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    Financial management Financial management Document Transcript

    • Disha Institute of IT & Management Financial ManagementUnit IMeaning of Financial Management:-Financial Management is such a managerial process which is concerned with theplanning and control of Financial resources. It is being studied as a separatesubject in 20th century. Till now it was used as a part of economics. Now, itsscope has undergone some basic changes from time to time. In present time, itanalyses all financial problems of a business. Financial Manager estimates therequirements of funds, plans the different sources of funds and perform functionsof collection of funds and its effective utilisation.Finance is such a powerful source that it performs an important role to operateand coordinate the various economic activities of business. Finance is of twotypes:- (1) Public finance. (2) Private finance.1. Public Finance:-means government finance under which principles and practices relating to theprocurement and management of funds for central government, stategovernment and local bodies are covered.2. Private Finance:-means procurement and management of funds by individuals and privateinstitutions. Under it we observe as to how individuals and private institutionprocure funds and utilise it.Scope:-What is finance? What are a firm’s financial activities? How are they related?Firm create manufacturing capacities for production of goods, some provideservices to customers. They sell goods or services to earn profit and raise fundsto acquire manufacturing and other facilities. Thus, the 3 most important activitiesof business firm are:- (1) Production (2) Marketing I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management (3) Finance.A firm secures whatever capital it needs and employs it (finance activity) inactivities which generate returns on invested capital (production and marketingactivities.)Real and financial Assets:- A firm acquire real assets to carry on its business. Real assets can betangible or intangible. Plant, machinery, factory, furniture etc. are examples oftangible real assets, while technical know-how, patents, copy rights are examplesof intangible real assets. The firm sells financial assets or securities such as shares and bonds ordebentures, to investors in capital market to raise necessary funds. Financialassets also include borrowings from banks, finance institutions and othersources. Funds applied to assets by the firm are called capital expenditure orinvestment. The firm expects to receive return on investment and distribute returnas dividends to investors.EQUITY AND BORROWED FUNDS:- There are two types of funds that a firm can raise:- Equity funds andborrowed funds. A firm sells shares to acquire equity funds. Shares represent ownershiprights of their holders. Buyers of shares are called share holders and they arelegal owners of the firm whose share they hold share holders invest their moneyshares of a company in expectation of return on their invested capital. The returnon shares holder’s capital consists of dividend and capital gain by selling theirshares. Another important source of securing capital is creditors or lenders.Lenders are not the owners of the company. They make money available to firmon a lending basis and retain title to the funds lent. The return on loans orborrowed funds is called interest. Loans are furnished for a specified period at afixed rate of interest. Payment of interest is a legal obligation. The amount ofinterest is allowed to be treated as expense for computing corporate incometaxes. Thus the payment of interest on borrowings provides tax shied to a firm.The firm may borrow funds from a large number of sources, such as banks,financial institutions, public or by issuing bonds or debentures. A bond or I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementdebenture is a certificate acknowledging the money lent by a bond holder to thecompany. It states the amount, the rate interest and maturity of bonds ordentures.FINANCE AND OTHER MANAGEMENT FUNCTIONS:- There exists an inseperable relationship between finance on the one handand production, marketing and other functions on the other. Almost, all kinds ofbusiness activities, directly or indirectly, involve acquisition and use of funds. Forexample, recruitment and promotion of employees in production is clearly aresponsibility of production department but it require payment of wages andsalaries and other benefits and thus involve finance. Similarly, buying a newmachine or replacing an old machine for the purpose of increasing productivecapacity affects flow of funds. A company in tight financial position will of course, give more weight tofinancial considerations and devise its marketing and production strategies inlight of financial constraint. On other hand, management of a company, whichhas a regular supply of funds, will be more flexible in formulating its productionand marketing policies. In fact, financial policies will be devised to fit production &marketing decision of firms in practice.OBJECTIVES OF FINANCIAL MANAGEMENT:- It is the duty of management to clarify the objectives of business so thatthe departmental objectives could be determined accordingly. Financialobjectives of a firm provide a concrete framework within which optimum financialdecisions can be made. The main objective of any firm should be to maximisethe economic welfare of its shareholders. Accordingly, there are 2 approaches inthis regard. (A) Profit maximisation Approach. (B) Wealth maximisation Approach. (A) PROFIT MAXIMISATION APPROACH:- According to this approach, a firm should undertake all those activitieswhich add to its profits and eliminate all others which reduce its profits. Thisobjectives highlights the fact that all decisions:- financing, dividend andinvestment, should result in profit maximisation. Following arguments are given infavour of profit maximisation approach:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management (i) Profit is a yardstick of efficiency on the basis of which economic efficiency of a business can be evaluated. (ii) It helps in efficient allocation and utilisation of scarce means because only such resources are applied which maximise the profits. (iii) The rate of return on capital employed is considered as the best measurement of the profits. (iv) Profit acts as motivator which helps the business organisation to be more efficient through hard work. (v) By maximising profits, social & economics welfare is also maximised.However this approach has been criticised on various counts:-(1) Ambiguity:- Profit can be expressed in various forms i.e it can be short term or longterm or it can be profit before tax or after tax or it can be gross profit or net profit.Now the question arises, which profits can be maximised under profitmaximisation approach.(2) Time Value of Money This approach is also criticised because it ignores time value of money i.e.under this approach income of different years get equal weight. But, in fact, thevalue of rupee today will be greater as compared to the value of rupee receivableafter one year. In the same manner, the value of income received in the first yearwill be greater from that which will be received in later year e.g. the profits of 2different projects are:-Example:-YEAR PROJECT1 PROJECT21 5,000 -2 10,000 10,0003 5,000 10,000 Both the projects have a total earnings of Rs 20,000 in 3 years andaccording to this approach both will be considered equally profitable. But Project1 has greater profits in the initial years of the project & therefore, is moreprofitable in terms of value of income. The profits earned in initial years can bereinvested and more profits can be earned.(3) Risk Factor:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management This approach ignores risk factor. The certainity or uncertainity of incomereceivable in future can be high or less. High uncertainity increases risk and lessuncertainity reduces risk. Less income with more certainity is considered betteras compared to high income with greater uncertainity. Thus, this approach was more significant for sole trader & partnershipfirms because at that time when personal capital invested in business, theywanted to increase their assets by maximising profits. Companies are nowmanaged by professional managers and capital is provided by shareholders,debenture holders, financial institutions etc. one of the major responsibilities ofbusiness management is to co-ordinate the conflicting interest of all theseparties. In such a situation profit maximisation approach does not appear properand practicable for financial decisions.B Wealth Maximisation Approach Value Maximisation Approach or Maximum net present worth. According to this approach , financial management should take suchdecision’s which increase net present value of the firm and should not undertakeany activity which decrease net present value. This approach eliminates all the 3basic crificisms of the profit maximisation approach. As the value of an asset is considered from view point of profit accruingfrom it, in the same manner the evaluation of an activity depends on the profitsarising from it. Therefore, all 3 main decisions of financial manager-financingdecision, investment decision dividend decision affect net present value of thefirm. The greater the amount of net present value, the greater will be value of firmand more it will be in the interest of share holders. When the value of firmincreases, the market price of equity shares also increase. Thus to maximise netpresent worth means to maximise the market price of shares. Net present worthcan be calculated with the help of following equation. A1 A2 An -c W= + + --------------------- + (1+k) (1+k)2 (1+k)n n At = ∑ -C t t=1 (1+k) I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementWhere W = Net present worth. A, A2--- An= Stream of expected cash benefits from a course of actionover a period of time.K = Discount rate to measure risk & timing.C= Initial outlay to acquire that assetIf W is positive, the decision should be taken & vice versa.If W is Zero, it would mean that it does not add or reduce the present value of theasset. This approach is considered good for the companies in present situation.This approach gives due consideration to the time value of expected incomereceivable over different period of time. Under this approach, risk and uncertaintyis analysed with the help of interest rate. If uncertainity & time period are greater,higher rate of interest will be used to calculate present value of expected futurecash benefits where as the interest rate will be lower for the projects with low risk& uncertainity. Besides, this approach uses cash flows instead of accountingprofits which removes ambiguity associated the term profit. On the basis of above explanation, we can conclude that wealthmaximisation approach is better to profit maximisation approach to establishmutual relation among the various data. It is possible only through statistics.Cash and inventory management, forecast of financial needs, credit policydecision all are based on the advanced techniques of statistics. Finance is also related to law. Any decision regarding financial policyshould be in line with the laws of the country.Organisation of Finance Function The organisation of finance function implies the division and classificationof functions relating to finance because financial decisions are of utmostsignificance to firms. Therefore, to perform the functions of finance, we need asound and efficient organisation. Although in case of companies, the main responsibility to perform financefunction rests with the top management yet the top management (Board ofDirectors) for convenience can delegate its powers to any subordinate executive I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementwhich is known as Director Finance, Chief Financial Controller, Financial Mangeror Vice President of Finance. Besides it is finally the duty of Board of Directors toperform the finance functions. There are various reasons to assign theresponsibility to the Board of Directors. Financing decisions are quite significantfor the survival of firm. The growth and expansion of business is affected byfinancing policies. The loan paying capacity of the business depends upon thefinancial operations. The organisation of finance function is not similar in all businesses but it isdifferent from one business to another. The organisation of finance function for abusiness depends on the nature, size financial system and other characteristicsof a firm. For a small business, no separate officer is appointed for the financefunction. Owner of the business himself looks after the functions of financeincluding the estimation of requirements of funds, preparation of cash budget andarrangement of the required funds, examination of all receipts and payments,preparation of credit policy, collecting debtors etc. with the increase in the size ofbusiness, specialists were appointed for the finance function and thedecentralisation of the finance function began. For a medium sized business, theresponsibility of the finance function is given to a separate officer who is knownas financial controller, finance manager, deputy chairman (finance), financeexecutive or treasurer. In a large sized company the finance function has become more difficultand complex and the position of financial manager has become very important.He is the member of top management of an organisation. For such largeorganisations it is not possible for a finance manager to perform all the financefunctions or to co-ordinate with the various departments. Therefore, finance andfinancial control are separated and allocated to two different sub-departments.For the ‘finance’ sub-department treasurer is appointed and for the ‘financialcontrol’ sub department, financial controller is appointed. Each of them havevarious sub-units under them. Financial planning and financial control are quite significant for a largesized organisation. Therefore, a finance committee is established between theBoard of Directors and Managing Director. It includes the financial Manger,representatives of the directors and departmental heads of various departments.Managing Director is the chairman of the committee. Its main function is toadvise the Board of Directors on financial planning and financial control and co-ordinate the activities of various departments. The following chart 1.1. explainsthe organisation of finance function. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management From the chart 1.1. it is clear that treasurer and financial control workunder finance Manager. Financial Manager is responsible to the ManagingDirector for his actions. Board of Directors Managing Directing Finance Committee Production Personnel Financial Marketing Manager Manager Manager Manager Treasurer ControllerBanking Cash Credit Assets SecuritiesRelations Magt. Analysis Protection Mgt.Corporate Annual Internal Planning & StatisticsAccounting Reports Auding Budgeting & Cost Treasurer performs the functions of procurement of essential funds, theirutilisation, investment, banking, cash management credit management, dividenddistribution, pension, management etc. Financial, controller is responsible for I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementgeneral accounting, cost accounting, auditing, budget, reporting and preparingfinancial statement etc. In India the function of financial manager is given tosecretary in most of the companies. He performs the functions of treasurer andfinancial controller along with the routine functions of secretary. He collectsnecessary data and information and sends them to the Managing Director.Functions of the Chief Financial Manager. Chief Financial manager is the top officer of finance department. InAmerica he is known as Vice-president finance and in India he is called ChiefFinancial Controller. He performs following functions: (1) Financial Planning :- He determines the capital structure andprepares financial plan. (2) Procurement of Funds:- Financial manager makes the necessaryfunds available from different sources. (3) Co-ordination:- Financial manager establishes co-ordination amongthe financial needs of various departments. He is a member of financecommittee. (4) Control:- Financial manager examines whether the work is beingperformed as per pre-determined standards or not. He gets the reports prepared,controls the cost and analyses profits. (5) Business Forecasting:- Financial manager evaluates the effects ofall national, international, economic, social and political events on industry andcompany. (6) Miscellaneous Functions:- It includes the management of assets,management of inventory, arrangement of data and management of bankdeposits etc.Functions of Treasurer The following are the functions of treasurer. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management (1) Provisions of finance:- It includes the estimation of funds necessaryfor procurement preparing programmes and implementing them, establishingrelation among various sources of funds, issuing the securities and managingdebt etc. (2) Banking Function:- It includes opening bank accounts, depositingcash, payment of company liabilities, accounting cash receipts & payments,responsibility for transacting actual assets etc. (3) Custody:- The treasurer is the custodian of funds and securities. (4) Management of credit and collection:- The treasurer determinescredit risk of customers and arranges for collection. (5) Investments: It involves the investment of surplus funds. (6) Insurance:- The treasurer signs the cheques, agreement and otherletters of company forecasts cash receipts and payments, pay property taxes andfollows government regulations.Functions of controller The controller performs the following functions:- (1) Planning:- The controller prepares plan for controlling the businessactivities which are the main constituents of management and in which properarrangement regarding profit planning, capital expenditure planning, salesforecasting and expenditure budgeting is made. (2) Accounting:- Controller determines the accounting system andarrangements for costing and management accounting systems and preparesfinancial statements. (3) Auditing:- Controller Manages internal auditing. (4) Reports :- Controller prepares financial reports according to variousneeds and presents them to the managers. He advises the management tocorrect the deviation between the standard performance and actual performance. (5) Government Reporting :- Controller sends essential information’s tothe government by obeying the legal requirement. (6) Tax Administration :- Controller prepares statement on tax liability. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management (7) Economic Appraisal :- He determines and analyses the effect ofeconomic and social factors on business.Time Value of Money:- The evaluation of capital expenditure proposals involves the comparisonbetween cash outflows & cash inflows. The pecularity of evaluation of capitalexpenditure proposals is that it involves the decision to be taken today where asthe flow of funds, either outflow or inflow, may be spread over a number of years.It goes without saying that for a meaningful comparison between cash outflowsand cash inflows, both the variables should be on comparable basis. As such,the question which arises is “that is the value of flows arising in future the samein terms of today.”For Example:- if a proposal involves cash inflow of Rs 10,000 after one year, isthe value of this cash inflow really Rs 10,000 as on today when capitalexpenditure proposal is to be evaluated.? The ideal reply to this question is ‘no’.The value of Rs 10000 received after one year is less than Rs 10,000 if receivedtoday. The reasons for this can be stated as below:-(i) There is always an element of uncertainety attached with the future cashflows.(ii) The purchasing power of cash inflows received after the year may be lessthan that of equivalent sum if received today.(iii) There may be investment opportunities available if the amount is receivedtoday which cannot be exploited if equivalent sum is received after one year.Time Value of money:Example:- If Mr. X is given the option that he can receive an amount of Rs 10000either on today or after one year, he will most obviously select the first optionwhy? Because, if he receives Rs 10000 today he can always invest the same sayin fixed deposit with the bank carrying interest of say 10% p.a As such, if choiceis given to him, he will like to receive Rs 10000 today or Rs 11000 (i.e. Rs 10000plus interest @ 10% p.a. on Rs 10000) after one year. If he has jto receive Rs10,000) only after one year, the real value of same in terms of today is not Rs10000 but something less than that. This concept is called time value of money. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementFinance Functions:-(a) Financing decisions(b) Investment decisions(C) Dividend policy decision(d) Liquidity Decision(a) Financing Decisions are decisions regarding process of raising the funds.This function of finance is concerned with providing answers to various questionslike -(a) What should be amount of funds to be raised.(b) What are the various sources available to organisation for raisaing therequired amount of funds? For this purpose, the organisation can go for internal& external sources.(c) What should be proportion in which internal & external sources should beused by organisation?(d) If organisation, wants to raise funds from different sources, it is required tocomply with various legal & procedural formalities.(e) What kinds of changes have taken place recently affecting capital market inthe country?(b) Investment decisions:- are decisions regarding application of funds raisedby organisation. These relate to selection of the assets in which funds should beinvested. The assets in which funds can be invested are of 2 types(a) Fixed assets:- are the assets which bring returns to organisation over alonger span of time. The investment decisions in these types of assets are“capital budgeting decisions.” Such decisions include1 How fixed assets should be selected to make investment ? What are variousmethods available to evaluate investment proposals in fixed assets?2 How decisions regarding investment in fixed assets should be made in situationof risk & uncertainity? I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management(b) Current assets:- are assets which get generated during course of operations& are capable of getting converted in form of cash with in a short period of oneyear. Such decisions include(1) What is meaning of Working Capital management & its objectives?(2) Why need for working capital orises?(3) What are factors affecting requirements of working capital?(4) How to quantity requirements of working capital?(5) What are sources available for financing the requirement of working capital?(c ) Dividend Policy Decisions:- Such decisions include(1) What are forms in which dividend can be paid to share holders?(2) What are legal & procedural formalities to be completed while paying dividenddifferent forms?(d) Liquidity Decisions:- Current assets should be managed efficiently for safeguarding firm against of liquidity & insolvency. In order to ensure that neitherinsufficient nor unnecessary funds are invested in current assets, the financialmanager should develop sound technique of managing current assets. DIVIDEND POLICYMeaning: Dividend is that part of business income which is distributed among shareholders. Dividend can be paid in the form of shares or securities or cash.Dividend is given to share holders as a return on their investment in thecompany. If a company does not pay regular dividend to its share holders, theywill not invest in it in future. Dividend is paid on equity as well as preferenceshares. But it is paid at fixed rate on preference shares where as no rate is fixedfor equity shares. Business will either distribute its net profit among share holdersor retain it in business. The part of profit which is retained in business is calledretained earning & it is source of funds for business. Therefore, there is inverserelationship between the amount to be distributed as dividend and amount ofprofits to be retained in business. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management Business should, therefore, determine as proper dividend policy.Definition Dividend policy means that decision of the management through which itis determined how much of net profits are to be distributed as dividend amongthe share holders and how much are to be retained in the business. Factors determining Dividend PolicyA External factors B Internal Factors.1) Phase of Trade cycles 1) Attitude of Management2) Legal Restrictions 2) Composition of share holding3) Tax Policy 3) Age of Company.4) Investment Opportunities. 4) Nature of Business5) Restrictions Imposed by Lending 5) Growth Rate of CompanyInstitutions. 6) Liquidity Position 7) Customers & Traditions.A External Factors:-1) Phase of trade cycle:- During the phase of boom, company may not like to distribute hugeamount of profit by way of dividend though earning capacity is more becausecompany will like to retain more profit which can be used during depression.Similarly, during depression company will like to hold dividend payment in orderto preserve its liquidity position.2) Legal Restrictions:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management If a company wants to pay dividend in cash, provisions of companies act1956, are required to be followed by company. If the company wants to issuebonus shares, relevant SEBI guide lines are required to be followed by thecompany.Tax Policy:- From companies point of view dividend can be paid out of profitafter fax from share holders point of view, dividend received by them consideredto be a taxable income which increases their individual tax liability.4) Investment Opportunities:- If investment opportunities involve higher rate ofreturn than cost of capital, the company will like to retain profits to be invested inthese projects.5) Restrictions imposed by lending institutions:- Sometimes, lending banksor financial institutions impose certain restrictions on the company preventingpayment of dividend if certain conditions are not fulfilled such as interest on loanis not regularly paid by company.Internal Factors:-1) Attitude of Management:- If attitude of management is aggressive, it maydecide to pay more dividend as the management is interested in increasingincome of share holders. Where as if the attitude of management is conservative,company will like to retain more profits to take care of contingencies.2) Age of Company:- A growing concern will like to retain maximum profit inbusiness in order to raise the funds while old company may follow high dividendpolicy.3) Composition of Share Holders:- If a company is private ltd. Company havingless number of shareholders, the company having less number of shareholders,the company will like to retain more profits and reduces dividend. If the companyis a public limited company, tax brackets of individual shareholders may not havesignificant impact on dividend policy of company.4) Nature of Business:- A stable company may follow long term dividend policywhere as an unstable company may like to retain its profits during boom toensure dividend policy is not affected by cyclical variations.5) Growth rate of Company :- A rapidly growing company may like to retainmajority of its profits in order to take care of its expansion needs. However, care I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementshould be taken by management to invest only in those projects which yield morereturns than its cost of capital.6) Liquidity Positions:- Before formulating dividend policy due considerationsshould be given to liquidity position of company. Eg At present, company’s cashposition may be comfortable, but it may need cash within a short time to payinstallments of term loans or to pay creditors for materials. In such case, financemanager may not like to impair its liquidity for making dividend payment.7) Customs & Traditions:- also affect dividend policy.For example:- if the company is following stable dividend policy for 20 years, itmay like to maintain trend in 21st year also, inspite of adverse profitability orliquidity situations.Unit IIILeverages:- The term leverages measures relationships between 2 variables. Infinancial analysis, the term leverage represents influence of one financial variableover some other financial variable. In financial analysis generally 3 types ofleverages maybe computed:-1) Operating leverage.2) Financial leverage.3) Combined leverage.1) Operating Leverage:- It measures effect of change in sales quantity onEarning Before Interest and Taxes (EBIT). It is Computed As: Sales- Variable Cost (i.e Contribution) Earnings before interest and tax.Indications:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management A high degree of operating leverage means that the component of fixedcost is too high in the overall cost structure. A low degree of operating leveragemeans that the component of fixed cost is less in over all cost structure. In otherwords, it measures the impact of % increase or decrease in sales on earningbefore interest and taxes.For Example:-Sales= Rs 20000 Contribution = Rs 10000Earnings before interest and tax Rs 5000As such operating leverage is – Contribution = Rs 10000 ____________________ = 2 EBIT Rs 5000 It means that every 1% increase in contribution will increase the EBIT by2% and vice versa. As such, when contribution = Rs 9000 Instead of Rs 10000I.e. the contribution is reduced by 10% the EBIT is reduced by 20% i.e. the EBIThas became Rs 4000 instead of Rs 5000Financial Leverage:-It indicates firm’s ability to use fixed financial charges to magnify effects ofchanges on EBIT on firm’s EPS. It indicates the extent to which Earnings perShare (EPS) will be affected with change in Earnings Before Interest and Tax(EBIT). It is computed as:- EBIT __________ EBIT- InterestIndications:- A high degree of financial leverage indicates high use of fixed incomebearings securities in capital structure of the company. A low degree of financialleverage indicates less use of fixed income bearing securities is capital structureof company.For Example I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management In case of A Ltd. EBIT is Rs 5000 and interest on debentures is Rs 900,When sales are Rs 20000 where as in case of B. Ltd. The EBIT is Rs 5000 andinterest on debentures is Rs 100 when sales are Rs 20000. As such degree offinancial leverage can be computed as EBIT ______________ EBIT-Interest A. Ltd B. LtdFinancial Leverage Rs 5000 Rs 5000 = = Rs 5000- Rs 900 Rs 5000-Rs900 =1.22 = 1.02 High degree of financial leverage is supported by knowledge of fact that incapital structure of A Ltd 90% is the debt capital component, where as in case ofB Ltd 10% is debt capital component. It means that in case of A Ltd every 1% increase in EBIT will increaseEPS by 1.22% and vice versa. As such, when EBIT is reduced from Rs 5000 to Rs 4000 (i.e. 20%reduction), EPS of A Ltd, gets reduced from Rs 20.50 to Rs 15.50 (i.e.24.40 %reduction) & EPS of B Ltd, gets reduced from Rs 2.72 to Rs 21.6 (i.e 20.40%reduction)Uses of Financial Leverage The degree of financial leverage gives an indication regarding extent towhich EPS may be affected due to every change in EBIT. As the use of debtcapital in capital structure increase EPS, the company may like to use more &more debt capital in its capital structure by using financial.For Example:- EPS in case of A Ltd, is Rs 20.50 when sales are Rs 20000 as 90% of itscapital is debt capital. But in case of B Ltd EPS is only Rs 2.72 when sales are I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementRs 20000 as only 10% of its total capital is debt capital. As such, the phase isoften used that financial leverage magnifies both profits and losses. Financial leverage also acts as a guide line in setting maximum limit uptowhich the company should use the debt capital.Limitations:-1) It ignores implicit cost of debt. It assumes that the use of debt capital may beuseful so long as company is able to earn more than cost of debt i.e. interest. Butit is not always connect. Increasing use of debt capital makes the investment inthe company a risky proposition, as such market price of shares may decline,which may not be maximising share holder’s wealth. Before considering capitalstructure, implicit cost of debt should be considered.2) It assumes that cost of debt remain constant regardless of degree of leveragewhich is not true. With every increase in debt capital, interest rate goes onincreasing due to increased risk involved with the same.3) Combined Leverage:-The combined effect of operating leverage & financial leverage measures theimpact of change in contribution on EPS.It is computed as:- Operating leverage X Financial leverage. Sales-Variable Cost EBIT = _______________ X___________ EBIT Ebit-Interest Sales-Variable Cost = __________________ EBIT- InterestFor Example:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management In case of both A Ltd & B Ltd when sales are Rs 20000 contribution is Rs10000 but earnings after interest and before tax are Rs 4100 and 4900. As suchcombined leverage can beSales- Variable Cost (i.e. Contribution)______________________________ EBIT-Interest A Ltd. B Ltd. _____ _____ 10000 10000 = ______ = ______ 4100 4900 = 2.44 = 2.04It Means that in case of A Ltd every IX increase in contribution will increase EPSby 2.44% & vice versa while in case of B Ltd. Every 1% increase in contribution,will increase EPS by 2.04%. As such when contribution gets reduced from Rs10000 to Rs 9000 i.e. 10% reduction, EPS of A Ltd gets reduced from Rs 20.50to Rs 15.50 ( i.e. 24.4% reduction) & EPS of B Ltd gets reduced from Rs 2.72 toRs 2.16 (i.e. 20.4 reduction)Indications:-(1) High Operating Leverage, High Financial Leverage:-It indicates very risky situation as a slight decrease in sales and contribution mayaffect EPS to great extant. So, this situation is should be avoided.(2) High Operating Leverage, Low Financial Leverageit indicates that a slight decrease in sales and contribution may affect EBIT togreat extent due to existence of high fixed cost but this possibility is alreadytaken care by low proportion of debt capital in overall capital structure.(3) Low Operating Leverage, High Financial LeverageIt indicates decrease in sales/contribution will not affect EBIT to great extent. Thissituation may be considered an ideal situation. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management(4) Low Operating Leverage, Low Financial LeverageIt indicates decrease in sales/contribution will not affect EBIT to great extent asthe component of fixed cost is negligible in overall cost structure.Unit II Cost of CapitalThe project’s cost of capital is minimum acceptable rate of return on fundscommitted to the project. The minimum acceptable rate or required rate of returnis a compensation for time and risk in use of capital by project. Since investmentprojects may differ in risk, each one of them will have its own unique cost ofcapital. The firm represent aggregate of investment projects under taken by it.Therefore, the firm’s cost of capital will be overall, or average, required rate ofreturn on aggregate of investment projects.Determining Component Cost of Capital:-1) Cost of Debt:- A Company may raise debt in various ways. It may borrow funds fromfinancial institutions or public either in form of public deposits or debentures for aspecified period of time at certain rate of interest. A debenture or bond may beissued at per or at discount or premium.(a) Debt issued at Par:- The before tax cost of debt is rate of return required by lenders. It is easyto compute before tax cost of debt issued & to be redemed at par, it is simplyequal to contractual interest. For example, a company decides to sell a newissue of 1 years 15% bond of Rs 100 Each at par. If company realises full facevalue of Rs 100 bond & will pay Rs 100 Principal to bond holders at maturity, thebefore tax cost of debt will simply be equal to rate of interest of 15%.Thus:- Kd= I= INT ___ BoWhere, I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementKD= before-tax cost of debt. I = coupan rate of interest. B = Issue price of debt.INT = amt. of interest.(B) Debt issued at Discount or Premium:- n INTt BnBo = ∑ _________ + _________ t=1 (1+kd)t (1+ kd)nWhereBn= repayment of debt on maturity and other variable as defined earlier. Thisequation is used to find out whether cost of debt issued at par or discount orpremium.i.e. Bo= f or Bo>f or Bo<F.Tax adjustment:- The interest paid on debt is tax deductible. The higher the interestcharges, the lower will be amount of tax payable by the firms. This implies thatthe government indirectly pays a part of lender’s required rate of return. As aresult the interest tax shield, after tax cost of debt to the firm will be substantiallyless than investor’s required rate of return. The before tax cost of debt, kd shouldtherefore, be adjusted for tax effect as follows.After-tax cost of debt = kd (I-T)Where T= Corporate tax rate.2). Cost of Preference Capital:-The measurement of cost of preference capital poses some conceptual difficulty.In case of debt, there is binding legal obligation on the firm to pay interest &interest constitutes basis to calculate cost of debt. However, in case ofpreference capital, payment of dividends is not legally binding on the firm & evenif the dividends are paid, it is not a charge on earnings, rather it is a distributionor appropriation of earnings to preference share holders.Irre Deemable Preference share:- The preference share may be treated as a perpetual security if it isirredeemable Thus, its cost is given by following equation:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management PDIV KP= _______ POWhere,Kp= Cost of Preference sharePDIV= expected preference dividendPo= Issue price of preference shares.Redeemable Preference Share:- n PDIVt PNPO =∑ ____ + ________ T=1 (1+Kp)t (1+Kp)nCost of Preference share is not adjusted for taxes because preference dividendis paid after corporate taxes have been paid. Preference dividends do not saveany taxes. Thus cost of Preference share is automatically computed on an aftertax basis. Since interest is tax deductible & preference dividend is not, the aftertax cost of preference is substantially higher than after tax cost of debt.3) Cost of Equity Capital:-Firms may raise equity capital internally by retained earnings. Alternatively, theycould distribute the entire earnings to equity share holders & raise equity capitalexternally by issuing new shares. In both cases, shareholder are providing fundsto the firm to finance their capital expenditures. Therefore, equity shareholdersrequired rate of return will be same whether they supply funds by purchasing newshares or by for going dividends which could have been distributed to them.There is, however, a difference between retained earnings & issue of equityshares from firms point of view.Cost of Retained Earnings:-The opportunity cost of retained earnings (internal earnings) is the rate of returnon dividends foregone by equity shareholders. The shareholders generallyexpect dividend and capital gain from their investment. The required rate ofreturn of shareholder can be determined from dividend valuation model.Normal Growth:- A firm whose dividend are expected to grow at a constant rateof g is as follows I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management Divl Po = Ke-gWhere DWl= DIVo (1+g)Super normal growth:- Dividends may grow at different rates in future. The growth rate may bevery high for a few years & after wards, it may, it may become normal indefinitelyin future. The dividend valuation model can be used to calculate cost of equityunder different growth assumptions. For example, If the dividends are expectedto grow at a super normal growth rates g for n year & there after, at a normalperpetual growth rate of In beginning in year n+1 then cost of equity can bedetermined by following formula. n DIV0 (1+gs)t Pn Po= ∑ __________ + ________ t=1 (1+ke)t (1+ke)nPn= Discounted value of dividend stream, beginning in year n+1 & growing at aconstant, perpetual rate gn, at end of year n and therefore it is equal to :- DIV n+1 Pn = ________ Ke-gnZero growth DIVl Ke =______ PoThe growth rate g will be zero if firm does not retain any of its earnings. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementCost of External Equity The minimum rate of return which equity share holders require on fundssupplied by them by purchasing new share to prevent a decline in existingmarket price of equity share is the cost of external equity. The firm can induceexisting or potential share holders to purchase new shares when it promises toearn a rate of return equal to:- Divl Ke= ______ + g PoWeighted Average (Cost of Capital) After calculating costs, they are multiplied by weights of various sources ofcapital to obtain a weighted cost of capital (WACC). The composite, cost ofcapital is the weighted average of costs of various sources of funds. It is relevantin calculating over all cost of capital.The following steps are involved to calculate weighted average cost of capital:-1) Calculate cost of specific sources of funds (i.e. cost of debt, cost of equity,cost of preference capital etc).2) Multiply cost of each sources by its proportion in capital structure.3) Add weighed components costs to get firm’s weighted average cost of capital. In order to calculate weighted cost of capital component cost should beofter tax costs. If we assume that a firm has only debt & equity in its capitalstructure, then its weighted average cost of capital,(Ro) Will be:- Ko= kd (1-T) Wd+kewe Ko= Kd (1-T) D+ + ke S ____ ___ D+S D+SWhere Ko= Weighted average cost of capital Kd(1-t) ke are after tax cost of debt& equity D= amount of debt, S= amount of equity. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementUnit- III Theories of Capital Structure(1) Net Income Approach:-The essence of net income approach is that the firm can increase its value orlower the overall cost of capital by increasing proportion of debt in capitalstructure.The assumption of this approach are:-1) The use of debt does not change the risk perception of investors, as a resultequity capitalisation rate (kc) & debt-capitalisation rate (kd) remain constant withchanges in leverage.2) The debt capitalisation rate is less than equity-capitalisation rate ( rate (i.e. kd< ke)3) The corporate income taxes do not exist. The first assumption implies that if ke & kd are constant, increased use ofdebt by magnifying the shareholders earnings, will result in higher value of thefirm via higher value of equity. Consequently, overall or weighted average cost ofcapital, ko will decrease. The overall cost of capital is measured by Eq- X Noi Ko= ___ =___ V VThus, with constant annual net operating income (NOI) overall cost of capital ofcapital would decrease as the value of firm, V increases.Ques6. Write notes on the following.Ans. NET OPERATING INCOME APROACH I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management According to the net operating income (NOI) approach the market value ofthe firm is not affected by the capital structure changes. The market value of thefirm is found out by capitalizing the net operating income at the over all or theweighted average cost of capital, which is constant. The overall capitalisation rate depends on the business risk of the firm. Itis independent of financial mix. If NOI and average cost of capital areindependent of financial mix, market value of firm will be a constant areindependent of capital structure changes. The critical assumptions of the NOIapproach are: a) The market capitalizes the value of the firm as a whole. Thus the split between debt and equity is not important. b) The market uses an overall capitalisation rate, to capitalize the net operating income. Overall cost of capital depends on the business risk. If the business risk is assumed to remain unchanged, overall cost of capital is a constant. c) The use of less costly debt funds increases the risk to shareholder. This causes the equity capitalisation rate to increase. Thus, the advantage of debt is offset exactly by the increase in the equity- capitalisation rate. d) The debt capitalisation rate is constant. e) The corporate income taxes do not exist.Thus, we find that the weighted cost of capital is constant and the cost equityincrease as debt is substituted for equity capital.Ques7. Explain the concept of working capital. Discuss the working capital needof a manufacturing firm.Ans. Money required by the company to meet out day today expenses to financeproduction and stocks to pay wages and other production etc is called theworking capital of the company. Working capital is used in operating thebusiness. It is mostly dept is circulation by releasing it back after selling theproducts and reinvesting it in further production. It is because of this regular cyclethat the working capital requirements are usually for short periods. Though, bothfixed and working capitals shall be recovered from the business, the differenceslies in the rate of their recovery. Working capital shall be recovered much morequickly as compared to fixed capitals which would last for several years. As theprocess of production become more round about and complicated the productionto fixed working capital increase correspondingly. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementTherefore, working capital management refers to the management of currentassets and current liabilities. Working capital, however, represents investment incurrent assets, such as cash, marketable securities, inventories and billsreceivables. Current liabilities mainly Cost of Capital (Percent) ke ko kd Leverage Figure 18.2 The effect of leverage on the cost of capital (NOI approach)EXISTENCE OF OPTMUM CAPITAL STRUCTURE:THE TRADITIONAL VIEWThe traditional view, which is also known as an intermediate approach, is acompromise between the net income approach and the net operating approach.According to this view, the value of the firm can be increased or the cost ofcapital can be reduced by a judicious mix of debt and equity capital. Thisapproach very clearly implies that the cost of capital decreases within thereasonable limit of debt and then increases with leverage. Thus, an optimumcapital structure exists, and it occurs when the cost of capital is minimum or thevalue of the firm is maximum. The cost of capital declines with leverage becausedebt capital is cheaper than equity capital within reasonable, or acceptable, limitof debt. The statement that debt funds are cheaper than equity funds carries theclear implication that the cost of debt, plus the increased cost of equity, togetheron a weighted basis, will be less than the cost of equity which existed on equitybefore debt financing.2 In other words, the weighted average cost of capital willdecrease with the use of debt. According to the traditional position, the manner in which the overall costof capital reacts to changes in capital structure can be divided into three-stages.3 I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementFirst Stage: Increasing ValueIn the first stage, the rate at which the shareholders capitalise their net income,i.e., the cost of equity, ke, remains constant or rises slightly with debt. But when itincreases, it does not increase 1. The traditional capital structure theory has been popularised by Ezra Solomon, op. cit. 2. Barges, Alexander, The Effect of Capital Structure on the Cost of Capital, Prentice-Hall, Inc., 1963, p.11. 3. Solomon, op. cit., p. 94.Fast enough to offset the advantage of low cost debt. During this stage, the costof debt, Kd, remains constant or rises negligibly since the market view the use ofdebt as a reasonable policy. As a result, the value of the firm, V, increases or theoverall cost of capital, K0 = X/V= Ke (S/V) + kd (D/V), falls with increasingleverage. Under the assumption that Ke remains constant within the acceptable limitof debt, the value of the firm will be: X - KdD kdD X - kdD X (ke-kd)DV=S+D = + = +D= + Ke kd ke ke keThus, so long as Ke and Kd are constant, the value of the firm V increases at aconstant rate. (Ke-Kd)/Ke. as the amount of debt increases.When equation(9) is solved for X/V, we get [See equation(6): X D = ko=ke-(ke-kd) V VThis Implies that, with ke>Kd, the average cost of capital will decline withleverage.Second Stage: Optimum ValueOnce the firm has reached a certain degree of leverage, increases in leveragehave a negligible effect on the value, or the cost of capital of the firm. This is sobecause the increases in the cost of equity due to the added financial risk offsets I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management the advantage of low cost debt. Within that range or at the specific point, the value of the firm will be maximum or the cost of capital will be minimum. Third stage: Declining value Beyond the acceptable limit of leverage, the value of the firm decreases with leverage or the cost of the capital increases with leverage. This happens because investors perceive a high degree of financial risk and demand a higher equity-capitalisation rate which offsets the advantage of low-cost debt. KeCost of capital ( per cent) Ko Kd Leverage 0 L L Figure 18.3 The costs of capital behaviour (traditional view) The overall effect of these three stages is to suggest that the cost of capital is a function of leverage. It declines with leverage and after reaching a minimum point or range starts rising. The relation between costs of capital and leverage is graphically shown in Figure 18.3 wherein the overall ITS STUDY CENTRE ko is cost of capital curve, saucer-shaped with a horizontal range. This implies that there SECTOR 15 of SCF-54 (B’MNT) is a range MARKET, capital structures in which the cost of capital is minimised. ke is assumed to FARIDABAD PH 5002194-95 increase slightly in the beginning and then at a faster rate. In Figure 18.4 the cost of capital curve is shown to be U-shaped. Under such a situation there is a precise point at which the cost of capital would be minimum. This precise point defines the optimum capital structure. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Ke Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org Ko
    • Disha Institute of IT & Management Cost of Capital (Per cent)-+ Figure 18.4 The costs of Capital behavior (traditional view-a variation)Many variations of the traditional view exist. As indicated in Figures 18.3 and18.4, some writers imply the cost of equity function to be horizontal over a certainlevel and then rising, while others assume the cost of equity function risingslightly in the beginning and then at a faster rate. Whether are cost of equityfunction is horizontal or rising slightly is not very pertinent from the theoreticalpoint of view, as a number of different cost of equity curves can be consistentwith a declining average cost of capital curve. The relevant issue is whether ornot the average cost of capital curve declines at all as debt is used. 1 All thesupporters of the traditional view agree that the cost of capital declines with debt.ILLUSTRATION 18.3 To illustrate the traditional approach, assume that a firm isexpecting a net operating income of Rs 1,50000 on a total investment of Rs10,00,000 The equity capitalisation rate is 10 per cent, if the firm has no debt; butit would increase to 10.56 per cent when the firm substitutes equity capital byissuing debentures of Rs 3.00000 and, to 12.5 per cent when debentures of Rs600000 are issued to substitute equity capital. Assume that Rs 300000debentures can be raised at 6 per cent interest rate, whereas Rs 600000debentures are raised at a rate of interest of 7 per cent. The market value of the firm, value of shares and the average cost ofcapital are shown in Table 18.6. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management1. Barges, op. cit., p.12.Table 18.6 MARKET VALUE AND THE COST OF CAPITAL OF THE FIRM(TRADIATIONAL APPROACH) No Debt 6% Rs 7%Rs 3,00,000 6,00,000 Debt DebtNet operating income, X 1,50,000 1,50,000 1,50,000Total cost of debt, INT = KdD 0 18,000 42,000Net income, X- INT 1,50,000 1,32,000 1,08,000Cost of equity, Ke 0.10 0.1056 0.125Market value of shares, S= (X- 15,00,000 12,50,000 8,64,000INT)keMarket value of debt, D 0 3,00,000 6,00,000Total value of firm, V= S+D 15,00,000 15,50,000 14,64,000Average cost of capital, Ko = X/V 0.10 0.097 0.103Criticism of the Traditional ViewThe validity of the traditional position has been questioned on the ground that themarket value of the firm depends upon its net operating income and risk attachedto it. The form of financing can neither change the net operating income nor therisk attached to it. It simply changes the way in which the income is distributedbetween equity holder and debt-holders. Therefore, firms with identical netoperating income and risk, but differing in their modes of financing, should havesame total value. The traditional view it criticised because it implies that totalityof risk is distributed among the various classes of securities.1 Modigliani and Miller also do not agree with the traditional view. Theycriticise the assumption that the cost of equity remains unaffected by leverage upto some reasonable limit. They assert that sufficient justification does not exist forsuch and assumption. They do not accept the contention that moderate amountsof debt in ‘sound’ firms do not really add very much to ‘riskiness’ of the shares.However, the argument of the traditional theorists that an optimum capital I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementstructure exists can be supported on two counts: the tax deductibility of interestcharges and market imperfections. IRRELEVANCE OF CAPITAL STRUCTURE: THE MODIGLIANI-MILLER HYPOTHESIS WITHOUT TAXESThe Modigliani-Miller (M-M) hypothesis is identical with the net operating incomeapproach. (M-M) argue that, in the absence of taxes, a firm’s market value andthe cost of capital remain invariant to the capital structure changes. In their 1958article,2 they provide analytically sound and logically consistent behaviouraljustification in favour of their hypothesis, and reject any other capital structuretheory as incorrect. 1. Durand, op. cit., pp. 229-30. 2. Modigliani, and Miller op. cit., pp. 261-297.AssumptionsThe M-M hypotheses can be best explained in terms of their Propositions I and II.It should, however, be noticed that their propositions are based on certainassumptions. These assumptions, as described below, particularly relate to thebehaviour of investors and capital market, the actions of the firm and the taxenvironment. • Perfect capital markets Securities (share and debt instruments) are traded in the Perfect capital market situation. This specifically means that (a) investors are free to buy or sell securities; (b) they can borrow without restriction at the same terms ad the firms do; and (c) they behave rationally. It is also implied that the transaction cost, i.e., the cost buying d selling securities, do not exist. • Homogeneous risk classes Firms can be grouped into Homogenous risk classes. Firms would be considered to belong to a homogenous risk class if their expected earnings have identical risk characteristics. It is generally implied under the M-M hypothesis that firms within same industry constitute a homogenous class. • Risk The risk of investors is defined in terms of the variability of the net operating income (NOI). The risk of investors depends on both the random fluctuations of the expected NOI and the possibility that the actual value of the variable may turn out to be different than their best estimate.1 I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management • No taxes In the original formulation of their hypothesis, M-M assume that no corporate income taxes exist. • Full payout Firms distribute all net earnings to the shareholders, which means a 100 per cent payout.Proposition IGiven the above stated assumptions, M-M argue that, for firms in the same riskclass, the total market value is independent of the debt-equity mix and is given bycapitalizing the expected net operating income by the rate appropriate to that riskclass.2 This is their Proposition I and can be expressed as follows:Value of the firm = Market value of equity + Market value of debt Expected net operating income = Expected overall capitalization rate X NOI V=(S+D)= = ko koWhereV= the market value of the firmS= the market value of the firm’s ordinary equityD= the market value of debtX= the expected net operating income on the assets of the firmK0 = the capitalisation rate appropriate to the risk class of the firm. 1. Robichek, A. and S. Myers, Optimal Financing Decisions, Prentice-Hall, 1965, PP. 31-34. 2. Modigliani and Miller op. cit., P. 266. Proposition I can be stated in an equivalent way in terms of the firm’s averagecost of capital which is the ratio of the expected earning to the market value of allits securities. That is: X X = = ko (S+D) V I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management If we define Kd as the expected return on the firm’s debt and Ke as theexpected return on the firm’s equity, then expected net operating income is givenas follows: X=KoV=keS+kdD As given in Equation (5), by definition X ko = V S D Ko = ke + kd S+D S+D Cost of capital (per cent) ko Ke D/V Leverage Figure 18.5 The cost of capital under M-M proposition I Equation (5) expresses Ko as the weighted average of the expected rate ofreturn of equity and debt capital of the firm. Since the cost of capital is defined asthe expected net operating income divided by the total market value of the firm,and since M-M conclude that the total market value of the firm is unaffected bythe financing mix, it follows that the cost of capital is independent of the capitalstructure and is equal to the capitalisation rate of a pure-equity stream of itsclass. The cost of capital function, as hypothesized by M-M through Proposition I, I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementis shown in Figure 18.5. It is evident from the figure that the average cost ofcapital is a constant and is not affected by leverage.Arbitrage ProcessWhy should proposition I hold good? The simple principle of proposition I is thattwo firms identical in all respects except for their capital structures, cannotcommand different market value or have different cost of capital. M-M do notaccept the NI approach as valid. Their opinion is that if two identical firms, exceptfor the degree of leverage, have different market values, arbitrage (or switching)will take place to enable investors to engage in personal or home-made leverageas against the corporate leverage to restore equilibrium in the market. Consideran example.ILLUSTRATION 18.4 Suppose two firms: unlevered firm U and levered firm L –have identical expected net operating income (x) of Rs 10000. The value of thelevered firm (V) is Rs 11000 the value of equity shares (Su)=Vu) is Rs100000.Firm L has borrowed at the expected rate of return (Kd) of 6 per cent. Assumefurther that you hold 10 per cent shares of the levered firm L. What is your returnfrom your investment in the shares of firm L? Since you own 10 per cent of the shares, you are entitled to 10 per cent ofthe equity income: Return = 0.10 (X-INT) (where INT= KdDt) = 0.10 (10000-0.06X 50.000) = 0.10 (10000- 3000= Rs 700and the value of your investment is: investment = 0.10 (1000-50000)= Rs 6000 You can earn same return at less investment through an alternateinvestment strategy. This you can do by selling your investment in firm L’s Sharefor Rs 6000, and by borrowing on your personal account an amount equal to yourshare of firm L’s corporate borrowing at 6 percent rate of interest 010(50000) =Rs5000. You have Rs 11000 with you. You can now buy 10 per cent of theunlevered firm U’s shares. Your investment will be: Investment = 0.10 (1,00,000) Rs= 10,000And your return will be: Return = 0.10 (10,000) Rs 1,000 I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementHowever, you have borrowed Rs 5,000 at 6 per cent. Therefore, you will have topay an interest of Rs 300: Interest =0.06X5,000= Rs 300Thus your net return is Rs 700 as shown below: RsEquity return from U 1,000Less: Interest on personal borrowing 300Net Return 700Note that you are also left with cash of Rs 1,000: RsSale of firm L’s shares, = 0.1 (60,000) 6,000Add : Borrowing, 0.1 (50,000) 5,000Less: Investment in firm U=0.1 (1,00,000) (10,000)Remaining cash 1,000 Due to the advantage of the alternate investment strategy, a number ofinvestors will be induced towards it they will sell their shares in firm L and buyshares and debentures of firm U. this arbitrage will tend to increases the price offirm U’s shares and to decline that of firm L’s shares. It will continue until theequilibrium price for firm U’s and firm L’s shares is reached. The arbitrage would work in the opposite direction if we assume that thevalue of the unlevered firm U (Vu) is greater than the value of the levered firm L(Vl). Let us assume that Vu=Su= Rs 1,00,000 and Vl=Sl+Dt=Rs 40,000+ Rs50,000 = Rs 90,000. Further, suppose that you own 10 per cent shares in theunlevered firm U: Your return will be: Return= 0.10 (10,000) = Rs 1,000And your investment will be: Investment = 0.10 (1,00,000) = Rs 10,000 You can design a better investment strategy. You sell your shares in firmU for Rs 10,000. Now you buy 10 per cent of firm L’s share and debt. Yourinvestment in firm L is Rs 9,000. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management Investment= 0.10 (40,000+50,000) =4,000+5,000= Rs 9,000Since you own 10 per cent of equity and debt of firm L, your return will includeboth equity income and interest income. Thus your return is Rs 1,000: Return = 0.10 (10,000) = Rs 1,000You can also calculate your return as follows: RsEquity income, 0.10 (10,000-3,000) 700Interest income, 0.06 (5,000) 300Return 1,000Note that your alternative investment strategy pays you off the same return at alesser investment. You are left with Rs 1,000 cash. RsSale of firm U’s shares, 0.1(1,00,000) 10,000Investment in firm L’s share, 0.1 (40,000) (4,000)Investment in firm L’s debt, 0.1 (50,000) (5,000)Remaining cash 1,000 Both strategies give the investor same return, but his alternativeinvestment strategy costs him less since Vt<Vu. In such a situation, marginalinvestors will sell their shares in the unlevered firm and buy the shares anddebentures of the levered firm. As a result of this switching, the market value ofthe levered firm’s shares will increases and that of the unlevered firm will decline.In the equilibrium Vt=Vu. We can generalize our discussion as follows. 1 In the first instance, letVt>Vu Both firms earn the same expected net operating income, X. Theborrowing and lending Rate is Kd.1. Modigliani, F and Miller, M.H.,Reply to Heins and Sprenkle, AmericanEconomic Review, 59 (Sept 1969), pp.592-95.Assume that an investor hold  (alpha) fraction of firm L’s shares. His investmentand return will be as follows: Investment Investment I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementInvestment in L’s share  )Vt-Dt) (X-kdDt)The investor in our example can design the following alternative investmentstrategy: Investment InvestmentBuy fraction of U’s share  Vu XBorrow equal to fraction of L’s debt - Dt -kdDtTotal (Vu-Dt) (X-kdDt)The investor obtains the same return,  (X-Kd D1), in both the cases, but his firstinvestment strategy costs more since V1> Vu. The rational investors at the marginwould prefer switching from levered to unlevered firm. The increasing demand forthe unlevered firm’s shares will decreases their market price. Ultimately, market ITS STUDY CENTREvalues of the two firms will reach equilibrium, and henceforth, arbitrage will not15 SCF-54 (B’MNT) SECTOR bebeneficial. MARKET, FARIDABAD PH 5002194-95 Let us take the opposite case where Vu>Vl. Suppose our investor holds fraction of firm U’s shares. His investment and return will be as follows: Investment ReturnInvestment in U’s shares  Vu XThe investor can design an alternate investment strategy as follows: Investment ReturnBuy fraction of L’s shares  (Vl-Dt)  (X-kdDt)Buy equal to fraction of L’s debt + Dt +  kdDtTotal  Vt X If you can earn the same return with less investment, other can alsobenefit similarly. Investors will therefore sell shares of firm U and buy shares offirm L. This arbitrage will cause the price of firm U’s shares to decline and that offirm L’s shares to increases. It will continue until the price of the levered firm’sshares equals that of the unlevered firm. Thus, in equilibrium Vl=Vu. On the basis of the arbitrage process, M-M conclude that the market valueof a firm (or its cost of capital) is not affected by leverage. Thus, the financing (orcapital structure) decision is irrelevant. It does not have any impact on the I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementmaximisation of market price per share. This implies that one capital structure isas much desirable as the other.Proposition IIM-M’s Proposition II, which defines the cost of equity, follows from theirProposition I. The cost of equity Formula can be derived from M-M’s definition ofthe average cost of capital. The expected yield on equity or the cost equity isdefined as follows: X-kdD Ke = SSince we know from Equation (4) that X ko = VAnd Ko and V are constant by definition, the following equation: X=koV=ko(S+D)Substituting Equation (10) into Equation (3), we have Ko(S+D)-kdD KoS+koD-kdD D Ke = = =Ko+(ko-kd) S S SEquation (7) states that, for any firm in agiven risk class, the cost of equity, Ke isequal to the constant average cost ofcapital, Ko, plus a premium for the Cost of Capital kefinancial risk, which is equal to debt- Cost of capitalequity ration times the spread between kothe constant average cost of capital andthe cost of debt, (Ko-Kd) D/S. the cost of kdequity, Ke, is a linear function ofleverage, measured by the market value I Disha Institute of IT & Management D/S 0 Leverage Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 Figure 18.6 Cost of equity under the M- E-mail : info@dishainstitute.org M
    • Disha Institute of IT & Managementof debt to equity, D/S. Thus, leveragewill result not only in more earnings pershare to shareholders but alsoincreased cost of equity. The benefit ofleverage is exactly taken off by theincreased cost of equity, andconsequently, the firm’s market valuewill remain unaffected. It should,however, be noticed that the functionalrelationship, ke=ko+(ko-kd) D/S, is valid irrespective of any particular valuationtheory. For example, M-M assume Ko to be constant, while according to the morepopular traditional view Ko is a function of leverage. The crucial part of the M-M thesis is that Ko will not rise even if veryexcessive use of leverage is made. This conclusion could be valid if the cost ofborrowings, Kd. remains constant for any degree of leverage. But in practice Kdincreases with leverage beyond a certain acceptable, or reasonable level of debt.However, M-M maintain that even if the cost of debt, Kd, increases Ke willincreases at a decreasing rate and may even turn down eventually.1 This isillustrated in Figure 18.6. M-M insist that the arbitrage process will work and thatas Kd increases with debt, Ke will become less sensitive to further borrowing. Thereason for this is that debt-holders, in the extreme situations, own the firm’sassets and bear some of the firm’s business risk. Since the risk of shareholdersis transferred to debt-holders, Ke declines.1. Modigliani and Miller, “The Cost of Capital….’ Op. cit.Criticism of the M-M HypothesisThe arbitrage process is the behavioural foundation for the M-M thesis. Theshortcomings of this thesis lie in the assumption of perfect capital market inwhich arbitrage is expected to work. Due to the existence of imperfections in thecapital market, arbitrage may fail to work and may give rise to discrepancybetween the market values of levered and unlevered firms. The arbitrage processmay fail to bring equilibrium in the capital market for the following reasons:1Leading and borrowing rate discrepancy The assumption that firms andindividuals can borrow and lend at the same rate of interest does not hold goodin practice. Because of the substantial holding of fixed assets, firms have ahigher credit standing. As a result, they are able to borrow at CENTRE ITS STUDY lower rates ofinterest than individuals. If the cost of borrowings SCF-54 (B’MNT) SECTOR 15the to an investor is more thanfirm’s borrowing rate, then the equalization process will fall short of completion. In MARKET, I FARIDABAD PH 5002194-95 Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementillustration 18.4, if the cost of debt paid by the firm is less than that paid by theinvestor, then the value of the levered firm, Vl, must exceed the value of theunlevered firm, VU, for total return to be equal. For example, if the investors canborrow at 9 per cent, his returns after switching will be only Rs 550.Consequently, it does not follow that market opportunities and forces will lead Vlinto equality with Vu.Non-substitutability of personal and corporate leverages It is incorrect toassume that “personal (home-made) leverage” is a perfect substitute for“corporate leverage.” The existence of limited liability of firms in contrast withunlimited liability of individuals clearly places individuals and firms on a differentfooting in the capital markets. If a levered firm goes bankrupt, all investors standto lose to the extent of the amount of the purchase price of their shares. But, if aninvestor creates personal leverage, then in the event of the firm’s insolvency, hewould lose not only his personal loan. Thus, in illustration 18.4 if the investorkeep his investment in the levered firm, his loss in the event of bankruptcy will beRs 6000. But if he engages in the arbitrage transactions and invests in theunlevered firm, he can lose his principal investment of Rs 5000 and will also beliable to return Rs 5000 borrowed by him on the personal account. Thus, it ismore risky to create personal leverage and invest in the unlevered firm thaninvesting directly in the levered firm.Transaction costs The existence of transaction costs also interferes with theworking of arbitrage. Because of the costs involved in the buying and sellingsecurities, it would become necessary to invest a greater amount in order to earnthe same return. As a result, the levered firm will have a higher market value.Institutional restrictions Institutional restrictions also impede the working ofarbitrage. Durand point out that “home-made” leverage is not practically feasibleas a number of institutional investors would not be able to substitute personalleverage for corporate leverage, simply because they are not allowed to engagein the “home-made” leverage.1. The M-M hypotheses have been widely debated and criticised. The basiccriticisms of the M-M hypotheses are contained in Durand, op. cit. and EzraSolomon, Leverage and the Cost of Capital, Journal of Finance, XVIII, (May1963). Also see Pandey, I.M., Capital Structure and the Cost of Capital, Vikas,reprint 1996.Unit IV I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management INVENTORY MANAGEMENT Inventories constitutes the most significant part of current assets of largemajority of companies in India. On an average, inventories are approximately60% of current assets in public limited companies in India. Because of the largesize of inventories maintained by firms, a considerable amount of funds isrequired to be committed to them. It is, therefore absolutely imperative tomanage inventories efficiently in order to avoid unnecessary investment. A firmnelegecting the management of inventories may fail ultimately. It is possible for acompany to reduce its level of inventories to a considerable degree e.g. 10 to20% without any adverse effect on production and sales, by using simpleinventory planning and control techniques. The reduction in ‘Excessive’inventories carries a favourable impact on a company’s profitability.Nature of Inventories:- Management of inventory constitutes one of the majorinvestments in current assets. The various forms in which a manufacturingconcern may carry inventory are:1) Raw Material: These represents inputs purchased and stored to be convertedinto finished products in future by making certain manufacturing process of thesame.2) Work in Process: These represent semi-manufactured products which needfurther processing before they can be treated as finished products.3) Finished Goods: These represents the finished products ready for sale inmarket.4) Stores and Supplies: These represents that part of inventory which does notbecome a part of final product but are required for production process. They maybe in form of cotton waste, oil and lubricants, soaps, brooms, light bulbs etc.Normally they form a very major part of total inventory and do not involvesignificant investment. MOTIVE/NEEDS OF HOLDING INVENTORYA Company may hold the inventory with the various motives as stated below:1) Transaction Motive: The company may be required to hold the inventory inorder to facilitate the smooth and unintrupped production and sale operations. Itmay not be possible for the company to procure the raw material whenever I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementnecessary. There may be a time lag between the demand for the material and itssupply. Hence it is needed to hold the raw material inventory. Similarly it may notbe possible to produce the goods immediately after they are demanded by thecustomers. Hence it is needed to hold the finished goods inventory. They need tohold work in progress may arise due to production cycle.2) Precaution Motive: In addition to the requirement to hold the inventory forroutine transactions, the company may like hold them to guard against risk ofunpredictable changes in demand and supply forces. Eg. The supply of rawmaterial may get delayed due to factors like strike, transport, disruption, shortsupply, lengthy processes involved in import of raw material etc. hence thecompany should maintain sufficient level of inventory to take care of suchsituations. Similarly, the demand for finished goods may suddenly increases(especially in case of seasonal type of products) and if the company is unable tosupply them, it may mean gain of competition. Hence, company will like tomaintain sufficient supply of finished goods.3) Speculative Motive: The Company may like to purchase and stock theinventory in the quantity which is more than needed for production and salespurpose. This may be with the intention to get advantage in term of quantitydiscounts connected with bulk purchasing or anticipating price rise. Objectives of Inventory Management Through the efficient Management of Inventory of the wealth of owners willbe maximised. To reduce the requirement of cash in business, inventory turnovershould be maximised and management should save itself from loss of productionand sales, arising from its being out of stock. On the other hand, managementshould maximise stock turnover so that investment in inventory could beminimised and on the other hand, it should keep adequate inventory to operatethe production & sales activities efficiently. The main objective of inventorymanagement is to maintain inventory at appropriate level so that it is neitherexcessive nor short of requirement Thus, management is faced with 2 conflictingobjectives.(1) To keep inventory at sufficiently high level to perform production and salesactivities smoothly.(2) To minimise investment in inventory at minimum level to maximiseprofitability.Both in adequate & excessive quantities of inventory are undesirable forbusiness. These mutually conflicting objectives of inventory management can be I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementexplained is from of costs associated with inventory and profits accruing from itlow quantum of inventory reduces costs and high level of inventory savesbusiness from being out of stock & helps in running production & sales activitiessmoothly.The objectives of inventory management can be explained in detail as under:-(i) To ensure that the supply of raw material & finished goods will remaincontinuous so that production process is not halted and demands of customersare duly met.(ii) To minimise carrying cost of inventory.(iii) To keep investment in inventory at optimem level.(iv) To reduce the losses of theft, obsolescence & wastage etc.(v) To make arrangement for sale of slow moving items.(vi) To minimise inventory ordering costs. Techniques of Inventory Management(i) A.B.C. Analysis A.B.C. analysis is a selective technique of controlling different items ofinventory. In actual practice, thousands of items are included in business asinventories. But all these items are not equally important. According to thistechnique, only those items of inventory are paid more attention which aresignificant for business. According to this technique, all items are classified into 3categories A.B. and C. In ‘A’ category those items are taken which are veryprecious and their quantity or number is small.(ii) In ‘B’ category those items are reserved which are less costly than the itemsof category ‘A’ but their number is greater.(iii) In category ‘C’ all those items are included which are low priced but theirnumber is highest.The rate of use of items of category ‘A’ is the highest and that of category ‘C’ isthe lowest. In a manufacturing organisation, the items of inventory can beclassified as under:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementExample:-Class Number of items in terms % as per their value of their %A 15 70B 30 20C 55 10 100 100 Thus, the number of items of category ‘A’ are 15% but their value is 70%of total inventory. Therefore, inventory management can be made more effectiveby concentrating control on this category. Effort are made to minimise investmentitems of this category. The % of number of items in category ‘B’ is 30 but theirvalue is 20%. Therefore this category will be paid less attention. The items incategory ‘C’ is 55% but their value is just 10% of total. Therefore, managementneed not spend much time for control of this class of inventory because very littleinvestment is made in them. These items are purchased in bulk quantity once in2-3 years. The management must be aware that theses items may be lessimportant in terms of value but their non-availabetety can break down theproduction process. Therefore, these item should available in time A.B.C.analysis can be presented by following diagram also. Y 0 10 20 30 40 50 60 70 80 90 100 % of Costs 10 20 30 40 50 60 70 80 90 100 X % of UnitsAdvantages of ABC Analysis(1) A Close and strict control is facilitated on the most important items whichconstitute a major portion of overall inventory valuation or overall materialconsumption & due to this, costs associated with inventories maybe reduced. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management(2) The investment in inventory can be regulated in proper manner & optimumutilisation of available funds can be assured.(3) A strict control on inventory items in this manner help in maintaining a highinventory turnover rates.2) FIXATION OF INVENTORY LEVELS:Fixation of various inventory levels facilitates initiating of proper action in respectof the movement of various materials in time so that the various materials may becontrolled in a proper way. However, the following propositions should beremembered.(i) Only the fixation of inventory levels does not facilitates the inventory control.These has to be a constant watch on the actual stock level of various kinds ofmaterials so that proper action can be taken in time.(ii) The various levels fixed are not fixed on a permanent basis and are subject torevision regularly.The various levels which can be fixed are as below.1) Maximum level:It indicates the level above which the actual stock should not exceed. If itexceeds, it may involved unnecessary blocking of funds in inventory while fixingthis level, following factors are considered.i) Maximum usage.ii) Lead time.iii) Storage facilities available, cost of storage and insurance etc.iv) Prices for materialv) Availability of funds. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementvi) Nature of material eg If a certain type of material is subject to governmentregulation in respect of import of goods etc maximum level may be fixed at ahigher level.vii) Economic order Quantity.2) Minimum Level: It indicates the level below which the actual stock notreduce, If it reduces, it may involve the risk of non-availability of materialwhenever it is required. While fixing this level, following factors are considered.i) Lead time.ii) Rate of consemption3). Re-order level It indicates that level of material stock at which it is necessary to take thesteps for the procurement of further lots of material. This is the level falling inbetween the two existences of maximum level and minimum level and is fixed insuch a way that the requirements of production are met properly till the new lot ofmaterial is received.4). DANGER LEVEL: This is the level fixed below minimum level. If the stock reaches this level,it indicates the need to take urgent action in respect of getting the supply. At thisstage, the company may not be able to make the purchases in the systematicmanner but may have to make rush purchases which may involve higherpurchase cost.CALCULATION OF VARIOUS LEVELS: The various levels can be decided by using the following mathematicalexpressions.1). Re-Order level:- Maximum lead time X Maximum usage.2). Maximum level:- Re-order level + Re order Quantity- (Minimum Usage X Maximum leadtime) I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management3). Minimum level:- Re-order level- (Normal usage + Normal lead time)4). Average level:- Minimum level + Maximum level 25). Danger level:- Normal Usage X Lead time for emergency Purchases.3). INVENTORY TURNOVER: Inventory turnover indicates the ratio of materials consumed to theaverage inventory held. It is calculated as below: Value of Material Consumed _______________________ Average inventory heldWhere value of material consumed can be calculated as:Opening stock + purchases- closing stock. Average inventory held can becalculated as: Opening stock + closing stock __________________________ 2Inventory turnover can be indicated in terms of number of days in which averageinventory is consumed. It can be done by dividing 365 days (a year) by inventoryturnover ratio.4. EOQ:- Economic order Quantity as per notesinclude bills payable, notes payable and miscellaneous accruals. Net workingcapital is the excess of current assets over current liabilities here. Current assetsare those assets which are normally converted into cash within an accountingyear; and current liabilities are usually paid within an accounting year.What for is working capital required by firm very much depends on the nature ofthe business which the firm is conducting. If the firm has business which deals I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementwith public utility services, obviously the requirement will be low. It is primarilybecause the amount becomes available as soon as services are sold and alsothe services arranged by the firm and immediately sold, without much difficultyand complication. On the other hand trading concerns need heavy amountsbecause these require funds for carrying goods traded. Similarly many industrialunits will also need heavy amounts for carrying on their business. Manymanufacturing concerns will also need sufficiently heavy amounts, the of coursedepends on the nature of commodities which are being manufactured. MANUFACTURING FIRMWe now come to manufacturing firm. If it is complex and complicate, it will beanother determinant. In this complex process obviously more capital will beneeded and goods will be produced after considerable delays. Longer it take toproduce a good, more will be its cost and more working capital will becomeunavoidable. When the companies are engaged in the production of heavymachinery and equipment, a way out is found out by demanding some advancemoney from the party or parties which plea orders or which usually take away thegoods.Ques. 8 Define EOQ. How is it computed ? Give an example.Ans. Economic order quantity refers to the size of the order which givesmaximum economy is purchasing any item of raw materials or finished product. Itis fixed mainly after talking into account the following costs:I. INVENTORY CARRYING COSTIt is the cost of keeping items in stock. It includes interest on investment.Obsolescence losses, store- keeping cost, insurance premium, etc. the larger thevolume of inventory, the higher will be the inventory carrying cost and vice versa.II ORDERING COSTIt is the cost of placing an order and securing the supplies. It various from time totime depending upon the number or orders placed and the number of timesordered. The more frequently the order are placed and fewer the quantitiespurchased an each order, the greater will be the ordering cost and vice versa. The economic ordering quantity can be determined by any of the followingtwo methods.1) FORMULA METHOD I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management In this case the EOQ can be determined as per the following for formula: E= Economic ordering quantity. U= Quantity purchase in a year. P= Cost of placing an order. S= Annual cost of storage of one unit.For Example:- A refrigeration manufacture, purchase 1600 units of a certain componentfrom 13. His annual usage is 1600 units. The order placing cost is Rs 100 andthe cost of carrying one unit for a year is Rs 8. Calculate the economic ordering qty by formula method: E = Sqrt. (2u*p)/s = Sqrt. (2*1.600*100)/8 = Sqrt. (40,000)=200 units EOQ model is based on the following assumptions: I. The firm knows with certainly the annual usage or demand of the particular item of inventories. II. The rate at which the firm uses the inventories or makes sales is constant through out a year. III. The order the replenishment of inventory are placed exactly when inventories reach the zero level.The above assumption may also be called as limitation of EOQ modes. There isevery likelihood of a discrepancy between actual and estimated demand for aparticular items of inventory. Similarly, the assumptions as to constant usage orsale of inventories and instantaneous replenishment of inventories are also ofdoubtful validity. On account of these reasons, EOQ model may sometimes givewrong estimate about economic order quantity.2. TABULAR METHOD This method is to be used in those circumstances where the inventorycarrying cost per units is not constant. This will be clear with the following.:Calculating the Economic Ordering Quantity using Tabular Method on the basisof data given. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementAnnual Orders Units Order Avg. Carrying TotalRequirement per year per placing stock in costs amount order costs units cost (50% of order placed)1600 1 1600 100 800 6400 6500 2 800 200 400 3200 3400 3 533 300 267 2136 2436 4 400 400 200 1600 2000 5 320 500 160 1280 1780 6 267 600 134 1072 1672 7 229 700 115 920 1620 8 200 800 100 800 1600 9 178 900 89 712 1612 10 160 1000 80 640 1640The above table shows that total cost in the minimum when each is of 200 units.Therefore, economics ordering quantity is 200 units only.As graphic presentation of the economic ordering quantity on the basis of figuresgiven in the above table will be as follows: _____________ Total cost on inventory management _____________ Inventory carrying costs. _________ Ordering cost [ EOQ =2000 units] I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management Cost in thousand (Rs) 0 1 2 3 4 5 6 7 8 9 10(5) Bill of Materials:In order to ensure proper inventory control, the basic principle to be kept in mindis that proper material is available for production purpose whenever it is required.This aim can be achieved by preparing what is normally called as “Bill ofMaterials”.A bill of material is the list of all the materials required for a job, process orproduction order. It gives the details of the necessary materials as well as thequantity of each item. As soon as the order for the job is received, bill ofmaterials is prepared by Production Department or Production PlanningDepartment.The form in which the bill of material is usually prepared is as below: BILL OF MATERIALSNo. Date of Issue Production/Job Order NoDepartment authorizedS. No Description Code Qty. For Department Use Only Remarks of Material No Material Date Quantity Requisition Demanded No I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementThe function of bill of materials are as below: (1) Bill of materials gives an indication about the orders to be executed to all the persons concerned. (2) Bill of materials gives an indication about the materials to be purchased by the Purchase Department if the same is not available with the stores. (3) Bill of material may serve as a base for the Production Department for placing the material requisition slips. (4) Costing/Accounts Department may be able to compute the material cost in respect of a job or a production order. A bill of material prepared and valued in advance may serve as base for quoting the price for the job or production order.(6) Perpetual Inventory System:As discussed earlier, in order to exercise proper inventory control, perpetualinventory system may be implemented. It aims basically at two facts. (1) Maintenance of Bin Cards and Stores Ledger in order to know about eh stock in quantity and value at any point of time. (2) Continuous verification of physical stock to ensure that the physical balance and the book balance tallies.The continuous stock taking may be advantageous from the following angles: (1) Physical balances and book balance can be compared and adjusted without waiting for the entire stock taking to be done at the year end. Further, it is not necessary to close down the factory for Annual stock taking. (2) The figures of stock can be readily available for the purpose of periodic Profit and Loss Account. (3) Discrepancies can be located and adjusted in time. (4) Fixation of various levels and bin cards enables the action to be taken for the placing the order for acquisition of material. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management (5) A systematic maintenance of perpetual inventory system enables to locate slow and non-moving items and to take remedial action for the same. (6) Stock details are available correctly for getting the insurance of stock. ILLUSTRATIVE PROBLEMS (1) A company uses annually 50,000 units of an item each costing Rs. 1.20 Each order costs Rs. 45 and inventory carrying cost 15% of the annual average inventory value. (a) Find EOQ (b) If the company operates 250 days a year, the procurement time is 10 days, and safety stock is 500 units. Find reorder level, maximum, minimum and average inventory.Unit II Investment decisionsThe investment decisions of a firm generally known as capital budgeting orcapital expenditure decisions. A capital budgeting decision may be defined as thefirm’s decision to invest its current funds most efficiently in the long term assetsin anticipation of an expected flow of benefits over a series of year. The long termassets are those which affect the firm’s operations beyond the one year period.The firm’s investment decision would generally include expansion, acquisition,modernisation and replacement of long term assets. Sale of a division orbusiness (Investment) is also analysed as an investment decision. Activities suchas changes in the methods of sales distribution or undertaking an advertisementcompaign or a research and development programme have long-termimplication’s for the firm’s expenditure and benefits and therefore, they may alsobe evaluated as investment decisions.Features:-1) The exchange of current funds for future lengths.2) The funds are invested in long term assets.3) The future benefits will occur to the firm over a series of year. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management Importance of Investment DecisionsInvestment decision require special attention because of the following reasons:1) They influence the firm’s growth in the long turn.2) They affect the risk of the firm.3) They involve commitment of large amount of funds.4) They are irreversible or reversible at substantial loss.5) They are among the most difficult decisions to make.1) GROWTH: A firm’s decision to invest in long term assets has a decisive influence onrate and direction of its growth. A wrong decision can prove disastrous forcontinued survival of firm, unwanted or unprofitable expansion of assets willresult in heavy operating costs to the firm. On other hand, inadequate investmentin assets would make it difficult for the firm to complete successfully and maintainits market share.2) Risk: A long-term commitment of funds may also change risk complexity of thefirm. If the adoption of an investment increases overage gain but causes frequentfluctuations in its earnings the firm will become more risky.3) Funding: Investment decisions generally involve large amount of funds which makeit imperative for firm to plan its investment programmes very carefully and makean advance arrangement for procuring finance internally or externally.4) Irreversibility: It is difficult to find a market for such capital items once they have beenacquired. The firm will incur heavy losses if such assets are scrapped.5) Complexity: I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management Investment decisions are an assessment of future events which aredifficult to predict. It is really a complex problem to correctly estimate future cashflow of an investment. The uncertainty in cash flow is caused by economic,political, social and technological forces.Techniques of Capital Budgeting:it may be grouped in the following two categories:-(A) Discounted cash flow (DCF) Criteria. (1) Net present value (NPV) (2) Internal Rate of Return (IRR) (3) Profitability Index (PI) (4) Discounted Payback Period.(B) Non-discounted Cash flow Criteria: (1) Pay back period (PB) (2) Accounting rate of return (ARR)(A) Discounted Cash Flow (DCP) Criteria – These techniques are consideredgood because they take into account time value of money.(1) Net Present Value (NPV) This method take into account time value of money. In this methodpresent value of cash flows is calculated for which cash flows are discounted.The rate of interest is called cost of capital and is equal to minimum rate of returnwhich must accrue from the project. Later, present value of cash out flows iscalculated in same manner and subtracted from present value of cash inflows.This difference is called Net Present value or NPV. In case investment is madeonly in beginning of the project, it present value is equal to the amount investedin the project. Taking this assumption, NPV can be calculated as under: NPV = CF1 CF2 Cfn + +-- -C (1+k)1 (1+k)2 (1+k)n n Cft = ∑ -C I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management t=1 (1+k)tWhere Cf1, Cf2 represent cash inflows K = Cost of Capital C = Cost of investment proposal n = Expected life of ProposalIf the project has a salvage value also, it should be added in cash inflows of lastyear. Similarly, if some working capital is also needed, it will be added to initialcost of project and to cash flows of last year.Acceptance Rule:-1) Accept if NPV >O (i.e. NPV is Positive)2) Reject if NPV <O (i.e. NPV is Negative)3) May accept if NPV= OAdvantage:1) It takes into account time value of money.2) It considers cash inflows form project throughout its life.3) In this method variable discount rates can be used for the projects with longerlife period.4) This method is more closely related to firm’s objective of maximising wealth ofshareholders.5) True measure of profitability.Disadvantages:(1) Difficult to use, calculate & understand.(2) In calculating NPV, discount rate is most significant because with differentdiscount rates NPV will be different. Thus comparable profitability of projects willchange with the change in discount rate. To determine required rate of returnwhich is called cost of capital, is a difficult task. Different authors have theirdifferent opinions regarding its calculation. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management(3) When the initial cost of 2 projects is different, this method is not very usefulbecause we will accept or project whose NPV is higher and such a project mayhave more initial cost as compared to other. This method evaluates absoluteprofitability rather than relative profitability.(4) When life of 2 projects is dissimilar, this method does not give satisfactoryresults. Normally, project with less life time is preferred. But as per this method,NPV of the project with longer life may be more, and thus finds will be blocked fora longer period, in this project. In such cases, NPV method may not presentactual worth of alternate projects.3) PROFITABILITY INDEX It is Benefit –Cost ratio (B/C Ratio) or Profitability Index (P1). It is the ratio of value of future cash benefits at required rate or return tothe initial cash outflow of the investment. PI method should be adopted when theinitial costs of projects are different. NPV method is considered good when theinitial cost of different projects is the same. Thus NPV is an absolute measure ofevaluating projects and PI is an absolute measures. Pl can be calculated asunder:- Present Value of Cash Inflows PI _________________________ Present Value of Cash outflowsAcceptance rule • Accept if Pl>1.0 • Reject if Pl<1.0 • Project may be accepted if Pl= 1.0MERITS • Considers all cash flows. • This method considers all benefits during the life time of the project. • This method takes into account the time value of money. • Pl method is considered better to NPV in case when the initial costs of projects are different for eg. The NPV of two project is equal ie, Rs 5000. The initial cost of project is Rs 40,000 and that of project B Rs 20,000. Project should be selected on the basis of profitability index, whereas under NPV method both the projects will be considered equally profitable. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management • Generally consistent with the wealth maximisation principle.Disadvantages/ Demerits1). It is difficult to understand and implement this method.2). The calculations in this method are complex as compared to traditionalmethods.3). Requires estimates of the cash flows which is a tedious task.4). At times fails to indicate correct choice between mutually exclusive projects.4). Discounted Pay Back Period:This is an improvement over the pay back period method in the sense that itconsiders time value of money. Thus discounted pay book period indicates thatperiod with which the discounted cash inflows equal to the discounted cashoutflows involved in a project.Pay Back Method:Under this method the pay back period of each project/ investment proposal iscalculated. The investment proposal, which has the least pay back period isconsidered profitable. Actual pay back period is compared with the standard one.If actual pay back period is less than the standard, the project will be acceptedand in case, actual payback period is more than the standard pay back period,the project will be rejected. Thus, the project with the least payback period isconsidered profitable.“Pay Back Period is the number of year required for the original investment to berecouped.For eg, if the investment required for a project is Rs 20,000 and it is likely togenerate cash flow of Rs 10,000 for 5 years, its payback period will be 2 years. Itmeans that investment will be recovered in first 2 year of the project. There are two methods of calculating payback period. First method isused when cash flows remains the same during the life time of the project. Insuch a case payback (PB) is calculated as under:- INVESTMENT CO PB = _______________________ =___ CONSTANT ANNUAL CASH FLOW C I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementFor eg, if the investment for a machinery is Rs 50,000 and it will generate Rs10,000 such year for 10 years, then its Pay Back period will be:- Rs 50000 PB = _________ = 5 Years Rs 10000For the pay back period of 5 years, it can be observed that the investment of Rs50,000 will be recovered by the business in 5 years.ACCEPTANCE RULE • Accept if PB < standard pay back. • Accept if PB > standard pay back.MERITS 1. Easy to understand and compute. 2. This method follows short terms view point, as a result, the obsolescence are minimum. 3. Emphasis liquidility, therefore useful for the companies which faces the problem of liquidity. Such companies will invest their funds in such projects in which investment can be recovered in minimum time. 4. Used to find out internal Rate of Return. 5. Suitable for those organisations which emphasise on short-term investments rather than long terms development. 6. Uses cash flow information. 7. Easy and crude way to cope with risk.Demerits 1. Ignores the value of money. 2. Ignores the cash flows occurring after the pay back period. Thus does not take into account the whole profitability of the project. For eg: investment in a project is Rs 50,000. Its life 10 years and cash flows every year are Rs 10,000. Then its Pay back period will be 5 years. But the cash inflows of Rs 50,000 during the last 5 years have been taken into account. 3. No objective way to determine the standard payback. 4. This method also does not take into account the time value of money. The time value of money is the interest on investment. The payback period of two projects may be the same but a project may get more CFAT in the I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management initial years and less in the later years. In such a case the cash flows in the initial years can fetch additional income of interest. Such a project may become more profitable than the others. But this method ignores this fact. 5. This method does not take into account the total life time of the project. 6. No relation with the wealth maximisation principle. 7. not a measure of profitability.II. Average Rate of Return Method: This method is also called Accounting Rateof Return Method. This method is based on accounting information rather thancash flows. There are various ways of calculating Average Rate of Return. It canbe calculated as:- Average annual Profit after Tax ARR = ___________________________X100 Average InvestmentAverage Annual Profit = Total of after tax profit of all the year ___________________________ No. Of yearsAverage Investment = Original Investment + Salvage Value ________________________________ 2 or Original Investment – Salvage Value ________________________________ + Salvage Value 2If working Capital is also required in the initial year of the project, the averageinvestment will be= Net working Capital + Salvage value + ½ (initial cost ofMachine- Salvage Value).In another method instead of average investment original cost is used. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementIn this method, to evaluate the project all those projects are accepted on whichaverage rate of return is more than the predetermined rate. Thus, the project isgiven more significant on which the average rate of return is the highest.Acceptance Rule • Accept if ARR > minimum rate. • Accept if ARR < minimum rate.Merits1). Easy to understand. Necessary informations to calculate average rate ofreturn are available easy.2). This method takes into account all the profits during the life time of theproject, whereas pay back period ignores the profits accruing after the pay backperiod3). Give more weightage to future receipts.4). Easy to understand and calculate.5). Uses accounting data with which executives are familiar.Demerits1). Ignore the time value of money.2). Does not use cash flow.3). No objective way to determine the minimum acceptable rate of return.4). This method does not account for the profits arising on sale of profit on oldmachinery on replacement.5). ARR method does not consider the size of investment for each project. It maybe time that the competing ARR of two projects may be the same but they mayrequire different average investments. It becomes difficult for the management todecide which project should be implemented.Unit IV MANAGEMENT OF RECEIVABLE “Receivables are asset accounts representing amounts owned to a firm asa result of sale of goods or services in ordinary course of business.”Receivables are also turned as trade receivables, accounts receivables,customer receivables, sundry debtors, bills receivable etc. Management of I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementreceivable is also called management of trade credit. The receivable arising fromcredit sales contain risk element.Purpose of ReceivablesThere a 3 purposes of investing or maintaining Receivables.(1) Growth in Sales:- In comparison to cash sales, firm can make high sales by selling on credit,because many customers do not want to pay cash. Some of the customers mayhave deficit of cash. Therefore, if any firm does not sell on credit, it sales may godown.(2) Increased Profits:- Due to credit sale of goods and services, the total sales of business canincreases. As a result of it, it profits also start increasing.(3) Meeting Competition:- Various firm sell goods on credit to their customer only because theircompetitors are doing so. If a firm does not follow credit policy of it competitors,its total sales will decrease because its customers will be attracted towards otherfirms.Objectives of Receivable Management From creation of receivables the firm gets a few advantages & it has tobear bad debts, administrative expenses, financing costs etc. In the managementof receivables financial manager should follow such policy through which cashresources of the firm can be fully utilised. Management of receivables is aprocess under which decisions to maximise returns on the investment blocked inthem are taken. Thus, the main objectives of management receivable is tomaximise the returns on investment in receivables & to minimise risk of baddebts etc. Because investment in receivables affects liquidity and profitability, itis, therefore, significant to maintain proper level of receivables. In other words,the basic objectives of receivables management is to maximise the profits.Efficient credit management helps to increase the sales of the firm. Thus,following are the main objectives of receivables management:-(1) To optimise the amount of sales. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management(2) To minimise cost of credit.(3) To optimise investment in receivables. Therefore, the main objective of receivable management is to establish abalance between profitability and risk (cost). A business can afford to invest in itsreceivables unless the marginal costs and marginal profits are the same.Although the level of receivables is affected by various external factors likestandards of industry, economic conditions, seasonal factors, rate of competitionetc, management can control its receivables. Though credit policies, credit terms,credit standards and collection procedures. Aspects/Areas/Variables of RMFormulation of Credit Analysis Collection Polices Evaluation ofCredit Policies Credit Policies - Trade References - Bank References Turnover of Aging - Financials statement Accounts scheduleCredit Credit Standards- Credit Bureau Report Receivable ofTerms - Past Experience Receivablea) Credit periodb) Cash Discountc) Cash Discount Period(A) Formulation of Credit Policies:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management Credit Policy means such factors which affect the amount of investment inreceivable and about which management has to take decisions for examplecredit period, cash discount period etc.Following are the main constituents of credit policy-(1) Credit Terms:- are these terms on the basis of which credit sales are madeto customers. These are also called terms of repayment of receivable. These are3 main constituents of credit terms. They are:(a) Credit Period:- It is the period for which goods are sold on credit to customers i.e. theperiod after which payment is to be made by customers. For example, ifcustomers are required to pay before the end of 30 ITS STUDY CENTRE it will days from date of sale,be written as ‘Net 30’. Credit period normally depends on the SECTOR 15 the SCF-54 (B’MNT) standard of MARKET,industry. By raising credit period, not only the sales and profits of firm rise but itscosts also rise. Similarly, by reducing the credit FARIDABAD& profits decline on period sales PH 5002194-95one hand & cost of fund & bad debt go down on the other. Therefore, onoptimum credit policy should be determined by establishing balance in costs andprofits of different credit periods.(b) Cash Discount:- A Firm gives cash discount to encourage its customers to payquickly. In terms of cash discount, we include rate of cash discount and period forcash discount. The customers who do not to avail of cash discount, they have tomake payment before expiry of general credit period. Due to availability of cashdiscount average collection period is reduced. As a result, the amount locked upin receivables declines. Cash discount is a loss to the firm. Therefore, decision toallow cash discount or to change its rate should be undertaken on the basisanalysis of its costs and benefits.(c ) Cash Discount Period:- is the period during which cash discount is available. The period of cashdiscount affects average collection period. Thus, the terms of credit collectively include credit period, cash discountand period of cash discount. For example, if terms of credit are expressed as‘2/10, Net 30’ , it means that if the payment is made with in 10 days, 2% cash I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementdiscount will be paid. If this cash discount is not avaited of, the payment has tobe made with in 30 days of date of sale.(2) Credit Standards:- The term ‘Credit standard’s is basic yardstick of making credit salesto the customers. On the basis of credit standard it is determined to whom goodsare to be sold or not to be sold. The credit standards followed by a firm affectsales, profits, investment in receivable & costs. If a firm follow loose creditstandards, its sales and receivables will be more as standards, its sales andreceivables will be more as compared, to firm which uses tight credit standards.(B) Credit Analysis:- is made to evaluate ability of the customers before making credit sales. Afirm should determine procedure to evaluate applications for credit. On the basisof credit analysis only, a firm should decide to whom it will sell on credit & for howmuch amount. To sell on credit, all customers should not be treated a like. Eachcustomer should be examined properly before selling goods on credit to him.1) Trade Refrences:- Firm can ask its customers to mention such names/firms with which theyare dealing at present. This is an important source of credit information afterreceiving trade references, firm should get desired informations from them.Sometimes, customer provides names of wrong persons, therefore, beforebelieving the informations received, the honesty and sincerity of traders shouldbe examined.2) Bank References:- The bank of the customers can also provide important credit information’sabout the customer. Such information’s are obtained by the firm with the help ofits bank. Sometimes, firm ask customers to direct his bank to provide necessaryinformation’s to it. The information’s like average bank balance of customer, loangiven to customer, experience with customer etc can be obtained from bank ofcustomer. Normally, bank does not give clear answer to firm’s question Thereforethe firms should collect information’s from other sources.3) Financial Statements:- This is one of easiest way to obtain information’s about credit worthinessof prospective customers. If prospective customer is a public limited company, I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementthere may not be any difficulty in getting financial statements, in form of profit &loss Account & balance sheet. However, getting financial statements may bedifficult in case of Private Limited companies of partnership firms.Past Experience:- This can be considered to be most reliable source of getting informationabout credit-worthiness of customer who is dealing with company presently. Ifthere is the question of extending further credit to existing customer, thecompany should inevitable consider pas experience while dealing with thatcustomer.(c ) Collection Policies:- are needed because all customers do not pay in time. Some customerspay at slow rate and some do not make payment at all. The objective ofcollection policy is to fasten the collection of debt. If the collection from debtors isdelayed, additional funds have to be procured for smooth operation of selling andproduction activities. Delay in realisation from debtors also increases possibilityof bad debts. Thus, the main objectives of realisation policy is to reduce the ratioof bad debt & reduce average collection period. The collection policy means the steps which are taken to realise the debtsfrom debtors for their default in non payment with in the stipulated time. Proper coordination in sales and accounting department should beestablished to determine clear collection policy. Another aspect of collection policy is the methods employed to realise theover dues. After the end of credit period, firm should undertake necessary stepsto make collection from debtors. Initially the efforts should be polite but with thepassage of time they can be made stringent. Among these methods following areincluded:- (1) Reminder letters (2) Telephone (3) Telegram (4) Extension of Payment Period (5) Legal Action Before taking any action, difficulties of customers should be examined.Therefore, following points must be considered for determining collectionprocedures:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management (1) Collection procedure must be clear. (2) Before Starting action for collection, the nature of the customers and their business connections should be considered. (3) The time gap between due date and action for realisation of debts should be determined separately for different classes of customers like regular customers, seasonal customers etc. (4) So far as possible, legal action should be avoided. (5) The expenses incurred on collection should not exceed the amount of collection of debt. (6) While estimating collection cost, past experience should be considered.(D) Evaluation of Credit Policies/ Monitering Receivable:- The collection policy followed by firm should be optimum. It should neitherbe too liberal nor too strict. Proper adjustment in credit policies should be madeaccording to changing ciramstances. To observe whether credit policy followedby firm is suitable or not, following methods can be used.(1) Turnover of Accounts Receivable:- This ratio is calculated by dividing annual credit sales by averageaccounts of receivables. The objective of this ratio is to measure liquidity. Credit Sales during the YearTurnover of Accounts Receivable =________________________ Average Accounts Receivable. Months or Days in a yearAverage collection Period = _____________________ Turnover of Accounts Receivable2) Aging Schedule of Receivable:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management In this schedule, receivables are classified on basis of their age. The mainobjective of preparing this schedule is to find out how much old are thereceivable. It is prepared in form of a statement. With the help of this schedulemanagement can find out such debtors & can adopt appropriate collectionmethod for them whose average credit period is higher and which are older. Thusmanagement can reduce possibility of bad debts. A specimen of this schedule isgiven as under:- Aging schedule of Accounts ReceivablesPeriod (No of No of Amt (Rs) No as % Total Amt as % ofDays) Accounts no. total0-20 100 30000 23.8 16.221-40 200 80000 41.6 43.241-60 40 20000 9.5 10.861-80 50 40000 11.9 21.681-100 20 10000 4.7 5.4Over 100 10 5000 2.5 2.8 420 185000 100.00 100.00 Management Of Cash Management of cash is one of most important STUDY CENTRE working ITS areas of overallcapital management. This is due to the fact that cash (B’MNT) SECTOR 15 SCF-54 is the most liquid type of MARKET,current assets. As such, it is the responsibility of finance function to see that FARIDABAD PH 5002194-95various functional areas of business have sufficient cash whenever they requirethe same. At the same time, it has also to be ensured that funds are not blockedin form of idle cash, because it will effect interest cost & opportunity cost. Assuch, management of cash has to find a mean between these 2 extremes ofshortage of cash as well as idle cash.Motives of holding Cash/ Need:-1) Transactive Motive:- Business needs cash for various payments in ordinarycourse of its operation which includes payment for purchase of material, wages,dividend, taxes etc. Similary business gets cash from its selling activities & otherinvestment. But there is no coordination between inflow and outflow of cash.When expected cash receipt is short of required payment, cash is needed by firmso that liabilities could be paid, if cash receipts match with cash paymentsbusiness does not need cash for transactional purpose. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management2) Precautionary Motive:- Firms need cash to meet some contingencies. Forexample. (1) Strikes, floods, failure of important customers. (2) Slow rate of cash collection from debtors. (3) Rejection of orders by customers due to their dissatisfaction. (4) Rise in cost of raw material etc.3) Speculative Motive:- It means to make use of profitable opportunities by firm.Sometimes, firm wants to make use of such profitable opportunities which areoutside operation of business. For this purpose, firm retains some cash. Some ofthese opportunities are:- (1) Opportunity to purchase raw material at low price by payment of cash immediately. (2) Opportunity to purchase securities at falling prices. (3) Purchasing raw material at a time when its prices are lowest.(4) Compensation Motive:- Bank provide number of services to its customerslike clearance by cheque, credit information about other customers, transfer offunds etc. for certain services banks charge commission but same of servicesare provided by them free of cost for which they require indirect compensation.For this purpose they wish their customer to maintain minimum cash balance.Objective of Cash Management:-1) To make Payment According to Payment Schedule:- Firm needs cash to meet its routine expenses including wages, salary,taxes etc. Following are main advantages of adequate cash- (1) To prevent firm from being insolvent. (2) The relation of firm with bank does not deteriorate. (3) Contingencies can be met easily. (4) It helps firm to maintain good relation’s with suppliers.(2) To minimise Cash Balance:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management The second objective of cash management is to minimise cash balance.Excessive amount of cash balance helps in quicker payments, but excessivecash may remain unused & reduces profitability of business. Contrarily, whencash available with firm is less, firm is unable to pay its liabilities in time.Therefore optimum level of cash should be maintain.Managing Cash Flows:- The main objective of managing cash flows is to accelerate collection ofcash and delay disbursement of cash without damaging credit worthiness. Afterpreparing cash budget, management should try that there should not be anysignificant difference in actual & budgeted cash flows.Accelerating Cash Collections:- The customers should be encouraged to make early payment by givingcash discount to fill time gap between sale of goods and its payment by cheque.There are 2 methods of reducing these time gaps:-(1) Concentration Banking:- It is a system of collecting cash from customers of large sized firms whichhave large number of branches. Some of these branches are selected forcollection of cash from debtors which are called collection centres. Firm opens itsaccount in local banks of these collection centre. On receiving cheque, centresends them to local branch of bank and then they are transferred to Head officedaily for disbursements. Thus, this method is profitable technique of realising debts at the earliestbecause it reduces time gap between sending of cheque by customer and theirreceipts by firm.(2) Lock box System:- Under concentration banking, cheques or drafts received by collectioncentres are deposited in local banks & therefore, sometime is wasted beforecheques or drafts are sent for collection. Under the lock box system, this timegap can be reduced. Under this system, firm takes on rent a lock box from post office atimportant collection centres. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management Customers are instructed to send their cheques/drafts in lock-box. Firmauthorises local banks to withdraw these cheques/drafts from lock box and creditthe same to firm’s account. Bank operates this lock-box several times a day.Local banks are also instructed to transfer funds exceeding a particular level toHead office. This system is considered better to concentration banking becausein this system, time involving in receiving cheque, their accounting & deposit ofthese cheque in banks is saved. But under this system, firm has to bear additional expenses of post office& bank.Slowing Disbursements:- The main objective of disbursement management is to slow down thepayments without farming goodwill & credit worthiness of firm. Following methodscan be used for slowing disbursements.:-1) Avoidance of Early Payments:- Under this management, firm should make payment on due date only,neither early nor afterwards. Firm is allowed some time to make payment. Butfirm should not bear loss of cash discount.2) Centralised Disbursements:- Under this system, all payments should be made from the central accountby Head Office. This system will help in delaying payments and it will increasetime gap in payment before they reach creditors. If payment is made by localbranch, it will not take much time to reach to creditors by post. In this system, firm will have to maintain lesser total cash as againstdeentralised disbursement.Where each branch will have to maintain some cash. In this method, greater timewill be involved in the presentation & collection of cheques. Control overpayments will also become easier.3). Float- Float is the amount which is trapped in cheques but which are yet to becollected. It means that although cheque has been issued but actual cash will berequired later when it will be actually presented for payment. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementFor Example:- if the payment of wages and salaries is made by cheque on Ist ofevery month. It is not necessary that all cheques would be presented on Ist day.In actual practice, some cheques will be presented on Ist day, some on 2nd &some on 3rd. Thus firm need not deposit extra amount in bank on very Ist day.4) Accruals:- Wages & other expenses can be paid after the date of actual servicesrendered to them.Determining Optimum cash Balance:- If available cash is more than operating requirements of firm, additionalcash should be invested in short-terms securities. Optimum cash balance is thatlevel of cash at which transaction cost & opportunity cost are minimum. If firmmaintains more cash than optimum level, opportunity cost increases andtransaction decreases and vice versa.Investing Surplus Cash:- If nature of surplus cash is permanent, it can be invested in long termassets. While investing cash in securities, their safety, maturity and marketabilityshould be considered.a) Safety:- Cash should be invested in those securities, the prices of which donot change substantially and there is no risk in repayment of its principal &interest.b) Maturity:- more changes take place in long term securities.c) Marketability:- of securities means easiness in converting them into cash.Therefore, the surplus cash should be invested in such securities which can beconverted into cash with out much loss.Unit-II Risk analysis Risk exists because of inability of decision maker to make perfectforecasts. Forecasts cannot be made with perfection or certainity since the futureevents on which they depend are uncertain. An investment is not risky if, we can I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementspecify a unique sequence of cash flows for it. But the whole trouble is that cashflows cannot be forecast accurately, & alternative sequence of cash flows canoccur depending on future events. Thus, risk arises in investment evaluationbecause we cannot anticipate occurrence of possible future events with certainity& consequently, cannot make any connect prediction about cash flow sequence.Techniques to handle Risk 1) Pay back 2) Risk-adjusted discount rate. 3) Certainty equivalent.2) Risk-adjusted Discount Rate:- To allow a risk, businessman required a premium over and above analternative which was risk free. Accordingly, more uncertain the returns in future,the greater the risk & greater premium required. Based on this reasoning, it isproposed that risk premium be incorporated into capital budgeting analysisthrough discount rate. That is, if time preference for money is to be recognised bydiscounting estimated future cash flows, at same risk-free rate, to their presentvalue, than, to allow for riskiness of those future cash flows a risk premium ratemay be added to risk free discount rate. Such a composite discount rate, calledrisk-adjusted discount rate, will allow for both time preference & risk preference &will be a sum of risk-free rate & risk-premium rate reflecting the investors attitudetowards risk. The risk adjusted discount rate method can be expressed asfollows: n NPV = ∑ NCFt t=0 (1+k)tWhere K= Risk-adjusted rate.That is, Risk-adjusted discount rate= Risk free Rate+ Risk Premium K= kf+kr I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementUnder CAPM risk- premium is difference between market rate of return & riskfree rate multiplied by beta of the project. The risk adjusted discount rate accounts for risk by varying discount ratedepending on degree of risk of investment projects. A higher rate will be used forriskier projects & a lower rate for less risky projects. The net present value willdecrease with increasing k, indicating that riskier a project is perceived, the lesslikely it will be accepted. In contrast to net present value method, if firm uses IRR method, then toallow for risk of an investment project, the IRR for project should be comparedwith risk-adjusted minimum required rate of return. If IRR is higher than thisadjusted rate, the project would be accepted, otherwise it should be rejected.Evaluation:-Advantages:-1) Simple to understood.2) Has a great deal of intuitive appeal for risk averse businessman.3) It incorporates an attitude towards uncertainity.Disadvantages:-1) There is no easy way of deriving a risk-adjusted discount rate.2) It does not make any risk adjustment is numerator for cash flows that are forcast over future years.3) It is based on assumption that investors are risk-averse. Though it is generallytrue, there exists a category of risk seekers who do not demand premium forassuming risks, they are willing to pay a premium to take risks. Accordingly,composite discount rate would be reduced, not increased, as the level of riskincreases. • It is based on the assumption that investors are risk averse. Though it is generally true, there exists a category or risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risk. Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases.1Certainty EquivalentYet another common procedure for dealing with risk in capital budgeting is toreduce the forecasts of cash flows to some conservative levels. For example, if I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementan investor, according to his ‘best estimate,’ expects a cash flow of Rs 60,000next year, he will apply an intuitive correction factor and may work with Rs40,000 to be on safe side. There is a certainty-equivalent cash flow. In formalway, the certainty equivalent approach may be expressed as: n tNCFt NPV = ∑ t=0 (1+kf)tWhere, NCFt= the forecasts of net cash flow without risk-adjustment t = the risk-adjustment factor or the certainty equivalent coefficient kf = risk-free rate assumed to be constant for all periods. The certainty- equivalent coefficient, t assumes a value between 0 and 1,and varies inversely with risk. A lower t will be used if greater risk is perceivedand a higher t will be used if lower risk is anticipated. The coefficients aresubjectively or objectively established by the decision maker. These coefficientsreflect the decision-maker’s confidence in obtaining a particular cash flow inperiod t. For example, a cash flow of Rs 20,000 may be estimated in the nextyear, but if the investor feels that only 80 per cent of it is a certain amount, thenthe certainty-equivalent coefficient will be 0.80. That is, he considers only Rs16000 as the certain cash flow. Thus, to obtain certain cash flows, we willmultiply estimated cash flows by the certainty-equivalent coefficients. The certainty-equivalent coefficient can be determined as a relationshipbetween the certain cash flows and the risky cash flows. That is: NCFt* Certain net cash flow t = = NCFt Risky net cash flowFor example, if one expected a risky cash flow of Rs 80,000 in period t andconsiders a certain cash flow of Rs 60,000 equally desirable, then t will be0.75=60,000/80,000.ILLUSTRATION 15.2 A project costs Rs 6,000 and it has cash flows of Rs 4,000,Rs 3,000, Rs 2,000 and Rs 1,000 in year 1 through 4. Assume that theassociated t factors are estimated to be: o = 1.00, 1=0.90, 2=0.70, 3=0.50 I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementand 4=0.30, and the risk free discount rate is 10 per cent. The net present valuewill be: 0.90(4,000) 0.70(3,000) 0.50(2,000) 0.30(1,000)NPV = 1.0(-6,000) + + + + = Rs 37 (1+0.10) (1+0.10)2 (1+0.10)3 (1+010)4 The project would be rejected as it has a negative net present value. If the internal rate of return method is used, we will calculate that rate ofdiscount which equates the present value of certainty-equivalent cash inflowswith the present value of certainty-equivalent cash outflows. The ratio so foundwill be compared with the minimum required risk-free rate. Project will beaccepted if the internal rate is higher than, the minimum rate; otherwise it will beunacceptable.Evaluation of Certainty EquivalentThe certainty-equivalent approach explicitly recognizes risk, but the procedure forreducing the forecasts of cash flows is implicit and is likely to be inconsistentfrom one investment to another. Further, this method suffers from many dangersin a large enterprise. First, the forecaster, expecting the reduction that will bemade in his forecasts, may inflate them in anticipation. This will no longer giveforecasts according to ‘best estimate.’ Second, if forecasts have to pass throughseveral layers of management, the effect may be to greatly exaggerate theoriginal forecasts or to make it ultra conservative. Third, by focusing explicitattention only on the gloomy outcomes, chances are increased for passing bysome good investments.Risk-adjusted Discount Rate VS. Certainty-EquivalentThe certainty-equivalent approach recognizes risk in capital budgeting analysisby adjusting estimated cash flows and employs risk-free rate to discount theadjusted cash flows. On the other hand, the risk-adjusted discount rate adjustsfor risk by adjusting the discount rate. It has been suggested that the certaintyequivalent approach is theoretically a superior technique over the risk-adjusteddiscount approach because it can measure risk more accurately.1 The risk-adjusted discount rate approach will yield the same result as thecertainty-equivalent approach if the risk-free rate is constant and the risk-adjusted discount rate is the same for all future periods. Thus, I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management t NCFt NCFt = (1+kf)t (1+k)tTo solve for l t NCF(1+k)t = NCFt (1+kf)t NCFt(1+kf)t (1+kf)t t = = NCFt(1+k)t (1+k)tFor period t+1, Equation (6) will becomes (1+kf)t+1 t+1 = (1+k)t+1 Earlier, we have stated that the values of 1 will vary between 0 and 1.Thus, if Kf and k are constant for all future periods, then K must be larger than Kfto satisfy the condition that t varies.1. Robichek and Myers, op. cit., pp. 82-86.Unit IV16 Management Of Working Capital Working capital management is an important component of overallfinancial management. Management of working capital like long-term financialdecisions affects the risk and profitability of business. In business two types ofassets are used. (1) Fixed Assets (2) Current Assets Fixed Assets include land, building, plant and machinery, furniture andfittings etc. fixed assets are used in the business for a long period and they arenot purchased for the purpose of selling them to earn profit. Current Assets, on the other hand, are used for day to day operation ofbusiness. For the efficient and effective use of fixed assets, there should beadequate working capital in the business. Current assets include cash, bank I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementstock debtors, bills receivable, marketable securities etc. the capital employed inthese assets is called working capital. In any business, there should be properbalance between fixed capital and working capital. The problem relating to management of working capital is different from thatof management of fixed assets. Fixed assets are purchased for long term use inbusiness and the return on them is received during their lifetime. On the otherhand, current assets get converted into cash in short term. One more significantcharacteristic of the current assets is that, if the amount of current assets is morein a business, it will increases the liquidity but profitability will reduce. On theother hand, if current assets are relatively lesser, profitability will improve butliquidity will be adversely affected. Therefore, the main objective of workingcapital management is to determine optimum amount of investment in currentassets so that balance in profitability and liquidity of the business could beascertained.Definition of Working Capital There is difference of opinion among different authors about the definitionof working capital. Considering the objectives and scope of working capital, it canbe defined in two ways:(i) Gross Concept(ii) Net Concept (i) Gross Concept:- According to the gross concept, working capitalmeans total of all the current assets of a business. It is also called gross workingcapital. Gross Working Capital= Total Current Assets (ii) Net Concept:- According to the net concept of working capital, networking capital means the excess of current assets over current liabilities. Ifcurrent assets are equal to current liabilities then according to this conceptworking capital will be zero and in case current liabilities are more than currentassets, the working capital will be called negative working capital. Net Working Capital= Current Assets-Current Liabilities I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management Current assets are those assets which are converted into cash within oneaccounting period, for example, stock, debtors, bills receivables, prepaidexpenses, cash and bank balance. Similarly, current liabilities are those liabilitieswhich have to be paid within an accounting year, for example, creditors billspayables, short term loans etc. Net working capital can also be defined in another manner. Net workingcapital is the part of current assets which has been financed from long termfunds. It is, therefore also called circulating capital. Gross concept and net concept of working capital have their ownsignificance. When individual current assets are to be managed, gross concept ofworking capital is used. Net concept of working capital emphasizes on how muchcurrent assets have been financed out of long term funds. Under this concept therelationship between current assets and current liabilities is established or theirliquidity is determined. The difference between gross working capital and networking capital can be understood with the help of following illustration.ILLUSTRATION I. From the following balance sheet, you are required to calculate theamount of Gross Working Capital and Net Working Capital:- Balance Sheet Rs RsShare Capital 10,00,000 Land and Building 10,00,000Reserves 1,00,000 Plant and Machinery 2,90,000Debentures 4,00,000 Cash and Bank Balance 10,000Short-term Loan 50,000 Marketable Securities 90,000Trade Creditors 40,000 Trade Debtors 1,00,000Bills Payable 10,000 Bills Receivable 40,000 Inventory 70,000 16,00,000 16,00,000Solution : Gross Working capital= Cash and Bank Balance+ Marketable Securities+Trade Debtors+ Bills Receivable+ Inventory= Rs. 10,000+Rs90,000+Rs1,00,000+Rs40,000+Rs70,000= Rs. 3,10,000 I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementNet Working Capital= Current Assets- Current Liabilities= Rs10,000 + Rs 90,000 + 1,00,000 + Rs 40,000 + Rs70,000- Rs50,000 – Rs40,000 – Rs 10,000= Rs 3,10,000- rs 1,00,000 = Rs 2,10,000Need For Working Capital For the efficient operation of the business, working capital is requiredalong with the fixed capital. Working capital is needed for the purchase of rawmaterial and for the payment of various day to day expenses. There will behardly any business which does not require working capital. The need forworking capital is different businesses. Financial management aims atmaximising the wealth of shareholders. To achieve this objective, it is necessaryto earn adequate profits. The profit depends largely on sales but sales do notresult in cash immediately. To increase sales goods are to be sold on credit, thecollection of which takes place after time terms. Thus, there exists a gap between ITS STUDY CENTREthe sale of goods and realisation of cash. During this (B’MNT) SECTORare to be SCF-54 period expenses 15incurred to continue business operations. For this purpose, working capital is MARKET,required. The need for working capital canFARIDABAD PH with the help of be explained 5002194-95operating cycle or cash cycle. Operating cycle means that time period which isrequired to convert raw material into cash. In a manufacturing enterprise rawmaterial is purchased with cash, then raw material is converted into work-inprogress, which in turn gets converted into finished goods; both receivablethrough sales and lastly cash is received from debtors and bills receivable. In the operating cycle, following events are included: (1) Conversation of cash into raw material. (2) Conversation of raw material into work-in-progress. (3) Conversation of work in progress into finished goods. (4) Conversation of finished goods into Debtors and Bills Receivable. (5) Conversation of Debtors and Bills receivable through sales into cash. Debtors and Bills Receivable I Disha Institute of IT & Management Cash Finished Goods Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org Raw Materials Work-in-
    • Disha Institute of IT & Management Operating Cycle The greater the period of operating cycle, more will be the requirement ofworking capital. Business enterprises engaged in manufacturing work have largerduration of operating cycle as compared to those engaged in trading businessbecause in such enterprises cash is directly converted into finished goods. Because no business is able to match its cash inflows and cash outflows,therefore, the business needs to maintain some cash to pay its current liabilitiesin time. Similarly, to maintain supply of goods to meet the demand in the market,the stock of finished goods has to be kept. For the smooth running ofmanufacturing work stock of raw material has to be maintained. Firm has to sellon credit due to competition. Thus, business needs adequate working capital.Permanent And Variable Working Capital In business current assets are required because of the operating cycle.But the need for working capital does not end with the completion of operatingcycle. Operating cycle goes on continuously and therefore, in order tounderstand the need for working capital, it becomes essential to distinguishbetween permanent or regular and variable or seasonal or temporary workingcapital. (a) Permanent Working Capital:- The requirements for current assets donot remain stable throughout the year and it fluctuates from time to time. Acertain minimum amount of raw material, work in progress and finished goodsand cash must be maintained regularly in the business so that day to dayoperation of the business could continue without any obstacles. This minimum I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementrequirement of current assets is called permanent or regular working capital. Thearrangement of permanent working capital should be made from long termsources only, for example share capital, debentures, long term loans etc. (b) Variable Working Capital:- In certain months of the year the level ofbusiness activities is higher than normal and therefore, additional working capitalmay be required along with the permanent working capital. It is known asvariable or temporary working capital. This part of the working capital is requireddue to changes in demand and supply of goods on account of change in seasonsetc. for example, in boom period, stock is to be kept to fulfill demand and theamount of debtors increases due to more sales. Similarly, in depression, theamount of stock and debtors declines. Thus, extra working capital required dueto changes in demand and production is called variable working capital. In order to run the business smoothly both types of working capital isrequired. Variable working capital is required for a short time. Therefore, it shouldbe financed from the short term sources only so that later on it can be refundedwhen it is not required. Y Amount of working capital (RS.) TEMPARARY WORKING CAPITAL PERMANENT WORKING CAPITAL X TIME Fig. 1. Permanent and Temporary Working CapitalFrom Fig.1 it is clear that the need for regular working capital remains the samefor whole the year, whereas variable working capital needs are sometimes highand sometimes low. In a growing concern the need for working capital goes onrising because in the level of business activities. It is presented in Fig. 2) Y UNT OF WORKING CAPITAL (RS.) TEMPARARY WORKING CAPITAL I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 PERMANENT TEMPARARY CAPITAL E-mail : info@dishainstitute.org X
    • Disha Institute of IT & Management Fig. 2. Permanent and Temporary Working CapitalFactors Affecting Working Capital Business should prepare its financial plan in such a way that it has neithersurplus nor inadequate working capital. The needs for every business aredifferent but generally the following factors must be considered while determiningthe requirement of working capital. (1) Nature of Business:- Nature of business affects the working capitalrequirements of the business. Railways, transport, electricity, water and otherpublic utilities require relatively lower working capital because the demand fortheir services is regular and fixed. They also get immediate payment. They neednot keep much stock. On the other hand, the trading institutions require moreworking capital because they have to keep adequate stock, cash and debtors. Infinancial institutions and banks, the need for working capital is more thanpermanent capital. (2) Growth and Expansion:- the large sized businesses require morepermanent and variable working capital in comparison to small business. If acompany is growing, its working capital requirements will also go on increasing.Thus, the growing concerns require more working capital as compared to thestable industries. (3) Production Cycle:- Production cycle means the time period betweenthe purchase of raw material and converting it into finished product. Therequirements of working capital in a business depends upon the productioncycle. It the period of production cycle is longer, more working capital will berequired. If the production cycle is small, the requirements of working capital willalso be small. Therefore, business should choose such an alternate method of I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementproduction which takes lowest time. Before selecting specific production process,it should be seen that it is completed in pre-determined time. (4) Business Fluctuations:- Business has to pass through the stages ofboom and depression. These fluctuations affect the requirement of workingcapital. During the boom period the business grows rapidly. Management has toinvest more in stock and debtors. This requires additional working capital. on theother hand, during depression, sale of business decreases. As a result thequantum of stock and debtors also reduces. It decreases the need for workingcapital. (5) Production Policy:- The determination of working capital needsdepends upon the production policy of the business. The demand for certainproducts is seasonal i.e, such product are purchased in certain months of a year.For such industries two type of production policy can be followed.Firstly they can produce the goods in the months of demand or secondly, theyproduce for the whole year. If the second alternative is followed, it would meanthat till the time of demand finishes, product will have to be kept in stock. It wouldrequire additional working capital. (6) Credit Policy:- Credit policy affects the working capital requirementsin two ways:- (i) Terms of credit allowed by customers to the firm. (ii) Terms of credit available to the firm. If the firm sells goods on credit to its customers, it would require moreworking capital. If the firm follows tight credit policy, the requirement for workingcapital will decrease. Similarly, if the firm purchases raw material on credit, lesserworking capital would be required. Thus, a liberal credit policy towards purchasewill reduce the amount of working capital requirement against a tight credit policy. (7) Availability of Raw Material:- Availability of raw material on thecontinuous basis affects the requirement of working capital. There are certaintypes of raw materials which are not available regularly. In such a situation firmrequires greater working capital to meet the requirements of production. Someraw materials are available in particular season only for example wool, cotton oilseeds, etc. They have to be kept in stock for the whole year for which additionalworking capital is needed. (8) Availability of Bank Credit:- If the firm is in a position to get financialhelp easily from the bank at the time of its need, it keep a low level of working I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementcapital but if such facility is not available, firm will have to keep greater workingcapital. (9) Turnover of Inventories:- The greater the turnover of inventories i.e.,finished product. Work-in-progress, raw material, lesser will be the requirement ofworking capital. If turnover is lower, more working capital is needed. (10) Magnitude of Profit:- Magnitude of profit is different for differentbusinesses. Nature of product, control on the market and ability of managers etc.determine the quantum of profit. If the profit margin is high, it will help to arrangefunds internally which will also increases the working capital. (11) Level of Taxes:- Whole of the cash profit is not available for workingcapital. Taxes and dividends are to be paid out of profits. Taxes are a statutoryliability but it can be planned. Taxes are to be paid within a reasonable time. Iftax liability is high, more working capital will be needed. (12) Dividend Policy:- Dividend policy also affects working capital needs.When dividend is paid in cash it has unfavourable effect on working capital. If themanagement does not pay dividend and the profits are retained, it increasesworking capital. Dividend as bonus shares does not affect the working capital.How much dividend is to be paid in cash and how much profits to be retained inbusiness, it all depends upon number of factors including liquidity position ofbusiness, past dividend policy, need of capital for business. (13) Depreciation Policy:- It also affects the working capital. Depreciationdoes not result in outflow of cash. Therefore , it affects working capital directly. Itaffects tax liability and dividend. High depreciation means lesser profit andaccordingly lesser taxes. Amount of dividend will also be lower. In all, there willbe lesser outflow of cash. (14) Price Level Changes:- Price level changes also affect workingcapital needs. If the prices of different goods increase, to maintain same level ofproduction, more working capital is needed.Debtors may be due to tight credit Minimum Cost Total Costpolicy, which would impair sales further. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 of Liquidity Cost Cost E-mail : info@dishainstitute.org Cost of Illiquidity
    • Disha Institute of IT & ManagementThus, the low level of current assetsinvolves costs which increases as thislevel falls. In determining the optimumlevel of current assets, the firm shouldbalance the profitability solvency tangleby minimizing total cost-cost of liquidityand cost of illiquidity. This is illustratedin Figure 22.5. It is indicated in thefigure that with the level of currentassets the cost of liquidity increaseswhile the cost of illiquidity decreasesand vice versa. The firm should maintainits current assets at that level where thesum of these two costs is minimized.The minimum cost point indicates theoptimum level of current assets inFigure 22.5 Figure 22.5 Cost trade-offESTIMATING WORKING CAPITAL NEEDSThe most appropriate method of calculating the working capital needs of a firm isthe concept of operating cycle. However, a number of other methods may beused to determine working capital needs in practice. We shall illustrate here threeapproaches which have been successfully applied in practice: Current assets holding period To estimate working capital requirementson the basis of average holding period of current assets and relating them tocosts based on the company’s experience in the previous year. This method isessentially based on the operating cycle concept. Ratio of sales To estimate working capital requirements as a ratio ofsales on the assumption that current assets change with sales. Ratio of fixed investment To estimate working capital requirements as apercentage of fixed investment. To illustrate the above methods of estimating working capital requirementand their impact on of return we shall take two hypothetical firms (as given inTable 22.6). The calculations are based on the following assumptions regarding eachof the three methods: I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementMethod 1. Inventory: one Month’s supply of each of raw material, semi finishedgoods and finished material. Debtors: one month’s sales. Operating cash: onemonth’s total cost.Method 2: 25-35% of annual sales.Method 3: 10-20% of fixed capital investment.The following calculations based on data of firm A are made to show how threemethods work:Method 1: Let us first compute inventory requirements. Raw material: one month’s supply: Rs 2,48,000+12= Rs 20,667Semi-finished material: one month’s supply (based on raw material plus one halfof normal conversion cost):Rs 20,667+ (Rs 1,71,200 + Rs 1,60,000+ Rs 57,600) ½ ÷12 = Rs 20,667+16,200= Rs 36,867Table 22.6 DATA FOR TWO FIRMS Firm A (Rs) Firm B (Rs)Material Cost,Raw Material consumed 2,48,000 2,48,000Less: By product 68,800 68,800Net material cost 1,79,200 1,79,200Manufacturing cost,Labour 1,71,200 1,71,200Maintenance 1,60,000 1,60,000Power and fuel 57,600 57,600Factory overheads 2,40,000 2,40,000Depreciation (DEP) 1,60,000 3,20,000Total product cost 7,88,800 9,48,800Total product cost 9,68,000 11,28,000Annual sales 14,48,000 14,48,000PBIT 4,80,000 3,20,000Investment (INVST) 16,00,000 32,00,000Period 1 year 1 yearPlant life 10 year 10 yearPBDIT 6,40,000 6,40,000 I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementROI [{PBIT/INVST-DEP)] 33.3% 11.1% Finished material: one month’s supply: Rs 9,68,000 ÷ 12= Rs 80,666 The total inventory needs are: Rs 20,667+ Rs 36,867 + Rs 80,666= Rs 138,200 After determining the inventory requirements, projection for debtors andoperating cash should be made. Debtors: one month’s sales: Rs14,48,000÷12= Rs 1,20,667 Operating Cash: one month’s total Cost: Rs 9,68,000÷ 12= Rs 80,667 Thus the total working capital required is: Rs 1,38,200+ Rs 1,20,667+ Td 80,666= Rs 3,39,533Method 2: The average ratio is 30 per cent. Therefore, 30% of annual sales (Rs14,48,000 is 4,34,400.Method 3. 15% (the average rate) of fixed investment (Rs 16,00,000) is Rs2,40,000. The first method gives details of the working capital items. This approachis subject to markets are seasonal. As per the first method the working capital requirement is Rs 3,39,533. ifthis figure is in calculating the rate of return, it is lowered from 33.3% to 27%. Onthe other hand, the return of firm B drops from 11.1% to 9.9%. the estimatedworking capital for firm B as per the method is Rs 3,66,200. Rates of return arecalculated as follows: I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementUnit –III Dividend ModelsA WALTER’S MODEL This model was propounded by Prof. James E. Walter who argues that thechoice of dividend policies almost always affect the value of the firm. He showsthe importance of relationship between the firm’s rate of return ® and its cost ofcapital (K) in determining the dividend policy that will maximise the wealth ofshareholders.Assumptions:-1) Internal financing:- The firm finances all investment through retained earnings, that is debt ornew equity is not issued.2) Constant return and cost of capital:- The firm’s rate of return (r ) and its cost of capital (k) are constant.3) 100% payout or retention:- All earning are either distributed as dividends or reinvested internallyimmediately.4) Constant EPS and DIV:- Beginning earnings and dividends never change. The value of theearnings per share, (EPS) and dividend per share (DIV) may be changed in themodel to determine results, but any given values of EPS or DIV are assumed toremain constant forever in determining a given value.5) Infinite time:- The firm has a very long or infinite life.Walter’s formula to determine the market price per share is as follows:- DIV r (EPS-DIV)/k P = + K K I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementWhere P= market price per share. DIV = Dividend price per share. EPS = Earning price per share. R= firm’s rate of return (average). K= firm’s cost of capital or capitalisation rate.Equation (1) reveals that the market price per share is the sum of present valueof 2 sources of income(i) Present value of infinite stream of constant dividends, (DIV/k) and(ii) Present value of infinite stream of capital gain r (EPS-DIV)/k k When the firm retains a perpetual sum of (EPS-DIV) at rate of return ®,itspresent value will be: R (EPS-DIV)/R This quantity can be known as a capital gain which occurswhen earnings are retained within the firm. If this retained earnings occur everyyear, the present value of an infinite number of capital gains, r (EPS-DIV)/k willbe equal to : [r(EPS-DIV)] /k. Thus, the value of a share is the present value of alldividends plus the present value of all capital gain as show in eg (1) which canbe rewritten as follows: P= DIV+(r/K) (EPS-DIV) ____________________ KTo show the effect of dividend or retention policy on the market value of share,we shall use Eq (2)E.g The effect of different dividend policies on the value of shares respectively forthe growth firm, normal firm and declining firm is constructed through given table. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management Dividend Policy and the value of share (Walter’s Model)Growth Firm (r>k) Normal Firm (r=k) Declining Firm (r<k)Basic Datar= 0.15 T= 0.10 r= 0.08k=0.10 K= 0.10 k = 0.10EPS = Rs 10 EPS = Rs 10 EPS = Rs 10Payout Ratio 10%DIV R 50P= [0+(0.15/0.10)(10-0)] DIV = Rs 0 DIV =Rs 50 0.10 P = 100 P= 80= Rs = 150Payout Ratio 40% DIV=Rs54DIV = Rs 4 DIV=Rs 4 P= Rs 88P=[4+0.15/0.10)(10-4) P= Rs= 100 0.10=Rs 130Payout Ratio 80% DIV = Rs 8 DIV = Rs 8DIV = Rs 8 P = 100 P = 96P = 110Payout Ratio 100% DIV= Rs 10 DIV = Rs 10DIV = Rs 10 P = Rs 100 P = Rs 100P = Rs 100 The above table shows that dividend policy depends on the relationshipbetween the firm’s rate of return ® and its cost of capital (k). Walter’s view on theoptimum dividend pay out ratio can be summarised as follows. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementGrowth firm: Internal Rate More than Opportunity Cost of Capital (r>k) Growth firms are those firms which expand rapidly because of ampleinvestment opportunities yielding returns higher than the opportunity cost ofcapital. These firms are able to reinvest earning at a rate ® which is higher thanthe rate expected by shareholders (k). They will maximise value per share if theyfollow a policy of retaining all earnings for internal investment. It can be seenfrom table above that the market value per share for growth firm is maximum (i.e.Rs150) when it retain 100% earnings & minimum (Rs100) if distributes allearnings. Thus, the optimum payout ratio for a growth firm is zero. The marketvalue per share P, increases as payout ratio decline when r>k.Normal firms: Internal Rate equal opportunity cost of Capital (r=k) Most of the firms do not have unlimited surplus-generating investmentopportunities, yielding returns higher than opportunity cost of capital. Afterexhausting super profitable opportunities, these firms earns on their investmentsrate of return equal to cost of capital (r=K). for normal firms with r=K, the dividendpolicy has not effect on market value per share in Walter’s Model. From abovetable it is shown that market value per share for normal firm is same (i.e. Rs 100)for different dividend-payout ratio. Thus, there is no unique optimum pay out ratiofor normal firm. One dividend policy is as good as the other. The market valueper share as not affected by payout ratio when r=k.Declining firms: Internal Rate less than Opportunity Cost of Capital (r<k). Some firms do not have any profitable investment opportunities to investearnings. The market value per share of declining firm with R<k will be maximumwhen it does not retain earnings at all from above table it is observed thatdeclinings firm’s payout ratio is 100% (i.e. o retained earnings) the market valueper share is Rs 100 & it is Rs 80 when payout ratio is zero. Thus, optimumpayout ratio for declining firm is 100%. The market value per share, P, increasesas payout ratio increases when r<k.Thus, • Retain all earnings when r>k. • Distribute all earnings when r<k. • Dividend (or retention) policy has no effect when r=k.Criticism:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management(1) No External Financing:- Walter’s model of share valuation mixes dividend policy with investmentpolicy of firm. The model assumes that the investment opportunities of the firmare financed by retained earnings only & no external financing debt or equity isused for the purpose. When such a situation exists, either the firm’s investmentor its dividend policy or both will be sub-optimum.(2) Constant rate of Return, This model is based on the assumption that r is constant. In fact, rdecreases as more and more investment is made. This reflects the assumptionthat the most profitable investment are made first & then poorer investment ismade. The firm should stop at a point where r=k.(3) Constant opportunity Cost of Capital, k A firm’s cost of capital or discount rate, k, does not remain constant, itchanges directly with the firm’s risk. Thus the present value of firm’s incomemoves inversely with cost of capital. By assuming that the discount rate, k, isconstant, Walter’s model abstracts from the effect of risk on the value of firm.Constant Opportunity Cost of Capital, kA firm’s cost of capital or discount rate, k, does not remain constant; it changesdirectly with the firm’s risk. Thus the present value of the firm’s income movesinversely with the cost of capital. By assuming that the discount rate, k, isconstant, Walter’s model abstracts from the effect of risk on the value of the firm.• DIVIDEND RELEVANCE: GORDON’S MODELOne very popular model explicitly relating the market value of the firm to dividendpolicy is developed by Myron Gordon.1 Gordon’s model is based on the followingassumptions:2 o All-equity firm The firm is an all-equity firm, and it has no debt. o No external financing No external financing is available. Consequently retained earnings would be used to finance any expansion. Thus, just as Walter’s model Gordon’s model too confounds dividend and investment policies. o Constant return The internal rate to return, r, of the firm is constant. This ignores the diminishing marginal efficiency of investment as represented in Figure 20.1 I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management o Constant cost of capital The appropriate discount rate K for the firm remains constant. Thus, Gordon’s model also ignores the effect of a change in the firm’s risk-class and its effect on K. o Perpetual earnings The firm and its stream of earnings are perpetual. o No taxes Corporate taxes do not exist. o Constant retention The retention ratio, b, once decided upon, is constant. Thud, the growth rate, g=br, is constant forever. o Cost of capital greater than growth rate The discount rate is greater than growth rate, K>br=g. If this condition is not fulfilled, we cannot get a meaningful value for the share.According to Gordon’s dividend-capitalisation model, the market value of a shareis equal to the present value of an infinite stream of dividends to be received bythe shareholders as explained earlier in Chapter 8. Thus: DIV1 DIV2 DIV DIVt Po = + +… =∑ (1+k) (1+k)2 (1+k) t=1 (1+k)tHowever, the dividend per share is expected to grow when earnings are retained.The dividend per share is equal to the payout ratio, (1-b), times earnings, i.e.,DIVt = (1-b) EPS, where b is the fraction of retained earnings. The retainedearnings are assumed to be reinvested within the all-equity firm at a rate of returnof r. This allows earnings to grow at the rate of g= br per period. When weincorporate growth in earnings and dividend, resulting from the retained earnings,in the dividend-capitalisation model, the present value of a share is determinedby the following formula: DIV(1+g) DIV(1+g)2 DIV(1+g)3 DIV(1+g) Po = + + +….+ (1+k) (1+k)2 (1+k)3 (1+k)t1. Gordon, Myron J., The Investment, Financing and Valuation of Corporation. Richard D. Irwin, 1962.2. Francis, op. cit., p. 352. DIV (1+g)t = ∑ t=1 (1+k)t I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & ManagementWhen Equation (4) is solved it becomes: DIV1 Po = K-gSubstituting EPS1 (1-b) for DIV, and br for g. Equation (5) can be rewritten as EPS1 (1-b) Po = k-brEquation(6) explicitly shows the relationship of expected earnings, EPS1,dividend policy, b, internal profitability, r, and the all-equity firm’s cost of capital,k, in the determination of the value of the share. Equation (6) is particularly usefulfor studying the effects of dividend policy (as represented by b) on the value ofthe share. Let us consider the case of a normal firm where the internal rate of returnof the firm equals its cost of capital, i.,e., r=k. Under such a situation, Equation (6)maybe expressed as follows: EPSl (1-b) rA(1-B) Po = = (since EPS =rA,A total assets per share) K-br k-brIf r=k, then EPSl(1-b) rA(1-b) EPS1 rA Po = = = = =A K(1-b) k(1-b) k rEquation (8) shows that regardless of the firm’s earnings, EPS1, or riskiness(which determines K), the firm’s value is not affected by dividend policy and isequal to the book value of assets per share. That is, when r=k, dividend policy isirrelevant since b, which represents the firm’s dividend policy, completely cancelsout of equation (8). Interpreted in economic sense, this finding implies that, undercompetitive conditions, the opportunity cost of capital, k, must be equal to therate of return generally available to investors in comparable shares. This meansthat any funds distributed as dividends may be invested in the market at the rateequal to the firm’s internal rate of return. Consequently, shareholders can neither I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementlose nor gain by any change in the company’s dividend policy, and the marketvalue of their shares must remain unchanged.1Considering the case of the declining firm where r<k, Equation (8) indicates that,if the retention ratio, b, is zero or payout ratio, (1-b), is 100 per cent the value ofthe share is equal to: rA Po = (if b=0) k If r<k then r/k<1 and from Equation (9) it follows that Po is smaller than thefirm’s investment per share in assets. A. It can be shown that if the value of bincreases, the value of the share continuously falls. 2 These result may beinterpreted as follows: 1. Dobrovolsky, Sergie P., The Economics of Corporation Finance, McGraw Hill, 1971, p.55. 2. ibid., p. 56.It the internal rate of return is smaller than k, which is equal to the rate availablein the market, profit retention clearly becomes undersirable from theshareholders’ standpoint. Each additional rupee (sic) retained reduces theamount of funds that shareholders could invest at a higher rate elsewhere andthus further depress the value of the company’s share. Under such conditions,the company should adopt a policy of contraction and disinvestment, whichwould allow the owner to transfer not only the net profit but also paid in capital (ora part of it) to some other, more remunerative enterprise.1 Finally, let us consider the case of a growth firm where r>k. The value of ashare will increase as the retention ratio, b increases under the condition of r>k.however, it is not clear as to what the value of b should be to maximise the valueof the share, P0. For example, if b=k/r, Equation (6) reveals that denominator, k-br=0, thus making P0 infinitely large, and if b=1,k- br becomes negative, thusmaking P0 negative. These absurd result are obtained because of theassumption that r and k are constant, which underlie the model. Thus, to get themeaningful value of the share, according to Equation (6), the value of b shouldbe less than k/r. Gordon’s model is illustrated in Illustration 20.2. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management ILLUSTRATION 20.2 Let us consider the data in Table 20.2. The implications of dividend policy, according to Gordon’s model, are shown respectively for the growth, the normal and the declining firms. Table 20.3 DIVIDEND POLICY AND THE VALUE OF THE FIRM (GORDON’S MODEL)Growth Firm (r>k) Normal Firm (r=k) Declining Firm (r<k)Basic Datar= 0.15 T= 0.10 r= 0.08k=0.10 K= 0.10 k = 0.10EPS1 = Rs 10 EPS1 = Rs 10 EPS1 = Rs 10Payout Ratio, (1-b) =, Retention g=br=0.6X0.10=0.06 g=br=0.6X0.08=0.048Ratio, B = 60%g=br=0.6X0.15=0.09 10(1-0.6) 10(1-0.6) P= P= 10(1-0.6) 0.10-0.06 0.010-0.048 P= 4 4 0.10-0.09 = Rs 100 = Rs 77 4 0.04 0.052= Rs 400 0.01Payout Ratio = (1-b) = 60% Retention g=br=0.4X0.10=0.04 g=br=0.4X0.08=0.032Ratio, b = 40%g=br=0.4X0.15=0.06 10(1-0.4) 10(1-0.4) 10(1-0.4) P= P=p= 0.10-0.04 0.10-0.032 0.10-0.06 6 6 6= Rs 150 = Rs 100 = Rs 88 0.04 0.06 0.068Payout Ratio = (1=b) = 90% , g=br= 0.10X0.10= 0.01 g=br=0.10X0.08=0.008Retention Ratio, b =10%g=br=0.10X0.15= 0.015 10(1-0.1) 10(1-0.1) P = P = 10(1-0.1) 0.10-0.01 0.10-0.008P= 0.10-0.015 9 9 = Rs 100 = Rs 98 9 0.09 0.092= Rs 106 0.085 It is revealed that under Gordon’s model: I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management • The market value of the share, P0, increases with the retention ratio, b, for firms with growth opportunities, i.e. when r>k. • The market value of the share, P0, increases with the payout ratio, (1-b), for declining firms with r<k. • The market value of the share is not affected by dividend policy when r=k. Gordon’s model’s conclusions about dividend policy are similar to that ofWalter’s model. This similarity is due to the similarities of assumptions whichunderlie both the models. Thus the Gordon model suffers from the samelimitations as the Walter model.• DIVIDENDS AND UNCERTAINTY: THE BIRD-IN-THE HAND ARGUMENTAccording to Gordon’s model, dividend policy is irrelevant where r=k, when allother assumptions are held valid. But when the simplifying assumptions aremodified to conform more closely with reality, Gordon concludes that dividendpolicy does affect the value of a share even when r=k. This view is based on theassumption that under conditions of uncertainty, investors tend to discountdistant dividends (capital gains) at a higher rate than they discount neardividends. Investors, behaving rationally, are risk-averse and, therefore, have apreference for near dividends to future dividends. The logic underlying thedividend effect on the share value can be described as the bird-in-the-handargument. The bird-in-the hand argument was put forward, first of all byKirshman in the following words:Of two stocks with identical earnings record, and prospects but the one paying alarger dividend that the other, the former will undoubtedly command a higherprice merely because stockholders prefer present to future values. Myopic visionplays a part in the price-making process. Stockholders often act upon theprinciple that a bird in the hand is worth two in the bush and for this reason arewilling to pay a premium for the stock with the higher dividend rate, just as theydiscount the one with the lower rate.11. Krishman, Johan, E., Principles of Investment. McGraw Hill, 1933, p. 737; cf.in Mao J.C.T., Quantitative Analysis of Financial Decision, Macmillan, 1969.Where Pb is the price of the share when the retention rate b is positive i.e., b>0.The value of Pb calculated in this way can be determined by discounting thisdividend stream at the uniform rate, k.Iz the weighted average of Kt:1 DIV0(1+g) DIV0(1+g)2 DIV0((1+g)t Po = + +……..+ I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management (1+kt) (1+kl)2 (1+kl)t DIVl (1-b) EPSl = = kl – g kl - br Assuming that the firm’s rate of return equals the discount rate, will Pb behigher or lower than P0? Gordon’s View, as explained above, it that the increasein earnings retention will result in a lower value of share. To emphasise, hereached this conclusion through two assumptions regarding investor’s behaviour:(i) investors are risk averters and (ii) they consider distant dividends as lesscertain than near dividends. On the basis of these assumptions, Gordonconcludes that the rate at which an investor discounts his dividend stream from agiven firm increases with the futurity of this dividend stream. If investors discountdistant dividend at a higher rate than near dividends, increasing the retentionratio has the effect of raising the average discount rate, K, or equivalentlylowering share prices. Thus, incorporating uncertainty into his model, Gordon concludes thatdividend policy affects the value of the share. His reformulation of the modeljustifies the behaviour of investors who value a rupee of dividend income morethan a rupee of capital gains income. These investors prefer dividend abovecapital gains because dividends are easier to predict, are less uncertain and lessrisky, and are therefore, discounted with a lower discount rate.2 However all donot agree with this view.• DIVIDEND IRRELEVANCE: MODIGLIANI AND MILLER’S HYPOTHESISAccording to Modigliani and Miller (M-M) under a perfect market situation, thedividend policy of a firm is irrelevant as it does not affect the value of the firm. 3They argue that the value of the firm depends on the firm’s earnings which resultfrom its investment policy. Thus, when investment decision of the firm is given,dividend decision the split of earnings between dividends and retained earningsis of no significance in determining the value of the firm. A firm, operating in perfect capital market conditions, may face one of thefollowing three situations regarding the payment of dividends: • The firm has sufficient cash to pay dividends. • The firm does not have sufficient cash to pay dividends, and therefore, it issues new shares to finance the payment of dividends. • The firm does not pay dividends, but a shareholder needs cash. I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management 1. Mao, James C.T., Quantitative Analysis of Financial Decision, Macmillan. 1969, p. 482. 2. Francis, op. cit., p.354. 3. Merton H. Miller and France Modigliani, Dividend Policy, Growth and Valuation of the Shares, Journal of business XXIV (October 1961), pp. 411-433. In the first situation, when the firm pays dividends, shareholders get cash intheir hand, but the firm’s assets reduce (its cash balance declines). Whatshareholders gain in the form of cash dividends, they lose in the form of theirclaims on the (reduced) assets. Thus, there is a transfer of wealth fromshareholder’s one pocket to their another pocket. There is no net gain or loss.Since it is a fair transaction under perfect capital market conditions, the value ofthe firm will remain unaffected. In the second situation, when the firm issues new shares to finance thepayment of dividends, two transactions take place. First, the existingshareholders get cash in the form of dividends, but they suffer an equal amountof capital loss since the value of their claim on assets reduces. Thus, the wealthof shareholders does not change. second, the new shareholders part with theircash to the company in exchange for new shares at a fair price per share. Thefair price per share is share price before the payment of dividends less dividendper share to the existing shareholders. The existing shareholders transfer a partof their claim(in the form of new shares) to the new shareholders in exchange forcash. There is no net gain or loss. Both transactions are fair, and thus, the valueof the firm will remain unaltered after these transactions. In the third situation, if the firm does not pay any dividend a shareholdercan create a “home-made dividend” by selling a part of his/her shares at themarket (fair) price in the capital market for obtaining cash. The shareholder willhave less number of shares. He or she has exchanged a part of his claim on thefirm to a new shareholder for cash. The net effect is the same as in the case ofthe second situation. The transaction is a fair transaction is a fair transaction, andno one loses or gains. the value of the firm remains the same, before or afterthese transactions. consider the example in illustration 20.3.ILLUSTRATION 20.3 The Himgir Manufacturing Company Limited currently has2 crore outstanding shares selling at a market price of Rs 100 per share. The firmhas no borrowing. It has internal funds available to make a capital expenditure(capex) of Rs 30 crores. The capex is expected to yield a positive net presentvalue of Rs 20 crore. The firm also wants to pay a dividend per share of Rs 15.Given the firm’s capex plan and its policy of zero borrowing, the firm will have to I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementissue new shares to finance payment of dividends to its shareholders. How willthe firm’s value be affected (i) if it does not pay any dividend; (ii) if it paysdividend per share Rs 15? The firm’s current value is: 2X100= Rs200 crore. After the capex, thevalue will increases to:200+20= Rs220 crore. If the firm does not pay dividends,the value per share will be: 220/2 = Rs 110. If the firm pays a dividend of Rs 15 per share, it will entirely utilize itsinternal funds (15X2=Rs 30 crores), and it will have to raise Rs 30 crore byissuing new shares to undertake capex. The value of a share after payingdividend will be: 110-15= Rs 95. Thus, the existing shareholders get cash of Rs15 per share in the form of dividends, but incur a capital loss of Rs 15 in the formof reduce share value. They neither gain nor lose. The firm will have to issue: 30crores/95= 31,57,895 (about 31.6 lakh) share to raise Rs 30 crore. The firm nowhas 2.316 crore shares at Rs 95 each share. Thus, the value of the firm remainsas: 2.316X95 = Rs 220 Crore. The crux of the M-M dividend hypothesis, as explained above, is thatshareholders do not necessarily depend on dividends for obtaining cash. In theabsence of taxes, flotation costs and difficulties in selling shares, they can betcash by devising “home-made dividend” without any dilution in their wealth.Therefore, firms paying high dividends (i.e. high-payout firms) need notcommand higher prices for their shares. A formal explanation of the M-Mhypothesis is given in the following pages.M-M’s hypothesis of irrelevance is based on the following assumptions:1 • Perfect capital markets The firm operates in perfect capital markets where investors behave rationally, information is freely available to all and transactions and flotation costs do not exist. Perfect capital markets also imply that no investor is large enough to affect the market price of a share. • No taxes Taxes do not exist,: or there are no differences in the tax rates applicable to capital gains and dividends. This means that investors value a rupee of dividend as much as a rupee of capital gains. • Investment policy given The firm has a fixed investment policy. • No risk Risk of uncertainty foes not exist. That is, investors are able to forecast future prices and dividends with certainty, and one discount rate is appropriate for all securities and all time periods. Thus, r=k=kt for all t. Under the M-M assumptions, r will be equal to the discount rate, k andidentical for all shares. As a result, the price of each share must adjust so thatthe rate of return, which is composed of the rate of dividends and capital gains, I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementon every share will be equal to the discount rate and be identical for all shares.Thus, the rate of return for a share held for one year may be calculated asfollows: Dividends + Capital gains (or loss) r= Share price (13) DIV1 + (P1 –Po) r= PoWhere P0 is the market or purchase price per share at time 0, P1 is the marketprice per share at time 1 and DIV1 is dividend per share at time 1. Ashypothesized by M-M, r should be equal for all shares. If it is not so, the low-return yielding shares will be sold by investors who will purchase the high returnyielding share. This process will tend to reduce the price of the low-return sharesand increase the prices of the high-return shares. This switching or arbitrage willcontinue until the differentials in rates of return are eliminated. The discount ratewill also be equal for all firms under the M-M assumptions since there are no riskdifferences. From M-M’s fundamental principle of valuation described by Equation(13), we can derive their valuation model model as follows: DIV1 + (P1 –Po) r= Po DIV1+P1 DIV1+P1 Po = = (1+r) (1+k) (14)Since r=K in the assumed world of certainty and perfect markets. Multiplying bothsides of equation (14) by the number of shares outstanding. n, we obtain the totalvalue of the firm if no new financing exists: nDIV1+P1) V = nPo = (1+k) (15) I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management If the firm sells m number of new share at time 1 at a price of P1, the valueof the firm at time 0 will be: n(DIV1+ P1) + mPl - mPl nPo = (1+k) (16) M-M’ s valuation Equation (16) allows for the issue of new shares, unlikeWalter’s and Gordon’s models. Consequently, a firm can pay dividends and raisefunds to undertake the optimum investment policy (as explained in figure 20.1).Thus, dividend and investment policies are not confounded in the M-M model,like Walter’s and Gordon’s models. As such, M-M’s model yields more generalconclusions. The investment programmes of a firm, in a given period of time, can befinanced either by retained earnings or the issue of new shares or both thus, theamount of new shares issued will be: mP1=I1-(X1-nDIV1)=I1-X1+nDIV1 (17) where I1 represents the total amount of investment during first period andX1 is the total net profit of the firm during first period. By substituting Equation (17) into Equation (16), M-M showed that thevalue of the firm is unaffected by its dividend policy, thus, nDIV1 + Pl) + mPl - mPl nPo = (1+k) nDIVl + (n+m) Pl – (Il – Xl + nDIVl) = (1+k) (n+m) Pl – Il + Xl = (1+k) (18) A firm which pays dividends will have to raise funds externally to finance itinvestment plans. M-M’s argument, that dividend policy does not affect thewealth of the shareholders, implies that when the firm pays dividends, itsadvantage is offset by external financing. This means that the terminal value of I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Managementthe share (say, price of the share at first period if the holding period is one year)declines when dividends are paid. Thus, the wealth of the shareholders dividendsplus terminal price-remains unchanged. As a result, the present value per shareafter dividends and external financing is equal to the present value per sharebefore the payment of dividends. Thus, the shareholders are indifferent betweenpayment of dividends and retention of earnings.ILLUSTRATION 20.4 The Vikas Engineering Ltd. Co., currently has 1,00,000outstanding shares selling at Rs 100 each. The firm has net profits of Rs10,00,000 and wants to make new investments of Rs 20,00,000 during the periodthe firm is also thinking of declaring a dividend of Rs 5 per share at the end of thecurrent fiscal year. The firm’s opportunity cost of capital is 10 per cent. What willbe the price of the share at the end of the year if (i) a dividend is not declared, (ii)a dividend is declared, (iii) How many new shares must be issued?The price of the share at the end of the current fiscal year is determined asfollows: DIVl + Pl Po = (1+k)The value of P when dividend is not paid is: Pl = Rs100(1.10)-0=Rs110When dividend is paid it is: Pl = Rs 100(1.10)-Rs 5 = Rs 105 In can be observed that whether dividend is paid or not the wealth ofshareholders remains the same. When the dividend is not paid the shareholderwill get Rs 110 by way of the price per share at the end of the current fiscal year.On the other hand, when dividend is paid, the shareholder will realise Rs 105 byway of the price per share at the end of the current fiscal year plus Rs asdividend. The number of new shares to be issued by the company to finance itsinvestments is determined as follows: mPl = I – (X-nDIVl) 105m = 20,00,000 – (10,00,000-5,00,000) 105m = 15,00,000 m = 15,00,000/ 105= 14,285 shares I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org
    • Disha Institute of IT & Management RELEVANCE, OF DIVIDEND POLICY:MARKET IMPERFECTIONSM-M hypothesis of dividend irrelevance is based on simplifying assumptions asdiscussed in the preceding section. Under these assumptions, the conclusionderived by them is logically consistent and intuitively appealing. But theassumptions underlying M-M’s hypothesis may not always be found valid inpractice. For example. We may not find capital markets to be perfect in reality;there may exist issue costs; dividends may be taxed differently than capitalgains; investors may encounter difficulties in selling their shares. Because of theunrealistic nature of the assumptions, M-M’s hypothesis is alleged to lackpractical relevance. This suggests that internal financing and external financingare not equivalent. Dividend policy of the firm may affect the perception ofshareholders and, therefore, they may not remain indifferent between dividendsand capital gains. The following are the situations where the M-M hypothesismay go wrong.Tax Differential: Low Payout ClienteleM-M’s assumption that taxes do not exist is far from reality. Investors have to paytaxes on dividends and capital gains. But different tax rates are applicable todividends and capital gains. Dividends are generally treated as the ordinaryincome, while capital gains are specially treated for tax I Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org