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It covers the theory part of Finance Management for MBA Students!!

It covers the theory part of Finance Management for MBA Students!!

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  • 1. Module - 1 -------------------------------------------------------------------------------Unit 1: Nature and Scope of Financial Management--------------------------------------------------------Objectives• to give an insight into the Financial Management• To identify major areas of decision making in financial management• To give a overall view of the scope of financial management.Unit Outline1.1 Introduction1.2 Meaning of Business Finance.1.3 Definitions of Financial Management1.4 Which are the major areas of decision making in financial management?1.5 Scope of financial management-------------------------------------------------------------------------------1.1INTRODUCTION---------------------------------------------------------------- Finance is the lifeblood of business organisations, without finance the formation, establishment, production, functioning or operating of big, medium or small business enterprise is not possible. Finance may be defined as the art and science of managing money. The major areas of finance are 1) financial services and 2) financial management. Financial Services is concerned with the design and delivery of products to individuals, business and government within the areas 1
  • 2. of financial institutions, personal financial planning, investments, real estate, andso on. Financial management is concerned with the duties of the financialmangers in the business firm. The subject of finance is traditionally classified intotwo classes1) Public Finance and 2) Private Finance. Public finance deals with the requirements, receipts, and disbursementof funds in the government institutions like states, local self-governments andcentral governments. Whereas the private finance deals with the requirements,receipts and disbursement of funds by the individual, a business organisation andnon-business organisation. The private finance from the above we can once againclassified into personal finance and business finance and finance of non-businessorganisation.-------------------------------------------------------------------------------1.2 MEANING OF BUSINESS FINANCE--------------------------------------------------------------------------- To understand the meaning of business finance there is a need tounderstand the concepts business and finance. Business may be understood as theorganised efforts of enterprises to supply consumers with goods and services forsatisfying these needs and wants and in the process. All businesses share thesame purpose that is to earn profits. Broadly speaking, the term business includesindustry, trade and commerce. Finance refers to provisioning of money at the time when it is required. Herefinance refers to management of flows of money through an organisation. HenceBusiness Finance concerned with acquisition of funds, use of funds anddistribution of profits by a business firm. The business finance can be further classified in to sole proprietary finance,partnership finance and company or corporate finance. The principle of businessfinance can be applied to any of the forms of business organisations. But since the 2
  • 3. business in an economy in terms of value in companies is more hence theemphasis to the financial practices and problems of the incorporated enterprisesare studied much in business finance. So most of the authors use corporatefinance interchangeably with business finance.-------------------------------------------------------------------------------1.3 DEFINITIONS OF FINANCIAL MANAGEMENT--------------------------------------------------------------------------- Financial management refers to that part of the management activity whichis concerned with the planning and controlling of firms financial resources. It dealswith finding out various sources for raising funds for the firm.Accoding to Soloman, Financial Management is concerned with the efficient useof important economic resource, manely, Capital Funds.According to Prather & Wert, "Business finance deals primarily with raisingadministering and disbursing funds by privately owned business units operating innon-financial fields of industry."Wheeler defines Business Finance as "that business activity which is concernedwith the acquisition and conservation of capital funds in meeting the financialneeds and administering the funds used in the business."According to Guthmann and Dougall, business finance can be broadly defined asthe activity concerned the planning, raising, controlling and administering thefunds used in the business.According to James C. Van Horne Financial Management is concerned with theacquisition, financing, and management of assets with some overall goal in mind.------------------------------------------------------------------------------- MAJORAREAS OF DECISION MAKING IN FINANCIAL MANAGEMENT 3
  • 4. ------------------------------------------------------------------------------- Therefore the decision function of financial management can be broken downinto three major areas: the investment, financing, and asset managementdecisions.Investment Decision The investment decision is the most important of the firms three majordecisions when it comes to the value creation. Investment decision relates to thedetermination of total amount of assets to be held in the firm, the composition ofthese assets like the amount of fixed assets, current assets and the extent ofbusiness risk involved by the investors. The investment decisions can be classified in to two groups: (1) Long-terminvestment decision or capital budgeting and (2) Short-term decision or Workingcapital decision.Financing Decision Financing decision follows the Investment decision. The Finance managernow has to decided how much of finance is required to meet the long-term andshort-term investment decisions, what are the sources of financing theseinvestment decisions, what is the composition of these finance and what should bethe financial mix and so on.Asset Management Decision The third important decision of the firm is the asset management decision.Once assets have been acquired and appropriate financing provided, these assetsmust still be managed efficiently. The finance manager has more responsibility inmanaging the current assets than fixed assets. A large share of the responsibilityof managing the fixed assets would reside in the hands of operating managers ofthe company.---------------------------------------------------------------------------1.5 SCOPE OF FINANCIAL MANAGEMENT---------------------------------------------------------------- 4
  • 5. Financial management is concerned with acquisition, proper utilisation orallocation of these funds. It is an activity concerned with the planning, raising,controlling and administering the funds used in the business. Hence the financemanager have to concentrate on the following areas of finance function. 1. Estimating Financial Requirements. The finance manager has to estimate what would be the short term and long-term financial requirement of his business. For this he has to prepare financial plan for present as well as for future. He should make correct estimate of finance for purchasing of fixed assets and current assets. The estimate should be accurate other wise it leads to either excess of funds or inadequacy both these situations will have adverse impact on the profitability of an organisation. 2. Deciding Capital Structure. The capital structure refers the composition and proportion of different securities for raising funds. After deciding the estimate of financial requirements for fixed and current assets of his business the finance manager must decide what should be composition of long-term funds like capital and debt ratio. Then he has to plan what should be its proportion by taking in to consideration the cost of funds. Similarly for short-term funds. 3. Selecting a Source of Finance. After selecting the capital structure the finance manager must select the sources of finance by considering the cost of capital and availability of funds in the market. 4. Selecting a pattern of investment. After procurement of funds, he has to decide the pattern of investment. He should decide about which assets should be purchased among fixed assets and which is the method of selecting the fixed assets or capital budgeting techniques to be used and cost analysis etc., 5. Proper Cash Management. Proper cash management is another important function of finance manager. He has to asses the cash needs of the organisation like for purchasing of raw materials, making payment to the 5
  • 6. creditors, wages, rent and other day-today expenses. He must identify the sources of raising cash like from cash sales, collection of debts, short-term loans from banks and so on. The cash in an organisation neither excess nor shortage. Excess cash will increase the idle funds in the organisation, whereas shortage of funds or cash will affect the creditworthiness of the company, hence it should be adequate. 6. Implementing Financial Controls. Efficient financial management requires implementation of some financial controls like ratio analysis, return on capital employed, return on assets, budgetary control, break-even analysis, return of investment, internal audit etc., to evaluate the performance of various financial policies of the organisation. 7. Proper use of surpluses. Proper use of profits or surpluses is also essential for the expansion and diversification plans and also protecting the interests of shareholders. Issue of bonus shares or ploughing back of capital etc., will increase the value of the shares of the company hence judicious utilisation of these surpluses is very important.----------------------------------------------------------------UNIT 2 OBJECTIVES OR GOALS OF FINANCIAL MANAGEMENT-------------------------------------------------------------------------------Objectives• To study the objectives of financial management• To analyse the relevance of each objective with the present scenario• To know other objectives of financial managementUnit outline 6
  • 7. 2.1 Objectives of financial management2.2 Profit maximisation2.3 Arguments in favour of Profit maximisation2.4 Criticisms on Profit maximisation objective2.5 Wealth maximisation2.6 Criticisms on wealth maximisation objective2.7 Other objectives---------------------------------------------------------------------------2.1 OBJECTIVES OR GOALS OF FINANCIAL MANAGEMENT---------------------------------------------------------------- Financial management is concerned with procurement and use of funds. Itsmain aim is to use business funds is such a way that value or earnings of thefirms are maximised. There are various alternative ways of using business funds.The organisation should go through the pros and cons of each alternative way ofusing these business funds before final selection. The financial managementprovides a framework for selecting a proper course of action and deciding a viablecommercial strategy. The following are the objectives of financial management.1. Profit Maximisation2. Wealth Maximisation, and3. Other objectives.---------------------------------------------------------------------------PROFITMAXIMISATION---------------------------------------------------------------------------The main objective of a business firm is profit maximisation because the businessfirm is a profit-seeking organisation. Hence the objective of the financialmanagement of business organisation is profit maximisation. There are somearguments in favour of this objective of business. They are. 7
  • 8. a) When profit earning is the aim of business then profit maximisation should be the obvious objective.b) Profitability is a barometer for measuring efficiency and economic prosperity of a business enterprise, therefore, profit maximisation is justified on the grounds of rationality.c) The economic and business conditions do not remain same at all the times like recession, depression, cut throat competition and so on. Hence the business organisations should earn more and more profits when the situations are favourable.d) Since profit is the main source finance for growth and development of a business organisation hence, keeping profit maximisation of profit, as an objective of the business is justifiable.e) Through maximisation of profitability of a business it is possible to contribute more and more funds for social activities to meet social goals. However, the concept of profit maximisation has been criticised and rejected asthe objective of financial management of a business organissation on account ofthe following reasons:a) It is vague. The term profit is vague and it cannot be precisely defined. It means the term profits if different to different people. Which profits are to be maximised, short term or long term profit, profits before tax or after tax, or total profits or profit per share and the like.b) It ignores timings. Profit maximisation objective ignores the time value of money and does not consider the magnitude and timing of earnings.1. It overlooks quality aspects of future activities. The business is not solely run with the objective of earning maximum profits. Some organisations give more emphasis to sales growth, by increasing its volume of sales by decreasing the profits or gain margin. Some organisations make more profits and contribute more amounts to the development of the society. 8
  • 9. -------------------------------------------------------------------------------WEALTHMAXIMISATION--------------------------------------------------------------------------- Wealth or net worth is the difference between gross present worth and theamount of capital investment required to achieve the benefits. Any financial actionwhich creates wealth or which has a net present worth above zero is a desirableone and should be undertaken. The operating objective for financial managementis to maximise wealth or net present worth. Wealth maximisation is, therefore,considered to be the main objective of financial management. The objective ofwealth maximisation is to maximise the economic welfare of the shareholders of acompany. The value of a companys shares depends largely on its new worthwhich itself depends on earning per share (EPS). A stockholders current wealth inthe firm is the product of the number of shares owned, multiplied with the currentstock price per share.Stockholders current wealth in the firm = (Number of shares owned) x (currentstock price per share)It is symbolically represented W o = NP oThus the business organisation should strive for the increase in the current stockprice per share or EPS, so that the current wealth of a firm will increases. This inturn depends upon the proper financial management.---------------------------------------------------------------------------CRITICISM OF WEALTH MAXIMISATION--------------------------------------------------------------------------- The wealth maximisation objective has been criticised by certain financialtheorists mainly on the following grounds. 9
  • 10. a) It is a prescriptive rather than descriptive. The objective should tell what the firm should actually do.b) The objective of wealth maximisation is not necessarily socially desirable.c) There is controversy as to whether the objective of a firm is maximise the stockholders wealth or wealth of the firm, since the firm includes stockholders, debenture-holders, preference shareholders etc.d) Since the management and ownership are separated in large corporate form of organisations, the managers will act in such a manner, which maximises the managerial utility rather than the wealth maximisation of stockholders of the firm. This is a controversial argument. In spite of all the criticism, we are of the opinion that wealth maximisation isthe most appropriate objective of a firm.-------------------------------------------------------------------------------OTHEROBJECTIVES--------------------------------------------------------------------------- Besides the above basic objectives, the following are the other objectives offinancial management.(a) Ensuring fair return to shareholders.(b) Building up reserves for growth and expansion.(c)Ensuring maximum operational efficiency by efficient and effective utilisation of finances.(d) Ensuring financial discipline in the organisation.-------------------------------------------------------------------------------Unit 3 FINANCIAL ENVIRONMENT--------------------------------------------------------Objectives• To study the environment under which the financial management is studied 10
  • 11. • To give a brief outline of functions of financial manager and organisation of finance function.Unit outlineFINANCIAL ENVIRONMENT3.1 Functional areas of Financial Management3.2 Organisation of Finance function3.3 Functions of Controller3.4 Functions of Treasurer-------------------------------------------------------------------------------3.1 FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT------------------------------------------------------------------------------- Financial management is an applied field of business administration.Principles developed by the financial mangers from accounting, economics andother fields are applied to the problems of managing finances. Moreover, everybusiness activity requires money and hence financial management is closelyrelated with all other areas of management. The relationship between financialmanagement and other areas of management has been explained briefly.Financial Management and Cost Accounting Most of the large companies have a separate cost accounting department tomonitor expenditures in their operational areas. The cost information is regularlysupplied to the management to control the costs. The finance manager isconcerned with proper utilization of funds and therefore he is concerned with theoperational costs of the firm. 11
  • 12. Financial Management and Marketing The success or failure of a firm is greatly depends upon the marketing. Oneof the important elements of marketing mix is price. The fixation of price for aproduct plays very important role. There are various policies of pricing. Themarketing department must observe the best pricing policy when compared to thecompetitors in the industry. Hence he collects the financial information from thefinance department, here the role of finance manager is very important.Financial Management and Assets Management The current assets and the fixed assets of the firm constitute the total assetsof a firm. The firms assets should be properly managed. Proper management ofassets refers to systematic acquisition and maintenance or better utilization ofassets. The finance manager plays very important role in the proper maintenanceof composition of these assets.Financial Management and Personnel Management Personnel management is concerned with selection, recruitment, trainingand placement of personnel department. The proper functioning and the abovesaid functions of personnel departments depend upon the decisions taken infinance department. Hence the functioning of finance department in anorganisation plays a vital role.Financial Management and Financial Accounting Financial management and financial accounting are quite distinct from eachother. Financial accounting is concerned with the systematic recording, analysing,reporting and measuring the business transactions. The objective of financialaccounting is measurement of funds and the objective of financial management isto management of funds. The management of funds depends on the measurementof financial accounting through profit and loss account and balance sheet. 12
  • 13. ---------------------------------------------------------------------------3.2 ORGANISATION OF THE FINANCE FUNCTION-------------------------------------------------------- A firm must give proper attention to the structure and organisation of itsfinance department. If financial data are missing or inaccurate, the firm may notbe in a position to identify the serious problems confronting the firm at any timefor correcting. The roles of different finance executives should be clearly defined inorder to avoid conflict and overlapping of functions. Organisation of the finance function differs from company to companydepending on their respective needs and the financial philosophy. The titles usedto designate the key finance official are also different viz., vice-president(Finance), Chief Executive (Finance), General Manager (Finance), etc. however, inmost companies, the vice-president (Finance) has under him two officers carryingout the two important functions - the accounting and the finance functions. Theformer is designated as Controller and the latter as the Treasurer. The controller is concerned with the management and control of the firmsassets. His duties include providing information for formulating the accounting andfinancial policies, preparation of financial reports, direction of internal auditing,budgeting, inventory control, taxes, etc. while the treasurer is mainly concernedwith managing the firms funds, his duties include the following: Forecasting the financial needs; administering the flow of cash; managingcredit; floating securities; maintaining relations with financial institutions andprotecting funds and securities.-------------------------------------------------------------------------------3.3 FUNCTIONS OF CONTROLLER---------------------------------------------------------------------------Planning and control. To establish, coordinate and administer, as part ofmanagement, a plan for the control of operations. 13
  • 14. 1. Reporting and interpreting. To compare performance with operating plans and standards and to report and interpret the results of operations to all levels of management and to the owners of the business.2. Tax administration. To establish and administer tax policies and procedures.3. Government reporting. To supervise or co-ordinate the preparation of report to the government.4. Protection of assets. To ensure protection of assets for the business through internal control, internal audit and proper insurance coverage.5. Economic appraisal. To appraise continuously economic and social forces and Government influences, and to interpret their effect upon the business. --------------------------------------------------------------------------3.4 FUNCTIONS OF TREASURER---------------------------------------------------------------------------Provision offinance. To establish and execute programmes for the provision of capital requiredby the business. 1. Investor relations. To establish and maintain an adequate market for the companys securities and to maintain adequate contact with the investment community.2. Short-term financing. To maintain adequate sources for the companys current borrowings from the money market.3. Banking and custody. To maintain banking arrangement, to receive, have custody of and disburse the companys monies and securities.4. Credit and collections. To direct the granting of credit and the collection of accounts receivables of the company.5. Investments. To achieve the companys funds as required and to establish and co-ordinate policies for investment in pension and other similar trusts.6. Insurance. To provide insurance coverage as may be required. 14
  • 15. -------------------------------------------------------------------------------UNIT 4 FINANCING DECISIONS--------------------------------------------------------Objectives• To study the financing of investment decisions• To have the exposure of various leverages• To identify how to arrive at optimum leverage for successful investment decisions.Unit Outline4.1 What is financing decision?4.2 Meaning of leverage4.3 Types of leverageFinancial leverageOperating leverageComposite leverage---------------------------------------------------------------------------4.1 FINANCING DECISIONS--------------------------------------------------------------------------- After the Investment decision is taken the firm has to decide upon the bestmeans of financing these investment policies. The investment decisions arecontinuous in nature because the companies make the new investments in itsregular course of business since the business is ever expanding. Hence the firmswill make plan continuous its financial needs. The financial decision is not only 15
  • 16. concerned with how best to finance new assets, but also concerned with the bestoverall mix of financing for the firm.---------------------------------------------------------------------------4.2 MEANING OF LEVERAGE--------------------------------------------------------------------------- The term Leverage refers to the ability of a firm in employing long termfunds having a fixed cost, to enhance returns to the owners; i.e. equityshareholders. . In other words leverage is the employment of fixed assets orfunds for which a firm has to meet fixed costs or fixed rate of interest obligationirrespective of the level of activities attained or the level of operating profitearned.James Horne has defined leverage as " the employment of an asset or sources offunds for which the firm has to pay a fixed cost or fixed return.,"The higher the leverage higher is the risk as well as return to the owners. A higherleverage obviously implies higher outside borrowings and hence riskier if thebusiness activity of the firm suddenly slows down. The leverage can have negativeor reversible effect also. It may be favorable or unfavorable.-------------------------------------------------------------------------------4.3 TYPES OF LEVERAGES---------------------------------------------------------------------------There are basically two types of leverages, 1) operating leverage, and 2) financialleverage. In addition to these two types of leverages there are composite leverageand working capital leverage. The leverage associated with the employment offixed cost assets is referred to as operating leverage. While the leverage resultingfrom the use of fixed cost/return source of funds is known as financial leverage.FINANCIAL LEVERAGE OR TRADING ON EQUITY 16
  • 17. The company can finance its investments by debt and/or equity. The companymay also use preference capital. The rate of interest on debt is fixed irrespectiveof the companys rate of return on assets. The rate preference dividend is alsofixed; but preference dividends are paid when the company earns profits. Theordinary shareholders are entitled to the residual income. That is, earnings afterinterest and taxes (less preference dividends) belongs to them, this dividends alsodepends on the dividend policy of the company. The use of the fixed charge sources of funds, such as debt and preferencecapital with the owners equity in the capital structure, is described as financialleverage or trading on equity. The use of long term fixed interest bearing debt and preference share capitalalong with equity share capital is called financial leverage or trading on equity. Thelong term fixed interest bearing is employed by a firm to earn more from the useof these resources than their cost so as to increase the return on owners equity, itis called trading on equity. A firms earnings are more than what debt wouldcost is known as favourable leverage and if the firms earnings are lessthan the debt cost then its is known as unfavourable leverage. The impact of financial leverage is to magnify the shareholders earnings. Itis based on the assumption that the fixed charges can be obtained at a cost lowerthan the firms rate of return on its assets.DEGREE OF FINANCIAL LEVERAGE The degree of financial leverage measures the impact of a change inoperating income (EBIT) on change in earning on equity capital or share.The formula to calculate the degree of financial leverage Earnings before Interest and Taxes EBITFinancial Leverage = ----------------------------------------- OR ------ Earnings before Taxes EBT 17
  • 18. 1. Operating Leverage The operating leverage occurs when a firm has fixed costs which must berecovered irrespective of sales volume. The fixed costs remaining same, thepercentage change in operating revenue (EBIT) will be more than the percentagechange in sales. This is known as operating leverage. The degree of operatingleverage depends upon the amount of fixed elements in the cost structure. Thedegree of operating leverage will be calculated as: Contribution Operating Leverage = ------------------- Operating profit If a firm does not have fixed costs then there will be no operating leverage.The percentage change in sales will be equal to the percentage change in profit.When fixed costs are there, the percentage change in profits will be more than thepercentage in sales volume. The degree of operating leverage is calculated as: Percentage Change in Profits Degree of operating leverage = ------------------------------- Percentage Change in SalesRisk Factor In a high leveraged situation will magnify the operating profits but it bringsin the risk element too. The percentage change in profits will be more in asituation with higher fixed costs as compared to that where fixed costs are lower.The higher degree of leverage brings in more decrease in operating profits.2. Composite Leverage The operating leverage measures the degree of operating risk and it ismeasured by percentage change in operating profit due to percentage change insales. The financial leverage measures the financial risk by measuring thepercentage change in taxable profit or EPS with the percentage change inoperating profit or EBIT. Both these leverages are closely concerned with the firmscapacity to meet the fixed costs. 18
  • 19. Composite leverage expressed the relationship between revenue on accountof sales (Contribution) and the taxable income (PBT) on account of change insales. The composite ratio is calculated as follows: Composite Leverage = Operating leverage X Financial leverage Or Contribution EBIT Contribution = --------------- X -------- = ------------- EBIT PBT PBT----------------------------------------------------------------UNIT 5 PROBLEMS FINANCIAL LEVERAGES--------------------------------------------------------Objective• To understand the practical application of various leverages in the firm for better financial decisionsUnit outline5.1 Problems on:• Operating leverage• Financial leverage• Composite leverage----------------------------------------------------------------5.1 PROBLEMS OF LEVERAGES---------------------------------------------------------------- 19
  • 20. 1. From the following data calculate the operating leverage, financial leverage and combined leverage: Sales: 10,000 units at Rs 25 per unit as selling price. Variable cost = Rs 5 per unit Fixed cost = Rs 30,000. Interest = Rs 15,000. Solution: Table to calculate OL, FL and CL Sales 2,50,000 Less Variable 50,000 cost Contribution 2,00,000 Less Fixed cost 30,000 EBIT 1,70,000 Less Interest 15,000 EBT 1,55,000 Contribution Operating Leverage = ------------------- Operating profit (EBIT) 2, 00,000 = ------------ 1, 70,000 = 1.17 times Earnings before Interest and Taxes EBITFinancial Leverage = --------------------------------------- OR ------ Earnings before Taxes EBT 1, 70,000 = ------------ 20
  • 21. 1, 55,000 = 1.10 times Composite Leverage = Operating leverage X Financial leverage = 1.17 X 1.10 = 1.29 times 2. Evaluate two companies firm A and firm B in terms of the financial and operating leverage. Firm A Firm B Sales Rs 20,00,000 Rs 30,00,000 Variable cost 40% of Sales 30% of Sales Fixed cost Rs 5,00,000 Rs 7,00,000 Interest Rs 1,00,000 Rs 1,25,000Solution:Table to calculate OL, FL and CL Firm A Firm B Sales 20,00,000 30,00,000 Less Variable cost 8,00,000 9,00,000 Contribution 12,00,000 21,00,000 Less Fixed cost 5,00,000 7,00,000 EBIT 7,00,000 14,00,000 Less Interest 1,00,000 1,25,000 EBT 6,00,000 12,75,000 Contribution Operating Leverage = ------------------- Operating profit (EBIT) Firm A Firm B 12, 00,000 21, 00,000 = --------------- = ---------------- 21
  • 22. 7, 00,000 14, 00,000 = 1.71 times = 1.50 times Earnings before Interest and Taxes EBITFinancial Leverage = ------------------------------- OR --------- Earnings before Taxes EBT Firm A Firm B 7, 00,000 14, 00,000 = ---------- ------------ 6, 00,000 12, 75,000 = 1.16 times = 1.10 times Composite Leverage = Operating leverage X Financial leverage Firm A Firm B =1.17 X 1.16 = 1.50 X1.1 = 2 times = 1.63 times Firm A has more business and financial risk when compared to FirmB.3. The following data are available for X Ltd.,: Selling price per unit Rs 120 Variable cost Rs 70 Fixed cost Rs 2, 00,000 a) What is the operating leverage when X Limited sells 6,000 units. b) What is the % change that will occur in the EBIT of X limited if output increases by 5%. 22
  • 23. Solution:a) Table to calculate OL, if sales is 6,000 units Sales 7,20,000 Less variable cost 4,20,000 Contribution 3,00,000 Less Fixed cost 2,00,000 EBIT 1,00,000 Contribution Operating Leverage = ------------------- Operating profit (EBIT) 3, 00,000 = ------------ 1, 00,000 = 3 timesb) When the output increases by 5%. Now the total output increases to 6,300 unitsTherefore the change in EBIT is Sales 7,56,000 Less variable cost 4,41,000 Contribution 3,15,000 Less Fixed cost 2,00,000 EBIT 1,15,000The change in EBIT = 1, 15,000 - 1, 00,000 = 15,000Therefore the % change in EBIT = 15,000/1, 00,000 x 100 = 15% 23
  • 24. 4. Calculate the Financial leverage and Operating leverage under situation A and situation B, under financial plans II and I from the following information relating to operations and capital structure of ABC Limited. Installed capacity = 1000 units. Actual production and Sales = 800 units.Selling price per unit = Rs 20. Variable cost = Rs 15. Fixed cost: Situation A Rs 800 Situation B Rs 1,500. Capital Structure: Particulars Plan I Plan II Equity share 5,000 7,000 capital Debt 5,000 2,000 Cost of debt 10% 10%Solution: Situation A Plan I Plan II Sales 16,000 16,000 Less Variable 12,000 12,000 cost Contribution 4,000 4,000 Less F. C 800 800 EBIT 3,200 3,200 Less interest 500 200 EBT 2,700 3,000 Plan I Plan II ContributionO. L = ------------------- =4,000/3,200 4,000/3,200 Operating profit (EBIT) 24
  • 25. = 1.25 times = 1.25 times EBITF.L = --------- = 3200/2700 = 3200/3000 EBT = 1.19 times = 1.07 times Situation B Plan I Plan II Sales 16,000 16,000 Less Variable 12,000 12,000 cost Contribution 4,000 4,000 Less F. C 1,500 1,500 EBIT 2,500 2,500 Less interest 500 200 EBT 2,000 2,300 Plan I Plan II ContributionO. L = ------------------- =4,000/2,500 =4,000/2,500 Operating profit (EBIT) = 1.60 times = 1.60 timesF.L = EBIT ------- = 2,500/2,000 = 2500/2300 EBT = 1.25 times = 1.09 timesConclusion: It is advisable to the management that the OL should be less and FLshould be more in order to maximise the returns. Therefore OL under situation A is1.25 times and FL under situation B (Plan I) is 1.25 times, which is considered asan ideal situation. 25
  • 26. 5. From the following data of A,B and C companies prepare their income statement: Particulars A B C VC as a % of 66 2/3 75 50 sales Interest Rs 200 Rs 300 Rs 1,000 OL 5:1 6:1 2:1 FL 3:1 4:1 2:1 Income Tax rate 50 % 50 % 50 %Solution: We knew, EBIT EBIT F.L = --------- = --------- EBT EBIT - InterestIn Company A 3 EBIT --- = ----------- 1 EBIT-200 3 EBIT - 600 = EBIT 2 EBIT = 600 EBIT =Rs 300 In Company B 4 EBIT ---- = ----------- 1 EBIT-300 4 EBIT - 1200 = EBIT 3 EBIT = 1200 EBIT = Rs 400 In Company C 2 EBIT --- = ----------- 1 EBIT-1000 26
  • 27. 2 EBIT - 2000 = EBIT EBIT = Rs 1000 Operating Leverage Contribution OL = ---------------- EBIT In Company A In company B Contribution OL = ---------------- EBIT 5 Contribution 6 Contribution --- =---------------- --- =--------------- 1 300 1 400 Contribution = Rs 1500 Contribution = Rs 2400 In company C 2 Contribution -- = ---------------- 1 1000 Contribution = Rs 2000Computation of Sales: Contribution = Sales - VCCompany A Let Sales = 100 VC = 66 2/3Therefore Contribution = 100 -200/3 = 100/3 27
  • 28. = Rs 1,500Therefore Sales = 1500 x 100 x 3 / 100 = Rs. 4,500Variable Cost = Rs 3,000Computation of Sales: Contribution = Sales - VCCompany B Let Sales = 100 VC = 75%Therefore Contribution = 100 -75 =25Therefore Sales = 2400 x 100/25 = Rs. 9,600Variable Cost = Rs 7,200Computation of Sales: Contribution = Sales - VCCompany C Let Sales = 100 VC = 50Therefore Contribution = 100 -50 = 50Therefore Sales = 2,000 x 100/ 50 = Rs. 4,000Variable Cost = Rs 2,0006. PQR and Co’s latest Balance Sheet is as follows;Balance Sheet of PQR & Co. Liabilities Amount Assets Amount (In Rs.) (In Rs.) 28
  • 29. Equity Capital 60,000 Fixed Assets 150,00 (Rs 10/- each) 0 Current 10% Long term 80,000 Assets 50,00 debt 0 20,00 Retained 0 earnings 40,00 Current 0 Liabilities Total 200,000 Total 200,00 0 The Company’s total assets turnover ratio=3, Fixed cost=Rs1, 00,000/-and Variable Cost=40% of Sales, Tax=50%. Find OL, FL and CL.SolutionTotal Assets Turnover Ratio = Sales/Total Assets 3 = Sales/2,00,000 Therefore Sales = Rs.6, 00,000/-Therefore V.C=40% of Sales = 40/100 x 600000 =Rs. 240000Interest = 10%Long term debt=10/100 x 80000 =Rs.48000/-Income Statement Sales 600000 (-)V.C 240000 Contribution 360000 (-)FC 100000 EBIT 260000 (-)Interest 800 (10%on80,000) 0 29
  • 30. EBT (-)Tax50% 252000 126000 EAT 126000Operating Leverage = Contribution/EBIT = 360000/260000=1.38 timesFinancial Leverage = EBIT/EBT =260000/252000=1.03 timesCombined Leverage = OL X FL= 1.38X1.03=1.42 times7. X Limited has estimated that for a new product, its BEP is 2000 units of theitem is sold for Rs 14per unit., the cost accounting department has currentlyidentified VC of Rs. 9/- per unit. Calculate OL for sales volume of 2500 units and3000 units. [BEP = Break Even Point]. Fixed cost not given.SolutionSelling Price=Rs14/-per unitVariable cost =Rs9/- per unitCalculation of Fixed cost.Sales 28000(-)VC 18000Contribution 10000(-)FC - 10000EBIT = 0Therefore Contribution will be considered as Fixed cost i.e. Rs. 10,000/- Income Statement 30
  • 31. Particulars 2500Uni 3000Uni ts ts Sales 35000 42000 (-)VC 22500 27000 Contributi 12500 15000 on 10000 10000 (-)FC 2500 5000 EBITTherefore OL (2500Units) = Contribution/EBIT= 12500/2500=5 timesOL (3000Units) = Contribution/EBIT=15000/5000=3 times If sales volume is increased by 25 %(from 2000 to 2500Units) the EBITincreases unto Rs2500/- from BEP. If sales volume increases up to Rs 5000/-(doubled: 2500 to 5000)8. Following information is obtained from a hypothetical company which has thethree different situations X,Y and Z and Financial plans I, II and III. You arerequired to calculate OL, FL and CL. The total capacity of the project=10000Units,Explored capacity of sales=7500 UnitsS.P Per Unit=Rs.20/-V.C Per Unit=Rs15/-Fixed Cost; X=Rs10000 Y=Rs20000 Z=Rs25000Financial Plans;1) Rs50000/-Equity and Rs40000/-debt at 10% interest2) Rs60000/- Equity and Rs30000/-debt at 10% interest3) Rs30000/- Equity and Rs60000/- debt at 10% interest 31
  • 32. SolutionSituation Plan-I Plan-II Plan-IIISales 1,50,000 1,50,000 1,50,000(-)VC 1,12,500 1,12,500 1,12,500Contribution 37,500 37,500 37,500(-)FC 10,000 10,000 10,000EBIT 27,500 27,500 27,500(-)Interest 4000 3000 6000EBT 23500 24500 21500Operating Leverages(I) OL=37500/27500=1.36 times(II) OL=37500/27500=1.36 times(III) OL=37500/27500=1.36 timesFinancial Leverages(I) FL=27500/23500= 1.17 times(II) FL=27500/24500= 1.12 times(III) FL=27500/21500= 1.28 timesCombined Leverages(I) CL=1.36 x 1.17 = 1.59 times(II) CL=1.36 x1.12 = 1.52 times(III) CL=1.36 x 1.28 = 1.74 times Situation-Y Plan-I Plan-II Plan-III Sales 1,50,000 1,50,000 1,50,000 (-)VC 1,12,500 1,12,500 1,12,500 Contribution 37,500 37,500 37,500 (-)FC 20,000 20,000 20,000 EBIT 17,500 17,500 17,500 (-)Interest 4000 3000 6000 32
  • 33. EBT 13500 14500 11500Operating Leverages(I) OL=37500/17500=2.14 times(II) OL=37500/17500=2.14 times(III) OL=37500/17500=2.14 timesFinancial Leverages(I) FL=17500/13500=1.30 times(II) FL=17500/14500=1.21 times(III) FL=17500/11500=1.52 timesCombined Leverages(I) CL=2.14X1.30=2.78 times(II) CL=2.14X1.21=2.59 times(III) CL=2.14X1.52=3.25 timesSituation-Z Plan-I Plan-II Plan-IIISales 1,50,000 1,50,000 1,50,000(-)VC 1,12,500 1,12,500 1,12,500Contribution 37,500 37,500 37,500(-)FC 25,000 25,000 25000EBIT 12,500 12,500 12,500(-)Interest 4000 3000 6000EBT 8500 9500 6500Operating Leverages;(I) OL=37500/12500=3 times(II) OL=37500/12500=3 times(III) OL=37500/12500=3 timesFinancial Leverages;(I)FL=12500/8500=1.47 times(II)FL=12500/9500=1.32 times(III)FL=12500/6500=1.92 times 33
  • 34. Combined Leverages;(I)CL=3X1.47=4.41 times(II)CL=3X1.32=3.96 times(III)CL=3X1.92=5.76 times The OL is least in situation X (all plans) and the FL is highest in situation ZPlan III.------------------------------------------------------------------------------- Unit 6 CAPITAL STRUCTURE-------------------------------------------------------Objectives• To bring clarity in concepts of capital structure, differentiating with financial structure and decide about the optimum capital structure.• To bring out the essential features for appropriate capital structure• To identify the factors which determines the capital structure.Unit Outline5.1 Introduction6.2 Meaning of capital structure6.3 Difference between capital and financial structure6.4 Optimum Capital structure6.5 Features of Appropriate Capital Structure6.6 Factors determining Capital Structure--------------------------------------------------6.1 INTRODUCTION------------------------------------------------- 34
  • 35. The funds required by the business organisation are raised through theownership securities i.e., by equity shares, preference shares and creditorshipsecurities i.e., debentures and bonds. But the business organisation must raisethese funds by a proper mix of both these securities in such a way that the costand the risk of both these securities should be minimum. The mix of differentsecurities is disclosed by the firms capital structure.------------------------------------------------------------------------------ 5.2 MEANING OF CAPITAL STRUCTURE-------------------------------------------------------------------------- In ordinary language it implies the proportion of debt and equity in the totalcapital of a company.According to Gerstenberg Capital Structure refers to the the make up of a firmscapitalisation. In other words, it represents the mix of different sources of longterm funds in the capitalisation of the company.------------------------------------------------------------------------------- 5.3 DIFFERENCE BETWEEN CAPITAL STRUCTURE AND FINANCIAL STRUCTURE-------------------------------------------------------------------------- Financial Structure is the entire left hand side of the company balance sheeti.e., ownership securities, creditorship securities and current liabilities. Whereascapital structure refers to sources of all long-term funds like ownership securitieslike equity capital and preference capital and creditorship securities likedebentures, bonds and long term loans.--------------------------------------------------------------------------6.4 OPTIMUM CAPITAL STRUCTURE-------------------------------------------------------------------------- The optimum capital structure is obtained when the market value per equityshare is the maximum. It may be defined as that relationship of debt and equitysecurities which maximizes the value of a companys share in the stock exchange.Or at optimum capital structure, the value of an equity shares is the maximumwhile the average cost of capital is the minimum. 35
  • 36. ---------------------------------------------------------------------------6.5 FEATURES OF APPROPRIATE CAPITAL STRUCTURE-------------------------------------------------------------------------An appropriate capital structure will posses the following features.1. Profitability. The most profitable capital structure of a company is one that tends to minimize cost of financing and maximise earning per equity share. Hence these companies naturally are profitable.2. Solvency. The pattern of capital structure should be devised in such a way that the company does not run into the risk of becoming insolvent. Excess use of debt threatens the solvency of the company.3. Flexibility. The capital structure should be in such a way that it should have a provision of easily switching over to requirements of changing conditions by easy swap and also there should be availability of funds for profitable activities.4. Conservatism. The capital structure should be conservative so that the debt content in the total capital structure does not exceed the limit which the company can bear.5. Control. The capital structure should be so devised that it involves minimum risk of loss of control of the company.--------------------------------------------------------------------------6.5 FACTORS DETERMINING CAPITAL STRUCTURE-------------------------------------------------------------------------- Great caution is required at the time of determining the initial capitalstructure of a company since it will have long-term implications. Hence the financemanager should be careful but it can be changes subsequently as per therequirements. This capital structure decision is a continuous one and has to betaken whenever a firm needs additional finances. 36
  • 37. The following are the factors which determines the capital structure of acompany. 1. Trading on equity or Financial Leverage. The use of long-term fixed interest bearing debt and preference share capital along with equity share capital is called financial leverage or trading on equity. Making profit to shareholders by using the other funds like debentures, preference capital is called trading on equity. In other words if the rate of return on the total capital employed is more than the rate of interest on debentures or rate of dividend on preference shares. 2. Retaining control. The capital structure of a company is also affected by the extent to which the promoters or existing management of the company desire to maintain control over the affairs of the company. if the existing management want maintain the same control over the company for further funds they will issue only debentures and preference capital instead of issuing equity shares. 3. Nature of enterprise. The nature of enterprise will determine the capital structure of the organisation. If the company is a public utility organisation or a monopoly organisation in that product then it can earn stable profit. Hence it goes for debentures or bonds since they will have adequate profits to meet recurring costs. 4. Legal requirements. The promoters of a company must comply with the legal requirements of the organisation. For example the banking companies has to raise funds only through equity share capital as per the Banking Regulations Act. 5. Purpose of financing. The purpose of financing is another factor which determines the capital structure of the organisation. The purpose of financing is for productive purposes like purchase of machinery , payment of old debts borrowed at high interest are financed through debentures 37
  • 38. and bonds. If the purpose of financing is for non productive purposes like welfare activities etc then it is raised through equity capital. 6. Period of finance. The capital structure of a company depends on the period of finance. For example the funds required for the business is 5 to 10 years it is raised through debentures, redeemable preference shares and bonds. Whereas if funds are raised for permanently then it is raised through equity shares or preference shares. 7. Government policy. Government policy is an important factor in planning the companys capital structure. The controller of capital Issues and Government of India can interfere and dictate the capital structure of the organisation. 8. Market sentiments of investors. The market sentiments of the investors will determine the capital structure of the organisation. If companys investors expect absolute safety attitude in their investment pattern then the companies will go for raising the finance required through debentures. If the investors want to make high profits through speculation then the companies raise its capital by issuing equity shares.----------------------------------------------------------------UNIT 7 CAPITAL STRUCTURE THEORIES---------------------------------------------------------------Objectives• To give an idea of basic capital structure theories and to select optimum capital structure.• To highlight the essential features for a sound capital mixUnit outline 38
  • 39. 7.1 Capital Structure Theories: • Net Incomes (NI) Approach, • Net Operating Income (NOI) Approach, • Modigilani - Miller (MM) Approach, and • Traditional Approach.7.2 Capital Structure Management or Planning the Capital Structure7.3 Essential features of a sound capital mix------------------------------------------------------------------------------7.1 CAPITAL STRUCTURE THEORIES--------------------------------------------------------------------------------------------- To achieve the basic goal of optimum capital structure in the organisationthe finance manager must have the basic knowledge of capital structure theories.There are extreme opinions on the optimum capital structure, hence it calls forvarious theories in this. They are: • Net Incomes (NI) Approach, • Net Operating Income (NOI) Approach, • Modigilani - Miller (MM) Approach, and • Traditional Approach.These theories are based on the following general assumption. They are:(a) The firm employs only two types of capital-debt and equity.(b) The firm pays 100% of its earnings as dividend. Thus there are no retained earnings.(c)The firms total assets given are assumed to be constant in investment decisions.(d) The operating earnings are not expected to grow.(e) The business risk remains constant and is independent of capital structure and financial risks. 39
  • 40. (f) The firm has a continuous life.1. Net Incomes (NI) Approach Durand has suggested this approach. According to this approach, capital structure decision is relevant to the valuation of the firm because the change in capital structure decision causes a corresponding change in the overall cost of capital as well as the total value of the firm. According to this approach a higher debt content in the capital structure (high financial leverage) will result in decline in the overall or weighted average cost of the capital and increase in the value of equity shares of the company. This approach is based on the following three assumptions. (i) There are no corporate taxes. (ii) The cost of debt is less than cost of equity or equity capitalisation rate. (iii) The debt content does not change the risk perception of the investors. On the basis of Net Income approach the value of the firm is calculated as: V=S+BWhere,V= Value of Firm.S= Market value of Equity.B= market value of Debt. Market value of equity = NI/ke, where, NI = Earnigs availabe for equityshareholders; ke = cost of equity or equity capitalisation rateOverall cost of capital (Ko) = EBIT/V2. Net Operating Income (NOI) Approach This approach has also been suggested by Durand. According to this approachthe market value of the firm is not affected by the change in capital structure. 40
  • 41. Because the market value of the firm is ascertained by capitalising the netoperating income at the overall cost of capital (k), which is considered to beconstant. Assumptions of this approach are: a) The overall cost of capital remains constant for all degrees of debt-equity mix. b) The market capitalises the value of the firm as a whole hence, the split between debt and equity is not relevant. c) The use of debt having low cost increases the risk of equity shareholders, this results in increase in equity capitalisation rate. d) There are no corporate taxes. According to this approach, the Value of the firm is calculated with the helpof the following formula. EBIT (1-Tax rate) Value of Firm (V) = -------- Ko Ko = Overall cost of capitalValue of equity = V - BAccording to NOI Approach, the total value of the firm remains constantirrespective of the debt-equity mix or the degree of leverage.Overall cost of capital (Ko) = Ke (S/V) + Kd (B/V)Whereas Kd= Cost of debt or {Interest rate (1-Tax rate)} eg. 10%(1-0.35) B = Market value of Debt V = Value of firm S=V-B EBIT-1Ke = ------- X 100 V-B 41
  • 42. 3. Modigiliani - Miller Approach This approach is similar to the NOI approach. It also states that the value ofthe firm is independent of its capital structure. Nevertheless, there is a basicdifference the two is that the NOI approach is purely definitional or conceptual. Itdoes not provide operational justification for irrelevance of the capital structure inthe valuation of the firm. Assumptions of MM Theory The MM theory is based on the following assumptions: 1) Perfect capital markets exist where individuals and companies can borrow unlimited amounts at the same rate of interest. 2) There are no taxes or transaction costs. 3) The firms investment schedule and cash flows are assumed constant and perpetual. 4) Firms exist with the same business or systematic risk at different levels of gearing. 5) The stock markets are perfectly competitive. 6) Investors are rational and expect other investors to behave rationally.a) MM Theory: No taxation.b) MM Theory with Corporate Tax4. Traditional Approach or weighted average cost of capital (WACC)The traditional approach or intermediate approach is a mid-way between the twoapproaches. It partly contains features of both the approaches as given below:a) The traditional approach is similar to NI Approach to the extent that it accepts that the capital structure or leverage of the firm affects the cost of capital and 42
  • 43. its valuation. However, it does not subscribe to the NI approach that the value of the firm will necessarily increase with all degree of leverages.b) It subscribes to the NOI approach that beyond a certain degree of leverage, the overall cost of capital increases resulting in decrease in the total value of the firm. However, it differs from NOI approach in the sense that the overall cost of capital will not remain constant for all degree of leverage. According to Traditional approach the firm through judicious use of debt-equity mix can increase its total value and thereby reduce its overall cost ofcapital. This is because debt is relatively cheaper source of funds as compared toraising money through shares because of tax advantage. However, beyond a pointraising of funds through debt may become a financial risk and would result in ahigher equity capitalisation rate. Traditionally, optimal capital structure is assumed at a point where weightedaverage cost of capital (WACC) is minimum. For a project evaluation, this WACC isconsidered as the minimum rate of return required from project to pay-off theexpected return of the investors and as such WACC or Composite cost of capital isgenerally referred to as the required rate of return. It is calculated as follows: WACC = (Cost of Equity X % Equity) + (Cost of debt X % debt)---------------------------------------------------------------7.2 PLANNING THE CAPITAL STRUCTURE------------------------------------------------------------- Determining the capital mix and also the estimation of capital requirementsfor current and future need of a firm are very important for a firm. Equity capitaland debt are the two principle sources of finance of a business. But it should be inwhat proportion? How much of financial leverage a firm should employ? Are thetwo important questions comes before finance manager. The relationship betweenfinancial leverage and cost of capital will answer this question. 43
  • 44. The capital structure planning, which aims at the maximisation of profits andthe wealth of the shareholders, ensures the maximum value of a firm or theminimum cost of capital. It is very difficult for a finance manager to determine theproper mix of debt and equity for his firm. The financial manager must try to reachas near as possible of the optimum point of debt and equity mix.----------------------------------------------------------------7.3 ESSENTIAL FEATURES OF A SOUND CAPITAL MIX---------------------------------------------------------------- The following are the essential features of a sound capital mix.1. Maximum possible use of leverage.2. The capital structure should be flexible.3. The use of debt should be within the capacity of a firm.4. It should involve minimum possible risk of loss of control.5. It must avoid undue restrictions in agreement of debt.---------------------------------------------------------------UNIT 8 PROBLEMS ON COST STRUCTURE THEORIES--------------------------------------------------------Objective• To familiarise about various cost structure theories for practical applicationsUnit outline8.1 Problems on Cost Structure Theories 44
  • 45. ---------------------------------------------------------------------------8.1 PROBLEMS ON COST STRUCTURE THEORIES-----------------------------------------------------------------------------------------------1. Companies P and Q are identical in all respects including risk factors except for debt / equity, P having issued 10% debentures of Rs, 9 lakhs while Q has issued only equity. Bothe the companies earn 20% before interest and taxes on their total assets of Rs. 15 lakhs. Assuming tax rate of 50% and capitalisation rate of 15% for an all-equitycompany, compute the value of companies P and Q using (a) net income approachand (b) net operating income approach.Particulars P QEBIT (@ 20% on Rs. 15 lakhs) 3,00,000 3,00,000Less : Interest 90,000 - ------------ -------------EBT 2,10,000 3,00,000Less : Tax @ 50% 1.05,000 1,50,000 ------------ ------------Earnings after Tax (EAT) 1,05,000 1,50,000(a) Valuation of company under Net Income ApproachCalculation of value of EquityValue of Equity (capitalised @ 15%)P = (1,05,000 x 100 / 15) = 7,00,000 Q = (1,50,000 x 100 / 15) =10,00,000Value of Debt P = 9,00,000, Q = 0Value of Company = S + DP = 7,00,000 + 9,00,000 = 16,00,000Q = 10,00,000 + 0 = 10,00,000(b) Valuation of companies under Net Operating Income Approach EBIT (1 - T) V= -------- K 45
  • 46. Value of equity (S) = V - BCompany P EBIT (1 - T) V (value of equity) = -------- K 3,00,000 (1 - 0.50) V= ---------------------- = 10,00,000 0.15 Value of Debt = (9,00,000 x 1 - 0.5) = 4,50,000 Value of Equity (S) = V - B = 10,00,000 - 4,50,000 = 5,50,000 Add value of Debt = 9,00,000 ------------------ Value of company 14,50,000 -----------------Company Q EBIT (1 - T) V= -------- K 3,00,000 (1 - 0.50) V = ---------------------- = 10,00,000 0.15 Value of Equity (S) = V - B = 10,00,000 Value of Debt = - ---------------- Value of company 10,00,000 ---------------2. The following information is available regarding the two firms A and B which are identical in all respects except the degree of leverage. Firm A has 6% debt of Rs 6 lakhs while firm B has no debt. Both the firms are earning an EBT of Rs 2,40,000 each. The equity capitalization rte is 10% and the corporate tax is 60%. Compute the value of the two firms on MM Model.SolutionValue of unlevered firm B 46
  • 47. Vu = EBT (1 - T) / ke = 2,40,000 (1-0.6) / 10% = 96,000 / 0.10 = 9,60,000Value of levered firm AVi = Vu + Bt = 9,60,000 + 6,00,000 (0.6) = 9,60,000 + 3,60,000 = Rs. 13,20,0003. The values for two firms X and Y in accordance with the traditional theory are given below: X YExpected operating income Rs. 50,000 Rs. 50,000Total cost of debt 0 10,000Net Income 50,000 40,000Cost of equity (ke) 0.10 0.11Market value of shares (s) 5,00,000 3,60,000Market value of debt 0 2,00,000Total value of the firm 5,00,000 5,60,000Average cost of capital (ke) 0.10 (0.09)Debt equity ratio 0 0.556 Compute the values for firms X and Y as per the MM theses. Assume that (i) Corporate income taxes do not exist, and 47
  • 48. (ii) The equilibrium value of ke is 12.5% Solution: COMPUTATION OF THE VALUES OF FIRMS Company X Company Y Rs. Rs.Expected net operating income ¯x 50,000 50,000Less: cost of debt (D) 0 10,000 ------------ ----------Net income for equity 50,000 40,000 ---------- ---------Equilibrium cost of capital (ko) 0.125 0.125Total value of company (V)= ¯x / ko 4,00,000 4,00,000Market value of debt (B) - 2,00,000Market value of equity (V - B) 4,00,000 2,00,000Cost of equity (ke) = ¯x - D/ s 12.5% 20% 4. In considering the most desirable capital structure of a company, the following estimates of the cost of Debt and Equity capital (after Tax) have been made at various levels of Debt-Equity Mix: Debt as % of total Cost of Debt Cost of Equity capital employed (%) (%) 0 5.0 12.0 10 5.0 12.0 20 5.0 12.5 30 5.5 13.0 40 6.0 14.0 50 6.5 16.0 60 7.0 20.0 48
  • 49. Calculate the optimal Debt-Equity Mix for the company by calculating compositecost of capital.Solution:Calculation of Optimal Debt-Equity MixDebt as % of Cost of Cost of WACCtotal capital Debt Equityemployed (%) (%)0 5.0 12.0 (5 x 0 ) + (12 x 1.00) = 12.0010 5.0 12.0 (5 x 0.10) + (12 x 0.90) = 11.3020 5.0 12.5 (5 x 0.20 ) + (12 x 0.80) = 11.0030 5.5 13.0 (5.5 x 0.30 ) + (13 x 0.70) = 10.7540 6.0 14.0 (6 x 0.40 ) + (14 x 0.60) = 10.8050 6.5 16.0 (6.5 x 0.50 ) + (16 x 0.50) = 11.2560 7.0 20.0 (7 x 0.60 ) + (20 x 0.40) = 12.20At optimum debt-equity mix 30: 70, the WACC is at minimum level of 10.75%.-------------------------------------------------------UNIT 9 COST OF CAPITAL-----------------------------------------------------Objectives• To familiarise about the cost of capital• To incorporate the importance of cost of capital in business financial decisions.Unit outline9.1 Meaning9.2 Significance or Importance of Cost of Capital9.3 COMPUTATION OF COST OF CAPITAL 49
  • 50. A. Computation of specific cost of capital---------------------------------------------------------------9.1 MEANING OF COST OF CAPITAL-------------------------------------------------------------- The main goal of business firm is to maximise the wealth of shareholders inthe long-run, the management should only invest in projects which give a return inexcess of cost of funds invested in the projects of the business. The term cost ofcapital refers to the minimum rate of return a firm must earn on its investments sothat the market value of the company equity shares does not fall. This is intendedto achieve the objective of wealth maximisation. This is possible when the firmearns a return on the projects financed by equity shareholders funds at a ratewhich is at least equal to the rate of return expected by them. The cost of capital is the rate of return the company has to pay to varioussuppliers of funds in the company. According to Solomon Ezra, "Cost of capital is the minimum required rate ofearnings or the cut-off rate of capital expenditures." Hampton, John J. defines cost of capital as the rate of return the firmrequires from investment in order to increase the value of the firm in the marketplace". Thus, we can say that cost of capital is that minimum rate of return which afirm, must and, is expected to earn on its investments so as to maintain themarket value of its shares.-------------------------------------------------------------------------------9.2 SIGNIFICANCE OR IMPORTANCE OF COST OF CAPITAL--------------------------------------------------------------------------- The determination of cost of capital of a firm is important to themanagement to take some financial decisions like: 50
  • 51. a) Capital Budgeting decisions. In capital budgeting decisions, the cost of capital is often used as a discount rate on the basis of which the firms future cash flows are discounted to find out their present values.b) Capital structure decisions. The cost of capital is an important consideration in capital structure decisions. The finance manager must raise capital from different sources in a way that it optimises the risk and cost factors.c) Basis for evaluating the financial performance. The actual profitability of the project is compared to the projected overall cost of capital and the actual cost of capital of funds raised to finance the project. if the actual profitability of the project is more than the projected and the actual cost of capital, the performance may be said to be satisfactory.d) Basis for taking other financial decisions. The cost of capital is also used in making other financial decisions such as dividend policy, capitalisation of profits, making the right issue and working capital.------------------------------------------------------------------------9.3 COMPUTATION OF COST OF CAPITAL--------------------------------------------------------------------------B. Computation of specific cost of capitalComputation of specific cost of various sources of finance viz., debt, preferenceshare capital, equity share capital and retained earnings is discussed as below:1. Cost of Debt (Kd). The cost of debt is the rate of interest payable on debt. The interest paid on debts will have tax benefits i.e., tax is paid on the profits after allowing debenture interest.a) Cost of Irredeemable Debentures: I (1 - t) Kd = ---------- NP Where, I = Annual interest T = Companies tax rate 51
  • 52. NP = Net proceeds of loans or debenturesIn case of debt is raised at premium or discount, we should consider P as theamount of net proceeds received from the issue and not the face value ofsecurities. The formula is I Kd = ---------- NPIn case of underwriting commission (UC) paid if any is deducted from NP (UC isalways calculated at par value. Maximum permissible limit is 2.5%).2. Cost of Preference shares a) Irredeemable Preference shares Kp = PD / NP b) Redeemable Preference shares PD + RV-NP --------- n Kp = ------------------------- RV + NP ----------- 2Where PD is preference dividendDividend paid on preference shares is an appropriation of profit and hence is doesnot get tax benefit.Any premium or discount on issue of shares is to be adjusted with net proceeds.Underwriting paid if any is also deducted from the net proceeds (Max. permissiblelimit 5% calculated on par value)Note: there is no difference in calculation of Kp whether to be calculated beforetax or after tax because it doesnt get tax benefit.3. Cost of Equity 52
  • 53. Cost of equity is assumed to be nil because of the following reasons: a) There is no fixed rate of dividend paid to equity shareholders. b) There is no legal binding for declaring dividends to equity shareholders. The following are the approaches to cost of equity: a) Dividend price approach (DP approach) The rate of dividend expected by the equity shareholders is considered as cost of equity. b) Earning price approach Ke = Dividend / Market Price x 100 c) DP + Growth approach Ke = Dividend / Market Price x 100 + Growth Rate d) Realised Yield approach (past) Ke = Dividend / Market Price x 100 + Growth Rate Note: Dividend MP = --------- Ke - GR There is no tax effect and always it is irredeemable.4. Weighted Average Cost of Capital (WACC) It refers to overall cost of capital after taking into consideration the weights of each source of capital. Weights can be of two types: a) Weights assumed on face value (book price) b) Weights assumed on market price.----------------------------------------------------------------UNIT 10 PROBLEMS ON COST OF CAPITAL 53
  • 54. ----------------------------------------------------------------Objective• To study the costs of various sources of capital for better selection of source on the basis of cost of capital.Chapter outline10.1 Problems on cost of capital---------------------------------------------------------------10.1 PROBLEMS ON COST OF CAPITAL-------------------------------------------------------------I Cost of DebtProblems1. A company issues Rs. 10,00,000 16% debentures of Rs. 100 each. The company is in 35% tax rate. You are required to calculate the cost of debt after tax if debentures are issued at (i) Par (ii) 10% Discount (iii) 10% Premium (iv) If brokerage is paid at 2% what will be the cost of debenture if issued at par. (v) Calculate Kd before tax for (iv) above.Solution I (1 - t) 1,60,000 (1 -0.35) 54
  • 55. (i) Kd (at Par) = ---------- = --------------------- = 10.4% NP 10,00,000 1,60,000 (1 - 0.35) (ii)Kd (at Discount) = ---------------------- = 11.56% 9,00,0000 1,60,0000 (1 - 0.35) (iii) Kd (at Premium) = ----------------------- = 9.45% 11,00,000 1,60,0000 (1 - 0.35) (iv) Kd (Brokerage at 2%) = -------------------------= 10.61% 10,00,000 - 20,000 I 1,60,000 (v) Kd (before tax) = ------ = ---------------------= 16.33% NP 10,00,000 - 20,000b) Cost of Redeemable debentures Formula I (1 - t) + (RV - NP) ------------ n Kd = ----------------------------------- X 100 (RV + NP) ------------ 2 Where, RV = Redemption value n = number of years2. A 7 year Rs 100 debenture is available at a net cost of Rs 95. The coupon rate is 15% and the bond will be redeemed at a premium of 6% on maturity. The firms tax rate is 40%. Calculate the cost of debenture.Solution I (1 - t) + (RV - NP) ------------ n Kd = ----------------------------------- X 100 55
  • 56. (RV + NP) ------------ 2 15 (1 - 0.4) + (106 - 95) ------------ 7 Kd = ------------------------------- X 100 = 10.52% (106 + 95) ------------- 23. A 10% Rs. 1,000 par bond of 10 years sold at Rs. 950 and underwriting commission 5%. Calculate cost of debt. a) Before tax , and b) After tax Solution Calculation of Net proceeds: Par value Rs 1,000 (-) Discount 50 ----------- 950 (-) Underwriting commission on 1,000 at 5% 50 ---------- Net proceeds 900 a) Before tax I + (RV - NP) ------------ n Kd = ----------------------------------- X 100 (RV + NP) ------------ 2 100 + (1000 - 900) ------------ 10 Kd = ------------------------- X 100 = 11.58% (1000 + 900) 56
  • 57. ------------- 2b) After tax I (1 - t) + (RV - NP) ------------ n Kd = ----------------------- X 100 (RV + NP) ------------ 2 100 (1 - 0.35) + (1000 - 900) ------------ 10 Kd = ------------------------------- X 100 = 7.9% (1000+ 900) ------------- 24. ABC Ltd., issues 2 sets of debentures. One at discount at 10% and the other at a premium of 15% respectively. Series 1: 12%, 1,000 debentures of Rs 100 each. Series 2 : 7 ½ % 1000 debentures of Rs 10 each. Series 2 was redeemed after a period of 8 years at a premium of 15%.Underwriting commission is paid on both the series as per the maximum limitsspecified under companys act. Calculate Kd after tax and before tax for both theseries.SolutionSeries 1: I (1 -t) 12,000 (1 -0.35)a) Kd = --------- = --------------------- x 100 = 8.91% NP 87,500 57
  • 58. Calculation of N P:Par value 1,00,000(-) Discount 10,000 ---------- 90,000(-) UnderwritingCommission @ 2.5% 2,500(1,00,000 x 2.5%) ----------- Rs. 87,500 -----------------b) Kd = I/Np = 12,000 / 87,500 x 100 = 13.71%Series 2:Calculation of NP:Par value 1,000(+) Premium 150 ------ 1,150(-) UnderwritingCommission 25 ------ 1,125 I (1 - t) + (RV - NP) ------------ n a) Kd = ----------------------------------- X 100 (RV + NP) ------------ 2 75 (1 - 0.35) + (1,150 - 1,125) ------------ 8 Kd = ----------------------------------- X 100 (1,150 - 1,125) ------------ 2 = 4.56 % 58
  • 59. I + (RV - NP) ------------ n b) Kd = ----------------------------------- X 100 (RV + NP) ------------ 2 75 + (1,150 - 1,125) ------------ 8 Kd = ----------------------------------- X 100 = 6.87 % (1,150 - 1,125) ------------ 2-------------------------------------------------------------------------------UNIT 11 PROBLEMS OF COST OF PREFERENCE SHARES----------------------------------------------------------------Unit Outline Problems of Cost of Preference shares a) Irredeemable Preference shares Kp = PD / NP b) Redeemable Preference shares PD + RV-NP --------- n Kp = ------------------------- RV + NP ----------- 2 c) Problems on Cost of Equity Approaches to the cost of equity: 59
  • 60. Dividend price approach (DP approach) Earning price approach Ke = Dividend / Market Price x 100 e) DP + Growth approach Ke = Dividend / Market Price x 100 + Growth Rate f) Realised Yield approach (past) Ke = Dividend / Market Price x 100 + Growth Rate Note: Dividend MP = --------- Ke - GR There is no tax effect and always it is irredeemable.1. Assuming that the firms tax rate is 50% compute after tax cost and before tax Cost of preference shares in the following cases:a) 9 % Preference shares sold at par.b) A Company issues 14% irredeemable preference shares, the face value of share is Rs. 100 but the issue price is Rs 95. What is the cost of Preference shares? What is the cost if the issue price is Rs 105?c) A Company Preference shares sold at Rs 100 with a 10% dividend and redemption Rs 112 if the company redeems within 5 years.Solution:a) Kp = PD / NP = 9 / 100 = 9%b) i) Kp = PD / NP = 14 / 95 = 14.74% ii) Kp = PD / NP = 14 / 105 = 13.33% PD + RV-NP --------- n 60
  • 61. c) Kp = ------------------------- x 100 RV + NP ----------- 2 10 + 112- 100 --------------- 5 Kp = ------------------------- x 100 = 11.7 % 112 + 100 ----------- 2Cost of equity shares (Ke) A companies share is quoted in market at Rs 40 currently. A company pays adividend of Rs 2 per share and investors expects a growth rate of 10% computea) The Companies cost of equity capital.b) If anticipated growth rate is 11% p.a. Calculate the indicated growth market price per share.c) If companies cost of capital is 16% and anticipated growth rate is 10% p.a. Calculate the market price if dividend of Ts 2 per share is to be maintained.Solution:a) Ke = D/MP x 100 + GR = 2 / 40 x 100 + 10% = 15 %b) MP = D /Ke% - GR% = 2 / 15% - 11% = 2 / 4% = Rs. 50.c) MP = 2 / 16 - 10 = 2 / 6% = Rs. 33.33%---------------------------------------------------------------- 61
  • 62. Unit 12 Problems on Weighted Average cost of Capital (WACC)---------------------------------------------------------------- Unit outline • Problems on Weighted Average cost of Capital (WACC) 1. Calculate WACC of A Ltd. From the following information: Sources Capital Cost of capital Debt 4,00,000 14% Equity share 6,00,000 20% Assume corporate tax rate as 35%. Solution: Method 1: Sources Capital Weights Cost of capital WACC Debt 4,00,000 0.4 0.091 0.0364 Equity 6,00,000 0.6 0.2 0.12 ------------- ---------- 10,00,000 0.1564 ------------- ---------- WACC = 0.1564 x 100 = 15.64% Method 2: Sources Capital Cost of capital Total cost of capital Debt 4,00,000 9.1% 36,400 62
  • 63. Equity 6,00,000 20% 1,20,000 ----------- ---------- 10,00,000 1,56,000 ------------- ------------- WACC = 1,56,400 / 10,00,000 x 100 = 15.64% Working Notes: Cost of capital: Debt = 14 x 0.65 (after tax) = 0.091 because it gets taxbenefit.2. Z Ltd, Y Ltd, and X Ltd., are in the same type of business and hence havesimilar operating risks. However the capital str5ucture of each of them is differentand the following are the details.Particulars X Ltd. Y Ltd. Z Ltd.Equity share capital:(Face value Rs. 10 / share 5,00,000 2,50,000 4,00,000Market Value per share Rs. 12 20 15Dividend per share 2.88 4 2.7Debentures(Face value Rs.100) 2,50,000 1,00,000Market valueper debenture Rs 80 125Interest rate 8% 10% Assume that the current level of dividends are generally expected tocontinue indefinitely and the income tax rate is at 50%. You are required tocompute the WACC of each of the company.Solution:Cost of equity: Formula Ke = D / M x 100 63
  • 64. X ltd, Y ltd, Z ltd, 2.88 /12 x 100 4 / 20 x 100 2.7 / 15 x 100 = 24% = 20% = 18%Cost of Debt:FormulaKd = I (1 - T) / MPX ltd, Y ltd, Z ltd,8 (1 - 0.5) /80 10 (1 - 0.5) / 125 0% = 5% = 4% Sources Capital Cost of capital Total COC WACCX: Debt 2,50,000 5% 12,500 1,32,500 ---------- x 100 Equity 5,00,000 24% 1,20,000 7,50,000 ----------- ------------- 7,50,000 1,32,500 = 17.67% ----------- -------------Y: Debt 1,00,000 4% 4,000 54,000 --------- x 100 Equity 2,50,000 20% 50,000 3,50,000 ------------ ---------- 3,50,000 54,000 = 15.43% ----------- ---------Z: Debt --- 0% --- 72,000 -------- x 100 Equity 4,00,000 18% 72,000 4,00,000 ---------- --------- 4,00,000 72,000 = 18% ---------- --------On Face value:X Ltd., Ke = 2.88 /10 x100 = 28.8 %Y Ltd., Ke = 4 /10 x100 = 40%Z ltd., Ke = 2.7/10 x100 =27% 64
  • 65. X ltd., Kd = I (1 - t) / FV = 8 (1 -0.5) / 100 = 4%Y Ltd., Kd = 10 (1- 0.05)/100 = 5%. Sources Capital Cost of capital Total COC WACCX: Debt 2,50,000 4% 10,000 1,54,000 ---------- x 100 Equity 5,00,000 28.8% 1,44,000 7,50,000 ----------- ------------- 7,50,000 1,54,000 = 20.53% ----------- -------------Y: Debt 1,00,000 5% 5,000 1,05,000 --------- x 100 Equity 2,50,000 40% 1,00,000 3,50,000 ------------ ---------- 3,50,000 1,05,000 = 30% ----------- ---------Z: Debt --- 0% --- 1,08,000 -------- x 100 Equity 4,00,000 27% 1,08,000 4,00,000 ---------- --------- 4,00,000 1,08,000 = 27% ---------- -------- ------------------------------------------------------------- Unit 13 Problems on Marginal cost of capital ------------------------------------------------------------- Chapter Outline • Problems on Marginal cost of capital Marginal cost of capital 65
  • 66. The cost of rising additional finance over and above the existing requirement is called as marginal cost of capital.1. XYZ Company provides you with the following information: Sources Amount after tax COC Equity 2,00,000 12% Debentures 2,00,000 4% The company is considering an investment proposal requiring an additional investment of Rs. 1,00,000. It has taken decision to finance this amount by taking a loan from financial institution at a cost of 10% presuming the corporate tax rate at 50%. Find out: a. Marginal cost of capital b. WACC before additional financing c. WACC after additional financing d. What will be WACC if the additional amount of debt of 1,00,000 is raised proportionately from equity and debt at the existing specific cost. Solution: a. MCC = I (1-t) / NP = 10 (1.05) /100 = 5% b. WACC (before AF) Sources Capital Cost of capital Total COC WACC Debt 2,00,000 12% 24,000 32,000 ---------- x 100 Equity 2,00,000 4% 8,000 4,00,000 ----------- ------------- 4,00,000 32,000 =8% ----------- ------------- c. WACC (after AF) Sources Capital Cost of capital Total COC WACC Debt 2,00,000 12% 24,000 37,000 ---------- x 100 Equity 2,00,000 4% 8,000 5,00,000 66
  • 67. AF 1,00,000 5% 5,000 ------------ ---------- 5,00,000 37,000 = 7.4 % ----------- ----------d. WACCSources Capital Cost of capital Total COC WACCExisting Equity 2,00,000 12% 24,000Additional Equity 50,000 12 % 6,000 40,000 -------- x 100 5,00,000Existing Debt 2,00,000 4% 8,000Additional Debt 50,000 4% 2,000 = 8% ---------- --------- 5,00,000 40,000 ---------- ---------2. The cost of specific sources of capital for Bharath Nigam ltd., are:Rate of equity (re) : 16 %Rate of Pref. Shares (rp): 14%Rate of debt (rd) : 12% The market value proportions of equity, preference and debt are:-E/V (Equity value) = 0.6P/V (Pref. Value) = 0.05D/V (Debt value) = 0.35 The corporate tax rate is 30%. Calculate WACC of Bharath Nigam ltd.,Solution:Sources COC Weights WACCKe 0.16 0.6 0.096Kp 0.14 0.05 0.007 67
  • 68. Kd 0.084 0.35 0.029 (12 x 70%) Total 0.1322 WACC = 13.22 % Module 2----------------------------------------------------------------UNIT 1 SOURCES OF LONG-TERM FINANCE---------------------------------------------------------------- Objectives• To give an insight into the various long-term finance sources• To get in depth idea of various sources of long-term and what is its relative advantages and disadvantages.• To give more input to decide which are the better source for long-term source of capital.Unit outline2.1 introduction2.2 Classification of capital of a business organisation2.3 Various sources of long-term capital• Ownership securities or Capital Stock 68
  • 69. • Creditorship securities or Debt Capital• Hybrid Financing/Instruments2.4 Kinds of Ownership securities or Shares are.1. Equity Shares2. Preference Shares3. Deferred Shares4. No par Stock/Shares5. Shares with differential Rights6. Sweat Equity----------------------------------------------------------------INTRODUCTION---------------------------------------------------------------- In the day today business, finance is required by the business organisationsirrespective of it is big, medium or small for its operations and to achieve itsobjectives. Without adequate finance, the business enterprise cannot accomplishits objectives. Capital required for a business enterprise can be classified under two maincategories viz., 1. Fixed Capital, and 2. Working Capital. Long-term funds arerequired to create production facilities by purchasing fixed assets like land,building, plant, furniture, machinery etc., any investment of funds on these isblocked up on a permanent basis hence it is called fixed capital. Funds arerequired for short-term purposes for the purchase of raw materials, payment ofwages and other day-to-day expenses. These funds are known as working capital.--------------------------------------------------------------------------- THEVARIOUS SOURCES OF RAISING LONG-TERM CAPITAL 69
  • 70. ---------------------------------------------------------------------------• Ownership securities or Capital Stock• Creditorship securities or Debt Capital• Hybrid Financing/InstrumentsA. Ownership securities It is known as Capital Stock represents shares. Companies issue differenttypes of shares to mobilise funds from various investors. The Companies Act of1956 has limited the type of shares are issued from Preference Shares, OrdinaryShares, and Deferred Shares to only two types of Share like Preference shares andEquity Shares.-------------------------------------------------------------------------------KINDS OFOWNERSHIP SECURITIES OR SHARES---------------------------------------------------------------------------1. Equity Shares2. Preference Shares3. Deferred Shares4. No par Stock/Shares5. Shares with differential Rights6. Sweat Equity1. Equity Shares Equity shares are also known as Ordinary shares. It represents the owners capital in a company. These equity shareholders are the real owners of the 70
  • 71. company. They have the voting right and they have control over the working ofthe company. Equity shareholders do not have preference in paying dividend ofthe company. They are eligible for dividend only when the company earns profitand after paying dividend to the preference shareholders. These shareholdersdo not have any preferential rights over the dividend and also capital of thecompany when it is liquidated. Characteristics of Equity shareholders a) Maturity period: The equity capital is a permanent source of capital it is paid back only when the company is liquidated and after paying all the claims and preference capital. It does not have maturity period. b) Claims or Right to Income. They equity shareholders are paid the earnings only after paying dividend to the preference shares. c) Claim on Assets. Equity shareholders have a residual right over the assets of the company. Equity shareholders can get back their capital invested in a company after making payment to the creditors of the company, preference shareholders and if there is any amount left out after realisation of the assets the remaining amount is paid to the equity shareholders. d) Voting Rights: Equity shareholders are the real owners of the company hence they enjoy the voting rights in effective control of the working of the company. e) Limited liability: Equity shareholders will have limited liability in the company. if the company is running under the loss and liquidated then the shareholders are liable to the extent of paid up capital of the company. f) Pre-emptive Right: shares offered to existing shareholders are called Right Shares and their prior right to such is known as pre-emptive right. 71
  • 72. The shareholders will enjoy this right as per the provisions of the Companies Act of 1956.2. Preference shares Preference shares are those which have preferential rights over the dividend and preference capital of the company at the time of liquidation. These shareholders enjoy the preference of payment of dividend. The equity shareholders will get dividend only after the payment of dividend to the preference shareholders similarly the preference share capital is paid back to them prior to the payment of capital of equity shareholders but only after paying the creditors of the company when it is liquidated. These shareholders are not the owners of the company, hence they do not enjoy the right to vote and any say in the working of the company. They are eligible for fixed dividend even though company earns less profit or incurs loss. Types of preference shares Following are the types of preference shares a) Cumulative Preference Shares: If the company do not earn profits its dividend is cumulated till the company earn profit and it is paid to the preference share holders when the company earns profit. b) Non-Cumulative Preference Shares: Normally these preference shareholders do not have any claim over the arrears of dividend during the period of incurring loss by the company. c) Redeemable Preference Shares: Preference capital is also a permanent capital of the company hence it is paid back only if the company is liquidated. But in the case of redeemable preference shares, if the articles of 72
  • 73. association permit the company can pay back the capital before liquidation out of profits or from fresh issue of capital. d) Irredeemable Preference shares: These preference shares cannot be redeemed during the lifetime of the company unless it is liquidated. e) Participating Preference Shares: These preference shares get their fixed rate of dividend out of the profits of the company and also have the right to participate in the surplus profits of the company. f) Non-Participating Preference Shares: These preference shares get only their fixed rate of dividend and they do not participate in the profits of the company. g) Convertible Preference Shares: These preference shares have the right to convert in to equity shares after a fixed period, if articles of association permit. h) Non-Convertible Preference Shares: These shares do not enjoy the benefit of converting in to equity shares forever.3. Deferred Shares These are the shares issued to the promoters or founders for rendering theservice at the time of formation of a company. These shares do not enjoy anypreference over the equity shareholders in payment of dividend and return ofcapital. Since their dividend payment can be deferred or postponed they are calleddeferred shares. The issue of these shares by the public limited or its subsidiariesis not allowed under the Companies Act of 1956.4. No Par Stock/Shares No par stock refers to shares which do not have face value. The companiesthat are issuing such shares are dividend into a number of specified shares without 73
  • 74. any specific denomination. In the share certificate of the company it simplymentions the number of shares held by its owner without mentioning any facevalue. The value of a share can be determined by dividing the real net worth of thecompany with the total number of shares of the company. The dividend on suchshare is paid not on the basis of face value but it is paid per share.5. Shares with differential rights Shares with differential rights refers to issued of shares with differentialrights as to voting, dividend or other wise subject to fulfillment of the conditionslaid down at the time of issue of such equity shares, as per the Companies Act(Issue of Share Capital with Differential Voting Rights) Rules, 2001. This conceptof differential rights is new to the Indian corporates and it will require experienceto ascertain its effectiveness.6. Sweat Equity It means if the equity shares issued by a company to its employees ordirectors at a discount or for consideration other than cash for providing know-howor making available rights in the nature of intellectual property rights (like patentsor copyright) or value additions. Section 79A of the companies Act, 1956 (insertedwith effect from 31st October 1998) allows companies to issued sweat sharessubject to some conditions in the Act.----------------------------------------------------------------Unit 2 CREDITORSHIP SECURITIES---------------------------------------------------------------------------• To determine which are the creditorship securities 74
  • 75. • To study relative merits and demerits of each of them• To know about new creditorship instruments available in the marketUnit outline2.2.1 CREDITORSHIP SECURITIESDebentures or Bonds• Types of debentures2.2.2 Hybrid Financing/Instruments• Preference share capital• Convertible debentures/bonds• Warrants and• Options2.2.3 Forms of options.• Rights,• Warrants, and• Calls and putsEURO IssuesGlobal Depository Receipts (GDRs)Foreign Currency Convertible Bonds (FCCBs)American Depository Receipts (ADRs)-------------------------------------------------------------------2.2.1 CREDITORSHIP SECURITIES--------------------------------------------------------------------------- 75
  • 76. The term Creditorship securities also know as debt capital representsdebentures and bonds. These instruments of finance occupy a very important rolein the financial plan of the company.1. Debentures or Bonds The company can raise its long-term loans through issue of Debentures orbonds. A debenture is an acknowledgment of a debt. Issued by a company underits common seal assuring them for the payment of a principal sum at a specifieddate and till that at fixed rate of interest per cent is paid and it may or may nothold any charge on the assets of the company. A debenture holder is a creditor ofa company. A fixed rate of interest is paid on debentures.Types of DebenturesDebentures may be of the following types:a) Bearer Debentures: These debentures are easily transferable like negotiable instruments. The bearer of this debentures will become lawful owner of the by good faith the coupons of interest are attached to the debentures, he can get interest from the companys bank it becomes due.b) Simple, Naked or Unsecured Debentures: These debentures are not given any security on assets of the company. They have no priority as compared to other creditors. They are treated along with unsecured creditors at the time of winding up of the company.c) Secured or Mortgaged Debentures: The debenture will have security over the assets of the company. In case of default in payment of interest or principal amount the debenture holders can realise the assets in order to satisfy their claims.d) Registered Debentures: These are debentures which are payable to the registered holders i.e., the persons whose names are appear in the register of 76
  • 77. debenture holders. These debentures are transferred in the same way as shares.e) Perpetual or Irredeemable Debentures: The debentures whose principal amount is paid only at the time of winding up or any happening of the contingency or expiry of a long period of time.f) Redeemable Debentures: these debentures are issued for a specified period of time. On the expiry of that specified time the company has the right to pay back the debenture holders out of the assets mortgaged. Generally the debentures are redeemable.g) Convertible Debentures: These debentures have option to get convert into a equity share after a lapse of a specified period if the articles of association of the company permits.h) Zero Interest Bonds/Debentures: On these zero interest bonds interest is not paid, this loss of interest is compensated by converting these bonds in to equity shares after a specific period of time.i) Zero Coupon Bonds: these bonds do not carry any interest but it is sold by the issuing company at deep discount from its eventual maturity value. The difference between the issue price and the maturity value represents the gain or interest earned by its investor.-------------------------------------------------------------------------------HybridFinancing/Instruments--------------------------------------------------------------------------- 77
  • 78. As hybrid source of financing has characteristics of both straight debt andstraight equity falling between. The hybrid instruments/sources of financing are i)Preference share capital, ii) Convertible debentures/bonds, iii) Warrants and iv)Options. In this chapter the preference shares were already discussed and alsoconvertible preference share is also as a type of preference share is mentioned.The second one is Convertible Debentures/Bonds.Convertible debentures/bonds Convertible debentures give the debenture-holders the right (option) toconvert them into equity shares on certain terms. The holders are entitled to afixed income till the conversion option is exercised and would share the benefitsassociated with equity shares after the conversion. The convertible debentures presently in India can be of three types: (i)compulsory convertible within 18 months, (ii) optionally convertible within 36months and (iii) convertible after 36 months will call an put features. However,only the first two types are popular.Warrants A warrant entitles its holders to subscribe to the equity capital of a companyduring a specified period at a stated/particular price. Warrant means it is aninstrument that gives its holder the right to purchase a certain number of sharesat a specified price over a certain period of time.Options Option is a derivative security and derives its value from an underlyingsecurity/asset. An option is an instrument that provides to its holders anopportunity to purchase/sell a specified security/asset at a stated price on/beforea specified expiration date. The focus in options is on options related to shares.Thy are traded in India on the NSE and BSE as securities. There are three basicforms of options. 78
  • 79. -------------------------------------------------------------------------------FORMS OFOPTIONS---------------------------------------------------------------------------Rights,• Warrants, and• Calls and putsa) Rights: the option to the shareholders to purchase a specified number of equity shares at a stated price during a given period is called rights. It is a legal right of existing shareholders to be offered by the company in the first opportunity to purchase additional equity shares in proportion to their current holdings.b) Calls and puts: A call option is an option to purchase a specified number of shares on/before a specified future date at stated/strike price. The striking price is the price at which the holder of the option can buy the shares at any time prior to the expiration date of the option. A put option is an option to sell a given number of shares on/before a specified future date at a stated striking price.EURO Issues As a part of new economic policy since 1991-92 India acceptedLiberalisation, Privatisation and Gobalisation has its Industrial policy. Thence thegovernment undertook two major steps-that of allowing Foreign InstitutionalInvestors (FIIs) to invest in the Indian capital market and permitting IndianCompanies to float their stocks in foreign markets. Two primary instruments 79
  • 80. floated by the Indian Companies in international markets are GDRs and ForeignCurrency Convertible Bonds (FCCBs) more commonly known as the Euro Issues. Euro Issued denotes that the Issue is made abroad through instrumentsdenominated in foreign currency and the securities issued are listed on anyoverseas Stock Exchange. Euro issue is a method of mobilising resources requiredby a company in foreign exchange. A Euro Issue is different from foreign issue. Incase of foreign issue issuer is not incorporated in the country in which thesecurities are being issued, but the securities are denominated in the currency ofthe country of issue and are aimed at domestic investors in the country where theissue is made.Global Depository Receipts (GDRs) A GDR is an instrument which allows Indian Corporates, Banks, NBFCs etc.,to raise finds through equity issues abroad to augment their resources fordomestic operations. A GDR is a dollar denominated instrument of a company,traded in stock exchanges outside the country of origin. It represents a certainnumber of underlying equity shares. Though the GDR is quoted and traded indollar terms, the underlying equity shares are denominated in rupees only. Instead of issuing in the names of individual shareholders, the shares areissued by the company to an intermediary called the depository, usually inOverseas Depository Bank in whose name the shares are registered.Foreign Currency Convertible Bonds (FCCBs) Bonds issued in accordance with the scheme and subscribed by a non-resident in foreign currency and convertible into ordinary share of the issuingcompany in any manner either in whole or in part on the basis of only equityrelated warrants attached to debt instrument. The FCCBs are like convertibledebentures issued in India. The Bond has a fixed interest or coupon rate and is 80
  • 81. convertible into certain number of shares at a pre-fixed price. The bonds are listedand traded on one or more stock exchanges abroad.American Depository Receipts (ADRs) A foreign company (eg.,Infosys) might make issue in U S A by issuingsecurities through appointment of Bank as depository. By keeping the securitiesissued by the foreign company, the U S Bank will issue receipts called ADRs to theinvestors. It is a negotiable instrument and also entitled for dividends as and whendeclared. The ADR holder can transfer the instrument as in the case of domesticinstrument and also entitled for dividends as and when declared-------------------------------------------------------------------------------Unit 3 Dividend Policy----------------------------------------------------------------Objective• To give a general idea of Dividend, Dividend policy generally prevailed and nature of dividend decisions.• To study various dividend theories existing and their relative pros and cons.Unit outline 2.1.1 Meaning 2.1.2 Dividend Policy 2.1.3 Nature of Dividend Decision 2.1.4 Theories on Dividend Policies 81
  • 82. The Irrelevance Theory or The Irrelevance Concept of DividendA) Residual Approach andB) Modigliani and Miller approach.The Relevance theory or Relevance concept of Dividend. A) Walters Approach and B) Gordons Approach--------------------------------------------------2.3.1 MEANING OF DIVIDEND---------------------------------------------------------------------------Dividend refers to that part of the profits of a company which id distributedamongst its shareholders. It is the return that a shareholder gets from thecompany for his shareholding, out of its profits. According to the Institute ofChartered Accountants of India, dividend is "a distribution to shareholder out ofprofits or reserves available for this purpose.--------------------------------------------------2.3.2 DIVIDEND POLICY--------------------------------------------------------------------------- The company will not distribute entire profits earned as dividend to itsshareholders, because it needs to provide funds to finance its long-term growth.Hence company will keep some money for its expansion and growth otherwise ithas to depend upon entirely on outside resources like issue of new shares or debt.On the other hand it has to look after the maximization of wealth of its 82
  • 83. shareholders, by declaring more returns to its shareholders. Hence company mustrequire a dividend policy. The term dividend policy refers to the policy concerning quantum of profitsto be distributed as dividend. The concept of dividend policy implies thatcompanies through their Board of Directors evolve a pattern of dividend payments,which has a bearing on future action.--------------------------------------------------2.3.3 NATURE OF DIVIDEND DECISION--------------------------------------------------------------------------- The dividend decision of the firm is very important to the finance manager.This dividend decision will determines the amount of profit to be distributed amongshareholders and the amount of profit to be retained in the business for financingits long-term growth. There is an indirect relationship between between theamount of dividends distributed and retained earnings. Higher the amount ofdividend distribute lower will be the retained earnings. This dividend decision willhave its impact on the value of the firm, since the value of the firm depends onthe dividend decision.--------------------------------------------------2.3.4 THEORIES ON DIVIDEND POLICIES--------------------------------------------------------------------------- There are conflicting theories regarding impact of dividend decision on thevaluation of a firm. According to one school of thought, dividend decision dose notaffects the shareholders wealth and also the valuation of the shares of the firm(Irrelevance theory). According to another school of thought, dividend decisionmaterially affects the shareholders wealth and also the valuation of the firm(Relevance theory). 1. The Irrelevance Theory or The Irrelevance Concept of Dividend 83
  • 84. There are two approaches in the Irrelevance theory they are A) Residual ApproachandB) Modigliani and Miller approach.A) RESIDUAL APPROACHAccording to this approach or theory, dividend decision has no effect on the wealthof the shareholders or the value of the shares, and hence it is irrelevant so far asthe valuation of the firm is concerned. This theory says dividend decision merelyas a part of financing decision because the earnings available may be retained inthe business for re-investment. But if the funds are not required in the businessthey may be distributed as dividends. Thus, the decision to pay dividends or retainthe earnings may be taken as a residual decision. The firm can retain the earningsif it has profitable investment opportunities otherwise it should pay them asdividends.B) MODIGLIANI AND MILLER APPROACH (MM MODEL) Modigliani and Miller have expressed in the most comprehensive manner insupport of the theory of irrelevance. This theory maintain that dividend policy hasno effect on the market price of the shares and the value of the firm is determinedby the earning capacity of the firm or its investment policy. They observed that"under conditions of perfect capital markets, rational investors, absence of taxdiscrimination between dividend income and capital appreciation, given the firmsinvestment policy its dividend policy may have no influence on the market price ofthe shares".Assumptions of MM Hypothesis. MM hypothesis of irrelevance of dividends is based on the followingassumptions1. Capital markets are perfect. 84
  • 85. 2. Investors behave rationally3. They have the knowledge of markets since the Information freely available.4. There are no transaction costs.5. The firm has a fixed investment policy.6. No investor is large enough to influence the market price of shares.7. There are either no taxes or there are no differences in the tax rates applicable to dividends and capital gains.8. Risk or uncertainty does not exist. In other words, investors are able to forecast future prices and dividends with certainty and one discount rate can be used for all securities at all times.Criticism of MM approachMM hypothesis has been criticised on account of various unrealistic assumptions.They are.1. Perfect capital market does not exist in reality.2. Free availability of information is not available to all the investors.3. The firms will incur transaction cost while issuing securities.4. Taxes do exit and there is normally different tax treatment for dividends and capital gains.5. The firms do not follow a rigid investment policy.6. The investors have to pay brokerage, fees, etc, while doing any transaction.7. Single Discount rate for discounting cash flows at different time period in not correct. 2. Relevance theory or Relevance concept of Dividend. This theory of thought advocates that dividend decisions considerably affect the value of the firm. This theory was advocated by Myron Gordon, Jone Linter, James Walter, Richardson. According to them dividend decisions will effect the firms position in the stock market. Higher dividends increase the value of stock 85
  • 86. while low dividends decrease their value. This id because dividendscommunicate information to the investors about the firms profitability. Thereare two theories which advocate this they are.B) Walters Approach and B) Gordons ApproachA) WALTERS APPROACH Prof. James E. Walter strongly supports the doctrine that dividend policyalmost always affects the value of the enterprise. The finance manager can,therefore, use it to maximise the wealth of the equity shareholders. Therelationship between the internal rate of return earned by the firm and its costof capital is very significant in determining the dividend policy to maximise thewealth of the shareholders. Prof. Walters model is base on the relationshipbetween the firms (i) return on investment, i.e. r and (ii) the cost of capital orthe required rate of return, i.e. k. According to Prof. Walter, it r >k, i.e., the firm can earn a higher return thanwhat the shareholders can earn on their investments, the firm should retain theearnings. Such firms are termed as growth firms and the optimum pay-outwould be zero in their case. This would maximise the value of shares. In case of a firm which does not have profitable investment opportunities(i.e., r < k), the optimum dividend policy would be to distribute the entireearnings as dividend. For such firms, the optimum pay-out would be 100 %and the firms should distribute the entire earnings as dividends. In case of firms where r = k, it does not matter whether the firm retains ordistributes its earnings. In their case the value of the firms shares would notfluctuate with change in the dividend rates. There is, therefore, no optimumdividend policy for such firms.Assumptions 86
  • 87. Walters model is based on the following assumptions.1. The investments of the firm are financed through retained earnings only and the firm does not use external sources of funds.2. The internal rate of return (r ) and the cost of capital (k) of the firm are constant.3. Earnings per share and dividend per share do not change while determining the given value.4. The firm has a very long life.According to Walters model the formula to determine the value of a share (E - D) D + r -------- ke P= -------------------- ke D r(E - D)/keor P = ----- + -------------- ke keWhere, p = market price per share D = dividend per share r = internal rate of return E =earnings per share ke = cost of equity capitalCriticisms of Walters ModelThis model also based on the unrealistic assumptions. 87
  • 88. 1. The basic assumption that investments are financed through retained earnings only is seldom true in real would. Firms do raise funds by external financing. 2. The assumption of internal rate of return ( r) will remain con stand does not remain constant. As a matter of fact with increased investments, r also changes. 3. The assumption that k will also remain constant does not also hold good. A firms risk pattern does not always remain constant and as such it is not correct to presume that k will always remain constant. B) GORDONS APPROACH Prof. Gordon has also developed a model on the lines of Prof. Walter suggesting that dividends are relevant and the dividend decision of the firm affects its value. His basis valuation model is based on the following assumptions: 1. The firm is an all equity firm. 2. No external financing is available or used retained earnings represent the only source of financing investment programmes. 3. The rate of return on the firm investment r, is constant. 4. The retention ratio, b, once decided upon is constant. Thus, the growth rate of the firm g = br is also constant.--------------------------------------------------UNIT 4 TYPES OF DIVIDEND POLICY 88
  • 89. ---------------------------------------------------------------------------Objective• To study various dividend policies• To know various factors influencing dividend policy• To highlight the corporate dividend practices in India.Unit outline2.4.1 Types of dividend policy • Constant payout Ratio Policy • Constant Dividend Rate Policy • Multiple Dividend Increase Policy • Regular Dividend plus Extra Dividend Policy • Uniform Cash Dividend plus Bonus Shares Policy2.4.2 Factors Influencing Dividend Policy2.4.3 Corporate dividend practices in India 89
  • 90. --------------------------------------------------UNIT 2.4.1 TYPES OF DIVIDEND POLICY---------------------------------------------------------------------------There are various types of Dividend Policies among them are.1. Constant payout Ratio Policy: This method is known as stability of dividends which means always paying a fixed percentage of the net earnings every year. Under this method, if earnings vary, the amount of dividends also varies from year to year. The dividend policy is entirely based on companys ability to pay, by following a regular practice of retained earnings. A very few firms will select this method, since in most firms, earnings are quite volatile. The relation between Earnings Per Share (EPS) and Dividend PerShare (DPS) under Constant Dividend Payout Ratio Policy2. Constant Dividend Rate Policy: It is a most popular kind of dividend policy in which the payment of dividend is paid at a constant rate, even when earnings vary from year to year, through the maintenance of Dividend Equalisation Reserve. Firms are generally careful to set the dividend at a sustainable level and raise it only when the firm can sustain the higher level and cut dividends in adverse situations. This constant dividend rate policy is possible only when the earnings pattern of the company does not show wide fluctuations. The relation between Earnings Per Share (EPS) and Dividend PerShare (DPS) under Constant Dividend Payout Rate Policy 90
  • 91. 3. Multiple Dividend Increase Policy: some firms follow a policy of very frequent and very small dividend increases to give the illusion of movement and growth. The clear hope behind such a policy is that the market rewards consistent increases.4. Regular Dividend plus Extra Dividend Policy: under this type of dividend policy some firms consciously divide their announced into two portions a regular dividend and an extra dividend. The regular dividend is the dividend that will continue at the announced level, whereas the extra dividend payment will be made as circumstances permit.5. Uniform Cash Dividend plus Bonus Shares Policy: Under this method, a minimum rate of dividend per share is paid in cash plus bonus shares are issued out of accumulated reserves. But the issue of bonus shares is not on annual basis. It depends upon the amount kept in reserves over a period say 3 to 5 years. This policy is usually adopted in case of companies which have fluctuating earnings.--------------------------------------------------UNIT 5 FACTORS INFLUENCING DIVIDEND POLICY---------------------------------------------------------------------------OBJECTIVES 1. To know various factors influencing dividend policy 91
  • 92. CHAPTER OUTLINE • various factors influencing dividend policy Though there is difference of opinion that the dividend policy will have itsimpact on the value of the firms equity shares in the stock market, it is evidentthat the dividend policies do have a significant effect on the value of the firmsequity share in the stock market. But there is no uniform dividend policy becausethe different firms at different times follow different dividend policy. The followingare the important general factors applicable to individual firms, which determinethe dividend policy of a firm.1. Legal Restrictions: The company may also be legally restricted from declaring and paying dividends. Legal provisions relating to dividends as laid down in sections 93, 205, 205A, 206 and 207 of the Companies Act, 1956 are significant because they lay down a frame work within which dividend policy is formulated. These provisions require that dividend can be paid only out of current profits, past profits or moneys provided by the Central or State Governments for the payment of dividends in pursuance of the guarantee given by the Government. The Companies (Transfer or Profits to Reserves) Rules, 1975 require a company providing more than 10% dividend to transfer certain percentage of the current years profits to reserves. Companies Act further provides that dividends cannot be paid out of capital, because it will amount to reduction of capital adversely affecting the security of its creditors.2. Magnitude of Trend of Earnings: The amount and trend of earnings will determine the dividend policy. The dividends are paid only out of present or past years profits. The past trend of the companys profits should be kept in consideration while making the dividend decision. 92
  • 93. 3. Desire and Type of Shareholders: The Board of Directors are appointed by the shareholders of the company, hence the desires of the shareholders should be kept in mind while declaring dividend. There may be different types of shareholders (investors) like retired persons, widows and other economically weaker persons their desires also should be taken care while declaring dividend.4. Nature of Industry: The nature of industry will influences the dividend policy of a company. Certain industries will have a steady and stable demand irrespective of the prevailing economic conditions then this type of industries can follow a higher dividend payout ratio. The industry with uncertain profits can follow conservative policy.5. Age of the Company: The newly established companies cannot pay higher dividends though they earn more profits, since they have to reserve these profits for growth and future developments. Whereas, the old companies need not reserve more funds for its expansion hence, they can follow liberal dividend policy for example Hero Honda declared 1000% dividend during this current year 2003-04.6. Future Financial Requirements: The Future financial needs of the company are to be considered by the management while taking the dividend decision. Though the management wants to give importance to the shareholders interest, on the contrast the company should more weight to the financial needs of the company.7. Economic policy of the Government: The dividend policy of the company must be adjustable to the economic policy of the government. During different economic situations like inflation, depression etc., the government will insist to follow the directed state policy in declaration of dividend.8. Tax policy: The tax policy followed by the government also affects the dividend policy. The government may give tax incentives to companies retaining larger share of their earnings. 93
  • 94. --------------------------------------------------UNIT 6 CORPORATE DIVIDEND PRACTICES IN INDIA---------------------------------------------------------------------------OBJECTIVE1. To highlight the corporate dividend practices in India.CHAPTER OUTLINE• To highlight the corporate dividend practices in India. The main objective of maximization of wealth of shareholders is mainlyinfluenced by the dividend policy of the company. Hence the company must retainthe earnings if it has profitable investment opportunities, giving a higher rate ofreturn than the cost of retained earnings, otherwise it should pay them as 94
  • 95. dividends. It implies that a firm should treat retained earnings as the activedecision variable, and the dividends as the passive residual.Module-3--------------------------------------------------UNIT 1 INVESTMENT DECISIONS---------------------------------------------------------------------------Objectives• To identify long term investment decisions• To study the significance of Capital Budgeting• To torch on capital budgeting processUnit outline3.1.1 IntroductionClassification of investment decisions• Long-term investment decision or capital budgeting and• Short-term decision or Working capital decision.Expenses comes under capital investment3.1.2 Meaning of Capital Budgeting 95
  • 96. 3.1.3 Importance of Capital Budgeting3.1.4 Capital Budgeting Process--------------------------------------------------3.1.1 INTRODUCTION--------------------------------------------------------------------------- The investment decision is the most important of the firms three majordecisions when it comes to the value creation. Investment decision relates to thedetermination of total amount of assets to be held in the firm, the composition ofthese assets like the amount of fixed assets, current assets and the extent ofbusiness risk involved by the investors. The investment decisions can be classified in to two groups: (1) Long-terminvestment decision or capital budgeting and (2) Short-term decision or Workingcapital decision.In this module the long-term investment decision or capital budgeting is discussedin detail. The capital budgeting decisions, require comparison of cost againstbenefits over a long period. The investment made in capital assets cannot berecovered in the short run. Such assets will generate returns ranging from 2 to 20years or more. Such investment decision involve a careful consideration of variousfactors like profitability, safety, liquidity and solvency etc. a business organisationhas to face quite often the problem of capital investment decisions. Capitalinvestment refers to the investment in projects whose results would generaterevenue or earnings from alter a year and it will continue for several numbers ofyears. The following are the expenses which comes under capital investment are:i) Replacements of old technology with new technology 96
  • 97. ii) Expansion of production activityiii) Diversification of products due to competition and for growthiv) Research and Development expenditurev) Miscellaneous expensed for installation of equipment, pollution controlequipment etc.--------------------------------------------------3.1.2 MEANING OF CAPITAL BUDGETING--------------------------------------------------------------------------- Capital budgeting is the process of making investment decisions in capitalexpenditures. A capital expenditure refers to an expenditure whose benefits areexpected be received over period of time exceeding one year. Charles T. Horngreen has defined capital budgeting as, "Capital budgeting islong term planning for making and financing proposed capital outlays". Richard and Greenlaw have referred to capital budgeting as "acquiring inputswith long-run return". Lynch defines it as "Capital budgeting consists in planning development ofavailable capital for the purpose of maximising the long term profitability of theconcern."--------------------------------------------------3.1.3 IMPORTANCE OF CAPITAL BUDGETING--------------------------------------------------------------------------- A capital budgeting or investment decision involves huge capital on capitalassets of the concern. Any wrong decision in capital budgeting will cost theorganisation through its capital loss and also revenue loss of the company. Hence 97
  • 98. this decision is so critical and important, the finance manager should take specialcare in making these decisions. They are a) It involves heavy funds. Capital budgeting decisions, generally, involve large investment of limited funds. These funds are to be invested properly. Hence it is important to plan and control these funds. b) These funds will have long term implications. Since the funds are limited and also involves huge investments for long term or permanent basis. Hence it involves more risks, it should be properly managed. c) Irreversible decisions. Once the investment is made on capital assets, it is not possible to reverse the decisions without incurring heavy losses. d) Long term impact on profitability. Capital budgeting decisions will have a long-term and significant effect on the profitability of a concern. An unwise decision may prove disastrous and greater loss to the organisation. e) Difficulties of Investment decisions. The capital budgeting decisions require an assessment of future events which are uncertain, hence it is very difficult to estimate the probable events it is very difficult to asses the probable costs, benefits accurately in this dynamic environment. f) It is national important. The investment decision taken by the individual concern is of national importance because it generates employment, economic activities and economic growth.--------------------------------------------------3.1.4 CAPITAL BUDGETING PROCESS--------------------------------------------------------------------------- 98
  • 99. Capital budgeting involves complex process because it involves investmentof current funds for achieving benefit in future and the future is always uncertain.However, the following procedure may be adopted in the process of capitalbudgeting:1) Identification of Investment proposal. It is first and important stage in the capital budgeting process. The proposal or the idea bout potential investment opportunities may originate from top management or may come from the any part of organisation structure. The ideas are analysed by the departmental head in the light of the corporate objectives and strategies.2) Screening the proposals. Each proposal received by the department is screened from various angles to see whether it is technically feasible, amount of expenditure involved, returns generated, risks involved etc.,3) Evaluation of various proposals. the next stage is to evaluate the various proposals received from the departments by using capital budgeting techniques.4) Fixing priorities. After evaluating various proposals, the unprofitable or uneconomical proposals are rejected. Out of selected proposals once again are listed on the basis of priorities after considering urgency, risk and profitability of the proposal.5) Final approval and preparation of capital expenditure budget. For the approved proposal in the meeting the capital expenditure budget is prepared. This budget lays down the amount of estimated expenditure to be incurred on fixed assets during the budget period.6) Implementing proposal. While implementing the project or proposal, it is better to assign responsibilities for completing the project within the given time frame and cost limit so as to avoid unnecessary delays and cost over runs. Network techniques used in the project management such as PERT 99
  • 100. and CPM can also be applied to control and monitor the implementation of the projects.7) Performance review. The last stage in the process of capital budgeting is the evaluation of the performance of the project. The evaluation is made through post completion audit by way of comparison of actual expenditure on the project with the budgeted one. Any unfavourable variances, if any should be looked into and the causes of the same be identified so that corrective action may be taken in future.--------------------------------------------------UNIT 2 METHODS OR TECHNIQUES OF CAPITAL BUDGETING---------------------------------------------------------------------------Objective• To understand the various techniques of Capital Budgeting 100
  • 101. Unit outline3.2.1 Technique that recognize Payback of Capital Employed: Payback Period Method.3.2.2 Techniques that use Accounting Profit for Project evaluation: a. Accounting Rate of Return method. b. Earning Per Share.3.2.3 Techniques that recognize Time Value of Money: a. Net Present Value Method. b. Internal Rate of Return Method. c. Net Terminal Value Method. d. Profitability Index Method. e. Discounted Payback Period Method.-------------------------------------------------- UNIT 2 METHODS OR TECHNIQUES OF CAPITAL BUDGETING---------------------------------------------------------------------------Methods or techniques of capital budgeting or Investment AppraisalTechniques 101
  • 102. The techniques available for appraisal of investment proposal are classified threeheads:I. Technique that recognize Payback of Capital Employed: Payback Period Method.II. Techniques that use Accounting Profit for Project evaluation: c. Accounting Rate of Return method. d. Earning Per Share.III. Techniques that recognize Time Value of Money: f. Net Present Value Method. g. Internal Rate of Return Method. h. Net Terminal Value Method. i. Profitability Index Method. j. Discounted Payback Period Method.-------------------------------------------------------------------------------3.2.1 Technique that recognize Payback of Capital Employed---------------------------------------------------------------------------Payback Period Method. The term payback refers to the period in which the project will generate thenecessary cash to recover the initial investment. For example, if a project requires 102
  • 103. Rs. 30,000 as initial investment and it will generate an annual cash inflow of Rs.6,000 for ten years, the pay back period will be 5 years, it is calculated as follows: Initial Investment Pay back period = ------------------- Annual Cash Inflow Rs 30,000 = ------------ Rs 6,000 Cash inflow is calculated by taking into profits from the project beforedepreciation and after Tax. When the cash inflow is uneven then the payback period is calculated bucumulative cash inflows and by interpolation, the exact payback period can becalculated. For example, if the project requires an initial investment of Rs. 40,000and the annual cash inflows for 5 years are Rs. 12,000, Rs, 10,000, Rs. 14,000,Rs. 11,000 and Rs. 9,000 respectively, the pay back period will be calculated asfollows: Year Cash inflows Cumulative cash inflows (in Rs) (in Rs) 1 12,000 12,000 2 10,000 22,000 3 14,000 36,000 4 11,000 47,000 5 9,000 56,000 103
  • 104. From the above table we are clear that in 3 years Rs. 36,000 has beenrecovered. Rs. 4,000 is left out of initial investment. In the fourth year the cashinflow is Rs. 11,000. It means the pay back period is between three to four yearscalculated as follows. Amount to be recovered Pay back period = 3 years + ------------------------------------- Amount available in the next year. = 3 + 4,000/ 11,000 = 3.33 years.Advantages of Pay back period a. The main advantage of this method is that it is simple to understand and easy to calculate. b. In this method, as a project with a shorter pay back period is preferred to the one having a longer pay back period. Hence the project of loss from quick obsolescence can be overcome from this method. c. This method gives an indication to the prospective investors specifying when their funds are likely to be repaid. d. This method is suitable when the future is very uncertain.Disadvantages a. This method does not take into account the cash inflows earned after the pay back period and the true profitability of the projects cannot be correctly assessed. b. This method ignores the time value of money and does not consider the magnitude and timing of cash in flows. c. It does not take into consideration the cost of capital which is a very important factor in making sound investment decisions. 104
  • 105. d. It treats each asset individually in isolation with other assets which is not feasible in real practice. e. This method does not consider the salvage value of an investment.---------------------------------------------------------------------------3.2.2 Techniques that use Accounting Profit for Project evaluation--------------------------------------------------------------------------Accounting Rate of Return MethodIt is also known as return on investment or return on capital employed. Thismethod applied the normal accounting technique to measure the increase in profitexpected to result from an investment by expressing the net accounting profitarising form the investment as a percentage of the capital investment. That is: Average annual profit after tax ARR = ----------------------------------- X 100 Average or Initial Investment Initial investment + Salvage value Average investment = ----------------------------------------- 2Under this method the project which gives highest rate of return will be selected.Merits1. It is easy to calculate because it makes use of readily available accounting information.2. It is concerned with profits available for shareholders rather than cash flows.3. This method takes into consideration all the years profit throughout its life.4. Quick decision of capital investment proposals is possible.5. If high profits are required, this is certainly a way of achieving them. 105
  • 106. Demerits1. It does not take into account the time value of money.2. It uses the straight line method of depreciation. Once this method is changed the method will not be easy to use.3. It is biased against short-term projects in the same way that payback is biased against longer-term ones.4. There are different methods for calculating the accounting rate of return due to diverse concepts of investments as well as earnings. Each method gives different results. This reduces the reliability of the method.-------------------------------------------------------------------------------3.2.3 Techniques that recognize Time Value of Money--------------------------------------------------------------------------Net present Value Method This is generally considered to be the best method for evaluating the capitalinvestment proposals. In this method first cash inflows and cash outflowsassociated with each project are worked out. The present value of these cashinflows and outflows are then calculated at the rate of return acceptable to themanagement. This rate of return is considered as the cut-off rate and is generallydetermined on the basis of cost of capital adjusted risk element in the project. TheNet Present Value (NPV) is the difference between the total present value of futurecash inflows and the total present value of future cash outflows. The Net Present Value can be used as an accept or reject criterion. In casethe NPV is positive the project should be accepted. If the NPV is negative, theproject should be rejected. 106
  • 107. Merits1. It recognises the time value of money and is suitable to be applied ina situation with uniform or uneven cash inflows even at different periods of time.2. It takes into account the earnings over the entire life of the project and the true profitability of the profit can be evaluated.3. It takes into consideration the objective of maximum profitability.Demerits1. As compared to traditional method, the NPV method is more difficult to understand and operate.2. It is not easy to determine an appropriate discount rate.3. The method is based on the presumption that cash inflow can be invested at the discounting rate in the new projects. But this presumption does not always hold good because it all depends upon the available investment opportunities.Internal Rate of Return (IRR) Internal Rate of Return is that rate at which the sum of discounted cashinflows equals the sum of discounted cash outflows. In other words, it is the ratewhich discounts the cash flows to zero. It is also known as time adjusted rate ofreturn method or trial and error yield method.Merits1. It also takes into account the present value of money.2. It considers the profitability of the project for its entire economic life and hence enables evaluation of true profitability. 107
  • 108. 3. The determination of cost of capital is not a pre-requisite for the use of this method and hence it is better than NPV method where the cost of capital cannot be determined easily.4. It provides for uniform ranking of various proposals due to the percentage rate of return.Demerits1. It is difficult to understand and is the most difficult method of evaluation of investment proposals.2. This method is based upon the assumption that the earnings are reinvested at the internal rate of return for the remaining life of the project, which is not a justified assumption.3. The results of NPV method and IRR method may differ when the projects under evaluation differ in their size, life and timings of cash flows.Discounted Pay back Period Method. Under this method the draw back of time value of money not considered inpay back period is considered. Hence this method is improvement over the payback period method. Under this method the project which gives the greatest postpay-back period may be accepted. Under this method the present values of allcash outflows and inflows are computed at an appropriate discount rate. The timeperiod at which the cumulated present value of cash inflows equals th presentvalue of cash outflows is known as discounted pay back period.Profitability Index Method or Benefit Cost RatioIt is also a time-adjusted method of evaluating the investment proposals.Profitability index also called as Benefit-Cost Ratio or Desirability factor is therelationship between present value of cash inflows and present value of cashoutflows. Thus 108
  • 109. Present value of cash inflowsProfitability Index = ------------------------- Present value of cash outflows The proposal is accepted if the profitability index is more than one and isrejected in case the PI is less than one.--------------------------------------------------UNIT 3 PROBLEMS ON CAPITAL BUDGETING---------------------------------------------------------------------------Objectives• To give practical exposure to the working of capital budgeting• To help in decision making process, in selecting a best method of capital budgeting• To know the working knowledge of these methodsUnit outline3.3.1 Problems on capital budgeting• Payback period• Accounting Rate of Return• Net Present Value• Internal Rate of Return• Profitability index 109
  • 110. -------------------------------------------------------------------------------3.3.1 Problems on capital budgeting-------------------------------------------------------------------------------1. Calculate the cash inflow under pay back period with the following information;Profit Before Tax and Before Depreciation (PBTBD) =50000, Depreciation =10,000,Tax=35%Solution: PBTBD 50,000 Less Depreciation 10,000 _____ PBTAD 40,000 Less: Tax 35% 14,000 _____ PATAD 26,000 (+) Depreciation 10,000 _____ PATBD 36,000 _____ To calculate tax we have to first change depreciation.2. Calculate the Pay Back Period (PBP) from the following: Years Inflows I 500000 110
  • 111. II 400000 III 300000 IV 100000 Initial Investment = Rs.10,00,000Solution:PBP = 2+1,00,000/3,00,000=2.33 years3. Calculate PBP form the following; Initial investment 10, 00,000, life of theproject 4years, PBD and before Tax (PBTBD) I 5,00,000 II 4,00,000 III 3,00,000 IV 1,00,000Solution:Calculation of Depreciation;DEPN= Cost of asset + Installation charges-Scrap value/Life of Asset =10,00,000/4=2,50,000 Rate of tax is assumed as 35%.Given Year PBTBD (-) Depn. PBTAD (-) Tax 35% PATAD (+)Dep. PATBD I 500000 250000 250000 87500 162500 250000 412500 II 400000 250000 150000 52500 97500 250000 347500 III 300000 250000 50000 17000 32500 250000 282500 111
  • 112. IV 100000 250000 (150000) - (150000) 250000 100000PBP=2+2,40,000/2,82,500 (2,40,000=10,00,000-7,60,000) = 2.85 Years.4. A Project involves the investment of Rs. 500000 which yields PADAT as statedbelow:Years PATAD I 25000 II 37500 III 62500 IV 65000 V 40000 At the end of 5 years the machinery in the project can be sold for 40,000. Thecut-off rate is 8%. Suggest the management whether or not to accept theproposal based on ARR.SolutionStep I: Average profit= Total cash inflows/life of project =230000/5=46000Step II; ARR=AP/Initial Investment (I I) =46000/(500000-40000) x 100=10% Interpretation: It is advisable to accept the project since ARR is abovethe cut-off rate. 112
  • 113. Interpretation of NPV; If NPV is greater than or equal to zero then accept or elserejects the project. 5. Calculate NPV and IRR of a project involving the initial cash outflow ofRs.1,00,000 and generating annual cash inflow of Rs.35,000, Rs.40,000,Rs.30,000, and Rs.50,000 for 4 years respectively. Assume discounting rate ofreturn at 15%.Solution:Calculation of NPVYears Cash inflows Discount @15% [1/(1+r)n] NPV values 1 35000 0.8696 30436 2 40000 0.7561 30244 3 30000 0.6575 19725 4 50000 0.5718 28590 ________ Total Discount Cash inflows 1,08,995 Less; Initial Investment 1,00,000 ______ Net NPV 8995Interpretation: Since NPV is Greater than or equal to zero we accept the project. 113
  • 114. Calculation of IRRYears Cash Inflows Discount @5% Discounted C.I Discount @20% Discounted C.I.1 35000 0.9524 33334 0.8333 29165.52 40000 0.9070 36280 0.6944 277763 30000 0.8638 25914 0.5787 173614 50000 0.8227 41135 0.4823 24115 ________ _____________ Total DCI 136663 98418 Less I.I 100000 100000 ________ _________ NPV 36663 (1582) + ve NPVIRR= LRR+ ------------------------------ x difference in rates (+ ve NPV) + (- ve NPV) 36,663IRR= 5 + ------------------------------ x 15 (36,663) + (1,582) = 19.38% 114
  • 115. 6. A Company has an investment opportunity costing Rs. 40,000 with the followingexpected net cash flow (after tax before depreciation).Years Net Cash flow1 Rs. 7,0002 7,0003 7,0004 7,0005 7,0006 8,0007 10,0008 15,0009 10,00010 4,000 Using 10% as the cost of capital (rate of discount) determine the following: a) Pay back period. b) Net present value at 10% discount factor. c) Profitability Index at 10% discount factor. d) Internal Rate of Return with the help of 10% discount factor and 15% discount factor.Solution:a) Pay back period = 5 + 5000/8000 = 5.625 years. 115
  • 116. b) Net Present Value Year Cash Inflow Discount @ Discounted cash Rs. 10% inflow 1 7,000 0.9091 6364 2 7,000 0.8264 5785 3 7,000 0.7513 5259 4 7,000 0.6830 4781 5 7,000 0.6209 4346 6 8,000 0.5645 4516 7 10,000 0.5132 5132 8 15,000 0.4665 6998 9 10,000 0.4241 4241 10 4,000 0.3855 1542 ---------- 48,963 (-) Initial Invt. 40,000 --------- NPV 8,963c) Gross PI = Discounted cash inflow/Discounted Cash outflow = 48,963/40,000 = 1.23 Net PI = Gross PI - 1 = 1.23 - 1 = 0.23d) Internal Rate of Return Year Cash Inflow Discount @ Discounted cash Rs. 15% inflow 1 7,000 0.8696 6087 2 7,000 0.7561 5293 3 7,000 0.6575 4603 4 7,000 0.5718 4003 5 7,000 0.4972 3480 116
  • 117. 6 8,000 0.4323 3458 7 10,000 0.3759 3759 8 15,000 0.3269 4904 9 10,000 0.2843 2843 10 4,000 0.2472 989 -------- 39,418 Less Initial 40,000 Invt. -------- (-)ve NPV (-) 582 + ve NPVIRR= LRR+ ------------------------------ x difference in rates (+ ve NPV) + (- ve NPV) 8,963IRR= 10 + ------------------------------ x (15 - 10) 8,963 + 582 = 14.695 %7. The L Company Ltd, is considering the purchase of a new machine. Twoalternative machines (A&B0 have been suggested each costing Rs. 4,00,000.Earnings after taxation but before depreciation are expected to be as follows:Year Machine A Machine B1 40,000 1,20,0002 1,20,000 1,60,0003 1,60,000 2,00,0004 2,40,000 1,20,0005 1,60,000 80,000 Total 7,20,000 6,80,000 117
  • 118. The company has a target rate return on capital at the rate of 10%. On this basisyou are required:1. Compare profitability of Machines and state which alternative you consider financially preferable.2. Compute Pa;yback period for each project3. Compute annual rate of return for each project.Solution:1. Net Present Value.Yea Machine Discount Discount Machine B Discountr A @10% ed cash ed cash inflow inflow1 40,000 0.9091 36,364 1,20,000 1,09,0922 1,20,000 0.8264 99,168 1,60,000 1,32,2243 1,60,000 0.7513 1,20,208 2,00,000 1,50,2604 2,40,000 0.6830 1,63,920 1,20,000 81,9605 1,60,000 0.6209 99,344 80,000 49,672 ---------- ---------- ∑Discounted - ∑Discounted ----- Cash inflow Cash inflow 5,23,208 (-) Initial Invt. 5,19,004 (-) Initial Invt. 4,00,000 4,00,000 NPV ---------- ---------- -- ---- 1,19,004 1,23,208Interpretation: It is advisable to accept Machine B since NPV is more whencompared to Machine A.2. Pay back period.Machine A = 3 + 80,000/2,40,000 = 3.33 yearsMachine B = 2 + 1,20,000/2,00,000 = 2.6 yearsInterpretation: It is advisable to accept Machine B as per PBP. 118
  • 119. 3. ARR.Calculation of Depreciation: = Cost of asset + Installation charges-Scrap value/Life of Asset = 4,00,000/5 = 80,000 p.a.PATBD of PATBD of (-) PATAD of PATAD ofMachine A Machine B Depreciation Machine A Machine B40,000 1,20,000 80,000 - 40,000 40,0001,20,000 1,60,000 80,000 40,000 80,0001,60,000 2,00,000 80,000 80,000 1,20,0002,40,000 1,20,000 80,000 1,60,000 40,0001,60,000 80,000 80,000 80,000 0Average profit (A) = 3,20,000/5 = 64,000ARR = 64,000/4,00,000 x 100 = 16%Average profits (B) = 2,80,000/5 = 56,000ARR = 56,000/4,00,000 x 100 = 14%Interpretation: it is advisable to accept Machine A as per ARR. 119
  • 120. 9. The expected cash flows of the project are as follows:Years Cash flows0 - 1,00,0001 20,0002 30,0003 40,0004 50,0005 60,000 The cost of capital is 12% calculate the following.a) NPVb) Benefit cost ratio (GPI)c) PBPd) IRRe) Discounted PBPSolution:a) NPV Year Cash Inflow Discount factor Discounted @ Cash inflow 12% 1 20,000 0.8929 17,858 2 30,000 0.7972 23,916 3 40,000 0.7118 28,472 4 50,000 0.6355 31,775 5 60,000 0.5674 17,022 ------------ ∑ Cash inflow 1,19,043 - Initial invt. 1,00,000 ------------ NPV 19,043b) Benefit cost ration (GPI) = Discounted Cash inflow / Discounted Cash outflow 120
  • 121. = 1,19,043 / 1,00,000 = 1.19c) Pay Back period = 3 + 10,000 / 50,000 = 3.2 yearsd) IRR Year Cash Inflow Discount factor Discounted @ Cash inflow 20% 1 20,000 0.8333 16,666 2 30,000 0.6944 20,832 3 40,000 0.5787 23,148 4 50,000 0.4823 24,115 5 60,000 0.4019 12,057 ------------ ∑ Cash inflow 96,818 - Initial invt. 1,00,000 ------------ NPV - 3,182 + ve NPVIRR= LRR+ ------------------------------ x difference in rates (+ ve NPV) + (- ve NPV) 19,043 IRR= 12 + ------------------------------ x (15 - 10) 19,043 + 3,182 = 18.85%e) Discounted Pay Back period 121
  • 122. = 3 + 29,754 / 31,775= 3.9 years 122
  • 123. -------------------------------------------------------------------------------Unit 4 Risk and Uncertainty in Capital Budgeting-------------------------------------------------------------------------------ObjectivesThe objectives of this unit are:• To bring clarity in the concepts of Risk and Uncertainty• To study the methods of accounting the risk in capital budgetingUnit outline3.4.1 Risk and Uncertainty in Capital BudgetingThe following methods are suggested for accounting for risk in capital budgeting. (i) General Techniques: (a) Risk adjusted discount rate; (b) Certainty equivalent coefficient. (ii) Quantitative Techniques: (a) Sensitivity analysis (b) Probability assignment (c)Standard deviation (d) Coefficient of variation (e) Decision tree analysis-------------------------------------------------------------------------------3.4.1 Risk and Uncertainty in Capital Budgeting---------------------------------------------------------------------------- 123
  • 124. All the techniques of capital budgeting require the estimation of future cashinflows and cash outflows. The future cash flows are estimated, based on thefollowing factors:(1) Expected economic life of the project.(2) Salvage value of the asset at the end of its life.(3) Capacity of the project.(4) Selling price of the product.(5) Production cost(6) Depreciation and tax rate(7) Future demand for the product etc., But due to uncertainties about the future most of the above factors cannotbe exact. For example, the product becomes absolute, technology becomesobsolescence, in these situations taking investment decisions becomes difficult.But some allowances for the element of risk have to be provided. The following methods are suggested for accounting for risk in capitalbudgeting. (i) General Techniques: (a) Risk adjusted discount rate; (b) Certainty equivalent coefficient. (ii) Quantitative Techniques: (a) Sensitivity analysis (b) Probability assignment (c)Standard deviation (d) Coefficient of variation (e) Decision tree analysisRisk adjusted discount rate 124
  • 125. The risk adjusted discount rate is based on the presumption that investorsexpect a higher rate of return on risky projects as compared to less risky projects.The rate requires is determined by i) risk free rate and ii) risk premium rate. Riskfree rate is the rate at which the future cash inflows should be discounted andthere been no risk. Risk premium rate is the extra return expected by the investorover the normal rate on account of the project being risky. Therefore risk adjusteddiscount rate is a composite discount rate that takes into account both the timeand risk factors. A higher discount rate will be used for more risky projects andlower rate for less risky projects. From the following data, state which project is better> Year Cash inflows Project X Project Y 0 -10,000 -10,000 1 5,000 6,000 2 4,000 6,000 3 2,000 4,000 Riskless discount rate is 5%. Project X is less risky as compared to Project Y.the management considers risk premium rates at 5% and 10% respectivelyappropriate for discounting the cash inflows. Solution: Project Risk adjusted discount rate X 5% + 5% = 10% Y 5% + 10% = 15% Year Discounted Cash inflows 125
  • 126. Project X Project Y 0 -10,000 -10,000 1 4,545 5,218 2 3,320 4,536 3 1,502 2,630 --------- --------- NPV - 633 2,384 --------- ---------Project Y is superior to Project X. since NPV is positive it may be accepted.Sensitivity analysis Where cash inflows are very sensitive under different circumstances, morethan one forecast of the future cash inflows may be made. These inflows may beregarded as Optimistic, Most Likely and Pessimistic. Further cash inflows maybe discounted to find out the NPV under these three different situations. If the NPVunder the three situations differ widely it implies that there is a great risk in theproject and the investors decision to accept or reject a project will depend uponhis risk bearing abilities.Illustration Mr. Tanu is considering tow mutually exclusive projects A and B. You arerequired to advise him about the acceptability of the projects from the followinginformation. Project A Project B Rs. Rs. Cost of the Investment 50,000 50,000 126
  • 127. Forecast Cash Inflows per annum for 5 years Optimistic 35,000 40,000 Most Likely 25,000 20,000 Pessimistic 20,000 5,000 (The cut-off rate is 15%) Solution Computation of NPV of cash in flows at a Discount Rate of 15% (Annuity of Re. 1 for 5 years)Project A Project B Annual Discou Present NPV Annual Discou Present NPV cash nt Value cash nt Value inflow factor inflow factor @ 15% @ 15%Optimistic 35,000 3.3522 1,17,327 67,327 40,000 3.3522 1,34,088 84,088Most Likely 25,000 3.3522 83,805 33,805 20,000 3.3522 67,044 17,044Pessimistic 20,000 3.3522 67,044 17,044 5,000 3.3522 16,761 -33,239 The NPV calculated above indicate that Project B is more risky as compared to Project A. at the same time during favorable conditions, it is more profitable. Probability Technique A probability is a relative frequency with which an event may occur in the future. When future estimates of cash inflows have different probabilities the expected monetary values may be computed by multiplying cash inflow with the probability assigned. Illustration: The ABC company Limited has given the following possible cash inflows fro two of their projects X and Y out of which one they wish to undertake together with their associated probabilities. Both the projects will require an equal investment of Rs. 5,000. 127
  • 128. You are required to give your considered opinion regarding the selection ofthe project. Project X Project Y Possible Cash inflows Probability Cash Probabilit event inflows y A 4,000 .10 12,000 .10 B 5,000 .20 10,000 .15 C 6,000 .40 8,000 .50 D 7,000 .20 6,000 .15 E 8,000 .10 4,000 .10Solution:Computation of Expected Monetary values for Project X and Project Y Project X Project Y Cash Probabilit Expecte Cash Probabili Expecte inflows y d value inflows ty d valueA 4,000 .10 Rs. 400 12,000 .10 1,200B 5,000 .20 1,000 10,000 .15 1,500C 6,000 .40 2,400 8,000 .50 4,000D 7,000 .20 1,400 6,000 .15 900E 8,000 .10 800 4,000 .10 400 Total 6000 Total 8,000 128
  • 129. The expected monetary value of Project Y is higher than the expectedmonetary value of Project X. Hence Project Y is preferable to project X.Decision Tree Analysis Decision tree anlysis is another technique which is helpful in tackling riskycapital investment proposals. Decision tree is a graphic display of relationshipbetween a present decision and possible future events, future decisions and theirconsequences. The sequence of event is mapped out over time in a formatresembling branches of a tree. In other words, it is a pictorial representation intree form which indicates the magnitude, probability and interrelationship of allpossible outcomes.Module -4---------------------------------------------------------------------------UNIT 1 Working Capital Management---------------------------------------------------------------------------Objectives 1. To familiarise about the concept of Working Capital 2. To know various classifications of working capitalUnit outline 129
  • 130. Classifications of working capitala) Gross working capital and Net working capitalb) Permanent working capital and Temporary working capitalc) Operating cycle concept of working capital.Importance or advantages of adequate working capital-------------------------------------------------------------------------------4.1.1 INTRODUCTION------------------------------------------------------------------------------- Working capital management is concerned with the problems that arise inmanaging the current assets, the current liabilities and the interrelationship thatexists between them. The term current assets refer to those assets which can beconverted into cash with in one year with out undergoing a decrease in value andwithout disrupting the operations of the firm. The major components of currentassets are cash, marketable securities, accounts receivable and inventory. Currentliabilities are those liabilities which are to be paid within a year, out of currentassets or earnings of the firm. The current liabilities are accounts payable, billspayable, bank overdraft, and outstanding expenses. The goal of working capital management is to manage the firms currentassets and liabilities in such a way that a satisfactory level of working capital ismaintained. If the working capital in not kept at satisfactory level, the firm likelywill become insolvent. The current assets should be large enough to cover its 130
  • 131. current liabilities. Each current asset should be properly managed to maintainsatisfactory level of liquidity, either excess or deficiency of the current assets willhave adverse impact on the firms working capital management.--------------------------------------------------------------------------4.1.2 Concepts and Definitions of Working Capital-----------------------------------------------------------------------------Working capital is defined as the excess of current assets over current liabilities.Working capital is classified in to:d) Gross working capital and Net working capitale) Permanent working capital and Temporary working capitalf) Operating cycle concept of working capital.Gross working capital refers to the firms investment in current assets. Theconstituents of current assets are:i) Cash in hand and at bank. ii) Bills receivables. iii) Sundry debtor less provisionof bad debts. iv) Short term loans and advances. V) Inventories of stock consistsof raw materials, work in process, stores and spares and finished goods. vi)Temporary investments of surplus funds. Vi) Prepaid expenses. Vii) AccruedincomesNet working capital refers to the excess of current assets over current liabilities.The constituents of current liabilities are:i) Bills payable. Ii) Sundry creditors. Iii) Accrued expenses. Iv) Short term loans,advances and deposits. V) Dividends payable. Vi) Bank overdraft. Vii) Provision fortaxation.Permanent working capital represents the assets required on continuing basisover the entire year. Temporary working capital refers to additional assetsrequired at different items during the operation of the year. Operating Cycleconcept of working capital refers to the average time elapses between the 131
  • 132. acquisition of raw materials and the final cash realisation. Cash is used to buy rawmaterials and other stores, so cash is converted into raw materials and storesinventory, in production process it remains as a work in process, this work inprocess is converted into finished product, this finished product are sold on creditor cash. If it is sold on credit, then it will be in the form of bills receivable, later onit is transformed in to the original form of cash.Thus operating cycle consists of the following cycles• The raw materials and stores inventory stage• The work in process stage• The finished goods inventory stage• The receivables stage--------------------------------------------------------------------------4.1.3 Importance or advantages of adequate working capital---------------------------------------------------------------Working capital is very important to the business firm to meet its daily running.The working capital, should not be either excess or shortage, it should beadequate. The main significance or importance of adequate amount of workingcapital are:a) Adequate working capital helps the business organisation to maintain solvency by providing uninterrupted flow of production.b) The sufficient working capital to make prompt payments will enhance the goodwill of a concern.c) The concern can raise easy loans in the financial market because of high solvency and good credit rating.d) Adequate working capital will help the concern to avail cash discounts on purchases and this in turn reduces the cost of production. 132
  • 133. e) Adequate working capital will ensures regular supply of raw material and continuous production.f) It ensures regular payment of salaries and other day today expenses of the business.g) The concerns with adequate capital will ensure proper exploitation of markets to avail discounts while purchasing their requirements in bulk quantities.h) Adequacy of working capital creates an environment of security, confidence, and high morale will create overall efficiency in a business. 133
  • 134. Unit 2 ADEQUATE WORKING CAPITALObjectives1. To determine the factors which influences the working capital requirements2. To diagnose the symptoms of poor working capital management3. To identify the basic functions of working capital managementUnit OutlineFactors determining the working capitalSymptoms of Poor Working Capital ManagementBasic functions of working capital management A. Estimating the working capital management. B. Financing of working capital needs, and C. Analysis and control of working capital.--------------------------------------------------------------- 134
  • 135. 4.2.1 Factors determining the working capital-------------------------------------------------------------------------------Various factors will determine the working capital of the company. The importantof them are.1. Nature of Business. The working capital requirement of a company depends basically on the nature of its business. If the nature of business is Trading and manufacturing of goods and services require huge amount of working capital. If the nature of its business is public utilities, then it requires less amount of working capital.2. Size/scale of production. The size of scale of production will determine the amount of working capital of a firm. If the size of production is small it requires less amount of working capital to purchase raw material, wages and other expenses and if the scale of operation is large it requires more amount of working capital.3. Production policy. The production policy of the firm will determine the amount of working capital. If the production policy is to accumulate production in slack season and keep inventory and to sell in the peak season, then the firm requires more working capital.4. Length of production cycle. In manufacturing concern, the requirement of working capital increase in direct proportion to length of manufacturing process.5. Working capital cycle. The working capital cycle will determine the amount of working capital of a business concern. If working capital cycle is short ie., without credit sales then the amount requirement for working capital will be less otherwise it requires more.6. Credit policy. The credit policy of a concern in its dealing with debtors and creditors will determine the amount of working capital.7. Business cycles. The stage of business cycle of a firm will determine the amount of working capital. If the concern is in boom period naturally it require more working capital or if it is in recession, then it requires less amount. 135
  • 136. 8. Inflationary condition. The higher the price level requires higher the amount of working capital.---------------------------------------------------------------------------4.2.2 Symptoms of Poor Working Capital Management---------------------------------------------------------------------------The following are the symptom to be seen in the case of poor working capitalmanagement.1. Excessive carriage of inventory over the normal levels requires for the business will result in increase in creditor balance.2. Slow down in collection of debtors will result in working capital problems.3. If the capital goods are purchased from working capital, this will result in the problem in day to day requirement of working capitals.4. Unplanned production schedules will cause excessive stocks of finished goods or failures in meeting despatch scheduled.5. Over trading will cause shortage of working capital.6. Dependence in short term sources of finance for financing permanent working capital causes lesser profitability and will increase strain on the management in managing working capital.7. Inefficiency in cash management causes embezzlement of cash.8. Inability to get working capital limits will cause serious concern to the company. A finance manager can achieve adequate Working Capital Management byfollowing these three basic functions. D. Estimating the working capital management. E. Financing of working capital needs, and F. Analysis and control of working capital.-------------------------------------------------------------------------------4.2.3 Estimating the working capital management.-------------------------------------------------------------------------- 136
  • 137. In order to determine the amount of working capital needed by a firm, anumber of factors viz., production policies, nature of business, length ofmanufacturing process, credit policy etc., are to be considered by the financemanager of a company. The following format can be uses in estimating theworking capital requirement. Statement of Working Capital Requirements Amount RsA. Current assets:1. cash2. Debtors or Receivables3. Stocks i) Raw materials ii) Work in processiii) Stores and sparesiv) Finished goods4. Advance payment, if any5. OthersB. Current Liabilities:1. Creditors2. Outstanding payments3. Any otherWorking Capital (A-B)-------------------------------------------------------------------------------4.2.4Financing of working capital needs--------------------------------------------------------------------------The working capital of a concern can be classified in to two:1. Permanent or Fixed working capital requirement.2. Temporary or Variable working capital requirement. 137
  • 138. Permanent or Fixed working capital is required to invest permanently in currentassets to ensure minimum quantity to maintained for continuous use thisminimum cannot be reduced, because it is required for day to day operation of thebusiness. The amount invested on these permanent fixed assets is called fixedworking capital. Similarly some working capital is required for meeting seasonaldemands and some special purchases like increase in prices, strikes, calamitieseta. This is called temporary working capital. The fixed or permanent working capital is generally financed by the sources likeissue of shares, debentures, public deposits, ploughing back of profits, loans fromfinancial institutions etc. The temporary working capital is financed through the sources like IndigenousBankers, Trade credit, cash credit or bank overdraft, advances accounts receivableor Factoring, accrued expenses, Deferred incomes, Provision for depreciation,Commercial Paper, Commercial Banks.Unit 3 CASH MANAGEMENTObjectives1. To familiarise about cash management2. To identify the problems in cash management 138
  • 139. Unit outlineManagement of different components of working capital Management of CashFeatures of Effective Cash ManagementMotives for Holding CashBasic problems in Cash Management1. Controlling level of cash2. Controlling inflows of cash3. Controlling outflows of cash and4. Optimum investment of surplus cash-------------------------------------------------------------------------------4.3.1 Management of different components of working capital-------------------------------------------------------------------------- Working capital management of a firm involves its different components like:1. Management of Cash2. Management of inventories3. Management of receivables4. Management of payables etc.,------------------------------------------------------------------------------- 4.3.2 Management of Cash-------------------------------------------------- Cash management is rapidly emerging as a vital area in any businessorganisation. It is one of the important components of current assets. CashManagement implies making sure that all the business generated revenues areeffectively controlled and utilised in the best possible manner to result in gains forthe organisation. 139
  • 140. Features of Effective Cash Management Effective cash management involves the proper management of cash inflowsand outflows which includes: • Improving forecasts of cash flows • Synchronising cash inflows and outflows. • Using floats. • Accelerating collections. • Getting available funds to where they are needed. • Controlling disbursements.-------------------------------------------------------------------------------4.3.3 Motives for Holding Cash---------------------------------------------------------------------------One distinguishing feature of cash as an asset, in any of the firms is that it doesnot earn any substantial return for the business. In spite of this fact the firm withthe following motives holds cash.1. Transaction motive. A firm enters into a variety of business transactions resulting in both inflows and outflows. In order to meet the business obligations in such situations, it is necessary to maintain adequate cash balance. Thus, the firms keep cash balance with the motive of meeting routine business payments.2. Precautionary motive. A firm keeps cash balance to meet unexpected cash needs arising out of unexpected contingencies such as floods, strikes, unexpected slow down in collection of receivables, increase in the prices of raw materials etc. Higher the possibility of contingencies higher will be the cash kept by the firm for meeting them.3. Speculative motive. A firm keeps cash balance to take advantage of unexpected change in the prices of the securities in the stock market. This motive is a speculative in nature, so that the firm can make profit out of this cash investment in securities. 140
  • 141. 4. Compensating motive. A firm keeps cash balance to compensate banks for providing certain services and loans. Banks provide a variety of services to business firms, such as clearance of cheque, supply of credit information, transfer of funds, and so on. While for some of these services banks charge a commission or fee, for others they seek indirect compensation this the banks will get from prescribing to maintaining minimum balance from the customers bank account, which is not allowed to use of transaction purposes.---------------------------------------------------------------------------4.3.4 Basic problems in Cash Management------------------------------------------------------------------------------There are four basic problems in cash management. They are1. Controlling level of cash2. Controlling inflows of cash3. Controlling outflows of cash and4. Optimum investment of surplus cash1. Controlling level of cashOne of the basic objectives of cash management is to minimise the level of cashbalance with the firm. This objective can be achieved by the following ways.a) Preparing Cash Budget. Preparing cash budget or cash forecast is the most significant device for planning and controlling the use of cash. In cash budget involves the projection of future receipts and payments of the firm over various intervals of time. It reveals the amount of expected cash inflows and outflows over a period of time to the finance manager. With this the finance manager will determine the cash needs of the firm, plan for the financing of these needs and exercise control over the cash and liquidity of the firm.b) Providing for unpredictable discrepancies. Cash budget will help to predict the cash receipts and disbursement over a period of time and by this it predicts the discrepancies between cash inflows and cash outflows in the normal business 141
  • 142. activities. By this it is possible to predict what will be the cash requirements during uncertainties like strikes, short term recession, floods etc.,c) Consideration of short costs. Short cost refers to the cost incurred as a result of shortage of cash. They are meeting the claims of creditors at the time of default in making payment, borrowing at high interest charges.d) Availability of other sources of funds. A firm can avoid holding unnecessary large balance of cash for contingencies in case it has to pay a slightly higher rate of interest than that on a long-term debt.2. Controlling inflows of cash. After preparing the cash budget, the finance manager should also ensure that there is not significant deviation between projected cash inflows and cash outflows. The finance manager must devise the techniques which are appropriate in prevention of fraudulent diversion of cash receipts and to speedup the cash collection. The following are the methods.a) Prompt payment by the customers. To accelerate the prompt payment the firm must ensure prompt billing, informing the customers about the date and amount of payment, sending the bills in self addressed envelop, giving cash discounts etc.,b) Quick conversion of payment into cash. If the amount is received in cheque from the customers it must be presented for collection immediately.c) Decentralised collections. If the firm operates in a wide geographical area, the firm should setup collection centres at various places to speedup its collection of cheques and immediately the firm make arrangements to present it for payments.d) Lock box system. It is sytem or technique of reducing mailing, processing and collecting time. Under this system the firm selects some collecting centres at different places. The places are selected on the basis of number of consumers and the remittances to be received from a particular place. The firm hires a 142
  • 143. post box in a post office and the parties are asked to send the cheques on that post box mumbler. A local bank is authorised to operate the post box and to process these cheques.3. Controlling outflows of cash A Company can keep cash by effectively controlling disbursements. Theobjective of controlling cash outflows is to slow down the payments as far aspossible. The following methods can be used to delay disbursements: a) Paying on last date. The disbursements can be delayed on making payments on the last due date only. It can help in using the money for short periods and the firm can make use of cash discount also. b) Payments through drafts. A company can delay payment by Ussing drafts to the suppliers instead giving cheques. When a cheque is issued then the company will have to keep a balance in its account so that the cheque is paid whenever it comes. On the otherhand a draft is payable only on presentation to the issuer. The receiver will give the draft to its bank for presenting it to the buyers bank. it takes number of days before it is actually paid. c) Payroll funds. In case of payment of payroll funds the finance manager must see that the frequency of payments are increased. Secondly the payments are to be made through cheque by this the employees can not present cheques on the same day for clearance and the payment cannot be made on the same day, like this the payment can be delayed. d) Technique of Paying float. Through this technique it is possible to maximise the availability of funds. The term float means the amount tied up in cheques that have been drawn but have not yet been presented for payment. 143
  • 144. 4. Investment of surplus cash. Following are the two basic problems regardingthe investment of surplus cash:(i) Determination of surplus cash.(ii) Determination of the channels of investment.(i) Determination of surplus cash. Surplus cash refers to the excess cash over the firms normal cash requirements. While determining the amount of surplus cash, the finance manager should take into account the minimum cash balance to be maintained in the firm to avoid risk of shortage of cash for the day today needs. In this regard he has to consider two basic factors a) desired days of cash and b) average daily cash outflows. By multiplying these two it is possible to determine safety level of cash.(ii) Determination of the channels of investment. After determining whether these surplus finds are temporary surplus of cash or temporary the finance manager has to invest them in the various instruments based on the availability of cash and its type. Some of these type of investments are:• Treasury Bills• Certificate of Deposits• Ready Forwards.• Inter corporate deposits• Call deposits• Deposits• Investment in marketable securities.• Money market mutual funds etc. 144
  • 145. Unit 4 INVENTORY MANAGEMENTObjectives1. To familiarise about the concept of Inventory2. To know the benefits of holding inventories3. To identify the tools and techniques of Inventory ManagementUnit outlineManagement of inventoriesBenefits of holding inventoriesTools and techniques of Inventory Management----------------------------------------------------------------4.4.1. Management of inventories. Inventories are very important constitutes of working capital management.For the successful running of any company mainly depends on the availability ofinventory in right quantity at right time, at reasonable price. Inventory constitutesRaw material, work-in-progress, finished goods, consumable stores and spareparts. Inventory management refers to systematic control over purchasing,storing and issuing of inventory with an intention of maximising the profits.---------------------------------------------------------------------------4.4.2 Benefits of holding inventories--------------------------------------------------------------------------- 145
  • 146. The following are the specific benefits of holding inventories.1. If a company maintains adequate inventory, it avoids losses of sales and loss of customers due to shortage of finished goods in the market.2. If a company orders for adequate inventory in large quantity it can reduce orderings cost like checking, approving, mailing the order etc.,3. Advantage of bargaining power, if company purchases in large quantity.-------------------------------------------------------------------------------4.4.3 Tools and techniques of Inventory Management-------------------------------------------------------------------------- Effective Inventory Management requires an effective control system forinventories. The following are the important tools and techniques of inventorymanagement.1. Determining of Stock Levels like Minimum level, Max. level, Reorder level etc.,2. Classification and Codification of Inventories.3. Determining of Safety Stocks.4. Selecting a proper system of Ordering for Inventory.5. Determining Economic Order Quantity.6. Perpetual Inventory System.7. Always Better Control Analysis (ABC Analysis)8. Vital Essential and Desirable (VED) Analysis.9. Inventory Turnover Ratios.10. Aging Schedule of Inventories.11. Preparation of Inventory Reports.Unit 5 RECEIVABLE MANAGEMENTObjectives1. To familiarise about the management of receivables2. To ascertain the cost of maintaining receivables 146
  • 147. 3. To determine the factors affecting the size of receivablesUnit outlineManagement of receivablesCosts of maintaining receivablesFactors affecting the size of receivables-------------------------------------------------------------------------------4.5.1. Management of receivables-------------------------------------------------------------------------- Next to Inventories in the current assets of the business firm accountsreceivable constitutes a major portion in the current assets. The accountreceivables arise because of credit sales. Under this system, when a firm sellsgoods or services on credit, the payments are postponed to future dates andreceivables are created. Receivables represent amounts owed to the firm as a result of sale of goodsor services in the ordinary course of business. These are claims of the firm againstits customers and form part of its current assets. Receivables are also known asaccounts receivables, trade receivables, or book debts. The period of credit andextent of receivables depends upon the credit policy of the firm. Receivable is a direct result of credit sale. Credit sale is resorted to by a firmto push up its sales which ultimately result in increasing in profits earned. At thesame time, selling goods on credit results in blocking of funds in accountsreceivable which results in demand for additional funds, increase in bad debts,maintaining and supervising the accounts of the customers. Hence it all calls forgood receivables management. Receivable management is a process of making 147
  • 148. decisions relating to the investment of funds in this asset which will result inmaximizing the overall return on the investment of the firm.--------------------------------------------------------------------------4.5.2. Costs of maintaining receivables--------------------------------------------------------------------------- The major categories of costs associated with the extension of credit andaccounts receivable are:1. Capital costs2. Administrative costs3. Collection costs and4. Defaulting costs.-------------------------------------------------------------------------------4.5.3 Factors affecting the size of receivables--------------------------------------------------------------------------- The size of account receivables is determined by a number of factors. Someof the important factors are as follows:1. Levels of sales2. Credit policies3. Terms of trade like Credit period and Cash discount. 148
  • 149. Unit 6WORKING CAPITAL CONTROL AND BANKING POLICYObjective1. To get insight into the various committees constituted and their recommendations with regard to the financing of working capital requirements of the companies. 149
  • 150. Unit outlineWorking Capital Control and Banking PolicyCommittees and their findings and recommendations.1. Dehejia Committee Report, 1969.2. Tandon Committee Report, 1975.3. Chore Committee Report, 1980.4. Marathe Committee Report, 1884.5. Chakravarty Committee Report, 1985.6. Kannan Committee Report, 1997.------------------------------------------------------------------------------4.6.1. Working Capital Control and Banking Policy--------------------------------------------------------The availability of bank credit to industry has been a subject-matter of regulationand control in the recent years keeping in view the basic objective of ensuring itsequitable distribution to various sectors of the Indian economy. Since November1965, a Credit Authorisation Scheme has been in operation as part of theReserve Bank of Indias credit policy. Under this scheme all scheduled commercialbanks are required to obtain prior authorisation of RBI before sanctioning anyfresh credit limits of Rs. One crore or more to any single party or any limit thatwould enable the party avail Rs one crore or more from the entire banking system 150
  • 151. on secured on unsecured basis. This limit of Rs one crore was subsequently raisedto Rs five crores. To regulate and control bank finance, the RBI has been issuing directivesand guidelines to the banks from time to time on the recommendations of certainspecially constituted committees. The following are the committees and theirfindings and recommendations.7. Dehejia Committee Report, 1969.8. Tandon Committee Report, 1975.9. Chore Committee Report, 1980.10. Marathe Committee Report, 1884.11. Chakravarty Committee Report, 1985.12. Kannan Committee Report, 1997.DEHEJIA COMMITTEE In order to determine "the extent to which credit needs of industry, andtrade are likely to be inflated and how such trends could be checked", the NationalCredit Council constituted in 1968 a committee under the chairmanship of Shri.V.T. Dehejia. The committee submitted its report in September 1969. The committee was of the opinion that there was also a tendency to divertshort-term credit for long-term assets. Although committee was of the opinion thatit was difficult to evolve norms for lending to industrial concerns, the committeerecommended that the banks should finance industry on the basis of a study ofborrowers total operations rather than security basis alone. The Committeefurther recommended that the total credit requirements of the borrower should besegregated into Hard Core and Short-term component. The Hard Corecomponent which should represent the minimum level of inventories like rawmaterial, finished product and stores which the industry was required to hold for 151
  • 152. maintaining a given level of production should be put on a formal term loan basisand subject to repayment schedule. The committee was also of the opinion thatgenerally a customer should be required to confine his dealings to one bank only.TANDON COMMITTEE RBI set up a committee under the chairmanship of Shri. P.L. Tandan in July1974 to study the following:1. To suggest guidelines for commercial banks to follow up and supervise credit from the point of view of ensuring proper end use of funds and keeping a watch on the safety of advances.2. To suggest the type of operational data and other information that may be obtained by banks periodically from the borrowers and by the RBI fro the leading banks.3. To suggest for prescribing inventory norms for the different industries like public and private sectors.4. To make recommendations regarding resources for financing the minimum working capital requirements.5. To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to borrowing.6. To suggest whether the existing pattern of financing working capital requirements by cash credit overdraft requires to be modified.Findings of the committee. The committed identified the following majorweaknesses:1. It is the borrower who decides how much he would borrow.2. Bank credit, instead of being taken as a supplementary to other source of finance.3. Bank credit is extended on the amount of security available and not according to the level of operations of the borrower. 152
  • 153. 4. There is a wrong notion that security by itself ensures the safety of bank funds but actually it lies in efficient follow-up of the industrial operations of the borrower.Recommendations: The report was submitted on 9th August, 1975 with thefollowing recommendations.1. A proper financial discipline has to be observed by the borrower and he must supply the relevant information should be provided for proper appraisal of credit plans.2. The main function of a banker as a lender is to supplement the borrowers resources to carry an acceptable level of current assets.3. The bank should know the end-use of bank credit so that it is used only for purposes for which it is made available. The recommendations of the committee regarding lending norms have been suggested under three alternatives. According to the first method, the borrower will have to contribute a minimum of 25% of the working gap from long-term funds. Under the second method the borrower will have to provide a minimum of 25% of the total current assets from long-term funds: this will give a minimum current ratio of 1.33:1. In the third method, the borrowers contribution from long-term funds will be to the extent of the entire core current assets and a minimum of 25% of the balance current assets.CHORE COMMITTEE REPORT The RBI appointed another committee under the chairmanship of Shri. K.B.Chore in March, 1979 to review the working of cash credit system in recent yearswith particular reference to the gap between sanctioned limits and the extent oftheir utilisation and also to suggest alternative types of credit facilities to ensurefinancial discipline. The following are the important recommendations of the committee. 153
  • 154. 1. The banks should obtain quarterly statements in the prescribed format from all borrowers having working capital credit limits of Rs 50 lakhs and above.2. The banks should undertake a periodical review of limits of Rs 10 lakhs and above.3. The banks should not bifurcate cash credit accounts into demand loan and cash credit components.4. If a borrower does not submit the quarterly returns in time the banks may charge penal interest of one per cent on the total amount outstanding for the period of default.5. Banks should discourage sanction of temporary limits by charging additional one percent interest over the normal rate on theses limits.6. The banks should fix separate credit limits for peak level and non-peak level, wherever possible.7. Banks should take steps to convert cash credit limits into bill limits for financing sales.MARATHE COMMITTEE REPORTThe RBI appointed another committee in March, 1979 under thechairmanship of Marathe to review the working of Credit AuthorisationScheme and suggest measures for giving meaningful directions to the creditmanagement function of the RBI. The principle recommendations of thecommittee are:1. The committee has declared the Third Method of Lending as suggested by the Tandon Committee to be dropped. Hence the banks should provide credit for working capital according to the Second Method of Lending.2. The committee has suggested the introduction of the Fast Track Scheme to improve the quality of credit appraisal in banks. it recommended that commercial banks can release without prior approval of the RB 50% of 154
  • 155. the additional credit required by the borrowers against the following requirements.a) The estimates/projections in regard to production, sales, chargeable current assets, other current assets, current liabilities other than bank borrowings, and net working capital are reasonable in terms of the past trends and assumptions regarding most likely trends during the future projected period.b) The classification of assets and liabilities as current and non-current is in conformity with the guidelines issued by the RBI.c) The projected current ratio is not below 1.33:1.d) The borrower has been submitting quarterly information and operating statements (Form I,II, and III) for the past six months within the prescribed time and undertakes to do the same in future also.e) The borrower undertakes to submit to the bank his annual account regularly and promptly.CHAKRAVARTY COMMITTEE REPORTThe RBI appointed another committee under the chairmanship of SukhamoyChakravarty to review the working of the monetary system of India and itsubmitted its report in April, 1985. The following are the two majorrecommendations of the committee with regard to working capital finance.1. The committee has suggested that the government must insist that all public sector units, large private sector units and government departments must include penal interest payment clause in their contracts for payments delayed beyond a specified period of 2% higher than minimum lending rate of the suppliers bank.2. The committee further suggested that the total credit limit to be sanctioned to a borrower should be considered under three different heads. 155
  • 156. a) For Cash credit portion is maximum prevailing lending rate of the bank. b) For Bill Finance portion 2% below the basic lending rate of the bank. c) For Loan Portion the rate may vary between the minimum and maximum lending rate of the bank. KANNAN COMMITTEE REPORT In view of the ongoing liberalisation in the financial sector, the IBAconstituted a committee headed by Shri K. Kannan, to examine all the aspects ofworking capital finance including assessment of maximum permissible bankfinance and this committee submitted its report in February, 1997. Therecommendations of this committee are:1. The arithmetical rigidities imposed by Tandon Committee in the form of maximum permissible bank finance (MPBF) computation in practice till now should be scrapped.2. It suggests that freedom to each bank be given in regard to evolving its own system of working capital finance for a faster credit delivery so as to serve various borrowers more effectively.3. It suggests that line of credit system, as prevalent in many advanced countries, should replace the existing system of assessment/fixation of sub-limits within total working capital requirements.4. The committee proposed to shift emphasis from the liquidity level lending to the cash deficit lending called Desirable Bank Finance. 156
  • 157. Unit 7PROBLEMS ON ESTIMATING WORKING CAPITAL &CASH BUDGETObjective1. To know the practical determination of working capital and its estimationChapter outlineProblems on estimating working CapitalProblems on cash budget 157
  • 158. Problems on estimating working Capital 1. A Proforma cost sheet of a company provides the following particulars:Elements of cost Amount per unitMaterials 40%Direct labour 20%Overheads 20%The following further particulars are available:a) It is proposed to maintain a level of activity of 2,00,000 units.b) Raw materials are expected to remain in stores for an average period of one month.c) Materials will be in process, on average of half a month.d) Selling price per unit Rs. 12.e) Finished foods are required to be in stock for an average of one month.f) Credit allowed to debtors is 2 months.g) Credit allowed by suppliers is one month. You may assume that sales and production follow a consistent pattern.Solution:Statement showing the details of calculation of net working capital 158
  • 159. Current Assets Raw Materials(one month): (2,00,00X12X40/100X1/12) 80000 Work in Progress:(1/2month): Raw Materials 40000 (200000X12X40/100X0.5/12) Labour 20000 (200000X12X20/100X0.5/12) Overheads 20000 (200000X12X20/100X0.5/12) Finished goods (One Month): Raw Materials 80000 (200000X12X40/100X1/12) Labour 40000 (200000X12X20/100X1/12) Overheads 40000 (200000X12X20/100X1/12) Debtors (2months) Raw Materials 160000 (200000X12X40/100X2/12) Labour 80000 (200000X12X20/100X2/12) Overheads 80000 (200000X12X20/100X2/12) Total Current Assets(A) 640000 Current Liabilities: 80000 Raw Materials (200000X12X40/100X1/12) Total Current Liabilities(B) 80000 NET WORKING CAPITAL(A-B) 5600002. A Proforma cost sheet of a company provides the following particulars: 159
  • 160. Elements of cost: Amount Per UnitMaterials 50%Direct Labour 15%Overheads 15% The following further particulars are available;(a) It is proposed to maintain a level of activity of 30000Units.(b) Selling Price=Rs20 P.U© Raw materials are expected to be in the stores for an average of 2 months.(d) Materials will be in process, on average of one month.(e) Finished goods are required to be in stock for an average of 2 months.(f) Credit allowed to debtors is 2 months.(g) Credit allowed to creditors is 2 months. You may assume that sales and production follow a consistent pattern.Solution:Statement showing the details calculation of net working capital 160
  • 161. Current Assets: Raw materials(2months) (300000X20X50/100X2/12) 500000 Work- in- progress Raw materials (300000X20X50/100X1/12) 250000Direct Labour (300000X20X15/100X1/12) 75000 Overheads (300000X20X15/100X1/12) 75000 Finished goods(2 months) Raw materials (300000X20X50/100X2/12) 500000 Direct Labour (300000X20X15/100X2/12) 150000 Overheads (300000X20X15/100X2/12) 150000 Debtors(2 months) Raw materials (300000X20X50/100X2/12) 500000 Direct Labour (300000X20X15/100X2/12) 150000 Overheads (300000X20X15/100X2/12) 150000 Total Current Assets(A) 2500000 Current Liabilities; Raw materials (300000X20X50/100X2/12) 500000 Total Current Liabilities(B) 500000 Net Wording Capital(A-B) 2000000 161
  • 162. 3. X and C. is desirous to purchase a business and has consulted you and onepoint on which you are asked to advice them is the average amount of workingcapital which will be required in the first year’s working. You are given the following estimates and are instructed to add 10% to yourcomputed figure to allow for contingencies:(1) Amount blocked up in stocks: Rs. Stock of finished goods 5000 Stock of Stores materials 8000 162
  • 163. (2) Average Credit Sales: Inland sales-6 weeks credit 3,12,000 Export sales-one and half months 78,000(3) Lag in payment of wages and other outgoing;Wages-one and half weeks 2,60,000Stock of materials-One and half weeks 48,000Rent, Royalties-6 months 10,000Clerical Staff 62,400Manager-half month 4800Miscellaneous expenses-One and half month 48,000(4) Payment in Advances;Sundry expenses(paid Quarterly in advance) 8000(5) Un drawn profit on the average throughout the year Rs 11,000 163
  • 164. Solution:Statement shows the details of calculating of net wording capital. Current Assets Rs Stock of finished goods 5000 Stock of stores, materials 8000 Sundry debtors;- Inland(312000X6/52) 36000 Export(78000X1.5/52) 2250 38250 Payment in advance;- Sundry expenses(8000X3/12) 2000 Total Current Assets 53250 Current Liabilities Lag in payment of wages (260000X1.5/52) 7500 Lag in payment to materials (48000X1.5/12) 6000 Rent and royalties (10000X 6/12) 5000 Clerical staff (62400X0.5/12) 2600 Manager’s salary (4800X0.5/12) 200 Miscellaneous expenses (48000X1.5/12) 6000 Total current liabilities 27300 Gross working capital(A-B) 25950 Add; 10% contingencies 2595 Net Working capital 28545 164
  • 165. 4. A proforma cost sheet of a company provides the following particulars;Elements of cost: Amount per UnitMaterials 50%Direct Labour 10%Overheads 10% The following further particulars are available(a) It is proposed to maintain a level of activity of 10000Units.(b) Selling price=Rs.10 p.u.© Raw materials are expected to be in the stores for an average of 2 months.(d)Materials will be in process, on average of one month.(e) Finished goods are required to be in a stock for an average of 2months.(f) Credit allowed to debtors is 3months. 165
  • 166. (g) Credit allowed to suppliers is 2months.Solution:STATEMENT SHOWING THE DETAILS CALCULATION OF NET WORKING CAPITAL 166
  • 167. Current Assets Raw materials (one month) (100000X10X50/100X2/12) 83333 Work-in-Progress(one month) Raw materials (100000X10X50/100X1/12) 41667 Labour (100000X10X10/100X1/12) 8333 Overheads (100000X10X10/100X1/12) 8333 Finished Goods(2months) Raw materials (100000X10X50/100X2/12) 83333 Labour (100000X10X10/100X2/12) 16667 Overheads (100000X10X10/100X2/12) 16667 Debtors(3months) Raw materials (100000X10X50/100X3/12) 125000 Labour (100000X10X10/100X3/12) 25000 Overheads (100000X10X10/100X3/12) 25000 Total Current Assets 433333 Current Liabilities: Raw materials 83333 (100000X10X10/100X2/12) Total current liabilities 83333 Net working capital 3500005. A proforma cost sheet of a company provides the following particulars;Elements of c Amount per unit (Rs) 167
  • 168. Materials 80Direct labours 30Overheads 60Total cost 170(+) profit 30 Selling Price 200The following further particulars are available;(a) Raw materials are in stock on an average for one month(b) Raw materials are in process on an average for half a month.(C) Finished goods are in a stock on an average for one month.(d) Credit allowed by suppliers is one month.(e) Lag in payment of wages is one and half weeks.(f) Lag in payment of overheads is one month(g) 1/4 output is sold against cash.(h) Cash in hand and at bank is expected to be Rs. 25000(i) Credit allowed to customers is 2months. You are required to prepare a statement showing the working capital neededto finance level of activity of 104000Units of production. You may assume that production is carried on evenly throughout the year,wages and overheads accrued similarly and a time period of 4 weeks is equivalentto a month.STATEMENT SHOWING THE DETAILS CALCULATIONS OF THE NET WORKINGCAPITAL 168
  • 169. Current Assets;Raw materials(104000X80X4/52) 640000Work-in-progressRaw materials(104000X80X2/52) 320000Labour(104000X30X2/52) 120000Overheads(104000X60X2/52) 240000Finished goods;Raw materials(104000X80X4/52) 640000Labour(104000X30X4/52) 240000Overheads(104000X60X4/52) 480000Debtors;Raw materials(104000X80X8/52X3/4) 960000Labour(104000X30X8/52X3/4) 360000Overheads(104000X60X8/52X3/4) 720000Cash in hand 25000Total Current Assets 4745000Current LiabilitiesCreditors-Rawmaterials(104000X80X4/52) 640000Wages O/S(104000X30X1.5/52) 90000Lag in payment of wages(104000X60X4/52) 480000Total Current liabilities 1210000Net working capital(A-B) 3535000 169
  • 170. Problem on Cash BudgetThe following information is available in respect of XYZ Company ltd.: 1. Materials are purchased and received one month before being used and payment is made to suppl8ers two months after receipt of materials. 2. Cash is received from customers three months after finished goods are sold and delivered to them. 3. No time lag applies to payments of wages and expenses. 4. The following figures apply to recent and future months: Month Materials Sales Wages and received expenses January 20,000 30,000 9,500 February 22,000 33,000 10,000 March 24,000 36,000 10,500 April 26,000 39,000 11,000 May 28,000 42,000 11,500 June 30,000 45,000 12,000 July 32,000 48,000 12,500 August 34,000 51,000 13,000 5. Cash balance at the beginning of April is Rs. 10,000. 6. All products are sold immediately they have been made and that materials used and sums spent on wages and expenses during any particular month relate strictly to the sales made during that month. Solution: Cash Budget from April to JulyParticulars April May June July 170
  • 171. Opening Balance 10,000 7,000 4,500 2,500Collections from debtors 30,000 33,000 36,000 39,000 ------------ ---------- --------- -------- 40,000 40,000 40,500 41,500A ------------ ---------- --------- --------Payments 11,000 11,500 12,000 12,500Wages and expenses 22,000 24,000 26,000 28,000Payments to suppliers ------------ ---------- --------- ---------B 33,000 35,500 38,000 40,500 ------------ ---------- --------- ---------Closing balance (A - B) 7,000 4,500 2,500 1,500 171