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Financial management book @ bec doms baglkot mba


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Financial management book @ bec doms baglkot mba

Financial management book @ bec doms baglkot mba

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  • 1. FINANCIAL MANAGEMENTUnit -1 Financial Management: An introduction - Concept, Nature, Evolution andSignificance - Finance functions - Risk return trade off - Maximization andminimization vs. optimization.Unit - 2 Long Term Capital Resources: Equity and debt sources - Equity shares,Preference shares and Debentures - Uses - Significance of convertible issues andright issues - Borrowings from term lending institutions - Institutional frame work -Types of assistance - General procedure and conditions - Public deposits - Meaning,scope and regulations.Unit-3 Working Capital: Concept and types - Determinants - Financing approaches -Sources of working capital - Financing working capital Financing by commercialbanks - Types of assistance - Working capital gap -Recommendations of TandonCommittee and Chore Committee reports.Unit-4 Capital Budgeting: Concept - Significance - Methods of evaluation of capitalinvestments - Payback, Average Return, NPV, 1RR, Decision free Simulation.Sensitivity and CAPM methods.Unit-5 Capital Structure Planning; Determinants of capital structure - Optimumcapital structure - Capital structure theories – Significance and limitations -Cost ofcapital: Concepts - Cost of debt, equity, preference share capital and retained earning- weighted average cost. BSPATIL
  • 2. Unit – 6 Management of Current Assets: Forecasting of current assets needs-Management of cash and liquidity - Objectives - budgeting - Planning the optimumlevel of cash - Inventory model, stochastic model - Model of Miller and Orr - Paymentand collection practices -Management of receivables -Credit policy - Credit period -Credit terms - Collection policies - Control of receivables - Inventory management -Meaning and importance - Inventory costs - Inventory levels - Inventory managementtechniques - Stock out cost determination techniques.Unit-7 Dividend Theories: Valuation under Gordon and Walter Theories -Dividendirrelevance under MM Theory - Assumptions and limitations -Dividend policy:Different policies and practices - Factors affecting dividend decision. UNIT-I FINANCIAL MANAGEMENT - FUNCTIONS & GOALS In this unit you will learn, concept of financial management, nature of financialmanagement, evolution of financial management, significance of financialmanagement, functions of financial management, goals of financial management, riskreturn -trade off and aspects of maximization, minimization and optimization infinancial management.INTRODUCTION Of the different factors of production, capital is very crucial. Capital isotherwise called finance. BSPATIL
  • 3. Finance is one of the requisites for all human endeavours -personal, businessor government. Finance refers to the money resources -owned or borrowed availableto individuals, businesses or governments for their operations. Ours is a moneyeconomy and every person, individual or otherwise, needs finance and mobilizesfinance. As every other resource, finance is not unlimited. Printing currency notes orminting coins would only add to the money supply resulting in inflation and reducedvalue of oney. So, more money circulation would not mean more finance availability. ctually, finance is monetized form of capital, and capital is the savings (S)available for investment. Amount of savings depends on income (Y) and consumption(C). There are certain macroeconomic equations: Y = C + S ; Y = C + I and S = I When savings become available for investment, capital formation takes place.Capital, thus formed, is finance. Finance has two sides, just as a coin. One side isconcerned with assets and the other with liability. The assets side representsinvestments and the liability side represents sources and types of finances depended. That is to say, finance is a scarce resource. Consequently, no one hasunlimited access to finance nor can afford frittering away the resources unwisely.Both mobilizing and investing financial resources have to be managed properly.Hence, financial management has emerged as a priority function for all concerned. There are three branches of financial management Personal, business andgovernment financial management Personal financial management deals with howindividuals, you and I, manage our finances. Business financial management dealswith how business undertakings manage their finances. Government financialmanagement known as public finance, deals with how governments manage theirfinances. In this paper, we are however dealing with business financial managementonly.1.1 DEFINITIONS AND CONCEPT OF FINANCIAL MANAGEMENT BSPATIL
  • 4. What is meant by financial management? Very simple indeed. Financialmanagement is management principles and practices applied to finance. Howard andUpton view that financial management is the application of general managementfunctions to the area of financial decision making. General management functionsinclude planning, execution and control. Financial decision making includesdecisions as to size of investment, sources of capital, extent of use of different sourcesof capital and extent of retention of profit or dividend payout ratio. Financialmanagement, is therefore, planning, execution and control of investment of moneyresources, raising of such resources and retention of profit/payment of dividend. Howard and Upton define financial management as "that administrative area orset of administrative functions in an organisation which have to do with themanagement of the flow of cash so that the organisation will have the means to carryout its objectives as satisfactorily as possible and at the same time meets itsobligations as they become due. Bonneville and Dewey interpret that financing consists in the raising, providingand managing all the money, capital or funds of any kind to be used in connectionwith the business. According to James C Van Home and John M. Wachowicz financialmanagement is concerned with acquisition, financing and management of assets withsome overall goal in mind. Osbon defines financial management as the "process of acquiring and utilisingfunds by a business”. Considering all these views, financial management may be defined as that partof management which is concerned mainly with raising funds in the most economicand suitable manner, using these funds as profitably as possible; planning futureoperations, and controlling current performances and future developments throughfinancial accounting, cost accounting, budgeting, statistics and other means.Financial management provides the best guide for future resource allocations. Itdesigns and implements certain financial plans, investment plans and value addition BSPATIL
  • 5. plans.1.2 NATURE OF FINANCIAL MANAGEMENT Nature of financial management is concerned with its functions, its goals,trade-off with conflicting goals, its indispensability, its systems, its relation with othersubsystems in the firm, its environment, its relationship with other disciplines, theprocedural aspects and its equation with other divisions within the organisation. i) Financial Management is an integral part of overall management. Financial considerations are involved in all business decisions. Acquisition, maintenance, removal or replacement of assets, employee compensation, sources and costs of different capital, production, marketing, finance and personnel decisions, almost all decisions for that matter have financial implications. So financial management is pervasive throughout the organisation. ii) The central focus of financial management is valuation of the firm. That is financial decisions are directed at increasing/maximization/ optimizing the value of the firm. Weston and Brigham depict the above orientation in Figure 1.1.Fig. 1.1 Orientation of Financial Management BSPATIL
  • 6. iii) Financial management essentially involves risk-return trade-off Decisions on investment involve choosing of types of assets which generate returns accompanied by risks. Generally higher the risk, returns might be higher and vice versa. So, the financial manager has to decide the level of risk the firm can assume and satisfy with the accompanying return. Similarly, cheaper sources of capital have other disadvantages. So to avail the benefit of the low cost funds, the firm has to put up with certain costs, disadvantages or risks, so, risk- return trade-off is there throughout. Fig 1,1 implies this aspect of financial management also.iv) Financial management affects the survival, growth and vitality of the firm. Finance is said to be the life blood ofbusiness. It is to business, what blood is to us. The amount, type, sources, conditions and cost of finance squarely influence the functioning of the unit.v) Finance functions, i.e., investment, rising of capital, distribution of profit, are performed in all firms - business or non-business, big or small, proprietary or corporate undertakings. Yes, financial management is a concern of every Financial management is a sub-system of the business system which has other subsystems like production, marketing, etc., In systems arrangement financial sub-system is to be well-coordinated with others and other sub-systems well matched with the financial sub- system.vii) Financial management of a business is influenced by the external legal and economic environment. The investor preferences, stock market conditions, legal constraint or using a particular type of funds or on investing in a particular type of activity, etc., affect financial decisions, of the business. Financial management is, therefore, highly influenced/constrained by external environment. BSPATIL
  • 7. viii) Financial management is related to other disciplines like accounting, economics, taxation operations research, mathematics, statistics etc., It draws heavily from these disciplines. The relationship between financial management and supportive disciplines is depicted in figure 1.2. given below.Fig. 1.2. Relationships between Finance and other disciplines ix) There are some procedural finance functions - like record keeping, credit appraisal and collection, inventory replenishment and issue, etc., These are routinized and are normally delegated to bottom management. x) The nature of finance function is influenced by the special characteristic of the business. In a predominantly technology oriented business, it is R & D functions which get more dominance, in a consumer fashion product business it is marketing and marketing research which get more priority and so on. Here, finance assumes a low profile importance. But one should forget that the strength of a chain depends on its weakest link.1.3 EVOLUTION OF FINANCIAL MANAGEMENT Finance, as capital, was part of the economics discipline for a long time. So, BSPATIL
  • 8. financial management until the beginning of the 20th century was not considered asa separate entity and was very much a pan of economics. In the 1920s, liquidity management and raising of capital assumed importance.The book, FINANCIAL POLICY OF CORPORATIONS written by Arthur Stone Dewingin 1920 was a scholarly text on financing and liquidity management, i.e., cashmanagement and raising of capital in 1920s. In the 1930s tfoere was the Great Depression, i.e., all round price decline,business failures and declining business. This forced the business to be extremelyconcerned with solvency, survival, reorganisation and so on. Financial Managementemphasized on solvency management and on debt-equity proportions. Besidesexternal control on businesses became more pronounced. Till early 1950s financial management was concerned with maintaining thefinancial chastity of the business. Conservatism, investor/lender related protectivecovenants/information processing, issue management, etc. were the prime concerns.It was an outsider-looking-in function. From the middle of 1950s financial management turned into an insider-looking-in function. That is, the emphasis shifted to utilization of funds from rising offunds. So, choice of investment, capital investment appraisals, etc., assumedimportance. Objective criteria for commitment of funds in individual assets wereevolved. Towards the close of the 1950s Modigliani and Miller even argued that sourcesof capital were irrelevant and only the investment decisions were relevant. Such wasthe total turn in the emphasis of financial management. In the 1960s portfolio management of assets gained importance. In theselection of investment opportunities portfolio approach was adopted, certaincombinations of assets give more overall return given the risk or give a certain returnfor a reduced risk. So, selection of such combination of investments gained eminence. BSPATIL
  • 9. In the 1970s the capital asset pricing model (CAPM), arbitrage pricing model(APM), option pricing model (OPM), etc., were developed - all concerned with how tochoose financial assets. In the 1980s further advances in financial management werefound. Conjunction of personal taxation with corporate taxation, financial signaling,efficient market hypothesis, etc., were some newer dimensions of corporate financialdecision paradigm. Further Merger and Acquisition (M&A) became an importantcorporate strategy. The 1990s, saw the era of financial globalization. Capital moved West to East,North to South and so on. So, global financial management, global investmentmanagement, foreign exchange risk manage lent, etc., become more important topics. In late 1990s and 2000s, corporate governance got preeminence and financialdisclosure and related norms are being great concerns of financial management. Thedawn of 21st Century is heralding a new era of financial management with cybersupport. The developments till mid 1950s are branded as classical financialmanagement. This dealt with cash management, cash flow management, raisingcapital, debt-equity norms, issue management, solvency management and the like.The developments since mid - 1950s and upto 1980s, are branded as modemfinancial management. The emphasis is on asset management, portfolio approach,capital asset pricing model, financial signaling, efficient mark*, hypothesis and soon. The developments since the 1990s may be called po^ modern financialmanagement with great degree of global financial integral m net supported financesand so on.1.4 SIGNIFICANCE OF FINANCIAL MANAGEMENT Financial management is a very important function of overall businessmanagement. The reasons are laid down here. i) Financial Management covers a very large spectrum of activities of a business. True, whatever a business does it has a financial BSPATIL
  • 10. implication. Hence its pervasiveness and significance. Finance knowledge is a must for all irrespective of position, place, portfolio and what not.ii) Financial Management influences the profitability or return on investment of a business. Yes, the choice of capital investment decisively affect the profitability of an undertaking.iii) Financial Management affects the solvency position of a business. Solvency refers to ability to service debts paying interest and repaying principal as these become due. Profitability and nature of debts - both concerns of financial management, govern the solvency aspect. Hence the significance of financial managementiv) Financial Management affects the liquidity position of a business. Liquidity refers to ability to repay short term loans. Efficient cash management, cash flow management and management of relations with the banker influence the level of liquidity. All these factors are aspects of financial management.v) Financial Management affects cost of capital. Able financial managers find and use less cost sources, which in turn contributes to profitability. In using fixed cost instruments of capital, the efficacy of sound financial management would be known well. Variable cost instruments of capital are the order of the day. Finance savvy persons go for such Financial Management, if well steered can ward off difficulties such as restrictive covenants imposed by lenders of capital, inflexibility in capital structure, dilution of management control on the affairs of the business and so on. Failure to do so, has landed many firms in difficulties and financial mess.vii) Good financial management enables a business to command capital BSPATIL
  • 11. resources flowing into the business. There is always capital available at attractive terms, if business finance is handled well. Even overseas capital can be easily mobilized, if sound financial management is ensured. viii) Market value of the business can be increased through efficient and effective financial management. As share and stock are quoted at high prices, more funds, when needed, can be mobilized easily either thro1 public and/or rights offers. ix) Efficient financial management is necessary for the survival, growth, expansion and diversification of a business. x) Financial Management significantly influences the businesss credit rating, employee commitment, suppliers confidence, customers patronage and the like. xi) Financial Management is an exercise on optimizing costs given revenues, or optimizing revenues given costs. This is vital to ensure purposeful resource allocation. xii) Today financial management has global dimensions with opportunity to mop up resources and put up investments across borders. Global trend in finance is better learnt by all. The significance of financial management can be well appreciated if oneconsiders the analogy. Finance is what blood is to living beings. Financialmanagement is what the blood circulation system is to living beings. The functions ofheart, veins, arteries, etc., in maintaining the circulation of blood are lifes worth toliving beings. So is the worth of financial management to a business.1.5 FINANCE FUNCTIONS Finance functions simply refer to functions of financial management. BSPATIL
  • 12. The functions of financial management are divergent. Severalclassifications are used. Here are presented the functions of financial management asnoted by eminent authors. Figure 1.3 gives the details.Fig. 13 Functions of Financial Management Authors 1 2 3 4Robert W Financial Raising of Investing Meeting specialJohnson Planning funds funds problems and controlGrunwald Investment Providing Generating MaximizingNemmars of funds liquid assets earnings market value of the firmVan Home & Investment Financial DividendWachowicz function function functionEarnest W. Financial Financial co- FinancialWalker planning ordination controlWeston& Financial Fixed asset Capital IndividualJrigham planning and working structure financing and control capital decisions episodes management Well. The above figure presents the functions of financial management, orfinance functions shortly, as perceived by the different authors. Let us look at themin a more analytical way. Finance functions are classified on two dimensions -managerial" and operative. The managerial financial functions include planning,organisation, direction, coordination and control of the operative functions. Theoperative functions include investment function, financing function and dividendfunction. We have a matrix of functions as given in Fig. 1.4.Fig. 1.4 : Matrix of Financial Functions BSPATIL
  • 13. Operative Managerial Functions Functions Co- Planning Organizing Direction Control ordinationInvestment Size andand asset typesmanagementFinancing and Structureliability and costmanagementDividend Impact onpayout value andmanagement liquidityand internalfinancing Each one of the operative functions has got to be planned, organized,directed, coordinated and controlled. Investment function is concerned with the assetto be acquired. Fixed and current assets are needed. Commitment of funds in them isdealt by investment function. Financing function is concerned with the capitalsources to be tapped. Equity and debt funds are available. The mix of them is dealtby financing function. We may put this way. The investment function deals with theasset side of balance sheet and financing function with the liabilities side of balancesheet. Dividend function deals with how much of profit to be distributed as dividendand how much be retained. Evidently, each of the operative functions involves a hostof dimensions as to size, variety, proportions, timing, sourcing and so on requiring atotal managerial approach to decide each on each dimension. Hence the interplay ofmanagerial and operative functions. Now a more detailed account of each of the operative functions isattempted.a) Investment and Asset Management Function BSPATIL
  • 14. A detailed discussion on investment function of financial management istaken up. This function essentially covers the following: i) the total amount to be committed in assets ii) the proportion of fixed to current assets iii) the mix of fixed assets to be acquired iv) the timing, sourcing and acquisition of fixed assets v) the evaluation of capital investments as to risk and return features vi) the mix of current assets vii) the management of each item of current assets to optimize liquidity and return viii) the effecting of a healthy portfolio of assets Actually the above aspects of investment function are concerned withmuch pregnant issues with which financial management is concerned. The firstaspect deals with the size of the firm, the second and third deal with the level of riskthe business is willing to assume, the fourth with appraisal of investment as to theirprofitability, pay back period, etc., the fifth with actual execution of investmentdecisions, the sixth with the liquidity of the business, the seventh with structural andcirculatory aspects of current assets and the eighth with the overall balancing ofvarious investments held by the business taking into account competing anddivergent claims. Investment function is, concerned capital budgeting and current assetmanagement. Capital budgeting deals with fixed assets management. Investmentappraisal, capital rationing, and acquisition, maintenance, replacement and renewalof fixed assets come under fixed assets management. Inventory management,receivables management, marketable securities management, cash management andworking capital administration come under current assets management. (You willlearn every one of these in the subsequent lessons). A good deal of planning,organisation, coordination and control is needed in every decision area.b) Financing and Liability Management Function BSPATIL
  • 15. The financing function refers to raising necessary iunds for backing upthe investment function. Financing function is dealing the capital structure of thebusiness and covers the following: i) determination of total capital to be raised ii) determination of the debt-equity ratio or the proportion of debt to equity capital and the mix of long term and short-term capital. iii) determination of the level of fixed-change funds like bonds, debentures, loans, etc. iv) determination of the sources of borrowing - development banks, public or private v) determination of the securities/charges to be given vi) determination of the cost of capital vii) determination of the extent of lease financing viii) determination of the degree of sensitivity of earnings per share to earnings before interest and taxation ix) determination of the method of raising capital-public issue or private placement; under-writing and brokerage, rights issue and the like x) the legal restrictions, if any, on the scale, form, timing and other aspects of raising capital Like investment function, financing function also affects the liquidity(less short term debt means more liquidity), solvency (more equity means moresolvency), profitability (low cost capital means more profitability), flexibility of capitalstructure (more equity, more flexibility), control on business (more debt and less BSPATIL
  • 16. equity mean more concentration of control on the affairs of the business) and so on.That is, financing function is equally influencing the fortunes of the business. Butauthors like Modigliani and Miller would argue that financing function is not all matrelevant requiring our deep concern. Any capital mix or structure is equally good orbad as any other. (You will learn more of these in subsequent lessons). Lot ofmanagerial planning and control ate needed in the financing function.c) Dividend Payout Management Function The third and last, but not the least important, function of financialmanagement is dividend function. The fruits of the carefully executed earlier twofunctions are the profits. How the profits are to be utilized, is the concern of thedividend function. How much of the profits to be distributed as dividends to theshareholders? In other words, what should be the pay-out ratio? What should be theretention ratio? Dividend payment is necessary, for shareholders expect a return ontheir shareholding for they can invest / spend the dividend income; for maintainingor enhancing the value of the shares in the market, for dividend declaration has afinancial signaling effect and so on. Retaining the profits ane ouging back the same inthe business itself may become necessary because; the >mpany can invest moreprofitably than the shareholders; the company can get established and canmodernize, diversify and expand using the retained profits; the share holders areexpecting capital gain rather than current income; and because the cost of raisingnew capital form the public is costlier and time consuming. So, there are conflictingissues in paying dividend as well as in retaining the earnings. A well thought out planof action is called for. Hence the significance of the dividend function. (You will learnmore on this function in the last lesson). There is another classification of finance functions. Treasurer functionsand controller function are the two types. Treasurers responsibilities include assetmanagement, capital budgeting, bank-institutional relationship, credit management,dividend disbursement, investors relations, insurance risk management, taxanalysis, etc. The controller deals with accounting, data processing, budgeting,internal control, government reporting, etc. BSPATIL
  • 17. 1.6 GOALS OF FINANCIAL MANAGEMENT Goals provide the foundation for any managerial activity. They ai the endstoward which all activities are directed. The purpose and direction of an organisationare seen in its goals. Goals act as motivators, serve as the standards for measuringperformance, help in coordination of multiplicity of tasks, help in identifying inter-departmental relationships and so on. Simply put, goals are what you aim at So,goals have to be specific and quantitative. Generally, goals are multiple. Financialmanagement may pursue different goals such as increasing profit by 20% every year,reducing cost of capital by 1%, maintaining the debt-equity ratio at 3:2 and so on. Letus examine all these in detail.1.6.1 Types of Goals The goals can be classified in many ways. Official goals, operative goals andoperational goals are one classification. Official goals are the general aims of theorganisation. Maximization of return on investment and market value per share maybe tenned as official goals. Operative goals indicate what the organisation is reallyattempting to do. They are focused and help in choice making. Expected return oninvestment, cost of capital, debt-equity norms, eic dong with time horizon arespecified or their acceptable ranges/limits are static keeping in view the official goals.The operational goals are more directed quantitative and verifiable. The scale, mixand timing of specific form of finance are detailed. The official, operative andoperational goals are structured with a pyramidal shape, the official goals at the top(concerned with the top executives), operative goals at the middle (concerned withmiddle management) and operational goals at the base. The goals can be classified in a functional way. Return related goals,solvency related goals, liquidity related goals, valuation related goals, risk relatedgoals, cost related goals and so on. Return related goals refer to the aims onminimum, average and, maximum returns. What should be the minimum returnfrom a project in order to accept the same, what should be average return the firmshould settle for and what is the maximum return possible (for risk increases withreturn). Similarly, goals as to solvency, liquidity, market value etc., can be thought of BSPATIL
  • 18. You have to state to what extent the stated goal factor is important and be activelypursued/and the extent of the goal factor required; the minimum, average and themaximum levels be specified. The different goals of financial management are givenbelow in Table 1.1. BSPATIL
  • 19. Profit Maximization Profit maximization is a stated goal of financial management. Profit is theexcess of revenue over expenses. Profit maximization is therefore maximizing revenuegiven the expenses, or minimising expenses given the revenue or a simultaneousmaximization of revenue and minimization of expenses. Revenue maximization ispossible through pricing and scale strategies. By increasing the selling price one mayachieve revenue maximization, assuming demand does not fall by a commensuratescale. By increasing quantity sold by exploiting the price-elasticity of the demandfactor, revenue can be maximized. Expenses minimization depends on variability ofcosts with volume, cost consciousness and market conditions for inputs. So, a mix offactors is called for profit maximization. This objective is a favoured one for the following reasons:1st profit is a measure of success in business. Higher the profit greater is the degree ofsuccess. 2nd profit is a measure of performance. Performance efficiency is indicated bythe quantum of profit, 3rd profit making is essential for the growth and survival of anyundertaking. Only protit making business can think of tomorrow and beyond. It canonly think of renewal and replacement of its equipment and can go for modernizationand diversification. Profit is an engine doing away the odds threatening the survival ofthe business. 4th profit making is the basic purpose of business. It is accepted bysociety. A losing concern is a social burden. The sick business undertakings cause aheavy burden to all concerned, we know. So, profit criterion brings to the lightoperational inefficiency. You cannot conceal your inefficiency, if profit is made thecriterion of efficiency. 5th profit making is not a sin. Profit motive is a sociallydesirable goal, as long as your means are good.However, profit maximization is net very much favoured. Certain limitations arepointed out. First, concept of profit is vague. There are several concepts of profit likegross profit, profit before tax, profit after tax, net profit, divisible profit and so on. Sothe reference to the profit has to be clear. Second, profit maximization in the long-runor in the short-run is to be stated clearly. Long-run or in the short-run profitorientations differ in the nature, emphasis and strategies. Third, profit maximizationdoes not consider the scale factors. Size of business and level of profit have to berelated. Otherwise no sensible interpretation of performance or efficiency is possible. BSPATIL
  • 20. Fourth, profit has to be related to the time factor. Inflation eats up money value. Arupee today is worthier today than tomorrow and day after. Time value of money isnot considered in profit maximization. Consider the case of three businesses makingsame absolute profits over a 3 year time span given below. Year Unit-1 Unit-2 Unit-3 Rs. Rs. Rs. 1 20,000 40,000 5,000 2 20,000 15,000 15,000 3 20,000 5,000 40,000 Total 60,000 60,000 60,000 The profit maximization objective would not differentiate among the threebusiness. But, evidently, unit-2 is the best of the three, followed by Unit-1 and Unit-3in that order. Fifth, profit maximization might lead to unfair means being adopted.The end through and means is no good. Ethics is business dealings may beundermined any this is not good. So, profit maximization is not accepted as a flawlessgoal. BSPATIL
  • 21. Profitability Maximization Profit as an absolute figure conveys less and conceals more. Profit must berelated to either sales, capacity utilisation, production or capital invested. Profit whenexpressed in relation to the above size or scale factors it acquires greater meaning.When so expressed, the relative profit is known as profitability. Profit per rupee sales,profit per unit production, profit per rupee investment, etc., are more specific. Hence,the superiority of this goal to the profit maximization goal. Further profit per rupee investment or return on investment, (ROI) is acomprehensive measure. ROI = Return or Profit / Average Capital invested. This canbe written as: Profit Sales X Sales Investment Profit divided by sales measures the profit per rupee of sales and sales dividedby investment measures the number of times the capital is turned over. The former isan index of profit earning capacity and the latter is an index of activeness of thebusiness. Maximization of profitability (ROI) is possible through either the former orthe latter or both. The favourable scores of this objective are the same as those of the profitmaximization objective. The unfavourable scores of this objective again are the sameas those of the profit maximization objective except one aspect. Profit maximizationgoal does not relate profit to any base. But profitability maximization relates profit tosales and/or investment. Hence it is a relative measure. So it is better than profitmaximization goal on this score. But as other limitations continue, this objective toogets only a qualified report as to its desirability.1.6.13 EPS Maximization Maximization EPS involves maximizing earnings after tax given the number of BSPATIL
  • 22. outstanding equity shares. This goal is similar to profitability maximization in respectof merits and demands. It is very specific both as to the type of profit and the base towhich it is compared. One disadvantage is that EPS maximization may lead to valuedepletion too, because effect of dividend policy on value is totally discarded. Liquidity Maximization Liquidity refers to the ability of a business to honour its short-term liabilities asand when these become due. This ability depends on: the ratio of current assets tocurrent liabilities, the maturity patterns of currents assets and the current liabilities,the composition of current assets, the quality of non-cash current assets; therelations with the short-term creditors; the relations with bankers and the like. Ahigher current ratio, a perfect match between the maturity of current assets andcurrent liabilities, a well balanced composition of current assets, healthy andmoving1 current assets, i.e., those that can be converted into liquid assets with muchease and no loss, understanding creditors and ready to help bankers would helpmaintaining a high-liquidity level for a business. All these are not easy to obtain andthese involve costs and risks. How far is it a good goal? It is a good goal, though not a wholesome one. Everybusiness has to generate sufficient liquidity to meet its day-to-day obligations. Last,the business would suffer. A liquidity rich business can exploit some rareopportunities like buying inventory in large quantity when price is lower, lend to thecall money borrowers when the interest rate is high, retire short-term-creditors takingadvantage of cash discounts and so on. So many benefits accrue. But, high liquiditymight result in idle cash resources and this should be avoided. Yes, excess liquidityand profitability move in the opposite directions, they are conflicting goals and haveto be balanced. Solvency Maximization Solvency is long run liquidity. Liquidity is short-run solvency. The business hasto pursue the goal of solvency maximization. Solvency is the capacity of the businessto meet all its long-term liabilities. The earning capacity of the business, the ratio of BSPATIL
  • 23. profit before interest and tax to interest, the ratio of cash flow to debt amortization,the equity-debt ratio and the proprietary ratio influence the solvency of a business.Higher the above ratios greater is the solvency and vice-versa Is this a significant goal? Yes, Solvency is a guarantee for continued operation,which in turn is necessary for survival, growth and expansion. Borrowed capital is asignificant source of finance. Its cost is less; it gives tax leverage; So, equity earningsincrease; so market valuation increases. So, wealth maximization is enabled throughborrowed capital. But to use borrowed capital, solvency management is essential. Youhave to decide the extent to which you can use debt capital and ensure that the costof debt capital is minimum. Higher dependence and higher cost (higher than the ROI)would spell doom to the business. If the cost is less, (cost is the post tax interestrate), and your earnings are stable, a higher debt may not be difficult for servicing.Solvency maximization is increasing your ability to service increasing debt and doesnot mean using less debt capital. Increasing the debt service ability would requiregenerating more and stable cash flows through the operations of the business.Ultimately, the nature of investments and business ventures influence solvency. You would now understand that liquidity maximization and solvencymaximization emerge to a large extent from wealth maximizationobjective. Flexibility Maximization Flexibility means freedom to act in ones own way. The finance manager mustenjoy a good degree of freedom. This is possible when more equity capital is used,there are no restrictive covenants and exit options are available. Minimization of Risk So far, maximization financial goals were dealt with. Now, if we turn the coin,the minimization goals come to light. Minimization of risk is one of the goals. Riskrefers to fluctuation, instability or variations in what we cherish to obtain. Variationsin sales, profit, capacity utilisation, liquidity, solvency, market value and the like are BSPATIL
  • 24. referred to risk. Business risk and financial risk are prominent among different risks.Business risk refers to variation in profitability while financial risk refers to variationin debt servicing capacity. The business risk, alternatively, refers to variations inexpected returns. Greater the variations, greater the business risk. Risk minimizationalso does not mean taking no risk at all. It means minimizing risk given the returnand given the risk maximizing return. Risk reduction is possible by going in for a mixof risk-free and risky investments. A portfolio of investments with risky and risk-freeinvestments, could help reducing business risk. So, diversification of investments, asagainst concentration, helps in reducing business risk. BSPATIL
  • 25. Financial risk arises when you depend more on high-geared capital structure andyour cash flows and profits before interest and tax (PBJT) vary. To minimize financialrisk, the quantum of debt capital be limited to the serviceable level, which dependson the minimum level of PBJT and the cash flow. Of course, debt payment schedulingand rescheduling may help in financial risk reduction and the creditor must beagreeing to such schedules/reschedules. Here; too, a portfolio of debt capital can bethought of to reduce risk. Minimization of Cost of Capital Minimization of cost of capital is a laudable goal of financial management.Capital is a scarce resource, A price has to be paid to obtain the same. The minimumreturn expected by equity investors, the interest payable to debt capital providers, thediscount for prompt payment of dues, etc., are the costs of different forms of capital.The different sources of capital - equity, preference share capital, long term debt,short-term debt and retained earnings, have different costs. In theory, equity is thecostliest source. Preference share capital and retained earnings cost less than equity.The debt capital costs less, besides there is the tax advantage. So, to minimize costyou have to use more debt and less of other forms of capital. Using more debt toreduce cost is however is beset with some problems, viz., you take heavy financialrisk, create charge on assets and so on. Some even argue, that more debt meansmore risk of insolvency and bankruptcy cost arises. So, debt capital has, besides theactual cost, another dimension of cost - the hidden cost. So, minimizing cost ofcapital means minimizing the total of actual and hidden costs. This is a good goal. Minimization of capital cost increases the value of the firm.If the overall cost of capital is less, the firm can take up even marginal projects andmake good returns and serve the society as well. But, it should avoid the temptationto fritter away scarce capital. Capital should be directed into productive andprofitable avenues only.1,6.1.9. Minimization of dilution of control: Control on the business affairs is, generally, the prerogative of the equity BSPATIL
  • 26. shareholders. As the Board holds a substantial equity it wants to preserve its hold onthe affairs of the business. The non-controlling shareholders too, in heir financialpursuit, want no dilution of their enjoinment of fruits of equity ownership. Dilationtakes place when you increase the capital base. By seeking debt capital controldilation is minimized. Also, by rights issue of equity dilation of control can beminimized. It is evident, minimization of dilution of control is essentially a financing -mixdecision and the latters relevance and significance had been already dealt with. Butyou cannot minimize dilution beyond a point, for providers of debt capital, directly orindirectly, affect business decisions. The convertibility clause is a shot in the arm forthose creditors. Yes, controlling power has to be distributed. Especially, in Indiancontext one need not be a 51% owner to exercise full control. Even with as little as26% or 30% equity holding maximum control can be exercised. This is bad. So, suchcontrol better is not controlled. So, there is need and score for sharing of controllingpower. The present scenario is a fulfillment of the above. Wealth maximization: Wealth maximization means maximization of networth of the business, i.e. themarket valuation of a business. In other words, increasing the market valuation ofequity share is what is pursued here. This objective is considered to be superior andwholesome. The pros and cons of this goal are analysed below.Taking the positive side of this goal, we may mention that this objective takes intoaccount the time value of money. The basic valuation model followed discounts thefuture earnings, i.e. the cash flows, at the firms cost of capital or the expectedreturn. The discounted cash inflow and outflow are matched and the investment orproject is taken up only when the former exceeds the latter. Let the cash inflows beexpressed by CFi, CF2, CFs.... CFn, where the subscripts l,2,3...n are periods whencash flows realised. Let, the cash investment at time zero be T. The present value i.e.the discounted value of CFi, CFi, CF3..., CFto at the discount rate V is given by:n∑ CFt / (1+r)t or BSPATIL
  • 27. t=1CF + CF2 + CF + …….. + CF(1+r)1 (1+r)2 (1+r)3 (1+r)n The value addition is given by PV - I. By adopting this methodology the firmgives adequate consideration to time value of money, the short-run and long-runincome as the return throughout the entire life span of the project is considered andso on. The term cash flow used here is capable of only one interpretation, unlike theterm profit. Cash inflow refers to profit after interest and tax but before depreciation.Otherwise put, profit after tax and interest as increased by depreciation. Cash outflowis the investment. Salvage value of investment, at its present value can be reducedfrom investment or added to inflow. So, the cash flow concept used in wealthmaximization is a very clear concept. This goal considers the risk factor in financial decision, while the earlier twogoals are silent as though risk factor is absent. Not only risk is there and it isincreasing witH the level of return generally. So, by ignoring risk, you cannotmaximize profit for ever Wealth maximization objective give credence to the wholescheme of financial evaluation by incorporating risk factor in evaluation. Thisincorporation is done through enhanced discounting rate if need be. The cash flowsfor normal-risk projects are discounted at the firms cost of capital, whereas riskyprojects are discounted at a higher than cost of capital rate so that the discountedcash inflows are deflated, and the chance of taking up the project is reduced. Cashflows - inflows and outflows are matched. So, one is related to the other: i.e. there isthe relativity criterion too. So, wealth maximization goal comes clear off all thelimitations all the goals mentioned above. Hence, wealth maximization goal isconsidered a superior goal. This is accepted by all participants in the businesssystem. The profit, profitability, liquidity, solvency and flexibility maximization goalsand risk, cost and dilution of control minimization goals lead to reaping of wealthmaximization goal. Wealth maximization is, therefore, a super-ordinate goal. BSPATIL
  • 28. Maximization of economic value added A modern concept of finance goal is emerging now, called as maximization oreconomic value added (EVA). EVA = NGPAT - CCC, where, EVA is economic valueadded, NGPAT is net generating profit after tax but before interest and dividend andCCC is cost of combined capital. CCC = Interest paid on debt capital plus fairremuneration on equity. EVA is simply put excess of profit over all expenses,including expenses towards fair remuneration paid/payable on equity fond.1.7. RISK-RETURN LINKAGE AND TRADE-OFF Risk is the uncertainties or fluctuations in expected gain or benefit. Return isthe gain of reward. Risk and return are linked, in a probabilistic way. Higher risk maygive you more return and vice versa. There is no certainty relationship. If mat wereso, the concept of risk gets vanished. You put your money with nationalised banks indifferent schemes. Your return at the maximum would be 10% or so, but you are surethis return would be given to you with no hitch or hindrance. So there is nofluctuation in your earnings from your deposits with these banks. So, there is norisk, but your return is minimum. You put your money in debentures of ‘AAA’ ratedcompany. A 12% interest may be promised. You may not run any risk, but theGovernment guarantee is not there as in the case of bank deposits. So some risk isthere. Hence a 2% extra return. You take some risk and there is additional return.You put your money in a BBB plus companys debentures and you are promised 13%return. Yes, you take more risk than in the case of your investment in an *AAAcompany and hence the added return. In these two cases referred to above you takethe risk. But returns are only promised. If promises are not fulfilled, higher returnshave not resulted. Hence, the probabilistic but direct relationship between risk andreturn. As risk and return move in the same direction, a trade-off has to be effected.What is the level of risk you want to take? Then the return is specified What is thereturn you want to earn? Then the risk is given. If you decide one, the other is givenand you cant have any bargain over that. You decide one and take the other as given. BSPATIL
  • 29. If you reduce the level of risk, this is accomplished by a reduction in return too andvice versa. So, every unit of return has a price - i.e. the risk. You pay the price - i.e.assume the extra risk and get the extra return and vice versa. This exchangearithmetic is referred to risk-return trade-off. All financial decisions involve risk-return trade-off. Consider these. Moreliquidity means less risk of running out of cash. You keep more liquid cash. Resultmore barren assets and less return. So, less risk - less return situation arises. Moresolvency means less risk, because you possibly use less debt capital. Less debtmeans more overall cost of capital, for you have used less of low cost debt capital andmore of high cost equity capital. More overall cost of capita) means reduced return.So, again less risk and less return situation results. When high risk is involved, highreturn is expected This relationship is put into an equation of risk and return. Rf + Rp, where,E(R) is expected return, Rf is risk-tree return as in the case return on good bonds andRp is risk premium, i.e. additional return expected for any additional dose of riskassumed and Rp varies with risk level.1.8 MAXJMISATION-MINIMISATION-OPTIMISATION-SATISFICING So far the goals of financial management were dealt either in terms ofmaximization or minimization, as the case may be. Now the reality of thesemaximization and minimization may be required into, and alternative approaches tothem, if need be, evolved, Both maximization and minimization are devoid of clear expression ordefinition, as these have not definite limits. Hence these are unrealistic. Unrealistic,not because conceptualization is difficult. We can even conceptualize by mentioningsome bench mark levels or some min-max ranges. But once such levels arementioned, human tendency is to conform to the limits. You may not maximizereturn beyond the minimum expected and may not minimize cost below themaximum acceptable. The divorce between ownership and management in a case inpoint. Shareholders are no longer the managers. The interest of shareholders differ BSPATIL
  • 30. from the interests of the management The principals interest may not be realised bythe agents, unless the agents own set of interests are fulfilled. Michael C.Jensen andWilliam H.Meckling refer to this as the agency cost. Managements have to be offeredincentives - a percentage commission on profit, a fat salary, a diverse perquisites,stock options and so on But the above are costs reducing the shareholders lot. Socost get escalated instead of getting reduced and returns gets reduced instead ofgetting escalated. Even assuming the management is a reasonable one, i.e., notinterested in fat salary nor varied perks, as humans their judgments are subject tohuman errors. So maximization of benefits and minimization of costs cannot be takenfor granted. So, in reality these approaches to setting goals of financial managementare unrealistic. But Eugene F.Fama would tell that the above approach is normativein nature, like the official goal. Toward these maxima and minima the organisationhas to move. They are merely directional and not decisional Optimization is yet another approach. This is definable, objective andmeasurable too. Optimization is getting the best solution, having regard to allconstraints. Inventory management, receivable management, resource management,liquidity management, etc., involve very many situations where optimizing techniquesare used. The Economic Order Quantity (EOQ) technique is a versatile optimizingmodel. Similarly, waiting line theory, linear programming, assignment models, etc.,can be used in financial management in optimizing goal achievement. Waiting linetheory is used finding out whether or not additional facilities are required to ensure acertain level of service and to reduce costs of waiting and servicing. Linearprogramming is used in efficient resource allocations. Job-machine optimalassignment is facilitated with the use assignment models. Optimization is butconstrained maximization or minimization and that it has the same limitations ofmaximization or minimization goals. However, unlike maximization, constrainedmaximization is decisional and so is constrained minimization. So, optimization is agood goal. But it is too ideal to practice. Satisfying is another approach. Maximization and minimization are both UtopiaOptimization is prone with constraints. So, satisficing comes. You try to "satisfy*rather than maximize or minimize or optimize. The satisficing goal is behaviourallysuited and perfectly manageable. You dont search for the best, but get satisfied withthe considered good*. Often the search cost of the best over the better or even the BSPATIL
  • 31. good might be more than the additional gains of the best. So satisficing approachhas become a more practical approach.1.9 SUMMARY Financial Management is an integral part of business management. As adiscipline it emerged only in the early 20th century. Traditional concept of financialmanagement confined it to cash management and raising of capital. Modern financialmanagement, evolved since the middle of 1950s, deals with both raising andutilisation of capital, portfolio management and so on. Finance functions can beclassified on two dimensions - managerial and operative. Operative functions includeinvestment, financing and dividend functions. Each of these functions needs carefulmanagerial planning, execution and control. And that is financial management. There is a multiplicity of goals of financial management. Wealth maximizationis a wholesome goal. Maximization of profit, profitability, liquidity and solvency areother goals. But these are sectional and fragmented. Similarly, minimization of cost ofcapital, risk and dilution of control address particular aspects. Well, all these puttogether throw much light on the whole gamut of financial management as such.Now, maximization of economic value added is added to the list of goals of financialmanagement. Maximisation / minimisation is but vague as they do not refer to anyabsolute value. Besides, with ownership separated from management, maximizationof benefitstoainimization of costs is not possible, behaviourally speaking. Clash ofinterests of the two parties comes in the way of realisation of these objectives.Optimization is a viable alternative approach. But models have to be built,constraints specified and objective function expressed clearly. Search costs areinvolved therein. So, satisfying approach - a satisfactory goal/a satisfactory level, hasbecome prominent. Of course it does not mean the best course, but not necessarilyless than the optimum.1.10 SELF ASSESSMENT QUESTIONS1. Bring out the nature and significance of financial management.2. Explain the concept, importance and functions of financial management. BSPATIL
  • 32. 3. Discuss the evolution of financial management and bring out the changing emphasis of finance functions.4. What are finance functions? Explain them briefly.5. Distinguish between financing and investment functions.6. What considerations are involved in dividend decision?7. Define finance goals. Explain them briefly.8. Wealth maximization is superior to profit maximization. Discuss.9. Elucidate risk-return trade-off. Also bring out the nature of relationship between risk and return.10.Satisfying approach to goal setting is gaining ground in recent times to maximizing. Why?11.Finance goals are multiple and conflicting. How do you resolve the conflict?12.What is EVA maximization? How is it different from maximization of wealth?13.What is time value of money? In annual inflation is 8%, what is the present value of Rs. 11664 receivable after two years?14.HNOPAT of a firm in a period is Rs.4,50,000. It has equity capital of Rs. 10,00,000 and debt capital of Rs. 5,00,000 with annual interest rate of t2%. Equity capital needs a return of 18% p.a. Find the EVA for the firmREFERENCES 1. Financial Management and Policy - Van Horne 2. Financial Decision Making – Hampton 3. Management of Finance - Weston and Brigham 4. Financial Management - P.Chandra BSPATIL
  • 33. UNIT-II LONG-TERM CAPITAL: TYPES & SOURCES In this unit you will learn instruments of raising long-term capital (equityshares, preference shares and debentures), significance of different modes of issue ofcapital instruments (public, right and private placement), term lending institutionsand borrowings and public deposits as a means of long-term capital.INTRODUCTION Long-term capital is capital with maturity exceeding one year. Long-termcapital is used to fund the acquisition of fixed assets and part of current assets.Public limited companies meet their long-term financial requirements by issuingshares and debentures and through borrowing and public deposits. The requiredfund is to be mobilized and utilized systematically by the companies.21 SOURCES OF CAPITAL Broadly speaking, a company can have two main sources of funds internal andexternal. Internal sources refer to sources from within the company External sourcesrefer to outside sources. Internal sources consist of depreciation provision, general reserve fund or freereserve - retained earnings or the saving of the company. External sources consists ofshare capital, debenture capital, loans and advances (short term loans fromcommercial banks and other creditors, long term loans from finance corporations andother creditors). Share capital is considered as ownership or equity capital whereasdebentures and loans constitute borrowed or debt capital. Raising capital throughissue of shares, debentures or bonds is known as primary capital sourcing. Otherwiseit is called new issues market. Long-term sources of finance consist of ownership securities Equity shards andpreference shares) and creditor-ship securities (debentures, borrowing from the BSPATIL
  • 34. financing institutions and lease finance). Short-term sources of finance consists oftrade credit, short term loans from banks and financial institutions and publicdeposits,2.2 LONG-TERM CAPITAL INSTRUMENTS Now, an attempt is made to discuss the long term capital instruments of acompany i.e. shares and debentures.Corporate securities also known as company securities are said to be thedocumentary media of raising capital by the joint stock companies. These are of twoclasses: Ownership securities; and Creditor-ship securities.Ownership Securities Ownership securities consist of shares issued to the intending investors withthe right to participate in the profit and management of the company. The capitalraised in this way is called owned capital*. Equity shares and securities like theirredeemable preference shares are called ownership securities. Retained earningsalso constitute owned capital.Creditor-ship Securities Creditor-ship securities consist of various types of debentures which areacknowledgements of corporate debts to the respective holders with a right to receiveinterest at specified rate and refund of the principal sum at the expiry of the agreedterm. Capital raised through creditor-ship securities is known as ‘borrowed capital’.Debentures, bonds, notes, commercial papers etc. are instruments of debt orborrowed capital.2.2.1 Equity Shares Equity shares are instruments to raise equity capital. The equity share capitalis tie backbone of any companys financial structure. Equity capital representsownership capital. Equity shareholders collectively own the company. They enjoy the BSPATIL
  • 35. reward of ownership and bear the risk of ownership. The equity share capital is alsotermed as the venture capital on account of the risk involved! in it. The equityshareholders’ liability, unlike the liability of the owner in a proprietary concern andthe partners in a partnership concern, is limited to their capital subscription andcontribution. In India, under the Companies Act 1956, shares which are not preferenceshares are called equity shares. The equity shareholders get dividend after thepayment of dividend to the preference shareholders. Similarly, iif the event of thewinding up of the company, capital is returned to them after the return of capital tothe preference shareholders. The equity shareholders enjoy a statutory right to votein the general body meeting and thus exercise their voice in the management andaffairs of the company. They have an unlimited interest in the companys profit andassets. If the profit of the company is substantial, the equity shareholders may getgood dividend; if not, there may be little or no dividend with reduced or nil profit Theequity shareholders* return of income, i.e. dividend is of fluctuating character and itsmagnitude directly depends upon the amount of profit made by a company in aparticular year. Now a days equity capital is raised through global equity issues. Globaldepository receipts (GDRs), American depository receipts (ADRs), etc. are certaininstruments used by Indian companies to overseas capital market tc get equitycapital.Advantages of Equity Share Capital i) Equity share capita] constitutes the corpus of the company. It is the ‘heart’ to the business. ii) It represents permanent capital. Hence, there is no problem of refunding the capita]. It is repayable only in the event of companys winding up and that too only after the claims of preference shareholders have been met in full. iii) Equity share capital does not involve any fixed obligation for payment of dividend. Payment of dividend to equity shareholders depends on the BSPATIL
  • 36. availability of profit and the discretion of the Board of Directors.iv) Equity shares do not create any charge on the assets of the company and the assets may be used as security for further financing.v) Equity capital is the risk-bearing capital, unlike debt capital which is risk- Equity share capital strengthens the credit worthiness and oorrowmg or debt capacity of the company. In general, other things being equal, the larger the equity base, the higher the ability of the company to secure debt capital.vii) Equity capital market is now expanding and the global capital market can be accessed. BSPATIL
  • 37. Disadvantages of Equity Shares Capial i) Cost of issue of equity shares is high as the limited group of risK-seeking investors need to be attracted and targeted. Equity shaiv attract only those classes of investors who can take risk. Conservative and cautious investors do not to subscribe for equity issues, Su underwriting commission, brokerage costs and other issue expense are high for equity capital, raising up issue cost. ii) The cost of servicing equity capital is generally higher than the cos issuing preference shares or debenture since on account of higher n the expectation of the equity shareholders is also high as compared preference shares or debentures. iii) Equity dividend is payable from post-tax earnings. Unlike intent paid on debt capital, dividend is not deductible as an expense from, profit for taxation purposes. Hence cost of equity is hi«be : Sometimes, dividend tax is paid, further rising cost of equity share capital. iv) The issuing of equity capital causes dilution of control of the equji holders. v) In times of depression dividends on equity shares reach low be which leads to drastic full in their market values. vi) Excessive reliance on financing through equity shares reduces the capacity of the company to trade on equity. The excessive use of equity shares is liJcely to result in over capitalization of the company. BSPATIL
  • 38. 2.2.2 Preference Shares Preference shares are those which carry priority rights in regard to the paymentof dividend and return of capital and at the same time are subject to certainlimitations with regard to voting rights. *The preference shareholders are entitled to receive the fixed rate of dividend out ofthe net profit of the company. Only after the payment of dividend at a fixed rate ismade to the preference shareholders, the balance of profit will be used for payingdividend to ordinary shares. The rate of dividend on preference shares is mentionedin the prospectus. Similarly in the event of liquidation the assets remaining afterpayment of all debts of the company are first used for returning the capitalcontributed by the preference shareholders.Types of Preference Shares There are many forms of preference shares. These are: i) Cumulative preference shares ii) Non-Cumulative preference shares iii) Participating preference shares iv) Non-participating preference shares v) Convertible preference shares vi) Non-convertible preference shares vii) Redeemable preference shares viii) Non-redeemable preference shares ix) Cumulative convertible preference shares BSPATIL
  • 39. Cumulative and non-cumulative In the case of cumulative preference shares, the unpaid dividend goes onaccumulating until paid. The unpaid dividends on cumulative preference sharesbecome payable out of the profit of the company in the subsequent years. Only aftersuch arrears have been paid off, any dividend can be paid to other classes of shares.In case of non-cumulative preference shares, the right to claim dividend lapses ifthere is no profit in a particular year. Thus, the non-cumulative preferenceshareholders are not entitled to claim arrears of dividend. As a result, the dividendcoupon on non-cumulative preference shares is more than that of cumulativepreference shares.Participating and non-participating The preference shares which are entitled to participate in the surplus of profitsof the company available for distribution over and above the fixed dividend are calledas participating preference shares. Non-participating preference shares do not havesuch rights.Convertible and convertible Convertible preference shares are convertible into equity shares as per normsof issue and conversion. Non-convertible preference shares are not converted.Convertibility is resorted to enhance attractiveness of the instrument to prospectiveinvestors, who prefer equity to preference shares.Redeemable and IrredeemableRedeemable preference shares are those which can be redeemed during the life timeof the company, while irredeemable preference shares can be redeemed only when thecompany goes for liquidation. BSPATIL
  • 40. Cumulative Convertible Cumulative convertible preference shares have both the features ofcumulativeness of unpaid dividend and convertibility. These features make thepreference shares more preferred.Merits of Preference shares i) The preference shares have the merits of equity shares without their limitations. ii) Issue of preference shares does not create any charge against the assets of the company. iii) The promoters of the company can retain control over the company by issuing preference shares, since the preference shareholders have ^>nly limited voting rights. iv) In the case of redeemable preference shares, there is the advantage that the amount can be repaid as soon as the company is in possession of funds flowing out of profits. v) Preference shares are entitled to a fixed rate of dividend and the company many declare higher rates of dividend for the equity shareholders by trading on equity and enhance market value. vi) If the assets of the company are not of high value, debenture holders will not accept them as collateral securities. Hence the company prefers to tap market with preference shares. vii) The public deposit of companies in excess of the maximum limit stipulated by the Reserve Bank can be liquidated by issuing preference shares. viii) Preference shares are particularly useful for those investors who want higher rate of return with comparatively Jower risk. ix) Preference shares add to the equity base of the company and they strengthen the financial position of it Additional equity base increases the ability of the company to borrow in future. x) Preference shares have variety and diversity, unlike equity shares, Companies have thus flexibility in choice.Demerits of Preference Shares BSPATIL
  • 41. i) Usually preference shares carry higher rate of dividend than the rate of interest on debentures. ii) Compared to debt capital, preference share capital is a very expensive source of financing because the dividend paid to preference shareholders is not, unlike debt interest, a tax-deductible expense. iii) In the case of cumulative preference shares, arrears of dividend accumulate. It is a permanent burden on the profits of the company. iv) From the investors point of view, preference shares may be disadvantageous because they do not carry voting rights. Their interest may be damaged by a equity shareholders in whose hands the control is vested. v) Preference shares have to attraction. Not even 1% of total corporate capital is raised in this form. vi) Instead of combining the benefits of equity and debt, preference shar capital, perhaps combines the banes of equity and debt.2.2.3 Debentures A debenture is a document issued by a company as an evidence of a debt duefrom the company with or without a charge on the assets of the company. It is anacknowledgement of the companys indebtedness to its debenture-holders.Debentures are instruments for raising long term debt capital. Debenture holders arethe creditors of the company. In India, according to the Companies Act, 1956, the term debenture includes"debenture stock, bonds and any other securities of a company whether constitutinga charge on the assets of the company or not" Debenture-holders are entitled to periodical payment of interest aij agreed rate. BSPATIL
  • 42. They are also entitled to redemption of their capital as per the agreed terms. Novoting rights are given to debenture-holders. Under section 117 of the Companies Act,1956, debentures with voting rights cannot be issued. Usually debentures aresecured by charge on or mortgage of the assets of the company.Types of debentures Debentures can be various types. They are: i) Registered debentures ii) Bearer debentures or unregistered debentures iii) Secured debentures iv) Unsecured debentures v) Redeemable debentures vi) Irredeemable debentures vii) Fully convertible debentures viii) Non-convertible debentures ix) Partly convertible debentures x) Equitable debentures xi) Legal debentures xii) Preferred debentures xii) Fixed rate debentures xiii) Floating rate debentures xiv) Zero coupon debentures xv) Foreign currency convertible debenturesRegistered debentures : Registered debentures are recorded in a^register ofdebenture-holders with full details about the number, value and types of debenturesheld by the debenture-holders. The payment of interest and repayment of capital ismade to the debenture-holders whose names are entered duly in the register ofdebenture-holders. Registered debentures are not negotiable. Transfer of ownershipof these type of debentures cannot be valid unless the regular instrument of transferis sanctioned by the Directors. Registered debentures are not transferable by meredeliveryBearer or Unregistered debentures: The debentures which are payable to the bearer BSPATIL
  • 43. are called bearer debentures. The names of the debenture-holders are not recorded inthe register of debenture-holders. Bearer debentures are negotiable. They aretransferable by mere delivery and registration of transfer is not necessary.Secured debentures: The debentures which are*secured by a mortgage or change onthe whole or a part of the assets of the company are called secure,: debentures.Unsecured debentures: Unsecured debentures are those which do not cam ... chargeon the assets of the company. These are, also, known as ‘naked’ debentures.Redeemable debentures: The debentures which are repayable after a certain periodare called redeemable debentures. Redeemable debentures may be bullet-repaymentdebentures (i.e. one time be payment) or periodic repayment debentures.Irredeemable debentures: The debentures which are not repayable during the lifetime of the company are called irredeemable debentures. They are also known asperpetual debentures. Irredeemable debentures can be redeemed only in the event ofthe companys winding up.Fully convertible debentures: Convertible debentures can be converted intoj equityshares of the company as per the terms of their issue. Convertible debenture-holdersget an opportunity to become shareholders and to take part inj the companymanagement at a later stage. Convertibility adds a ‘sweetner’ to thej debentures andenhance their appeal to risk seeking investors.Non-Convertible debentures: Non-convcnible debentures are not convertible Thevremain as debt capital instruments.Partly convertible debentures: Partly convertible debentures appeal toinvestors who want the benefits of convertibility and non-convertibility in oneinstrument.Equitable debentures: Equitable debentures are those which are secured by depositof title deeds of the property with a memorandum in writing to create a charge. BSPATIL
  • 44. Debentures: Legal debentures are those in which the legal ownership of property ofthe corporation is transferred by a deed to the debemure holders, security for theloans."Referred debentures: Preferred debentures are those which are paid first in theevent of winding up of the company. The debentures have priority over otherVentures.“Fixed rate debentures : Fixed rate debentures cany a fixed rate of interest Now-a-days this class is not desired by both investors and issuing institutions.“Floating rate debentures : Floating rate debentures cany floating interest ratecoupons. The rates float over some bench mark rates like bank rate, LIBOR etc.Zero-coupon debentures: Zero-coupon debentures do not carry periodic interestcoupons. Interest on these is paid on maturity. Hence, these are also called as deep-discount debentures.Foreign Currency convertible debentures: Foreign currency convertible debenturesare issued in overseas market in the currency of the country where the floatationtakes place. Later these are converted into equity, either GDR, .VDR or plain equity.Merits of debentures i) Debentures provide runds to the company for a long period without diluting its control, since debenture holders are not entitled to vote. ii) Interest paid to debenture-holders is a charge on income of the company and is deductible from computable income for income tax purpose whereas dividends paid on shares are regarded as income and are liable to corporate income tax. The post-tax cost of debt is thus lowered. iii) Debentures provide funds to the company for a specific period. Hence, the company can appropriately adjust its financial plan to suit its requirements. BSPATIL
  • 45. iv) Since debentures are generally issued on redeemable basis, the company can avoid over-capitalisation bv refunding the debt when the financial needs are no longer felt. v) In a period of rising prices, debenture issue is advantageous. The burden of servicing debentures, which entail a fixed monetary commitment for interest and principal repayment, decreases in real terms as the price level increases. vi) Debentures enable the company to take advantage of trading on equity and thus pay to the equity shareholders dividend at a rate higher than overall return on investment. vii) Debentures are suitable to the investors who are cautious and conservative and who particularly prefer a stable rate of return with minimum or no risk. Even institutional investors prefer debentures for this reasonDemerits of Debentures i) Debenture interest and capital repayment are obligatory payments. Failure to meet these payment jeopardizes the solvency of the firm. ii) In the case of debentures, interest has to be paid to the debenture holders irrespective of the fact whether the company earns profit or not. It becomes a great burden on the finances of the company. iii) Debenture financing enhances the financial risk associated with the firm. This may increase the cost of equity capital. iv) When assets of the company get tagged to the debenture holders the result is that the credit rating of the company in the market comes down and financial institutions and banks refuse loans to that company. v) Debentures are particularly not suitable for companies whose earnings fluctuate considerably. In case of such company raising funds throifgh BSPATIL
  • 46. debentures may lead to considerable fluctuations in the rate of dividend payable to the equity shareholders.2.2.4 Financing through equity snares and debentures - Comparison A company may prefer equity finance (i) if long gestation period is involved, (ii)if equity is preferred by the market forces, (iii) if financial risk perception is high, (iv)if debt capacity is low and (v) dilution of control isnt a problem or does not rise. A company may prefer debenture financing as compared to equity sharesfinancing for the following reasons: i) Generally the debenture-holders cannot interfere in the management of the company, since they do hot have voting rights. ii) Interest on debentures is allowed as a business expense and it is tax deductible. iii) Debenture financing is cheaper since the rate of interest payable on it is lower than die dividend rate of preference shares. iv) Debentures can be redeemed in case the company does not need the funds raised through this source. This is done by placing call option in the debentures. v) Generally a company cannot buy its own snares but it can buy its own % debentures. vi) Debentures offer variety and in dull market conditions only debenture; help gaining access to capital market.2.2.5 Convertible Issues A convertible issue is a bond or a share of preferred stock that can be converted BSPATIL
  • 47. at the option of the holder into common stock ot ihe same company. Once convertedinto common stock, the stock cannot be exchanged again for bonds or preferredstock. Issue of convertible preference shares and convertible debentures are calledconvertible issues. The convertible preference shares and convertible debentures areconverted into equity shares. The ratio of exchange between the convertible issuesand the equity shares can be stated in terms of either a conversion price or aconversion ratio.Significance of convertible issues : The convertible security provides the investorwith a fixed return from a bond (debenture) or with a specified dividend frompreferred stock (preference shares). In addition, the investor gets an option to convertthe security (convertible debentures or preference shares) into equiu shares andthereby participates in the possibility of capital gains associated with, being aresidual claimant of the company. At the time of issue, the .convertible security willbe priced higher than its conversion value. The difference between the issue price andthe conversion value is known as conversion premium. The convertible facilityprovides a measure of flexibility to the capital structure of, the company to thecompany which wants a debt capital to short with, butj market wants equity. So,convertible issues add sweetners to sell debt securities! to the market which wantequity issues.Convertible preference shares: The preference shares which carry the right ofconversion into equity shares within a specified period, are called convertiblepreference shares. The issue of convertible preference shares must be dulj authorizedby the articles of association of the company.Convertible debentures: Convertible debentures provide an option to holders toconvert them into equity shares during a specified period at particular price. Theconvertible debentures are not likely to have a goc investment appeal, as the rate ofinterest for convertible debentures is lesser than the non-convertible debentures.Convertible debentures help a company to sell future issue of equity shares at a pricehigher than the price at which the companys equity shares may be selling when theconvertible, debentures are issuea By convertible debentures, a company getsrelatively cheaper financial resource for business growth. Debenture interestconstitutes tax deductible expenses. So, till the debentures are converted, the BSPATIL
  • 48. company gets a tax advantage. From the investors* point of view convertibledebentures prove an ideal combination of high yield, low risk and potential capitalappreciation.2.3 DIFFERENT MOOES OF CAPITAL ISSUES Capital instruments, namely, shares and debentures can be issued to themarket by adopting any pf the four modes: Public issues, Private placement, Rightsissues and Bonus issues. Let us briefly explain these different modes of issues.2.3.1 Public Issues Only public limited companies can adopt this issue when it wants to raisecapital from the general public. The company has to issue a prospectus as perrequirements of the corporate laws in force inviting the public to subscribe to thesecurities issued, may be equity shares, preference shares ;or debentures/bonds. Aprivate company cannot adopt this route to raise capital. The prospectus shall give anaccount of the prospects of investment in the company. Convinced public apply to thecompany for specified number of shares/debentures paying the application money,i.e., money payable at the time of application for the shares/debentures usually 20 to30% of the issue price of Jie shares/debentures. A company must receivesubscription for at least 95% of the shares/bonds offered within the specified days.Otherwise, the issue has to be scrapped. If the public applies for more than thenumber of shares/debentures the situation is called over subscription. In undersubscription public ;ribes for less number of shares/debentures offered by thecompany. For companies coupled with better market conditions, over -subscriptionIts. Prior to issue of shares/debentures and until the subscription list is opencompany go on promoting the issue. In the western countries such kind of iog theissue is called road-show. When there is over-subscription a BSPATIL
  • 49. part of the excess subscription, usual!) upto 15% of the otter, can be retained andallotment proceeded with. This is called as green-shoe option. When there is over-subscription, pro-rata allotment (proportionate basisallotment, i.e., say when there is 200% subscription, for every 200 share applied 100shares allotted) may be adopted. Alternatively, pro-rata allotment For some applicant,full scale allotment for some applicants and nil allotment for rest of applicants canalso be followed. Usually the company co-opts authorities from stock-exchange wherelisting is done, from securities regulatory bodies (SEBI in Indian, SEC in USA and soon) etc. in finalizing mode of allotment. Public issues enable broad-based share-holding. General publics savingsdirected into corporate investment. Economy, company and individualnvestors benefit. The company management does not face the challenge of dilution ofcontrol over the affairs of the company. And good price for the share and competitiveinterest rate on debentures are quite possible.2.3.2 Private Placement Private placement involves the company issuing security places the same at thedisposal of financial institutions like mutual funds, investment funds >r banks theentire issue for subscription at the mutually agreed upon pro-rata of interest. This mode is preferred when the capital market is dull, shy and] depressedDuring the late 1990s and early 2010s, Indian companies preferred] privateplacement, even the debt issues, as the general public totally deserted the} capitalmarket since their hopes in the capital market were totally shattered,] Privateplacement is inexpensive as no promotion is issued. It is a wholesale} deal.2.3.3 Right Shares Whenever an existing company wants to issue new equity shares, the existingshareholders will be potential buyers of these shares. Generally the Articles orMemorandum of Association of the Company gives the right to existing shareholders BSPATIL
  • 50. to participate in the new equity issues of the company. This right is known as pre-emptive right" and such offered shares are called 4Right shares or Right issue. A right issue involves selling securities in the primary maricet by issuing rightsto the existing shareholders. When a company issues additional share capital, it hasto be offered in the first instance to the existing shareholders on a pro rata basis.This is required in India under section 81 of the Companies Act, 1956. However, theshareholders may by a special resolution forfeit tfcis right, partially or fully, to enablethe company to issue additional capital to public. Under section 81 of the Companies Act 1956, where at any time after the expiryof two years from the formation of a company or at any time after the expiry of oneyear from the allotment of shares being made for the first ume after its formation,whichever is earlier, it is proposed to increase the subscribed capital of the companyby allotment of further shares, then such further shares shall be offered to thepersons who, at the date of the offer, are holders of the equity shares of the company,in proportion as nearly as circumstances admit, to the capital paid on those shares atthat date. Thus the existing shareholders have a pre-emptive right to subscribe to thenew issues made by a company. This right has at its root in the doctrine that eachshareholder is entitled to participate in any further issue of capital by the ompanyequally, so that his interest in the company is not diluted,Significance of rights issue i) The number of rights that a shareholder gets is equal to the number of shares held by him. ii) The number rights required to subscribe to an additional share is determined by the issuing company. iii) Rights are negotiable. The holder of rights can sell them fully or partially. iv) Rights can be exercised only during a fixed period which is usually less than thirty days. BSPATIL
  • 51. v) The price of rights issues is generally quite lower than market price and that a capital gain is quite certain for the share Rights issue gives the existing shareholders an opportunity for the protection of their pro-rata share in the earning and surplus of the company.vii) There is more certainty of the shares being sold to the existing shareholders. If a rights issue is successful it is equal to favourable image and evaluation of the companys goodwill in the minds of the existing shareholders. BSPATIL
  • 52. 2.3.4 Bonus Issues Bonus issues are capital issues by companies to existing shareholders wherebyno fresh capital is raised but capitalization of accumulated earnings is done. Theshares capital increases, but accumulated earnings fall A company shall, whileissuing bonus shares, ensure the following: i) The bonus issue is made out of free reserves built out of the genuine profits and shares premium collected in cash only. ii) Reserves created by revaluation of fixed assets are not capitalized. iii) The development rebate reserves or the investment allowance reserve is considered as free reserve for the purpose of calculation of residual reserves only. iv) All contingent liabilities disclosed in the audited accounts which have, bearing on the net profits, shall be taken into account in the calculation; of the residua! reserve. v) The residual reserves after the proposed capitalisation shall be at k 40 per cent of the increased paid up capital. vi) 30 per cent of the average profits before tax of the company for previous three years should yield a rate of dividend on the exj capital base of the company at 10 per cent. vii) The capital reserves appearing in the balance sheet of the company as a result of revaluation of assets or without accrual of cash resources are capitalized nor taken into account in the computation of the residual reserves of 40 percent for the purpose of bonus issues. viii) The declaration of bonus issue, in lieu of dividend is not made. BSPATIL
  • 53. ix) The bonus issue is not made unless the partly paid shares, if any existing, are made fully paid-up. x) The company - a) has not defaulted in payment of interest or principal in respect of fixed deposits and interest on existing debentures or principal on redemption thereof and (b) has sufficient reason to believe that it has not defaulted in respect of the payment of statutory dues of the employees such as contribution to provident fund, gratuity on bonus. xi) A company which announces its bonus issue after the approval of the board of directors must implement the proposals within a period of six months from the date of such approval and shall not have the option of changing the decision. xii) There should be a provision in the Articles of Association of the Company for capitalisation of reserves, etc. and if not, the company shall pass a resolution at its general body meeting making decisions in the Articles of Association for capitalisation. xiii) Consequent to the issue of bonus shares if the subscribed and paid-up capital exceed the authorized share capital, a resolution shall be passed by the company at its general body meeting for increasing the authorized capital. xiv) The company shall get a resolution passed at its generating for bonus issue and in the said resolution the managements intention regarding the rate of dividend to be declared in the year immediately after the bonus issue should be indicated. xv) No bonus shall be made which will dilute the value or rights of the holders of debentures, convertible folly or partly.SEBI General Guidelines for public issues BSPATIL
  • 54. i) Subscription list for public issues should be kept open for at least 3 working days and disclosed in the prospectus. ii) Rights issues shall not be kept open for more than 60 days. iii) The quantum of issue, whether through a right or public issue, shall not exceed the amount specified in the prospectus/letter of offer. No retention of over subscription is permissible under any circumstances, except the special case of exercise of green-shoe option. iv) Within 45 days of the closures of an issue a report in a prescribed form with certificate from the chartered accounts should be forwarded to SEBI to the lead managers. v) The gap between the closure dates of various issue e.g. Rights and Indian public should not exceed 30 days. vi) SEBI will have right to prescribe further guidelines for modifying the existing norms to bring about adequate investor protection, enhance the quality of disclosures and to bring about transparency in the primary market. vii) SEBI shall have right to issue necessary clarification to these guidelines to remove any difficulty in its implementation. viii) Any violation of the guidelines by the issuers/intermediaries will be] punishable by prosecution by SEBI under the SEBI Act. ix) The provisions in the Companies Act, 1956 and other applicable lai shall be complied with the connection with the issue of shares debentures.2.4 INSTITUTIONAL FINANCE: FRAMEWORK, FUND TYPES AND PROCEDURE BSPATIL
  • 55. An important pre-requisite for industrial development is the availabilityof adequate institutional finance. Government has set up several financialinstitutions which provide term loans and also render assistance in several otherforms. Term loans, also referred to as term finance represent a source of debt financewhich is generally repayable over a period of years. Term loans are granted forpurposes such as new projects and for expansion, diversification, modernization andrenovation of existing projects. The security cover for term loans comprises theexisting assets as well as those to be acquired from such loans. Where the total term-loan required by an industrial unit is too large for a single institution, some form ofparticipation arrangement is also made on the part of different financial institutions,known as co-financing or consortium finance or syndicated loans. Till the middle of 1990s the role of term-loans considerably increased andin many cases greater reliance has been placed on term-loans vis-a-vis the ownedfunds, because of the growth of term lending institutions and growing participationby commercial banks in term lending as well. Today, the era is universal banking,where the line of demarcation between short and long term loans is removed and anyinstitution is prepared to provide fund for any period, short or long.Factors responsible for the growth of Term Leading Institutions A string of institutions had been established in India as an integral; ofthe capital market development for the following reasons : i) Need for higher capital formation: Developing countries suffer by dearth of term finance due to low rate of capital formation. The gap between savings and investment is intended to be bridged by the financial institutions. Institutional investors ensure higher rate of capital formation, by mopping savings from within and outside the country and extending capital assistance to industries and trade. ii) Shyness of Capital: Capital is reluctant to go to new and untried industries in economically backward areas. In this situation, establishment of financial institutions becomes essential to achieve balanced industrial BSPATIL
  • 56. development of all regions of the nation. Moreover, the financial institutions undertake pioneering risk by providing necessary long term capital including seed capital, venture capital and so on.iii) Venture Capital: Industrial economy continues to change. In a span 10 years, some industries totally become irrelevant and new ones take the place. It is therefore essential to incubate their businesses on an ongoing basis. For this venture capital is needed. Financial institutions provide this form of capital through their own venture capital arms/units.iv) Need for Promotional Activities: Financial institutions provide technical and managerial know-how in the formulation and evaluation of j new industrial projects or investment proposals. Spotting fundable projects,] shaping up them and supporting the same are thus taken by financial institutions.v) Finance for Small Scale Industries: The financial need of si scale industries, differ from those of large inr stries. Special financi package and delivery system are needed in this context. Finam institutions like the SIDBI, fillip the Planned Economic Development: Planned economic develop! requires large investment in basic and key industries for provi< instrumental for quick industralisation. The financial institutions essential to participate actively in the execution of our development to bring out planned economic development.vii) Reconstruction Programme: Industrial reconstruction, rehabilit and modernization are vital in any economy. Funding such programme an essential task of financial institutions. BSPATIL
  • 57. 2.4.1 Institutional Framework of Term Lending Institutions Specialised term finance institutions have been established a countryafter independence to meet the specific financial needs of in enterprises. Theseinstitutions help mobilize scarce resources, such as capital technology,entrepreneurial and managerial talents and channelise them into industrial activitiesin accordance with the national priorities. The following list gives an account ofstructure of term finance institutions in India. The following is the list of all - India and State level financial institutions.a) All-India Institutions i) Industrial Development Bank of India (1964) ii) Industrial Finance Corporation of India (1948) iii) Industrial Credit and Investment Corporation of India Ltd. (1955) iv) Life Insurance Corporation of India (1956) v) Unit Trust of India (1964) vi) General Insurance Corporation of India (1973) vii) Industrial Reconstruction Bank of India (1985) (Now Industrial Investment Bank of India. viii) Small Industries Development Bank of India (1990) ix) National Bank of Agriculture and Rural Development (1982) BSPATIL
  • 58. x) Infrastructure Development Company Ltd. (1997). xi) Ex-im Bank (1982)b) State level financial institutions i) State Financial Corporations ii) State Industrial Development Corporations iii) Technical Consultancy Organisations. A short description of each of these financial institutions follows now: Industrial Development Bank of India Industrial Development Bank of India (IDBI) established in 1964 was originallya subsidiary of RBI Parliament 12 years since its inception, IDBIs ownership waspassed on to Government of India in 1976. In 1995, Govts holding in IDBI wasdiluted from 100% to 72%, and public ownership was pushed through. Further in2001, Govt share holding in IDBI was scaled down to 58.47%. Industrial Development Bank of India (IDBI) established on July 1, 1964 is theprincipal financial institution for industrial finance in the country Besides providingdirect assistance to medium and large projects and resource support to otherDevelopment Financial Institutions (DFIs), IDBI coordinates the working of other termlending institutions engaged in financing, promoting or developing industries andassist in the development of these institutions. IDBI promotes and providesdevelopmental finances to industries to fill the gaps in the industrial structure in thecountry. IDBI also provides technical and administrative assistance, undertakesmarket and investment research and; surveys as also techno-economic studiesrelated to envelopment of industry During the about 4 decades of its service toindustry, IDBI evolved a number i innovative schemes of assistance and undertookvarious promotional activities meet the growing needs of industry, IDBI is the firstfinancial institution in country to get ISO 9000 certification for treasury operations in1994 and foi services in 2000. Aggregate sanctions by IDBI during the Seventh Five Year Period (1985-86 to BSPATIL
  • 59. 1989-90) amounted to Rs.27,844.1 crore registering a grw of over one and a halftimes over Rs. 10,286.6 crore sanctioned during the Sii Plan Period (1980-81 to1984-85). As on 31.3.2001, IDBFs total equity was Rs.92 bn, borrow amount to Rs.538bn and other resources Rs.88 bn. Out of the total resources I Rs.720 bn, outstandingloans amounted to Rs.493 bn or 70% of funds are in accounts.Schemes of Direct Assistance IDBI’s direct assistance to industry is extended mainly under its ProjectFinance Scheme and to a limited extent, under the Technical Development FundScheme. Assistance under the Textile Modernisation Fund, Venture Capital Fund,Technology Upgradation and Equipment Finance for Energy Conservation Schemes isalso covered under the Project Finance Scheme. i) Project Finance Scheme: Project loans are given in the form of rupee loans, foreign currency loans, under writing/direct subscription to public issues of shares/bonds and guarantees for deferred parents. Tbtal sanctions upto Mar 2001 were Rs.1103 bn, disbursements Rs.640 bn and outstanding amount Rs. 562 bn. ii) Non-Project Finance: Non-project finance takes the form of asset credit, equipment finance, working capital loan, short term credits, equipment leasing, investment etc., Total sanctions upto March 2001 were Rs.656 bn, disbursement Rs.517 bn and outstanding amount Rs. 13 bn.Schemes of Indirect Assistant: Schemes of indirect finance, include bill rediscounting, bill direct mnting,refinance, loans to other finance institutions, investments in other trial institutions,retail finance, seed capital assistance, secondary market rtions, etc. i) Refinance: The scope of re-finance scheme for modernization covers loans granted by eligible institutions to small and medium units for acquiring BSPATIL
  • 60. instruments for energy audit/monitoring energy consumption. In view of the high priority accorded to tourism, term loans sanctioned for financing tourism and tourism related facilities have been made eligible for irefinance assistance from IDBI In view of the high priority accorded to JMonal Sericulture Project (NSP) by Government, assistance extended by SPCs and banks to finance the industry component of NSP has been made Agible for refinance assistance on concessional terms. Sanctions upto 2001 March stood at Rs.205 bn, disbursements Rs.161 bn and outstanding amount Rs. 11 bn. ii) Bills Finance Schemes: Bills discounting and re-discounting constituted bill finance. Total sanctions upto March 2001 were Rs.203 bn, disbursement Rs 148 bn and outstanding amount Fs.25 bn. IDBI carved out its activities concerning small scale businesses and put them under the fold of its subsidiary SJDBI in 1990. In 2000, IDBIs shareholding in SIDBI has been broad based with participation by LIC, GIC, etc. IDBI was instrumental in establishing technical consultancy organisatinos in the states of AP, Bihar, J&K, Kerala, North-Eastem States, Orissa, UP and West Bengal. iii) Resources Support to other institutions: IDBI supports ICICI, IFCI, IDBI Bank, IDBI Capital Market Services Ltd., IDBI Infotech, IDBI AMC, IIBI (Formerly IRBI), IDFC, National Securities Depository, NSTCs, NSE, NABARD, NEDFC, SIDBI, SFCs. SIDCs, SSIDCs, SHO, TCOs, TFCI, UTI, CARE, DFffl, Banks, etc. Loans and investment in financial institutions aggregated upto March 2001 to Rs. 58 bn in sanction, Rs. 53 bn in disbursements and Rs.28 bn as outstanding amount as on Industrial Finance Corporation of India Industrial Finance Corporation of India (IFCI) was set up under the IndustrialFinance Corporation Act in 1948 with the objective of providing medium and longterm financial assistance to the industrial sector. IFCIs functions cover project BSPATIL
  • 61. financing, financial services and promotional activities. Over the years, apart fromincrease in the volume IFCIs assistance, the scope of its activities has widened. Togive more operational freedom to IFCI, it was converted into a company with effectfrom May 1993. The financing operations of IFCI primarily consist of project finance, financialservices, corporate advisory services etc. Rupee loans, foreign currency loans,underwriting, direct subscription, guarantees, equipment leasing, suppliers credit,buyers credit, loans to leasing and hire purchase companies, corporate loans, short-term loans, working capital loans, etc. The promotional activities of IFCI covers fiindssupport for technical consultancy, risk capital, venture capital, technologydevelopment, tourism, housing, development ofsecurities market, entrepreneurship parks and subsidy support to helpentrepreneurs and enterprises in the village and small industries sector. Total cumulative assistances (sanctions) under various schemes stood atRs.436 bn and disbursement at Rs.413 bn as on 31.3.2001. Outstanding loans as on31.3.01 stood at Rs.223 bn. IFCI has been instrumental in establishing technology consultancyorganizations in Harvana, HP, MP, Punjab and Rajasthan. IFCI earlier in 1988 floated Risk Capital and Technology Finance Corporationas its venture capital arm. Later it was converted into IFCI Venture Capital Fund Ltd.Tourism Finance Corporation of India was floated by IFCI to fund tourism attitudes. During 1989-90, IFCI introduced two new schemes viz. EquipmentCredit and Buyers Credit as part of its financial services, in addition to the existingschemes of equipment financing, equipment leasing, equipment procurement andsuppliers’ credit. Under the Equipment Credit Scheme introduced in July 1989, IFCIfinances the entire cost of the equipment ^jmrchased/fabricated by an existing actualuser-purchaser concern. The cost of ^equipment and the interest payable arerecoverable in 54 equal monthly installments. Under the buyers’ credit scheme BSPATIL
  • 62. introduced in July 1989, IFCI a non-revolving line of credit to actual user-purchasersof machinery/ lipment to enable them to acquire such equipment on deferredpayment basis, scheme also covers equipment directly fabricated by actual users asalso equipment BSPATIL
  • 63. IFCFs current business strategy is to concentrate on core snce, focused lendingto established clients, building up strong market-business culture targetinglarge/high growth industries, providing shensive lending, innovative pricing ofproducts/services offered, etc.Industrial Credit and Investment Corporation of India Ltd.Industrial Credit and Investment Corporation of India Ltd. (ICICI) was established in1955 as a public limited company, primarily for financing the exchange component ofindustrial projects and for encouraging and assisting industrial development andinvestment in the country. The International Bank for Reconstruction andDevelopment (World Bank) played a key role in its formation. ICICI providesassistance by way of rupee and foreign currency loans, underwriting and directsubscriptions to shares/debentures and guarantees. ICICI also provides financialservices to industry by way of deferred credit, equipment leasing, installment sale andthe recently introduced asset credit facility, besides rendering merchant bankingservices. Upto March 2001, cumulative sanctions by ICICI amounted to Rs.2476 bnand disbursements Rs. 1462 bn and outstanding loans as on 31.3.01 stood at Rs.638bn. ICICI has number of subsidiaries like ICICI bank, ICICI Capital market, ICICIVenture Funds Management Co. Ltd., etc. ICICI was instrumental establishingtechnical consultancy organizations in the States of Gujarat, Tamil Nadu andMaharashtra. ICICI has evolved served new products and e vpanded the basket offinancial products to meet charging needs of customer. Its strategy is more customerfocus orientation than product focus orientation. ICICI provides a complete spectrum of wholesale banking products and servicesincluding project finance, corporate finance, hybrid] financial structures, treasuryservices, cashflow based financial products, It finance, equity finance, risk finance,advisory services, banking services through ICICI bank etc. Medium term loans tomanufacturer sector, structured finance infrastructure, oil, gas and petrochemsector, loan syndication, IPO manage! etc. its main offerings in 2000-01. ICICIfinances corporate mergers acquisitions to a grand scale are loans to captive or solesuppliers of large companies was introduced in 2000-01. ICICI does securmsation of BSPATIL
  • 64. certain cl of assets like student fees receivables, road toll receivables, employee loan,etc; During 2000-01, ICICI made significant investments in setting a strong retailbusiness architecture, direct marketing agents, auto fini home financing, commercialbanking, investment banking, non-banking fim investor servicing, venture capitalfinancing, on-line stock trading, im etc. ICICI was recently reverse merged with ICICIbank. Life Insurance Corporation of India Life Insurance Corporation of India (LIC), was set up in 193 the nationalisation!of life insurance business in the country. It was vested, the responsibility ofexclusively managing the life insurance business until recently and, in consonancewith national priorities and objectives, prudently deploying the funds of the policy-holders to their best advantage. LIC has made rapid strides in development ofindividual as well as group insurance business over the years thereby extending ameasure of social security. Through its landless labour insurance scheme, it coveredeven remote rural areas. Besides investing in Government and other approved securities in the form ofshares, bonds and debentures, LIC extends assistance for development of socially-oriented sectors and infrastructure facilities like housing, rural electrification, watersupply and sewerage and provides finance to industrial concerns by way of termloans and underwritingtfirect subscription to shares and debentures. LIC alsoextends resource support to term lending institutions by subscribing to their sharesand bonds. Recently, LIC has set up three subsidiaries viz. LJC Mutual Fund, LICInternational and the LIC Housing Finance Limited. LIC subscription to shares of JDBI was Rs.41 bn, IFCI Rs, 9 bn, ICICI Rs.41bn, IIBI Rs 1 .3 bn and other institutions including SIDBI was Rs. 14 bn as on 31.32001 LIC’s investment in public sector stood at Rs.1414 bn in joint sector at Rs 22bn, in co-op sector at Rs.8 bn and in private sector Rs.228 teas on 31 3 2 BSPATIL
  • 65. Aggregate investible funds of LIC, consisting of Life insurance {business andcapital redemption insurance business, stood at Rs.1755 bn as on 31.03.2001. Lifeinsurance business represented 98% of the total investible funds K as at the end ofMarch 2001, balance 2% accounted by capital and Jeevan Suraksha Schemes.Investment Pattern LIC’s total outstanding investments (in Government and other approvedsecurities, for providing infrastructure facilities, assistance to industry, etc.,) as atthe end of March 2001 stood at Rs. 1755 bn, 20% higher than at the end of March2000. Investments in Government and other approved ties (Rs.1030 bn) as at the endof March 2001 were higher by 20% and 58.9% of total investments of LIC comparedto position in 2000. The share of direct assistance to industry was 22% as at the endof March 2001 as against 20% and 17% as at the end of the preceding two years. The cumulative loan sanctions upto 31.3.2001 to corporate sector stood atRs.398 bn and disbursements Rs.331 bn. The relevant figures for public-sectorcompanies were Rs.203 bn and Rs. 177 bn and for private sector Rs. 185 bnandRs.151 bn. Unit Trust of India Unit Trust of India (UTI), established in 1964, plays an important: role inmobilizing savings of the community through sale of units under its various schemesand channelising them into corporate investments. Over the years, it has floated 85schemes, including off-shore country funds, to suit diverse investment needs ofinvestors. Consequent upon amendment to the UTI, Act, effective April 23,1986, UTIhas been extending assistance to the corporate-sector by way of term loans, billsrediscounting, equipment leasing and hire purchase financing. UTI manages funds tothe tune of Rs.600 bn and caters to 42 million investors as on 31.3 2002. UTI along with ICICI launched a Venture Capital Fund of Rs,H crore which ismanaged by the ICICI Venture Fund Management Company Lt for investment inGreenfield projects. UTI International Ld., a 100% subsidy ofj UTI is marketing UTTsoff-shore funds in Europe and USA. India IT Fi India Debt Fund and India Public BSPATIL
  • 66. Sector Fund were launched overseas, to overseas capital into Indian capital market.UTI helps NRI investors in a way too. In June 1990, UTI set up the UTI Institute of Capital (UTHCM) with a view ofpromoting advanced professional education, trail and research in the field of capitalmarkets. The institute located in New Boml is envisaged to be not only a center fordevelopment of Investment specialists! the country but also as regional center forstudy of international capital and for opening a window on Indian and Internationalcapital markets. Di the year, UTI, for the first time, acted as a consultant to studypolicy issi relating to the development of securities market in Indonesia. BSPATIL
  • 67. Aggregate sanctions by UTI to corporate sector upto 31.3.2001 stood at Rs.595bn and disbursement at Rs.443 bn on account of project finance. Non-project financefigures stood at Rs.88 bn and Rs.80 bn. Both project and non-project financetogether stood at Rs. 683bn and Rs.523 bn respectively for sanctions anddisbursements as on 31,3.2001. As on 31.3.2001, UTTs instrument in corporate equity shares stood at Rs.403bn (57.3% of total), pref shares Rs.47 bn (0.7%) debentures Rs.229 bn (32.6%), Fixeddeposits with companies Rs. 9 bn (1.3%), term loans Rs.9 bn (1.3%), deposits withbanks Rs.1.5 bn (0.2%) and govt. securities Rs.46.6 bn (6.6%). Of the UTTs projectfinance of Rs.443 bn disbursed utpo 31.3.2001, Rs.121 bn is invested in publicsector companies, Rs.315 bn in private sector companies. General Insurance Corporation of India General Insurance Corporation of India (GIC) was established in 1973 afternationalisation of general insurance companies in the country. GIC, along with itsfour subsidiaries viz. National Insurance Company Ltd., New India AssuranceCompany Ltd., Oriental Fire and General Insurance Company Ltd. and United IndiaInsurance Company Ltd., operates a number of insurance schemes to cater to thediverse needs of society, In terms of the provisions of the Insurance Act, 1938, and inkeeping with Government guidelines issues from time to time, GIC is required tochannelise 70% of annual accretions to its investible fluids to socially-orientedsectors of the economy. GIC also participates in consortium financing of industrialprojects along with other AIFIs find extends assistance by way of term loans andundenvriting/direct subscriptions to shares/ debentures of new and existingindustrial undertakings. BSPATIL
  • 68. GIC’s aggregate sanctions upto the end of March 2001 totaled Rs. 146 bn of which asum of Rs.48 bn was disbursed. The figures for project finance stood at Rs.70 bn andRs.48 bn for sanction and disbursement. The gate sanctions on non-project financestood at Rs.20 bn and disbursements B.6.7 bn as on 31.3.2001. Investments in loansto financial institutions relegated the Rs.30 bn, cumulative upto 31.3,2001, sanctionsto corporate sector stood at Rs.90 bn and disbursement Rs.67 bn. The private sectorcompanies accounted for over 75% of total assistance by UT1. Industrial Investment Bank of India (Formerly Industrial Reconstruction Bank of India) Industrial Reconstruction Bank of India (IRBI), established in 1985 underthe IRBI Act 1984, after reconstruction of the erstwhile Industrial ReconstructionCorporation of India, is the principal credit and reconstruction agency forrehabilitation of sick and closed industrial units. IRBI assists industrial concerns bygrant of term loans and advances, underwriting of stocks, shares, bonds anddebentures and guarantees for loans/deferred payments. The range of its servicesincludes provision of infrastructure facilities, consultancy, managerial and merchantbanking facilities and making available machinery and other equipment on a lease orhire-purchase basis. IRBI was renamed as Industrial Investment Bank of India and] broughtunder Companies Act, 1956, since March 17, 1997. With this, IIBI hasj become fullfledged development financial institution with operational flexibilit and financialautonomy. IIBI finances new projects, modernization wor balancing equipmentneeds, correcting in balance in cvTent assets, relievir strain on cash resources,repayment of pressing liabilities and other activities. Cumulative sanctions and disbursements of IRBI, upto the end, March2001, aggregated Rs.96 bn and Rs.90 bn respectively and outstanding on 31.3.2001was Rs.45 bn. The figures for project finance stood at Rs. 54 bn, Rs bn and Rs.29 bn.The relevant figures for non-project finance Rs.34 bn, Rs.33 and Rs.12 bn. Together,the figures for direct finance are Rs.88 bn, Rs.82 on Rs.40 bn. The Figures for loans& investments in shares/bonds of financij institutions are Rs.3.8 bn, Rs.3.7 bn andRs.1.3 bn. The figures for seconc market operations are Rs, 4.4 bn, Rs.3.95 bn and BSPATIL
  • 69. Rs.2.96 bn. Infrastructure Development Finance Co. Ltd. Infrastructure Development Finance Co. Ltd. (IDFC) was boi of the needfor a specialized financial intermediary to professionalise the of infrastructuredevelopment in the country. Incorporated in 1997 with an naid-uo caoital of Rs.10,000 million, IDFC was conceived as an institute to facilitate the flow of privatefinance to commercially viable infrastructure jWojects and help mitigate commercialand structural risks contained therein, by designing innovative products andprocesses.Operations IDFC mainly operates in the areas such as energy, telecommunications &information technology, integrated transportation, urban infrastructure and food &agri-business infrastructure. IDFC has been assigned lead arranger mandates in itsareas of operations and in its role as policy advisor, it is actively involved in exerciseentailing rationalizing policy and regulatory frameworks that govern infrastructuresectors. It is involved in identification of best practices, drawing on the expertise ofPolicy Advisory Boards and promoting policy dialogue amongst stakeholders such asCentral and State Governments, regulators and investors. IDFC offers a variety of services to projects in the infrastructure sector,mezzanine structures and advisory services. Apart from above, IDFC encouragesbanks to participate in infrastructure projects through ‘take-out’ financing for aspecific term and at a preferred risk profile, with IDFC taking out the obligation aftera specific period. Using risk participation facilities, IDFC also strengthens linksbetween financial institutions and infrastructure projects. Further, IDFC, throughguarantees structure, helps promoters raise resources from international markets.Mutual funds and pension funds being potential Kpces of long-term funds forinfrastructure projects, IDFC intends offering advisory services to these funds tofacilitate and strengthen their connectivity with infrastructure projects. During 2000-01, to propel its vision for infrastructure towards reality, BSPATIL
  • 70. IDFC addressed issues such as conditional lending for power sector, ipetitive biddingfor infrastructure services and issues in transport pricing and icing. IDFC is alsodeveloping its vision for the urban water and sanitation In the power sector, IDFChas been working with progressive state lents to prepare road maps for reforms in thepolicy framework, with a belief that its multi-pronged and focused approach towardsreforming the power would ultimately translate into desired investment opportunities.With a to develop an alternative to escrow based lending that restrict privatization ofdistribution, IDFC financed a 210 MW power project set up by Karnataka PowerCorporation, based on a reform linked multipartite agreement with variousstakeholders in Karnataka, The agreement envisages privatization of distribution,besides committing state government to financial discipline and envisaging creationof dedicated power sector fund. Based on the multipartite agreement in Karnataka,lenders are exploring alternative to escrow based lending in other states as well. IDFC has developed a Model Concession Agreement for shadow tollprojects, which was approved by the High Powered Committee of the Government ofIndia. TDFC also assists private sponsors in structuring projects and negotiating theconcession framework for projects being set up in the roads and ports sectors. IDFCassisted the Planning Commission in the formulation of Integrated Transport Policyand is involved with the Expert Committee on Railways as well as a group constitutedto examine the needs of the shipping ndustry. During the year, IDFC created a decentralized infrastructure and newtechnologies group to undertake initiatives such as identification of new echnologiesfor application, development of financial models with the help of a iocal servicepartner and initiating dialogue with donor agencies, relevant ministries and multi-lateral agencies to enable and stimulate commercially viable decentralizeddevelopment. During 2000-01, IDFCs total sanctions and disbursements amounted toRs. 24,670 million for 31 projects and Rs. 7,620 million for projects, respectively.This compares favourably with previous year’s performance of Rs. 18,660 millionsanctions for 20 projects and Rs. 6,420 million, disbursements for 11 projects,indicating an increase of 32.2% in sanctions and] 18.7% in disbursements in2000-01 as against the growth rates of 10.9% am 71.2% in 1999-2000. Up to end BSPATIL
  • 71. March 2001, IDFC sanctioned fmancia assistance to 60 projects aggregating Rs.63,100 million. Of this, disbursemei including non-funded commitments) were madefor 27 projects aggregating Rs. 17,790 million. BSPATIL
  • 72. NABARD National Bank for Agriculture and Rural Development (NABARD),established in July, 1982 under an Act of Parliament, is an apex development bankfor promotion and development of agriculture, small-scale industries, cottage andvillage industries, handicrafts and other rural crafts and other allied economicactivities in rural areas. The Banks objective is to promote integrated ruraldevelopment necessary for overall prosperity of rural areas in the country. NABARDsmulti-faceted functions have, besides financing, promotional, developmental andregulatory dimensions.Operations NABARD extends credit support by way of refinance to eligible institutions viz.State Co-operative Agriculture and Rural Development / Banks (SCARDBs), State Co-operative Banks (SCBs), Commercial Banks (CBs), Regional Rural Banks (RRBs) andScheduled primary (Urban) Co-operative Banks (PCBs) for farm as well as non-farmsectors (NFS). NABARD provides long-term investment credit to farm sector forvarious approved agricultural and allied activities such as minor irrigation, plantation& horticulture, forestry, land development, farm mechanization, agriculturalequipments, animal husbandry and fisheries. Medium-term credit facilities areavailable to SCBs and RRBs for approved agricultural purpose and short-term creditfacilities are extended to SCBs on behalf of District Central Co-operative Banks(DCCBs) and RRBs for financing seasonal agricultural operations, marketing of crops,purchase, procurement and distribution of agricultural fertilizers and other inputs. Refinance for NFS up to Rs.1.5 million is available to SCBs, SCARDBs,RRBs and CBs on automatic basis, and under pre-sanction procedure up to SSI limitto CBs and SCBs, enabling them to provide investment &edit to rural enterprises.Short term refinance facilities under NFS include Credit limits to SCBs (on behalf ofDCCBs) for meeting the working capital j&quirements of primary/apex weavers co-operative societies, industrial cooperative societies and rural artisan members ofPrimary Agricultural Credit Societies (PACS) for pursuing various production,procurement and marketing activities. Short-term credit limits are also extended to BSPATIL
  • 73. RRBs for financing non-agricultural activities. Refinance support is extended to CBsfor financing handioom weavers co-operative societies in areas where the co-operative credit structure is weak. NABARD also extends refinance to banks for financing governmentsponsored programmes like Swamjayanti Gram Swarozgar Yojana (SGSY), PrimeMinisters Rozgar Yojana (PMRY), action plans of SC/ST Development Corporations,SEMFEX-II and for development of non-conventional energy sources. Considering promotion of NFS as an important and necessary adjunct toits crore refinancing function, NABARD provides grant/revolving fund assistance toNGOs, voluntary agencies, Trusts and Promotional organizations. The objective is togenerate and enhance opportunities for employment and income generation in ruralareas in a sustainabie, demonstrative and cost-effective manner. With a view to providing operational flexibility ro to 3ank in meeting thechanging requirements of the rural sector, comprehensive amendments to NABARDAct, 1982 were effected from February 1, 2C01. Tlu amendments relate to explicitreference to NABARD as a Development bank’, enhancement of capital limit fromRs.5,000 million to Rs.50,000 miaic,i, allowing holding of private equity up to 49%with a minimum of 51% by tie Government of India and RBI, flexibility in resourcemobilization and credit-delivery by the Bank, introduction of new products andsetting up of subsidiaries. Besides, the major policy initiatives by NABARD during 2000-01 includeliberalisation of the existing scheme of financing the marketing ofj agriculturalproduce covering even non-borrowing members of PACS rationalisation ofclean cash credit limits by SCBs/DCCBs to co-operative factories, permitting cashcredit limits to sugar factories for payment of bonus workers, permittingSCBs/DCCBs to finance activities in service sec rationalization of interest rate onrefinance on investment credit, rationalizatioif of quantum of refinance for investmentcredit bringing SCBs, RRBs commercial banks on par, po/cy changes relating torefinance to non-farm sectq and making available Kisan Credit Cards to all theeligible farmers within next three years. BSPATIL
  • 74. The other important developments include setting up of a micro-FinanceDevelopment Fund (MFDF) by NABARD with an amount of Rs. 1,000 million, inpursuance of the proposal contained in the Union-Budget 2000-01. The fund hasreceived an initial contribution of Rs.800 million equally contributed by RBI andNABARD. Also, the Bank has set up a Watershed Development Fund with a corpus ofRs.25000 million. Ten state governments have signed MoUs with NABARD forparticipating in the programme NABARDs operations under Rural Infrastructure Development Fund(RIDF) are likely to gain further momentum, with an increased allocation ofRs.50,000 million in the Union-Budget 2001-02. In addition, implementation of theprojects through ground level organizations, particularly fqr social infrastructuredevelopment would be encouraged. Agro/food processing and post-harvestmanagement with upgraded technology would be the new areas of focus for the Bank. NABARDs refinance assistance to co-operative banks, commercial banksand RRBs and loans to state governments, NGOs and other agencies during 2000-01aggregated Rs. 1,64,610 million as compared to Rs. 1,47,780 million during1999-2000, registering a growth of 16.1%. Of the total refinance support, investmentcredit disbursed by NABARD for financing farm and NFS amount to Rs. 61,581million during 2000-01 as compared to Rs. 52,153 million during 1999-2000,registering a growth of 18.1%. State Industrial Development Corporations The State Industrial Development Corporations (SIDCs) were establishedunder the companies Act, 1956 as wholly owned undertakings of the StateGovernments with the specific objectives of promoting and developing medium andlarge industries in their respective states/union territories. These eorporations extendfinancial assistance in the form of rupee loans, underwriting & direct subscriptions toshares/debentures, guarantees, inter-corporate deposits and also opens letters ofcredit on behalf of its borrowers. SIDCs undertake a range of promotional activitiesincluding preparation of feasibility reports, Conducting industrial potential surveys,entrepreneurship training & development programmes and developing industrial BSPATIL
  • 75. areas/estates. Some SIDCs also offer package of developmental services that includetechnical guidance, assistance in plant location and co-ordination with otheragencies. With a view to providing infrastructural facilities for the establishment ofindustrial units, SIDCs are involved in the setting up of industrial growth centers. Tokeep place with the changing economic environment, SIDCs have initiated variousmeasures to expand the scope of their activities and have entered into various tee-based activities. Of the 28 SIDCs in the country, those in Andaman & Nicobar, VrunachalPradesh, Daman & Diu and Dadra & Nagar Haveli, Goa, Manipur, Vleghalaya,Mizoram, Nagaland, Tripura, Pondicherry and Sikkim also act as SFCs to provideassistance to small and medium enterprises and act as a promotional agencies forthis sector.Operations During 2000-01, financial assistance sanctioned and disbursed by SIDCsincreased by 29.9% and 3.1% to Rs. 20,801 million and Rs. 16,644 million,respectively as against a decline in sanctions and disbursements of 29.8% and 25.8%in 1999-2000, respectively. Up to end March 2001, aggregate sanctions anddisbursements amounted to Rs. 2,23,309 million and Rs. 1,76,47; millionrespectively. During 2000-01, direct finance constituting 66.6% of overall sanctions,increased by 4.1% to Rs. 13,849 million as against a decline of 41.6% in 1999-2000.Of the direct finance, project finance forming 50.9% of total sanctions, grew by 7.8%to Rs. 10,5 81 million. Of the project finance, rupee loans declined by 2.3% over adecline of 49% in the previous year. Underwriting & direct subscriptions, however,registered a growth of 315.4%. Non-project finance constituting 15.7% of the totalsanctions, declined by 6.4% during 2000-01. Of the non-project finance, assistanceunder asset credit scheme/equipnu finance/corporate loans increased by 48.3%while working capital/short-ter loans declined by 41.5%. Sanctions under billsfinance, accounting for 31.8% the total sanctions, grew by 144.7% to Rs. 6,604million during 2000-01. BSPATIL
  • 76. During 2000-01, disbursements under direct finance were lower 4%,constituting 59.6% of overall disbursements. Disbursements under proj< financegrew by 1.3% to Rs.7,533 million, accounting for 45.3% of the tot disbursements. Ofthe project finance, rupee loans declined by 12,7%, while underwriting & directsubscriptions increased by 341.1%. Non-project finance, accounting for 14.4% oftotal disbursements, declined by 17.4%. Disbursements under asset creditscheme/equipment finance/corporate loans and working capital/short-term loanswere lower by 17.6% and 25.9% respectively, during 2000-01. Disbursements underbills finance accounting for 38.4% of total disbursements, grew by 9.9%. Export - Import Bank of India Exim Bank of India, established in 1982, is a wholly government ownedfinancial institution set up for the purpose of financing, facilitating and promotingIndias foreign trade. Towards the end, the Bank plays a four^ronged role - that of aco-coordinator, a financier, consultant and promoter. The Banks financing servicesinclude a range of fund and non-fund based programmes to enhance the exportcompetitiveness of Indian companies. Its major operations presently comprisefinancing of projects, products and services exports, building export competitiveness,promotional programmes and financing of research & development activities ofexporting companies. The information, advisory and support services provided by theBank enable exporters to evaluate international risks, exploit export opportunitiesand improve competitiveness. The Bank also helps Indian companies in identifyingtechnology suppliers, partners and in consumption of domestic and overseas jointventures, through its network of alliances and its overseas offices. Upto end March 2001, the Exim Bank sanctioned and disbursed fund basedassistance aggregating Rs. 2,42,497 million and Rs. 1,93,171 million, respectively.Loans outstanding as at end March 2001 were Rs. 56,443 million, registering anincrease of 11% over the previous year. Sanctions of fund based assistance to Overseas Entities by way of lines ofcredit and buyers credit increased sizably to Rs. 1,873 million to 2000-01 from BSPATIL
  • 77. Rs.200 million in 1999-2000, while sanctions to Indian Exporters under variousprogrammes declined by 29.3% to Rs. 19,870 million from Rs. 28,118 million in theprevious year. During 2000-01, the Bank sanctioned guarantees aggregating Rs .2,118million as against Rs. 4,404 million in 1999-2000. Guarantees issued Minted to Rs.1,741 million as against Rs. 3,017 million. These guarantees related to overseasprojects in sectors such as telecommunications, power generation, transmission anddistribution, oil exploration, cement and petrochemicals. Outstanding guarantees asat end March 2001 were Rs. 10,740 million. During 2000-01, 38 export contracts worth Rs. 18,330 million for exportto 23 countries were secured by 21 Indian exporters with the Exim Banks support asagainst 53 contracts worth Rs.34,440 million covering 19 countries secured by 27Indian exporters during 1999-2000, The export contracts secured during 2000-01consisted of 19 turnkey contracts, 11 service contracts, 7 supply contracts and 1construction contract. During 2000-01, the Bank sanctioned term loan of Rs. 4,871 million to33 export-oriented units (EOUs) and disbursed Rs.4,821 million as compared to thesanctions and disbursements of Rs.8,459 million and Rs.4,747 million in theprevious year. During 2000-01, the Bank sanctioned loans aggregating Rs. 1,570million to 9 companies for setting up ventures abroad and for acquisition of overseascompanies. The salient feature was Banks participation in a nonrecourse leveragedbuyout transaction of an international tea company representing the largest overseasacquisition so far by an Indian company Disbursement during the year amounted toRs. 1,230 million. During 2000-01, the Bank provides a wide range of fee basedinformation, advisory and support services to Indian companies and overseasentitles. The scope of services included market-related information, sector andfeasibility studies, technology supplier identification, partner search, investmentfacilitation and development of joint venture both in India and abroad. The Banks BSPATIL
  • 78. operations also included information and support service to Indian companies toimprove their prospects for securing business in projects funded by World Bank,Asian Development bank, African Development Bank and European Bank forReconstruction and Development. During 2000-01, under the Product and Process Quality CertificationProgramme, the Bank sanctioned financial support to the tune of Rs. 14.6 million to19 companies covering a diverse range of certifications industry-specific, market-specific and activity-oriented. Under Technical Assistance programme with IFC, Washington and OtherInternational agencies, for sponsoring and part-funding Indian consultants, the Banksponsored 13 Indian consultants for various projects. These consultants wereselected for assignments in East Africa, Egypt, Ghana, Kosovo, Nigeria and Vitenamin areas such as pharmaceuticals, cashew nut processing, general management,investment banking, rural electrification, information technology, stock exchangeexpertise and marketing and investment planning. Sate Financial Corporations State Financial Corporations (SFCs) are the stare level developmentbanks set up under the SFCs Act, 1951 for the development of small and mediumscale industries in their respective states. SFCs aim at bringing about balancedregional development by wider dispersal of industries, catalyzing greater investmentand generating larger employment opportunities. SFCs, numbering 18 at present, provide financial assistance to industriesby way of term loans, direct subscriptions to equity/debentures, discounting of billsof exchange and guarantees. Most of this IDBI schemes for assistances to small andmedium sectors are operated through SFCs. These include composite loan scheme,schemes foi women entrepreneurs, modernization scheme, equipment financescheme, scheme for hospitals and nursing homes, scheme for ex-servicemen, singlewindow scheme and special capital and seed capital schemes. BSPATIL
  • 79. Technical Consultancy Organisations A network of Technical Consultancy Organisations (TCOs) was set up inseventies and eighties by IDBI, IFCI and ICICI in collaboration with state-levelfinancial/development institutions and commercial banks to provide inexpensiveconsultancy services of small and new entrepreneurs in the country. At present, there are 18 TCOs in the country, some of which cover morethan one state. The activities of TCOs include preparing project profiles and feasibilitystudies, undertaking industrial potential surveys, conducting entrepreneurshipdevelopment programmes (EDPs) and rendering technical and administrativeassistance. Over the years, TCOs have diversified into newer areas such as provisionof consultancy services for modernization and rehabilitation of industrial units,transfer of technology, design and engineeriitg services, management and exportconsultancy, rural industrial development retailer consultancy services, turn-keyassignments and energy audit and conservation services. TCOs also provideconsultancy services to State Governments, state-level development financingagencies and banks. During 2000-01, TCOs completed 1774 assignments including 1092feasibility studies/project profiles/reports, 121 project appraisals, 131 industrialpotential surveys/area development surveys, 82 valuation of assets, 85modernisation / rehabilitation / diagnostic studies, 18 functional industrialcomplexes/tum-key assignments and 245 other works. Besides TCOs conducted 158EDPs for 38806 persons. 753 entrepreneurship awareness programmes, 66 skillupgradation programmes/EDPs under SEEUY and 76 other programmes.List of Technical Consultancy Organisations 1. Andhra Pradesh Industrial & Technical Consultancy Organisation Ltd. 2. Bihar Industrial & Technical Consultancy Organisation Ltd. (BTTCO) 3. Gujarat Industrial & Technical Consultancy Organisation Ltd. (GITCO) BSPATIL
  • 80. 4. Haryana-Delhi Industrial Consultancy Organisation Ltd. (HARDICON) 5. Himachal Consultancy Organisation Ltd. (HIMCON) 6. Industrial & Technical Consultancy Organisation of Tamil Nadu Ltd. (ITCOT) 7. Jammu & Kashmir Industrial & Technical Consultancy Organisation Ltd. (J&KITCO) 8. Kerala Industrial & Technical Consultancy Organisation Ltd. (KITCQ) 9. Madhya Pradesh Consultancy Organisation Ltd. (MPCON) 10.Maharashtra Industrial & Technical Consultancy Organisation Ltd. (MTTCON) 11.North-Eastern Industrial Consultant Ltd. (NECON) 12.North-Eastern Industrial & Technical Consultancy Organisation Ltd. (NEITCO) 13.North India Technical Consultancy Organisation Ltd. (NITCON) 14.Orissa Industrial & Technical Consultancy Organisation Ltd. (ORITCO) 15.Rajasthan Consultancy Organisation Ltd. (RAJCON) 16.Uttar Pradesh Industrial Consultants Ltd. (UPICO) 17.West Bengal Consultancy Organisation Ltd. (WEBCON) 18.Technical Consultancy Service Organisation of Kamataka (TECSOK) 2.43 Lending Procedures of the Term Landing Financial Institutions The essential requirements insisted upon by the financialnstitutions before taking up a request for financial assistance for consideration are: BSPATIL
  • 81. i) the applicant concern should have obtained industrial license or shouia have made some kind of commitment, where necessary ii) the applicant should have obtained/applied for permission of the Securities and Exchange Board of India to issue capital, wherever necessary iii) the applicant should have obtained the approval of the Government regarding the terms of technical and/or financial collaboration agreement, if any iv) the applicant should have a clearance from the Capital Goods Committee in respect of the machinery proposed to be imported v) the applicant should have selected a site for the location of the factory and have prepared a detailed project report. After the receipt of the filled up application in triplicate in the case ofnon-corporate units and quadruplicate in the case of corporate bodies, the project isappraised by ;i team of technical, financial and economic officers of the Corporationfrom several angles - technical, financial, economic, managerial and social. Technical Appraisal The technical appraisal of the project involves a critical analysis of thefollowing: i) Feasibility of the selected technical project and its suitability in Indian conditions. ii) Location of the project in relation to the sources and availability of inputs - raw materials, water, power, fuel, transport, skilled and unskilled labour and in relation to the market to be served by the product/service. iii) Adequacy of the plant and machinery and their specifications BSPATIL
  • 82. iv) Adequacy of the plant layout v) Arrangements for securing technical know-how, if necessary vi) Availability of skilled and unskilled labour and arrangements for training to the labourers. vii) Provision for the disposal of factory effluents and utilisation of byproducts if any. viii) Whether the process proposed for selection is technically sound and upto date etc. Another important feature of technical appraisal relates to the type oftechnology to be adopted for the project. In case new technical processes are adoptedfrom abroad, attention is to be paid to the terms and conditions.2.43.2 Economic Appraisal The economic appraisal of a project involves: i) Consideration of natural and industrial property of the project and contribution to the national economy of the country in terms of contribution to GDP, down stream and upstream projects. ii) Savings in foreign exchange or prospects of exports. iii) Employment potential, direct and indirect. iv) A critical study of the existing and future demand of the products proposed to be manufactured, the licensed and installed capacity, the level of competition etc. v) Scrutiny of the project in relation to the import and export policies of the Government and various other factors like regulatory controls, if any, in regard to production, prices and raw materials. BSPATIL
  • 83. Financial Appraisal Financial appraisal of the existing concern deals with an analysis of itsworking results, balance sheets and cash flow for the past years/projected futureyears and an examination of the following aspects in all cases. i) Estimated cost of the project. ii) Financial plan with reference to capital structure, promoters contribution, debt-equity ratio and the availability of other resources. iii) Crucial examination of the investments made outside the business and justification therefor. iv) Projections of cash flow, both during the construction and the operation periods. v) Projects break-even level of operation and time required to reach that level operation. vi) Estimation of future profitability in the light of competition and product/service obsolescence. vii) Internal rate of return, debt-service coverage and projected dividends on share capital, pay-back period, abandonment value at the end of different levels of milestones or years of operation.Managerial Appraisal The confidence of the lending institution in repayment prospects of aloan is largely conditioned by its opinion of the borrowing units managementTherefore, it has been remarked that appraisal of management is the touch sto*ie ofterm credit analysis. Where the technical competence, administrative abi/fty, BSPATIL
  • 84. integrity and resourcefulness of the management are well established, the loanapplication gets the most favourable consideration. The expertise, experience andearnestness of the management tells in the efficiency, effectiveness and excellence ofthe project2.4.3.4 Social Considerations The social objectives of the project are considered keeping in view theinterest of the general public. The projects, which provide large employmentopportunities and canalize the income of the agricultural sector for productive use,projects located in totally less developed areas and projects that stimulated smallscale industries are considered to serve the society well. The social benefits are more.The social cost ofxpollution consumption of scarce resources, etc. are also to beweighed. BSPATIL
  • 85. Conditions for Assistance from Financial Institutions Different financial institutions stipulate different kinds of conditionsdepending on the nature of the project, the borrower etc. The main conditions of aterm loan are as follows; i) The borrower (applicant) has to obtain all relevant Government clearances such as licensing, capital goods clearance for imported machines, import license, clearance from pollution control board, etc. ii) For consortium loan, the borrower has to satisfy all the institutions participating in lending. iii) Concurrence of the financial institution is necessary for repayment of any existing loan or long-term liabilities. iv) The term loan agreement may stipulate the debt-equity ratio to be followed by the company. v) As long as the loan is outstanding, the declaration of dividend is made subject to the institutions approval. vi) The term lending institution reserves the right to nominate one or more directors in the management of the company. vii) Once the loan agreement is signed, any major commercial agreements such as orders for equipment, consultancy, collaboration agreement, selling agency agreement etc. and further expansion need the concurrence of the term lending institution. viii) The borrower is not permitted to create any additional charge on the assets without the knowledge of the financial institutions. ix) The financial institutions may appoint suitable personnel in the areas of marketing, research and development, depending upon the nature of the BSPATIL
  • 86. project. x) The promoters cannot dispose their shareholders without the consent of the lending institutions. This is stipulated for keeping the promoters involved as long as the institutions involve in the business.2.43.6 Schemes of Assistance of Financial Institutions Financial institutions provide the bulk of finance required for industry.For fulfilling the socio-economic objectives of our country, today the financialinstitutions perform a variety of financing and promotional activities and havedesigned special programmes specifically for the development of industries inbackward areas, encouraging competent new entrepreneurs, supportingmodernization schemes and development of small scale industries.Fig. 2.1 gives the schemes of assistance.Fig. 2.1 Schemes of Assistance. BSPATIL
  • 87. 2.5 PUBLIC DEPOSITS Deposits with companies have come into prominence in r cent years. Ofthese the more important are the deposits accepted by trading and manufacturingcompanies. The Indian Central Banking Enquiry Committee in 1931 recognised theimportance of public deposits in the financing of cotton textile industry in India ingeneral and at Ahmedabad in particular. The growth of public deposits has beenconsiderable. From the companys point of view, public deposits are a major source offinance to meet the working capital needs. Due to the credit squeeze imposed by theResearch Bank of India on bank loans to the corporate sector during 1970s - 1980sand also due to the recommendations of the Tandon Committee, restricting credit,many companies were not getting as much money in the 1980s as they used to get, inthe past, from the banks. So, public deposits came handy as working capital fund forbusinesses. While to the depositor the rate offered is higher than that offered bybanks, the cost of deposits to the company is less than the cost of borrowings frombank. Moreover, the availability and volume of bank credit are restricted byconsideration of margin, security offered, periodical submission of statements etc.The credit available to companies through public deposits is not affected by suchconsideration. There is no problem of margin or security. Since the fixed depositsfrom the public are unsecured, the borrowing company need not mortgage orhypothecate any of its assets to raise loans in this form. These deposits are availablefor comparatively longer terms than bank creditMerits of Public deposits The merits of public deposits are as follows: i) There is no need of creation of any charge against any of the assets of the company for raising funds through public deposits. ii) The company can get advantage of trading on equity since the rate of interest and the period for which the public deposits have been accepted are fixed. iii) Public deposit is a less costly method for raising short-term as well as BSPATIL
  • 88. medium-term funds required by the companies, because of less restrictive covenants governing this as against bank credits. iv) No questions are asked about the uses ot public deposits. v) Tax leverage is available as interest on public deposits is a charge on revenue.Demerits of public deposits The main demerits of the public deposits are as follows: i) This mode of financing,, puts the company into serious financial difficulties. Even a siignt rumour about the inefficiency of the company may result in a rush of the public to the company for getting premature payments of the deposits made by them. ii) Easy availability of fund encourages lavish spending. iii) Public deposits are unsecured deposits and in the event of a failure of the company, depositors have no assurance of getting their money back.RBI Regulations for Public Deposit The RBI regulation of public deposits has six main aspects: i) There is a ceiling on the quantum of deposits in terms of paid-up capital and reserves by the company because undue accumulation of short-term liabilities in the form of deposits can lead a company into financial difficulties. In the beginning the definition of deposits was quite narrow and excluded unsecured loans accepted from the public and guaranteed by the directors. Now the term deposit covers “any money received by a non- banking company by way of deposit or loan or in any other form but excludes money raised by way of share capital or contributed as capital by proprietors”. BSPATIL
  • 89. ii) The second aspect of the Reserve Banks regulation is the limit on the period of such deposit. Formerly, in order to avoid direct competition with short- term public deposits, companies were prohibited from accepting deposits for a period of less than 12 months. But the 1973 amendment reduced the period to less than 6 months. The short-term deposit is now pegged down to 10 per cent of the ajjgreu.tX1 of the paid-up capital and free reserves of the company while secured and unsecured deposits shall not exceed 15 per cent and 25 per cent, respectively, of the paid-up capital and free reserves.iii) The Reserve Bank has made obligatory on the part of the companies accepting deposits to regularly file returns, giving detailed information about them, their repayment, etc. so that the Reserve Bank camverify whether the companies adhere to the restrictions. However such statements are not filed late and the Reserve Banks action to prevent a defaulting company from accepting any deposit fails to afford any protection to existing depositors.iv) The Reserve Bank has stipulated that while issuing newspaper advertisements (or even the application forms) soliciting such deposits, certain specified information regarding the financial position and the working of the company must accompany. This clause is often mis-ued as much advertisement often carried words like “as per Reserve Bank directive”, thereby giving a wrong impression that these deposits are actually governed by the Reserve Bank. Now such advertisements would be illegal and attract penal provision prescribed in this behalf. Similarly, the catalogues and handouts issued by brokers stating that the companies mentioned therein had complied with Reserve Bank directives would also attract the penal provision.v) The Reserve Bank has entrusted the auditors of the companies with additional responsibilities of reporting to it that the provision under the Act has been strictly followed by the The Reserve Bank has issued a broad "RBI Directives on Company Deposit in order to clarify its role in protecting depositors. The bank has reiterated BSPATIL
  • 90. that the deposits or loans are fully protected or are absolutely safe merely because the companies claimed to have complied with the RBI directives and that they should not presume that the Reserve Bank can come to their rescue in the event of failure of a company to meet its obligations.2.6 SUMMARY The long term capital resources of a company are equity capital,preference capital, debenture capital and borrowings from term lending institutions(term loans). Equity shareholders are owners of the company. They have the right ofcontrol and pre-emptive right to purchase additional equity issued by the company.Equity shareholders get residual claim over assets in the event of liquidation. Equityshare capital is a permanent capital to the company and it increases the creditworthiness also. The issue cost of equity capital is high and sale of equity shares tooutsiders results in dilution of control. Preference shareholders have two rights over equity share holders - rightto receive dividend and also right to receive back the capital in the event ofdissolution or liquidation, if there by any surplus. Preference share capital enhancesthe cfeditworthiness of the company. There is no legal obligation to pay preferencedividend and the issue of preference shares does not create any charge against assetsof the company. Compared to debt capital, preference capital is a very expensivesource of financing and skipping dividend on preference shares may adversely affectof the company and create control problems. Debenture is an acknowledgement of the companys indebtedness to itsdebenture-holders. Debentures are instruments for raising long term debt capital.Debenture-holders are the creditors of the company. Raising funds by issue ofdebentures does not result in dilution of control. Interest paid to debenture-holders isa charge on income of the company and is deductible from income for income taxpurpose. In a period of rising prices, the burden of servicing debentures in real termsis less. Debenture interest and capital repayment are obligatory payments. Failure tomeet these payments jeoparadiscs the solvency of the firm. If the capital structure is BSPATIL
  • 91. heavily loaded with debentures, the major portion of the companys earnings isabsorbed in servicing the debt and little is left for distribution by way of dividends.This may reduce the value of shares in the market. Institutional loans represent debt finance which is generally repayable inmore than one year but less than 10 to 15 years. The companies use institutionalloans for acrrisition of fixed assets and working capital margin. The terr<i loans of(he financial institutions are secured borrowings. With the help of term loans thecompanies perform their replacement, rehabilitation and renovation programmes.Payment of interest on term loans is a contractual obligation. All the projects aresubject to technical appraisal, economic appraisal, financial appraisal andmanagerial appraisal for sanctioning of term loans, and the financial institutionsstipulate different kinds of conditions depending on the nature of the project, theborrower etc. The term tending institutions may be grouped into two categories, i.e.All India Institutions and State Level Institutions. All India Institutions are theIndustrial Finance Corporation of India, the Industrial Credit and InvestmentCorporation of India, Industrial Development Bank of India, IndustrialInvestment Corporation of India and other all-India Institutions. The State-levelinstitutions are the State Fin --ial Corporations and State Industrial DevelopmentCorporation. The assistance of the financial institutions, consists of providing ongterm loan, underwriting equity, preference and debenture issues and guaranteeing ofdeferred payments of machinery imported from abroad or purchased in India.Financial institutions provide concessional finance to the projects in backward areasand soft loans for modernization of industries. They provide technical andadministrative assistance and undertake market ar-d investment research surveysand also technical and economic studies related to development of industry. Public deposits are a major source of finance to companies to meet theworking capital needs. For public deposits there is no need of creation of any chargeagainst any of the assets of the company. It is less costly method to the companies forgetting short term and medium term funds.2.6 SELF ASSESSEMENT QUESTIONS BSPATIL
  • 92. 1. Discuss the sources of long term finance of a company.2. Critically evaluate equity shares a source of finance both the point of (i) the company and (ii) investing public.3. Discuss the features of preference shares and evaluate preference share capital from the companys point of view.4. What are right shares? Explain the significance of the same form the companys and investors view point.5. Define ‘debenture’ and bring out its salient features as an instrument of corporate financing.6. Explain the different types of debentures that may be issued by a company.7. What are the advantages and disadvantages of debenture finance to a company?8. List out the SEBI guidelines for issuing bonus shares.9. What are the major types of activities of financial institutions in India?10. Discuss the importance of Industrial Development Bank of India as an apex institution of Industrial finance.11. Explain the lending procedures of the term lending financial institutions in India.12. Discuss briefly the working of a) Industrial Finance Corporation of India b) Industrial Credit and Investment Corporation of India c) Industrial Reconstruction Bank of India d) Life Insurance Corporation of India e) State Financial Corporation f) State Industrial Development Corporations BSPATIL
  • 93. 13. What do you mean by Public Deposits? Explain their merits and demerits. 14. Explain the types of appraisal to be made in sanctioning project finance.REFERENCES 1. Financial Management and Policy - Van Home 2. Financial Decision Making – Hampton 3. Management of Finance - Weston and Brigham 4. Financial Management - P.Chandra 5. Report on Development Banking in India, 2001, IDBl. BSPATIL
  • 94. UNIT-III WORKING CAPITAL MANAGEMENT In this unit you will learn, meaning and concepts of working capital,kinds of working capital, working capital management functions, factors, affectingworking capital, estimation of working capital requirement, sources of workingcapital, Tandem committee recommendations, Chore committee recommendations,Marathe committee recommendations and Vaz committee recommendations onworking capital.INTRODUCTION The capital required for a business is of two types. These are fixed capitaland working capital. Fixed capital is meant for taking up capital expenditures whileworking capital is for meeting revenue expenditures. Fixed capital is the capitalrequired for acquiring fixed assets such as land, building, plant, machinery, fixtures,fittings, etc. forking capital refers to the capital (i.e. funds) needed to meet day-to-dayoperations of the business, like payment for purchase of raw materials, payment ofwages and salaries, payment of recurring overhead expenses and so on. Forecastingand managing working capital arc somewhat more difficult than that of fixed capital.This is due to variability and variety in respect of working capital needs of a business.Careful management of working capital is needed, for poor working capitalmanagement would lead ti> closure of business. It is said while faulty fixed capitalmanagement has lead u closure of units in 10s, faulty working capital managementhas lead to closure o 100s of units. Hence the significance of working capitalmanagement.3.1 MEANING AND CONCEPTS OF WORKING CAPITAL Let us examine the meaning and concepts of working capital now3.1.1 Meaning James C. Van Home defines working capital management as the administrationof the firms, current assets and the financing needed to support current assets. Aswas already referred to working capital is the day-to-day requirement of funds. For BSPATIL
  • 95. day-to-day operations, a business needs to carry certain amount of raw material of allsorts so that commencement of production is not delated (for want of raw materials),certain amount of work-in-process so that produc ion operations go smoothly, certainamount of finished goods so that supply to ».ie market is not hampered byfluctuations in production, certain amount of book debts so that sales take placecontinuously and certain amount of cash and bank balance for meeting daily routinepayments and for providing for any unforeseen contingencies, jn other words,working capital refers to the investment in the current assets of the business.Working capital is also referred to as revolving capital as current assets and currentliabilities are converted from one form to other and again converted back to originalform and reconverted into other on and on. Hence it is called revolving capital orfloating capital.3.1.2 Concepts of Working Capital There are several concepts of working capital- We just saw that workingcapital means investment in the different current assets. Here two interpretations arepossible. These are: i) The value of all the current assets and ii) The value of allcurrent assets minus the value of all current liabilities, because to the extent ofcurrent liabilities, the firms investment in current assets stands reduced.Accordingly we have two concepts of working capital, viz., Gross concept and Netconcept. Gross working capital refers to investment in all current assets -rawmaterials, work-in-progress, finished goods, book debts, bank balance and cashbalance. The gross concept of working capital is significant in the context ofmeasuring working capital needed, measuring the size of the business, continued andsmooth flow of operations of the business and the like. Net working capital refers to the excess of current assets over currentliabilities. That is, value of current assets minus value of current liabilities (currentliabilities include trade creditors, bills payable, outstanding expenses such as wages,salaries, dividend payable and tax payable, bank overdraft, etc.) The net concept ofworking capital is significant in the context of financing of working capital, the short BSPATIL
  • 96. term liquidity aspects of the business, and the like.3.2 KIND OF WORKING CAPITAL There are two kinds of working capital. These are i) permanent workingcapital, ii) temporary/varying working capital. Permanent Working Capital refers to the minimum amount of allcurrent assets that is required at all times to ensure a minimum level ofuninterrupted business operations. Some minimum level of raw materials, workingprocess, bank balance, finished goods, etc. a business has to carry all the timeirrespective of the level of manufacturing/marketing operations. This level of workingcapital is referred to as core working capital or core current assets. Van Home definespermanent working capital as the “amount of current assets required to meet a firmslong-term minimum needs”. You should note, that the level of core current assets isnot, however, a constant sum all the times. For a growing business the permanentworking capital will be rising, for a declining business it will be decreasing and for astable business it will be remaining more, or less stay-put. So permanent workingcapital is perennially needed one though not fixed in volume. This part of the workingcapital being a permanent investment, needs to be financed through long-term funds. Temporary or varying working capital varies with the volume ofoperations. If fluctuates with scale of operations. This is additional working capitalrequired during up seasons over the above the fixed working capital. During seasonsmore production/sales take(s) place resulting in larger working capital needs. Thereverse is true during off-seasons. As seasons alternate, temporary working capitalmoves up and down like tides. Van Home defines temporary working capital as the“amount of current assets that varies with seasonal requirements”. Temporaryworking capital can be financed through short term funds, ie, current liabilities.When the level of temporary working capital moved up, the business might use short-term funds and when the level of temporary working capital recedes, the businessmight retire its short term loans. Chart 3.1 gives the graphic versions of permanent and temporary BSPATIL
  • 97. working capital for growth, normal and declining firms. BSPATIL
  • 98. 3.3 WORKING CAPITAL MANAGEMENT FUNCTIONS Thus for we dwelt only on the concepts and kinds of working capital. Now let ussee what is working capital management. Working capital management refers to theplanning, execution and control of investment in and financing of working capital.3.3.1 Investment in Working Capital Investment in working capital involves determination of the totalquantum of current assets, the size of individual items of current assets and theoperating cycle. These may be planned, adopting any of the following approaches, viz.industry norm approach, economic mode approach and strategic choice approach. Under the Industry norm approach the size and composition of currentassets are determined according to the convention or norms adopted by die firms inthe industry. For instance, 2 months production requirements of raw materials, 1months production needs of work-in-process, 3 months sales to. finished stock, 2months credit to customers, etc. may be norms. And yoi, follow the norms. When thisapproach is adopted, automatically total volume arid component size of currentsassets become proportional with level of activity. But this approach is not scientific. Itis a rule of thumb. But we cannot say it is a wrong course. Under the economic model approach, for each item of current assetsthe economic lot/order size is worked out. Economic lot size is that quantity ofinventory where the sum of both the costs of carrying and costs of ordering is theleast. When all the optimal quantities are added up you get the optimal size ofinvestment in current assets. This approach is good for it satisfies one criterion ofefficiency of working capital management. The level of working capital should beneither too much nor too low. If it is too much, more capital is locked up and thebusiness loses interest, incurs loss on account of obsolescence, pilferage, pays moretowards storage and insurance. Perhaps more bad debts could also result. If the sizeis too low, there is a hand-to-mouth living. There may result some lost sales,customer dissatisfaction and desertion, haste purchases, sub-optimal productionruns, etc. So; an optimal investment in current assets is needed. The economic model BSPATIL
  • 99. approach helps in finding this optional size. But this approach is based on a set ofassumptions, which may render the results of the approach subject to ifs and buts. In the strategic choice approach which is more pragmatic, themanagement decides the level of investment in each type of current asset case bycase taking into account the cost and benefits involved. No rule of thumb or pre-designed plain models are used. Managerial consideration, competitors strategies,business exigencies and other relevant factors are used in deciding the size andcomponents of working capital.3.3.2 Financing and approaches to financing working capital Having dealt with the size of investment current assets, the methods offinancing of working capital needs our attention. Working capital is financed bothinternally and externally through long-term and short-term funds, through debt andownership funds. In financing working capital, the maturity pattern of sources offinance depended much coincide with credit period foi sales for better liquidity. Theseare basically three approaches to financing working capital. These are: the hedgingapproach, the conservative approach and the aggressive approach. These threeapproaches are presented in the chart 3.2. The management has to decide which approach it wants to adopt. Theessential difference between conservative and aggressive approach is ; The formeruses long term funds not only to finance permanent current assets, but also a part oftemporary current assets, while the later uses short term funds to finance a part ofpermanent current assets. Risk preferences of management shall decide the approachto be adopted. The risk neutral will adopt the hedging approach, the risk averse theconservative approach and risk seekers will adopt the aggressive approach. Figure 3.1 gives a summary of the relative costs and benefits of the threedifferent approaches:Fig 3.1 : Impact of Financing Approaches BSPATIL
  • 100. Factors Conservative Aggressive HedgingLiquidity More Less ModerateProfitability Less More ModerateCost More Less ModerateRisk Less More ModerateAsset utilization Less More ModerateWorking capital More Less Moderate Thus management of working capital is concerned with determining theinvestment needed and deciding the financing pattern. You would be now knowingthat deciding the financing pattern is essentially determining the size andcomposition of current liabilities in relation to those of current assets. Cost ofdifferent types of funds (the long-term and short-term funds), the return on differenttype of current assets, ability to bear risk, desired liquidity levels, etc. have to beconsidered to decide working capital management related issues. BSPATIL
  • 101. 3.4 FACTORS AFFECTING WORKING CAPITAL The level of working capital is influenced by a score effectors. In thissection let us examine the influencing factors. Nature of Business is one of the factors. Usually in trading businessesthe working capital needs are higher as most of their investment is foundconcentrated in stock. On the other hand, manufecturing/processing business needa relatively lower (compared to that of trading business/level of working capital. Theterms of ‘higher’ and ‘lower’ used above are relative and not absolute. That is, of thetotal capital employed in the businesses a higher or lower, as the case may be,portion is employed in current assets. Size of Business is also an influencing factor. As size increases, anabsolute increase in working capital is imminent and vice versa Chart 3.2 gives agraphic version.Chart 3.2 : Size of business and working capital Size of business Credit terms are important factors affecting the size and components ofworkings capital. Consider these: i) buy on credit and sell on cash, working capital is lower ii) buy on credit and sell on credit, working capital is medium iii) buy on cash and sell on cash, working capital is medium BSPATIL
  • 102. iv) buy on cash and sell on credit, working capital is higher In situation (i) referred to above it is likely, the firm has more cash andmore trade creditors and in situation (iv) it might be having less cash and more tradedebtors. Hence the impact of credit terms on size and composition of working capital. Credit policy influences the working level. A liberal credit policy ifadopted more trade debtors would result and when the same is tightened size ofdebtors gets slim. Credit periods also inflv ince the size and composition of working capital.When longer credit period is allowed to customers as against the one extended to thefirm by its suppliers, more working capital is needed and vice versa In the formercase, there will be a relatively higher trade debtors and in the latter there will be ahigher trade creditors. Collection policy is another influencing factor. A stringent collectionpolicy might not only deter away some credit seeking customers, also force existingcustomers to be prompt in settling dues resulting in lower level of working capital.The opposite is true with a liberal collection policy. Collection procedures do influence the level of working capital. Adecentralised collection of dues from customers and centralised payments tosuppliers, shall reduce the size of working capital. Centralised collections andcentralised payments or decentralised collections and decentralised payments wouldlead to a moderate level of working capital. But with centralised collections anddecentralised payments, the working capital need will be the highest.Seasonally of production is another influencing factor. Agriculture and food/fruitprocessing and preservation industries have a seasonal production. During seasonswhen production activities are in their peak working capital need is high. Seasonally in supply of raw materials affects the size of workingcapital. Industries that use raw materials which are available during seasons only, BSPATIL
  • 103. like flour and rice-milling industries, have to buy and stock wheat, paddy, etc. Theycannot afford jto buy these items in a phased way, since either supplies becometardier or prices become higher. From the point of view of quality of raw materialsalso, it pays to buy in bulk during the seasons. Hence the high level of workingcapital needed. Seasonality of demand for finished goods is yet another factor. In thecase of products like umbrella, rain-coats, text books and to some extent some of theconsumer durables like textile, jewellery, etc. the demand is seasonal, climate andfestival oriented. But the production has to be continuous throughout, though theoff-take is skewed. There happens a pile up of finished goods, resulting in higherworking capital. Trade cycle is another influencing factor. Trade cycle refers to theperiodic turns in business opportunities from extremely peak levels, via a slackeningto extremely trough levels and from there, via a recovery phase to peak levels, thuscompleting a cycle. There are four phases of a trade cycle. These and their featuresare: i) boom period: more business, more production, more working capital ii) depression period: less business, less production, less working capital iii) recession period: slackening business, stock pie-up, more working capital iv) recovery period: recouping business, stock moves fast, less working capital. Inflation has a bearing on level of working capital. Under inflationaryconditions generally working capital increases, since with rising prices demandreduces resulting in stock pile-up and consequent increase in working capital. Level of trading is another factor. There are two levels of trading, viz.over trading and under trading. Over trading means the business wants to maximizeturnover with inadequate stock level, hastened production cycle and swiftestcollection from debtors. Eventually the working capital will be lower. It is no good,however, for the business is starved of its legitimate working capital needs. Under BSPATIL
  • 104. trading is the opposite of over-trading. There is lethargy and overt lags. There resultsa higher work-capital. This is no good either, since the working capital is noteffectively utilized. It is wastage of capital. Length of the manufacturing process is an important factor influencingthe level of working capital. The time lapse between feeding of raw material into themachine and obtaining of the finished goods from out of the machine, is what isdescribed as the length of the manufacturing process. It is otherwise known as theconversion time. Longer this time period, higher is the volume and value of work-in-process and hence higher is the working capital and vice-versa. System of production process is another factor that has a bearing. Ifcapital intensive, high technology automated system is adopted for production, moreinvestment in fixed assets and less investment is current asses are involved. Also, theconversion time is likely to be lower, resulting in further drop in the level of workingcapital. On the other hand, if labour intensive technology is adopted less investmentin fixed assets and more investment in current assets (especially work-in-progressdue to inclusion of an enhanced wage component and prolonged processing) result. Finally rapidity of turnover comes. There is a negative correlationbetween rapidity of turnover and size of working capital. When sales are fast andswift, lower is the investment in working capital. Actually stock of inventory is veryminimum. But, when sales are happening far and in-between, i.e. rather slow, as inthe case of jewellery, elaborate investment in working capital results. Thus fastersales lead to lower working capital and vice-versa.3.5 ESTIMATION OF WORKING CAPITAL REQUIREMENT We nave already touched upon the aspect of planning of working capitalunder the sub-heading management of working capital. It is concerned withdetermining in advance the size and components of working capital. Two approachesto determining the size of working capital are dealt with.3.5.1 Estimation through components approach BSPATIL
  • 105. Here we take up one of the planning models of working capital toestimate working capital. The method adopted here attempts at estimation of working capital andits components by taking into account, the period for which the various items remainas stock or as outstanding, the cost structure of production and annual production.It assumes even production and even sales, throughout and what is produced iscompletely sold. Let us take an example. A companys cost sheet gives the following unit cost composition: Rawmaterial Rs.5; wages Rs. 4. production overhead Rs. 4; selling overhead Rs.2; profitRs.10 and therefore the selling price is = Rs.25 per unit. It expects to produce andsell 36,000 units the coming year for which It needs a working capital budget. Thefollowing turnover ratios are given:Age of raw materials = Average stock of raw materials = 45 days Average daily consumption of Raw materialAge of work-in-progress= Average work-in-progress inventory = 30 days Average cost of ProductionAge of furnished goods = Average finished stock inventory = 60 days Average cost of sales per dayAge of debtors = Average book debts = 50 days Average Credit sales per day = 30 days BSPATIL
  • 106. Age of Trade creditors = Average trade creditors Average credit per dayAge of Expense creditors = Average expenses outstanding = 15 days Average expenses per day With the above information one can find the working capital required bythe business. The same is attempted below. (Cash balance required Rs.20,000).Step 1: Computation of daily requirementsDaily requirements of = Annual production x Cost of raw materials In units per unit of outputRaw materials 360 days 36000 x 5 Rs. 500 = 360Similarly, Daily wage bill = 36000 x 4/360 = Rs.400 Daily production overhead bill = 36000 x 4 / 360 = Rs.400 Daily Selling overhead bill = 36000 x 2 / 360 – Rs. 200 Daily profit earnings = 36000 x 10 / 360 = Rs. 1000Step 2: Computation of component values of working capitala. Stock of raw material = Daily requirements x Age of raw materials = 500 x 45 = Rs. 22,500b. Stock of W-I-P = Daily requirement x Age of each component of Working in progress (i.e. WIP)i) Raw material component = Rs.500 x 30 = Rs. 15,000ii) Wages component = Rs.400 x 30 = Rs. 12,000 BSPATIL
  • 107. iii) Production overhead component = Rs.400 x 30 = Rs. 12,000 Total Rs. 39,000 BSPATIL
  • 108. c. Stock of finished goods = Daily requirement x Age of each component i) Raw material component = Rs.500 x 60 = Rs. 60,000 ii) Wages component = Rs.400 x 60 = Rs. 24,000 iii) Production overhead = Rs.400 x 60 = Rs. 24,000 iv) Selling overhead = Rs.200 x 60 = Rs. 12,000 Total Rs.l 12,000d. Value of outstanding debtors = Daily requirement x Age of eachcomponent i) Raw material component = Rs.500 x 50 = Rs. 25,000 ii) Wages component = Rs.400 x 50 = Rs. 20,000 iii) Production overhead component = Rs.400 x 50 = Rs. 20,000 iv) Selling overhead component = Rs.200 x 50 = Rs. 10,000 v) Profit = Rs. 1000 x 50 = Rs. 50,000 Total Rs. 125,000e. Value of outstanding creditors - daily raw material requirementsx age of creditors = Rs. 500 x 30 = Rs. 15,000f. Outstanding wages = daily wages x outstanding period or age in days = Rs.400 x 15 = Rs. 6,000g. Outstanding production overhead = daily expenses x outstanding period = Rs.400xl5 = Rs. 6,000h. Outstanding selling overhead = daily expense x outstanding period = Rs = 200 x l5 = Rs. 3,000Step 3 : Computation of working capital Add: Raw material stock Rs. 22,500 WIP Stock Rs. 39,000 Finished goods stock Rs. 90,000 Debtors Rs. 1,25,000 Cash (given value is taken) Rs. 20,000 Sub total Rs.2,96,000 Less: Outstanding creditors Rs. 15,000 BSPATIL
  • 109. Outstanding wages Rs. 6,000 Outstanding production overhead Rs. 6,000 Outstanding selling overhead Rs. 3,000 Subtotal (-) Rs. 30,000 Working capital needed Rs. 2,66,500 To this figure an amount towards contingency may be added. Taking a10% contingency need, the working capital required would be: Rs.2,66,500 + 10% ofRs,2,66,500 = Rs.2,66,500 + Rs.26,650 = Rs.2,93,150Note: Certain variations could be introduced in the above computations.For example,i) In respect of (i) WIP, the production overhead sub-component may be taken not atthe full value as in the above computation, but at say 70% or 80% of the same. Someauthors might even exclude the whole of production overheads regarding stock ofWIP. ii) In respect of finished goods stock, the selling overhead sub component maybe deleted or taken at say 50% or 60% of the level as the whole of selling expendituremight not have been expended but only a part, like distribution to regional depots,and the like has been spent, iii) In respect of debtors, the profit sub-component maybe deleted entirely for there is no out-of-pocket cost is involved. But from heopportunity cost point of view, the inclusion of the same is justified.3.5.2 Estimation through operating cycle approach It was earlier referred to that working capital is also known as revolvingcapital. That is, a circular path of conversion / re-conversion takes place. Considerthis example. You start your business operation with an initial investment. Withcredit extended by expense creditors (labour, employees, utilities, etc.) you startproduction process. Goods of varying levels of finish result. This is what we call aswork-in-process or work-in-progress. Once complete processing is done, you getfinished goods. Until these goods are sold, they remain in stock. Sales may be forcash and/or on credit basis. You need to wait a little to realize cash from the creditcustomers. The realized cash is used to pay creditors. You need to maintain a cashbalance for day-to-day transactions as well as for meeting sudden spurt in payment BSPATIL
  • 110. obligations accompanied by sluggish cash collections from debtors. Thus a revolutionor cycle from cash to raw materials to WIP, to finished goods, to debtors, and back tocash is taking place. This revolution or cycle is known as operating cycle. You maylook at the operating cycle in chart 3.3. BSPATIL
  • 111. Efficient woildng capital management is one which ensures continuousflow without any interruptions/holdups at any of the stages referred to above andinvolves as for as possible a rapid completion of the revolutions. In other words, whenraw materials remain in store pending issue for production for a less duration, whenraw materials get converted into WIP in short duration, when WIP is converted intofinished goods in short duration, when finished goods remain in dept pending salesfor a short while only, and when cash realizations out of sales are made quickly andfinally when payment to creditors is made slowly, the operating cycle would besmaller and consequently the working capital will also be reasonable. There should be neither too little nor too much investment in workingcapital. Efficient handling of the operating cycle would make pcssible the above. Note,what is suggested is optimization, and not minimizat :on of current assets andmaximization of current liabilities. That will affect your liquidity and yourprofitability. Too little means more illiquidiry, £ut more profitability, but not moreabsolute profits. We want both high profitability and high profits. Too much currentliability means illiquidity but more profitability as it is assumed short-term funds areless expensive for they can be redeemed the moment you dont need thus savinginterest. The reverse is true with too little current liability. Actually the business hasto trade-off between risk and return. If it wants less risk it has to carry more currentassets and less current liability. This will lead to lower profits. Low risk means lowprofits. If the business takes more risk, ie., it carries less working capital, it mightmake more profits. There is no guarantee however that higher level of risk yieldshigher profits. In terms of operating cycle concept, too long an operating cycle givesmore liquidity but only low returns and vice versa. The optimum operating cycle hasto be worked out taking into account the costs and benefits and levels of risk andlevels of return for varying lengths of operating cycle.Computation of length of operating cycle You can compute the length of operating cycle this way. Consider dieexample. BSPATIL
  • 112. Period covered 1 Year or 365 days Average credit period allowed by creditors 16 days Average total of debtors outstanding Rs. 4,80,000 Total consumption of raw material per annum Rs. 41,00,000 Total production cost per annum Rs. 10,000,000 Total cost of sales Rs. 10,500,000 Sales during the year Rs. 16,000,000 Value of stock maintained : Rs. 3,20,000 Raw materials Rs. 3,50,000 Work in progress Rs. 2,60,000 Finished goods stock (FGS) Rs. Calculate operating cycle (Here are used the formulae already given)Add: 3,20,000Age of raw materials = ———————————— = 27 days 44,00,000/365 3,50,000Age of WIP = ———————————— = 13 days 1,00,00,000/365 2,60,000Age of FGS = ———————————— = 9 days 10,500,000/365 4,80,000Age of Debtors = ———————————— = 11 days 16,000,000/365Sub Total 60 daysLess: Age of creditors (given directly) 16 daysLength of Operating Cycle 44 days BSPATIL
  • 113. Computation of working capital needed through operating cycle: The length of operating cycle can be used to estimate total workingcapital required. First, we have to calculate the number of operating cycles in theperiod under study, normally a year. No. of days in a yearSo, No. of Operating Cycles = ——————————————————— Length of operating cycle in days In the example we have taken, the no. of cycles per annum would be:365/44 = 8.3 times Cost of salesAmount of working capital = ———————————————————— No. of operating cycle In the case of ow( illustration, the amount of working capital thu» comes to Rs. 105,00,000 / 8:3 = Rs. 12,65,000. Hence the significance of operating cycle conceptin the efficient management of working capital. To this, cash balance required may be added to get working capital figure inclusive of cash balance as well.SOURCES OF WORKING CAPITAL Sources of working capital are many. There are both external or internalsources. The external sources are both short-term and long-term. Trade credit,commercial banks, finance companies, indigenous bankers, public deposits,advances from customers, accrual accounts, loans and advances from directors andgroup companies etc. are external short-term sources. Companies can also issuedebentures and invite public deposits for working capital which are external longterm sources. Equity funds may also be used for working capital. A brief discussionof each source is attempted below. Trade credit is a short term credit facility extended by suppliers of raw BSPATIL
  • 114. materials and other suppliers. It is a common source. It is an important source.Either open account credit or acceptance credit may be adopted. In the former as perbusiness custom credit is extended to the buyer, the buyer is not signing any debtinstrument as such. The invoice is the basic document. In the acceptance creditsystem a bill of exchange is drawn on the buyer who accepts and returns the same.The bill of exchange evidences the debt. Trade credit is an informal and readilyavailable credit facility. It is unsecured. It is flexible too; that is advance retirement orextension of credit period can be negotiated. Trade credit might be costlier as thesupplier may inflate the price to account for the loss of interest for delayed payment. Commercial banks are the next important source of working capitalfinance commercial banking system in the country is broad based and fairlydeveloped. Straight loans, cash credits, hypothecation loans, pledge loans, overdraftsand bill purchase and discounting are the principal forms of working capital financeprovided by commercial banks. Straight loans are given with or without security. Aone time lump-sum payment is made, while repayments may be periodical or onetime. Cash credit is an arrangement by which the customers (business concerns) aregiven borrowing facility upto certain limit, the limit being subjected to examinationand revision year after year. Interest is charged on actual borrowings, though acommitment charge for utilization may be charged. Hypothecation advance isgranted on the hypothecation of stock or other asset It is a secured loan. Theborrower can deal with the goods. Pledge loans are made against physical deposit ofsecurity in the banks custody. Here the borrower cannot deal with the goods untilthe loan is setded. Overdraft facility is given to current account holding customerst^ overdraw the account upto certain limit. It is a very common form of extendingworking capital assistance. Bill financing by purchasing or discounting bills ofexchange is another common form of financing. Here, the seller of goods on creditdraws a bill on the buyer and the latter accepts the same. The bill is discounted percash will the banker. This is a popular form. Finance companies abound in the country. About 50000 companiesexist at present. They provide services almost similar to banks, though not they arebanks. They provide need based loans and sometimes arrange loans from others forcustomers. Interest rate is higher. But timely assistance may be obtained. BSPATIL
  • 115. Indigenous bankers also abound and provide financial assistance tosmall business and trades. They change exorbitant rates of interest by very muchunderstanding. Public deposits are unsecured deposits raised by businesses for periodsexceeding a year but not more than 3 years by manufacturing concerns and not morethan 5 years by non-banking finance companies. The RBI is regulating deposit takingby these companies in order to protect the depositors. Quantity restriction is placedat 25% of paid up capital + free services for deposits solicited from public isprescribed for non-banking manufacturing concerns. The rate of interest ceiling isalso fixed. This form of workim capital financing is resorted to by well establishedcompanies. Advances from customers are normally demanded by producers ofcostly goods at the time of accepting orders for supply of goods. Contractors mightalso demand advance from customers. Where sellers* market prevail advances fromcustomers may be insisted. In certain cases to ensure performance of contract inadvance may be insisted. Accrual accounts are simply outstanding dues to workers, suppliers ofoverhead service requirements and the like. Outstanding wages, taxes due, dividendprovision, etc. are accrual accounts providing working capital finance for short periodon a regular basis. Loans from directors, loans from group companies etc. constituteanother source of working capital. Cash rich companies lend to liquidity crunchcompanies of the group. Commercial papers are usance promissory notes negotiable byendorsement and delivery. Since 1990 CPs came to be introduced. There arerestrictive conditions as to issue of commercial papers. CPs are privately placed afterRBIs approval with any firm, incorporated or not, any bank or financial institution.Big and sound companies generally float CPs. BSPATIL
  • 116. Debentures and equity fund can be issued to finance working capital sothat the permanent working capital can be matchingly financed through long termfiinds.3.6 TANDON COMMITTEE RECOMMENDATIONS Tandon committee was appointed by RBI in July 1974 under thechairpersonship of Shri. P.L.Tandon who was the Chairman of PNB then. The termsof references of the committee were: i) To suggest guidelines for commercial banks to follow up and supervise credit from the point of view of ensuring proper use of funds and keeping a watch on the safety of advances. ii) 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 from the lending banks. iii) To make suggestions for prescribing inventory norms for different industries both in the private and public sectors and indicate the broad criteria for deviating from these norms. iv) To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to borrowing. v) To make recommendations regarding resources for financing the minimum working capital requirements. vi) To suggest whether the existing pattern of financing working capital requirements by cash credit/overdraft requires to be modified, if so, to suggest suitable modification. BSPATIL
  • 117. Findings of the committee: The committee studied the existing system ofextending working capital finance to industry and identified the following as its majorweaknesses: i) It is the borrower who decides how much he would borrow. The banker cannot do any credit planning since he does not decide how much he would lend. ii) Bank credit, instead of being taken as a supplementary to other source of finance, is treated as the first source of finance. iii) Bank credit is extended on the account of secuntv available and not according to the level of operations of the borrower. iv) There is a wrong notion that security by itself ensures the safety of bank funds. As a matter of fact safety essentially lies in efficient follow-up of the industrial operations of the borrower. Commitment Recommendations: The report submitted by the TandonCommittee introduced major changes in financing of working capital by commercialbanks in India. The report was submitted on 9th August 1975. Fixation of norms. An important feature of the Tandon Committeesrecommendations relate of fixation of norms for bank lending to industry.i) Working capita! gap In order to reduce the dependence of businesses on banks to; workingcapital, ceiling on bank credit to individual firms has been prescribed. Accordingly,businesses have to compute the current assets requirement on the basis ofstipulations as to size. So, flabby inventory, speculative inventory cannot be carriedon with bank finance. Normal current liabilities, other than bank finance, are alsoworked out considering industry and geographical features and factors. Workingcapital gap is the excess of current assets as per stipulations over normal current BSPATIL
  • 118. liabilities (other than bank assistance). Bank assistance for working capital shall bebased on the working capital gap, instead of the current assets need of a business.This type of financing assistance by banks was introduced on the basis ofrecommendations of Tandon Committee.ii) Inventory and Receivables norms: The committee has suggested norms for15 major industries. The norms proposed represent the maximum level for holding inventoriesand receivables. They pertain to the following: i) Raw materials including stores and other items used in the process of manufacture. ii) Stock in process iii) Finished goods iv) Receivables and bills discounted and purchased. Raw materials are expressed so many months cost of production Stockin process is expressed as so many months cost of production. Finished goods andreceivables are expressed as so many months cost of sales and sales respectively.iii) Lending norms : The lending norms have been suggested in view of threalization that the bankers role as a lender is only to supplement the borrower*resources. The committee has suggested three alternative methods for wor out themaximum permissible level of bank borrowings. Each successive me reduces theinvolvement of short-term credit to finance the current assets, increases the use oflong term funds. The first method provided for a maximum 75% of bank funding of theworking capital gap. That is, at least 25% of working capital gap must be financedthrough long term funds. The second method provided for full bank financing of BSPATIL
  • 119. working capital gap based on 75% of current assets only. That is, 25% of currentassets should be financed through long term fund. 25% of current assets is greaterthan 25% of working capital gap. Hence 2nd method meant more non-bank finance forworking capital. The third method provided for long- term fimd financing of wholepermanent current asset and 25% of varying ci assets. That is bank financing will belimited to working capital gap computed taking 75% of varying current assets only. The three methods are discussed below to show permitted funding ofworking capital: BSPATIL
  • 120. Items Method 1 Method 2 Method 3Core current assets 2,00,000 2,00,000 2,00,000Varying current assets 7,00,000 7,00,000 7,00,000Total 9,00,000 9,00,000 9,00,000Less: Long-term FundTo the extent of core - - 2,00,000current asset 9,00,000 9,00,000 7,00,000Less: Long-term fundTo the extent of 25% - 2,25,000 1,75,000current assets or balance ofcurrent asset (method 3) 9,00,000 6,75,000 5,25,000Less:Financed by short term 3,00,000 3,00,000 3,00,000other than bank (Say Rs.4,00,000) 6,00,000 3,75,000 2,25,000Less:25% of WCG financed by I 1,25,000 - -torn foods (method 1)Maximum Bank Funding 4,75,000 3,75,000 2,25,000Of the total current assets, 1,25,000 2,00,000 3,50,000long-term fund financingamounted to: BSPATIL
  • 121. Current Ratio: CA 8,00,000 8,00,000 8,00,000 CL 7,00,000 6,00,000 4,50,000 = 1.14 = 1.33 = 1.78 Today, Tandon committee recommendations are not relevant. Nowjbanks are flush with funds. But good borrowers arent many. Tandon committeerecommendations were relevant when controlled economy prepared. Today, it is openeconomy. Besides, these recommendations were relevant in these years j when moneymarket was tight and capital rationing was needed. Today, whole environment haschanged. Now banks want to provide long-term loans well. Actually from April 15,1997, all instructions relating to maximt permissible bank finance (MPBF) were withdrawn.3.7 CHORE COMMITTEE RECOMMENDATIONS Following the Tandon Committee the Chore Committee under theChairmanship of Shri. K.B.Chore, of RBI, was constituted in April 1979. terms ofreference were: i) to review the working of cash credit system. ii) to study the gap between sanctioned and utilized cash credit levels. iii) to suggest measures to ensure better credit discipline. iv) to suggest measures to enable banks to relate credit limits with oil levels. The recommendations of the committee were: i) To continue the present system of working capital financing, vizi/ credit, bill finance and loan. ii) If possible supplement cash credit system by bill and loan financing. iii) To oeriodicallv review cash credit levels. iv) No need to bifurcate cash credit accounts into demand loan and cash credit BSPATIL
  • 122. components. v) To fix peak level and non-peak level limits of bank assistance wherever, seasonal factors significantly affect level of business activity. vi) Borrowers to indicate before commencement of each quarter the requirement of bank credit within peak and non-peak level limits sanctioned. A variation of 10% is to be tolerated. vii) Excess or under utilization beyond 10% tolerance level is to be considered as irregularity and corrective actions b? taken up. viii) Quarterly statement of budget and performance be submitted by all borrowers having Rs.50 lakh working capital limit from the whole of banking system. ix) To discourage borrowers depending on adhoc assistances over and above sanctioned levels. x) The second method of financing of working capital as suggested by the Tandon committee be uniformly adopted by banks. xi) To treat as working capital term loan the excess of bank funding when the switch over to the second method bank financing is adopted and the borrower is not able to repay the excess loan.MARATHE COMMITTEE RECOMMENDATIONS Later Marathe Committee was appointed to suggest meaningful dirctions to thecredit Management function of the RBI. The recommendations are: i) the second method of financing Tandon committee should be followed ii) fast-track system of advance releasing upto 50% of additional credit BSPATIL
  • 123. required by borrowers pending RBIs approval of such enhanced credit authorization. iii) the bank should ensure the reasonableness of projections as to sales, current assets, current liability, net working capital by looking into past performance and assumptions of the future trend. iv) the current assets and liabilities to be classified in conformity with the I guidelines issued by the RB1. For instance current liability should include any liability that needs to be retired within 12 months from the] date of previous balance sheet. v) a minimum of 1.33 current ratio should be maintained. That is, 25% of current assets should be financed from long term funds. vi) a quarterly information system (Q1SO giving details as to project level of current assets and current liabilities be evolved such that information is given to the banker in the week preceding commencement of the quarter to which the data are related, adopted. vii) a quarterly performance reporting system giving data on performs within 6 weeks following the end of the quarter to which the ds related be adopted. viii) a half yearly operating and fund flow statement to be submitted 2 months from the close of the half-year. ix) the banker should review the borrowers accounts at least once3.9 VAZ COMMITTEE RECOMMENDATIONS As per VAZ committee recommendations working requirement is taken as25% of annual turnover, and the borrower has^ 5% of projected turnover from long-term sources as his contribution projected turnover will be provided by the financingbank. Thus," for working capital is totally de-linked from current assets level Hence BSPATIL
  • 124. the total departure from Tandon and Chore committee recommendations. Since15-4-1997, banks were instructed to evolve their own method such of turnovermethod, the cash budget system or any other system including erstwhile workingcapital gap system, for assessing the working capital needs of businesses.3.10 SUMMARV Working capital is the life sustaining system of businesses. There aredifferent types and concepts of working capital. Permanent working capital,temporary working capital, gross working capital and net working capital arc differenttypes. There are aggressive, matching and conservative approaches to financingworking capital. Trade credit, bank finance, internal accruals, debt ttd equityfinances are used to finance working capital.3.11 SELF ASSESSMENT QUESTIONS 1. Define working capital and describe its components 2. Bring out the kinds and concepts of working capital and the nature and significance each type of working capital 3. What do you mean by working capital management? What approaches would you adopt to ensure effectiveness? 4. Discuss clearly the factors affecting the size and composition of working capital. 5. Explain how would you plan the working capital requirements of a manufacturing undertaking. 6. What is operating cycle? Explain its significance in the context of estimation of working capital and ensuring efficient management of working capital. 7. Explain the different sources of working capital finance. BSPATIL
  • 125. 8. What is working capital gap? Explain the Tandon Committee views about the same. 9. Discuss the terms of reference and recommendations of the Tandon Committee. Give the impact on financing of working capital. 10.What are the recommendations of Chore Committee? Explain them. 11.The cost structure for a firm is: Raw materials Rs. 10 per unit; labour Rs. per unit; overhead Rs.10 per unit; profit Rs.7 per unit. Credit allowed creditors is 2 months and allowed to debtors is 3 months. Time lag payment of expenses 1 month. Production and consumption are equal even. For an equal production of 1,80,000 units prepare working budget. Cash balance required is Rs. 50,000 and provision for continj is required at 5%. 12.A business has projected its turnover as Rs.12 crs. As per Vaz coi find its working capital need and extent of bank finance. 13.Now bank finance for working capital is de-linked from current Examine implications of such a policy. 14.A firms cost of goods sold is expected to be Rs.6 crs. Expected operating cycle is 90 days. It wants to keep a cash balance of 1% of cost of] sold. Find its expected working capital taking 360 days in the year.REFERENCES 1. Financial Management and Policy - Van Home. 2. Financial Decision Making – Hampton 3. Management of Finance-Weston and Brigham 4. Financial Management - P.Chandra 5. Financial Management - Ravi M. Kishore BSPATIL
  • 126. UNIT-4 CAPITAL BUDGETING In this unit you will learn capital projects, significance of capitalbudgeting, appraisal techniques of capital projects, under conditions of certainty, riskand uncertainty, etc.INTRODUCflON Capital budgeting is budgeting for capital projects. TTie exercise involvesascertaining / estimating cash inflows and outflows, matching the cash inflows withthe outflows appropriately and evaluation of the desirability of the project,4.1 CAPITAL PROJECTS Businesses invest in capital projects of different nature. These capital projectsinvolve investment in physical assets, as opposed to financial assets like shares,bonds or funds. Capital projects necessarily involve processing/manufacturing/service works. These require investments with a longer time horizon.The initial investment is heavy in fixed assets and investment in permanent workingcapital is also heavy. The benefits from the projects last for few to many years. Capital projects may be new ones, expansion of existing ones, [diversification ofexisting ones, renovation or rehabilitation of infirm ones, R&D activities, or captiveservice projects. An enterprise may put up a new subsidiary, stake in existingsubsidiary or acquire a running firm. All these are isidered capital projects. Capital projects involve huge outlay and last for years. Hence are riskierthan investments in financial assets. Capital projects have iclogical dimension andenvironmental dimension. So, careful analysis needed. Decisions once taken cannotbe reversed in respect of capital rts. So, "listen before leaping" and "think beforejumping" are the caveats 1. Thorough evaluation of costs and benefits is needed. BSPATIL
  • 127. 4.2 SIGNIFICANCE OF CAPITAL BUDGETING Every business has to commit funds in fixed assets and permanentworking capital. The type of fixed assets that a firm owns influences i) the pattern ofits cost (i.e. high or low fixed cost per unit given a certain volume of production), ii)the minimum price the firm has to charge per unit of product, iii) the break-evenposition of the company, iv) the operating leverage of the business and so on. Theseare all very vital issues shaping the profitability and risk complexion of the business.Hence the significance of capital budgeting. Capital budgeting is significant because it deals with right kind of ievaluation of projects. A project must be scientifically evaluated, so that undue favouror dis-favour is shown to a project A good project must not U; rejected and a badproject must not be selected. Hence the significance of capitalf budgeting. Capital investment proposals involve i) longer gestation period, ii) hugecapital outlay, iii) technological considerations needing technoloj forecasting, iv)environmental issues too, which require the extension of scope of evaluation to gobeyond economic costs and benefits, v) irreversit decision once get committed, vi)considerable peep into the future which > normally very difficult, vii) measuring ofand dealing with project risks whu a daunting task in deed and so on. All these makecapital budgeting a signifk task. Capital budgeting involves capital rationing. That is the avail fundsmust be allocated to competing projects in the order of project potentials. Usually, theindivisibility of project poses the problem of capital ratk because required funds andavailable funds may not be the same. A slightly 1 return projects involving higheroutlay may have to be skipped to choose with slightly lower return but requiring lessoutlay. This type of trade-off has) be skillfully made.The building blocks of capital budgeting exercise are estimates of price and variablecost per unit output, quantity of output thai, be sold, the tax rate, the cost of capital,the useful life of the project, etc. period of years. A clear system of forecasting isneeded. Hence the signifk of capital budgeting. What should be the discount rate? Should it be the pre-tax overall cost of BSPATIL
  • 128. capital? Or the post-tax overall cost of capital? The choice is very crucial makingcapital budgeting exercises significant ones. Finally, which is the appropriate method of evaluation of projects There isa dozen or more methods. The choice of method is important. And different methodsmight rank projects differently leading to a confused picture of project desirabilityranks. A clear thinking is needed so that confusion is not descending on the choice ofprojects. Hence the significance of capital budgeting. ,4.3 APPRAISAL OF CAPITAL PROJECTS Appraisal means examination and evaluation. Capital projects need to bethoroughly appraised as to costs and benefits. The costs of capital projects include the initial investment at theinception of the project. Initial investment made in land, building, machinery, plant,equipment, furniture, fixtures, etc. generally, gives the installed capacity. Investmentin these fixed assets is one time. Further a one-time investment in working capital isneeded in the beginning, which is fully salvaged at the end of the life of the project Against this fund committed returns in the form of net cash earnings areexpected. Net cash earnings - sales - variable cost - Fixed cost: (includingdepreciation, Tax + Depreciation. These are computed as follows. T stand for price perunit, ‘V for variable cost per unit, ‘Q’ for quantity & sold, ‘F’ stand to total fixedexpenses exclusive of Depreciation, stand to depreciation on fixed assets, T forinterest on borrowed capital T for tax rate).Then cash earnings = [(P-V)Q-F-D-I](1 -T) + D These cash earnings have to be estimated through out the lie life of theinvestment. That is, all the variables in the equation have to be forecast well over aperiod of years. Now that, we have the benefits from the investment estimated, the same BSPATIL
  • 129. may be compared with costs of the capital project and netted to find out whether costs exceed benefits or benefits exceed costs. This process of estimation of costs and benefits and comparison of the same is called appraisal. Payback period, accounting rate of return, net present value, internal rate of return, decision tree technique, sensitivity analysis, simulation analysis and capital asset pricing model (CAPM) are certain methods of appraisal. 4.4 REQUISITES FOR APPRAISAL OF CAPITAL PROJECTS The computation of profit after tax and cash flow are mucbj relevant in evaluation of projects. Hence this is presented here as a prelude better understanding the whole process. Say in fixed assets at time zero, you are investing Rs.20 lakhs. You have estimated the following for the next 4 years.Year Expected Expected Tax Expected Fixed Sales selling price rate Variable expenses (Units) cost per (excluding unit depreciation) (Q) (P) (T) (V) (F) Rs. Rs. Rs. 1 30000 200 30% 100 12,00,000 2 30000 250 30% 120 13,00,000 3 20000 300 40% 150 14,00,000 4 21000 300 40% 200 15,00,000 With this information we can estimate profit after tax for business. For that, apart the given variable expenses and fixed expenses depreciation of the fixed assets has to be considered. The annual depreciation is given by the cost of fixed assets divided by number of life. In our case the figure comes to Rs. 20,00,000/4 = Rs.5 lakhs. The calculations are given in three stages, viz. computation of profit before tax (PBT), profit after tax (PAT) and cash flow. BSPATIL
  • 130. The profit before tax (PBT) for a period is given by: (selling price per unit - variable cost per unit) * (No, of units sold) - Fixed expenses - Depreciation. So, for the 1st year PBT = (200-100) (30000) - 12,00,000 - 5,00,000 = 30,00,000 - 1 7,00,000 = 13,00,000. Table 4.1 gives the working and results. Table 4.1Year (P-V) * (Q) - F - Dep. = PBT Rs. Rs. Rs. 1 (200-100) * (30000) - 12,00,000 - 5,00,000 = 13,00,000 2 (250-120) * (30000) - 13,00,000 - 5,00,000 = 21,00,000 3 (300-150) * (20000) - 14,00,000 - 5,00,000 = 11,00,000 4 (300-200) * (21000) - 15,00,000 - 5,00,000 = 1,00,000 Profit after tax (PAT) for the different years is obtained by tax from the PBT. Profit after tax - PAT « PBT (1-Tax Rate. So, for the first year T- 13,00,000 (1-30%) = 13,00,000 (0.7) = 9,10,000. Similarly for the other . the profit figures can be obtained as in table 4.2. Year Table 4.2 PBT Tax Tax = (PAT) x (Tax (PAT = PBT -Tax) Year Rs. rate Rate) or PBT(l-TR) 1 13,00,000 30% 3,90,000 9,10,000 2 21,00,000 30% 6,30,000 14,70,000 3 11,00,000 40% 4,40,000 6,60,000 4 1,00,000 40% 40,000 60,000 BSPATIL
  • 131. Total 46,00,000 - 15,00,000 31,00,000 Cash-flow from business is equal to PAT plus depreciation. Ti 4.3 givescash flow from business.Year PAT + Rs. + DEP Rs. = Cash Flow Cumultaive Rs. Cash Flow Rs. 1 9,10,000 + 5,00,000 = 14,10,000 14,10,000 2 14,70,000 + 5,00,000 = 19,70,000 33,80,000 3 6,60,000 + 5,00,000 = 11,60,000 45,40,000 4 60,000 + 5,00,000 = 5,60,000 51,00,0004.5 PAYBACK PERIOD (PBP) METHOD Pay back period refers to the number of years one has to back the capitalinvested in fixed assets in the beginning. For this we have’ cash flow from business. We have invested Rs. 20,00,000 at time zero. After one year a sum ofRs.14,10,000 is returned By next year a sum of Rs. 19,70,000 is returned. But wehave to get back only Rs. 5,90,000 (i.e 20,00,00 - 14,10,000). So, in the second wehave to wait only for part of the year to get backRs. 5,90,000. The part of the year -5,90,000/19,70,000 - 0.30. That is, pay back period is 1.30 years or 1 year, 3months and 19 days. In general pay-back period is given by V in the equation n Σ CFt - I = 0. t-1where ‘t’ = 1 to n, I = initial investment, CF t = cash flow at time t and t = time red inyears. Normally business as want projects that have lease pay back period,because the invested money is got back very soon. As future is risky, earlier one gets BSPATIL
  • 132. back the money invested the better for him. Some businesses fix a maximum limit onpay back period. This is the cut-off pay back period, ig as the decision criterion.Accordingly a pay back period ceiling of 3 years means, only projects with paybackperiod equal to or Jess than 3 years will be accepted.Merits of payback period i) It s cash flow based which is a definite concept ii) Liquidity aspect is taken care of well iii) Risky projects are avoided by going for low gestation period projects iv) It is simple, common sense oriented,Demrits of payback period i) Time value of money is not considered as earnings of all years are simply added together. ii) Explicit consideration for risk is not involved iii) Post-payback period profitability is ignored totally.4.6 ACCOUNTING RATE OF RETURN (ARR) METHOD Here the accounting rate of return (ARR) is calculated. It is also called asaverage rate of return. To compute ARR average annual profit is calculated first. Fromthe PBT for different years (as in table 4.1) average annual PBT can calculated.The average annual PBT = Total PBT / No. of years AAPBT = 46,00,000/4 = 11,50,000ARR = AAPBT / Investment = 11,50,000 / 20,00,000 - 0.574 = 57.4% The denominator can be average investment, i.e., (original value plusterminal value)/2. Here it is 10 lakhs. Then the ARR will beRs.11,50,000/Rs.10,00,000 = 1.148 or 114.8% BSPATIL
  • 133. ARR can also be computed on the basis of PAT. The formula is AverageAnnual PAT / Original investment.Average Annual PAT = Total PAT / No. of years = 31,00,000/4 = 7,75,000 So, ARR = 7,75,000 / 20,00,00 = 0.3875 = 38.75% The denominator can be the average investment, instead of originalinvestment, then ARR is - Rs.7,75,000 / Rs. 10,00,000 = 0.775 or 77.5%.Merits of ARR i) It is simple, common sense oriented ii) Profits of all years taken into accountDemerits of ARR i) Time value of-money is not considered ii) Risk involved in the project is not considered iii) Annual average profits might be same for different projects but accrual of profits might differ having significant implications on risk and liquidity iv) The ARR has several variants and that it lacks uniform understanding. A minimum ARR is fixed as the benchmark rate or cut-off rate. Theestimated ARR for an investment must be equal to or more than this {benchmark orcut off rate so that the investment or project is chosen.4.7 NET PRESENT VALUE (NPV) METHOD Net present value is computed given the original investment, anual cashflows (PAT + Depreciation) and required rate of return which is equal to the cost ofcapital. Given these, NPV is calculated as follows n BSPATIL
  • 134. NPV = - I + Σ CFt / (l + k)t t=1I = Original or initial investmentCFt = annual cash flowsK = cost of capital andt = time measured in years. For the problem we have done under the pay back period method we canget the NPV, taking k = say 10% or 0.1. Then theNPV = -I + CF1 / (1+k)1 + CF2 / (1+k)2 + CF3 /(I+k)3 + CF4/(l+k)4 = 20,00,000+14,10,000/1.1+19,70,000/1.12+11,60,000/1.13+5,60,000/1.14= - 20,00,000 + 14,10,000x0.909 + 19,70,000x0.826 + 11,60,000x0.751 + 5,60,000x0.683= - 20,00,000 + 12,81,818 +16,28,099 + 8,71,525 + 3,79,042= - 20,00,000 + 41,60,484 = Rs. 21,60,484 If it is required that k = 10%, 11%, 12% and 13% respectively for year 4through year 4, the formula is written as follows.NPV = -I CFt/(l+kt)t = -I + CF1 / (1+k1)1 + CF2 / (l-fk2)2 + CF3 /(l+k3)3 +In the above exampleNPV = -20,00,000+14,10,000/1.1+19,70,000/1.112+11,60,000/1.123+ 5,60,000/1.134=-20,00,000+14,10,OOOx0.909+19J70,OOOx0.817+ll,60,OOOx0.712+ 5,60,000 x 0.635= - 20,00,000 + 40,49,482 = Rs. 20,49,482 BSPATIL
  • 135. If the NPV – 0’ or greater than zero, the project can be case there areseveral mutually exclusive projects with NPV >0, we will the one with highest NPV. Inthe case of mutually inclusive projects you first take up the one with highest NPV,next the project with next highest NPV, and so on as long as your fund forinvestments lasts. The factor "k" need not be same for all projects. It can be high forprojects whose cash flows suffer greater fluctuations due to risk, and lower forprojects with lower fluctuation.4.8 INTERNAL RATE OF RETURN (IRR) METHOD Internal Rate of Return (IRR) is the value of "k" in the eqation, -I + Σ CFt/ (1+k)t - 0. In other words, IRR is that value of "k" for which aggregated discountedvalue of cash flows from the project is equal to original investment in the projectWhen manually computed, "k" i.e., IRR is got through trial and error and if need be,adopting a sort of interpolation. Suppose for a particular value of k, -I + Σ CFt / (l+k)t> 0, we have to use a higher k in our next trial and if the value is < 0, a lower k’ hasto employed next time. Then you can interpolate k. The value of k thus got is theIRR. For the project in question (dealt under NPV), the IRR is worked out as follows; If we take, k = 50%, then, Σ CFt/(l+k)t comes to 22,69,877 i.e.,[14,10,000/1.5 + 19,70,000/1.52+ 11,60,000/1.53 + 5,60,000/1.54]. This is higrierfan the T by 2,69,877. So, V is enhanced to 60%. Then 14,10,000/1.6 +19,70,000/1.62 + 11,60,000/1.63 + 5,60,000/1.64, i.e., Σ CFt / (l+k)t comesto !fti20,19,433. This is marginally higher than T. So, we have to still try at rate, say 61%. The PV comes to Rs.19,97,083. Now, we can take theinterpolated value as the IRR, which is between 60% and 61%.IIRR = 60% + [(20,19,433 - 20,00,000)/(20,19,423 - 19,97,083)] X (61%-60%) = 60% + [19433/22350 ] X 1% = 60% + 0.869% = 60.869% If the computed IRR is equal to or greater than cost of capital, the t willbe selected. Otherwise, it is rejected. For mutually exclusive projects, project withhighest IRR, subject to it being equal to or greater than cost of capital, will be chosen. BSPATIL
  • 136. For mutually inclusive projects, you start taking up first the project with highest IRR,next, the next highest IRR project and so on subject to (i) the IRR is greater than orequal to cost of capital and (ii) you have investible fund.4.9 DECISION TREE APPROACH Decision tree approach is a versatile tools used for decision makingunder conditions of risk. The features of this approach are: (1) it takes into accountthe results of all expected outcomes, (ii) it is suitable where decisions are to be madein sequential parts - that is, if this has happened already, what will happen next andwhat decision has to follow, (iii) every possible outcome is weighed using jointprobability model and expected outcome worked out, (iv) a tree-form pictorialpresentation of all possible outcomes is presented here and hence the term decision-tree is used. An example will make understanding easier. An entrepreneur is interested in a project, say introduction of a fashionproduct for which a 2 year market span is foreseen, after which thej product turnsfade and that within the two years all money invested must be] realised back in full.The project costs Rs. 4,00,000 at the time of inception. During 1st year, three possible market outcomes are foreseen. Lowpenetration, moderate penetration and high penetration are the three outcome whoseprobability values, respectively, are 0.3, (i.e., 30% chance), 0.4 and and the cashflows after tax under the three possible outcomes are respects estimated to beRs.1,60,000, Rs. 2,20,000 and Rs. 3,00,000. The level of penetration during the 2nd year is influenced by le ofpenetration in the first year. The probability values of different penetratw levels in the2nd year given the level of penetration in the lsl year and respecth cash flows areestimated as follows: BSPATIL
  • 137. Level of If low penetration If moderate If highPenetration in first year penetration penetration in in first year in first year year 2 Cash flow year 2 Cash flow year 2 Cash flow year 2 Amount Prob. Amount Prob. Amount Prob.Low 80000 0.2 260000 0.3 320000 0.1Moderate 200000 0.6 300000 0.4 400000 0.8High 300000 0.2 320000 0.3 480000 0.1 How do you read the above table? It is very simple, penetration resultedin 1st year, low presentation in 2nd year with probability of 0.2 and cash flow ofRs.80,000, moderate penetration in 2nd year with probability of 0.6 and cash flow ofRs.2,00,000 and high penetration in 2nd year with probability of 0.2 and cash flow ofRs.3,00,000 are possible. Similarly you can follow for other cases. Combining 1st and 2nd year penetration levels together, 9 outcomes arepossible. These are: S. 1st Year 2nd vear 1st year 1st year 2nd 2nd year Joint pro- No. penetra- penetra- cash probability year proba- bability tion tion flow (P1) cash bility (P1xP2) flow (P2)1 Low LOW 160000 .3 80000 -2 0.052 Low Moderate 160000 .3 200000 .6 0.183 Low High 160000 .3 300000 .3 0.064 Moderate Low 220000 .4 260000 .3 0.125 Moderate Moderate 220000 .4 300000 .4 0.166 Moderate High 220000 .4 320000 -3 0.127 High Low 300000 .3 320000 .1 0,038 High Moderate 300000 .3 400000 .8 0.249 High High 300000 .3 480000 .1 0.03 At this stage, we may go for present value evaluation of these set of BSPATIL
  • 138. outcomes. And this is done below. For this we require a discounting rate. Let take a10% discount rate. Then the present value of Rs. 1 receivable at 1st year isRs.0.909(i.e. 1/1.1) and at 2nd year end is Rs.0.826 (i.e., 1/1.12). Now the resent values of the9 cash flow streams can be worked out. These values, the ?V relevant to each stream(i.e., the aggregate of the present value of the two flows of each stream minusinvestment Rs.4,00,000), joint probability (i.e., luct of probabilities of the two cashflows of each stream) and expected lue of NPV (i.e., joint probability times NPV ofeach stream) are given below liable 4.5.Table 4.5S.No. PVofi* PVof 2nd PV of both NPV of each Joint Expected year flow year flow year flows stream Prob. NPV. (1) (2) (3) (4) = (2)+(3) (5)=(4)-40000 (6) (7)=(5) (6) 0 1 145440 50080 195520 -204480 0.06 - 122691 2 145440 165200 310640 - 89360 0.18 - 16085 3 145440 247800 393240 - 6760 0.06 - 403 4 199980 214760 414740 14740 0.12 1709 5 199980 247800 447780 47780 0.16 7645 6 199980 264320 464300 64300 0.12 7716 7 272700 264320 537120 137130 0.03 4111 8 272700 330400 603100 203100 0.24 48744 9 272700 346920 619620 219620 0.03 6889 Total 1.00 47395 The expected NPV of the project is negative at Rs. 12269 if lowpenetration prevailed both in the 1st and 2nd year and this has a probability of 6 out of100 or .06. The expected NPV is negative at Rs.16085, if low penetration in 1 st yearand moderate penetration in 2nd year prevailed and the probabilit this happening is18%. S.No.8 tells that NPV of Rs.48744 with probability of 24% is possible when highpenetration in first year and moderate penetration in the 2 year result. The expectedNPV of the project is the aggregate of the expected NPVs of the different streams == BSPATIL
  • 139. Rs.47395. Since, it is positive, the project may be taken up.4.10 CAPITAL ASSET PRICING MODEL (CAPM) Capital Asset Pricing Model (CAPM) is one of the premier methods ofevaluation of capital investment proposals. CAPM gives a mechanism by which therequired rate of return for a diversified portfolio of projects can be calculated giventhe risk. According to CAPM the required rate of return comprised of two parts: first,a rise-free rate of return and second a risk premium for the amount of systematic riskof the portfolio. The formula is: Required rate of return = Rf + (Rm- Rf) B whenRf - risk free rate of returnRm - return on market portfolioBi - Beta or risk coefficient of the evaluated portfolio given market portfolio beta= l. CAPM, therefore, gives a risk-return relationship for portfolio of projects.4.10.1 CAM technique for evaluating capital projects Just we have to calculate the required rate of return for the capital projectgiven its beta coefficient, risk free return and market return. Then get the estimatedreturn for the project. If the estimated return for the project is greater than or equalto the required rate of return accept the project Otherwise reject the project. The risk-free return is the rate of cejurp obtainable on risk freeinvestments, like investment in government bonds. The market rate of return is the grand average rate of return obtainableon market representative portfolio. A surrogate for this can be return ofrepresentative market indices like NASDAG, DOW JONES INDUSTRIAL, 500, BSE BSPATIL
  • 140. SENSEX (India), and the like. Beta of the project -covariance between returns of the project and chosenmarket portfolio divided by variance of the return on the market portfolio. The returnsreferred to here can be historical or future expected or both. So, given the returns(expected or actual) of the market portfolio over a period of time and those of thecapital project over the same time horizon as above, beta of the project can becalculated. The formula is : Beta = Σ (Rm-MRm) (Ri- MRi)/ Σ (Rm – MRm)2When Rm = return on market portfolio over timesMRm = mean return on market portfolioRi = returns on the capital project over timesMRm = mean return of the capital project Suppose the following are the R^ and Ri for 5 years given in rows (i) and(ii) below. Beta is computed based on the above formula as given in the rest of therows below : 1 2 3 4 5 Totali) Rm 14 16 10 22 -2 60ii) Ri 15 18 15 28 -6 70iii) Rm- MRm 4-2 +4 -2 +10 -14 0iv) Ri-MRi 1 4 1 14 -20 0v) = (iii) (iv) 2 16 -2 140 280 1vi) (Rm- MRm)2 4 16 4 100 196 320MRm = 60/5 -12 andMRm = 70/5 -14 BSPATIL
  • 141. β = Beta = Σ (Rm- MRm) (Ri-MRi)/ Σ (Rm- MRm)2 = 436/320=1.365Let Rf = 8%Required rate of return = Rf + (MRm - MRi) β = 8% + (12% - 8%) 1.3625 = 8% + 5.45% =13.45% The mean Ri = 14%. So, the actual or expected return is greater than therequired return. This project can be accepted. CAPM assumes perfect capital market, free flow of information,homogenous risk-return expectations of investors, that diversification thoroughlyreduces the unsystematic risk, existence of representative market portfolio and soon.4.11 SIMULATION ANALYSIS When uncertainly haunts in the estimation of variables in a capitalbudgeting exercise, simulation technique may be used with respect to a few of thevariables, taking the other variables at their best estimates. We know that P, V, F, Q, T, K, I, D and N are the important variables. (P -Price per unit of output, V - Variable cost per unit of output, F -rixed cost ofoperation, Q - Quantity of output, T - Tax rate, K - Discount rate cost of capital, I -Original investment, D - Annual depreciation and N -iber of years of the projects life). Suppose in a project, P, V, F, Q, N and I are fairly predictable but ‘K’ and‘T’ are playing truant. In such cases, the K and T will be dealt through nulation whileothers take given values. Suppose that P= Rs.300/unit, V - Rs. 150/unit, F =Rs.15,00,000/p.a, Q - 20,000/p.a, N - 3 years and I = Rs. 18,00,000. Th0en lualprofit before tax - [(P-V)Q] - F - D = [(300-150)* 20000] - 15,00.000 -),6,00000 = Rs. BSPATIL
  • 142. 9,00,000/p.a. The profit after tax and hence cash flow cannot be computed as tax rate, T is not predictable. Further as ‘k’ is not predictable, present value cannot be computed as well. So, we use simulation here. Simulation process gives a probability distribution to each of the truant playing variables. Let the probability distribution for T and K be as follows: T K Probability Value Probability Value 0.20 30% 0.30 10% 0.50 35% 0.50 11% 0.30 40% 0.20 12% Next, we construct cumulative probability and assign random number ranges, as follows separately for T and K. Two digit random number ranges are used. We start with 00 and end with 99, thus using 100 random numbers. For the different values of the variable in question, as many number of* random number as are equal by the probability values of respective values are used. Thus, for variable T, 20% of random numbers aggregated for its first value. 30% and 50% of random number for its next value 35% and 40%. Table 4.6 : Cumuiative Probability and Random Number rangeValue Profitability Cumulative Random Value Profitability Cumulative Random profitability no. range profitability no. range30% 0.20 0.20 00-19 10% 0.30 0.30 00-2935% 0.50 0.70 20-69 11% 0.50 0.80 30-7940% 0.30 1.00 70.99 12% 0.20 1.00 80-99 BSPATIL
  • 143. For the first value of the unpredictable variable, we assign randomnumber 00 to 19. For the second value was assign random numbers 20 - 69 and forthe third value 70 - 99 are assigned. Similarly for the variable ‘K’ random numbersare assigned. These are given in the above table 4.6. Simulation process now involves reading from random number table,random number pairs (one for ‘T’ and another for ‘K’). The values of ‘T’ and Kcorresponding to the random numbers read are taken from the above table. Supposethe random numbers read are: 48 and 80. Then T is 35% as the random number 48falls in the random number range 20-69 corresponding to 35% and K is 12% as therandom number 80 falls in the random number range 80-99 corresponding to 12%.No w taking the T- 3 5% and K- 12%, the NPV of the project can be worked out. Weknow that the project gives a PBT of Rs.9,00,000 p/a for 3 years. So, the PAT =9,00,000 - Tax @ 35% = Rs.9,00,000 -3,15,000 = Rs.5,85,000 p.a. To this we have toadd depreciation Rs.6,00,000 (i.e. Rs. 18,00,000 / 3 years) to get the cash flow. So,the cash flow = 5,85,000 + 6,00,000-Rs. 11,85,000p.a nNPV = Σ CFt/(l+k)t - I t=1 = (11,85,000/1.12+ 11,85,000/1.122+ II,85,000/1.123)- 18,00,000 = 11,85,000 [1/1.12 + 1/1.122 + 1/1. 123]- 18,00,000 – = 11,85,000X2.4018-18,00,000 = 28,56,798 - 18,00,000 = Rs. 10,56,798 We have just taken one pair of random numbers trom the table and calculatedtheNPVisRs.10,56,798. This process must be repeated at least 20 times, reading 20 pairs ofrandom numbers and getting the NPV for values of T and K corresponding to eachpair of random numbers read. Suppose the next pair of random numbers is 28 and BSPATIL
  • 144. 49. Corresponding ‘T’ = 35% and K - 1 1%. Then the PAT = PBT -T - 9,00,000 -3,15,000 - 5,85,000. The cash flow = 5,85,000 + 6,00,000 -Rs. 11, 85,000. nNPV = Σ CFt/(l+k)t - I t=1 = (11,85,000/1.11 + 11,85,000/1.1 12 + 11,85,000/1.1 13) – 18,00,000 = (10,67,598 + 9,61,773 + 8,66,462)- 18,00,000 = 28,95,803 - 18,00,000 = Rs. 10,95,803 Similarly the NPV for other simulations be obtained. Thus computedNPVs may be averaged and if the same is positive the project may selected.4.12 SENSITIVITY ANALYSIS Sensitivity analysis attempts to study the level of sensitivity of projectworth, say the NPV, for changes in a key influencing factor, keeping influence of allother influencing factors at constant level. Sensitivity analysis presumes uncertainty of the values of all or some ofthe influencing factors. For such factors, the range of their values and most likelyvalues are given. Other factors take constant values. We know that NPV of a project is influenced by P, V, Q, F, I, N, D, T andK. Let F, I, N, D and K are constant at Rs. 15,00,000, Rs. 18,00,000, 3 years,Rs.6,00,000 and 15% P, V, Q and T are hence the uncertain variables. Let their rangeof values and most likely values be as follows: P : Rs.200-Rs.350; Most Likely value Rs.300 V: Rs.100-Rs.250; Most Likely value Rs.150 Q : 15000-22000; Most Likely value 20,000 T: 30%-40%; Most Likely value 35% BSPATIL
  • 145. Suppose we want to study the sensitivity of NPV with respect to T. thenother uncertain variables, namely, P, V and Q will be assigned their most likelyvalues. Needless to say, the variables taking constant values will take their fixedvalues. The variable T will be taking different values within the range of its values foreach such values of T, the NPV will be worked out and sensitivity of the NPV to thatfactor is analysed. Accordingly, for our purpose: I = Rs. 18,00,000, N - 3 years, D =Rs.6,00,000, F = Rs. 15,00,000, k = 15%. P, V and Q at their most likely values:Rs.300, Rs.150 and 20,000 units. ‘T shall take different values within its range, say30%, 32.5%, 35%, 37.5% and 40%. For each of these 5 values of T, NPV will beworked out and sensitivity of NPV analysed. First let T be 30%. The annual cash flow is : = [(P-V)Q - F - D] (I-T) + D = [(300-150) 20000 - 15,00,000 - 6,00,000] (1-30%) + 6,00,000 = [30,00,000 - 21,00,000] (0.70) + 6,00,000 = 9,00,000 (0.70)+ 6,00,000 = Rs.12,30,000 p.a.NPV =(12,30,000, 15 + 12,30,000/1.152 + 12,30,000/1.153)- 18,00,000 = 28,08,369 - 18,00,000 – Rs. 10,08,369 Let T be 32.5%, The annual cash flow is: = [(P-V)Q - F - D] (I-T) + D =[(30CM50) 20000 - 15,00,000 - 6,00,000] (1-32.5%) + 6,00,000 = [30,00,000 - 21,00,000] (0.675) + 6,00,000 = 9,00,000 (0.675) + 6,00,000 = Rs. 12,07,500 p.aNPV = (12,07,500/1.15 + 12,07,500/1.152+ 12,07,500/1.153)- 18,00,000 = 27,56,994 - 18,00,000 = Rs. 9,56,994 Let T be 35%. The annual cash flow is: = [(300-150) 20000 - 15,00,000 - 6,00,000] (1 -35%) + 6,00,000 = [30,00,000 - 21,00,000] (0.65) + 6,00,000 = 9,00,000 (0.65) + 6,00,000 BSPATIL
  • 146. = Rs. 11,85,000 p.aNPV = (11,85,000/1.15 + 11,85,000/1.152 + 11,85,000/1.153)- 18,00,000 = 27,05,622- 18,00,000 = Rs. 9,05,622 Let T be 37.5%. The annual cash flow is: = [(P-V)Q - F - D] (I-T) + D = [(300-150) 20000 - 15,00,000 - 6,00,000] (1-37.5%) + 6,00,000 = [30,00,000 - 21,00,000] (0.625) + 6,00,000 = 9,00,000 (0,625) + 6,00,000 = Rs.l 1,62,500 p.aNPV = (11,62,500/1.15 +11,62,500/1.152 +11,62,500/1.153)- 18,00,000 = 26,54,249 - 18,00,000 - Rs. 8,54,249 Let T be 40%, The annual cash flow is : = [(P-V)Q - F - D] (I-T) + D = [(300-150) 20000 - 15,00,000 - 6,00,000] (1-40%) + 6,00,000 = [30,00,000 - 21,00,000] (0.60) + 6,00,000 = 9,00,000 (0.60) + 6,00,000 = Rs. 11,40,000 p.aNPV = (11,40,000/1.15 + 11,40,000/1.152 + 11,40,000/1.153) - 18,00,000 = 26,02,876 - 18,00,000 - Rs. 8,02,876You might have noted that as T rises, NPV falls.Rate of change in NPV for a given change in T. When T rises to 32.5% (i.e. (0.325) ftom 30% (i.e. 0.3) NPV fallstoRs.9,56,994 fiom Rs.10,08,369. ANPV/NPVRate of change = —————— AT/T. -51375/10083.69 -0.0509= ————————— = ————— =-0.61 0.025/0.3 0.0833 When T rises to 35% (i.e. (0.35) from 32.5% (i.e. 0.325) NPV falls to BSPATIL
  • 147. Rs.9,05,622 fix>m Rs.9,56,994. ANPV/NPVRate of change = —————— AT/T= -51372/956994 -0.05368 __________________ = ____________ = -0.698 .025/0.325 0.07692 When T rises to 37.5% from 35% NPV falls to Rs.8,54,249 fromRs.9,05,622. ANPV/NPVRate of change = —————— AT/T= -51373/905622 -0.0567 __________________ = ____________ = -0.794 0.025/0.35 0.0714 When T rises to 40% from 37.5% NPV falls to Rs.o,02,816 frcRs,8,54,249. ANPV/NPVRate of change = —————— AT/T= -51373/854249 -0.0601 __________________ = ____________ = -0.9015 0.025/0.375 0.0667 The rate of fall in NPV is rising with the rise :r. tax rets. Henc? NPV ishighly negatively sensitive with tax rate. We can study the sensitivity of NPV to ‘T’ in the form of a graph, takingNPV on the y-axi^m«d T on the x axis also. We can do the sensitivity analysis of NPV with respect to anotheruncertain variable, say P* keeping V, Q and T at their most likely values, othervariables at their fixed values and changing the value of P within its given range pfvalues. Similarly, we can do the sensitivity analysis of NPV with respect to V, keeping BSPATIL
  • 148. P, Q and T at their most likely values, other variables at their fixed values andchanging the value of V within its given range of values. So, also we can replicate thesensitivity with respect to Q. Now of the 4 uncertain variables, namely, P, V, Q and T, with respect towhich the NPV is most sensitive can be seen. Knowledge of the same will helpmonitoring the project with respect to those variables very ably. Hence the utility ofsensitivity analysis.Illustration 4.1 A firm is currently using a machine purchased two years ago forRs.14,00,000. It has further 5 years of life. It is considering replacing of the machinewith a new one which will cost Rs.28,00,000 cost of installation Rs.2,00,000. Increasein working capital is Rs.4,00,000. The profits before tax and depreciation are asfollows for the two machines: BSPATIL
  • 149. Year 1 2 3 4 5Current 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000machine(Rs)New 10,00,000 12,00,000 14,00,000 18,00,000 20,00,000machine Rs) The firm adopts fixed installment method of depreciation. Tax rate 540% and capital gain tax is 10% on inflation un-adjusted capital gain. Is it desirable to replace the current machine by the new one, along the resale value of old machine at Rs. 16,00,000 at present and using, PBP, RR, NPV and IRR? (For NPV method take 10% as discount rate, for ARR Dethod cutoff rate is 15% and for PBP method cutoff period is 3.5 years). Solution First we have to calculate the size of investment needed. This includes, purchase cost of new machine, cost of installation and working capital addition needed, reduced by net sale proceeds (after capital gain tax) of old machine. The old machines original cost = Rs. 14,00,000 Depreciation for the past 2 years @Rs.2,00,000 [14,00,000 + life 7 years] Rs. 4,00,000 Rs. 10,00,000 It is sold for Rs. 16,00,000 Total Gain Rs. 6,00,000 This gain has two components, capital gain and revenue gain. Capital gain = Rs. Sale value - original cost - Rs.16,00,000 - Rs.14,00,000 = Rs.2,00,000. Revenue gain = Total gain-capital gain - Rs.6,00,000 -Rs.4,00,000 = Rs.2,00,000. Tax on revenue gain - Rs.4,00,000 x 40% = Rs. 1,60,000. Tax on capital gain 200000 x 10% = 20,000. Therefore, after-tax adjustment, net sales proceeds of old machine = Rs.16,00,000 - Rs.20,000 -Rs. 1,60,000 - Rs. 14,20,000. Now we can compute net investment at time zero, i.e. at beginning as follows: BSPATIL
  • 150. Cost of new machine : Rs, 28,00,000 Add installation cost : Rs. 2,00,000 Cost of machine : Rs. 30,00,000 Add. Addl. Working capital : Rs. 4,00,000 Rs. 34,00,000 Less net sale proceeds of old machine : Rs. 14,20,000 Net investment : Rs. 19,80,000 Now we have to calculate change or increment in cash flow because ofthe firm going for replacement of old machine by new one. For this purpose, what isthe cash flow from new machine and what would be the cash flow from old machinehad the firm continued with that must be computed. The difference of former over thelatter is the change in cash flow. First let us take cash flow from new machine BSPATIL
  • 151. Details Year 1 Year 2 Year 3 Year 4 Year 5PBT&D 1,00,000 12,00,000 14,00,000 18,00,000 20,00,000Less depreciation 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000(30,00,000 » 5)PBT 4,00,000 6,00,000 8,00,000 12,00,000 14,00,000Less Tax @ 40% 1,60,000 2,40,000 3,20,000 4,80,000 5,60,000PAT 2,40,000 3,60,000 4,80,000 7,20,000 8,40,000Add depreciation 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000working capitalrecovery 4,00,000(1) Cash flow 8,40,000 9,60,000 10,80,000 13,20,000 18,40,000 Second, let us take cash flow from old machine Details Year l Year 2 Year 3 Year 4 Year 5PBT & D 6,00,000 6,00,000 6,00,000 6,00,000 6,00,000Less depreciation 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000(14,00,000 » 5)PBT 4,00,000 4,00,000 4,00,000 4,00,000 4,00,000Less Tax @ 40% 1,60,000 1,60,000 1,60,000 1,60,000 1,60,000PAT 2,40,000 2,40,000 2,40,000 2,40,000 2,40,000Add depreciation 2,00,000 2,00,000 2,00,000 2,00,000 2,00,000(2) Cash flow 4,40,000 4,40,000 4,40,000 4,40,000 4,40,000Increment cashflow = (l)-(2) 4,00,000 5,20,000 6,40,000 8,80,000 14,00,000CumulativeA cash flow 4,00,000 9,20,000 15,60,000 24,40,000 38,40,000 Payback period (PBP) method evaluation Fresh additional investment needs is Rs. 19,80,000. Upto 3 years from now, Rs. 15,60,000 cumulative cash flow is got. So, PBP is 3 years plus that fraction of 4th year to recover balance Rs.4,20,000 (i.e. Rs. 19,80,000 -Rs. 15,60,000). The fraction of year - 4,20,000 / 8,80,OU « 0.4772 a year. So, pay back period - 3.4772 years or 3 years and 5.8 months. The projects PBP of 3.4772 years is less than the cut off period of 3.5 years. So, replacement is advisable. ARR method of evaluation For ARR method, we have get incremental PBT. This is computed as follows. BSPATIL
  • 152. Year 1 Year 2 Year 3 Year 4 Year 5PBT: New Machine 4,00,000 6,00,000 8,00,000 12,00,000 14,00,000PBT: Old machine 4,00,000 4,00,000 4,00,000 4,00,000 4,00,000APBT 0 2,00,000 4,00,000 8,00,000 10,00,000 Annual average APBT = Σ PBT/5 = 24,00,000 / 5 = Rs.4,80,000 Average investment = (Investment + Working capital) / 2 = (19,80,000 + 4,00,000) / 2 =1 1 ,90,000 ARR = (4,80,000 / 1 1,90,000) X 100 = 40.34% Note: Working capital Rs.4,00,000 introduced at the beginning is recoverable at the end of the last year and this is treated as salvage value. NPV method of evaluation (Discount rate 10%) n NPV = Σ CFt/(l+k) t I t=1 =(4,00,000/1.1+5,20,000/1.12+6,40,000/1.13+8,80,000/l.14+14,00,000/1.15)-19,80,0 00 = (3,63,636 + 4,29,752 + 4,80,841 +6,01,051+8,69,296)- 19,80,000 = 27,44,576 - 19,80,000 = Rs. 7,64,576 As NPP > 0, replacement is advised. IRR method of evaluation NPV at 10% discount rate is +ve. This itself shows that the IRR > 10%. So, the replacement is advised. Any how, we can calculate IRR too. Let us take the assumed IRR as 20%. At 24%, the NPV is: 20,51,826 - 19,80,000 = 71,826. So, IRR is still higher. Let using at 22% as assumed IRR. The NPV = 19,44,920 - 19,80,000 - - 35,080. Since the NPV at 22 is negative and at 20% it is positive, ERR is > 20% but < 22%. We can interpolate as follows: IRR = 20% + (71 826/(71826+35080))x2% = 20% + 1.34 = 21.34%. BSPATIL
  • 153. As the IRR at 21.34% is > cut-off IRR of 10%, replacement is advised.Illustration 4.2 A company brought a machine 2 years earlier at a cost of Rs.60,000 andestimated useful life of 12 years in all. Its current market price is Rs.25,000. Themanagement considers replacing this machine with a new one, life 10 years, price Rs.1,00,000. The new machine can produce 15 units more per hour. The annualoperating hours are 1000 both for new and old machines. Selling price per unit isRs.3. The new machine will involve addl. Material cost by Rs.6,000 and labour byRS.6,000 p.a. But savings in cost of consumable stores of Rs. 1000 and repairs ofRs.lOOOp.a. will result. The corporate tax rate is 40%. Advice on the replacementassuming additional working capital of Rs. 10000 introduced now, can be redeemedat 10 years later, cost of capital as 10% and SLM of depreciation, using NPV method. BSPATIL
  • 154. Solutioni) Computation cash outflow at present Cash of new machine : Rs. 1,00,000 Add: Addl Working capital : Rs. 10,000 1,10,000 Less: Sales value of old machine : Rs. 25,000 Tax shield on loss of old Machine (book value -Market value) x tax rate [(50000-25000)x40%] Rs. 10,000 35,000 75,000ii) Computation of Addl. Gross incomeAddl. Production per annum = Hours of operation x Addl. Output = 1000x15=15,000Addl. Gross income per annum = Addl. Production p.a x unit price = 15,000 x Rs.3 = Rs.45,000From 1 year to 10th year, Rs.45,000 addl. Income is thus predicted.iii) Cash flow computationDetails Year 1 to 9 Year 10Addl. Gross income 45,000 45,000Add. Savings in consumable stores & repairs 2,000 2,000 47,000 47,000Less: Addl. Material & labour cost 12,000 12,000PBD&T 35,000 35,000Addl. Depreciation (10000 - 5000) 5,000 5,000PBT 30,000 30,000Less Tax @40% 12,000 12,000PAT 18,000 18,000 BSPATIL
  • 155. Addl. Depreciation 5,000 5,000Add : Working capital recovery - 10,000Cashflow 23,000 33,000NPV = ∑ CFt/(l+k)t + CF10/(l+k)10- I t=1Since uniform cash flow is found throughout 1st to 9th years, the NPV formulates canbe slightly modified as:NPV = [ACF ∑ 1/(1+k)t + CF10 X 1 (1+k)10] - I = 23000[1/1. 1 + 1/1. 12 +……… 1/1.99]33000 x1/1. 110-75000 = (23000 x 5.759) + (33000 x 0.386) - 75000 = 145195 - 75000 = Rs. 70195The replacement is advised.Illustration 4.3 A company has 3 investment proposals. The expected PV of cash flowsand the amount of investment needed are as below:Projects Investment required PV of cash flows1 Rs. 2.00 lakhs Rs. 2.90 lakhs2 Rs. 1.15 lakhs Rs. 1.85 lakhs3 Rs. 2.70 lakhs Rs. 4.00 lakhs If projects 1 and 2 are jointly taken, there will be no economics ordiseconomies. If projects 1 and 3 are undertaken, economics result in investment andcombined investment will be Rs.4.4 lakhs. If 2 and 3 are combined, the combined PV BSPATIL
  • 156. of cash flow will be Rs.6.2 lakhs. If all the 3 projects are combined, all the aboveeconomics will result but diseconomy in the form of additional investment of Rs.1.25lakhs will be needed. Find which project projects be taken.Solution Projects Invt. Needed PV of cash flows NPV 1 2,00,000 2,90,000 90,000 2 1,15,000 1,85,000 70,010 3 2.70,000 4,00,000 1,30,000 1&2 3,15,000 4,75,000 1,60,000 1&3 4,40,000 6.90,000 2,50,000 2&3 3,85,000 6,20,000 2,35,000 1,2&3 6,80,000 9,10,000 2,30,000Projects 1 & 3 will be chosen as NPV is higher.4.13 RISK ANALYSIS IN THE CASE OF SINGLE PROJECT Project risk refers to fluctuation in its payback period, ARR, IRR, NPV orso. Higher the fluctuation, higher is the risk and vice versa. Let us take NPV basedrisk. If NPV from year to year fluctuate, there is risk. This can be measuredthrough standard deviation of the NPV figures. Suppose the expected NPV of a projectis Rs. 18 lakhs, and std. deviation of Rs.6 lakhs. The coefficient of variation C V isgiven by std. deviation divided by NPV.C. V = Rs.6,00,000 / Rs. 18,00,000 - RISK RETURN ANALYSIS FOR MULTI PROJECTS BSPATIL
  • 157. When multiple projects are considered together, what is the overall riskof all projects put together? Is it the aggregate average of std. deviation of NPV of allprojects? No, it is not Then what? Now another variable has to be brought to thescene. That is the correlation coefficient between NPVs of pairs of projects. When twoprojects are considered together, the variation in the combined NPV is influenced bythe extent of correlation between NPVs of the projects in question. A high correlationresults in high risk and vice versa. So, the risk of all projects put together in the formof combined std. deviation is given by the formula: σp = [∑pij σi σj]1/2where,σp - combined portfolio std. deviationpij - correlation between NPVs of pairs of projectsσi σj - std. deviation of iin and jth projects, i.e., any pair of projects taken at a time. Three projects have their std. deviations as follows: Rs.4000, Rs.6000and Rs.10000. The correlation coefficients are 1&2 : 0.6, 1&3 : O.V and 2&3 : -0.5.What is the overall std. deviation of the portfolio of projects?σp = [∑pij σi σj]1/2 = [σ12 +σ22 +σ32 +2p12 σ1 σ2+ 2p23+σ2 σ3 +2p13+ σ1 σ3] 1/2 =[40002+60002+100002 + 2x0.6x4000x6000 +2x0.78x6000x10000+ 2x (-0.5)x 10000 x 4000]1/2= 6000000+36000000+100000000+28800000+93600000-4000000]1/2= [234400000]1/2 = Rs. 15,310 What is the return from these multiple projects? This is simple. It is theaggregate NPVs. Suppose the three projects have NPVs of Rs. 16,000, Rs.20,000 andRs.44,000. The combined NPV = 16000 + 20000 + 44000 = Rs.80000. The combined coefficient of variation = combined std. deviation combinedNPV - Rs.15340/Rs.80000 = 0.19 - 19%. If we take the correlatiol factor unadjusted BSPATIL
  • 158. figures of combined std. deviation and combined NPVs, thi coefficient of variationwould have been: 20000/80000 = 0.25 = 25%. Thi factor has resulted in reducingoverall portfolio risk from 25% to 19%. This results essentially when there is lowdegree of correlation among the projects. More so if there is higher negativecorrelation among the projects.Illustration 4.4 Three projects involve an outlay of Rs.2,00,000, Rs.3,00,000 andRs,5,00,000 respectively. The estimated return from the projects are 14%, 16% and20%. The std deviation of returns are 5%, 10% and 10%. The correlation coefficientsare 1&2 : 0.4,2&3 : 0.6 and 1&3 : 0.2. Find the portfolio return and risk.Solution The portfolio or combined return is simply the weighted return ofprojects. This is given by: ∑wi Ri where wi - is the weight (0.2, 0.3 and 0.5 fee threeprojects respectively) and Ri - is the respective project return.Portfolio return = (wiRi = 0.2x14% + 0.3x16% + 0.5x20% = 2.8% + 4.8% + 10% = 17.6%Portfolio risk = [(wi wj pij (i (j]]1/2 = [w1w1(1(l + w2w2 (2(2 + w3w3(3(3 + 2w1w2(12 (1(2 + 2w2w3(23 (2(3 + 2w1w3(13(1(3]l/2[Putting the given values, we get that, σp = [0.2 + 0.9 + 2.5 + 2.4 + 18 + 2]1/2 = [25]1/2 = 5.099% BSPATIL
  • 159. 4.15 SUMMARY Capital budgeting essentially involves evaluation of the worth of capitalinvestment proposals based on estimates of cash inflows and outflows. It is scientificexercise and uses several techniques. PBP, ARR, NPV and IRR are certaintytechniques. CAPM, sensitivity analysis, simulation analysis, decision tree techniqueetc. are techniques of evaluation used under conditions of risk and uncertainty.CAPM technique can be used for single as well as a portfolio of projects. For aportfolio of projects, overall return (in NPV or IRR mode) and overall risk (in the formof std. deviation Af NPV or IRR) can be computed to judge the efficiency of theportfolio.4.16 SELF ASSESSMENT QUESTIONS1. Bring out the meaning and significance of capital projects2. Explain various tools of evaluation of capital investment projects.3. Calculate pay-back period, ARR, NPV (at k=10%) and IRR given Years 1 2 3 4 PBT (Lakhs Rs 40 45 50 55 Tax Rate 45% 40% 5% 35%4. Using decision tree approach find the expected NPV of the project given the following cash flows: Time zero Time 1 Time 2 10 lakhs 6 lakhs P. (.6) 4 lakhs P. (.6) 5 lakhs P. (.4) 10 lakhs P. (.4) 6 lakhs P. (.4) 2 lakhs P. (.6) The cost of capital is 10% P = Probability5. For two mutually exclusive projects the projected cash flows are: Period Project A Project B BSPATIL
  • 160. Time zero (outflow) Rs.2,20,000 Rs.2,70,000 1 to 7 years (inflow each year) Rs. 60,000 Rs. 70,000 using IRR method, find the better of the two (an annuity of the I fa 7 years has a present value of Rs.3.92, Rs.3.81, R13.91 and Rs.3.60 at 17%, 18%, 19% and 20%).6. Machine A costs Rs. 10,00,000 payablej immediately, while Machine B costing Rs. 12,00,000 can be paid Rs.6,00,000 down and balance 1 year hence. The cash flow from the machines are: Year 1 2 3 4 5 A (Rs. in lakhs) 2 6 4 3 2 B (Rs. in lakhs) Nil 6 6 8 Nil At 7% discount rate which is better by NPV?7. Texas filaments ltd has the following figures for its expansion plan, involving a capital outlay of Rs.5 crs. Year 1 2 3 4 Unit selling price (Rs.) 7.0 10.0 12.0 15.0 Addl. Sales quantity (Crs) 0.9 0.95 1 1.05 Unit variable cost (Rs) 4.0 5.0 6.5 8.0 Tax rate 30% 30% 35% 35% Find the PBP and ARR of the expansion project.8. A project has an equity beta of 1.2 and debt beta zero and is a have a debt - equity ratio of 3:7. Given risk free rate of return of 10% and market return of 18%, Find the required return for the project per CAPM.9. The P, V, Q,F, I, T and K of a project are as follows: P = Rs. 300; Investment I = Rs. 20,00,000; N - 4 years, K - 10%, T = 30% fixed cost (excluding depreciation) = Rs. 15,00,000. The quantity of sales (a) is a sensitive factor with the range 12,000 to 20,000 with most likely value 17000. Similarly, variable cost, V, is a sensitive factor with range Rs.130 to Rs.180, BSPATIL
  • 161. with most likely value of Rs.160 per unit perform sensitivity analysis w.r.t. quantity and variable cost10. A projects cash flow, life and discount rate have the following probability distribution. Cashflow Prob. Life Prob. Dis. Rate Prob. Rs.5 crs .20 2 .25 9% .22 Rs.8 crs .72 3 .45 10% .66 Rs.10 crs 08 4 .30 12% .12 Perform simulation of PV of cash flow for five runs taking the following random number sets: i) 12, 18, 82; ii) 70, 38, 48; iii) 78, 02, 49; iv) 22, 18,79; v) 65, 92, 36. If the project outlay is Rs.18 crs, find the expected NPV of the project.REFERENCES1. Financial Management and Policy - Van Home2. Financial Decision Making - Hampton3. Management of Finance - Weston and Brigham4. Financial Management - P.Chandra ****** UNIT-V COST OF CAPITAL AND CAPITAL STRUCTURE In this unit you will learn concepts of cost of capital, methods ofcomputing cost of capital for a specific and combination of sources of capital, conceptof capital structure, theories of capital structure, optimum capital structure andrelated issues.INTRODUCTION BSPATIL
  • 162. Cost of capital and capital structure are important aspects as far as thefinancing of a business. Cost of capital influences the choice of capital structure aswell. Cost of capital even influences the choice of investments or projects of abusiness. Capital structure has a bearing on value of the business. Hence thesignificance of the cost of capital and capital structure.5.1 COST OF CAPITAL Capital, like all resources, involves a cost. Business organizations whenmobilizing capital incur cost and later when serving the capital incur servicing cost.The former known as floatation cost is one-time and includes underwriting andbrokerage commission, cost of printing and vetting of prospectus, financialadvertisement costs, etc. Floatation cost accounts for 3% to J% of issue size, it issaid. Higher the issue size less is the floatation cost varies. In boom sentiments thecost is lower and vice versa. The servicing cost is recurring and includes dividend,interest etc. paid periodically. While interest rates are fixed and payment of interest iscompulsory, dividend rates are varying and dividend payment is not a legal bindingon the management. Yet, companies pay dividend lest share price shall fall. Cost ofcapital is computed considering the above factors. The components of cost of capitalconsist of risk-free rate premium for financial risk, premium for business risk and thelike.5.1.1 Concepts of cost of capital There are several concepts of cost of capital Cost of capital is theminimum return expected by investors in financial investments. The minimum returnexpected by debenture holders is the cost of debt, by the shareholders is the cost ofequity and so on. The fiim must provide this minimum return in order to enthuse thepublic to subscribe to the debentures or shares, as the case may be. Cost of capital isthe minimum return that should be earned by a business (so as to be in a position tosatisfy the providers of capital). If 16% return is expected by investors in bonds of acompany, the company must earn at least 16%on the funds mobilized through issueof bonds. Hence minimum return expected by investors and minimum return to beearned by a company both mean one and the same. BSPATIL
  • 163. Cost of capital may refer to specific cost or combined cost of capital.Specific cost of capital refers to cost of each component of capital, like share capital,debt, etc. combined cost of capital is the overall cost of all funds employed by abusiness. Actual and imputed cose concepts need to be looked into. Actual cost ofcapital refers to the out of pocket cost of capital. In the case of debentures payment ofinterest is an actual expenditure. So cost of debenture is generally actual as to sharesin the initial years dividend payment may not be there. But a, capital appreciationmight be there in the stock market due to potentials of the scrip. So, equity capital inthis context has an inputted Cost of capital may be of the opportunity cost type. The retained earningsbelong to shareholders but are not capitalized. Yet, they involve a cost, anopportunity cost which means what the shareholders could have earned had thesebeen distributed as dividend or capitalized by means of bonus share issue. Cost of capital may be marginal cost and average cost. Marginal cost isthe cost of additional capital that may be raised, whereas average cost is thecombined cost of total capital employed. Cost of capital can be pre-tax or post-tax cost. Debenture interest isdeducted while computing income for tax purposes. So, debentures’ post-tax cost islower than pre-tax cost. Accordingly, overall cost of capital also can be classified intopre-tax and post-tax overall cost of capital. Cost of capital may be explicit or implicit cost. Explicit cost o capital issimilar to out-of-pocket cost It is an accounting cost. Implicit cost hidden and it maynot involve actual payment and hence may not be directly accounted for. Cost of capital may be classified into past and future costs. Post cost isirrelevant for decision making, while future cost is relevant. For funds raised alreadythe floatation cost is a past cost, whereas future interest/ iividend commitments are BSPATIL
  • 164. future cost. /5.1.2 Computation of cost of capital Now computation specific and overall cost of capital is attempted. Cost of debt (K, or Kb) Debt capital is a predominant method of corporate financing. Debt may beshort-term or long-term debt. Short term debt takes over several forms like bankloan, bank cash credit and bank overdraft, trade credit, bill discounting, etc. The rateof interest applicable to bank loan, cash credit, overdraft and bill discounting is thepre-tax cost of those credit forms. The post tax cost of these forms of financing isobtained by multiplying pre-itax cost of capital by (1-Tax rate) Cost of trade credit Regarding trade credit, the supplier may prescribe a payment term suchas, 5/30, net 60 days which means, a cash discount of 5% if payment is made within30 days, else full payment by the 60th day. It means on a transaction of Rs. 100, Rs.95 payment is enough if payment is made by 30ih day, otherwise Rs. 100 be paid bythe 60th day. That is, failing to pay Rs. 95 by 30th day, entails payment of Rs. 100 by60th day, or Rs. 5 interest for 30 days, on a capital of Rs. 95. So, interest rate comesto : 100 x 5 x 360 /95 x 30 = 63%. Failing to take advantage of cash discount resultsin heavy interest cost. This is an opportunity cost. Cost of Debenture Debentures are debt instruments. These are issued by companies withinterest rate coupon depending on the market rate of interest and the credit rating ofthe issuing company. BSPATIL
  • 165. Suppose irredeemable debentures of Rs, 100 with a coupon of 14% areissued by a company at a net issue price of Rs.98, The company pays 40% tax. Thepre tax and post tax cost of debentures can be computed. Coupon InterestKd (Pre-tax) = ———————————— x 100 x 100 =14.3% Net PriceKd (Post-tax) = Kd (Pre-tax) x (1-Taxrate) = 14.3% (1 – 4) = 8.58% For redeemable debentures the cost of debt is computed differently. Letthe net issue price be Rs. 98 and redemption price after 8 years be Rs. 102. Thecoupon rate is 17% p.a, then the cost of debt will be: Actually, the above formula is an approximation of the formula: Annual Coupon Interest + Redemption Premium/ No. of years to redemption)Kd(Pre-tax) = ________________________________________________ x 100 (IssuePrice + Redemption Price)/2 Rs. 17 + (102-98)/8 Rs.17.5 = _______________________ x 100 = _________ x 100 =17.5% (98+100)/2 100Actually, the above is an approximation of: Rs.17 Rs.17 Rs.17 Rs.100Rs.98 = (1+r) + (1+r) +……+ (1+r)8 (l+r)8 Where ‘r’ is the pre-tax cost of debt This is the present value model. Thegeneral form is: BSPATIL
  • 166. I1 I2 I3 In AP= + + +….+ + (l-r) (1+r)2 (1+r)3 (1+r)n (1+r)nKd (Post-tax) = Kd (Pre-tax) (I -Tax rate) = 17.5% (1-40%) - 17.5% (0.6) = 10.5% Where interest payments are made semiannuaJly or quarterly, the effectivecost will be slightly higher. Assuming a semi-annual interest payment and using thepresent value model, the pre-tax cost of debt is the value of ‘r’ in the formula. Rs.8.5 Rs.8.5 Rs.8.5 Rs.8.5Rs.98 = + +……..+ + (l-r/2)(1+r/2)2 (1+r/2)16 (1+r/2)16The general form here, is : I I2 I3 In AP= + + +….+ + (l-r/2) (1+r/2)2 (1+r/2)3 (1+r/2)n (1+r/2)2n Cost of debt that we have seen is the explicit or out of pocket cost. Theremay be an implicit cost due to restrictive covenants imposed, bankruptcy cost in theevent of forced winding up and so on. Explicit cost varies with credit standing andmarket factors. With higher credit rating, larger issue size and booming marketsentiment, explicit cost decreases and vice versa. Cost of Term Loans The pre-tax cost of term loans is the combinational interest rate/ [The BSPATIL
  • 167. post-tax cost is pre-tax rate multiplied by (1-tax rate).Cost of Preference Shares (Kps) In the case of irredeemable preference shares, the cost of capital is givenby Coupoon dividedKps = ______________________________ Issue Net Price Say Rs. 200 face value preference shares carry a dividen4 rate of 1 5%p.a. Issue expenses amounted to 3%. Then the Kps is : Rs.30 30 ——————— X 100 = _________ (Rs.200-3%) 194 No tax benefit is available to the company on preference dividend paid.Hence 1 5 .4% is the effective cost. Sometime back dividend tax was levied. Thisenhanced the cost of preference share capital. If the preference shares are redeemable preference shares,adopting the present valuation model, cost of preference share can be computed bysolving for ‘r’ in the usual equation: D1 D2 Dn AP = ————— + ———— +..... + ————— + ————— (l+r/2) (l+r/2)2 (l+r/2)n (l+r/2)n Where, P = net issue price, Dl, D2, ... Dn are dividends for 1 st throughnth years, A = redemption price, n = number of years to maturity and r discount rate(ie., the cost of capital). An approximation for the above model is Redemption Premium D+ ————————————— No. of years to maturity BSPATIL
  • 168. Kps = ———————————————— x 100 (Issue price + Redemption price)/2 Let us take an example. Issue Price (P) = Rs. 96. Coupon dividend is 17%Redemption at a premium of 2% after 6 years. Then Rs.l7 + (102-96)/6 18 x 100Kps = ————————————— x 100 = —————— = 18.2% (Rs.96+102)/2 995.1.2.2 Cost of Equity (Ke) There are several cost models relating to equity capital. These aredividend approach, dividend plus growth approach and earnings approach. These areexplained below. D/P Approach Dividend Approach (D/P), assumes a constant dividend per share (DPS)continually for an infinite period. Then Ke = D/P, where ‘D’ is the fixed [DPS and ‘P’ iscurrent price. A company’s equity share gives Rs. 5 dividend p.a. an infinite time tocome and its price is Rs. 50 at present. Then Ke (D/P) x 100 = (5/50) x 100 - 10%.Constant dividend model is not realistic. Hence the above method lacks practicalsignificance. D/P + g Approach Dividend plus growth (D/P + g) approach assumes a constantly igdividend, at ‘g’ rate p.a. Here, K = (D1/P) + g, where D1 is the dividend ted one yearfrom now, P is the current price and g1 is the annual growth lividend expected tocontanue infinitely. Let’s take a case. A company has declared Rs. 1.00, Rs. l.10 and Rs. 1.21for the past three years. The current market price is Rs. 12. The cost of equity is K e =(D1/P) + g. BSPATIL
  • 169. A look at the annual dividends of the past indicates a 10% in dividend.So, ‘g’ = 10% D1 = Dividend one year hence = Rs. 1.21 + 10% Rs. 1.21 +.121 = Rs.1.331. So, Rs.1.331Ke = _______________ x 100 + 10% = 11.1% + 10% = 21.1% Cost of Convertible Debentures (K«i) Cost of convertible debentures is to be calculated adopting present valuemodel. Present value of interest payable upto conversion and present value of sharesthat may be allotted on conversion should be equated to issue price of the convertibledebenture. The discount rate that equates the two is the cost of convertibledebenture. A company has issued convertible debentures carrying a coupon rate of12% p.a, at a net issue price of Rs. 90 (ie., at 10% discount). After three years eachconvertible debenture is to be converted into an equity share. The equity dividends forthe last three years were Rs. 5, Rs, 5.50 and Rs. 6.05 and the; current market price isRs. 80. To find the cost of convertible debenture we must know the of shares thatwill be given at the end of the 3rd year in lieu of the debent. That is equal to:Expected dividend 4 years hence. And this is equal to D4 g.K-(DI/P) + g. Dl = dividend per share one year hence = Last year dividend growth for 1year. Growth, g - 10% p.a (you can easily know this by a glance over the past DPS,viz., Rs. 5, Rs. 5.5 and Rs. 6.05. So, Dl = Rs. 6.05 + 10% Rs. 6.66. Ke = Rs. (6.66/Rs.80) x 100 + 10% = 8.3% + 10% = 18.3%. Expected dividend 4 years hence = Rs. 6.05(1 + g) 4 = Rs. 6.05 x (1.1)4 = Rs. 8.87. Value of the share at the time of conversion =8.87 / (18.3% -10% = Rs. 8.37 / 8.3% = Rs. 107. Now we can use the present value model to get the convertibledebentures. As per the model, current net issue price is the value of future cash BSPATIL
  • 170. earnings in the form of interest for 3 years and value share receivable at the end of3rd year from now. That is: I I2 I3 107Rs. 90 = _________ + _________ + _________ + _________ or, (1+r) (1+r)2 (1+r)3 (1+r)3 Rs.12 Rs.12 12 107Rs. 90 = _________ + _________ + _________ + _________ (1+r) (1+r)2 (1+r)3 (1+r)3where ‘r’ = cost of convertible debenture. We can get the value of Y by trial and errormethod. It may be arrived at through the approximation formula as well. I + (Premium / No. of Years) 12 + (107-90)73KCD = ___________________________________________ x 100 = ————————— x100 (90+107)/2Average of issue and redemption price 12 + 5.67 17.67 17.67= ________________ X 100 = ________ x 100 =18% 98.5 Cost of Retained Earnings (Kr) Retained earnings are accumulated profits and free reserves belonging toequity shareholders. Though it has no explicit cost, opportunity cost is involved. It isnot cost free, though it may appear to be so. The business musi earn at least whatthe shareholders can earn on this sum if it is distributed as dividend. Say a companyhas Rs. 10,00,000 retained earnings. Assume it declares the whole sum as dividend.The shareholders receive dividends Rs. 10,00,000. But they are assessed to tax onthe dividends. Let us assume the marginal rate of taxation of the shareholders is30%. So, 30% of Rs. 10,00,000 is paid as tax. So only a sum of Rs. 7,00,000 is leftwith the shareholders. Let us assume they invest in various financial assets earningan overall return of 18% p.a. Cost of investment amounted to 3%. That is, of the Rs.7,00,000, 3% is spent on incidentals to investment and that only, Rs. 6,79,000 are BSPATIL
  • 171. invested earning 18%. The return would be Rs. 1,22,220. That is, shareholders makean earning of Rs. 1,22,220 on the dividend of Rs. 10,00,000 received. If the companydoes not pay dividend, it must at least earn Rs. 1,22,220 on the Rs. 10,00,000retained earnings, equal to what the shareholders can earn. This is the breakeven ofparity return. The rate comes to 12.222%. So, Kr = 12.222%. It can be calculated adopting the formula; Kr = Ke (1-TR) (l-FC), where,Ke= cost of equity, or minimum return expected by equity investors, TR = marginaltax rate of shareholders and FC = floatation cost. Kr - 18% (1- 30%) (1-3%) = 18% (.7)(.97) = 12.222%. BSPATIL
  • 172. Weighted Average Cost (KJ When different sources of capital are employed, overall or weightedaverage cost of capital can be calculated. This gives an idea about the average returnthat the firm must earn on its investment. To compute the weighted average cost of capital two factors are cost ofindividual sources of capital. The latter has been dealt at so far. The former is asimple concept. But there are several alternatives of weights. Book weights, marketweights and marginal weights are the alternative forms of weights. Book weights method uses book weight of individual sources of capital.Book weight = book value of source divided by total book value of all; sources capitalemployed. Book weights are definite and historical but devoid of realism as currentmarket values are not reflected. Hence K0 computed on this basis may lead todeflated K0 and investment decisions based on such K0 may prove to be fatally wrong. Market weights method uses market value based weights individualsources of capital. Market weight - market value of a source; capital employed dividedby total market value of all sources of employed. Market weights are realistic, butsubject to fluctuation. So, weight based K0 is also fluctuating. Sometimes marketvalues may not. known. Hence the difficulty.Formula: K0 = ∑ Wt Kt, where Wt and Kt are respectively the weight and cost of the tthsource of capital An example may be taken up now to further discuss KO BSPATIL
  • 173. Source of capital Cost Book Value Market Value Rs. Rs Equity share capital 18% 8,00,000 28,50,000 Retained earnings 15% 10,00,000 — Pref. Share capital Debentures 14% 12% 4,00,000 4,50,000 27,00,000 (Tax rate 50%) 28,00,000 50,00,000 60,00,000 The book weight and market weight based KO values are computed below:Source Ko.-Book Weight Ko.-Market Weight (K)(Wt) (K)(Wt)Eq.share capital 18%x8/50=2.88% 18x285/600=8.55%Retained earnings 15%x10/50=3.00% —Pref.share capital 14%x4/50=1.12% 14%45/600=1.05%Debentures 6%x28/50=3.36% 6x270/600=2.70% K0 10.36% K0 12.30%(Post-tax Kd = 6% at 50% tax rate) Marginal weight method becomes relevant when additional capital is raised from more than one source, If only one source is used to raise additional capital, specific cost of that source is the overall cost of marginal capital raised. In other situations using marginal weights, the marginal overall cost of capital is calculated. Acceptance or rejection of new investment proposals is done by comparing marginal rate of return of the new investment with the marginal cost of additional capital funding the investment. The marginal ROI should at least be equal to marginal K0. BSPATIL
  • 174. A concern is considering an investment proposal requiring an investmentof Rs. 50,00,000 and promising an ROI of 14% Debt capital to the tune of Rs.30,00,000 is available at 18% (The tax rate is 45%). Balance of capital is to befinanced through retained earnings. Ke - 25%. Marginal tax rate of share holders is20%. Floatation cost is 2%. Can the project be taken up? Marginal cost of capital = Marginal Wt. + Marginal Wt. Cost cost debt of retained profitMarginal cost of debt = 18% (1-45%)= 9.9%Marginal cost of Kr, = Ke (1-20%) (1-2%) = 25% (0.8) (0.98) =19.6%Overall marginal cost = ∑ marginal cost x marginal weight = 9.9%x0.6 + 19.6%xO.4 = 5.94% + 7.84% = 13.78% The projects ROI at 14% is greater than the marginal cost of capital at13.72%. Hence the project may be accepted. As long as marginal ROI > MCC, thatproject can be taken up.5.1.3 Uses of Cost of Capital: To know whether capital has been mobilised cost effectively, cost ofcapital data are useful Cost of capital of firms of like nature can be compared andefficiency or inefficiency in capital mobilisation can be spotted. Cost of capital is usedas the acceptance - rejection criterion of investment proposals. If the return oninvestment is higher than the cost of capital, the proposal is to be accepted and viceversa. Cost of capital is the minimum target retum that a firm must earn to remain inbusiness. Cost of capital should be closely monitored and moderated, if need be byaltering the capital structure, if possible.5.2 CAPITAL STRUCTURE BSPATIL
  • 175. Capital structure refers to the portfolio of different sources of capitalemployed by a business. It is the mix of capital. It is the portfolio of liabilities ofbusiness. It is the structure of long term liabilities of a business. Short term liabilitiesbeing fluctuating type, for structure analysis, which is some what long term innature, are not considered for capital structure analysis. There is another conceptviz., financial structure which studies the structure of whole of the liabilities ofbusiness including both short term and long term capital. In final analysis, capitalstructure analysis is considered with the equity and debt composition of capital of abusiness.5.2.1 Capital Structure Planning The capital structure for a business should be planned. The debt-equityproposition, mix of equity sources, mix of debt sources and the like need to beplanned. To plan capital structure, therefore, means determining the debt-equityproportion and mix of individual components of equity (paid equity and earnedequity, that is ratio of paid up equity capital to retained earnings) and mix of debtcapital types (bank loan, debentures, public deposits, etc.,) so that the firm isoptimally capitalized. Optimum capital structure is one that maximizes value ofbusiness, minimizes overall cost of capital, that is flexible, simple and futuristic, thatensures adequate control on affairs of the business by the owners and so on. To reapthe above benefits without accompanying costs, planning of capital structure isneeded.5.2.2 Determinants of Capital Structure There are several factors, which influence the capital structure. Theseare: cost of capital of different sources of capital, the tax advantage of different debtsources of capital, the restrictive conditions as to debt capital^debt capacity ofajbusiness, the financial leverage, securitibility of assets, preference for trading ofequity, stability of earnings, gestation period of projects, financial risk perception,variety of debt instruments available, experience in using debt capital, investorpreferences, tax rates on capital gain and interest income, capital market conditions,management philosophy and so on. A short description of these determinants is BSPATIL
  • 176. taken up now. Cost of capital of different sources of capital influences capitalstructure. A company would be interested in less overall cost of capital and that asource that is less expensive will be used more than the one that is costlier. Generallydebt capital is said to be less expensive, hence the tendency to use more debtcapitaUBut, of late, equity capital has become cheaper due to free pricing ofcapitaj^ssues. Hence, now, more equity capital is used by companies. Among debtcapital, bank loans are viewed more expensive than market borrowings and that moredebt capital is raised through the capital market than from bank loans. Tax advantage of debt capital is a factor in favour of using more; debtcapital. The interest paid on debt capital is deducted while computing taxableincome. So, tax saving to the extent of interest paid times tax rate is enjoyed by thecompany, reducing the effective cost of debt. This advantage lures companies to usemore debt capital) A Restrictive covenants such as restriction on business expansion, onraising additional capital, on declaration of dividend, nominee directors on the board,convertibility clause, etc. go with^ debt financing, especially; borrowings from termlending financial institutions. These restrictive condition^; are the implicit cost ofdebt capital normally not considered, but should considered in deciding the mix ofcapital. Debt capacity of a business needs consideration. How much del capitala business can bear, that is, comfortably service is a factor to reckoned. Debt servicecoverage ratio is calculated using the formula Annual Cash flowDSCR= —————————————————————————————— Interest + (Annual Principal Installments)/(l-TR)Where TR - Tax rate on corporate profit. BSPATIL
  • 177. DSCR should be at least 3 for comfortable 4e^t servicing. Businesses thatdo not generate sufficient cash flow should think of alternative sources. Interest coverage ratio is another measure of debt capacity of a firm.The formula for ICR is ICR = EBIT /1, Where EBIT - is earning before interest tax andI - is interest on debt capital. The ICR should be in the range of 4 or more for betterdebt servicing capacity. Debt equity norm in the industry / region is another factor. Normally a2:1 debt equity ratio is in vogue with dilution in favour of more debt |for small scalebusiness, capital intensive projects, projects undertaken by weaker sections, etc. Leverage effect has to be looked into. Financial leverage refers to rate ofchange in Earnings per Share (EPS) for a given change in Earnings re Interest andTax (EBIT). A more than proportionate positive change in for a given change in EBITmight tempt management to use further debt initially to enhance EPS and later go foradditional equity capital at a num. Securitibility of assets is a determining factor for using debt Firmswhich have assets that are readily accepted as security can raise capital. Land atprime locations, modem buildings, machinery in good tion, etc. are accepted assecurity, undertakings owning these assets can go more debt financing. Trading on equity is a technique by which low cost debt is used avely toenhance earnings for equity share holders. If the management is in this it would usemore debt capital. ROI must be greater than cost of reap benefit of trading on equity.Suppose a firms investment is Rs.100 ite overall ROI is 18% and it pays 10% on debtcapital. Suppose a debt-equity of 1.1. Then available earnings for equity capital willbe Rs.l8crs – Rs.5crs = Rs.13 crs. The rate of earning on equity is 26%. If a debt-equity ratio of 3:1 is adopted the earnings available for effect will be Rs. 18crs -Rs.7.5crs = Rs.10crs. The rate of earnings on equity will be 42%, i.e.; Rs.10.5 crs /Rs.26 crs = 0.42 or 42%. Thus by rising debt component, return on equity isenhanced. BSPATIL
  • 178. This is called trading on equity. If the management has high preference for this it willgo for more debt and vice versa. Gestation period refers the period between commencement of projectconstruction and first conimercial operation of the project. Longer the gestationperiod, more equity financing is advised as there will not be need for servicing ofcapital in the initial times. Reliance Petroleum Limited used triple convertibledebentures equivalent to equity, to fund its integrated petroleum project inJamnagar, Gujarat, in the 1990s. Financial risk perception is an influencing factor of capital structure.Financial risk refers to the chances of bankruptcy proceedings against the firm fornon-repayment of debt or failure to service debt for a period. If the risk is higher, lessdebt capital is good. Variety of debt instruments available is another factor. While ordinarybonds may be unsuitable for long gestation period project, zero coupoi bonds are agood substitute. Convertible bonds are again superior to ordinan bonds in terms ofsaleability. Now variety is available as against the recent past. And this influences thechoice in favour of more debt. Experience in using debt capital is another factor. Debt needs to behandled expediently. Periodic servicing, roll over, swap early retirement and the likeneed to be adopted when needed. Not all are good at dealing with debt. Henceexperience in using debt capital is important. Investor preferences for securities for investment need to be kept inmind. At times people want debt securities, while at other times equity is preferred.The risk averse prefer debt instruments, while the risk seekers go for equityinvestments. Capital market conditions are another factor. When capital market isbooming, firms can take the market route to raise capital. In the depressed situation,firms depend on bank finance, and other debt finance. BSPATIL
  • 179. Cost of floating can also influence capital structure. Cost of floating ishigh in India; the same is less in International market. Some Indian firms raisedcapital by floating GDRs (Global Depository Receipts), an equity capital form,involving lower, 3-5%, floating cost as against the domestic ituation of, as high as,over 8% floating cost. Rate of tax on capital gain and current income may influence form )fcapital. People in the higher tax bracket prefer capital gain as against current ncome.Hence preference for equity instruments is evinced by them. So, firms nay opt forequity capital. Management philosophy comes next Some management are notinterested in debt financing at all. Colgate-Palmolive Ltd. is an all-equity firm bychoice. Some companies depend extensively on debt capital. Management orientationis one of the deciding factors. Legal stipulation as to debt ceiling is another factor influencing capitalstructure. Earlier a debt equity norm of 2:1 was generally insisted on by thecontroller of capital issues. Though no longer this legal stipulation exists with therepealing of the Capital Issue Control Act, it has become a rule of thumb. Banks andfinanciers look at the debt equity ratio before committing further debt investment in afirm. Free-pricing of public capital issues, now in vogue in the country madecompanies using more equity financing than debt financing.5.2.3 Optimal Capital Structure As already referred to companies want to be optimally structured i tocapital. Neither over dependence on equity nor on debt capital is advised. Againextent of dependence on any type of capital is influenced by both firm lific andmarket-wide factors. Optimal capital structure as earlier referred to is one that:maximizes value of the firm, minimizes overall cost of capital, rigidity of capital BSPATIL
  • 180. structure, enhances control over affairs of the less, increases simplicity of capitalstructure, ensures enjoyment of tax , helps reaping financial leverage benefits to themaximum and so on. Optimum capital structure is a classical concept. Debt capital and capitalare in fine balance here producing optimal results on value, cost, ige, and the like. Asa firm uses debt upto a level its value increase. Beyond level debt capital provescostlier and value starts dropping downwards.The debt equity, point at which value is maximized, is called the optimal capitalstructure. Optimal capital structure varies with firms and with market factors. Asmarket and firm specific factors keep changing, optimal capital structure also varies. Businesses try to reach optimal capital structure. Do they reach isquestion mark. Mostly, they are about, but not at optimal capital structure.5.2.4 Theories of Capital Structure The theories of capital structure analyses whether or not value of the firmis influenced by capital structure. There are several theories of capital structure. Netincome, net operating income and Modigliani-Miller theories are some capitalstructure theories. The theories are based on the following general assumptions: i) Only two sources of capital, debt and equity, are used ii) Debt capital is cheaper than equity capital iii) Debt capital cost is fixed iv) There is no corporate taxation v) There is perfect competition in capital market vi) There is 100% dividend payout. vii) The total assets do not change, there is no expansion viii) The operating profit, ie., EBIT remains constant BSPATIL
  • 181. ix) Business risk is constant over time and is independent of capital struct and financial risk. x) There is perpetual life of the firm. 5.2.5 Net Income Theory The Net Income Theory (NIT) was propounded by D.Durand. The theory considers that capital structure influences value of the business. As more and more of debt capital is employed, value of the firm increases, as per the theory. Chart 5.1 gives a graphical explanation of the theory. Vertical axis measures cost and horizontal axis measures leverage, ie., debt / Equity. Chart 5.1 Net Income Theory Leverage (D/S) The theory assumes that both Ke and Kd are constant. As more and debt is used, the Ko decreases and at extreme position Ko - Kd when no rity is used. As, Ko decreases, value, ‘V’ rises. Let EBIT = Rs. 1,00,000. Let the debt carry 10% coupon. The Ke = L5%. Then for varying levels of debt capital being employed, the value of the - changes as deduced below: Details: Case l Case 2 Case 3Debt Rs.2,00:000 Rs.4,00,000 Rs.6,00,000 BSPATIL
  • 182. EBIT Rs. 1,00,000 Rs. 1,00,000 Rs.1,00,000(Less) interest on debt@10% (I) Rs. 20,000 Rs. 40,000 Rs. 60,000Net income on equity (NI) Rs. 80,000 Rs. 60,000 Rs. 40,000Ke% 12.5 12.5 12.5Value of equity(S):NI/Ke Rs.6,40,000 Rs.4,80,000 Rs.3,20,000Value of debt (D): I/Kd Rs.2,00,000 Rs.4,00,000 Rs.6,00,000IK/KdValue of debt (V):(S+D) Rs.8,40,000 Rs.8,80,000 Rs.9,20,000Ko=EBIT 11.9% 11.4% 10.9% It is seen above that value increases and overall cost of capita! decreases as more and more of debt is used. The optimum capital structure is undefined here. As we use more of debt we may approach the optimum capital structure. 100% debt firm is perhaps optimally capital structured as per this! theory. But that is the most unreal. Such situation has no capital structure at alt] as only one type of capital is used. 5.2.6 Net Operating Income Theory (NOIT) Net operating income theory is also suggested by D.Durand this is a negation of the NIT. As per the NOIT all capital structures are equally good or bad. So any capital structure can be taken as optimum. It can be also told that there is no optimal capital structure. That is value of firm and overall cost of capital are unaffected by capital structure. The theory assumes that both Kd and Ko are constant and it is the equity capitalisation rate (Ke) that is changing. Ke changes with leverage, Ke = Ko + (Ko-KdXD/S), Where D - value of debt, S - value of equity and S = V-D, where V is the value of the firm = EBIT/Ko. Ko depends on risk complexion of the business and not on capital structure. In Chart 5.2 NOIT is represented. BSPATIL
  • 183. Let EBIT - Rs. 1,20,000; Kd = 10%; Ko = 12%. We can prove that Vremains constant as shown below. Case 1 Case 2 Case 3Debt Rs. 2,00,000 Rs. 4,00,000 Rs. 6,00,000EBIT Rs. 1,20,000 Rs. 1,20,000 Rs. 1,20,000V=EBIT/Ko Rs. 10,00,000 Rs. 10,00,000 Rs. 10,00,000Dept interst 10% Rs. 20,000 Rs. 40,000 Rs. 60,000Earnings after interest Rs. 1,00,000 Rs. 80,000 Rs. 60,000Market value D (I/Kd) Rs. 2,00,000 Rs. 4,00,000 Rs. 6,00,000S=V-D Rs. 8,00,000 Rs. 6,00,000 Rs. 4,00,000Ke=NI/S 12.5% 13.3% 15.0% It is seen that Ke is raising with rising leverage, that is more and use ofdebt Ke is increasing in a linear ratio with leverage (D/S). For instance, whenD=2,00,000 and S=8,00,000, Ke = Ko+(Ko-Kd)B/S = 12 + (12-12,00,000/8,00,000 -12 + 2(0.25) = 12.5%. When D - 6,00,000 and S = 4,00,000, Ke = 12 (12-10) 1.5=15%. As leverage rises, equity shareholders expect higher return in order tocompensate the increasing financial risk they are exposed to.5.2.7 Modigfiani - Miller (MM) Theory: (Without corporate taxation) Franco Modigliani and Merton H.Miller proposed a theory of capital BSPATIL
  • 184. structure which appeared like the NOIT in effect, but different in process. Like NOIT,MM theory holds that Ko and V are independent of capital structure Ko and V areconstant for all leverage. Ke is rising with leverage and is equal to the sum of Ke of anequity capitalisation rate of a pure-equity firm and a financial risk premium which isequal to the difference between the equity capitalisation rate of pure equity firm andcost of debt times the leverage ratio, i.e., debt to equity. MM adopt the arbitrage process to prove their theory. Suppose two firms,one using debt capital (L-Levered firm) and another not using any debt capital (U-Unlevered firm) are identical in all other aspects. EBIT = Rs.2,00,000; Debt used Rs.10,00,000 with a coupon of 10%. Let the equity capitalisation of L be 16% and of Ube 12.5%. Then the value and Ke of the firms shall be as shown below: L UEBIT 2,00,000 2,00,000Less Debt interest 1,00,000EAI 1,00,000 2,00,000Ke 16% 12.5%Value of shares S = EAI/Ke 6,25,000 16,00,000Value of Debt = D 10,00,000Valueoffirm = V = S+D 16,25,000 16,00,000Ko-EBIT/V 12.3% 12.5% The levered firm is purported to have less cost and higher value man theunlevered firm. But this situation will not lost long and the difference will be ironedout over a period by a process of arbitrage. The arbitrage process is dealt below. Here Ls shares are commanding a higher market price. So, investors willbegin to sell the shares. Say A is holding 1% of shares of L. His present income is 1%of Rs. 1,00,000 or Rs.iOOO. By selling his holding he realizes Rs.6250, ie., 1% of BSPATIL
  • 185. Rs.6,25,000, the value of shares of I/. He in turn buys 1% of shares in “U”. To buy 1% of shares in U, whose shares are under-priced, ‘A’ ; needs Rs.16,000 an additional sum of Rs,9750 is needed, which he borrows at 10%. It isassumed that A can borrow at the rate companies do borrow and ‘A’ is not to feeluncomfortable of such personal borrowing. And with the Rs. 16,000, now he has Abuys 1% of shares in U. His gross income will be 1% Rs.2,00,000 or Rs.2000. Out ofthis Rs.2000, he has to pay interest Rs,.975 on borrowed sum. His net income isRs.2000-Rs.975 - Rs.1025, which is iter than the income which he used to get on hisshare holding in L. The additional income of this arbitrate process drives moreinvestors to sell their holding in ‘L’ and buy shares of U. Due to selling pressureprice of shares of ‘L’ falls and due to buying pressure price of shares of ‘U’ rises andthat the ial position of price of shares of L being higher than that of ‘U’ is no longerexisting. Thus, in the long run, whether a firm is levered or unlevered, ie., whetherone uses debt or not, value and overall cost of capital cannot be influenced by thisfactor, other things remaining constant. Thus this is similar to NOI theory.5.2.8 M-M Approach (With corporate taxation) If corporate taxes are there, value of the levered firm will be higher andoverall cost of capital of the firm will be less than those of an unlevered firm. That, VLVu + DT, Where VL= value of levered firm, Vu - value of unleavred firm and DT is thevalue of debt times corporate tax rate. So, to the against of debt multiplied by taxrate, the levered firm is going high in value as against the unlevered firm. Chart 5.3gives a pictorial presentation of value of leveraged and unlevered firms. BSPATIL
  • 186. Chart 5.3 MM Theory value otlevereri and unlevered firm (with tax)5.2.9 Limitations of Capital Structure Theories First the assumption that Kd remains constant for all levels of leverage isnot right. As debt rises Kd is likely to rise. Second, under MM theory, the individualhas to go for personal debt to effect the arbitrage process. Such practice may not beliked by all investors. Asking a person to go for a leveraged portfolio may not becomfortably received. Third, for personal loan, rate of interest is generally higher thanon corporate borrowings. Hence the incentive for arbitrage is wiped out. Fourth, theassumption of perfect competition is no good. Fifth some corporate investors cannotgot for leverage portfolio and that arbitrage process cannot take place. Mostassumptions of the theories are bordering around unreality.5.2.10 Traditional theory As per traditional theory of capital structure, upto certain level ofleverage, Ko declines, afterwards it increases. In other words, there is a definedoptimum capital structure. At the optimum capital structure, marginal real cost ofdebt is equal to the marginal real cost of equity. For a debt equity ratio before theoptimum level, marginal real cost of debt is lower than that of equity and beyondoptimum level of debt equity, marginal real cost of debt is more than that of equity.Marginal rea! cost of debt = out of pocket cost + implicit cost of debt like bankruptcycost. Initially implicit cost is negligible and that overall cost falls. Both the out ofpocket and implicit costs rise, as leverage rises. As a result overall cost rises. In the BSPATIL
  • 187. process, Ko passes through a minimum point. That is called the optimum capitalstructure. Chart 5.4 gives a pictorial presentation of the traditional theory. Ke isrising with leverage, while Kd is constant and Ko initially slopes down. Once Kd startsrising after certain leverage level, Ko starts rising. The lowest point of Ko is theoptimum capital structure.Chart 5.4 Traditional Theory5.2.11 Significance of Capital Structure Analysis In a world of corporate taxation, capital structure is analysis is relevant.It helps firms to have optimum capital structure. More the tax rate, more debt willhelp maximizing value of the business. Yet, there is a limit, beyond which debt capitalinduced leverage benefit may be eaten away by enhanced financial and business riskrequiring the firm to pay more interest on debt as well as more reward to equityinvestors.53 SUMMARY BSPATIL
  • 188. Cost of capital, one of the influencing factors of choice of capitalstructure, varies with type of capital and the tax factor. There are differentapproaches to compute specific cost of capital. Overall cost of capital can becomputed taking book weights, market weights or marginal proportions used. Cost ofcapital is a significant factor as this influences even/the choice of projects a firm cantake up. Capital structure refers to the proportion of different types of long-termfunds used by a business. Capital structure is supposed to influence the overall costof capital and the value of the business. There are different theories of capitalstructure. Net income and net operating income theories were proposed by Durand.The former tells extensive use of debt enhances value, while latter tells that value isindependent of capital structure. MM theory with out taxation is similar to NOI theoryin the final disposition. But MM theory with corporate taxation is similar to NI theoryin the effect on value. MM theory however uses a different line of argument.Traditional theory of capital structure recognizes the concept of optimal capitalstructure.5.4 SELF ASSESSMENT QUESTIONS1) Explain the different concepts of cost of capital.2) Present the opportunity cost of capital for retained earnings and for trade credit with cash discount option.3) A firm has issued, 5 year Rs.500 debentures at a net price of Rs.460. The debentures carry a coupon of 12% p.a and redeemable at 5% premium. Ta rate is 40%. Find the pre-tax and post-tax cost of debentures.4) A firm has floated preference shares redeemable at par after 7 years, face value Rs. 1000, coupon dividend 10% and issue expenses 3%. Findthei of the shares.5) XYZ Ltd. has a paid up capital of Rs.6 crs of equity shares of Rs.10 each. Its BSPATIL
  • 189. shares due currently quoting at Rs.45. The company has declared dividend as follows for past 5 years.Year 1 2 3 4 5Dividend 9 10.5 15 18 21(Rs. crs)Find the cost of equity as per D + g approach.6) Given Ke = 18%, Floatation cost 3% and tax bracket of shareholders of a firm at 25%. Find the cost of retained earnings.7) A firm employs the following capital funds of costs mentioned against each. Find the weighted cost as per book and market weights. ( Cost Book Market (%) value value Equity share 18 8 12Preference share 15 3 2Debentures 14 4 48) ABC Ltd. is setting up a project with a capital outlay of Rs;60 lakhs and it has the following alternatives in financing the project: Alternative I = 100% Equity finance Alternative II = Debt = Equity 2:1The Kd is 18% p.a and corporate tax rate is 40%. Calculate the EBIT at which both BSPATIL
  • 190. the alternatives provide the same EPS.9) ABC Ltd is a 100% equity firm with a Ke of 21%, XYZ Ltd, similar to ABC, except in capital mix, has a debt - equity ratio of 2:1 and its Kd is 14%. Find the Ke of XYZ Ltd. as per MM Hypothesis and find the overall average cost of capital. [Hint: KeL. = Keu + (Keu – Kd) D/E]The Ke and Kd at different levels of D/E ratio are as follows:D/E Ke(0%) Kd(0%)0.0 21 00.4 21 121.8 22 121.2 22 141.6 24 142.0 24 162.4 28 20Find the optimum capital structure.REFERENCES1. Financial Management and Policy - Van Home2. Financial Decision Making - Hampton3. Management of Finance - Weston and Brigham4. Financial Management - P.Chandra5. Financial Management - Ravi M. Kishore *** BSPATIL
  • 191. MANAGEMENT OF CURRENT ASSETS In this unit you will learn forecasting of current assets, objectives andtechniques of cash and liquidity management, objectives and techniques ofreceivables management, evaluation of alternative credit policies and significance,objectives and methods of inventory management.INTRODUCTION Current assets constitute an important investment of any business.Current assets include inventory (raw materials, working progress, finished goods,sundry materials, tools and jigs, etc.) receivables (bills receivable and sundrydebtors), deposits with suppliers, cash on hand, balance with banks, prepaidexpenses, etc. The management of current assets is concerned with the size andcomposition of the current assets of the business. The size must be optimum so thatthere is neither over nor under investment. The composition should reflect the qualityof current assets.6.1 FORECASTING OF CURRENT ASSETS Level of current assets required by a business is influenced by severalfactors. We have studied the same in our lesson on working capital. Seasonal factors,operating cycle, credit policy, etc. influence current assets. To forecast current assetsbudgetary techniques, accounting techniques, and Statistical techniques can beused. BSPATIL
  • 192. 6.1.1 Budgetary Technique The budgetary technique involves budgeting for various components ofcurrent assets, based on average life of each items of current assets, average value ofeach item of current assets in terms of selling price per unit and total sales volumeprojected for the budget period.Illustration 6.1 Budgeted sales for the next year for a firm is 104000 units. The coststructure per unit of output is as follows:Raw material (Rs) 4Labour 5Production overhead 2Administrative overhead 1Selling overhead 3Profit 6 Total 21 4 weeks raw material stock, 2 weeks’ work in process stocks and 6 weeksfinished goods stock are needed. Two months credit need to be given for customers.A contingency of 10% to the computed currents assets figure is needed. Find thecurrent assets required for the business. Production and salt are even throughout theyear.Solution BSPATIL
  • 193. We have to work out the value of each item of current assets namely, rawmaterial, work in progress, finished stock, debtors and contingency component. Thesame is attempted below:Annual sales and production : 104000 UNITSAnnual weekly production : 104000 / 52 - 2000 unitsThe following formula is adopted for any component,Value of the component = Weekly production x unit cost of that component x period of stock of that component.Raw material stock = 2000 x Rs.4 x 4 - Rs.32000Work-in progress stock = 2000 x Rs. 11 x 2 - Rs. 44000(Note: WIP unit cost = Raw material + Labour + Production overhead each per unitRs. 5+4+2 = Rs.11)Finished goods stock - 2000 x Rs. 1 2 x 6 - Rs. 1 ,44,000(Note: Finished stock unit cost = WIP cost per unit + Admn. Overhead= Rs. 11+1 =Rs. 12)Debtors stock - 2000 x Rs.21 x 8 = Rs.3,36,000(Note: Weekly units x selling price per unit x weeks of credit; 2 months = 8 weekly).Total of all the four components - Rs.32000 + 44000 + 144000 + 336000 =Rs.556000.To this 10% contingency be added. BSPATIL
  • 194. Total current assets = Rs. 5,56,000 +10% = Rs. 5,56,000 + 55,600 = Rs. 6,11,6006.1.2 Accounting Technique Accountants estimate current assets need of a business by studying therelationship between current assets and sales. A percentage of estimated sales aretaken as the value of current assets needed.Illustration 6.2 For the year just ended a firms current assets were: stock Rs.10 lakhs,receivables Rs. 11 lakhs and cash Rs. 1 lakh. The sales amounted to Rs.50 lakhs. Forthe ensuring year sales are estimated at Rs.90 lakhs. Find the current assetsrequirement of the business,Solution First let us find the percent of current assets to sales for the last year. Rs. 10 lakhsStock as % of sales = ——————— x 100 = 20% Rs.50 lakhs Rs. 11 lakhsReceivables % of sales = —————— x 100 = 22% Rs.50 lakhs Rs. 1 lakhCash as % of sales = ——————— x 100 - 2% Rs.50 lakhs BSPATIL
  • 195. So, the current year current assets needed on basis of last years percentbasis are as under: Stock: 20% of sales = 20% of Rs.90 lakhs = Rs. 18.00 lakhs Receivables:22% of sales = 22%of Rs.90 lakhs= Rs. 19.80 lakhs Cash : 2% of sales - 2% of Rs.90 lakhs = Rs. 1.80 lakhs Total = Rs. 38.6 lakhs6.1.3 Statistical Techniques Statistical techniques analyse the relationship between ci assets andcomponents of current assets and one or more other variables sales, cost ofproduction, etc. Through regression (simple or multiple) analysis the relationshipequation is established And then the value of current assets is computed. Time seriesmodel can also be used to estimate current s«ets needed.Illustration 6.3 The sales and current assets of a business over a period of years arestudied and a definite relationship is established. During the last five years the, salesand current assets are: BSPATIL
  • 196. Sales value ( 160 220260 285 345Current assets (Rs. crs): 110 135157.5 217.5 225 Estimate the current assets needed for the current year with projectedsales of Rs.435 crs, using simple linear regression.Solution The linear regression model has TO be used here. Sales Current Assets X Y XY X2 160 110.00 17600.0 25600 220 135.00 29700.0 48400 260 157.5 40950.0 67600 285 217.5 61987.5 81225 345 225.0 77625.0 119025 1270 845.0 227862.5 341850So, ∑X = 1270, ∑Y = 845, ∑XY = 227862.5, ∑X2 = 341850For linear regression: Y = a + bx, we have to solve two equations to get the value landb.Na + ∑Xb = ∑Y ; a∑X + b∑X2 = ∑XYThe equations are: 5a+1270b = 845 --- (1) 1270a + 341850b = 227862.5 --- (2)(1) x254; 1270a + 322580b = 214630 --- (3)(2) - (3): 19270b = 13232.5 b = 0.6867 5a = 27 ; a=5.4 BSPATIL
  • 197. Y = -5.4 + 0.6867X. Suppose X = 400; then Y = -5.4 + 0.06867x400 = 269.286.2 CASH AND LIQUIDITY MANAGEMENT Management of cash and liquidity is concerned with providing sufficientcash for meeting cash needs of a business as and when needed. It involvessynchronizing outflows and inflows of cash. Outflows of cash are of several types.Redemption of debt, retirement of debentures, repayment of bank loans, payment oftaxes, interest, dividend etc. are capital account outflows of cash. Payment of wages,for purchases, for overhead expenses, etc. are operating cash flows. Similarly, inflowsare of several types. Issue of shares and debentures, raising of debt and publicdeposit, receipt of dividend/interest on inter corporate investment, etc. are capitaltype of cash inflows; cash sales, realisation from debtors, etc. constitute operatingcash inflows. A matching of cash inflows with cash outflows is essential. But this isnot possible to the complete extent. So, occasionally outflows might exceed inflowsresulting in cash deficiency and occasionally cash inflows may exceed cash outflows-resulting in surplus. ^Managing cash deficiency by holding reserve cash managingcash surplus by going for investment of excess cash are essent functions of cashmanagement. Van Home defines cash management “efficient collection, disbursementand temporary investment of cash”.6.2.1 Objectives of Cash Management Cash is a barren asset. Holding too much of cash involves cost. There isloss of interest. But more liquidity is there. Holding too little of cash also involves acost as day-to-day operations may be hindered reducing liquidity. Profitability may behigh as there is no idle cash. Businesses need both profitability as well as liquidity.Hence optimum cash level need to be maintained. Determining and maintaining suchoptimum balance of cash is the prime objective of cash management. The objectives of cash management may be elaborated as; i) to provide cash to meet day-to-day needs of the business. BSPATIL
  • 198. ii) to providecash to meet business contingencies T. iii) to provide cash to profit from speculative trades iv) to match inflows of cash with outflows of cash v) to tide over cash deficiency ably. iv) to profitably employ excess cash, if any, vii) to ensure that there is neither paucity of cash nor excess cash balance. v) to maintain good relations with bankers so that they do not hesitate to come to the help of the firm, if need be. vi) to ensure prompt collection of dues to the firm from varied parties. vii) I to ensure that payments are effected timely taking advantage of cash discounts, etc if that is profitable to do so.62.2 Motives for Holding Cash Individuals and institutions have a preference to hold cash. This is asliquidity preference, to use the language of J.M.Keynes. What are the motives behindthis liquidity preference? These are given as: transaction motive, precautionarymotive and speculative motive. Transaction motive of cash holding refers to cash holding for meetingtransaction needs of the business. To pay for purchases, for labour, for overheadsand others, a firm needs to carry cash. Depending on the size of operation, the cash-credit composition of transactions and the like, the holding of cash for meetingtransactions shall vary. In a general sense, the main motive for holding cash is to promptly payoff creditors as and when dues to them mature for payment. This is the transactionmotive. Advance retirement of debts to take advantage of cash discount, if any,allowed is another transaction motive. To make cash deposit with suppliers, toensure uninterrupted supply cash may be needed. This is again transaction motive. BSPATIL
  • 199. Precautionary Motive of cash holding refers to holding of cash formeeting unforeseen business contingencies. Due to a sudden pick up a demand orfall in debt collections or cash sales, or urgent expenses cash need my rise. Abusiness must provide for such contingencies. Businesses that ar inctioning in avolatile market, that are subject to seasonal pulls and pressures, lat face fast rate offashion changes, that face stiff competition and the like hold ,iore cash for meetingunforeseen contingencies. Speculative Motive of cash holding refers to cash holding to profit fromprice fluctuation. If prices of inputs are expected to rise in the future, a firm withstrong cash base may buy now for sale later and profit thereby. Similarly, if j pricesare expected to fall, a firm may short sell (selling without holding) nowj and buy laterat lower price and may profit thereby. This profiteering by the by the price movementis known as speculation. Some management, especially the and cash rich dospeculate and gain. It is a risky affair. So, only the able shrewd do the speculation. Apart these liquidity motives, a firm may be required to hold ascompensation balance with banks. A minimum credit balance need to maintained inbank accounts. This is known as compensation balance, quantum of compensationbalance varies with banks. Foreign and the newly formed private sector banks inIndia demand a high minimum credit balance inaccount6.23 Cash Budgeting Budgeting is determining in advance the level of activity income andexpenses) for a definite period of time and the policy to be paid to be pursued toachieve the planned level of activity. Cash budgeting is determining in advance diecash inflows and cash outflows for a definite future period. It is a tool for foreseeingthe period or periods when cash surplus and extent of surplus and cash deficiencyand the amount of deficiency are expected and devising .measures to manage boththe situations. Cash budget is usually prepared for a sbort period, ranging betweenfew weeks and a maximum of 6 months. Long-run forecast is resorted to in a limited BSPATIL
  • 200. way. Usually the duration of cash budget Id cover one cash cycle period. There are three methods of preparing cash; budget. Batancesheet Method, cash flow statement method and receipts and payments method are the 3 methods. In the balancesheet method a forecast balancesheet is prepared to the cash balance on the date of the balance sheet. This method has no tional use except indicating the net cash position on the particular date. The cash flow statement method prepares cash inflows and outflows during an accounting period based on forecast incomes and expenses it and forecast balancesheet. This is slightly better than the balance sheet lod for one can find cash inflow and outflow on various heads. But only jgates for an entire period are given. As break up figures are not available is eroded. An exercise on this method of preparing cash budget follows. Illustration 6.1 Forecast Balance Sheets of X Ltd. on 1-1-2003 and 31-12-2003 are as follows : Balance Sheet (Figures in Rs.) Liabilities 1-1-2003 31-12-2003 Assets 1-1-2003 31-12-2003Creditors 40,000 44,000 Cash 10,000 7,000Mrs. X’s 25,000 - Debtors 30,000 50,000loanLoan from 40,000 50,000 Stock 35,000 25,000bankCapital 1,25,000 1,53,000 Machinery 80,000 55,000 Land 40,000 50,000 Building 35,000 60,000 BSPATIL
  • 201. 2,30,000 2,47,000 2,30,000 2,47,000 During the year 2003, a machine costing Rs.10,000 (accumulateddepreciation Rs. 3,000) is to be sold for Rs. 5,000. The provision for depreciationagainst machinery as on 1-1-2003 is Rs. 25,000, and on 31-12-2003 it is Rs. 40,000.Net profit for the year 2003 is estimated to be Rs. 45,000. You are required to preparecash flow statement.Solution Forecast Cash Flow StatementCash balance as on 1-1-2003 Rs. 10,000Add: Cash in flow:Cash from operation 59,000Loan from bank 10,000Sale of machinery 5,000 74,000Less: Cash out flows: 84,000Purchase of lands 10,000Purchase of building 25,000Mr. Xs Loan repaid 25,000Drawings 17,000 77,000Cash balance as on 31-12-2003 7,000Working notes 45,000Cash from operations 18,000Profit made during the year 2,000Add: Depreciation on machinery 10,000Loss on sale of machinery 4,000 34,000Decrease in staff 79,000Increase in creditors 20,000Less: increase in debtors 59,000Cash from operations BSPATIL
  • 202. BSPATIL
  • 203. Machinery AccountTo balance b/d 1,05,000 By Bank 5,000 Loss on sale of machinery 2,000 Provision for depreciation 3,000 Balance c/d 95,000 1,05,000 1,05,000 Provision for depreciationTo Machinery a/c 3,000 To Balance b/d 25,000To Balance c/d 40,000 By P&L A/c (depreciation charged balancing figure) 18,000 43,000 43,000 The receipts and payments is the third method. Under this methodmonthly/weekly/fortnightly receipts and payments can be known. And that a hettermonitoring of cash position is possible here. Let us consider the methodology ofpreparing a cash budget here, on a monthly basis. Start with opening cash balance for the 1st month of the cash budgetperiod. Record various receipts month-wise and item-wise. Cash sales are first item.Collections from debtors is the second item. Depending on the terms of credit,collections from debtors are effected. Other occasional receipts are then recordedwhenever expected. Dividend received, share capital raised, debt capital raised, etc.come here. For the first month now total resources (opening BSPATIL
  • 204. balance & receipts) can be found. Payments are now recorded. First cash purchasesand other cash operating expenses are recorded. Payments to creditors, as per termsof credit allowed, are recorded. Occasional payment like purchase of plant,machinery, redemption of debt, payment of tax, dividend and interest, etc. arerecorded. Total payments can be found month-wise now. From total resources of 1stmonth, total payments of 1st month are deducted to get closing balance of 1st month.This becomes opening balance for the second month. Then for the second month totalresources and total payments can be found and then for that month closing balanceis found- Negative closing balance reflects deficiency and the next period openingbalance is therefore a negative balance reducing that months total resource. Anillustration is given below.Illustration 6.2 The projected sales of ABC Limited for the months of July toNovember are Rs. July 6,20,000 August 6,40,000 September 5,80,000 October 5,60,000 November 6,00,000The anticipated purchases are Rs. July 3,80,000 August 3,33,000 September 3,50,000 October 3,90,000 November 3,40,000 The wages are expected to be Rs. 1,00,000 per month. The management isexpected to pay two months wages as bonus during October. The company isexpected to pay an advance tax Rs. 90,000 before 15th September. The company has BSPATIL
  • 205. ordered in June for a machine costing Rs.16,00,000. IDBI has agreed to finance thepurchase of machine which is expected to be delivered in January next. The companyhas advanced 5% in June with order, and they agreed to pay another 10% advanceafter 3 months. The company extends 2 months credit for the customers and thecompany enjoys one month credit from the suppliers. The general expenses for thecompany is Rs. 60,000 per month payable at the end of each month. The companyanticipates to receive interim dividend of 10% for the investment of 90,000 shares ofRs. 10 each during October. The company anticipates to have an overdraft of Rs.40,000 on 1st September (limit sanctioned is Rs. 55,000). Draw a cash budget forSeptember-November for approaching your bankers for a short-term further credit.Solution Working notes are: (1) In Sep, collection for July sales, in Oct collectionfor Aug sales and in November collection for Sep sales are obtained (2) Interimdividend is received m Oct. (3) As there is no opening cash, total resource for Sep, isRs. 6,20,000. (4) Payment for Aug purchases is made in Sep, for Sep purchases inOct and for Oct purchases is Nov. (5) Wages paid monthly, (6) Bonus paid in Oct. (7)Advance tax and Advance for purchase of machine are paid in Sep. (8) Gen. Expensespaid monthly, (9) Total payment for Sep. is Rs. 7,43,000. (1) Deficit in Sep. is Rs.1,23,000 for which bank loan is obtained. (11) So there is no closing cash balance inSep and hence no opening balance for Oct. (12) For other months figures are workedsimilarly. BSPATIL
  • 206. ABC Limited Cash Budget for September - November September October November Rs. Rs. Rs.Receipts :1 . Cash Balance in the beginning 0 0 02. Collection from debtors 6,20,000 6,40,000 5,80,0003. Interim dividends — 90,000Total cash available (A) 6,20.000 7,00,000 5.80.000Payments:1, Payments to creditors for purchases 3,33,000 3,50,000 3,90,0002 Wages 1,00,000 1,00,000 1,00,0003 Bonus of workers - 2,00,000 -4. Advance tax for income tax 90,000 - -5. Advance for the purchase of 1,60,000machine6. General expenses 60,000 60,000 60,000Total payments (B) 7,43,000 7,10,000 5,50,000"Surplus (Deficit) (A-B) (1,23,000) 20,000 30,000Finance requires:Borrowings 1,23,000 - -Repayments - 20,000 30,000Total effect of financing (C) 1,23,000 20,000 30,000Closing Cash Balance (A+C-B) 0 0 06.2.4 Planning optimum level of cash: Determining the optimum level of cash that should be held is a crucialpoint in cash management. It was seen already that firms hold cash for transaction,precaution and speculation purposes. How much? It should not be too much, asholding cost will rise (loss of interest that could be earned). It would not be too littleeither as opportunities may be missed and frequent short term cash resource raisingactivities may have to be entertained resulting in added transaction cost. Hence anoptimum cash balance be held. Inventory model may be adopted here to find theoptimum cash balance.EOQ Model BSPATIL
  • 207. To find the optimum cash balance the net cash outflow during a period,the interest rate per rupee per period and the transaction cost per transaction areneeded. The optimum cash balance (EOQ Model) is obtained by taking the squareroot of 2AT/I, Where A is the annual net cash needs (which is the excess of outflowsover inflows), T is the transaction cost per transaction; and T is the interest per rupeeper annum. The chart 6.1 given at the end gives a pictorial explanation optimum cashbalance. Cash balance is taken on the horizontal axis and cost i taken on the verticalaxis. As cash balance rises, the carrying cost (interest increases and vice versa. Thetransaction cost moves in the opposite directk cash balance. At optimum level of cashbalance, both the transaction cost carrying cost are equal to each other and total costis the least.Illustration 6.3 During, a year a firm forecasts that is cash outfiows will exceed cashinflows by Rs. 8,00,000. The transaction cost per transaction is Rs. 150 and interestrate is 15% p.a.Solution BSPATIL
  • 208. The optimum cash balance is square root of 2 x 8,00,000 x 150 / 0.15 =Square root of: 2 x 8,00,00 x 1000 = Rs. 40,000. Total number of transactions will be:8,00,000/40,000 or 20. The total transaction cost: 20 x Rs. 150 = Rs. 3,000. Thecarrying cost is: average cash times interest rate. Average cash balance is Rs.40,000/2 = Rs. 20,000. Carrying cost is = Rs. 20,000 x 0.15 = Rs. 3,000. The totalcost is Rs. 6,000. Instead of Rs. 40,000 optimum cash balance, suppose Rs. 80,000 isconsidered as cash balance. Then the total carrying cost will be Rs. 6000 and totaltransaction cost Rs. 1500 and total cost Rs. 7500. Thus, cost is minimum at theoptimal cash balance of Rs. 40000. 20 times over the year, or every 18th day, Rs.40000 cash will be arranged to manage excess outflows. The method assumes uniform rate of cash inflows and outflows.Transaction cost, carrying cost etc. are known to be constant. This certaintyassumption, however, is not sustainable in a world of risk and uncertainty. The dailycash balance under this model shall be as in chart 2. Q is the EOQ level of cash,steady payments reduces balances to zero. Immediately cash balance is restored toQ and payment made,Miller - Orr Stochastic Model A Stochastic model is suggested by Miller and Orr. The certaintyassumption of inventory model is not tenable in real world. So, a model based onbusiness realism is needed. Miller-Orr model assumes away certainty and is based onuncertainty. The model is based on a two-asset theory. That is, the firm has cash andmarketable securities to complement each other. When excess cash is there, thesame is invested in marketable securities and when deficiency of cash balance is felt,marketable securities are realised into cash. The model establishes two cash levels -the minimum and maximum. In between an optimum level (Z) is fixed which is: 3√S2b / 4i, where s2 is the variance of daily net cash balance, b is the transaction cost(cost of investing in marketable securities or cost of liquidating investment) pertransaction, ‘i’ is the interest per day per rupee investment in marketable securities. BSPATIL
  • 209. In Chart 6.2, the Miller-Orr model is exp* ned. Once the optimal level, ‘Z’is determined an upper bound is fixed such that the upper level ‘H’ is 3 times theoptimum level. The lower bound, ‘U’ is fixed, below the optimum level, independentlyof the model. When actual cash balance touches the upper bound, ‘ZH’ level of cash isinvested in securities, bringing cash level to the optimum level ‘Z’. When cash balancetouches the lower bound, ‘L’, ‘LZ’ amount of cash is generated by selling marketablesecurities. The model is complex and difficult to operate. Short-term borrowing as analternative to selling of marketable securities is not considered by the model. Itscomplexity makes it less practicable.Chart 6.2 : Miller Orr ModelIllustration 6.4 The daily net cash balances in a business for a 15 days period are:Rs.1500,1400,1300,1200,1100,1000,900, 800, 900, 1000, 1100, 1200,1300, 1400and Rs. 1500, The interest rate per day per rupee is 0.001 or 36.5% per annum.Transaction cost is Rs. 40 per transaction fix Z & H. Then the s is 186667. Then Z =cube root of 3 x 186667 x 40 / .001 x 4 - cube root of 3 x 186667 x 10000 = Rs. BSPATIL
  • 210. 1750. ‘H’ will be 3 times of Z or Rs. 5250. Let the low point be Rs. 750. As long ascash balance moves within Rs. 5250 and Rs. 750 range no intervention will be taken.If however, when the cash balance reaches the Rs. 5250 mark, Rs. 3500 will beinvested in marketable securities reducing cash balance to the optimum level of Rs.1750. If cash balance falls to Rs. 750, marketable securities will be sold to the extentof Rs. 1000 to take the cash balance to Rs. 1750. Can instantaneously and in exactquantities such investment/ disinvestment be made are debatable questions.7. Collection Practices Cash management is intimately connected with realization from debtors.Prompt collection from debtors is preferred for that involves less money being locked-up in accounts receivables, less bad debts, etc. How can collections be prompted? Wecan give cash discount to prompt collections. Besides a system of decentralisedcollection is suggested for prompt collections.Concentration Banking is a technique of decentralised or prompt collection.Concentration banking system works this way: (i) there is decentralised billing ofcustomers, so that immediate dispatch of goods, invoices are made and dispatched,(ii) customers are directed to send the remittances to corresponding regional offices,(iii) regional offices on receipt of remittances send them to banks for collection, (iv)After collection is effected, after retaining a minimum sum, the regional office sendsthe balance on account to the head-office bank account. As all such cash balanceremittances get concentrated in the head-office bank account, the method is knownconcentration banking. This system involves quick dispatch of invoices, quickreceipt of remittances, quick posting of entries, quick forwarding of remittances tobanks for collection, quick collection by banks and lump-sum transfer to theconcentration bank of collections from debtors. As a result, collection float, that is,total time between mailing of a cheque by a consumer and the availability of cash tothe receiving firm, is reduced. Lock-box System is another method of prompt collection. Here (i) the BSPATIL
  • 211. regional branch offices send invoices to credit elastomers in respective branch areasand direct them to send remittances to specified post-boxes hired from post-officeunder an arrangement (ii) the bankers of the company clear the post boxes severaltimes a day and process for collection and also inform the firms branch office of theremittance (iii) after keeping a minimum balance, thef rest of funds is remittedonward to the firms main bank account. Lock box system is an improvement over the concentration system. Inlock-box system the bankers clear the remittances from post-boxes instead ofremittances being sent to branch offices and branch offices sending the cheques andbills to the bankers for collection. Thus one more interim step is skipped to speedupthe collection. Preauthorised debit is another method of prompt collection. He thetransfer of funds from payers bank to payees bank is pre-authorised triggered, bythe payee with payers advance authorization. Now-a-days cash transfer is also done electronically - E-cash is used toinstantly transfer funds from payers bank to the payees bank. Electronic fundtransfer through SWIFT i.e., Society for Worldwide Inter-bank FinancialTelecommunication, and CHIPS, ie.. Cleaning House Inter-bank Payment System; isnow in vogue to instantaneously transfer funds.8. Payment Practices While collections are prompted through decentralisation, payments maybe centralised, so that the same are delayed to the net advantage of the firm.Suppliers are directed to send bill for payment to the Head-office. A transmissiondelay is quite possible to the advantage of the firm. This is also known as mailingfloat. A processing delay, due to centralised processing, is also imminent. Chequesare issued and posted to suppliers. Another transmission delay results. The suppliermight cause a processing delay at his end before die cheque is sent for collection toits banker. The banker sends the instrument for collection, again involving a delay.Knowing that these delays are systematic, the firm may issue cheques without BSPATIL
  • 212. sufficient cash balance on the day of issue of the cheque. This practice is known as"playing the float. The different floats involved here arc: First transmission float Processing float  Second transmission float  Processing float  Collection float. Payable through Drafts only, Zero Balance Account, remotedisbursement, controlled disbursement, etc are other alternatives of delayed paymenttactics.9. Are Prompt Collection and delayed payment possible? If one firm wants to speed up collection, others may also do so. So,prompt collection and prompt payment are likely to go together in practice. One firmmay ask its customers to send remittances to regional branch offices. Similarly, thefirms suppliers may also go for decentralised collection. The firm must adjust to thecollection practices of its suppliers. Lest, suppliers might stop supplying. Of course,everything depends on the firms equation with customers and with suppliers. If thefirms market for its output is of the sellers market type, prompt collection may beresorted to and if it is of the buyers market type this system of collection may not bepossibly. Similarly, if the firms input market is of the sellers market type delayedpayment cannot be adopted and if it is of the buyers market type delayed paymentcan be adopted. Collection efforts and payment practices are generally governed bygeneral trade practices. But in any case, every customer and every supplier areindividual cases and that the treatment meted out to them should help establishinglong-run relationship.10. MANAGEMENT OF RECEIVABLE Receivables are an important current assets. Businesses havereceivables, i.e., dues from credit customers. To increase sales, to earn more, to meetthe competitors, to achieve break even volumes, to gain a foot hold in the market, tohelp the customers on whom the business fortune is intimately in nexus and todevelop a strong brand, receivable, ie., credit sales, is vital. Maintaining accounts BSPATIL
  • 213. receivable involves cost. Administrative cost, capital cost, collection cost, bad-debtcost, etc., are diverse costs involved. As in any financial decision matching costs withbenefits is needed here too. And what is the optimum level of accounts receivable isto be decided. Too little of accounts receivable, that is very limited credit salesreduces sales, loss of customer to the competitors camp, reduced profit and so on. Ofcourse no bad debt, less capital locked up in accounts receivables resulting lowercapital cost etc., are benefits. But, a little more risk can be taken and profits can beinflated. Too much of accounts receivables lead to scale advantage and hence y-oreprofit, but costs of added bad-debt, capital cost, etc., are involved. Perhaps byreducing accounts receivables costs can be steeply reduced, when benefits are notsimilarly decreasing. Therefore optimum investment in accounts receivable has to beplanned and achieved.63.1 Credit Policy Policy is a guide line to action. Policy establishes guideposts or limits foractions. Credit policy, therefore, refers to guidelines regarding credit sales, size ofaccounts receivables, etc. Credit policy has a few variables. Credit standard, creditperiod, credit terms and collection policies are the policy variables. Credit standard refers to classification of customers on the basis of theircredit standing and stipulation of credit eligibility of different classes of customers.The high rated customers may be extended unlimited credit, the moderate creditstanding class may be extended a limited credit facility and the rest may not be givenany credit facility at all. Credit period refers to how long credit, is allowed. Longercredit period might help drawing more customers and vice versa Credit terms refer todiscount incentive for prompt payment. Even though a longer credit period may beallows, prompt payment by offering, cash discount can be ensured. 2/30, net 45means, 2% cash discount for payment within 30 days, failing which full payment bythe 45th day of transaction. Collection Policy refers the seriousness or otherwise withwhich collection is dealt with, especially the delinquent customers. It may be harsh orwarm. Credit policy can be liberal or stringent Liberal credit policy adopts a BSPATIL
  • 214. lenient credit standard (i.e., almost all are extended credit), longer credit period,higher cash discount for a longer entitlement period and informal and accommodativecollection procedure. Stringent credit policy does not opposite. Both policies haveadvantages and accompanying costs. Hence, choice must be exercised by individualfirms after assessing the net effect of liberalizing or tightening up the credit policy.6.3.2 Lenient Vs. Stringent Credit Policy An analysis of effects of lenient and stringent credit policies is depictedbelow in a table form. Factors Lenient policy Stringent policy Sales More Less Capital locked up More Less Customer base More Less Competitive edge More Less Profit More Less Customer goodwill More Less Capital cost More Less Bad debt loss More Less Administrative cost More Less Collection cost More Less Discount allowed More Less Lenient credit policy enhances benefits as well as costs. Stringenireduces both benefits and costs. Hence the problem of choice. Hence the need fordetailed evaluation for decision making. Evaluation needs to be done in respect eachand every credit policy variable. The same is done in the rest of this lesson.6.3.3 Credit StandardIllustration 6.4 A firm classified its customers into 4 classes-the nil risk, the less risk (1to 2% bad debt), moderate risk (2 to 5%) and the high risk (bad-debt exceeding 5%). Itextended unlimited credit for the less risk and insisted cash dealings with the rest. Itscurrent sales (So) amdunt to Rs. 50 lakh p.a. Average collection period (ACP) is 60days. SeHing: price and variable cost of sales (V) are Rs. 10 and Rs. 7. Cost of capital BSPATIL
  • 215. (K) is 12% p.a. The firm is considering extending credit facility to the moderate riskclass, as a result of which sales will rise to Rs. 60 lakh (Sn) p.a. Bad debts which arecurrently 0.5% of sales will rise to 1% of sales. In the credit standard relaxationwelcome? BSPATIL
  • 216. Solution The impact of the credit standard deviation can be studied in terms ofbenetfts and costs. Here, the benefit is contribution on additional sales.C = Additional Sales x Contribution Ratio Sales - Variable cost(Rs.60 lakh - Rs.50 lakh) x —————————————— Sale 10-7= Rs.l01akh x ————— =Rs.3 lakhs 10 The additional costs are ii) cost of capital additionally locked ip and ii)additional bad debt. Additional Cost of Capital = Addl. Capital x cost of capital = (Add. Sales X ACP XV) XK 360 = Rs. 10,00,000 x 60 360 = Rs. 14,000Additional Bad Debt = Bad debt on proposed - Bad debt on Present policy = (Rs. 60,00,000 X 1/100) = (Rs. 50,00,000 X 1/200) = Rs. 60,000 -Rs. 25,000 = Rs. 35,000 BSPATIL
  • 217. The net benefit = Addl. Contribution - Addl. Capital Cost - Addl. Bad Debt = Rs. 3,00,000 - Rs. 14,000 - Rs. 35,000 = Rs. 2,5 1,000 The credit relaxation is good for the business. A formula approach can be adopted here. AP = (AS X CR) - (AC X k) - ABD, where AP is change in profit, AS -change: in sales, CR - Contribution ratio, AC - Change in capital, k - cost of capital,ABD - Change in bad debts. If AP is positive, change is advised.1.4 Credit Period Credit period relaxation or tightening may be effected. The effect suchchange in policy can be evaluated and decision taken.Illustration 6.5 A firm is giving 2 months credit to its credit customers. It proposes toreduce the credit period to 45 days. Present sales are Rs, 60,00,000, CR is 10%,present bad debt is 1% of the sales and cost of capital is 15%. The effect of creditperiod contraction is expected to be a 15% fall in sales and bad debt to sales gettingreduced to 0.75% of 1 %. Assess the policy.Solution Here the benefits are reduced capital cost and reduced bad debt; The costis reduced contribution.Reduced Capital Cost = (Old Capital in Receivable - New Capital inj Receivable) X K = (S0 X ACPo/360) - ( Sn X ACPn/360 X 45/360) X K = (60,00,000 X 60/360) - (51,00,000 X 45/360) X 15/100 BSPATIL
  • 218. = Rs, 54,375. (Sn = New Sales, S0 = Old Sales, ACPn = New Collection Period, ACP0 - Old Collection Period)Contribution Loss = Reduction in sales X CR = Rs. 9,00,000X10/100 = Rs. 90,000.Reduction in Bad debt - (S0 X Old Bad debt ratio) - (Sn X New Bad debt ratio) = (60,00,000 X 1/100) - (51,00,000 X 75/10,000) 60,000 - 38,250 = Rs. 21,750.The net effect is = Benefit - Cost= (54,375 + 21,750) - 90,000= 76,125 - 90,000 = - Rs. 13,875.There is reduced profit So the policy change is not good.Illustration 6.6 Take another example. Here credit period is increased to 60 days from 45days resulting in sales rising to Rs. 60,00,000 from Rs. 51,00,000. Assuming K =15%, CR = 20%, and bad-debts to sales ratio of 1% and 1.5 in the I pre and postrelaxation period we can evaluate the relaxed credit policy.Solution Addl. Profit = Addl.S x CR -AddLCapital x K - Addl.Bad debt. Addl Sales = 60,00,000 -51,00,000 - Rs. 9,00,000. Addl. Sales X CR = Rs. 9,00,000 X 20% = Rs. 1,80,000. Capital has two components. Additional capital on old accounts andadditional capital on new accounts. BSPATIL
  • 219. Addl. Capital on old accounts = S0 x (ACPn. ACP0)/360 = Rs. 51,00,000 X (60 –45)/360 = Rs. 2,12,500.Addl. Capital on new accounts = Addl. Sales X V X ACPn /360 = 9,00,000X0.8 X 45/360 = 90,000.Therefore Addl. Capital = Rs. 2,12,500 + Rs. 90,000 = Rs. 3,02,5000; Capital Cost = Rs. 3,02,5000 X. 15 = Rs. 45,375.Addl. Bad debt = Sn x Bad debt ratio - S0- x Bad debt ratio = 60,00,000X1.5/100-51,00,000X1/100 = Rs, 39,000.Therefore Net effect = Addl.Contribution - Addl. Capital Cost – Addl. Bad effect = Rs. 1,80,000 - Rs. 45,375 - Rs. 39,000 = Rs. 95,625. The change is good and hence good to implement. Sometimes, capital locked up, (C) is calculating using average cost figureinstead of basing the same on variable cost. Suppose the average cost per unit is Rs.8 in this problem. Then AC is computed as follows. AC has two components. Increasein capital on existing accounts and fresh capital on new accounts. The former iscalculated on the average cost basis and the later on the variable cost basis.Illustration 6,6 Let the current ACP be 45 days, with sales of 30000 units. Variable costper unit is Rs. 6, average cost per unit is Rs. 8 and selling price per unit Rs. 10. Cost BSPATIL
  • 220. of capital is 15%. Increased credit period resulting in an ACP of 75 days, is likely torise sales by 4500 units. Bad debts are likely to go up to 2% of sale? from 1% of sales.What is the impact of credit period relaxation on profit?SolutionP = AS x CR – AC x K - ABDS x CR  = 4,500 (Rs. 10 - Rs. 6) - Rs. 18,000. So x AC x (ACPD - ACP0) + AS x VC x ACPnC = 360 360 30,000 x Rs.S x (75-45) + 4500 Rs.6 x 75= 360 360= 20,000 + 5625 = Rs.25,625C x K = Rs.25,625 x 0.15 = 3844BD = New Bad debt-Old bad debt = 34500 x 10 x 0.02 - 30000 x 10 x 0.01 = 6900-3000-Rs.3900 APP = Rs. 18000 -Rs.3844 - Rs.3900 = RS. 10256.63.5 Credit Terms Credit terms refer to cash discount rates, eligibility period for availingcash discount, the maximum credit period allowed and so on. Credit policy is madeliberal by increasing the cash discount rate and/or lengthening the eligibility periodand the same is made stringent by decreasing both the cash discount rate and timeto avail the same. There are both costs and benefits in each move. Hence evaluationis to be done for each proposed move and decision taken. BSPATIL
  • 221. Illustration 6.7 A firm is currently allowing: 2/20, net 45 days. Its current sales are Rs.60 lakhs, 50% of accounts are cleared by 20th day, the balance on 45th day. There isno bad debt. It is considered that, a 2/30, net 45 days will boost sales to 72 lakhsand 90% sales getting collected by 30th day. A 1% bad debt on additional sales isexpected. The contribution to sales ratio is 20%. The cost of capital is 20%. Ascertainthe utility of the above move.Solution(i) Additional Contribution = Addl. S x CR - 12,00,000 x 20/100 = Rs. 2,40,000(ii) Old ACP = 50% of 20 days + 50% of 45 days = 32.5 days,(iii) New ACP - 90% of 30 days + 10% of 45 days = 31.5 days.(iv) Decrease in capital locked up with old customers = (32.5-31.5) = 60,00,000 x _________ 360= Rs. 16,667 31.5 80(v) Capital locked in Addl. S = 12,00,000 x ——— x —— 360 100 = Rs.84,000(vi) Net addl. Capital locked up = Rs. 84,000 - Rs. 16,667 = Rs. 67,333(vii) Cost of capital locked up = Rs, 67,333 x .2 = Rs. 13,467.(viii) Discount availed earlier = 60,00,000 x 50% x 2% = Rs. 60,000(ix) Discount availed after policy change = 72,00,000 x 90% x 2% = Rs. 60,000(x) Addl. Discount now allowed BSPATIL
  • 222. = Rs. 1,29,600-Rs. 60,000(xi) Bad debt likely to occur = Addl S x 1% = 12,00,000 x 1% = Rs. 12,000(xii) Change in profit = Addl. Contribution - Addl. C x K - Addl. Discount - Baddebt Rs. 2,40,000 - Rs. 13,467 - Rs. 69,000 - Rs. 12,000 = Rs. 1,44,933The policy change gives a net benefit of Rs. 1,44,933 additional profit. BSPATIL
  • 223. 6.3.6 Collection Efforts Collection efforts refer to the extent of seriousness of measures taken tocollect dues from customers. Firms may be liberal with customers or very stringent.In the later situation each account is closely monitored, normal remainders are sentinitially and if still payments do not forthcome conditional remainders are made. Thiswould involve additional cost. There may be reduced sales too. But capital lock upwill be slim and bad debts small. If a liberal attitude is adopted bad debts and capitalcost shall be higher, sales higher with reduced administrative cost Collection effortsshould not be stringent nor too general. Individual cases must be considered onmerits and relaxation or lightening up may be undertaken.Illustration 6.8 A firm is thinking of tightening its collection policy. The details are:Current sales 3,60,000 units on credit. Price Rs.32 per unit. The variable and averagecost per unit are Rs. 25 and Rs. 29 respectively. The ACP is 58 days with a bad debtsof 3%. Collection expenses Rs. 1,00,000. A tightening of collection efforts isconsidered which will result in a sale contraction to 3,55,000 units, additionalcollection amount Rs. 2,00,000, bad debts 1% and ACP 40 days. Cost of capital 20%.Ascertain whether the tightening up is in the overall interest of the firm?Solution(i) Loss of contribution = Reduction in units x contribution per unit = 5,000 x (32 - 25) = Rs, 35,000(ii) Addl. Collection Cost = Rs. 2,00,000.(iii) Total Cost of the Decision = (I) + (ii) = Rs. 2,35,000(iv) Capital locked up as per Existing plan 3,60,000Existing plan = ——————— x 58 x Average cost per unit 360 = Rs. 16,82,000. BSPATIL
  • 224. (v) Capital locked up as per New project 3,60,000 x 40 x 29 5,000 x 40 x 25New Project = 360 360 = Rs.l 1,60,000 - Rs. 13,900 - Rs. 11,46,100(vi) Reduction in Capital Locked up = Rs, 16,82,000 - Rs. 11,46.100 = Rs. 5,35,900(vii) Capital cost of Savings = Rs. 5,35,900 x .2 = Rs. 1,07,180(viii) Reduction in bad debt = 3% of 3,60,000 x 32 - 1% of 3,55,000 x 32 = 3,45,600- l,13,600 = Rs. 2,32,000(ix) Total benefits of the decision = (vii) + (viii) = 3,39,180(x) Net benefit - (ix) - (iii) - Rs. 1,04,180 The tightening of the credit collection is ;hoixibre advantageous to thefirm.6.3.7 Control on Accounts Receivables As was earlier referred to the investment in accounts receivable shouldbe within accepted level. To achieve this, control measures are needed so that whenactuals fall outside the prescribed range, corrective actions can be taken. Incontrolling accounts receivables certain techniques are adopted* Three suchtechniques are described below. These are: (i) Debtors turnover ratio (ii) Debtorsvelocity and (iii) Age of debtors. Debtors Turnover Ratio (DTK) refers to ratio of sales to accountsreceivable (Sundry debtors plus bills receivables). The accounts receivable may beclosing figure, or average of year beginning and year-end figures or average of BSPATIL
  • 225. monthly opening and closing figures. An acceptable range for the ratio be fixed. Say aDTR of 5 to 6 times is fixed as ideal. When the actual ratio is within this band, it is allright. If the actual DTR is less than 5, it means more money’s locked up in accountsreceivables. Either sales have slumped relative to size of debtors, or debtors haverisen relative to sales. If the ratio exceeds the upper band, it means customerspromptly pay willingly or by out offeree. However, if more sales can be bookedthrough relaxation should be considered. Debtor’s velocity refers to how many days’ sales are outstanding with thecustomers. This is given by: Accounts receivables/Per day credit sales. In fact,debtors velocity indicates the average collection period (ACP). If the ACP is hoveringaround the credit period allowed, every thing is fine. If it exceeds the credit periodallowed, it signals snag in our collection, or unattractiveness of cash discountallowed, which should be corrected. If ACP is less than credit period allowed, it can beconsidered as good, but behind it a very stringent collection policy or very liberal cashdiscount facility might be there. The exact cause and the desirability of itscontinuation needs to be examined. Debtors velocity can be computed, this way also,that is: Number of working days in the year/DTR. Age of debtors refers how long debts are outstanding. Say 10% ofaccounts receivable is 6 months old, 15% is 5 months old, 25% is 4 months old, 25%is 3 months old, 15% is 2 months old and 10% is 1 month old. The average age ofdebtors comes to: ΣW; Ai, Where Wi is proportion and Ai is age in months. = .6 + .75 +1.00 + .75 + .3 + .1 = 3.5 months. An ideal breakup of accounts receivables can beestablished and actual position is monitored accordingly. The ideal average age andactual average age on accounts receivables can be compared and control is exercisedand accounts receivables.6.4 INVENTORY MANAGEMENT Inventory is an important current asset, the management of which isdealt now. What is inventory? What are its varieties? Inventory is the buffer betweentwo related sequential activities. Between purchase and production, between thebeginning and completion of production, and between production and marketing BSPATIL
  • 226. buffers are needed. Buffer means a cushion to fall back on. Production should notsuffer due to some difficulty in purchase of raw materials. Marketing should notsuffer due tg some difficulty in production. If the business has some stock of rawmaterials, a temporary difficulty in purchase will not effect production since the stockof raw materials can be used. If there is a stock of finished goods marketing will notbe effected duetto any temporary hurdle in production. The stocks ofrraw materialsand finished goods, therefore serve as buffers absorbing the difficulties in purchaseand production respectively. So, inventory takes different forms. Stocks of rawmaterials, work-in-process and finished goods are prime inventory. Stocks ofconsumable stores (like cotton waste, lubricants,) maintenance materials (tools, jigs,etc), and packing materials are some secondary inventory. A business has to carrycertain amount of inventory. Carrying too much or too little of inventory is bad.Inventoiy management is concerned with deciding of right quantity. You will sea howthis right quantity is determined in the course of this lesson. BSPATIL
  • 227. Inventory management refers to the planning and control of the size ofindividual items of materials that is carried on by a business. Take any businessfirm-trading or manufacturing. Many and diverse materials are dealt with/used bythe firm. Quite a lot of money is locked up in these materials carried as stock. Severalfactors account for this. The nature of the business, the size of the business, theseasonality of production/consumption of the production, the seasonality of rawmaterial availability, the terms of purchase/sale, the length of the production cycle,the dependability of transport facilities, the inventory policy of the business, the costsof emergency action courses, the lead time and the lead time consumption needs andthe probabilities associated therewith etc, influence the size of inventory. To elaboratea little, trading and most manufacturing businesses, large businesses, seasonalbusinesses (like those in the manufacture of umbrellas, rain-coats, etc), businessesusing raw materials which are available only during certain seasons (like flour mills,edible oil mills, etc), businesses which buy on cash and sell or credit terms,businesses with longer production cycle (where the time gap between beginning ofproduction process and its completion is more), businesses with uncertain transportinfrastructure, businesses pursuing cautious inventory policy (which cany morestock relative to their level of operation), businesses where emergency purchases costheavily, and businesses with large/ fluctuating lead time and lead time requirementscarry a lot more inventory than other businesses. Well, coming back to determination of the optimum size of inventory, dueregard given to all the above said factors, different questions arise. There are i) Howmuch to order every time? ii) When to order or what is the re-order level? Whatshould be the safety stock? What stock-out probabilities and levels are acceptable?Inventory management has to find optimal/satisfying answers to these and the size ofinventory is thus determined. The quantum of inventory carried depends on the motives of theorganisation. There are principally three motives, namely, transaction motive,precautionary motive, and speculative motive. Inventory carried in order to facilitatesmooth running of day-to-day operations (production and sales) comes under the firstcategory. Inventory held to avoid slock-outs due to unforeseen contingencies (likespurt in demand, increase in rate of usage, delay in arrival of ordered inventory, etc) BSPATIL
  • 228. comes in the second category. When excessive inventory is held taking advantage offavourable price trends in the market, such excessive inventory is called inventoryheld for speculative motives Inventory requirements for meeting the transactional and precautionaryneeds can be planned with fair degree of accuracy given the rate of usage, lead time,the level of insurance against stock-out that is considered prudent and other relevantinformation. With the help of these information the maximum, minimum and reorderlevel of stock and the optimum quantity of stock to be ordered each time can beascertained, the stock level and optimum order quantity plans help achieving theobjective of inventory management.6.4.1 Importance of inventory Management Inventory forms a significant segment of current assets. Formanufacturing businesses a chunk of their current asset is in inventory. For durablegoods manufacturers work-in-process constitutes a good portion of their currentassets. For trading businesses finished goods account for a good portion of currentassets. In manufacturing businesses roughly 30% to 70% of current assets is ininventory of one form or the other. In trading businesses the maximum range caneven approach 100% and the maximum may never fall below 50% or so. So largefunds are kept invested in inventory. As these funds are not free of costs andinvestible funds are limited, every business has to see that it carries only just enoughinventory which must ensure that: i) the increasing demand of the customers is met, ii) there is no lost sales (i.e., sales that could have been madebut for stock availability) and there is no loss of consumer goodwill, ii) the production operations go smoothly, iii) there is no pile-up of stock of any item and consequent lossdue to obsolescence, theft, etc, and iv) there is no lock-up of more than adequate capital BSPATIL
  • 229. inventory. These objectives are conflicting. The first three objectives call for moreinvestment in inventory, while the rest pull in the opposite. Herein the managementhas to play its role and balance these divergent objectives and set the optimal level ofinvestment in inventory. Hence the significance of inventory management.6.4.2 Inventory Costs There are three types of costs. These are: Ordering costs (costs associatedwith placing orders), cost of materials and carrying costs. Ordering costs include costof stationery, postage, telegram, etc in placing an order, and cost of administration ofthe purchase organisation. Ordering costs are generally assumed to be fixed per orderand directly proportional with the number of orders. Cost of materials is the purchaseprice, plus transport and insurance during transit. Carrying costs include space cost,storage costs, insurance, taxes, obsolescence, theft and pilferage, wastage and loss,the interest on capital locked-up, etc. If you carry more inventory all the above costswill be increasing, though not proportionally and vice versa. Besides, if you carry lessinventory there are also costs like high unit price for the inherent smaller order siz^s,contribution on sales lost, cost of lost consumer patronage, and so on. Fof any givenlevel of inventory, these three components of carrying costs are present in someproportional-mix. Inventory management aims at reducing both the ordering cost andcarrying cost. As these move in opposite directions, minimizing the total of both thesecosts is the crux of the whole of inventory management exercises. Economic orderquantity technique of inventory management is based on this minimization effect.6,4.3 Inventory Levels Better inventory management is possible by setting inventory levels, likemaximum level, reorder level and minimum level.Maximum stock level represents the quantity of inventory beyond which the stockshould never move up. Reorder level refers to the level of stock at which an order for BSPATIL
  • 230. replenishing the inventory has to be placed. Minimum level or safety level is the stocklevel below which the size of inventory should not normally fall. Lead time, lead timeconsumption and the economic order quantity (EOQ) determine these inventorylevels. Lead time refers to the time lapse between order placement and receipt ofgoods. Lead time consumption refers to the requirement/demand during the leadtime. Lead time is not a constant factor, neither lead time consumption is. So,minimum, average and maximum lead times and minimum, average and maximumlead time usage rates (per period) are found from experience. EOQ is a fixed quantitywhich the square root of twice the period (say a year) requirement of material timesordering cost per order divided by carrying cost of a unit of material per period (ayear). You may refer to cash management, where EOQ was computed. The different inventory levels are given by:i) Reorder stock level = Maximum lead time x maximum usage rate or Minimum stock + (Average lead time X average usage rate)ii) Maximum stock level = Reorder level + EOQ - (Minimum lead time X Minimum Usage rate)iii) Minimum stock level = Reorder level - (Average lead time X Average Usage rate)iv) Average stock level = Minimum level + ½ of EOQ or (Minimum level + Maximum level1)/2v) Danger stock level = Minimum usage rate X Emergency lead time.6.4,4 Inventory Management Techniques Several inventory management techniques are available. The abovereferred to EOQ and inventory levels are themselves are some techniques ofmanagement of inventory under conditions of certainty and uncertainty. These arepresented right now. Then the ABC control technique is presented. BSPATIL
  • 231. EOQ Technique When an organisation is operating under conditions of absolutecertainty, inventory planning is relatively a simple affair. By conditions of certainty’,it is meant that the rate of usage of or demand for the item of inventory in question isstable, the lead rime is fixed, and the supplier of the item is able to execute ordersany time. When all these conditions are satisfied, it would be enough if theorganisation maintains adequate inventory for its transactional needs. In otherwords, there is no need to hold inventory for meeting contingencies. All that it needsto do is to determine the optimum reorder quantity and the reorder-level. Undercertainty business conditions there is no need to carry any safety stock at all and theminimum stock level is zero. The maximum stock level shall be equal to the reorder-quantity. To determine the optimum order quantity the costs of inventory areconsidered. Inventory holding involves two types of costs, namely, carrying costs andnon-carrying costs. Whatever the level of inventory held there would involve certainamount of both these costs. Carrying costs refer to cost of capital locked up ininventory, space and storage, insurance, tax, etc. Non-carrying costs refer to orderingcosts, lovt sales, lost quantity discounts, etc. At optimum order quantity the twocosts together are the minimum. Given the total quantity needed during a certain period of time be ‘A’units, the quantity to be ordered be ‘Q’ units each time, the cost of carrying one unitof inventory being Cf rupees per period and the cost of placing an order be ‘O’ rupees,the total carrying costs would be QC/2 and total ordering costs would be AO/Q. At optimum order quantity the total inventory cost i.e. (AO/Q) -(QC/2)would be the least. By differentiating (AO/Q) + (QC/2) with respect toquantity and setting the same as equivalent to Zero, we get — _ AO + C by putting this is equal to zero, we get Q Q2 2 AO = C BSPATIL
  • 232. Q2 2 i.e.; 2AO = Q2C i.e.; Q2 = 2AO/2 i.e.; Q= 2AQ CIllustration 6.9 If the annual usage is 36000 units, cost per unit is Rs. 100, cost ofcarrying one unit for one year is 20% of cost and cost of placing an order is Rs. 400,find the optimum order quantity.Solution EOQ = V2AO/C = V2x36000x400 / 20 - 12 0 unitsCase l: But in practice an organisation cannot always stick to the optimum orderquantity, due to limitations of facility or restricuons on the size of orders imposed bythe supplier or varying quantity discounts offered by the supplier depending on thesize of individual orders. In all these cases the relative costs of all possiblealternatives have to be found out before the decision is finally taken on the size ofreorder quantity or the EOQ.Illustrative Cases Continuing the example already given and assuming that theorganisation is having storage facility to accommodate only 1000 units but hasfacility to hire space to store additional 200 units at an extra cost of Rs. 2000 perannum, the right quantity to be ordered would be calculated as given below: BSPATIL
  • 233. TABLE 1 Amount of cost Items of Cost Ordering quantity 1000 units (Rs.) 1200 units (Rs.) Ordering Cost = (A/Q) x 0 14,400 12,000 Carrying Cost = (Q/2) x C 10,000 12,000 Additional Cost of facility hired - 2,000 Total 24,400 26,000 Obviously the organisation would fix its order quantity at 1000 units,though its optimum order quantity is 1200 units originally. The cost saving is Rs.1,600/- per annum. 2. Sometimes the supplier may stipulate that orders in multiples of say,500 units only are acceptable to him. In such cases, the optimal order quantity is tobe calculated ignoring the restriction and then the total cost of inventory is computedat ordering quantities satisfying the stipulation immediately above and below theoptimal order quantity level. In our case 1000 and 1500 units are the alternativeordering quantities in question. The cost computations are as under TABLE 2 Amount of cost Ordering quantity Items of Cost 1000 units (Rs.) 1200 units (Rs.)Ordering Cost A xO/Q 14,400 9,600Carrying Cost QxC/2 10,000 15,000 Total 24,400 25,600 An order quantity of 1000 units is marginally economical.3. The supplier may quote differing prices for different order quantities. Let usassume that in our case the supplier quotes the following prices for different BSPATIL
  • 234. quantities of order given under. Quantity Ordered Price per Unit Less than 1000 Rs. 100.00 1001-1500 Rs. 99.90 1501-2000 Rs. 99.75 2000 and above Rs. 99.60 The organisation considers order sizes of 1000, 1200, 1800, 2000 and2400 units. The computation of optimal order quantity is carried out below: TABLE 3 Order Size (Q) Carrying Ordering cost Discount Net Cost cost Q/2 x A/QXO earned AX (2)+(3)-(4) price x Discount 20% Rate (1) (2) (3) (4) (5) (Rs.) (Rs.) (Rs.) (Rs.) 1000 10000 14400 - 24400 1000 11988 12000 3600 20388 1800 17955 8000 9000 16955 2000 19950 7200 9000 181502400 23904 6000 14400 15504 The optimum order quantity is that quantity level where the cost ofcarrying and ordering less the discount earned is die minimum (Discount earned =Annual purchases X Discount per unit). An order quantity of 2,400 units is theoptimum level since the net cost is the least here, namely Rs. 15,504. BSPATIL
  • 235. Stock level techniques When rate of usage and lead times are varying, then we say there isuncertainty (Other uncertainties like price fluctuations, seasonal factors, etc., are notconsidered). In such cases effective inventory management needs two factors to besatisfied, namely, investment in inventory does not exceed a certain limit and stockoat situation does not arise. In other words, the maximum stock level and minimumstock level are to be scientifically fixed taking into account various factors. Insituations of this nature, the maximum, average and minimum lead times and usagerates are first computed. Then the different levels of stocr are determined. Reorder level - Maximum lead time X Maximum usage rate Maximum level - Recorded level + optimum order quantity - (Minimum lead time X Minimum usage rate)Minimum level or - Recorded level - (Average lead time XSafety level Average usage rate)Continuing our example given in the very beginning, let us assume the following. BSPATIL
  • 236. Usage Rate (UR) Lead Time in days in units (LT) Maximum 120 11 (MAX) Average (AYR) 100 7 Minimum MIN) 80 5 Assuming an opening inventory of 2000 units the order schedule, usage and inventory levels, under the most pessimistic, most optimistic and most likely levels of usage rate and lead time would be as given in Table-4. In the most pessimistic situation the stock level just prior to receipt of the reorder quantity is zero, but there is no stock-out. However, as stock level approaches ‘Zero’ there is the potential danger of running out of stock, i.e., as it reaches the danger level, urgent measures to procure materials are called for. Investment in inventory is best utilised here. In the most optimistic case, the usage rate is less and the delivery of order quantity is most prompt, resulting in relatively maximum stock position throughout. There is more safety here, but at the same time there is piling up the stock. In the most likely situation, there is neither fasi depletion nor pile up of stock. Fair level of safety and turnover of stock are ensured. Table 4 Details Most pessimistic Most optimistic Most likely situation situation situation1. Assumption on Max. LT & Max Min. LT & Min. AVR.LT&usage UR UR AVR.UR2. Opening Stock 2000 2000 20003. Less usage to 680 (reached in 680 (reached in 8 680 (reached inreorder level 5 days) ½ days) 6.8 days)4. Reorder level 1320 1320 1320(Max.LT & MaxUR)(New order isplaced) BSPATIL
  • 237. 5. Less usage- 1320 (11 x 120) 400 (5 x 80) 700 (7 x 100)until the receiptof the orderedquantity6. Balance just 0 920 620prior to receipt ofordered quantity7. Add: receipt of 1200 1200 1200ordered quantity8. Present stock 1200 2120 1820position9. Implications Potential danger Stock turn over is Fail degree of of running out very small and usage and safety of stock cost of stock is are assured more10. Time of next Immediate, Relatively After someorder since present long after since breathing time stock level is the present stock since we below reorder level is the present stock lies level maximum level between the recorder level and the maximum It could be seen from the above that the end stock position is influenced by the consumption during the lead time i.e., (URXLT). In the above analysis the cases, with varying levels of consumption having different impact on the end stock. The levels of consumption could be anything given by AVR LT X, MAX UR, AVR LTXMIN UR, MAX LTXAVR UR, MAX LTXMIN UR, MIN LTXAVR UR OR MIN LTXMAX UR. But in all these cases the consumptions would fall within the limits set by the most pessimistic and most optimistic situations. Hence, the organisation will not run out of stock, though the stock carried may be slightly excessive in certain cases. 6.4.43 ABC technique BSPATIL
  • 238. Here, inventory items are analysed into three categories on the basis oftotal annual cost of each item. ‘A’ category consists of inventory items whose valueoutweighs their volume, i.e. value is more, several-fold, than the volume, ‘C’ categoryconsists of inventory items whose volume outweighs their value, i.e. volume is more,several fold, than value. The ‘B’ category comes in the middle with moderate volumeand moderate value. A rough and ready count puts that ‘A’ category accounts for 70%of value but only 10% of volume, B category accounts for about 20% of value and20% volume and C for 10% of value and 70% of volume. In the computation volumepercentage different authors adopt different methods. Some count the number ofitems while others take head-counts of individual items. ‘A’ category is subjected to closer planning and control Less planning andcontrol is attached to ‘C’ Regarding ‘B’ categoiy a via-made course is adopted. Thereasons for this are not far to seek. By closer control of ‘A’ category inventory costsare reduced. Table 5 gives the planning and control approaches to the differentcategories of inventory. TABLES 5 ABC CONTROL TECHNIQUE Aspect A Category B Category Category 1. Nature a. Total Value High Medium Low b. Volume Low Medium Low 2. Order a. Size Low Medium High b. Number More Medium Few 3. Storage BSPATIL
  • 239. a. Care More Medium Less b. Records Complete Some Few 4. Issue a. Procedure Stringent Moderate Lenient b. Quantity Low Moderate Large 5. Overall a. Planning More Medium Low b. Control More Medium Low6.4.5 Safety stock and stock out cost concepts Safety stock is the minimum stock which the business must cany so thatno stock-out situation arises. If the inventory levels are set and adhered to stock-outsituations (i.e. out of stock positions) would not arise. But in actual practice howeversome organisations would like to take the risk of running out of stock, by making atrade off between the costs of stock out situations and the benefits of carrying lessersafety stock. A lesser safety stock level other than the one so far we considered maybe followed by the organisation. In determining this reduced level of safety stock thecosts of carrying different levels of minimum stock and the associated stock out costsare taken into account. The least cost alternative is chosen. Principally there are two methods of calculating the optimum safety stocklevel. The first method assumes a fixed amount of stock out cost irrespective of thelevel of shortage in stock and the second method assumes a varying amount of stockout cost depending on the extent of shortage in stock. The two methods are adoptedhere. With hypothetical figures the "modus operandi of the two methods is explained.Curiously enough almost similar results are obtained, though the results need notnecessarily be so.6.4.6 Computation of stock-out cost and determination of optimal stock In method I the stock out costs are computed by taking into account theprobabilities of stock-out at different levels of safety stock and the cost of stock out.The stock out cost is assumed to be constant. The probability times the stock out BSPATIL
  • 240. cost gives the expected stock out cost. The logic of the assumption that stock-out costis constant per occurrence is maintained here since the efforts involved to replenishstock in the case of run-out situation are same irrespective of the quantity ofshortage assuming that perfect market conditions are prevailing. Here with ahypothetical stock-out cost of Rs. 40,000 per occurrence and with a probabilitydistribution as given in Table 6. BSPATIL
  • 241. TABLES 6 UNIT AND STOCK OUT COST PER OCCURANCE Rs. 46000 Safety Probabilit Carrying Expected stock Total costStock (S) y of stock- cost out cost (Rs.) out (P) (SXRs.20) (PXRs.40000) (Rs.) (Rs.) 620 0.0 12400 0 12400 500 0.03 10000 1200 11200 400 0.07 8000 2800 10800 300 0.13 6000 5200 11200 200 0.19 4000 7600 11600 100 0.25 2000 10000 12000 0 0.33 0 13200 13200 1.00 The expected stock-out costs for different alternative levels of safety stockare computed in Table 6. T^e- least cost safety stock level is 400 units. Method II assumes that stock-out costs vary with the quantity of stock-out and the probability of stock-out situations given the safety stock. The quantity ofstock-out is equal to the excess of consumption during lead time over i the normalconsumption and the safety stock held. The point to be noted here is that safety stockis held tameet the excess in consumption over and above the normal consumption. Inother words enough stock to meet normal consumption is always to be carried on andthis stock is distinct from the safety stock. We have to consider an example here. Letthe rates of usage and lead time with their probability factors as under. BSPATIL
  • 242. Consumption Lead time Units per day Probability Days ProbabilityMaximu m 120 .2 11 .25Normal 100 .6 7 .5Minimum 80 .2 5 .25 Note that the usage and lead times are the same as those used in anearlier section of the lesson. The only addition is the probability factor. In table 7 theextent different safety stock levels, corresponding reorder point, lead time inventoryrequirement, extent of stock out and probability of stock out are given. TABLE 7 EXTENT AND PROBABILITY OF STOCK-OUT Safety Corresponding Lead time Extend of Probability ofstock (S) reorder point = requirement Stock-out Stock-out (700+S) (Cases exceeding Col. 2 only) 620 1320 Nil Nil - 500 1200 1320 120 .05 400 1100 1320 220 .05 300 1000 1320 320 .05 1100 100 15 200 900 1320 420 .05 1100 200 .15 100 800 1320 520 .05 1100 300 .15 880 80 .05 840 40 .10 700 1320 620 .005 1100 400 .15 BSPATIL
  • 243. 880 180 .05 840 140 .1 When the reorder point is fixed at 1320 units (i.e. normal consumptionduring normal lead time + Full safety stock level = 700 + 620 units) there is no stock-out at all, as it should be. When the reorder point is fixed at 1200 units (i.e. normalusage 700 -f reduced Safety stock, 500), the stock-out will be to the extent of 120units with a joint probability of .05, i.e. .2 X .25. With successive lesser safety stock,different levels of stock out arises with different joint probability factors. Table 7 givesthese figures in detail. Now the cost of stock out has to be ascertained. The stock out cost perunit of shortage may be taken as Rs. 200. It may be noted that stock-out cost perunit shortage is more since a shortage in stock even by one unit causes stoppage ofproduction, loss of customer goodwill, closure and resetting of production, and so on.Fixed expenses cannot be cut, though no utility is derived from them during theperiod. Hence stock-out cost per unit of shortage is much more than the cost of aunit of inventory. In manufacturing undertakings this is largely the case. In tradingconcerns the stock-out costs may be lower. Table 8 gives the cost of different alternative levels of safety stock. Theexpected stock-out, the probability and stock-out cost per unit, viz., Rs. 200. Of thesethree factors, the first and second are in Table 7 and the third one is assumed. Thesummarised values are given in Table 8. The carrying costs are obtained as usual,namely Safety Stock X Rs. 20. The least cost alternative is found to be 400 units ofsafety stock. In the first method also we got the same result, though the twoapproaches may differ in the results. TABLES 8 COST COMPUTATION FOR DIFFERENT LEVELS OF SAFETY STOCK Safety Stock Expected Stock- Carrying cost Total (S) out cost (Rs.) (SXRs.20) (Rs.) BSPATIL
  • 244. 620 0 12400 12400 500 1200 10000 11200 400 2200 8000 10200 300 6200 6000 12200 200 10200 4000 16200 100 15800 2000 17800 0 22800 0 228006.4.7 WORKED OUT PROBLEMS Illustration 6.10a) A manufacturer uses 200 units of a component every month and we buys them entirely from outside supplier. The order placing and receiving cost is Rs. 100 and annual carrying cost is Rs. 12. From this set of data calculate the economic order quantity.b) Private Limited uses three types of materials A, B and C for production of ‘X’ the final product. The relevant monthly data for the components are as given below. BSPATIL
  • 245. A B CNormal Usage (In Units) 200 150 180Minimum Usage (In Units) 100 100 90Maximum Usage (In Units) 300 250 270Reorder Quantity (In Units) 750 900 720Reorder Period (In month) 2 to 3 3 to 4 2 to 3Calculate for each component: (i) Re-order Level (ii) Minimum Level (iii) Maximum Level (iv) Average Stock LevelSolution(a) Annual consumption = 200 x 12 2400 unitsEOO = 2AO = 2x2400x100 = 200 units C 12 BSPATIL
  • 246. Particulars Materials A B Ci) Reorder level = 3x300 =900 4x250 3x270 maximum period x =1000 =810 maximum usageii) Minimum level = 900-(200x2 ½) 1000- (150x 3 810 -180 x 2 ½ Recorder level = 400 ½) = 360 -Normal usage = 475iii) Maximum level — 900-(100x2) + 1000 -(100x3) 810 -(90x2) + Recorder level 750 = 1450 + 900-1600 720=1350 -minimum consumption + EOQiv) Average stock (400+1450)/2 = (475 + 1600)/2 (360 + 1350)/2 = level= (Minimum 925 = 1038 855 level + Maximum level)/2Illustration 6.11 Annual requirement is 24000 units. Unit price Rs. 6 ordering cost Rs. 100 perorder. Carrying cost 20% calculate EOQ. If the order size is 6000 units a price off of5% given. Is it worm to order in lots of 6000 units, BSPATIL
  • 247. 2ACSolution EOQ = C = 2 x 24000 x 100 4800000 20% of Rs.6 = 1.2 = 2000 units Total cost of computation for the two alternative order sizes, viz the EOQof 2000 and the other one with 6000 units. SIZE SIZE Details 2000 units 6000 units Rs. Rs.Ordering Cost: (A/order size) x 100 600.00 200.00Carrying Cost: (order size/2) x c 1200.00 3420.00Inventory cost 1800.00 3620.00Add: Purchase cost 144000.00 136800.00Total cost 145800.00 140420.00Notes: i) The purchase price per unit when the order size is 6000 i Rs, 5.70 (i.e. Rs. 6 minus 5%) ii) Carrying cost is Rs. 1.2 when the size of the order is 200 units and Rs. 1.14 when the size of the order is 6000 uni (i.e. 20% of respective unit price)Illustration 6.12 BSPATIL
  • 248. A firm has several items of inventory. The average number of each ofthese as well as their unit costs is listed below: Average No. of Average No. Average cost Average costItem units in Item of units in per unit (Rs.) per unit (Rs.) inventory inventory 1 4000 1.96 11 1800 25.00 2 200 10.00 12 130 2.70 3 440 2.40 13 4400 9.50 4 2000 16.80 14 3200 2.60 5 20 165.00 15 1920 2.00 6 800 6.00 16 800 1.20 7 160 76,00 17 3400 2.20 8 3000 3.00 18 2400 10.00 9 1200 1.90 19 120 21.00 10 6000 0.50 20 320 4.00 The firm wishes to adopt one ABC inventory system. How should theitems be classified into A, B and C?Solution: Steps 1) Calculate the total cost item-wise (units x unit cost) BSPATIL
  • 249. 2) Arrange items in the decreasing total cost order (refer total cost column which is so arranged) 3) Work out percentage to total - both for costs and the quantity (head count is adopted). 4) Take to four items which together account for about 70% of costs and categorize them as "A". Items 11,13,4 & 18 constitute about 68% of cost and 30% quantity. 5) Take next few items which together account for about 20% of costs and these are branded as "B". The rest belong to "C". Unit cost Total cost % ofItem Units % of total Classification (Rs.) (Rs.) total11 1800 5.02 2.5 45000 21.7913 4400 12.29 9.5 41800 19.75 A 4 2000 5.58 16.8 33600 15.8818 2400 6.70 10.0 24000 11.34 7 160 0.44 76.0 12160 5.75 8 3000 8.37 3.0 9000 4.2514 3200 8.93 2.6 8320 8.93 B17 4000 11.17 1.96 7840 3.7117 3400 9.49 2.20 7480 3.5315 1920 5.36 2.00 3840 1.81 5 20 0.05 165.00 3300 1.5610 6000 16.76 0.50 3000 1.4219 120 0.33 21.00 2520 1.19 9 1200 3.35 1,90 2280 1.08 2 200 0.56 10.00 2000 0.94 C 6 300 0.83 6.00 1800 0.8520 320 0.89 4.00 1280 0.60 3 440 800 2.40 1056 0.5016 800 2.23 1.20 960 0.4512 130 0.36 2.70 351 0.16 BSPATIL
  • 250. 35810 100.00 100.00 211587 100.00 * Totals may not totally on account of roundmg off the figures.Illustration 6.12 The following information is available relating to fee stock out of a firm: Stock-out (units) Number of times Probability 800 2 .04 600 3 .06 400 5 .1 200 10 .2 0 30 .6 50 1.00 The selling price of each unit is Rs. 200. The carrying costs are Rs. 20per unit. The stock-out costs are Rs. 50 per unit. (i) If the firm wishes never to miss a sale, what should be its safety stock? What is the total costs associated with this level of safety stock? (ii) What is the optimal safety stock level?Solution Say the firm wishes to cany no safety stock. Then if, demand is 800units, for which there is a probability of .04, 800 units will be the stock out Then thestock out of cost is 800 x 50 x .04 = Rs. 1600, if the demand is 600, the stock outcost is 600 x 50 x .06 = Rs. 1800, if it is 400 and 200, the stock out costs are Rs.2000 each. If the safety stock is 200 and if the demand is 800, the stock out is 600and stock out cost is 600 x 50 x 0.04 = 1200 and id demand is 600 units the stockout is 400 and the cost is 400 x 50 x .06 = Rs. 1200 and if the demand is 400, thestock out is 200 units and the cost is Rs. 1000. Similarly for other safety stock levelsthe cost are worked out.Solution: BSPATIL
  • 251. Computation of expected stock-out costsSafety Stock-out Stock-out Probabil Expected stock- Totalstock (units) cost (Rs. ity of out cost at this expected level (demand 50 per stock- Jevel (Rs.) stock-out -safety stock unit out (CoI.3xCol.4) costs (Rs.) 0 800-0=800 40,000 0.04 1,600 600-0=600 30,000 0.06 1,800 400-0=400 20,000 0.10 2,000 200-0-200 10,000 0,20 2,000 7,400 200 800-200-600 30,000 0.04 1,200 600-200=400 20,000 0.06 1,200 400-200=200 10,000 0.10 1,000 3,400 400 800-400=400 20,000 0.04 800 600-400=200 10,000 0.06 600 1,400 600 800-400=400 10,000 0.04 400 400 800 800-800=0 0 0 0 0 COMPUTATION OF TOTAL SAFETY Safety stock f Expected stock- Carrying cost (Rs. Total safety (Units) (Rs.) out costs (Rs.) 10 per unit) stock cost (Rs.) 0 7400 0 7400 200 3400 3800 7200 BSPATIL
  • 252. 400 1400 7600 9000 600 400 11400 11800 800 0 15200 15200 (i) The safety stock should be 800 units of the finn never wishes to miss a sale. The total cost associated with this level of safety stock is Rs. 15,200. (ii) The optimal safety stock is 200 units. It is because, at this level, total costs are minimum at Rs. 7,200.6.5 SUMMARY Cash and liquidity management is better carried out through cashbudgeting, EOQ model and Miller - Or model. Receivables management depends oncredit policy. There are four elements of credit policy, namely credit std. credit oeriod,discount terms and collection efforts. Inventory management is an essential and integral function of financialmanagement with linkages with production and marketing areas. Inventorymanagement aims at optimum inventory levels, reorder times and reorder quantity.Certain fundamental quantitative tools-optimization techniques, differential calculus,etc., help in setting the above different optima. Again different techniques are neededdepending on the business situations. In a certain business situation with verifyingrates of consumption, fluctuating lead time, etc. apart from the basic EOQ modelreorder quantity, minimum quantity and maximum quantity models, etc. are needed.Again, the use of probabilities helps making further economics in the inventory area.With the knowledge of probability distribution of usage rates and lead times, theextent of stock-out situations and the chances thereof can be ascertained for anygiven level of minimum stock. Given the stock-out cost per occurrence of per unit ofshortage the most economical minimum stock level can be detennined. Thus with theaid of quantitative techniques efficient inventory management .becomes possible.6.6 SELF ASSESSMENT QUESTIONS BSPATIL
  • 253. 1. Bring out the scope and importance of cash and liquidity management. 2. Explain the objectives of cash management. 3. What are the motives for holding cash? What are the factors that influence such motives and the size of cash needed for each? 4. Explain cash budgeting as a tool of cash management and the different methods of preparing cash budget. 5. XYZ Co., wishes to arrange overdraft facilities with its bankers during the period April to June, 1996 when it will be manufacturing mostly for stock. Prepare a cash budget for the above period from the following data, indicating the extent of the bank facilities the company will require at the end of each month.(a) Sales Purchases Wages Rs. Rs. Rs.February 1996 1,80,000 1,24,800 12,000March 1996 1,92,000 1,44,000 14,000April 1996 1,08,000 2,43,000 11,000May 1996 1,74,000 2,46,000 10,000June 1996 1,26,000 2,68,000 15,000 b) 50 per cent of credit sales are realised in the month following thesales, and the remaining 50 per cent in the second month following. Creditors arepaid in the month following the month of purchase. c) Cash at bank on 1.4.1996 (estimated) is Rs. 25,000. 6. Using the information given below prepare a cash budget showing expected cash receipts and disbursements for the month of May and balance expected at May 31,1996. BSPATIL
  • 254. Budgeted Cash Balance, May 1996 Rs. 60,000. SalesMarch Rs. 5,00,000April Rs. 3,00,000May Rs. 8,00,000-Half collected in the month of sale, 40% in the next month, 10% in the third month.-40% paid in the month of purchase, 60% paid in next month.Wages due in May Rs. 88,000.Three years insurance policy due in May for renewal Rs. 2,000 to bepaid in cash. Other expenses for May, payable in December Rs. 6,000; Fixed Depositreceipts due on May 15, Rs. 1,75,000 plus Rs, 10,000 interest. 7. Explain the use of inventory model of cash management? A firm expects that its cash receipts during a year shall be Rs. 80,000 and cash payments Rs. 5,20,000. Its transaction cost is Rs, 40 per transaction and interest rate 20% p.a Find the optimum cash balance. 8. Explain the Miller-Orr model of cash balances management. The variance of daily cash balance of a firm is 64,00,000. The transaction cost is Rs. 40 and return on marketable security per day per rupee is 0 003. Find the optimum cash balance and set the upper and lower boundaries cfcash balance. 9. Explain how collections can be prompted and payments delayed? 10. Explain: i) Playing the float, ii) mailing float, iii) Cash flow statement, iv) BSPATIL
  • 255. compensation balance, v) CHIPS, vi) SWIFT and vii) E-cash.11. Bring out the need for effective receivables management.12. Assess the relative merits and demerits of liberal and stringent credit policies.13. What is credit policy? What are its variables? Explain each of the variables.14. A companys current position is: Sales Rs. 80,00.000; Variable Cost Ratio = V = 80%; ACP = 40 days K *= 13%. It wants to relax its credit standard such that hither to cash-dealings-only-customers are extended credit facility. As a result additional sales Rs. 20 lakh are expected. Bad debts which were previously nil, is likely to become 1% of the additional sales. Evaluate.15. A firm is considering several alternative credit periods to choose the best one. A 45 days alternative guarantees a sale of Rs. 56 lakh, 60 days a sale of Rs. 60 lakh, 75 days a sale of Rs. 65 lakh and 90 days alternative is to give a sales of Rs. 80 lakh. Variable cost ratio is 80% of sales. Fixed cost Rs. 6 lakh p.a. If the firm wants 20% ROI, find the optimum credit period.16. A firm with 2/30, net 60 days credit terms, nets a sale of Rs. 50 lakh p.a. and incurs a capital cost of 12%, 80% of accounts are cleared on 30 days. The firm wants to switch over to 1/30, net 60 days. This is likely to reduce sales by 10% and the percentage of accounts availing cash discount to 60%. Assuming a variable cost to sales ratio of 85%, assess the new proposal.17. A company wants to liberalize its collection efforts. At present its sales are Rs. 40 lakh, ACP is 40 days, contribution to sale ration are 15% and the cost of capital 14% p.a. Bad debts are 1% and collection cost Rs. 25,000. The proposed relaxation of collection efforts will raise sales by 20% and raise ACP by 10%. Bad debts shall be 1.5% of sales and collection cost just Rs. 5,000. Ascertain whether it will be beneficial to relax collection efforts. BSPATIL
  • 256. 18. What do you mean by control of accounts receivables? Why such control is needed? What are the methods of control adopted? 19. Two firms have the following age distribution of accounts receivable: Month Old Firm A Firm B (Proportion of Accounts) Upto 1 month .1 .15 1-2 months .15 .15 2-4 months .50 .60 more than 4 months .25. .1Compute the average age of accounts receivables and ascertain which firm isrelatively swifter in collection. Make own assumptions, if any, needed. 20. Calculate DTR and Debtors Velocity given the following: Credit sales Rs. 3,65,00,000. Opening Bills Receivable Rs. 18,00,000 and debtors Rs. 42,00,000. Closing Bills are Rs. 8,00,000 and debtors Rs. 32,00,000. If total credit sales have not declined compared to previous years what inferences do ; credit policy of the firm from the recent figures? 21. Give the meaning and significance of inventory and inventory management. 22. Explain inventory costs and their behaviour with volume. 23. Explain the use of EOQ and stock levels in efficient management. 24. What is stock out cost? What are the methods of determination of stock-out costs? 25. Can businesses manage with lesser minimum stock? if so, how?REFRENCES BSPATIL
  • 257. 1. Financial Management and Policy - Van Home2. Financail Decision Making - Hampton3. Management of Finance - Weston and Brigham4. Financial Management - P. Chandra BSPATIL
  • 258. UNIT – VII DIVIDEND MANAGEMENT In this unit you will learn the nexu between dividend and share value,dividend theories, determinants of dividend, dividend policies, dividend practices andrelated issues.INTRODUCTIONIn this unit, we take up a very crucial decision area of financial management. Theresult of successful investment and financing functions is profit, excess of incomeover expenditure. Profit here refers to divisible profit i.e., profit that can bedistributed as dividend to the shareholders. Obviously, therefore the profit after tax(i.e. PAT). The profit has to be effectively utilized. There are two ways to utilize theprofit – pay dividend and plough back profit in the business, itself. When you pay diinvestment in the company. When the profit is retained and ploughed back into thebusiness, the company makes use of the fund for its investment needs. The return forthe share holders, when profit is ploughed back is capital appreciation reflected byincrease in the value of share held by them. Whether to distribute or retain the profit, is a difficult question toanswer, for there are very many conflicting opinions on the effect of the alternativeways of application of profit. There are several theories, policies and dividend, payingless or more dividend decision – paying or not paying dividend, paying less or moredividend – affects the market valuation of the shaes. Another theory puts that theseare not related, i.e.. paying or not paying dividend or paying less or more dividend onthe one hand and value of the share on the other are not related issus. So, dividendirrelevance, i.e., irrelevance of dividend as a factor affecting market valuation of shareis emphasized. Many theories on both the sides are thus available. Apart theories, there are different dividend policies and dividend tractices BSPATIL
  • 259. adopted by companies. There are different factors affecting dividend ecisions. Allthese are dealt with in this lesson.7.1 DIVIDEND AND VALUE NEXUS Dividend is the current return provided on share capital. Payment therate of dividend affect market value of shares. Since wealth, i.e.. rising the market ofshares, is a foremost objective agement, the impact of dividend decision on marketvaluation nee. Generally, regular and stable dividend has a positive effect on shareprofit prices. The portion of profit that is retained also affects the share price. This isan internal finance available free of floatation cost and time. This money whenutilized profitability, the benefits do go the shareholders. So, retained jet share value.Hence dividend decision affects valuation of v is held by Graham and Dodd, JamesWalter and Myron Gordon. Graham and Dodd would say that liberal dividends as against niggardlydividends have overwhelmingly positive effect on stock prices. Walter and observethat the firm’s cost of capital, the internal rate of return, and the dividend payoutratio (i.e.. the per cent of profit paid as dividend together influence market value ofshares. Modigliani and Miller would say that value of firm depends on the firmsinvestment decision and not on the dividend (as well as the financing decision). Thisview is referred to as “the dividend irrelevance” in valuation. So, the dividend-valuation nexus is yet an BSPATIL
  • 260. 7.2 DIVIDEND THEORIES In this section we take up the different dividend theories for n-Doddtheory, Walter theory, Gordon Theory and Modigliani y of dividend are dealt below:7.2.1 Graham Dodd Theory Graham - Dodd theory is in support dividend value nexus. As per theirP= m(D+E/3), where p = market price per share, D = dividend per share, E =Earnings per shar and m is a multiplier. The above valuation formula can berewritten as follows: (D(E-D)) ) orP = m (D + 3 3D+D+(E-D)P=m( 3 ) orP = m/3 (4D+R), where E-D = R = retained eanings per share.As ‘m’ is a multiplier, m/3 becomes a constant.Value, (P), is 4 times influenced by D compared to a unit time influence from retainedearnings. So liberal dividends would enhance share value leaps and bounds.Example: Let E = Rs. 10, D = Rs. and m = 6 thenP = m/3 (4D+R) = 6/3 [(4x6) + (10-6)] = 2 (24+4) = Rs. 56. If D = rs. 8 given other things the same as before.P = m/3 (4D+R) = 6/3 [(4x8) + (10-8)] = 2 (32+2) = Rs. James Walter’s TheoryThis theory holds that market value is influenced by dividend decision. The value of BSPATIL
  • 261. the share (P) is given by:P = [D + (E-D) r/k] » k where,P = Price per share,D = Dividend per shareE = Earningspr = internal ratek = cost of capital andE-D = retained earnings per share. As per this theory, the present value of an infinite stream of D, i.e., andthe present value of an infinite stream of returns from retained ings, i.e.., [(E-D)r/k]»k. constitute the value of the share. So both the dend paid and the returnsfrom retained earnings affect share value. The assumptions of the theory are:a) Cost of capital (k) of the firm remains constantb) Return on investment (f) remains constantc) Firm has an infinite life andd) Retained earnings are the only source of finance. According to Walter, a company can increase its share price by declaringless dividend when its internal rate of return (r) is greater than its cost of capital (k);and by declaring more or 100% dividend when its Y is less than it ‘k’. If r=k, the sharevalue remains the same whatever the value of D. So when r>k, (here the firm is calleda growth firm), less dividend or a nil payout ratio brings the optimum result. For adeclining firm i.e.., when r<k, the optimal payout ratio is 100%. For a normal firm,i.e.; when r=k, there is no optimal payout ratio, as dividend payout does not effectvalue of the share. Below is presented the working of Walters model, in table 7.1. BSPATIL
  • 262. Table 7.1 WALTERS MODEL - AN EXPLANATION Growth firm Normal firm Declining firm r>k r=k r<k r = 20% r = 20% 10% k = 10% k = 20% k = 20% E = Rs.5 E = Rs.5 E = Rs.5 If D = Rs.5 If D = Rs.5 If D = Rs.5 P = [54<5-5).2/. 1] /. 1 = [5 + (5-5).2/.2] /.2 = [5 + (5-5). I/.2] / .2 = Rs.50 = Rs.25 = Rs.25 If D = Rs.3 If D = Rs.3 If D = Rs.3 P = [3+(5-3).2/. 1] /. 1 = [3 + (5-3).2/.2] / .2 = [3 + (5-3). 1/.2] / .2 = Rs.70 = Rs.25 = Rs.20 If D = Rs.3 If D = Rs.3 If D = Rs.3 P = [0+ (5-0).2/.l] / .1 = [0 + (5-0).2/.2] / .2 = [0 + (5-0).I/.2J / .2 = Rs.100 =Rs.25 = Rs.12.5 From the above explanation you know that when i>k, value increases asD decreases; that when r=k, value remains constant; and that when r<k, nil payout isoptimal When r=k, dividend-value nexus is absent BSPATIL
  • 263. Illustration 7.1 From the following information supplied to you, ascertain whether thefirm’s dividend payout ratio is optimal according to Walters theory. The firm wasstarted a year before with equity capital of Rs.20 lakhs (There is no debt capital).Earnings of the firm Rs. 2,00,000Dividend paid Rs. 1,50,000Price - earnings ratio 12.5Number of shares outstanding 20,000. The firm is expected to maintain its currentrate of earnings on investment.i) What is the value of share?ii) What should be the price-earning ratio at which dividend payout ratio will have no effect on the value of share?iii) Will your decision be changed if the P/E ratio is 8 instead of 12.5?Solution: First we have to compute, E, D, k and r.E = Rs.2,00,000/20,000 = Rs,10; D = 1,50,000/20,000 = Rs.7.5,k = inverse of price - earnings ratio - 1/12.5 - 8% andr - earnings/capital = Rs. 2,00,000 / 20,00,000 = 10%. BSPATIL
  • 264. 7.50 + (Rs.10-Rs.7.5) x (10%/8%)P = 8% = 7.50+ (Rs.2.5) x (1.25) ———————————— 8% = 7.50 + 3.125 Rs. 10.625 ————————— = ———————— = Rs.132.81 8% 8% This is a growth firm, since r>k. So, zero payout ratio is optimal. So thefirm’s present dividend payout ratio is not optimal. At 75% dividend payout ratio i.e..the current payout, the price per share is Rs. 132,81. The zero percent divided payoutratio would be optimum as at this ratio, the value of the share would be maximum.This is shown in the following calculations: 0 + (Rs. 10-0) x (10% /8%)P = —————————————————— 8% (10) 1.25 Rs. 12.50 = ————————— = ————————— = Rs. 156.25 8% 8%ii) P/E ratio of 10 times would have no effect on the value of the share because at thisrate k=10%. You know K = 1/PE Ratio - 1/10 = .1 = 10% you know r = 10%. Hence r= k.iii) If the P/E ratio is 8, k = 12.5% since k > r, the 100% dividend payout ratio wouldmaximize the value of the share. With the current 75% payout, P will be 7.50 + (Rs. 10-Rs. 7.5) x (10% / 12.5%)P = ———————————————————————— 12.5% BSPATIL
  • 265. = 7.50 + (Rs. 2.5) x (0.8) ————————————————— 12.5% = 7.50 + 2.00 Rs. 9.5 ——————— = ——————— = Rs. 76 12.5% 12.5%For 100% payout, 10 + (Rs. 10-Rs. 10) x (10% / 12.5%)P = ——————————————————— 12.5% = 10 + 0 Rs. 10 ————————— = ————————— = Rs. 80 12.5% 12.5%So, 100% payout is optimal.7.2.3 GORDONS Theory Myron Gordon’s theory of share valuation using dividend capitalisationassumes that:a) Retained earnings are the only source of finance for the firm.b) r and k are both constant,c) growth rate (g) of the firm is product of retention of ratio and rate of return andg<kd) the firm has an infinite life ande) there is no tax. BSPATIL
  • 266. Y1 (1-b)According to Gordon, P0 = ———————— Where, k-brP0 = price per share at time zero or the beginning of year 1Y1 = earnings per share at the end of year 1b = retention ratioI-b = dividend payout ratiok = cost of capitalbr = growth rate (retention ratio x r) Actually the above model is the dividend capitalisation approach whichwas dealt with when we studied cost of capital in an earlier lesson. Y1 (l-b) is equal toD1 and br = g.(You remember we formulated there an equation, P0 = D1 / (ke-g) from which wededuced that, ke = (D1/P0) + g in the lesson on cost of capital). The nature of influence of dividend decision on the share price of growthfirm, normal firm and a declining firm is dealt below under Gordon’s theory, in table7.2 BSPATIL
  • 267. Table 7.2s : GORDON THEORY - AN EXPLANATION Growth firm Normal firm Declining firmr>k r=k r<kr = 20% or .2 r = 20% or .2 r =10% =10% or.l k = 20% or .2 k = 20% or .2E = Rs.5 E = Rs.5 E = Rs.5If D = Rs.5 i.e.., b=0 If D = Rs.5 i.e.., b=0 If D = Rs.5 i.e.., b=0P = [5(1-0)] / [.1-0] P = [5(1-0)] / [.2-0] P = [5(1-0)] / [.2-0]= Rs.50 = Rs.25 = Rs.25If D = 4, i.e.. b=.2 If D = 4, i.e.. b=.2 If D = 4, i.e.. b=.2P = [5(1-.2)] / [.1-0.4] P = [5(1-.2)] / [.2-0.4] P = [5(1-.2)] / [.2-.02]= 4/.06 = 67 = 4/.16 = 25 = 4/.18 = 22If D = 3, i.e.. b=.4 If D = 3, i.e.. b=.4 If D = 3, i.e.. b=.4P = [5(1-.4)] / [.1-0.8] P = [5(1-.4)] / [.2-0.8] P = [5(1-.4)] / [.2-0.4]= 3/.02 = 150 = 3/.12 = 25 = 3/.16 = 19 You would understand that in the case of a growth firm, r>k as retentionratio (b) increases the value (P) of the share rises. For a normal firm value remainssame. For the declining firm as ‘b’ increases ‘p’ decreases. All these results are on thesame lines as these found with the Walter’s theory. Walters theory permitted 100% retention, i.e.; nil dividend, whereasGordons theory would not permit the same as the numerator then becomes zero.This is one difference. The other is in the values of P as you would know oncomparison of the two tables 7. 1 and 7.2. So, the optimal dividend payout for a declining firm is 100%; for a normalfirm the payout ratio is irrelevant and for a growth firm a lower payout ratio.Consequent to a lower payout ratio (and hence a higher retention ratio) the br mightbecome larger than k. Then ‘p’ becomes undefined. So, in the case of a growth firmthe optimal dividend payout ratio cannot be extremely low.Illustration 7.2 The following information is available in respect the rate of return oninvestments (r), the capitalisation rate (Ke) and earnings per share (E) of a BSPATIL
  • 268. manufacturing company: r = (i) 12% (ii) 1 1 % (iii) 8% Ke = 11% E = Rs.20 Determine the value of its shares as per Gordons model each alternative,assuming I) 10%, ii) 40% and iii) 70% payout ratios.Solution According to Gordons model, the value of ^e ^ 1S given by the followingformula: Y(l-b) P= ———————— K-brAlternative (i) when r = 12%a) Payout ratio 10%; so, retention ratio 90% br = (g) = 0.9x0.12 = 0.108 BSPATIL
  • 269. Rs.20(1-.9) Rs.2P = ———————— = ————— = Rs. 1,000 0.11-0.108 0.002b) Payout ratio 40%; so, retention ratio 60% br = (g) = 0.6 x 0.12 = 0.072 Rs.20(1-.6) Rs.8P = ———————— = ————— = Rs. 210.52 0.11-0.072 0.038c) Payout ratio 72%; so, retention ratio 30% br = (g) = 0.3 x 0.12 = 0.036 Rs.20(1-.3) Rs.14P = ———————— = ————— = Rs. 189.19 0.11-0.036 0.074Alterntive (ii) when r= 11%a) Payout ratio 10%; so, retention ratio 90% br = (g) = 0.9 x 0.11 = 0.099 Rs.20(1-.9) Rs.2P = ———————— = ————— = Rs. 181.82 0.11-0.099 0.011b) Payout ratio 40%; so, retention ratio 60% br = (g) = 0.6 x 0.11 = 0.066 Rs.20(1-.6) Rs.8P = ———————— = ————— = Rs. 181.82 0.11-0.066 0.044c) Payout ratio 70%; so, retention ratio 30% BSPATIL
  • 270. br = (g) = 0.3 x 0.11 = 0.033 Rs.20(1-.3) Rs.14P = ———————— = ————— = Rs. 181.82 0.11-0.033 0.077Alterntive (ii) when r= 10%a) Payout ratio 10%; so, retention ratio 90% br = (g) = 0.9 x 0.10 = 0.090 Rs.20(1-.9) Rs.2P = ———————— = ————— = Rs. 100 0.11-0.090 0.02a) Payout ratio 40%; so, retention ratio 60% br = (g) = 0.6 x 0.10 = 0.060 Rs.20(1-.6) Rs.8P = ———————— = ————— = Rs. 160.00 0.11-0.060 0.050a) Payout ratio 10%; so, retention ratio 30% br = (g) = 0.3 x 0.10 = 0.030 Rs.20(1-.3) Rs.14P = ———————— = ————— = Rs. 175.00 0.11-0.030 0.080 Thus far, the theories that support dividend - value nexus were seen. The BSPATIL
  • 271. above theories hold that dividend payout is a relevant factor in share pricedetermination. The reasons are not far to seek. A high payout ratio makes the shareholders feel certain about theirincome. This is what is called as resolution of the uncertainty of future income. Thereis an information content that the firm would make good profits in the future.Shareholders with high current income prefer companies with high payout ratio.Dividend income is exempted from taxation upto a limit. So, high payout increasesvalue. Similarly low payout might also increase value. This view is stressed byMichael J. Brennan. As there is no floatation cost, the cost of internally generatedequity is less than cost of fresh equity, and capital gain ir taxed at a lower rate. So, apreference for low payout ratio is also there. The conclusion is that, dividend payout is relevant to valuation.7.2.4 MM Theory Now the M-M theory is taken up. According to this theofy dividend -valuation nexus does not exist. Miller and Modigliani advanced their theory in 1961.Their assumptions are:a. capital market is perfect,b. investors are rational,c. there is no transaction cost,d. securities are divisiblee. information is freely availablef. no investor can influence market price singly,g. there is no tax andh. there is no floatation cost Their conclusion is that dividend decision is not significant in the context BSPATIL
  • 272. of ssaFe-valuation. In other words, the shareholders get the same benefit fromdividend as from capital gain through retained earnings. So, the division of earningsinto dividend and retained earnings does not influence shareholders perceptions. Sowhether dividend is declared or not, and whether high or low payout ratio is follows,it makes no difference on the value of the share. MM Prove their argument quantitatively as follows: 1 Po = -——— (D1 + P1) …(1) 1+kWhere, P0 - market price per share at the beginning of year 1P1 - market price per share at the end of year 1D1 - dividend per share at the end of year 1k - discount rate applicable to the firm. Equation 1 simply tells that the current price of a share is equal to thesum of the discounted value of year - end dividend and market price at the end of theyear. From equation 1, the value of outstanding equity shares of the firm at time 0,i.e.; beginning of the year is equal to : 1 nP0 = ——— [n D1 + (n+m) P1 - m P1] ....(2) 1+k BSPATIL
  • 273. where,n = number of shares outstanding at time 0,nP0 = total value of outstanding equity at time 0,k = discount ratem = number of additional shares issued at time 1n+m = number of outstanding shares at time 1,(n+m) P1 = value of all outstanding shares at time 1mP1 = market value of fresh issue at time 1. The value of equity issued at time 1, (mp1) is equal to total investment, I,proposed at time 1, minus retained earnings. Retained earnings = Earnings, (X),minus dividend, (nDi), i.e.., X - n D1 So, mP1 = I – (X-nD1) ....(3) By substituting the value of mPj as in equation 3 in the equation 2 above,we get 1 nP0= ——— [nD1 + (n+m) P1 - (I-(X-nD1)] 1+k 1 = ——— [nD1 + (n+m)P1 - I + ( X-nD1) 1+k 1 = ——— [(n+m)P1 - I + X] ….(4) 1+k In the equation (4), when gives valuation of current equity shares of thecompany, you dont find a place for D1 i.e.. dividend at all. So, Modigliani and Millerheld that value is independent of dividend decision. Hence their dividend irrelevancestand. The dividend irrelevance stand stems from their leverage irrelevance stand BSPATIL
  • 274. dealt with in an earlier lesson. You must note that M-M theory tells that dividenddecision does not alter the value of share, unlike the case with Walter, Gordon andGraham-Dodd theories.Illustration 7.3 A Ltd’s cost of equity is 10%. Its outstanding shares is 1,00,000, valuedeach Rs.40. The company plans to invest Rs. 13,60,000 one year hence. Its expressedearnings is Rs.3,00,000 and likely dividend one year after is Rs.2 per share. Showdividend irrelevance as per MM theory.Solution 1 Weknow, P0 = ———— (P1 + D1) 1+k 1 Rs.40 = ———— (P1+2) 1+10% 1 Rs.40 = ———— (P1+2) 1.1 Rs.44 = P1+2 or P1 = 42.Amount required for new financing = I - (X - n D1) = 13,60,000 - (3,00,000 - 2,00,000) = 12,60,000 at 1 year end.No. of shares needed to be issued = Rs. 12,60,000 / Rs.42 = 30,000 shares. So M =30000. Value of the firm 1 BSPATIL
  • 275. V = nP0 = ——— [n D1-(n+m)P1 - I + X - n D1] 1.1 1= ——— [2,00,000+(1,00,000+30,000)42-13,60,000+3,00,000-2,00,000] 1.1= 1 ——— [2,00,000+ 54,60,000 -12,60,000] 1.1 1= ——— (44,00,000) = 40,00,000 1.1 To show that dividend payment has no value on V, we have to show thatnon-payment of dividend also results in ‘V’ as same as V when dividend is declared.Let us now show that ‘V’ when dividend is not declared is same at Rs.40,00,000found earlier as the value of the firm with dividend payment.Now, P1 is got as follows : P1 + zero Rs.40 = ——————— or P1 = Rs.44 1.1 BSPATIL
  • 276. Amount needed to finance new project is: = I – (X-D) = 13,60,000 - (3,00,000 - 0) = Rs. 10,60,000No. of shares to be freshly issued is: Rs. 10,60,000 ——————— Shares Rs.44Value of the firm is 1V = nP0 = ——— [nD1+(n+m) P1 - I + X- nD1) 1= ——— [1,00,000+(10,60,000/44)] 44 +13,60,000-3,00,000 1.1 1= ——— [44,00,000+10,60,000-13,60,000+3,00,000] 1.1 1= ——— (44,00,000) = 40,00,000 1.1 See, the value of the firm is same as with dividend payment. Hence theirrelevance of dividend decision on valuation of firm. BSPATIL
  • 277. Criticisms on MM Dividend theory MM theory is criticized on the invalidity of most of its assumptions. Someof the criticisms are presented below. First, perfect capital market is not a reality.Second, transaction and floatation costs do exist. Third. Dividend has a signalingeffect. Dividend decision signals financial standing of the business, earnings positionof the business, and so on. All these are taken as uncertainty reducers and that theseinfluence share value. So, the stand of MM is not tenable. Fourth MM assumed thatadditional shares are issued at the prevailing market price. It is not so. Fresh issues -whether rights or otherwise, are made at prices below the ruling market price. Fifth,taxation of dividend income is not the same as that of capital gain. Dividend incomeupto Rs. 10000 is fully exempt, whereas capital gain attracts a flat 20% tax in thecase of individual assesses. So, investor preferences between dividend and capitalgain differ. Sixth, investment decisions are not always rational. Some, sub-marginalprojects may be taken up by firms if internally generated funds are available inplenty. This would deflate ROI sooner than later reducing share price. Seventh,investment decisions are tied up with financing decisions. Availability of funds andexternal constrains might affect investment decisions and rationing of capital, thenbecomes a relevant issue as it affects the availability of funds. Eighth, in the equation(4) ‘D1’ is not there. So dividend does not influence value, according to M-M. But inthe equation there is P1 which is influenced by TV as in equation (3). M-M theory iswrong on this count.7.3 DIVIDEND POLICIES Now the dividend policies may be discussed. A policy is a guideline foraction. What are the guidelines followed in respect of dividend function? Theguidelines relate to forms, scale, stability and timing of dividend payment.Accordingly dividend policies of diverse nature are available. Prominent of them aredealt with below.Dividend policies based on form of dividend From the point of view of form, dividend policies could be: cash dividend BSPATIL
  • 278. policy, scrip dividend policy or combined policy. Cash dividend policy stipulates thatdividends are payable in cash only. This is the most predominant method. Indianlaws recognize only this form as dividend. Scrip dividend policy underlies payment ofdividend through issue of fully-paid-up bonus shares. Well established companiesmake bonus issues. Conservation of firms liquidity, to make the balancesheet topresent a realistic picture of its capital base, to widen baies in the shares market, tofinance expansion programmes, to enhance the corporate image, to lower the rate ofdividend per share on future occasions and to get some tax benefits scrip dividend isissued. The combined policy, implies that both cash and scrip dividends areperiodically declared by the company.Dividend policies based on scale of dividend From the point of view of scale, the policy options are: high payout policy,low payout policy and medium payout policy. The high payout policy is supported byGraham and Dodd. The arguments in favour of such policy were already dealt with.Low payout policy underlies lesser dividend and higher retention. When r > k, thispolicy is suggested. And its strong points are already discussed. The via media policyis also good as it combines the advantages of both the other policies, without theirdisadvantages. BSPATIL
  • 279. Dividend policies based on stability of dividend From the stability point of view we have: fixed divided or varying payoutratio policy, varying dividend or fixed payout ratio policy, steadily changing dividendpolicy, target dividend payout policy and residual dividend policy. Fixed dividendpolicy ensures that a constant dividend per share (DPS) is paid periodically.Shareholders are certain of their current dividend income dd can plan their financialactivities accordingly. This policy implies that the payout ratio is changing and that adividend equalization fund may be required. This policy might ensure a high andstable share price. Such a condition favours investors. Varying dividend per sharepolicy implies that the DPS fluctuates. Perhaps this may be due to that a constantpayout ratio is adopted by the firm while its earnings fluctuate year after year. Shareprices might fluctuate and speculation might build up. Chart 7.1 and 7.2 give apictorial presentation of these two policies. A policy of steadily changing dividend per share is a good alternative toboth the above policies. Here the DPS is not infinitely held constant or allowed toscale peaks and fall into troughs alternatively. On the other hand the DPS isgradually changing (increasing or decreasing). Unless and until an upswing in EPS isstabilized, DPS is not scaled up and similarly only when a down-swing in EPS is moreor less constant, the DPS is scaled down. When an upswing in EPS is expected to be maintained for a reasonablylong time, the DPS is scaled up. BSPATIL
  • 280. Chart 7.1 Chart 7.2 A company may adopt, a policy of target payment ratio, wherein it fixesa payment ratio which it must reach over a period of time. This policy is also a viamedia to fixed and fluctuating dividend policies. There is another policy calledresidual dividend policy. Dividend is paid only when anything is left after meeting allinvestment needs. So, dividends would be very much fluctuating or mostly nil goinghill up or valley down.Dividend policies based on timing From the timing point of view we have regular and irregular, interimand annual and immediate and no-immediate dividend policies. Regular dividendpolicy implies that payment of dividend is a regular feature. The irregular dividendpolicy implies the opposite. Shareholders definitely prefer the former to the latterpolicy. Interim dividend policy is that the company declares dividend more man oncein a year. As and when disposable profits are available dividend is declared. Annualdividend policy means that only once in a year dividend is paid Immediate dividendpolicy means that the company pays dividend right from establishment. It adds valueto the company. No immediate dividend policy is one where the company does notstart paying dividend until it has good earnings. To finance expansion, growth anddiversification the internal funds may be used. Cost of fresh external capital may behigh and that no-dividend policy is adopted. Generally, few companies adopt thispolicy. But they have to be very cautious in this regard. BSPATIL
  • 281. 7.4 DIVIDEND PRACTICES AND LEGAL FORMALITIES Dividend practices are as divergent as dividend policies. Cash dividend,scrip dividend, interim dividend, annual dividend, regular and stable dividend, andregular and extra dividend practices are widely adopted. These are all alreadydiscussed. The company has to first of all formulate its policy as to form, scale,stability and timing of dividend payment. Once the formulation is over, dividendpractice becomes a routine affair with certain legal formalities to be fulfilled. Provisions of Companies Act relating to declaration and payment ofdividend have to be followed. In fact, the declaration and payment of dividend is aninternal matter of the company and is governed by its Articles. The power regardingappropriation of profits is given to the Board of Directors. However, they are governedby the provisions of Companies Act. The Directors are TO follow table A or theprovisions of Articles and the provisions of the Companies Act 1956 in this regard.The following are the rules regarding declaration and payment of dividend:1) Dividend on paid up capital: A company may, if so authorized by itsArticles, pay dividend on the paid up value of snares under Section 93 of theCompanies Act.2) Provisions of Articles of Association: Rules 85 to 94 of Table A providethat:i) A company may declare dividend in its general meeting provided it does not exceed the amount recommended by the Board of Directors.ii) The Board of directors may from time to time pay to the members such interim dividends, as appears it to be justified by the profits of the company.iii) Notice of any dividend should be given to those who are entitled to receive the BSPATIL
  • 282. same.iv) The directors may transfer any amount they thing proper to the reserve fund which may be utilised for any contingencies.v) When a dividend has been declared, it becomes a liability of the company to the shareholders from the date of its declaration, but no interest can be claimed on it.3) Dividends only put of profits : a) Dividend can only be declared or paid outof (i) the current profits of the company, (ii) the past accumulated profits and (iii)moneys provided by the Central or State Government for the payment of dividendsin pursuance of a guarantee given by that Government No dividend can be paid out of capital (Sec.205(i)). Director who is responsible for payment ofdividend out of capital, shall K personally liable to make good such amount tothe company.b) Companies are not entitled to pay any dividend unless present or arrears ofdepreciation have been provided from out of the profits and an amount of 10% ofprofits has been transferred to reserve. However, the Central Government mayallow any company to declare or pay dividends out of profits before providingfor any depreciation.c) Capital profits may also be utilised for the declaration of dividend provided(i) there is nothing in the article prohibiting the distribution of dividend out ofcapital profits; (ii) they have been realized in cash; and (iii) they remain as profitsafter revaluation of all assets and liabilities.d) Dividend cannot be paid out of accumulated profits unless current losses aremade good.4) Payment of dividend only in cash : (Sec.205(iii)) Dividends are to be paid incash only except in the following circumstances: BSPATIL
  • 283. i) by capitalising the profits by issue of fully paid bonus shares* if Articles sopermit, provided all legal formalities have been satisfied in respect of issue of bonusshares "ii) by paying up any unpaid amount on partly paid up shares.5) Payment of Dividend to specified Persons : (Sec. 206) Dividend shall be paid only to those whose names appear on the registerof members on the date of declaration of dividend of to the holders of dividendwarrant it issued by the company.6) Payment of Dividend with 42 days (Sec.207) Dividend must be paid within 42 days of its declaration except in thefollowing circumstances: i) by operation of law of insolvency; ii) in compliance of the directions of the shareholders; iii) where right to receive dividend is pending decision; iv) where it is not due to the default of the company; and v) if company lawfully adjusts the amounts against any debt due from the shareholder.7) Payment of Interim Dividend. The Director of a company can pay interim dividend subject to the provisions of Articles. Interim dividend can be paid at any time between the two annual general meetings taking into account full year’s accounts and after providing full year’s depreciation on fixed assets.7.5 FACTORS INFLUENCING DIVIDEND DECISION Scores of factors affect dividend decision. These are enumerated below withbrief explanation. BSPATIL
  • 284. Legal position Section 205 of the Companies Act, 1956 which lays down the sources fromwhich dividend can be paid, provides for payment of dividend (i) out of past profitsand (ii) out of moneys provided by the Central/State Government, apart from currentprofits. Thus, by law itself, a company may be allowed to declare a dividend even in ayear when the profits are inadequate or when there is absence of profit. However in ayear when there are meager profits, while one company may skip the payemnt ofdividend, another company may apply for the alternatives offered by the law. Concerning the declaration of dividend, two concepts are relevant, namely, (i)"profits available for distribution" and (ii) "Profits available for dividend". While theformer refers to the maximum profits which can be legally distributed as dividend,the latter denote profits which the directors recommend for distribution. Even whenthere are no profits in commercial sense, yet mere can be divisible profits. There is,legally, no prohibition against "profits from sale of fixed assets" from being distributedas dividend. Whether such a course of action is prudent or not is altogether adifferent matter, while one company may decide in favour of distributing dividendsout of such "profits", another company may disfavour it. When a company declares dividend it has to transfer a certain percentage of itsprofit to reserves, which of course, depends on the rate of dividend. Even aftertransferring profits to reserves and declaring dividends still there may be a balance inprofit. Whether this residue is to remain in the Profit and Loss Account itself or anyhigher percentage of profit is to be transferred to reserves depends largely on thepractical consideration and policy of the management. In a particular years whenthere is absence of profit or inadequacy of profit, the profits of earlier years (whichremain in P & L A/c itself) are more freely available for distribution than the earlieryears profits which are transferred to reserves. Because in the latter case, it would bedeclaration of dividend out of reserves and provisions of Section 205A(3) areapplicable: company concerned is bounded by the restrictions and conditions laiddown in the "Companies (Declaration of dividend out of Reserves) Rules 1975". BSPATIL
  • 285. ii) Magnitude and Trend in EPS EPS is the basis for dividend. The size of the EPS and the trend in EPS in recent years set how much can be paid as dividend A high and steadily increasing EPS enables a high and steadily increasing DPS. When EPS fluctuates a different dividend policy has to be adopted.iii) Taxability According to Section 205(3) of the Companies Act, 1956 no dividend shall be payable except in cash. However, the Income-Tax Act defines the term dividend so as to include any distribution of property or rights having monetary value. Even under Section 2(22) of the Income-Tax Act (which treats certain distributions as dividend under Income Tax (Act though they may not be regarded as dividend under the Companies Act). Issue of bonus shares to equity shareholders is not at all treated as dividend by company Act. Therefore liberal dividend policy becomes unattractive from the point of view of the shareholders/investors in high income brackets. Thus a company which considers the taxability of its shareholders, may not declare liberal dividend though there may be huge profit, but may alternatively go for issuing bonus shares later.iv) Liquidity and Working Capital Position Apparently, distribution of dividend results in outflow of cash and as such a reduction in working capital position. Even in a year when a company has earned adequate profit to warrant a dividend declaration, it may confront with a week liquidity position. Under the circumstance, while one company may prefer not to pay dividend since the payment may impair liquidity, another company following a stable dividend policy, may wish to declare dividends even by resorting to borrowings for dividend payment in cash. In the later case the company borrows money for the sake of pursuing regular dividend policy. At the same time, one could visualize totally a different phenomenon. There may be adequate profits and sufficiency of cash for BSPATIL
  • 286. payment of dividend. Here, the payment of dividend depends on the policy of management. The company may require funds to finance an expansion programme, and the directors may decide to skip the payment of dividend; and instead retain the earnings and invest them in the expansion programme. But, if the management follows a stable dividend policy, it may pay dividend and prefer to finance the expansion programme through borrowings. This will be very much so, if the company enjoys an enviable record of perennial dividend payments.v) Impact on share price The impact of dividends on market price of shares, though cannot be precisely measured, still one could gauge the influence of dividend on the market price of shares. The dividend policy pursued by a company naturally depends on how far the management is concerned about the market price of shares. Generally, an increase in dividend payout results in a hike in the market price of shares. This is significant as it has a bearing on new issues. For instance, a company which has a proposal to expand after few years and has plans of issuing new shares for financing its expansion may try to enhance the market price of its shares by maintaining a record of increasing trend in dividends. Whether it is fair on the part of the management to attempt to influence the market price of its shares is a different question. On the other hand, established concerns may follow a stable dividend policy, instead of varying dividend rates frequently. The market price of shares of former companies is higher than that of companies with fluctuating dividend Control consideration Where the directors wish to retain control, they may desire to finance growth programmes by retained earnings, since issue of fresh equity shares for financing growth plan may lead to dilution of control of the dominating group. So, low dividend payout is favoured by Board. BSPATIL
  • 287. vii) Type of Shareholders When the shareholders of the company prefer current dividend rather man capital gain a high payment is desirable. This happens so, when the shareholders are in low tax brackets, they are less moneyed and require periodical income or they have better investment avenues than the company. Retired persons, economically weaker sections and similarly placed investors prefer current income i.e. dividend. If, on the other hand, majority of the shareholders are moneyed people, and want capital gain, then low payout ratio is desirable. This is known as clinentele effect on dividend decision.viii) Industry Norms The industry norms have to be adhered to the extent possible. It most firms in me industry adopt a high payout policy, perhaps others also have to adopt such a policy.ix) Age of the company Newly formed companies adopt a conservative dividend policy so that they can get stabilized and think of growth and expansion.x) Investment opsportunities for the company If the company has better investment opportunities, and it is difficult to raise fresh capital quickly and at cheap costs, it is better to adopt a conservative dividend policy. By better investment opportunities we mean those with higher r relative to the k. So, if r>k, low payout is good. And vjce versaxi) Restrictive covenants imposed by debt financiersDebt financiers, especially term lending financial institutions, may impose restrictiveconditions on the rate, timing and form of dividends declared. So, that considerationis also significant.Floatation cost, cost of fresh equity and access capital market BSPATIL
  • 288. When floatation costs and cost of fresh equity are high and capitalmarket conditions are not congenial for a fresh issue, a low payout ratio is adopted.xii) Financial signaling Dividends are the best medium to tell shareholder of better days ahead of the company. When a company enhances the target dividend rate, it overwhelmingly signals the shareholders that their company is on stable growth path. Share prices immediately react positively.7.6 SUMMARY Dividend decision is an important decision area. Dividend valuationnexus is still an unresolved issue. Dividend valuation nexus is supported by Walter,Gordon and Graham, while Miller and Modigliani hold the contrary. Walters theoryand Gordons theory tell that if r>k, low payout ratio enhances value and vice versa.When r=k, dividend is irrelevant to valuation. But MM view that altogether valuationis not affected by dividend decision. There are many dividend policies which could beclassified from the points of view of form, stability, scale, timing of dividend payment.Several factors like legal considerations, taxability, trend in EPS, liquidity,shareholders preferences, floatation costs, access to capital market and the likeinfluence dividend decision.7.7 SELF ASSESSMENT QUESTIONS 1) Bring out the dividend - valuation nexus 2) Is dividend decision relevant to valuation? Substantiate 3) Compare and contrast Walters theory and Gordons theory of dividend -valuation. 4) Explain the MM theory of dividend irrelevance. BSPATIL
  • 289. 5) What are the different dividend policies? Briefly explain each.6) Between stable and fluctuating dividend policies, which one would you recommend. Why?7) Explain dividend payment practices and the legal formalities in that context.8) Discuss clearly the factors that affect dividend decision.9) Calculate the market price of X Ltds share given the following under Gordons theory and under Walters theory for different payout ratios: EPS = Rs.4; K - 16% and r = 18% Dividend payout ratios: 0%, 25%, 50% 75% and 100%. Also compute value under Graham - Dodd model, taking the multiple as 8.10) A company has 1,00,000 shares outstanding, with a current market value of Rs.80 per share. Its earning for the ensuring year is Rs.20,00,000. It has investment proposals of Rs.30,00,000 by the end of the year. The share holders expected return is 20% p.a. and they expect a DPS of Rs,10 per share by year end. Show that under MM theory, the market value of the shares is not affected by dividend decision.11) A companys RE ratio is 12.5%. Its r = 10%. The company declares a dividend of Rs.3 per share, with its EPS of Rs.5. Is the dividend policy optimum? If not why not? Will your answer differ, when r = 8% and r = 6%. Take Walters model.12) Explain i) Financial signaling, ii) Residual theory of dividend, iii) Scrip dividend, iv) Stable DPS policy and v) Clientele effect. ********* BSPATIL
  • 290. MBA DEGREE EXAMINATIONS Paper 2.4: FINANCIAL MANAGEMENT (MODEL QUESTION PAPER)Time 3 His. Max. marks 100 PART -A (5x8 = 40 marks) Answer any five questions1) Give an account of Risk-Return trade off.2) What is the significance of convertible debentures?3) Distinguish fixed and varying working capital.4) Examine the significance of simulation method.5) A business has projected its turnover as Rs. 12 crs. As per Vaz committee find its working capital need and extent of bank finance.6) A project has an equity beta of 1 .2 and debt beta zero and is a have a debt - equity ratio of 3:7. Given risk free rate of return of 10% and market return of 1 8%, Find the required return for the project per CAPM.7) ABC Ltd. is a 100% equity firm with a Ke of 21%, XYZ Ltd, similar to ABC, except in capital mix, has a debt - equity ratio of 2:1 and its K d is 14%. Find the Ke of XYZ Ltd. as per MM Hypothesis and find the overall average cost of capital. [Hint: Ke,L = Ke,u + (Ke,u – Kd) D/E]8) Two firms have the following age distribution of accounts receivable: BSPATIL
  • 291. Month Old Firm A FirmB (Proportion of Accounts)Upto 1 month .1 .151-2 months .15 .152-4 months .50 .60more than 4 months .25. .1 Compute the average age of accounts receivables and ascertain whichfirm is relatively swifter in collection. Make own assumptions, if any, needed. BSPATIL
  • 292. PART-B (4x15 = 60 marks) Answer any four questions9) The cost structure for a firm is: Raw materials Rs. 10 per unit; labour Rs.8 per unit; overhead Rs.10 per unit; profit Rs.7 per unit Credit allowed by creditors is 2 months and allowed to debtors is 3 months. Time lag in payment of expenses 1 month. Production and consumption are equal and even. For an equal production of 1,80,000 units prepare working capital budget Cash balance required is Rs. 50,000 and provision for contingency , is required at 5%10) The P, V, Q, F, I, T and K of a project are as follows: P = Rs. 300; Investment I = Rs. 20,00,000; N = 4 years, K = 10%, T = 30%fixed cost (excluding depreciation) - Rs. 15,00,000. The quantity of sales (a) is asensitive factor with the range 12,000 to 20,000 with most likely value 17000.similarly, variable cost, V, is a sensitive factor with range Rs. 130 to Rs. 180, withmost likely value of Rs. 160 per unit perfonn sensitivity analysis w.r.t. quantity andvariable cost.11) The Ke and Kd at different levels of D/E ratio are as follows. D/E Ke (%) Kd (%) 0.0 21 0 0.4 21 12 0.8 22 12 1.2 22 14 1.6 24 14 2.0 24 16 2.4 28 20 Find the optimum capital structure.12) A firm with 2/30, net 60 days credit terms, nets a sale of Rs. 50 lakh p.a. and incurs a capital cost of 12%, 80% of accounts are cleared on 30 days. The firm wants to switch over to 1/30, net 60 days. This is likely to reduce sales by 10% BSPATIL
  • 293. and the percentage of account? availing cash discount to 60%. Assuming a variable cost to sales ratio of 85%, assess the new proposal.13) A company has 1,00,000 shares outstanding, with a current market value of Rs.80 per share. Its earning for the ensuring year is Rs.20,00,000. It has investment proposals of Rs.30,00,000 by the end of the year. The share holders expected return is 20% p.a. and they expect a DPS of Rs.10 per share by year end. Show that under MM theory, the market value of the shares is not affected by dividend decision.14) Explain the Contemporary developments in business finance.15) Bring out the significance institutional finance for industries. ******** BSPATIL