source of short-term funds. The amount of such
financing depends on the volume of purchase and the payment timings. Small and new firms are
usually more dependent on the trade credit, as they find it difficult to obtain funds from other
sources.
(a) An opening account credit and (b) Acceptance credit management / bills payable.
Bank Loans
The bank loans, in general, are a short-term financing say for a year or so. This short-term
financing to business firm is regarded as self-liquidating. It means, banks routinely provide
finance to meet the seasonal demand e.g., to cover the seasonal increase in inventories or

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receivables. Sometimes, the banks may approve separate limits for peak season and non-peak
season. The main sources of short-term funds are cash credit, overdraft and bill discounting.
Types of Bank Loans In India banks provide financial assistance for working capital indifferent
shapes and forms. The usual forms of bank loans are as follows:
o Cash credit:.
o Overdraft.
o Bills discount and bills purchased
OTHER SOURCES
Factoring
In case of credit sales, it attracts more customers, resulting in increased sales and higher profit,
but it has a cost also. This cost may be of two types, namely investment cost and administrative
cost. Moreover, the sellers have to raise funds from various sources in order to finance the
receivables. While maintaining receivables, a firm may have to face two types of problems. First,
the problem of rising funds to finance the receivables, and second the problem relating to
collection, delay and defaults of the receivables. If the firm concentrates on managing funds and
receivables, it cannot concentrate on other functions like finance, production, marketing,
personal etc. Under this situation a firm can avail the services of a specialist organization
engaged in receivables management. These specialist firms are known as factoring firms.
COMMERCIAL PAPERS
Commercial Papers are debt instruments issued by corporate for raising short-term resources
from the money market. These are unsecured debts of corporate. They are issued in the form of
promissory notes, redeemable at par to the holder at maturity. Only corporate who get an
investment grade rating can issue CPs as per RBI rules. Though CPs is issued by corporate, they
could be good investments if proper caution is exercised.
Inter Corporate Deposits (ICD)

Sometimes, the companies borrow funds for a short-term period; say up to six months, from
other companies, which have surplus liquidity for the time being. The ICD are generally
unsecured and are arranged by a financier. The ICD are very common and popular in practice,
as these are not influenced by the legal hassles. The convenience is the basic virtue of this
method of financing. There is no regulation at present in India to regulate these ICD. Moreover,

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these are not covered by the section 58A of the companies Act, 1956, as the ICD are not for
long term
Cash Budget
Cash budget is an estimation of the cash inflows and outflows for a business or individual for a
specific period of time. Cash budgets are often used to assess whether the entity has sufficient
cash to fulfill regular operations and/or whether too much cash is being left in unproductive
capacities.
For individuals, creating a cash budget is a good method for determining where their cash is
regularly being spent. This awareness can be beneficial because knowing the value of certain
expenditures can yield opportunities for additional savings by cutting unnecessary costs.
For example, without setting a cash budget, spending a dollar a day on a cup of coffee seems
fairly unimpressive. However, upon setting a cash budget to account for regular annual cash
expenditures, this seemingly small daily expenditure comes out to an annual total of Rs.365,
which may be better spent on other things. If you frequently visit specialty coffee shops, your
annual expenditure will be substantially more.
Credit terms or terms of credit is the agreement between a seller and buyer that lists the timing
and amount of payments the buyer will make in the future. In other words, this is the contract
that describes the specific details of the seller’s payment requirements that the buyer must meet
into order to purchase goods on account.
Most companies have credit policies set up with vendors or customers, so purchases can be made
on account. These credit purchases help speed up commerce and increase sales because it allows
customers to purchase items before they actually have the funds to buy them.
Before a credit sale can be made, credit terms must be established. Most terms are dictated by
industry practices and the specific goods sold in those industries. A standard term rate that
applies across most industries is 2/10 N/30—often called 2/10 net/30
Problems
Illustration 1
From the following particulars, find out average value per item if astores has 50,000 items of
consumption and a yearly consumptionis Rs. 60,00,000.
Class Percentage of Total No. of Items Percentage ofTotal Value
A 5 80

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 B 20 15
C 75 5
Solution:
Category No. of % ofTotalNo. of ValueRs.4 % of theAverageValue
Items2 Items3 TotalValue5Per ItemRs.6
A 2,500 5 48,00,000 80 1,920
B 10,000 20 9,00,000 15 90
C 37,500 75 3,00,000 5 8
Total 50,000 100 60,00,000 100
Problem - 2
M/s Air Cool Services Ltd., Jalgaon manufacturers of Air Coolersgive the following information
in respect of two components namely
A and B used in the manufacturing process:
Normal Usage 200 units per week each.
Maximum usage 300 units per week each
Minimum Usage 100 units per week each.
Reorder quantity:
A 1,600 units
B 2,400 units
Reorder Period for:
A 2 to 4 weeks.
B 1 to 2 weeks.
Calculate for each component:
1. Reorder Level
2. Minimum Level
3. Maximum Level
4. Average stock Level
Solution:
Component A Component B
1. ReorderLevel
= (Maximum Consumption X

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Maximum Reorder period ) = 300 units x 4 weeks = 300 units x 2 weeks
= 1,200 Units. = 600 Units.
2. MinimumLevel
= [Reorder Level – (Normal
Consumption X Average Period of
Delivery)]
= 1,200 – (200 X 2+4/2)= 600 – (200 X 1+2/2)
= 600 Units = 300 Units
3. MaximumLevel
= {Reorder Level + Reorder
Quantity – (Minimum Consumption
X minimum Time for Reordering)}
= 1,200 + 1,600 – (100 X 2) = 600 + 2,400 – (100 X 1)
= 2,600 Units = 2,900 Units
4. Averagestock Level
= (Maximum Level + Minimum
Level / 2) = 2,600 +600 / 2 = 2,900 +300 / 2
= 1,600 Units. = 1,600 Units.
Illustration 3
POR Ltd. manufactures a special product, which requires ‘ZED’.
The following particulars were collected for the year 2009 – 10:
1. Monthly demand of Zed 7,500 Units
2. Cost of placing an order Rs. 500
3. Reorder Period 5 to 8 weeks
4. Cost per unit Rs. 60
5. Carrying Cost % p.a. 10%
6. Normal Usage 500 Units per week
7. Minimum Usage 250 Units per week
8. Maximum Usage 750 Units per week
Required:
1. Reorder Level

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 2. Minimum Stock Level
3. Maximum Stock Level
4. Average Stock Level
Solution
1. Reorder Level
= Maximum reorder period x Maximum usage
= 8 weeks x 750 unit per week
= 6,000 Units.
2. Minimum Stock Level
= Reorder Level + (Normal Usage x Normal reorder Period)
= 6,000 units – (500 x 6.5 weeks)
= 2,750 Units
3. Maximum stock Level
= (Reorder level + Reorder quantity) – (Minimum Usage x
Minimum reorder period)
= (6,000 units + 3,873 units) – (250 units x 5 weeks)
= 9,873 units - 1,250 Units
= 8,623 units
4. Average Stock Level
= (minimum Level + ½ reorder quantity) / 2
= (2,750 units + 8,623 units)/ 2
= 5,687
5. Minimum Level + ½ reorder quantity
= 2,750 units + ½ X 3,873 Units
= 4,686
Conclusion
A good inventory management is important to the successfuloperations of most organizations,
unfortunately the importance of inventory is not always appreciated by top management. This
maybe due to a failure to recognize the link between inventories andachievement of
organizational goals or due to ignorance of theimpact that inventories can have on costs and
profits.

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Inventory management refers to an optimum investment ininventories. It should neither be too
low to effect the productionadversely nor too high to block the funds unnecessarily.
Excessinvestment in inventories is unprofitable for the business. Bothexcess and inadequate
investments in inventories are not desirable.The firm should operate within the two danger
points. The purposeof inventory management is to determine and maintain the optimumlevel of
inventory investment.
Questions
1. What is inventory management?
2. What are the kinds of investment?
3. State the objectives of inventory management
4. Explain the techniques of inventory management
5. What is EOQ?
6. What is ABC analysis?
7. What is FIFO
8. Explain LIFO
9. State the difference between HIFO and NIFO.

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 Lesson – 15
WORKING CAPITAL FINANCING AND SOURCES
Introduction
Working capital financing is done by various modes such as trade credit, cash credit / bank
overdraft, working capital loan, purchase of bills / discount of bills, bank guarantee, letter of
credit, factoring, commercial paper, inter-corporate deposits etc.
Most small businesses at some point or another will need more working capital than the
company itself can supply. Fortunately there are several resources available to small business
owners that can provide the cash needed for daily and monthly operations.
TYPES OF WORKING CAPITAL FINANCING / LOANS
 TRADE CREDIT
This is simply the credit period which is extended by the creditor of the business. Trade credit is
extended based on the creditworthiness of the firm which is reflected by its earning records,
liquidity position and records of payment. Just like other sources of working capital financing,
trade credit also comes with a cost after the free credit period. Normally, it is a costly source as a
means of financing business working capital.
 CASH CREDIT / BANK OVERDRAFT
Cash credit or bank overdraft is the most useful and appropriate type of working capital
financing extensively used by all small and big businesses. It is a facility offered by commercial
banks whereby the borrower is sanctioned a particular amount which can be utilized for making
his business payments. The borrower has to make sure that he does not cross the sanctioned
limit. The best part is that the interest is charged to the extent the money is used and not on the
sanctioned amount which motivates him to keep depositing the amount as soon as possible to
save on interest cost. Without a doubt, this is a cost effective working capital financing.
 WORKING CAPITAL LOANS
Working capital loans are as good as term loan for a short period. These loans may be repaid in
installments or a lump sum at the end. The borrower should take such loans for financing
permanent working capital needs. The cost of interest would not allow using such loans for
temporary working capital.

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  PURCHASE / DISCOUNT OF BILLS
For a business, it is another good service provided by commercial banks for working capital
financing. Every firm generates bills in the normal course of business while selling goods to
debtors. Ultimately, that bill acts as a document to receive payment from the debtor. The seller
who requires money will approach the bank with that bill and bank will apply discount on the
total amount of the bill based on the prevailing interest rates and pay the remaining amount to the
seller. On the date of maturity of that bill, the bank will approach the debtor and collect the
money from him.
 BANK GUARANTEE
It is primarily known as non-fund based working capital financing. Bank guarantee is acquired
by a buyer or seller to reduce the risk of loss to the opposite party due to non-performance of
agreed task which may be repaying of money or providing of some services etc. A buyer ‘B1’ is
buying some products from seller ‘S1’. In this case, ‘B1’ may acquire bank guarantee from the
bank and give it to ‘S1’ to save him from the risk of nonpayment. Similarly, if ‘S1’ may acquire
bank guarantee and hand it over to ‘B1’ to save him from the risk of getting lower quality goods
or late delivery of goods etc. In essence, a bank guarantee is revoked by the holder only in case
of non-performance by the other party. Bank charges some commission for same and may also
ask for security.
 LETTER OF CREDIT
It is also known as non-fund based working capital financing. Letter of credit and bank guarantee
has a very thin line of difference. Bank guarantee is revoked and the bank makes payment to the
holder in case of non-performance of the opposite party whereas, in the case of a letter of credit,
the bank will pay the opposite party as soon as the party performs as per agreed terms. So, a
buyer would buy a letter of credit and send it to the seller. Once the seller sends the goods as per
the agreement, the bank would pay the seller and collects that money from the buyer.
 FACTORING
Factoring is an arrangement whereby a business sells all or selected accounts payables to a third
party at a price lower than the realizable value of those accounts. The third party here is known
as the ‘factor’ who provides factoring services to business. The factor would not only provide
financing by purchasing the accounts but also collects the amount from the debtors. Factoring is
of two types – with recourse and without recourse. The credit risk of nonpayment by the debtor

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is borne by the business in case of with recourse and it is borne by the factor in the case of
without recourse.
SOURCES OF WORKING CAPITAL
1. Bank Loans
Working capital, or the money a company needs to run its normal operating cycle, can be
obtained from small business loans. Borrowers can turn to commercial lenders, credit unions,
local banks and even the government’s Small Business Administration for these type of loans.
The repayment terms can a short as one-year and as long as seven years. Working capital loans
are generally secured by some of the company’s assets.
2. Lines of Credit
Another type of small business financing available from banks and other lenders is a line of
credit. This allows business owners to take out funds on an as-needed basis, similar in some
ways to a credit card. These often have shorter repayment terms and are best for short-term
working capital needs. Lines of credit are also typically secured by the firm’s assets but are often
slightly more expensive than standard bank loans.
3. Trade Credit
Businesses can also make trade credit agreements with their long-time suppliers. The suppliers
agree to provide the service or good with delayed payment terms. Trade credit terms are wholly
determined between supplier and small business owner, but most credit extended is typically due
no more than 90 days after service or supply date.
4. Factoring
Factoring companies will buy your accounts receivable at a discount and then collect the
balances for themselves. This is a pricier way to finance working capital, but it can be a short-
term solution for businesses truly strapped for cash.
With the help of one or more of these sources, small businesses can keep their daily operations
running smoothly until their profits become self-sustaining.

COMMITTEE REPORT

The following points highlight the six committees involved in financing working capital by
banks, i.e, 1. Dehejia Committee 2. Tandon Committee 3. Chore Committee 4.Marathe
Committee 5. Chakravarty Committee 6. Kannan Committee Report.

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1. Dehejia Committee Report:
National Credit Council constituted a committee under the chairmanship of Shri V.T. Dehejia in
1968 to ‘determine the extent to which credit needs of industry and trade are likely to be inflated
and how such trends could be checked’ and to go into establishing some norms for lending
operations by commercial banks.
The committee was of the opinion that there was also a tendency to divert short-term credit for
long-term assets. Although committee was of the opinion that it was difficult to evolve norms for
lending to industrial concerns, the committee recommended that the banks should finance
industry on the basis of a study of borrower’s total operations rather than security basis alone.
The Committee further recommended that the total credit requirements of the borrower should be
segregated into ‘Hard Core’ and ‘Short-term’ component.
The ‘Hard Core’ component which should represent the minimum level of inventories which the
industry was required to hold for maintaining a given level of production should be put on a
formal term loan basis and subject to repayment schedule. The committee was also of the
opinion that generally a customer should be required to confine his dealings to one bank only.
2. Tandon Committee Report:
Reserve Bank of India set up a committee under the chairmanship of Shri P.L. Tandon in July
1974. The terms of reference of the Committee were:
(1) To suggest guidelines for commercial banks to follow up and supervise credit from the
point of view of ensuring proper end use of funds and keeping a watch on the safety of
advances;
(2) To suggest the type of operational data and other information that may be obtained by
banks periodically from the borrowers and by the Reserve Bank of India from the leading
banks;
(3) To make suggestions for prescribing inventory norms for the different industries, both in
the private and public sectors and indicate the broad criteria for deviating from these
norms ;
(4) To make recommendations regarding resources for financing the minimum working
capital requirements;
(5) (5) To suggest criteria regarding satisfactory capital structure and sound financial basis in
relation to borrowings;

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 (6) (6) To make recommendations as to whether the existing pattern of financing working
capital requirements by cash credit/overdraft system etc., requires to be modified, if so, to
suggest suitable modifications.
The committee was of the opinion that:
(i) Bank credit is extended on the amount of security available and not according to the level of
operations of the customer,
(ii) Bank credit instead of being taken as a supplementary to other sources of finance is treated as
the first source of finance.
Although the Committee recommended the continuation of the existing cash credit system, it
suggested certain modifications so as to control the bank finance. The banks should get the
information regarding the operational plans of the customer in advance so as to carry a realistic
appraisal of such plans and the banks should also know the end-use of bank credit so that the
finances are used only for purposes for which they are lent.
The recommendations of the committee regarding lending norms have been suggested
under three alternatives. According to the first method, the borrower will have to
contribute a minimum of 25% of the working capital gap from long-term funds, i.e.,
owned funds and term borrowing; this will give a minimum current ratio of 1.17: 1.
3. Chore Committee Report:
The Reserve Bank of India in March, 1979 appointed another committee under the chairmanship
of Shri K.B. Chore to review the working of cash credit system in recent years with particular
reference to the gap between sanctioned limits and the extent of their utilization and also to
suggest alternative type of credit facilities which should ensure greater credit discipline.
The important recommendations of the Committee are as follows:
(i) The banks should obtain quarterly statements in the prescribed format from all borrowers
having working capital credit limits of Rs 50 lacs and above.
(ii) The banks should undertake a periodical review of limits of Rs 10 lacs and above.
(iii) The banks should not bifurcate cash credit accounts into demand loan and cash credit
components.
(iv) If a borrower does not submit the quarterly returns in time the banks may charge penal
interest of one per cent on the total amount outstanding for the period of default.

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(v) Banks should discourage sanction of temporary limits by charging additional one per cent
interest over the normal rate on these limits.
(vi) The banks should fix separate credit limits for peak level and non-peak level, wherever
possible.
(vii) Banks should take steps to convert cash credit limits into bill limits for financing sales.
4. Marathe Committee Report:
The Reserve Bank of India, in 1982, appointed a committee under the chairmanship of Marathe
to review the working of Credit Authorisation Scheme (CAS) and suggest measures for giving
meaningful directions to the credit management function of the Reserve Bank. The
recommendations of the committee have been accepted by the Reserve Bank of India with minor
modifications.
The principal recommendations of the Marathe Committee include:
(i) The committee has declared the Third Method of Lending as suggested by the Tanden
Committee to be dropped. Hence, in future, the banks would provide credit for working capital
according to the Second Method of Lending.
(ii) The committee has suggested the introduction of the ‘Fast Track Scheme’ to improve the
quality of credit appraisal in banks. It recommended that commercial banks can release without
prior approval of the Reserve Bank 50% of the additional credit required by the borrowers (75%
in case of export oriented manufacturing units) where the following requirements are fulfilled:
(a) The estimates/projections in regard to production, sales, chargeable current assets, other
current assets, current liabilities other than bank borrowings, and net working capital are
reasonable in terms of the past trends and assumptions regarding most likely trends during the
future projected period.
(b) The classification of assets and liabilities as ‘current’ and ‘non-current’ is in conformity with
the guidelines issued by the Reserve Bank of India.
(c) The projected current ratio is not below 1.33 : 1.
(d) The borrower has been submitting quarterly information and operating statements (Form I, II
and III) for the past six months within the prescribed time and undertakes to do the same in
future also.

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(e) The borrower undertakes to submit to the bank his annual account regularly and promptly,
further, the bank is required to review the borrower’s facilities at least once in a year even if the
borrower does not need enhancement in credit facilities.
5. Chakravarty Committee Report:
The Reserve Bank of India appointed another committee under the chairmanship of
SukhamoyChakravarty to review the working of the monetary system of India. The committee
submitted its report in April, 1985.
The committee made two major recommendations in regard to the working capital finance:
(i) Penal Interest for Delayed Payments:
The committee has suggested that the government must insist that all public sector units, large
private sector units and government departments must include penal interest payment clause in
their contracts for payments delayed beyond a specified period. The penal interest may be fixed
at 2 per cent higher than the minimum lending rate of the supplier’s bank.
(ii) Classification of Credit Limit Under Three Different Heads:
The committee further suggested that the total credit limit to be sanctioned to a borrower
should be considered under three different heads:
(1) Cash Credit I to include supplies to government,
(2) Cash Credit II to cover special circumstances, and
(3) Normal Working Capital Limit to cover the balance credit facilities.
The interest rates proposed for the three heads are also different. Basic lending rate of the bank
should be charged to Cash Credit II, and the Normal Working Capital Limit be charged as
below:
(a) For Cash Credit Portion: Maximum prevailing lending rate of the bank.
(b) For Bill Finance Portion: 2% below the basic lending rate of the bank.
(c) For Loan Portion: The rate may vary between the minimum and maximum lending rate of the
bank.
6. Kannan Committee Report:
In view of the ongoing liberalization in the financial sector, the Indian Banks Association (IBA)
constituted a committee headed by Shri K. Kannan, Chairman and Managing Director of Bank of
Baroda to examine all the aspects of working capital finance including assessment of maximum
permissible bank finance (MPBF). The Committee submitted its report on 25th February, 1997.

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It recommended that the arithmetical rigidities imposed by Tandon Committee (and reinforced
by Chore Committee) in the form of MPBF computation so far been in practice, should be
scrapped. The Committee further recommended that freedom to each bank be given in regard to
evolving its own system of working capital finance for a faster credit delivery so as to serve
various borrowers more effectively.
It also suggested that line of credit system (LCS), as prevalent in many advanced countries,
should replace the existing system of assessment/fixation of sub-limits within total working
capital requirements.
The Committee proposed to shift emphasis from the Liquidity Level Lending (Security Based
Lending) to the Cash Deficit Lending called Desirable Bank Finance (DBF). Some of the
recommendations of the committee have already been accepted by the Reserve Bank of India
with suitable modifications.
The important measures adopted by RBI in this respect are given below:
(i) Assessment of working capital finance based on the concept of MPBF, as recommended by
Tandon Committee, has been withdrawn. The banks have been given full freedom to evolve an
appropriate system for assessing working capital needs of the borrowers within the guidelines
and norms already prescribed by Reserve Bank of India.
(ii) The turnover method may continue to be used as a tool to assess the requirements of small
borrowers. For small scale and tiny industries, this method of assessment has been extended upto
total credit limits of Rs 2 crore as against existing limit of 1 crore.
(iii) Banks may now adopt Cash Budgeting System for assessing the working capital finance in
respect of large borrowers.
(iv) The banks have also been allowed to retain the present method of MPBF with necessary
modification or any other system as they deem fit.
(v) Banks should lay down transparent policy and guidelines for credit dispensation in respect of
each broad category of economic activity.
(vi) The RBI’s instructions relating to directed credit, quantitative limits on lending and
prohibitions of credit shall continue to be in force. The present reporting system to RBI under the
Credit Monitoring Arrangement (CMA) shall also continue in force.

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Conclusion
There are many types of working capital financing available, and choosing the right product
depends on your sector and circumstances, as well as what you're trying to achieve. To find out
more about working capital financing, browse the related articles below or get in touch.
Questions
1. What are the types of working capital financing?
2. Explain the sources of working capital.
3. Explain the 6 committee report of working capital.

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 UNIT – V
Lesson – 16
INTERNAL FINANCING
Introduction
In order to grow your small business into a larger one, it is important to invest in it. And to invest
in your business, you need access to finance. Unfortunately, external sources of finance —
lenders and investors — are often skeptical of small businesses. This can leave you to rely on
internal sources of finance for investing in your business.
Meaning
In the theory of capital structure, internal financing is the name for a firm using its profits as a
source of capital for new investment, rather than a) distributing them to firm's owners or other
investors and b) obtaining capital elsewhere. It is to be contrasted with external financing which
consists of new money from outside of the firm brought in for investment. Internal financing is
generally thought to be less expensive for the firm than external financing because the firm does
not have to incur transaction costs to obtain it, nor does it have to pay the taxes associated with
paying dividends. Many economists debate whether the availability of internal financing is an
important determinant of firm investment or not. A related controversy is whether the fact that
internal financing is empirically correlated with investment implies firms are credit
constrained and therefore depend on internal financing for investment.
ADVANTAGES AND DISADVANTAGES OF INTERNAL SOURCING
Advantages
 Capital is immediately available
 No interest payments
 No control procedures regarding creditworthiness
 Spares credit line
 No influence of third parties
 More flexible
 More freedom given to the owners
Disadvantages
 Expensive because internal financing is not tax-deductible
 No increase of capital

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 Losses (shrinking of capital) are not tax-deductible
 Limited in volume (volume of external financing as well is limited but there is more capital
available outside - in the markets - than inside of a company)
INTERNAL SOURCES OF FINANCE
1. Retained Earnings

Retained earnings are an easy source of internal financing to use because they are liquid assets.
Retained earnings are the portion of net income that you have retained in your company and not
paid out. In a small business, retained earnings are usually paid out to the owners, who often do
not draw a budgeted salary. Instead of paying out retained earnings, you can reinvest them into
the company.

2. Current Assets

Current assets consist of cash or anything that can easily be converted into cash. For example, if
your business has stock holdings in other companies, you can divest yourself of those stocks and
use the proceeds as a source of financing. You should be careful, however, not to decrease your
current assets to levels less than your current liabilities, as this may prevent you from paying off
your debts.

3. Fixed Assets

Fixed assets are those that are not easily converted to cash. Typically, these assets include
equipment, property and factories. Because these assets take time to convert to cash, they cannot
be relied on for short-term access to finance. If you have the time, however, you could — for
example — sell off some equipment or even property to invest in your business. This is
particularly useful if your needs have outgrown some of your fixed assets — for example, if you
need to purchase newer equipment.

4. Personal Savings

Personal savings are the backbone of many small businesses. If your business doesn't have the
assets to finance your project, you may still have personal finances that you can contribute to the
business. This provides an alternative to seeking external investors or loans and allows you to
retain control over your business.

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Conclusion
The term ‘Internal Source of Finance / Capital’ itself suggests the very nature of finance / capital.
This is the finance or capital which is generated internally by the business unlike finances such
as loan which is externally arranged from banks or financial institutions. The internal source of
finance is retained profits, the sale of assets and reduction / controlling of working capital.
Questions:
1. What is internal source of finance? Explain the advantages and disadvantages.
2. What are internal sources of finance?

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 Lesson – 18
DIVIDENDS
Introduction
A dividend is a payment made by a corporation to its shareholders, usually as a distribution
of profits. When a corporation earns a profit or surplus, the corporation is able to re-invest the
profit in the business (called retained earnings) and pay a proportion of the profit as a dividend to
shareholders. Distribution to shareholders may be in cash (usually a deposit into a bank account)
or, if the corporation has a dividend reinvestment plan, the amount can be paid by the issue of
further shares or share repurchase.
MEANING OF DIVIDEND
Dividend refers to the business concerns net profits distributed among the shareholders. It may
also be termed as the part of the profit of a business concern, which is distributed among its
shareholders. According to the Institute of CharteredAccountant of India, dividend is defined
as “a distribution to shareholders out of profits or reserves available for this purpose”.
FORM OF DIVIDEND
(A) Cash dividend: A cash dividend is a usual method of paying dividends. Payment
ofdividend is cash results in the reduction out flow of funds and reduces the net worth of
the company. The shareholders get an opportunity to invest the cash in any manner, they
desire. Hence, the ordinary shareholders prefer to receive dividends in cash. In case of
companies having cash dividends, the firm must have adequate liquid resources, so that
its liquidity position is not adversely affected on account of cash dividend.
(B) Scrip (or) Bond dividend: A scrip dividend promises to pay the shareholders at
afuture specific date. In case a company does not have sufficient funds to pay dividends
in cash, it may issue notes or bonds for amounts due to the shareholders. The objective
of scrip dividends is to postpone the immediate payment of cash. A scrip dividend bears
interest and is accepted as collateral security.
(c) Property Dividend: Property dividends are paid in the form of some assets
otherthan cash. They are distributed under exceptional circumstances and are not
popular in India.
(d) Stock Dividend: Stocks dividend means the issue and the bonus shares to
theexisting shareholders. If a company does not have liquid resources, it is better to

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 declare stock dividends. Stock dividend amounts to capitalization of earnings and
distribution of profits among the existing shareholders without affecting the cash
position of the firm.
BONUS SHARE: A company can pay bonus to its shareholders either in cash or in theform of
shares. Many a times a company need not in a position to pay bonus in cash, in spite of sufficient
profits, because of unsatisfactory cash position or because of its adverse effects on the working
capital of the company. In such cases, if the Articles ofAssociation provide any conditions, then
it can pay bonus to its shareholders in the form of cash. The dictionary meaning of bonus shares
is a premium or gift, usually a stock, by a corporation to shareholders. A Bonus share is neither
dividend nor a Gift.
FACTORS DETERMINING DIVIDEND POLICY
 Profitable Position of the Firm:Dividend decision depends on the profitable position of
the business concern. When the firm earns more profit, they can distribute more
dividends to the shareholders.
 Uncertainty of Future Income:Future income is a very important factor, which affects
the dividend policy. When the shareholder needs regular income, the firm should
maintain regular dividend policy.
 Contractual constraints:Often, the firm’s ability to pay cash dividends is constrained by
restrictive provisions in a loan agreement. Generally, these constraints prohibit the
payment of cash dividends until a certain level of earnings have been achieved, or they
may limit dividends to a certain amount or a percentage of earnings. Constraints on
dividends help to protect creditors from losses due to the firm’s insolvency. The violation
of a contractual constraint is generally grounds for a demand of immediate payment by
the funds supplier.
 Internal constraints:The firm’s ability to pay cash dividends is generally constrained by
the amount of excess cash available rather than the level of retained earnings against
which to charge them. Although it is possible for a firm to borrow funds to pay dividends,
lenders are generally reluctant to make such loans because they produce no tangible or
operating benefits that will help the firm repay the loan. Although the firm may have high
earnings, its ability to pay dividends may be constrained by a low level of liquid assets.
(Cash and marketable securities) We will take the previous example to explain this point.

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 In our example, the firm can pay Rs.1, 40,000 in dividends. Suppose that the firm has
total liquid assets of Rs.50, 000 (Rs.20, 000 cash +marketable securities worth Rs.30,
000) and Rs.35, 000 of this is needed for operations, the maximum cash dividend the firm
can pay is 15,000 (Rs.50, 000 – Rs.35, 000)
 Growth prospects:The firm’s financial requirements are directly related to the
anticipated degree of asset expansion. If the firm is in a growth stage, it may need all its
funds to finance capital expenditures. Firms exhibiting little or no growth may never need
replace or renew assets. A growth firm is likely to have to depend heavily on internal
financing through retained earnings instead of distributing current income as dividends
 Owner considerations:In establishing a dividend policy, the firm’s primary concern
normally would be to maximize shareholder’s wealth. One such consideration is then tax
status of a firm’s owners. Suppose that if a firm has a large percentage of wealthy
shareholders who are in a high tax bracket, it may decide to pay out a lower percentage of
its earnings to allow the owners to delay the payments of taxes until they sell the stock.
Of course, when the equity share is sold, the proceeds are in excess of the original
purchase price, the capital gain will be taxed, possible at a more favorable rate than the
one applied to ordinary income. Lower-income shareholders, however who need dividend
income will prefer a higher payout of earnings. As of now, the dividend income is not
taxed in the hands of the shareholders in India. Instead, for paying out such dividends to
its shareholders, the company bears the dividend distribution tax.
 Market Considerations:The risk-return concept also applies to the firm’s dividend
policy. A firm where the dividends fluctuate from period to period will be viewed as
risky, and investors will require a high rate of return, which will increase the firm’s cost
of capital. So, the firm’s dividend policy also depends on the market’s probable response
to certain types of policies. Shareholders are believed to value a fixed or increasing level
of dividends as opposed to a fluctuating pattern of dividends.
 Legal Constrains:The Companies Act 1956 has put several restrictions regarding
payments and declaration of dividends. Similarly, Income Tax Act, 1961 also lays
down certain restrictions on payment of dividends.

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  Liquidity Position:Liquidity position of the firms leads to easy payments of dividend.
If the firms have high liquidity, the firms can provide cash dividend otherwise, they
have to pay stock dividend.
 Sources of Finance:If the firm has finance sources, it will be easy to mobilize large
finance. The firm shall not go for retained earnings.
 Growth Rate of the Firm:High growth rate implies that the firm can distribute
more dividends to its shareholders.
 Tax Policy:Tax policy of the government also affects the dividend policy of the firm.
When the government gives tax incentives, the company pays more dividends
 Capital Market Conditions:Due to the capital market conditions, dividend policy may
be affected. If the capital market is prefect, it leads to improve the higher dividend.
TYPES OF DIVIDEND POLICY

Dividend policy depends upon the nature of the firm, type of shareholder and profitable position.
On the basis of the dividend declaration by the firm, the dividend policy may be classified under
the following types:
• Regular dividend policy
• Stable dividend policy
• Irregular dividend policy
• No dividend policy.

 Regular Dividend Policy Dividend payable at the usual rate is called as regulardividend
policy. This type of policy is suitable to the small investors, retired persons and others.
 Stable dividend policy means payment of certain minimum amount of
dividendregularly. This dividend policy consists of the following three important forms:
Constant dividend per share Constant payout ratio Stable rupee dividend plus extra
dividend.
 Irregular Dividend Policy When the companies are facing constraints of earnings
andunsuccessful business operation, they may follow irregular dividend policy. It is one
of the temporary arrangements to meet the financial problems. These types are having
adequate profit. For others no dividend is distributed.
 No Dividend Policy Sometimes the company may follow no dividend policy becauseof
its unfavorable working capital position of the amount required for future growth of the

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 concerns. Dividend is divisible profit distributed amongst members/shareholders of a
company in proportion to shares in the manner as prescribed under law. A dividend
cannot be declared unless:
1. Sufficient profit is there in a company.
2. It has been recommended by Board of Directors.
3. Its acceptance has been given by the shareholders in Annual General
Meeting (AGM)
KIND OF DIVIDEND
 Type of Security – Preference Dividend, - Equity Dividend
 Timings of Dividends – Interim Dividend – Regular Dividend
 Mode of Payment–Cash–Stock dividend (Bonus)–Script or Bond.
Dividend Policy - Policy followed by Board of Directors concerningquantum of profit to be
distributed as dividend. It also includes principal rules and procedure for planning and
distributing dividend after deciding rate of dividend.
- Stable: Long term policy without frequent changes i.e. long term
policy which is not affected by changes or quantum of profit.

- Lenient: Most of the profit is distributed amongst shareholders and a

very small part is kept as retained earnings. Even 90% to 95% profit is
distributed as dividend. This is generally done in initial years to gain
confidence of shareholders.
Factors affecting dividend policy or determinants of dividend policy
 Legal requirements: As per companies Act, dividend only out of earned profit.
 Liquidity position: In tight liquidity position, instead cash dividend, bonus shares or
scripts/bonds are issued.
 Trade Cycle: In boom conditions, higher profits are there and hence high dividend.
 Expectations of share holders
 Future needs : If future needs are high, low dividend and high retained earnings
 Debt repayment: If heavy debt liability, low dividend.
 Stability of Income: If income is stable, high dividend.
 Public Opinion: High dividend to gain public confidence.

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  Composition of Owners: If preference shareholders are large, less dividend to
ordinary shareholders.

Models of Dividend (Theories)

Walter’s Model –As per this model, dividend policy of a firm is basedon the relationship
between internal rate of return (r) earned by it and the cost of capital or required rate of
return (k). The optimumdividend policy will have to be determined by relationship of r & k
under following assumptions.
- Internal rate of return ® and cost of capital (k) are constant.
- All new investment opportunities are to be financed through retained
earnings and no external finance is available to the firm.
- A firm has perpetual or an infinite life
Hence, as per this Model, a firm should retain its earnings if the return on investment
exceeds cost of capital.
Gordon’s Model–This model is like Walters Model but a few extraassumptions are
- The firm operates its investment activity only through equity.
- The retention ratio once decided is constant forever.
As per this Model, Market value of share is equal to present value of its expected future
dividend.
Modigliani& Miller (M M Model)–This model says that dividenddecision and retained
earnings decision do not influence market value of shares. As per this model, “Under
conditions of Perfect Capital.
Market, rational investors, absence of tax, discrimination between dividend income and
capital appreciation given the firm’s investment policy. Its dividend policy may have no
influence on the Market price of shares.
Problems
Category #1: Walter Model
Problem #1
From the following information, ascertain whether the firm is following an optimal divided
policy as per Walter’s Model:

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Total earnings (Rs): 600,000: Number of equity shares of Rs100 each: 40,000: Dividend
paid (Rs): 160,000: Prices-earnings (P/E) ratio: 10
The firm is expected to maintain its rate of return on fresh investment. What should be theP/E
ratio at which dividend policy will have no effect on the value of the share? Will youdecision
change if the P/E ratio is five instead of ten?
Solution
Total Earnings = 600,000
No of Shares = 40,000
Dividend Paid =160,000
P/E = 10
K =1/(P/E)
=1/10 = 10%
r =Net Income
Equity Value =600,000
40,000 ∗ 100 = 15%
According to Walter model if r>K
i.e. when return on investment is greater than its cost of capital equity then the
companyshould put back all the earnings back into company & not distribute any dividends
i.e. thedividend payout ratio should be zero
In such a scenario optimal dividend payout ratio = 0%
However here since the company is paying out the dividends the dividend policy cannot
beconsidered as optimal.
If the P/E ratio is 5 instead of 10 then the required return or cost of equity will be 20%which
is greater than actual return on investment. Hence the optimal dividend payoutpolicy in such
a scenario is to payout all earnings as dividends.
For dividend policy to have no effect on value of share, according to Walter model
thiscondition is met when r= k
i.e when k = 15%
This Implies P/E ratio should be 1/15% = 6.67
Illustration2: ABC Ltd. belongs to a risk class for which the appropriate capitalization rate is
10%. It currently has outstanding 5,000 shares selling at Rs.100 each. The firm is contemplating
the declaration of dividend of Rs.6 per share at the end of the current financial year. The

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company expects to have net income of Rs.50,000 and has a proposal for making new
investments of Rs.1,00,000. Show that under the MM hypothesis, the payment of dividend does
not affect the value of the firm.
Solution:
A. Value of the firm when dividends are paid:
(i) Price of the share at the end of the current financial year.
P1 = P0 (1 + Ke) – D1
= 100 (1 + 10) – 6
= 100 x 1.10 – 6
= 110 – 6 = Rs.104

B. Value of the firm when dividends are not paid:

(i) Price per share at the end of the current financial year
P1 = P0 (1 + ke) – D1
= 100 (1+.10)-0
= 100´1.10
= Rs. 110
Hence, whether dividends are paid or not, the value of the firm remains the same Rs. 5,00,000.
Illustration 3: Expandent Ltd. had 50,000 equity shares of Rs. 10 each outstanding on January
1. The shares are currently being quoted at par the market. In the wake of the removal of
dividend restraint, the company now intends to pay a dividend of Rs. 2 per share for the current
calendar year. It belongs to a risk-class whose appropriate capitalization rate is 15%. Using MM
model and assuming no taxes, ascertain the price of the company's share as it is likely to prevail
at the end of the year (i) when dividend is declared, and (ii) when no dividend is declared. Also
find out the number of new equity shares that the company must issue to meet its investment
needs of Rs. 2 lakhs, assuming a net income of Rs. 1.1 lakhs and also assuming that the dividend
is paid
Solution:
(i) Price as per share when dividends are paid
P1 = P0 (1+ke) – D1
= 10 (1+.15)-2
= 11.5-2
= Rs. 9.5.
(ii) Price per share when dividends are not paid:
P1 = P0 (1+ke)-D1
= 10 (1+. 15)-0
= Rs. 11.5

Illustration-4
Acompanyhasthefollowingfacts:
Costofcapital(ke)=0.10

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Earningspershare(E)=$10
Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25%
Show the effect of the dividend policy on the market price of the shares.

Solution:

Case A:
D/Pratio= 50%

When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5

5 + [0.08 / 0.10] [10 - 5]

P = 0.10 => $90

Case B:
D/Pratio=25%
When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5

2.5 + [0.08 / 0.10] [10 - 2.5]

P = 0.10 => $85

Illustration – 5
Cost of Capital (k) = 10%
Earnings per share (E) = Rs. 10.
Assume Internal Rate of Return (r):
(i) 15%; (ii) 10%; and (iii) 8% respectively
Assuming that the D/P ratios are: 0; 40%; 76% and 100% i.e., dividend share is (a) Rs. 0, (b) Rs.
4, (c) Rs. 7.5 and (d) Rs. 10, the effect of different dividend policies for three alternatives of r
may be shown as under:

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Thus, according to the Walter’s model, the optimum dividend policy depends on the relationship
between the internal rate of return r and the cost of capital, k. The conclusion, which can be
drawn up is that the firm should retain all earnings if r > k and it should distribute entire earnings
if r < k and it will remain indifferent when r = k.

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Illustration:6

Solution:

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167
Conclusion
Many investors seek dividend-paying stocks as a means of generating income and growing
wealth. As with any investment, it is important to do your homework and find investments
that are suitable to your investing style, time horizon, financial situation and financial
objectives. A variety of resources and tools are available in print and online to help you make
investment decisions. You can consult with qualified financial planners and tax specialists to
determine the best course of action for your investment strategy.
Questions:
1. What is meant by dividends?
2. What are the form of dividends?
3. State the factors determining the dividends.
4. What are the types of dividends?
5. Explain the kinds of dividends.
6. What are the factor affecting dividends policy?
7. State the models of dividends.

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Introduction

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Key Terms

 APT Arbitrage Pricing Theory (APT) is one of the tools used by the investors and
portfolio managers which explain return of the severities on the basis of their respective
betas. This theory was developed by Stephen Ross.
 Acquisition – Refers to effective working control by one company overanother. This
acquisition may be through either a friendly takeover or through forced or unwilling
take over. Generally acquisition is done through mutual argument.
 ABC Analysis – It stands for “Always Better Control” it is a technique ofinventory
control where all etenis of inventory are classified in two „A‟, „B‟ & „C‟ category
where „A‟ represents items of high rahu but quantity is very less, B represents items
of medium native and quantity is also and „e‟ represent items. Which are very high
quantity items but their value is much less.
 Refers to situation where two or more existing companies are combined in to a new
company formed for the purpose old companies cease to exist and their shareholders
and paid by the new company in each or through starts or debentures.
 Bita Estimation – Beta is a measure of volatility of stock priers in relationto
movement in the stock index of the market. If data of a sarthenlar share is high, it
means its price tomorrow more, if market price inevenes.
 Bridge Loan – It is a financer provider for inLevin period to meet urgentneeds of
borrower till he gets regular book sanctioned by development financial institutions.
 Bamaul Model – Is a model of assessing optimum cash balance. It is likeEOQ model
of inventory. According to this model, optimum is one at which carrying cost of cash
or cost of receiving cash is minimum.
 Evedin Terms – Refers to terms on which eveth is lieing provided to aloanee. These
terms include period of Baymend, purpose of credit and allowing cash/trade discount.
 Credit Standards – Are guiding principles set by the credit controldepartment to
sever credit applicants for this credit worthiness? They are basic criteria for extension
of credit to customers.
 Commercial Paper – Commercial Credit Assessment – Refers to assessment of
credit worthiness of a loanee. Generally, this is done by using 5 c‟s i.e. character,
capital, capacity collateral and conditions of the borrower.

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 Collection Policy – Refers to the policy of an organization to receivemoney from
debtors. This policy may be benientashure organization does not stick to time
schedule of getting payment and stringent when one is strictly adhore the tire of
schedule of getting payment and stringent when one is strictly adhorei.s. the tire of
payment.
 Capital Budgeting – Refers to total process of generally, eradiating, selecting and follow
up of capital expenditure alternatives. Such expenditure has a long term effect and is
based on risk and return.
 Corporate restructuring – Refers to reorganizing a company or itsbusiness so as to
approval it more effectively, efficiently and profitability. This restructuring may be
financial, technological, organizational or marketing restructuring.
 Corporate Governance – Refers to governance of a corporate on theprinciples of
transparency, alternate of legal provision and rules framed there under, internal rules
and directors and ethical values.
 Paper is an unsecured promissory notissued by a listed company haring sufficient
credit rating from an approved credit rating.
 Cash Budget – Refers to statement showing estimate of cash receipts,
casedisbursement and net cash has been for a future period of time. It helps in finding
and when cash would be in differ and when cash would by in surplus.
 Cost of Capital – Is reward for use of capital. It is price paid to theinration for the use
of capital provided lump hire. It is investors required rate of return.
 Cash Management – Refers to optimizing amount of cash available to thecompany
and maximizing interest on surplus funds to ensure that adequate cash is available for
payments due, minimize idle cash and maximizing interest on surplus cash.
 Incantation Banking – Refers to establishing multiple centers in variousparts of city for
fast collection of charges. The bank in the head office of farm is known as cancastrations
bank.
 CAPM – Capital Asset Pricing Model (CAPM) is a useful technique ofmeasuring risk
factor as well as required rate of return. It is a useful model in dealing with risk.

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 Dividend Policy – Policy followed by an organization coursing grantorof profit to by
distribute as dividend. Quantum of dividend in Annual General meeting of
shareholders.
 E.O.Q. – It stands for economic order quantity and refers to optimum sizeof an order
for replenishment of an item of inventory. At this point, ordering cost is minimum.
 Excess working capital – Refers to a situation where an organization hasworking
capital much more than required. It leads to loss of interest on express capital, in
efficiency and adversely affects the profitability.
 Finance – Refers to procuring or raising of money (funds) and allocating(using )
these resources (funds) on the basis of monetary requirements of the business. It also
includes distribution of funds (profit).
 Financial Management – Refers to planning, organizing, coordinatingand
controlling of raising, investment & distribution of funds for achieving goals of an
organization.
 Financing working capital – Refers to arranging working capital in anorganization i.e.
different sources from which capital is to be arranged sources for raising temporary/short
term/variable capital and permanent/ long term capital are different.
 Float – Float arises due to time gap between cheque loosed and time whenamount is
actually debited in account. This float may be postal float, deposit float or band float.
 Financial Engineering – Refers to new techniques of financial analysisand finding
solutions of financial problems through complex mathematical models and high speed
computer solutions.
 FSN Analysis of Stock – FSN Stands for fast moving, slow moving andnot moving
items of stock. It is maintained for fast moving items and comparatively less for slow
moving and not moving items.
 Gordan Model – It is one of the models of dividend theories. As per thismodel
market nature of share is equal to present value of it vibrated future dividend.
 Gross working capital – Refers to forms investments in current assetswhich are
converted in to cash during an accounting year such as cash, bank balance, short
terms investments debtors, bills receivable, inventory & short term loans/adarners.

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 Hire Purchase – Involves a system under which an asset is sold oninstallment basis
and title remains with the seller on payment of last & final installment the title goes to
the purchaser.
 Hiller Orr Model – This model is model for working art optimum cashlevel in an
organization. It is based on assumption that cash balances changes randomly Orr a period
of time and size. It prescribes two lands of cash i.e. upper limit and lower limit. Optimum
cashes his between upon limit and lower limit.
 Installment Sale – In this sale, title of goods is immediately transferred infavor of
purchaser and seller can’t repossess thesold asset and he has to follow normal
procedure for recovering pending installment.
 Inventory – Refers to stock of goods in the form of raw material, stores orsupplies,
work in progress and finished product on a particular date. It involves all functional
areas of management i.e. purchase, production, marketing & finance.
 Inventory Management – Refers to efficient management control ofcapital invested
in inventory to obtain maximum return by keeping inventory cash at minimum tow
objectives of inventory control are operating objectives and financial objectives.
Operating objectives refers to regular flow of material for production and financial
objection refers to maximizing return on investments and minimizing inventory costs.
 Inventory costs – Refers to costs associated with inventory such as costson
purchasing material, ordering costs, carrying costs and stock and cash. Order
inventory control, these costs are to by kept at minimum level.
 Inventory Control –Refers to exercising due control on inventory as it isan important
part of working capital. Such control is exercised by various modern techniques like
EOQ, ROP, Stock levels, ABC analysis, FSN analysis, VED analysis, SDE Analysis
etc.
 Lease (Operating & Financial) – Is a contractile arrangement whereowner of the
asset transfers the right to use the asset to user in return of rentals. Operating lease is
for a short term and lease period is less than usual life of the asset and financial lease
generally corers usual economic life of asst or a period close to the life of asset.

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 LBO – Leverage Buy Out (LBO) is acquisition financed throughborrowings by a
small group of investors against stocks or assets of the company. Te debt is secured
by the assets of acquired firm.
 Interim dividend – Refers to payment of dividend for an interim periodsay 3 months,
6 months. It is declared on the basis of quarterly result or simian results/profit of a
company to attract more share capital.
 Lock Box System – When form takes on rent post office boxes in selectedareas and
instructs their customers to mail this payment in these boxes, it is known as lock Box
System.
 Merger – Refers to continuation of two or more companies in to singlecompany This
merger is governed by the companies Act. 1956.
 MBO – Management Buy Out (MBO) is a way of aequisitianwheremanagement buy
business from it owners. It is known as take over rather than aquisitiai and resorted
when owners are unable to run a company successfully and very existence of
company is at stake.
 Mgmt. of Markelahh Securities – Refers to investment of surplus inreadily marketable
securities which are considered or cash equivalents to cash interest is holding period and
covert them in cash as & when required Investment is made keeping in view principles of
safety, liquidity, yield and maturity.
 Modigilliane Model – Is a model of dividend theories. This model saysthat dividend
decisions and retained earnings decision do not influence market value of shares.
 Maximum Permissible Bank Finance – (As per Tandon committee) MPBSis the
optimum Permissible bank finance based on the appraisal of balance sheet. Tandon
committee suggested 3 methods of working and MPBS. As per method I, Current
assets less current liabilities and 75% of balance is MPBS. As per method II, 75% of
current assets less current liabilities. As per method III, 75% of current assets less
current liabilities less core current assets.
 Net Working Capital – Refers to difference between current assets andcurrent
liabilities or excess of current assets over current liabilities.
 Operating cycle method of working capital – It represent cycle duringwhich cash is
reconverted in to cash. In a manufacturing process cash is required for purchasing raw

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 material, raw material is converted in work in progress and finished product, and
finished product is than sold both in cash & credit. Total number of days to complete
this cycle is centered and based on that working capital requirements are assessed.
 Project financing – Refers to arranging finance for developing andimplementation of
a project. It includes determination and mobilization of required funds of different
stages of implementation of project. Two main sources are own funds and look funds.
Funds in large granitites for such project are provided by development financial
institution (DFI‟s)
 Profit Maximization – As per trading thinkers, maximizing profit is thekey
objectives of financial management. They argue their proposition as it is national, real
list of business maximum social welfare, main source of inspiration and basis for
decision making.
 Perpetual inventory system – Is a method of recording stares balanceafter each receipt
and issue to vacillate regular checking to obviate closing down for stock taking.
 Reordering Point (ROP) – Refers to level of inventory of which an ordershould he
placed for replenishment of an item of inventory.

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