AGURCHAND MANMULL JAIN COLLEGE

(A Unit of Sri. S. S. Jain Educational Society)

Meenambakkam, Chennai – 600114.
Co – Education

A Jain Minority Institution

Affiliated to the University of Madras

NAAC Reaccredited

Shift – II

Department of Accounting & Finance

And

Computer Application
FINANCIAL MANAGEMENT –
Notes
 UNIT-1
NATURE OF FINANCIAL MANAGEMENT
Meaning - Definition - Nature - History - Objectives of the firm -

Profit Maximization vs Wealth maximization - Functions of Finance

Organisation of the Finance Function.

FINANCIAL MANAGEMENT - MEANING
Financial Management is that administrative area or set of administrative
functions which relate to the management of finance, both its sources and uses. It enables the
enterprise to have the means to carry out its objectives as satisfactorily as possible.
FINANCIAL MANAGEMENT - DEFINITION
"Financial Management is an application of general managerial principles to the area of
financial decision-making" - Howard and Upton

"Financial Management is an area of financial decision-making. harmonising individual

motives and enterprise goals" - Weston and Brigham

"Financial Management is concerned with the efficient use of an important economic resource,
namely, Capital Funds".- Soloman

"Financial Management is the operational activity of a business that is responsible for obtaining
and effectively utilişing the funds necessary for efficient operations". - Joseph and Massie.

SCOPE OF FINANCIAL MANAGEMENT

Finance, production and marketing are the three important activities of a
business firm. A firm secures capital for its need through finance activity and employs it
through production and marketing activities. Thus business firm is an entity that engages in
activities to perform the functions of finance, production and marketing.
It acquires funds from the sources called investors when invested, the funds are
called investments. The firm expects to receive returns on investments over time, and
periodically distributes returns to investors. These processes are not sequential, but
simultaneous and continuous.
FUNCTIONS OF THE MODERN APPROACH

Changing role of the financial manager:

Traditional Role:

Role and responsibilities of a finance manager have undergone significant changes over
the past three decades. The traditional finance manager had a very Role in a business enterprise.
He was responsible only for maintaining financial records, preparing reports, arranging and
administering the finance needed by the company to meet their financial requirements.
New Role:
In a modern enterprise, the financial manager occupies a key position. He is one of the
executives of top management team. His role, is becoming more pervasive, intensive and
significant in solving the complex management problems. In his new role, he must ensure that
the funds of the enterprise are utilised in the most efficient manner. He must realise that his
actions will influence in size, profitability, growth, risk and survival of the firm and as a
consequence will affect the overall value of the firm.
Functions of financial management:
The functions of financial manager can be divided into two ways:
a) Executive function and
b) Routine function
The prime responsibility of financial management is to see that and adequate
supply of cash in on hand at the proper time of smooth of firm's activities. Since both cash
inflow and cash outflow are closely related to the volume of sales, it requires financial
forecasting. Thus the estimation of the prospective inflow and outflow of cash in the next year
is necessary to maintain the liquidity in the funds.
i) Investment decisions:

The investment decision is the most important aspect of executive functions of a

financial manager. In investment decisions, the allocation of capital to various investment
proposals is made in order of their profitability. Each investment decision necessarily involves
risk and a financial help in evaluating the various proposals under uncertainty with the process
of capital budgeting.

ii) Management policy:

The formulation of sound asset management policies is an indispensable prerequisite to

successful financial management. The fixed and current assets of the firm must be managed
efficiently to ensure success. The financial manager is charged with varying degrees of
opera financial manager is charged with varying degrees of operating responsibility over
existing assets. He is more concerned with the management of current assets than with fixed
assets.
iii) Management of income:

It includes the allocation of net earnings among shareholders. The finance manager tries
to get an optimal dividend pay-out ratio that maximizes shareholder's worth in the long run.

vi) Management of cash:

Estimating and controlling cash flow is also an important function of financial

management. All cash must be managed for the benefit of the owners. The financial manager
should try for two things:

a) To choose the best among the alternative uses of funds; and

b) To ascertain the best use that stockholders could find outside the company. So
he must select the most desirable temporary investment for the excess cash and near cash
resources of the firm.

vii) Assessment of attitude:

Assessing the capital market's attitude towards the company and its shares.

viii) Decision about new sources of finance :

A business firm is always in need of funds, so the financial manager on the basis of
forecast of the volume of operation should decide upon the needs and prepare the detailed
financial plan for the procurement of funds both short-term and long-term. It is the
responsibility of the financial manager to evaluate the prospective cost of funds as against the
anticipated profit from the use of these funds by the operating units to which they are to be
allocated.

xi) Contact and carry negotiations for new financing

The financial manager has to decide upon the needs and finding out a suitable source
first. Then he has to contact the source and carry on the negotiations to finalise the terms and
conditions of the contract.
x) Analysis and Appraisal of financial performance:

To carry out finance functions smoothly proper analysis like checking and appraisal of
financial performance are very essential. For this purpose various financial statements are
prepared, analysed and then the necessary guidelines are set for future.

xi) Advising the top management:

It is an expert duty of the financial manager to advise the top management in respect of
financial matters, to suggest various alternative solutions for any financial difficulty and to
make steady efforts to increase the profitability of capital invested in the firm.

B. Incident or routine functions:

i) Record keeping and reporting.

ii) Preparation of various financial statements.

iii) Cash planning and supervision.

iv) Credit management.

v) Custody and safeguarding the different financial securities and the like.

vi) Providing top management with necessary and accurate information on current and
prospective financial conditions of the business as a basis for policy decisions on marketing
and pricing.

RESPONSIBILITY OF FINANCIAL MANAGEMENT

The responsibilities are extended to the following spheres of finance functions.

1. Financial planning: It is the chief responsibility of the financial executive to make a

sound financial forecast and then to plan for it. He must always try for the efficient
management of cash, so that the firm might not experience financial crisis and defer its
payments. If financial crisis continues for a long time the goodwill of firm suffers
severely and leads even to liquidation.

2. Raising of necessary funds: Another main responsibility is to supply the firm

adequate funds for various operations. Before raising funds a cost-benefit analysis of
various alternative sources must be made. Impact of additional financing on the risk
 and income of equity shareholders should be evaluated in terms of its costs, its impact
on the capital structure etc.
3. Controlling the use of funds: An effective control on cash inflow and cash outflow
should be followed.
4. Disposition of profits: The proper disposition of profits is also an important pheno
menon, which is the allocation of net profit after tax into payment of dividend to the
shareholders and retaining it for the expansion. The The financial management balances
the expectations of investors and the need of retained earnings to acquire additional
assets.
5. Responsibility to maximise the value: It is a regular and recurring responsibility of
financial manager to make continuous efforts to maximise the value of the firm for its
shareholders.
6. Legal obligations: The financial manager is under an obligation to consider enterprise
in the light of its legal obligations.
7. Maintaining regular employment at satisfactory rates of pay: The financial
management must be capable of maintaining regular employment at satisfactory rates
of pay under favourable working conditions.

GOALS OF FINANCIAL MANAGEMENT

(OR)
DISTINGUISH BETWEEN PROFIT MAXIMIZATION AND WEALTH
MAXIMIZATION.
(OR)
OBJECTIVES OF MANAGEMENT

Profit Maximization :

Maximization of profits is the basic objective of a business enterprise. Investors purchase

the shares of a company with the hope of getting maximum profits from the company as
dividend. It is possible only when company's goal is to earn maximum profits out of its
available resources. Financial management aims to safeguard the economic interest of the
persons who are directly or indirectly connected with the company. They must get the
maximum return for their contribution. This is possible only when the company earns higher
profits or sufficient profit to discharge its obligations to them.
Wealth Maximization:

Another main objective of the business enterprise is to maximize the value of the
company in the long run. This is also known as wealth maximization and net present worth
maximization. The use of this objective is almost universally accepted as an appropriate
operational decision criterion to choose among the alternative financial actions.

The wealth, maximization criterion is based on the concept of cash flows generated by
the decision. The objective of wealth maximization helps in resolve two most troublesome
problems, attached with the flow of benefits, namely time value of money and the problem of
handling risk and uncertainty of expected benefits. These problems are handled by selecting an
appropriate rate of discount.

Cash benefits of a project with higher risk exposure are discounted at higher discount
rate, while lower discount rate is applied to discount expected cash benefits of a less risky
project. By using this appropriate discount rate the NPV of a project is calculated with the help
of the total present value of cash inflows and cash outflows.

It implies the wealth maximization objective is consistent with the objective of

maximising the owner's economic welfare. fundamental principle to maximize the market
value of its shares in the long run in order to work out a normalised market price. Thus wealth
maximization is the operationally appropriate decision criterion

Objectives:

i) to ensure a fair return to shareholders.

ii) to build up the reserves for adequate growth and expansion.
iii) to ensure effective funds operation by efficient and effective utilisation of finances.
iv) to ensure financial discipline in the organisation.

TRADITIONAL ROLE OF THE FINANCE MANAGER AND

ELUCIDATE HIS PRESENT ROLE.
Traditional approach:

The scope of financial management and the role of the financial manager were
considered confined to the raising of funds. He was called upon to raise funds during the major
events, such as promotion, reorganization, expansion etc. His only significant duty was to see
that the firm had enough cash to meet its obligations. The traditional view on financial
management was based on the assumption that the financial manager had no concern with the
decisions of allocating firm's funds. He is required to raise the needed funds from the
combination of various sources. It broadly covered the following three aspects:

i) Arrangements of funds from financial institutions.

ii) Arrangement of funds through financial instruments such as shares, debentures,
bonds etc.
iii) Looking after the legal and accounting relationship between a corporation and
its sources of funds.

Criticism of Traditional approach:

a) Outsider-looking-in approach: It treated the subject of finance from the view

point of suppliers of funds and ignored the view point of management.

b) Ignored routine problems: The approach did give any importance to day-to-day
managerial problems relating to finance of the business undertakings.

c) Ignored non-corporate enterprises: The approach focussed attention only on the

financial problems of corporate enterprises. Non-corporate industrial organisations
remained outside its scope.

d) The problems relating to short term working capital financing were ignored.

e) It did not emphasise on allocation of funds.

Modern approach

According to modern concept, financial management is concerned with both

acquisition of funds and their allocation.

The four broad decision areas of financial management are

a) funds requirement decision.

b) financing decision
c) investment decision and
d) dividend decision.

Besides his traditional function of raising money, the financial manager will be
determining the size and technology, setting the pace and direction of growth and shaping the
profitability and risk complexion of the firm by selecting the best asset mix and by obtaining
the optimum financing mix. The financial manager has to look after profit-planning which
means operating decisions in the areas of pricing, volume of output and the firm's selection of
product lines. Profit-planning is a prerequisite for optimising investment and financing
decisions.

FINANCE FUNCTION.

"In a modem money - using economy, finance may be defined as the provision of money
at the time it is wanted" - F.W. Paish

"Business finance may be broadly defined as the activity concerned with planning, raising
controlling and administering of funds used in the business” - H Guthman and H Douggal

TYPES OF FINANCE DECISIONS.

i) The Investment decision

It is concerned with the effective utilisation of funds in one activity or the other. This
comprises decisions relating to investment in both capital and current assets. The finance
manager has to evaluate different capital investment proposals and select the best keeping in
view the overall objective of the enterprise.

ii) The Financing decision

This determines as to how the total funds required by the firm will be made available
through the issue of different types of securities. A company cannot depend upon only one
source of capital. Hence, before using any particular source of capital, the relative cost of
capital, degree of risk control etc. have to be carefully examined by the finance manager.

iii) The Dividend decision

Dividend decision helps the management in the declaration and payment of dividend to
the shareholders. It decides how much of the earnings should be distributed among the
shareholders and how much should be retained in the business for future expansion.
SIGNIFICANCE OF FINANCIAL MANAGEMENT
i) It helps in proper planning of generating funds.
ii) It helps in ascertaining how the company would perform in future.
iii)It helps to indicate whether the firm generates enough funds to meet its various
obligations like repayment of the various instalments due on loans, redemption of
other liabilities etc.
iv) It helps in profit planning, capital spending and measuring the costs.
v)It helps in controlling the inventories, accounts receivable, cash and their costs.
vi) It helps in optimising the output from a given input of funds.
RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT AND
OTHER AREAS OF MANAGEMENT.
i) Financial Management and Cost Accounting
The finance manager is concerned with proper utilization of funds and he is rightly
concerned with operational cost of the firm. For this purpose the informations supplied by the
cost accounting department is used by him to keep costs under control.
ii) Management and Marketing
Marketing is one of the most important areas. In determining the appropriate price for
the firm's products, the finance manager has to take a joint decision with marketing manager.
The marketing manager rovides information as to how different prices will affect the demand
the company's products in the market. While the financial manager supplies information about
costs, change in cost at different levels of production and the profit margins required to carry
on the business.

iii) Financial Management and Production

The acquisition of assets and their effective utilization affects the firm's finances. Hence,
the financial Manager has to take a joint decision regarding current and future utilization of the
firm's assets with production manager.

iv) Financial Management and Personnel Management

The recruitment, training and replacement of staff are all the functions of the personnel
Department. However all these require finance and therefore it is a joint decision of both.
 UNIT- 2
CAPITAL STRUCTURE & LEVERAGES
Meaning – Factors affecting Capital structure – Planning – Theories

of Capital Structure – Determining Debt Equity Proportion –

Leverage Concept.
CAPITAL STRUCTURE - MEANING
Capital structure of a company means the composition of long- term sources of
funds , such as ordinary shares , preference shares , debentures, bonds , long-term
debts and the like . It refers to the kind and proportion of securities for raising long –
term funds . It implies the determination of form or make – up of a company’s
capitalisation .

CAPITAL STRUCTURE – DEFINITION

“Capital structure refers to the kind of securities that make up the
capitalisation” - W. Gerstenberg

“Capital structure is the combination of debt and equity securities that

comprise a firm’s financing of itsassets” - John , J. Hampton
“The term capital structure is frequently used to indicate the long – term sources
of funds employed in a business enterprise” - R.H.Wessel .
IMPORTANCE OF THE CAPITAL STRUCTURE.
a ) A well – defined capital structure enables a company to raise the requisite funds
from various sources at the lowest possible cost . It maximises the return to the
equity share holders and the market value of share held by them.
b) A balanced capital structure enables the company to minimise the various business
risks by making suitable adjustments in the components of capital structure
c ) A well devised capital structure ensures the retention of control over the affairs of
the company within the hands of Moaning wearing . "existing equity shareholders
by maintaining a proper balance between voting right and non - voting right capital .
d ) A sound capital structure enables a company to maintain a proper balance between
fixed and liquid assets and avoid the various financial and managerial difficulties .

OPTIMAL CAPITAL STRUCTURE

(OR )
BALANCED CAPITAL STRUCTURE
An optimal or balancedcapital structure is the ideal combination of debt and
equity that attains the stated managerial goal in the most relevant manner. That is
maximising of market value per share or minimisation of cost of capital.
FACTORS DETERMINING THE CAPITAL STRUCTURE OF A
COMPANY
A. INTERNAL FACTORS:
i) Nature of business: Nature of business is an important factor which affects the
capital structure of the company. Business enterprise which have stability in their
earnings or enjoy monopoly can afford to raise funds the through debentures or
preference shares. This is true in case of public utility concern.
ii) Size of company: Companies which are of small size find it difficult to obtain
long-term debt. Hence, such companies have to rely consideredly upon the owners
funds for financing. Large companies are generally considered to be less risky by the
investors. Therefore, they can issue different types of securities and collect their
funds from different sources.
iii) Regularity of Income: If a company expects regular income in future, debenture
and bonds may be issued. Preference shares may be issued if a company doesn't
expect regular income. But it is hopeful that it's average earnings for a few
years may be equal to or in excess of the amount of dividend to be paid on such
shares.
iv) Purpose of financing: The purpose of financing also affects the capital structure
of the company. If funds are needed for some productive purposes (eg: purchase of
machinery etc) the company can afford to raise the funds by issue of debentures. On
the other hand if the funds are required for non-productive purposes, the company
should raise the funds by issue of equity shares.
v) Period of finance: The period for which finance is required also affects the
determination of capital structure of companies. The funds required for 3 to 10 years ,
can be raised by issue of debentures . The funds required more or less permanently,
can be raised by issue of equity shares
vi) Development and expansion plans: Capital structure of a company is affected
by its development and expansion programs in future. While planning capital
structure the provision for future should also be kept in view. It will always be safe to
keep the best security to be issued in the last, instead of issuing all types of securities
in one instalment.
vii) Attitude of management: Management evaluates varying skill, experience,
temperament and motivation differently and the risk associated with these also differ .
 Their willingness to employ debt – capital also differ structure influenced by the
Thus capital age, experience, ambition conservativeness of the management.
viii) Trading on equity: A company ears the profits on its total capital both owned
and borrowed. But on the borrowed capital including preference share capital,
company pays interest or dividend at a fixed rate. If this fixed rate is lower than the
general rate of earnings of the company, the ordinary shareholders will have an
advantage in the form of additional profits. Thus, if a company employs borrowed
capital including preference share capital to increase the rate of return on equity
shares, it is said to be trading on equity.
B. EXTERNAL FACTORS
i) Requirements of investors: In order to collect funds from different categories of
investors, it will be appropriate for the companies to issue different categories of
securities. Some investors prefer security of investment and stability of income,
while others higher income and capital appreciation.
Hence, shares and debentures should be issued in accordance with the tastes
and preferences of all types of customers
ii) Conditions of capital market: Condition of capital market has an important
bearing on the capital structure of the company because investor is very often
influenced by the general mood or sentiment of the capital market
iii) Cost of capital: Cost of capitalis an important determinant of capital structure. It
influences the profitability and general rate of earnings, a company must raise capital
funds by borrowing when rate of interest is low and by issuing equity shares when
rate of earnings and share prices are high.
iv) Government Policy: Government policy is also an important factor in planning
the company’s capital structure. A change in the lending policy of financial
institution may need a complete change in the financial pattern. Besides this, the
money policies of the government also affect the capital structure decision.
v) Legal requirements: Every company has to comply the law of the country
regarding the issue of different types of securities. Therefore, hands of the
management are tied by these legal restrictions.
TRADING ON EQUITY
The use of long – term fixed interest bearing debt and preference share capital
along with equity shares is called trading on equity.
CAPITAL GEARING- MEANING
The term “capital gearing” denotes the relative share of fixed cost
bearing securities such as preference shares and debentures to the equity share
capital in the capital structure of a company.
CAPITAL GEARING- DEFINITION
“The relation of the ordinary shares (equity shares) topreferences share
capital and loan capital is described as the capital gearing” - J .Batty
“The term capital gearing is used to describe the ratio between the ordinary
share capital and fixed interest bearing securities of a company” – Brown and
Howard
POINT OF INDIFFERENCE
Point of indifference refers to the EBIT level at which EPS remains
unchanged irrespective of debt – equity mix. In other words, at this point, rate of
return on capital employed is equal to the rate of interest on debt. This is also known
as break- even of EBIT for alternative financial plans.
It can be calculated from the following formula:
X 1₁ = S1 S2 (X – 11) (1 – T) – PD (X – 12) (1 – T) - PD S1 S₂ = 12
Where:
T = Tax Rate
PD = Preference Dividend
X- Point ofIndifference or Break – even EBIT level
I1- Interest under alternative 1
I2 - Interest under alternative 2
S1-Number of Equity shares under alternative 1
S2- Number of Equity shares under alternative 2.
THEORIES OF CAPITAL STRUCTURE
There are four major theories explaining the relationship between capital
structure, cost of capital and value of the firm .
i) Net Income Approach (NI)
ii) Net Operating Income Approach (NOI)
iii) Traditional Approach and
iv) Modigliani and Miller Approach (MM)
Net Income Approach (NI):
According to this approach, a firm can minimize the weighted average cost of
capital and increase the value of the firm as well as market price of equity shares by
using debt financing to the maximum possible extent.
This approach is based upon the following assumptions:
i) The cost of debt is less than the cost of equity.
ii) There are no taxes.
iii) The debt content does not change the risk perception of the investors.
Net Operating Income Approach (NOI):
According to this approach, the market value of the firm is not at all
affected by the capital structure changes. The overall cost of capital remains
constant irrespective of the method of financing. Thus, there is nothing as an
optimum capital structure and every capital structure is the optimum capital
structure.
This approach is based upon the following assumptions:
i) The market capitalizes the value of the firm as a whole;
ii) The business risk remains constant at every level of debt equity mix;
iii) There are no corporate taxes.
Traditional approach:
The traditional approach, also known as Intermediate approach, is midway
between the NI and NOI approaches. According to this theory, the value of the firm
can be increased initially or cost ofcapital can be decreased by using more debts, as
the debt is a cheaper source of fund than equity. Thus, optimum capital structure can
be reached by a proper debt – equity mix.
Beyond a particular point, the cost of equity increases because increased debt
increases the financial risk. The advantages of cheaper debt at this point of capital
structure are offset by increased cost of equity. If exceeds certain limits of debt, an
acceptable range tends to increase both the cost of debt and cost of common stock
because the risk tends to increase.
Modigliani and Miller Approach:
According to this approach, the value of a firm is independent of its capital
structure. That is the average cost of capital does not change with the change in the
 debt weighted equity mix or capital structure of the firm. In addition, the theory
emphasises the fact that a firm’s operating income is a determinant of its total value

In the opinion of Modigliani and Miller, two identical firms in all respects
except their capital structure cannot have different market values or cost of capital
because of arbitrage process. In case two identical firms except for their capital
structure have different market values or cost of capital, arbitrage will take place and
the investors will engage in "personal leverage " as against the corporate leverage
and this will again render the two firms to have the same total value .

The M - M approach is based upon the following assumptions:

i) There are no corporate taxes;
ii) There is a perfect market
iii) Investors act rationally
iv) The expected earnings of all the firms have identical risk characteristics
v) The cut - off point of investment in a firm is capitalisation rate
vi) There are no transaction costs
vii) There are no retained earnings.
ARBITRAGE PROCESS
The term "Arbitrage" refersto an act of buying an asset or security in one market
having lower price and selling it in another market at higher price. This process will
continue till the market prices of the two homogeneous firms become identical. Thus,
arbitrage process restores equilibrium in value of securities.
FORMULAE TO FIND OUT THE VALUE OF THE FIRM UNDER
VARIOUS APPROACHES:
i) The value of the firm under Net Income Approach will be :

Overall Cost of Capital (K) = EBIT

V

Where, EBIT= Earnings Before Interest and Taxes

V=Value of the firm
Value of the firm ( V ) = S+ B
 Where, S = Market value of Equity
B = Market value of Debt.
Market value of Equity can be ascertained in the following manner:
S=NI/Ke
Where, S = Market value of equity
NI = Earnings available for equity shareholders
Ke =Equity capitalisation Rate

The value of the firm under Net Operating Income Approach

V=EBIT/Ko
Where, V = Value of firm;
Ko = Overall cost of capital;
EBIT = Eamings Before Interest and Taxes
The value of equity can be determined by the following equation:
S=V-B
Equity capitalization rate (Ke) = EBIT-I / V-B
Where, S = Value of equity;
V = Value of firm;
B = Value of debt.

iii) According to the M - M approach, the value of a firm unlevered can be

calculated as:
Vu= (1- t) EBT / Ke
Where, EBT = Earnings before tax;
T = Tax rate;
Кe = Equity capitalization rate
The value of levered firm can be calculated as:
Vl = Vu + Bt
Where, Vl = Value of a levered firm;
Vu= Value of an unlevered firm;
B- Amount of debt and T - Tax rate
 LEVERAGES
LEVERAGE - MEANING

The term Leverage is used to describe the firm's ability to use fixed cost of
assets or funds to increase the return to its owners.

LEVERAGE - DEFINITION

“Leverage is the employment of assets or funds for which the firm pays a fixed cost
and fixed return" - James V.Home

“Leverage is the ratio of net returns on shareholders, equity and the net rate of return
on total capitalisation” -Erza Solomon

“Leverage may be defined as meeting of a fixed cost or paying a fixed cost an

Employing resources or funds” - S.C kuchchal

TYPES OF LEVERAGES
There are three types of Leverages.
i) Operating Leverage
ii) Financial Leverage
iii) Composite Leverage
i) Operating Leverage:

It is the tendency of Operating profit to change disproportionately with sales.

Operating Leverage = Contribution / Operating Profit

ii) Financial Leverage:

The effect of earnings by the use of long-term fixed cost securities, such as
preference shares and debentures, is called financial leverage. It is also called trading or
equity.

Financial Leverages = Operating profit / profit before tax

 MASTER TABLE TO CALCULATE THE LEVERAGES AND EPS

Particulars Rs

Sales XXX
Less: Variable Cost XXX

Contribution XXX
Less: Fixed Cost XXX

Operating Profit/EBIT XXX

Less: Interest XXX

PBT(or) EBT XXX

Less: Tax XXX
EAT XXX

Less: Preference Dividend XXX

Earnings Available to Equity XXX
Shareholders

NOTE: EBIT=Earnings before Interest and Tax

EBT = Earnings Before tax

PBT = Profit Before Tax

EAT = Earnings after tax

COMPOSITE LEVERAGE
Composite Leverage is one, which shows the relationship between a change

in sales and the corresponding variation in taxable income. This leverage also

called as combined leverage.

Composite Leverage = contribution / PBT

TRADING OR EQUITY
The use of long-term fixed interest bearing debentures and preference share capital
along with equity share capital is called trading or equity.
DISTINGUISH BETWEEN OPERATING LEVERAGE AND
FINANCIAL LEVERAGE
Operating leverage Financial leverage

It is related to the investment It is more concerned with financial

activities. matters.

It is useful to take capital It is useful for mixing the debt

expenditure decision. and equity in the capital structure.

The fluctuation in the EBT The changes of EPS due to debt-equity

can be predicted. Mix is predicted.

It is used to predict the Business risk. It is used to predict the Financial risk.

SIGNIFICANCE OF LEVERAGE

a) It is useful to measure the return to the owners and the market price of the equity
share.
b) Financial and operating leverage are important tools to plan a balanced capital
structure and maximize the return of shares.
c) A firm with a low Operating leverage will gain by having a high financial leverage,
if it has enough profitable opportunities for the employment of borrowed funds.
d) Financial leverage is an important tool in the hand of financial management. If
used carefully, if can maximize the return of shareholders. A firm with low
Operating leverage and high financial leverage is considered as ideal situation for
the Maximization of profit with minimum risk.
LIMITATION OF TRADING OR EQUITY
(OR)
LIMITATION OF FINANCIAL LEVERAGE

i) It can be used to increase the EPS only when the rate of earnings of the
company is more than the fixed rate of interest. On the other hand, it does not
earn as much as the cost of interest bearing securities, then it will work
adversely and hence cannot be employed.
ii) It is beneficial only to the companies having stable and regular earnings.
EPS
Earnings per share (EPS) is the amount that the shareholder can get on every share
hold; It is calculated for the following formula:
EPS= Net profit available to equity shareholder / Number of ordinary shares
Outstanding

WRITE A NOTE ON:

A) DEGREE OF FINANCIAL LEVERAGE AND
B) DEGREE OF OPERATING LEVERAGE

a) The degree of financial leverage measures the impact of a change in

operating income on change in earnings on equity capital. It can be calculated
as:
DFL = Percentage change in EPS / Percentage change in EBIT
DFL = EPS / EBIT
b) The degree of Operating leverage is the percentage change in profit
resulting from a percentage change in sales. It can be calculated as:
DOL = Percentage change in profit / Percentage change in sales

INDIFFERENCE POINT
The EBIT Level at which the EPS is the same for two alternatives. Financial
plan is referred to as the indifference point.
It can be calculated from the following formula:
X (1-T) / S1 = (X-I) (1-T) - PD / S2
Where, X = point of indifference or Break-even EBIT level
I = Interest
T = Tax rate
PD = preference dividend
S1 & S2 = Number of equity shares under alternative 1 & 2.

FINANCIAL BREAK-EVEN POINT

Financial Break-even point is one, where the EBIT is equal to the amount
payable on interest bearing securities and preference shares.
 PROBLEMS
Pg 6.49; Problem 1:

ALL HALF EQUITY

Particulars EQUITY HALF 15% DEBT
EBIT 500,000 500,000
LESS: Interest on Debt 0 375,000
500,000 125,000
LESS: Interest on Loan 0 0
EBT 500,000 125,000
LESS: Tax (40%) 200,000 50,000
EAT 300,000 75,000

EPS(EAT/NO OF EQUITY 3,00,000/50,000 = Rs. 6

SHARE)
75000/25000=RS 3

Pg 6.50; Problem 6:

12500 12500
Particulars EQUITY DEBT 12500 8% PREF
SHARE 8% INT SHARE
EBIT 156250 156250 156250
LESS:INT ON DEBT 0 10,000 0
156250 146,250 156250
LESS: INT ON LOAN 0 0 0
EBT 156250 146,250 156250
LESS:TAX 50% 78125 73125 78125
EAT 78125 73,125 78125
LESS:PREF DIVIDEND 0 0 10000
PROFIT AVBL FOR EQUITY SHAREHOLDER 78125 73125 68125
EPS RS 1.25 RS1.46 RS 1.36

Problem 12:
 3L IN
EQUITY 3L IN EQUITY
ALL EQUITY
Particulars @100 2L SHARE 2L IN 10%
SHARE @100
IN PREF SHARRE
12%DEBT
EBIT 100000 100000 100000
LESS:INT ON DEBT 0 24,000 0
100000 76000 100000
LESS: INT ON LOAN 0 0 0
EBT 100000 76000 100000
LESS:TAX 50% 50000 38000 50000
EAT 50000 38000 50000
LESS:PREF DIVIDEND 0 0 20000
PROFIT AVBL FOR EQUITY SHAREHOLDER 50000 38000 30000
EPS RS 10 RS 12.67 RS10

Problem 19:

Particulars Rs
EQ SHAE @ RS 100 EACH 4000000
RETAINED EARNINGS 1000000
9% PREF 2500000
7% DEBT 2500000
10000000

EBIT = 12,00,000(10,00,000*12%) + 3,00,000(25,00,000*12%)

= 15,00,000

20000
EQUITY
SHARE 10% PREF
Particulars @12.5% SHARE 9%DEBT
EBIT 1500000 1500000 1500000
LESS:INT ON DEBT 175000 175,000 400000
1325000 1,325,000 1100000
LESS: INT ON LOAN 0 0 0
EBT 1325000 1325000 1100000
LESS:TAX 50% 662500 662500 550000
EAT 662500 662500 550000
LESS:PREF DIVIDEND 225000 475000 225000
PROFIT AVBL FOR EQUITY SHAREHOLDER 437500 187500 325000
EPS RS 7.29 RS 4.69 RS 8.125
Pg 6.61; Problem 28:
 (X-0) (1-0.55)-0/6,00,000
(X-3,00,000)(1-0.55)-0/300000
0.45X/6,00,000 = 0.45X-135000/3,,00,000
0.45X =0.90X - 270000
0.90X-0.45X = 2 70 000
X=270000/0.45
INDIFFERENCE POINT =RS 6,00,000

Problem 29:

(X-48000) (1-0.335) -0/60 000 = (X – 48000) (1-0.35) -28000/40000

0.65X-(31200/60000) = 0.65X-31200 – (28000/40000)
1.3X -62 400 =1.95X-177600
1.95X-1.3X=1,77,000-62 400
X=115200/0.65
INDIFFERENCE=RS 1,77 ,231
Problem 32 (a):
(X-0)(1-0.5) - 0/1,00,000 = (X-1,00,000)(1-0.5)-0/50000
0.5X = X-100000
X = 100000/0.5
INDIFFERENCE POINT = Rs. 2,00,000

Problem 32 (b):

(X-0)(1-0.5)-0/1,00,000 = (X-0) (1-0.5)-1,20000/50000

05X = X-240000
X= 240000/0.5X
INDIFERNCE POINT RS 4,80,000

Pg 6.65; Problem 39:

 V=S+D
S=PROFIT FOR EQ SHARE/EQ SHARE CAPITAL

EBIT 2,00,000
LESS: INT ON DEBT 70,000
PAT 1,30,000
S=1,30,000/12.5%
=10,40,000
V = 10,40,000 + 7,00,000
= RS 17,40,000
K0=EBIT/V =2,00,000/17,40,000*100
Ko = 11.49%
Pg 6.66; Problem 40:

V=S+D
S=70,000/12.5% (PAT -70,000 & Ke – 12.5%)
= 5,60,000
V = 5,60,000 + 3,00,000
= 8,60,000
Ko = 11.63% (1,00,000/8,60,000*100)

Problem 42:

V=S+D
S = 1,20,000/12.5% (PAT -1,20,000 & Ke – 12.5%)
= 9,60,000
V = 9,60,000 + 8,00,000
=17,60,000
K0=11.36% (2,00,000/17,60,000*100)

Pg 6.67; Problem 45 (a):

 NI Approach
For Company X:

V = S+D EBIT (15L*20%) 3,00,000

S = PAT/Ke (-) Int on Debt 90,000
= 7,00,000 (1,05,000/15%) (9L*10%) 2,10,000
V = 16,00,000 (7,00,000 + 9,00,000) (-) Tax (50%) 1,05,000
Ke = EBIT PAT 1,05,000
V
= 18.75% (3,00,000/16,00,000*100)

For Company Y:

V = S+D EBIT (15L*20%) 3,00,000

S = PAT/Ke (-) Int on Debt NIL
= 10,00,000 (1,50,000/15%) 3,00,000
V = 10,00,000 (10,00,000 + 0) (-) Tax (50%) 1,50,000
Ke = EBIT PAT 1,50,000
V
= 30% (3,00,000/10,00,000*100)

NOI Approach
KO is not given in the problem formula for NOI approach is different.

For Company X:

V = S+D
S = EBIT (100% - 50%)
Ke
= 3,00,000 (100%-50% = 10,00,0000
15%
D = Debt * Tax
= 4,50,000 (9,00,000*50%)

V = Rs. 14,50,000 (10,00,000 + 4,50,000)

For Company Y:

V = S+D
S = EBIT (100% - 50%)
Ke
= 3,00,000 (100%-50% = 10,00,0000
15%
No Debt
V = Rs. 10,00,000 (10,00,000 + 0)

Pg 6.68; Problem 46:

Traditional Approach
 Particulars NO DEBT 2,40,000 5% 10% DEBT
DEBT 3,40,000
EBIT 120,000 120,000 120,000
LESS: INT 0 12000 25200
EBT (or) PAT 120,000 108,000 94,800

S=PAT/KE 1,200,000 981818 790000

(1,20,000/10%) (1,08,000/11%) (94,800/12%)
V=S+D 1200000 1221818 1150000
Ko 10% 9.82% 10.43%

Pg 6.68; Problem 48:

Modigilani – Miller Approach

i) Value of Unlevered firm = EAT = 18,00,000 EBIT 30,00,000

Ke 18% (-) Int Nil
30,00,000
= Rs. 1,00,00,000 (-) Tax (40%) 12,00,000
EAT 18,00,000
ii) Value of firm with 40,00,000 debt:
= Value of unlevered firm + (Debt * Tax)
= 1,00,00,000 + (40,00,000 * 40%)
= 1,00,00,000 + 16,00,000
= Rs. 16,00,000

iii) Value of firm with 70,00,000 debt:

= Value of unlevered firm + (Debt * Tax)
= 1,00,00,000 + (70,00,000 * 40%)
= 1,00,00,000 + 28,00,000
= Rs. 16,00,000
Pg 6.69; Problem 51:
Value Of Firm A (Unlevered firm):
= EAT/Ke
= Rs. 5,00,000 (6,00,000/12% )
Value Of Firm B (Levered Firm)
= Value of unlevered firm + (Debt * Tax)
= 5,00,000+1,60,000 4,00,000*40%)
= Rs.6,60,000
Pg 6.69; Problem 52:
 MM Approach (Without Tax) – NOI
Approach

i) Value of Firm
Comp X = EBIT/Ko = Rs. 4,00,000 (50,000/12.5%)
Comp Y = EBIT/Ko = Rs. 4,00,000 (50,000/12.5%)
ii) Value of Equity
Comp X => S = V- D
= Rs. 4,00,000 (4,00,000 – 0)
Comp X => S = V- D
= 2,00,000 (4,00,000 – 2,00,000)
iii) Cost of Equity
Comp X = EBT/S = 12.5% (50,000/4,00,000*100)
Comp Y = EBT/S = 20% (40,000/2,00,000*100)

LEVERAGES

Pg 7.34; Problem 1:
Particulars OLD NEW
25,00,000 25,00,000
Sales (50,000*50) (50,000*50)
10,00,000 15,00,000
Less: Variable Cost (50,000*20) (50,000 *30)
CONTRIBUTION 15,00,000 10,00,000
7,50,000 7,50,000
Less: Fixed Cost (50,000*15) (50,000*15)
EBIT 7,50,000 2,50,000
Operating Leverage 2 TIMES 4 TIMES
(Contribution/EBIT)

Pg 7.34; Problem 3:
Particulars Comp A Comp B
Sales 50,00,000 60,00,000
25,00,000 15,00,000
Less: Variable Cost (50% of Sales) (25% of Sales)
CONTRIBUTION 25,00,000 45,00,000
Less: Fixed Cost 15,00,000 30,00,000
EBIT 10,00,000 15,00,000
Operating Leverage 2.5 TIMES 3 TIMES
(Contribution/EBIT)
Pg 7.35; Problem 6:

Particulars Comp A
Sales (5,000*30) 1,50,000
(-) Variable Cost (5,000*20) 1,00,000
Contribution 50,000
(-) Fixed Cost (50,000 – 20,000) 20,000
EBIT 30,000
(-) Int on Debt (10,00,000*10%) 10,000
EBT 20,000
Operating Leverage
1.667 TIMES
(50,000/30,000)
Financial Leverage
1.5 TIMES
(30,000/20,000)

Pg 7.36; Problem 12:

Particulars P Q R
SALES 9,00,000 18,75,000 2,50,000
Less: VC 3,00,000 5,62,500 50,000
CONT 6,00,000 13,12,500 2,00,000
Less: FC 3,50,000 7,00,000 75,000
EBIT 2,50,000 16,12,500 1,25,000
Less: INT 25,000 40,000 0
EBT 2,25,000 5,72,500 1,25,000
OL (Cont/EBIT) 2.4 2.14 1.6
FL (EBIT/EBT) 1.11 1.01 1
Pg 7.37; Problem 14:

Old (3,00,000 New (3,30,000

Particulars
units units)
SALES 15,00,000 16,50,000
Less: VC 9,00,000 9,90,000
CONT 6,00,000 6,60,000
Less: FC 2,00,000 2,00,000
EBIT 4,00,000 4,60,000
Less: INT (60,000*10%) 60,000 60,000
EBT 3,40,000 4,00,000
(-) Tax (35%) 1,19,000 1,40,000
EAT 2,21,000 2,60,000
(-) Preference Dividend 0 0
PAT 2,21,000 2,60,000
EPS (PAT/No. of Eq. Shares) 2.21 2.60
% Change in EPS (Diff btw old & new)
17.65%
Base year
OL (Cont/EBIT) 1.5 times 1.43 times
FL (EBIT/EBT) 1.76 times 1.01 times

Pg 7.38; Problem 16:

Particulars Taylor Bhatia

SALES 14,00,000 14,00,000
Less: VC 9,80,000 9,80,000
CONT 4,20,000 4,20,000
Less: FC 3,40,000 3,40,000
EBIT 80,000 80,000
Less: INT (60,000*10%) Nil 40,000
EBT 80,000 40,000
OL (Cont/EBIT) 5.25 times 5.25 times
FL (EBIT/EBT) 1 time 1 time
CL (Cont/EBT) 5.25 times 10.5 times
 UNIT- 3
COST OF CAPITAL
Definition – Cost of Equity Capital - Cost of Preference Capital –

Cost of Debt – Cost of Retained Earnings – Weighted Average (or)

Composite cost of capital (WACC).

MEANING - COST OF CAPITAL
The cost of capital is the minimum rate of return expected by investors.
Solomon Ezra defines cost of capital as the minimum required rate of earnings or the cut-off
rate of capital expenditures. The capital of a firm may consist of debt, preference share
capital, retained earnings and equity capital. Therefore, cost of capital of a firm is the
weighted Average cost of these sources.

Cost of capital may also be defined as the cost of obtaining funds. It is also
known as cut-off rate, target rate or hurdle rate.

If the firm is unable to earn the cut-off rate, the market value of its shares will
come down. Hence, cost of capital is the minimum rate of return, the firm is expected to earn
to maintain the market value of its shares.

FEATURES OF COST OF CAPITAL

1. Cost of capital is really a rate of return. It is the minimum rate of return expected by
investors.

2 Cost of capital is calculated on the basis of actual cost of different components of capital.

3. Cost of capital is usually related to long-term funds.

4 Cost of capital is used as a discount rate to discount future cash flows in order to determine
their present value.

5. Cost of capital has three components:

a) Return at the zero risk level

b) Premium for business risk

c) Premium for financial risk

6. It may be put in the form of the equation, k =r +b+f.

IMPORTANCE OF COST OF CAPITAL

Cost of capital is a central concept in financial management. It is important

because of the following reasons.

1. Financial Yardstick: Capital expenditure decisions are one of the t important financial
decisions taken by a firm. According to Present value method, if the total present value of
inflows is greater than the present value of investment, the project may be accepted:
Otherwise, the project may be rejected. To ascertain the present value of future cash flows,
cost of capital is used as the discount rate. Thus, cost of capital provides a financial yardstick
for making capital expenditure decisions.

2. Basis for Decisions: Cost capital represents a minimum rate of n or cut-off rate. It serves
as a basis for several other financial decisions such as leasing, hire-purchase, working capital,
dividend policy and issue of rights shares

3. Planning the Capital Structure: The objective of the management designing an optimum
capital structure is to maximise the value of firm or to minimize the cost of capital. The
capital structure comprises of different sources of finance. Therefore, the measurement he
cost of capital of various sources is necessary in designing the capital structure.

4. Evaluation of-Financial Performance: Cost of capital can be used to evaluate the

financial performance of a company. Such an evaluation will involve

a) Comparison of actual profitability of projects with the projected overall cost of

capital.

b) an appraisal of actual costs in raising the funds required.

In short, cost of capital represents a bench mark. It serves as a standard for

allocating the firm’s investible resources in the most optimal manner.

CLASSIFICATION OF COST OF CAPITAL

1. Historical Cost and Future Cost: Historical cost is the cost incurred in the past in
procuring funds for the firm. Future cost is cost estimated for the future. It is the cost
to be incurred in raising new funds.
 In financial decisions, future cost is more relevant than historical cost.
Historical cost is useful as a guide for the estimation of future cost.
2. Specific Cost and Composite Cost: Specific cost is the cost of a particular source of
capital e.g. cost of debentures Composite cost is the combined cost of different
sources of capital. It is the weighted average cost of capital or overall cost of capital.
In financial decisions, specific cost is relevant where only one source of capital is
employed. Composite cost is relevant where more than one source of capital is
employed. For example, weighted average cost of capital is considered in evaluating
capital structure decisions.
3. Average Cost and Marginal Cost: Average cost of capital is the combined cost of
various sources of long-term finance such as equity shares, preference shares and
debentures. It is the weighted average of the costs of different sources. Marginal cost
of capital is the average cost of new, additional or incremental funds raised by the
firm. Marginal cost is more relevant in making investment decisions.
4. Explicit Cost and Implicit Cost: Explicit cost refers to the discount rate at which
total present value of cash inflows is equal to the total present value of cash outflows.
It is also called the Internal Rate of Return. Inflows are funds received by the firm net
of under writing and other issue expenses. Outflows are payment of interest,
dividends and repayment of principal. Implicit cost is the opportunity cost. It is
defined as the rate of return that will be foregone if the particular project were
accepted. It is the cost the opportunity foregone in order to take up a particular
project. The licit cost of retained earnings is the rate of return the shareholders and get
by investing the funds elsewhere. For example, if the shareholders can get 18% pa. by
investing the funds elsewhere, the implicit cost is 18%.

COMPUTATION OF COST OF CAPITAL

Computation of overall cost of capital of a firm consists of the following steps

a) Computation of the cost of specific sources such as debentures, preference

capital and equity capital

b) Computation of the weighted average cost of capital or the overall cost of

capital.
a) COMPUTATION OF COST OF SPECIFIC SOURCES

COST OF DEBT

1. Cost of Irredeemable Debt

Irredeemable debt (or perpetual debt) is debt which is not redeemable during
the life time of the company. The cost of debt is the interest rate payable on the debt.
For example G Lad issued 10% debentures for Rs .10 lakhs. The before tax cost of
debt is 10%.

After-tax Cost of Debt

In the computation of income tax, interest is allowed as a deduction. Hence, a

firm saves tax on interest paid. As a result, after tax Cost is lower than the before-tax
cost of debt.

2. Cost of Redeemable Debt

Redeemable debt refers to debt which is to be redeemed after the stipulated

period. For example, is may be repayable after 5 or 7 or 10 years.

To calculate annual cost, the issue expenses, discount on issue, premium on

redemption and premium on issue are amortized over (spread over) the tenure of the
debt.

Average Value of Debt (AV)

Average value of debt is the average of net proceeds (NP) and redemption value (RV)
of debt.

3. Cost of Existing Debt

The method of computing the cost of debt raised has been explained in the
preceding section. Sometimes, ‘current cost’ of the existing debt may have to be
calculated. In such a case, cost of debt is approximated by the current market yield of
the debt.
4. Cost of Zero Coupon Bonds

In the case of zero coupon bonds, the interest rate is not specified. The
bonds are issued at a discounted price and redeemed at par. For instance, a company
may issue zero coupon bonds of Rs 100 each, repayable after 5 years, at a discounted
price of Rs 60. The difference between the redemption price (Rs 100) and the issue
price (Rs 60) represents the total interest for the period of the bonds.

The cost of zero coupon bonds is the rate at which present value of
outflow is equal to the present value of inflows. The rate is found by trial and error,
using present value tables.

5. Floating Rate Debt

Floating rate debt is also known as variable rate debt. The rate of
interest is not fixed. It is linked to some other standard rate such as the prime lending
rate (PLR) of a bank or the interest rate of gilt edged securities.

For example, suppose a company raises debt at a floating rate of PLR

+ 3%. If the PLR is 10%, the company will have to pay interest at 13%. (10 + 3).
If the PLR comes down to 8%, the company shall pay only 11% (8 + 3).

6. Inflation Adjusted Cost of Debt

During periods of inflation, the company pays only a fixed rate of

interest, although there is a fall in the value of money, due to increase in general price
level. Therefore, the real cost of debt is less than the nominal cost of debt.

COST OF PREFERENCE SHARECAPITAL

A fixed rate of dividend is payable on preference shares. The dividend

is payable at the discretion of directors. Yet, preference dividend is regularly paid by
companies when they earn profits.
1. Cost of Irredeemable Preference Capital

The cost of preference capital which is perpetual is calculated by the following

formula.

a) When preference shares are issued at par: NP = Face value – Issue expenses
b) When preference shares are issued at a premium : NP = Face value +
Premium - Issue expenses
c) When preference shares are issued at a discount: NP = Face value – Discount
– Issue expenses.

Preference dividend is not allowed as a deduction in the Computation of

income tax. Hence, before tax cost and after tax cost are the same.

2. Cost of Redeemable Preference Share capital (RPS)

Preference shares which are to be redeemed after the expiry of the stipulated
period are known as redeemable preference shares. The cost of Redeemable
Preference Shares (RPS)

COST OF EQUITY CAPITAL

It is not legally binding on a company to pay dividend on equity shares

even if it earns profits. Further, the rate of equity dividend is not fixed while the rate
of preference dividend and interest on debt are fixed. Hence, it is sometimes argued
that the equity capital is cost free. This view is not correct. The shareholders invest in
equity shares with the expectation of receiving dividends.

The market price of equity shares also depends on the return expected by
shareholders. Therefore, the cost of equity capital is the minimum rate of return that
must be earned to maintain the market price of the share unchanged. The methods of
computing the cost of equity capital are explained below.

1. Dividend Price Method [D/P] (or) Dividend Yield Method: According to this
method, cost of equity capital is the discount rate at which the present value of
expected future dividends per share is equal to the net proceeds (or current market
price) per share.
 NET PROCEEDS

When a company issues new shares it incurs floatation costs such as

fees to investment bankers, brokerage. Underwriting commission and commission to
agents. So, the net proceeds per share is considered to calculate the cost equity capital.
In the case of existing equity shares, market price is considered .

2. Dividend Price + Growth (D/P + g) Method: The Dividend / Price method

recognizes the importance of dividends. But it ignores retained earnings which have
an impact on the market price. The D/P method also ignores growth in dividends,
capital gains and future earnings. The method is suitable only when the company has
stable earnings and a stable dividend policy over a reasonable length of time.

Under this method, cost of equity capital is determined on the basis of

dividend yield and the growth rate in dividends.

The D/P+g method recognizes the importance of dividends as well the growth
in dividends. But, the method assumes that dividends grow at a constant rate. In
reality, it is not true.

3. Earnings Price Method (E/P Method]: Earnings price method is also called
earnings model. It considers earnings as more appropriate than dividends in
computing the cost of annuity capital. The cost of equity capital is the rate at which
total present value of expected future EPS is equal to the market price per share. Net
proceeds per share in case of new issue.

The E/P method takes in account the retained earnings. But it is criticised on
the ground that the E/P ratio does not reflect the expectations of shareholders. The
Earnings model is suitable when,

a) The EPS is expected to remain constant;

b) The pay out is 100 per cent (all the profits are distributed as dividends);

c) The firm does not employ any debt.

4. Realised Yield Method: Under this method, the cost of equity capital is computed on
the basis of return actually realised by the shareholders. The return to shareholders
consists of dividends and capital gains. Hence, the present value of dividends as well
as capital gains and the cost of shares are considered.
The cost of equity capital is the rate at which present value of inflows
(dividends and sale price) is equal to the present value of outflows (cost of the shares).
The rate is found by trial and error method..

The realised yield method can be useful in the following conditions.

i) The share holders expect the realised yield of the past in future as well.
ii) The firm remains in the same risk class
iii) The market price of the share does not change significantly .

COST OF RETAINED EARNINGS

All the profits earned by a company are not distributed as dividends to

shareholders. Generally, companies retain a portion of the earnings for use in
business. This is called retained earnings. The company does not have to pay any
dividend on the retained earnings. Hence, it is sometimes argued that retained
earnings do not have any cost. This view is not correct.

If the amount retained by the company had been distributed to

shareholders, they would have invested the amount elsewhere and earned some
return. As the earnings have been retained by the company the shareholders have
foregone the return. Therefore, retained earnings do have a cost. The cost of retained
earnings is the return foregone by shareholders.

It is thus, the opportunity cost of dividends foregone by shareholders.

It is to be noted that the shareholders cannot invest the entire dividend income. They
have to pay income tax on dividends. Further, they have to pay brokerage for
purchase of securities. (for investing the after tax dividends). Therefore,
adjustments are made for tax and brokerage in the computation of cost of retained
earnings.
 CAPITAL ASSET PRICING MODEL (CAPM)

The CAPM approach considers the risk element in determining the

cost of equity capital. The cost of equity capital is the return required by investors. It
has two elements. Premium (Pr) is the difference between market return from a
diversified portfolio (Rm) and the risk – free return (Rf).

Weighted Average Cost of Capital (WACC)

Weighted Average Cost of Capital is very important in financial decision

making. WACC is the weighted average of the costs of different sources of finance. It
is also known as composite cost of capital or overall cost of capital.

The steps for the calculation of WACC are:

1. After tax cost is relevant in financial decision making. Therefore, the

after tax cost of each of the source (x) of finance is ascertained.

2. The proportion of each source in the total capital (w) is determined. The
proportions are used as weights for finding out WACC.

3. The cost of each source (x) is multiplied by the appropriate weight (x) x (w)

4. The total of the weighted costs of each source is the weighted average cost
of capital (WACC =Exw).

Book Value Weights Vs Market Value Weights

In order to calculate the WACC, the proportion of each source of finance in

the total capital is used as weights. To determine the weights, book value or market
value may be used. Theoretically, market value weights are superior as they reflect
the expectations of investors. But in practice, book value weights are widely used.

The reasons are:

1. Book values are readily available.

2. It is difficult to use market values because of their fluctuations.

3. Firms use only book values in designing their capital structure.

4. Equity share capital gets more importance if market values are used.
PROBLEMS
 UNIT-4
DIVIDEND POLICY
Meaning – Dividend policies – Factors affecting dividend payment –

Provisions on Dividend Payment in Company Law – Dividend

Models – Walter’s Model – Gordon’s Model – M.M Model –

Hypothesis Model.
MEANING & DEFINITION – DIVIDEND:
Dividend is a divisible profit distributed amongst the members of a company in
proportion to their shares
"Dividend is a distribution to shareholders out of profits or reserves available for this
purpose” -I.C.A. of India.
DIVIDEND POLICY:
The term dividend policy refers to the policy concerning quantum of profits to be
distributed as dividend.
"Dividend policy determines the division of earnings between payments to shareholders
and retained earnings" - Weston and Brigham.
"The firm's dividend policy represents a plan of action to be followed whenever the dividend
decision must be made" - Gitman.
FACTORS WHICH INFLUENCE THE DIVIDEND POLICY
(OR)
AS A FINANCE MANAGER, WHICH FACTORS WILL YOU
CONSIDER WHILE DEVISING A DIVIDEND POLICY OF A
COMPANY
A) External factors:
i) Legal Restriction:
a) Dividend can be paid only out of profits and not out of capital.
b) In the event of inadequacy or absence of profits in a year the company may
declare dividends out of the accumulated profits.
c) The dividend is payable only in cash. However, the capitalisation of profits
by issuing fully paid bonus shares is not prohibited.
d) A company is not entitled to pay dividends unless
a) it has provided for present as well as all arrears of depreciation
b) a certain percentage of net profits of that year as prescribed by the
central government not exceeding 10%, has been transfered to the
reserves of the company.
ii) General state of economy:
The general state of economy affects to a great extent the
management's decision to retain or distribute earnings of the firm.
 In case of uncertain economic and business conditions and in periods
of depression, the management may like to retain the whole or a part of the
firm's earnings to face the future unrest.
iii) Inflation:
Inflation increases the replacement cost of assets. Hence, the funds
generated from providing depreciation may be insufficient to meet the rising
cost of assets which have to be replaced in future. Therefore, the management
should reduce the rate of dividend during the period of inflation.
(iv) State of capital market and access to it:
If a firm has an easy access to the capital markets and the funds
position in the capital market of the country is comfortable then it can follow a
liberal dividend policy.
On the other hand, if the firm has no easy access to capital market due
to weak financial position or due to unfavourable conditions in the capital
market, it is likely to adopt a more conservative dividend policy.
v) Tax policy:
The taxation policy of the government also affects the dividend
decision of a firm. A high or low rate of business taxation affects the net
earnings of company and thereby its dividend policy.
B) Internal Factors:
i) Desire of the shareholders
It cannot be overlooked by the directors while deciding the dividend,
the preference of shareholders for dividends and capital gains policy. To a
great extent the preference for dividends or capital gain is determined by the
economic status of the shareholder and the tax bracket to which he belongs.
The capital gains tax rate is generally lower than the dividend tax rate.
ii) Management's attitude towards control
As a matter of policy, some companies expand only to the extent of
their internal earnings. This is justified on the ground that raising funds by
selling additional shares would dilute the control of the company. Selling
debentures will increase the financial risk.
 iii) Future financial requirements
The financial requirements of the company are to be considered by the
management while taking the dividend decision. If a company has highly
profitable investment opportunities it can convince the shareholders for
retaining the substantial part of its current earnings to increase the future
earnings and stabilise its financial position.
But when profitable investment opportunities do not exist then the
company may not be justified in retaining substantial part of its current
earnings. However, the directors must retain some earnings, whether or not
profitable investment opportunity exists, to maintain the company as a sound
and solvent enterprise.
iv) Nature of earnings
A firm having stable income can afford to have a higher dividend
payout ratio as compared to a firm which does not have such stability in its
earnings.
v) Age of the company
The age of the company also influences the dividend decision of a
company. A new established concern has to limit payment of dividend and
retain substantial part of earnings for future growth and development, while
older companies which have sufficient reserves can afford to pay liberal
dividends.
vi) Liquidity position
The dividend policy of a firm is also influenced by the availability of
liquid resources. Although, a firm may have sufficient profits to declare
dividends, it may not be desirable to pay dividends if it does not have
sufficient liquid resources. Hence, the liquidity position of a company is an
important consideration in paying dividends.
TYPES OF DIVIDEND POLICIES
(OR)
STABLE DIVIDEND POLICY
I) Stable Dividend Policy.
The term stability of dividends' means consistency or lack of
variability in the stream of dividend payments. Therefore, the stable dividend policy
 maintains regularity in paying dividend even though its amount fluctuates from
year to year and may not be related to earnings. It can take any of the following three
forms.
a) Constant dividend per share.
Under this form of stable dividend policy a company follows a policy
of paying a certain fixed amount per share as dividend every year irrespective of the
fluctuations in the earnings. This does not mean that the amount of dividend is fixed
for all times to come. When the earnings of the company increase at a new level of
earnings, it increases the rate of dividend per share.
This dividend policy is easy to follow when company's earn are stable.
If earnings fluctuate widely the company can follow this policy by maintaining
dividend fluctuation funds.

b) Constant pay out ratio :

Constant payout ratio means payment of a constant percentage of net
earnings as dividends every year to the shareholders. The amount of dividend in such
a policy fluctuates in direct proportion to the earnings of the company.
The policy of constant pay out is preferred by the firms because it is
related to their ability to pay dividends.
c) Stable rupee dividend plus extra dividend.
According to this policy, a firm usually pays a fixed divider to the
shareholders and in years of prosperity, additional or extra dividend is paid over and
above the regular dividend. As soon as normal conditions return, the firm cuts the
extra dividend and pays the normal dividend per share.
Such a policy is most suitable to the firms with fluctuating earnings
from year to year.

Advantages of stable dividend policy

i) It is a sign of continued normal operations of the company.
ii) It stabilises the market value of shares.
iii) It creates confidence and removes uncertainty from the minds of the
shareholders.
iv) It attracts institutional investors.
 Disadvantages of stable dividend policy
a) It is not easier to change it.
b) It adversely affects the market price of shares of the company.
c) If a company pays stable dividends in spite of its incapacity, it
will be suicidal in the long-run.
II. Regular dividend policy:
Payment of dividend at the usual rate is termed as regular dividend. A
company should establish the regular dividend at a lower rate as compared to the
average earnings of the company.
III. Irregular dividends policy :
This policy is based upon the assumption that shareholders are entitled to as
much dividend as earnings and the financial condition of the company warrant.
This policy is followed on account of the followings.
a) Uncertainty of earnings.
b) Unsuccessful business operations.
c) Lack of liquid resources.
d) Fear of adverse effects of regular dividends on the financial standing
of the company.
IV. No immediate dividend policy :
A company may follow a policy of paying no dividends presently because of
its unfavourable working capital position or on account of requirements of funds for
future expansion and growth. A company follows this policy under the following
conditions.
a) If the company is new and growing.
b) The needed capital cannot be raised.
c) If the shareholders are willing to wait for capital gains.
V. Policy of regular and extra dividend :
This policy carries out regular dividend and at the same time it allows
shareholders to share in additional earnings through extra dividends.
VI. Policy of regular stock dividend:
It refers to the distribution of shares in lieu of or in addition dividend to the existing
shareholders.
MODIGLIANI MILLER'S APPROACH
Under what assumptions do the conclusions hold good? Modigliani
and Miller have expressed their opinion that the dividend policy has no effect on the
market price of the shares and the value of the firm is determined by the earning
capacity of the firm or its investment policy.
As observed by them, "Under conditions of perfect capital markets,
rational investors, absence of tax discrimination between dividend income and capital
appreciation, given the firms investment policy its dividend policy may have no
influence on the market price of the shares". Miller, M.H. and F. Modigliani,
"Dividend policy", Growth and Valuation of Journal of Business, October 1961.
Assumptions of MM hypothesis:
i) Capital markets are perfect.
ii) All investors are rational.
iii) There are no transaction costs.
iv) There are no flotation costs.
v) There are no taxes (or) no differences in tax rates applicable to capital gains and
dividends.
vi) Information is available to all free of cost.
vii) No investor is large enough to influence the market price of securities.
Critically examine the assumptions underlining the irrelevance
hypothesis of Modigliani and Miller regarding dividend distribution.
Unrealistic assumptions & Criticisms of MM Hypothesis:
i) Perfect capital market does not exist in reality.
ii) Information is not available to all the persons.
iii) The companies have to incur flotation costs while issuing securities.
iv) Taxes do exist and there is normally different tax treatment dividends and capital
gains.
v) The firms do not follow a rigid investment policy.
vi) The investors have to pay brokerage etc. while doing any transaction.
vii) Shareholders may prefer current income as compared to future gains.
DIFFERENT FORMS OF DIVIDEND
i) Cash Dividend:
A cash dividend is the most popular form of dividend. In this form,
shareholders are paid dividend in cash which results in outflow of funds and reduces
the company net worth. Ordinary shareholders prefer to receive dividends in cash,
because they get an opportunity to invest the cash in any manner they desire. But the
firm must have adequate liquid resources for this purpose. The cash dividend may
take two forms
a) Regular dividend or final dividend and
(b) Interim dividend.

a) Regular dividend: It is also known as final dividend because it is usually paid

after the finalisation of accounts. It is paid annually, proposed by the board of
directors and approved by the shareholders in general meeting.
b) Interim dividend: Interim dividend is declared between the two annual general
meetings. It is generally, declared and paid when company has earned heavy profits.
No interim dividend can be declared and paid unless depreciation for the full year has
been provided for.
ii) Stock dividend:
Stock dividend means the issue of bonus shares to the existing
shareholders. If a company does not have liquid resources it is better to declare stock
dividend. Stock dividend amounts to capitalisation of earnings and distribution of
profits among the existing shareholders without affecting the cash position of the
firm.
iii) Scrip dividend:
Scrip dividends are used when earnings justify a dividend, but the cash
position of the company is temporarily weak. So, shareholders are issued shares or
debentures of other companies held by the company as investment. Such payment of
dividend is called "scrip. dividend". The object of scrip dividend is to postpone the
immediate payment of cash.
iv) Bond dividend:
In rare instances dividends are paid in the form of debentures or bonds
or promissory notes for a long-term period bearing interest at fixed rate. The effect of
such dividend is the same as that of paying dividend in scripts. The shareholders
become the secured creditors if the bonds have a lieu on assets.
v) Property dividend:
Property dividends are paid in the form of some assets other than cash.
They are distributed under exceptional circumstances and the distribution of dividend
is made whenever the asset is no longer required in the business.

PROBLEMS
WALTER’S MODEL

D + r/k (E-D)
Market Price Per Share = k

D = Dividend
r = Rate of Return on invst by firm
k = Cost of Capital
E = EPS
Pg 8.33; Problem 1:

EPS (E) = 10; IRR (r) = 18%; Cost of Cap (k) = 20%; Pay Out = 40%

D + r/k (E-D)
Market Price Per Share = k

D = EPS * Pay Out

= 4 + 0.18/0.20 (10-4) = 4 + (0.9)6
0.20 0.20
V = Rs. 47
Pg 8.33; Problem 4:
EPS (E) = 24; IRR (r) = 15%; Cost of Cap (k) = 10%;

Mkt Price Per Share = D + r/k (E-D)

k
i) PAY OUT 50%

D=24*50%=12

V = 12+0.15/0.10 (24-12)
0.10
= Rs. 300

ii) PAY OUT 75%

V = 18+0.15/0.10 (24-18)
0.10
= Rs. 270

Pg 8.35; Problem 12:

EPS (E) = 10; IRR (r) = 15%; Cost of Cap (k) = 10%;

Mkt Price Per Share = D + r/k (E-D)

k
i) PAY OUT 20%

V= 2+0.15/0.10 (10-2)
0.10
= Rs. 140

ii) PAY OUT 50%

V= 5+0.15/0.10 (10-0)
0.10
= Rs. 125

iii) PAY OUT 0%

V= 0+0.15/0.10 (10-0)
0.10
= Rs. 150

iv) PAY OUT 100%

V= 10+0.15/0.10(10-0)
0.10
=Rs. 100
 GORDON’S MODEL
D
Market Price Per Share = k-g

D = Dividend (EPS * Pay Out)

k = Cost of Capital
g = Growth Rate (b*r)
(b = retention ratio;r = rate of return)
E = EPS
Pg 8. 38; Problem 23:
EPS= 8; Retention rate= 25%; Capitalization ratio (k) = 10%; rate of return (r) = 15%

D = EPS *Pay Out

= 8*75% = Rs. 6

G = b*r

= 25%*15% = 3.75%

Mkt Price of the firm = 6

6.25%

= Rs. 96

Pg 8. 38; Problem 25:

EPS = 18; K = 20%; r = 20%

i) PAY OUT 25% ; RETENTION RATE 75%

M.P= D/k-g

D = 18*25%

= 4.5

G= b*r

= 75%*20%

= 15%

M.P = 4.5/20%-15%
 = Rs. 90

ii) PAY OUT 50%; RETENTION RATE 50%

M.P = D/k-g

D = 18*50%

=9

G = b*r

= 50%*20% = 10%

M.P = 9/20%-10%

= Rs. 90

iii) PAY OUT 75%; RETENTION RATE 25%

M.P = D/k-g

D = 18*75%

= 13.5

G= b*r

= 25%*20% = 5%

M.P = 13.5/20%-5%

= Rs. 90

Pg 8. 40; Problem 31:

EPS = 5; DPS = 3; K = 16%; r = 20%; Retention ratio (b) = 40%

Walter’s Model:

M.P = 3+0.2/0.16 (5-3) = Rs. 34.38

0.16

Gordon’s Model:

G = 40% * 16% = 8%

M.P = 3 = 3 = Rs. 37.5

16% - 8% 8%
 MM MODEL (Theory of Irrelevance)

Market Price Per Share:

P1 = Po (1 + Ke) – D1
Where, P1 = Market price per share at the end of period
Po = Market price per share at the begining of period
Ke = Cost of Eq. Capital
D1 = Dividend per share at the end of the period.
Determination of No. of New Share:
Investment Proposed XXX
(-) Retained Earnings
Net Income XXX
(-) Dividend distributed XXX XXX
Amount to be raised by issue of new shares XXX

No of New Shares = Amount to be raised by issue of new shares

Issue Price per share

Pg 8. 40; Problem 34:

Market price per share under MM model:

i) If dividens are distributed:

P1= P0 (1+ke) - D1

= 100 (1+0.1) - 6

= Rs. 104

ii) If dividens are not distributed:

P1 = P0 (1+ke) -D1

= 100 (1+0.1) - 0

= Rs. 114
Computation of No of shares to be issued to finance investment proposal:

i) If dividens are distributed:

RS RS

Invest proposal 20,00,000

(-) retained earnings:

Net income 10,00,000

(-) Dividend distributed 6,00,000 4,00,000

Amt. raised by issue of share 16,00,000

No of new shares = Amount raised

Issue price

= 15,385 shares

Pg 8. 41; Problem 36:

Market price per share under MM model

i) If dividends are distributed:

P1 = P0 (1+ke) - D1

= 100 (1+0.12)-10

= Rs. 102

i) If dividends are not distributed:

P1 = P0(1+ke)-D1

= 100(1+0.12)-0

= Rs. 112
Computation of no of shares to issued of finance investment proposal

i) If dividends are distributed:

RS RS

Investment proposal 10,00,000

(-) Retained earnings:

net income 5,00,000

(-) Dividend distributed 1,00,000 4,00,000

Amt raised by issue of share 6,00,000

No of new shares = Amount raised

Issue price

= 5,882 shares
 UNIT-4
WORKING CAPITAL
Working Capital – Meaning and Importance – Factors Influencing

Working Capital – Determining (or) Forecasting of Working Capital

requirements – Working Capital Operating Cycle.

MEANING
Working capital is the lifeblood of a business. Funds required for the
purchase of raw materials, payment of wages and other day-to-day expenses are
known as working capital. It is the part of the firm's capital, which is used for
financing the short-term operations. Hence, it is also known as circulating capital or
short- term capital. .
There are two concept of working capital under the Gross concept total
funds invested in current assets is known as "Gross working capital". Under net
concept of the working capital is "The difference between current assets and current
liabilities". .
DEFINITION
“Working capital means current assets” - Mead, Malott and Field
“Any acquistion of funds which increases the current assets increases working capital,
for, they are one and the same” - Bonneville.
“The sum of the current assets is the working capital of a business” - J . S. Mill.
TYPES OF WORKING CAPITAL
i) Permanent or Fixed Working capital:
It is the minimum amount of current assets required for conducting the
business operation. This capital will remain permanent in current assets and should be
financed out of long-term funds. The amount varies from year to year, depending
upon the growth of a company. The permanent (or) fixed working capital may be
subdivided in three) Regular working capital and b) Reserve margin (or) cushion
working capital.
ii) Temporary or Variable working capital:
It is the amount of additional current assets required for a short period. It is
needed to meet the seasonal demands at different times during a year. It is temporary
hence it should be financed out of short-term funds. The working capital starts
decreasing when the peak season is over.
It may be subdivided into : a) Seasonal working capital (capital required to
meet seasonal needs) b special working capital (required to meet special exigencies
such as launching of extensive marketing campaigns and for research etc.)
iii) Gross working capital:
It is the amount of funds invested in the total current assets.
iv) Net working capital:
It is the excess of current assets over current liabilitie
v) Negative or quantitative working capital:
It occurs when current liabilities exceed current assets.
vi) Positive or qualitative net working capital:
It arises when current assets exceed current liabilities.
vii) Reserve working capital:
It refers to the short term financial arrangement made by the business units to
meet uncertain changes or uncertainties. .
FACTORS INFLUENCING WORKING CAPITAL
The need for working capital for day-to-day operation is influenced by number
of factors. Some of the important factors are given below:
a) Nature of Business:
Working capital depends upon the nature of business. Service oriented
concerns like electricity, water supplies need limited working capital whereas
manufacturing concerns require sufficient working capital, since they have to
maintain stocks and debtors.
b) Credit policies:
A company which allows credit to its customers will need higher amount of
working capital. Likewise, a company enjoying credit facilities from its suppliers will
need less amount of working capital. Amount of working capital Amount of working
capital
c) Manufacturing process:
Manufacturing process involves conversion of raw materials into finished
product. The longer the process, the higher the requirement of working capital.
Therefore length of manufacturing process is one of the factor which influence the
working capital requirements.
d) Changes in technology:
Changes in technology affect the requirement of working capital. It if goes for
automation, it improves the raw material processing, reducing the wastages and make
fast production. Hence the requirement of working capital is less.
e) Rapidity of turnover:
High rate of turnover require low amount of working capital and lower and
slow moving stocks needs a larger working capital. For example, slow moving
jewellery shops have to maintain different types of jewelleries which requires high
working capital. But, high moving grocery shops requires low working capital.
f) Business Cycle:
Change in the economy also influences the working capital. When a business
is prosperous, it requires huge amount of capital. Also during depression huge amount
of working capital required for unsold stock, uncollected debts.
g) Seasonal Variation:
If the supply of raw materials are highly fluctuating, industries which are
manufacturing and selling goods seasonally requires large amount of working capital.
h) Fluctuation of Supply:
Firms have to maintain large reserves of raw materials in stores to avoid
uninterrupted production, which requires large amount of working capital.
i) Dividend policy:
If a dividend policy is followed by the management, the need for working
capital can be met with the retained earnings. It consequently drains off large amounts
from working capital pool.
ADVANTAGES OF WORKING CAPITAL
Working capital is just like the heart of business. No business can run
successfully without an adequate working capital. The advantages of adequate
working capital are as follows:
i) Helps to receive cash discount from suppliers which in turn reduces the
purchase price.
ii) It create and maintain the goodwill of the firm.
iii) It provides facilities to meet the crisis during depression period.
iv) It enables the credit worthiness of the business.
v) It ensures regular supply of raw materials and continuous production.
vi) It boosts the morale of employees and their efficiency.
vii) It can create favourable market condition, by purchasing materials bulk
when prices are lower and hold stock to realise better price.
viii) It enables a concern to avail trade discounts on the purchases.
 ix) It generate high rate of return by using effective utilisation of fixed assets.
x) It enables a firm to pay regular dividends.
LIMITATIONS OF 'INADEQUATE' AND 'EXCESSIVE' WORKING
CAPITAL
A business firm must maintain an adequate working capital. It should be
neither excessive nor inadequate. However, out of the two, inadequate working capital
is more dangerous.
Disadvantages of inadequate working capital:
a) It results in interruption of production which in turn leads to increase in
cost and reduction in profit.
b) It leads to borrow loans at high rate of interest. The firm, can not buy the
raw materials in bulk order, and cannot take the advantage of cash
discount.
c) It results in non-payment of dividend because of non- availability of funds.
It leads to liquidation because of low liquidity position.
d) It leads to under utilisation of fixed assets, thus the rate of return on
investment falls.
Disadvantages of excessive working capital:

a) It results in idle funds which earns no profit. B

b) It makes an imbalance between liquidity and profitability.
c) It leads to more production then the demand.
d) It indicates excessive debtors and incidence of bad debts.
e) It may tempt to over trade and lose heavily.

WORKING CAPITAL MANAGEMENT

Working capital management is related with managing current assets, current
liabilities and the inter-relationship. It is an integral part of corporate management.
The main objective of working capital management is profitability and liquidity.
Liquidity ensures satisfactory financial obligations and profitability offers
satisfactory return on investments. A balanced working capital gives higher
profitability, proper liquidity and makes sound structure of the organisation.
 “Working capital management refers to all aspects of the administration of
both current assets and current liabilities” - Weston and Brigham.
“Working capital management is concerned with the problems that arise in
attempting to manage the current assets, the current liabilities and the inter -
relationship that exists between them”- Prof.K.V. Smith.
APPROACHES FOR DETERMINING THE FINANCING MIX.
There are three basic approaches for determining the financing mix.
i) The Hedging approach:
Under this approach, the majority of source of funds should match the nature
of assets to be financed. Therefore, it is also termed as "Matching Approach". It
divides the requirements of total working capital funds into two categories namely
permanent working capital and temporary (or) seasonal working capital.
The permanent working capital requirements should be financed by long-term
funds while the seasonal working capital requirements should be financed out of
short -term funds. It results in high profit and high risks.
ii) The conservative approach:
According to this approach all requirements of funds should be met from
Long-term sources. The short-term sources should be used only for emergency
requirements. The risk is low in this approach, so also the profit.
iii) Trade - off between hedging and conservative approaches
Under this approach a conservative approaches is determined. One way of
determining the level of trade-off is by finding the average of the minimum and the
maximum requirements of working capital during a period. The average working
capital so obtained may be financed by long-term funds and the balance by short -
term funds.
PROCEDURE FOR CALCULATING WORKING CAPITAL
FORECASTING.
Forecasting the working capital requirement is a difficult problem faced by
each businessman. The calculation of working capital requirements involves
estimation of various components of current assets and current liabilities. The
assessment can be:
a. Total quantity of units to be produced in a year.
b. Total costs incurred on materials, wages and overheads.
c. Length of time for which raw materials kept in stores.
d. Length of the period during which finished product is kept in warehouse.
credit allowed to debtors. Credit allowed by creditors.
e. Lag in payment of wages and overheads.
f. Suitable adjustments to be made to provide for contingencies and seasonal
factors.

PROBLEMS
OPERATING CYCLE
Particulars Days
Raw Materials storage period XXX
Add: Work-in-progress holding period XXX
Finished goods storage period XXX
Debtors collection period XXX
XXX
Less: Creditors collection period XXX
Operating Cycle XXX

Raw
Materials Avg. stock of R.M
= * 365
storage
Avg. stock of R.M consumed per day
period

WIP Avg. stock of WIP

holding = * 365
period Avg. cost of production per day

Finished
Goods Avg. stock of F.G
= * 365
storage
Avg. cost of goods sold per day
period
 Debtors Avg. A/c’s receivables
Collection = * 365
period Avg. credit sales per day

Creditors Avg. A/c’s payables

payment = * 365
period Avg. credit purchases per day

Pg 9.73; Problem 1:

Computation of Operating Cycle

Raw material storage period (1,24,000/842,000*365) 54

Add: WIP (72,000/14,25,000*365) 18

Finished goods storage period (1,22,000/15,30,000*365) 29

Debtor’s collection period (2,60,000/19,50,000*365) 49

150

Less: Creditor’s collection period 30

Operating Cycle 120 days

Pg 9.75; Problem 3:

a) Operating Cycle = RM + WIP + Finished goods + Debtors - Creditors

= 30+15+30+60-45

= 90 days

b) No of operating cycle = No of days in a year

Op. Cycle
=365/90

= 4 cycles

iii) Avg. Working Capital required = Annual cash op. cycle

No. of op.cycle
= 18000000/4

= Rs. 45 lakhs
Pg 9.75; Problem 5:

Cost Annual Sales

of = * 100
100% of Net Profit of Sales
Sales

65,00,000
= * 100
120

Computation of Operating Cycle

Current Assets

Raw material

Stock (54,16,667*8/52) 8,33,333

Debtors (54,16,667*10/52) 10,41,667

18,75,000

(-) Current Liabilities

Creditors (54,16,667*4/52) 4,16,667

14,58,333

(+) Contingencies (14,58,333 * 10%) 1,45,833

Net Working Capital Rs.16,04,166