CFM Full Notes (BCU)

CORPORATE FINANCIAL MANAGEMENT (CFM)
SYLLABUS BLUE PRINT
Units Unit Title Section-A
(2 Marks)
Contents Section-B
(5 Marks)
Contents Section-C
(15 marks)
Contents
UNIT-1 Introduction to
Financial
Management
2 Questions
(Theory)
Any question from your
syllabus
1 Question
(Theory)
syllabus
1 Question
(Theory)
syllabus
UNIT-2 Time Value of
Money
1 Question
(Theory)
syllabus
1 Question Problems on FV,PV,
Annuity, Valuation
NIL NIL
UNIT-3 **Financing &
Dividend Decisions
2 Question
(Theory)
syllabus
1 Question
(Theory)
syllabus
1 Question
(Theory)
syllabus
1 Question
(Practical)
*Problems on leverage 1 Question
(Practical)
*Problems on Earning Per
Share (EPS)
UNIT-4 **Investment
Decision
2 Questions
(Theory)
syllabus
2 Questions
(Practical)
*Problems on PBP, ARR,
NPV, IRR, PI
1 Question
(Practical)
*Combined Problems
(PBP+ARR+NPV+PI)
(PBP+IRR+NPV+PI)
UNIT-5 Working capital
Management
1 Question
(Theory)
syllabus
1 Question
(Theory or
Practical)
syllabus and Simple
*Problem on Statement of
Working Capital
1 Question
(Theory)
syllabus
*Important Practical Questions
** Important Chapters
Note:- Blue print has prepared by Analyzing Previous Year Question papers

CORPORATE FINANCIAL MANAGEMENT SYLLABUS

BBA CFM QUESTION PAPER PATTERN
Section-A
5 X 2 = 10 (5 Questions out of 7 Questions)
Section-B
Section-C

Unit-1
Introduction to Financial
Introduction to Financial
Management

The Finance Function is a part of financial
management. Financial Management is the activity
concerned with the control and planning of financial
concerned with the control and planning of financial
resources.
In business, the finance function involves the
acquiring and utilization of funds necessary for
efficient operations.

Investment Decisions
Financing Decisions
Dividend Decisions
Liquidity Decisions
The purpose of the finance function
Objectives of Finance Functions
The purpose of the finance function
There are two main purposes of the finance function:
To provide the financial information that other business functions
require to operate effectively and efficiently
To support business planning and decision-making

Difference
between
Profit
Maximization
and
Wealth
Maximization
Difference
between
Profit
Maximization
and
Wealth
Maximization

1. Nature of Business.
2. Size of Business.
3. Production Techniques.
4. Purchase of old equipments.
5. Reputation of the Business.
1. Shifts in Consumer.
2. Competitive Factors.
3. Shifts in Technology.
4. Government reputations of
Control.

Mr.Chethan.S
Asst. Professor, Department of Management
1
UNIT-2
TIME VALUE OF MONEY (TVM)
INTRODUCTION:-
“A bird in the hand is worth two in the bush” is a proverb that means the things we
currently have are worth a lot more than the things we have a chance of getting.
A bird in the hand is worth two in the bush is often used as advice or a warning for a person
who is making risky decisions or is about to risk a lot over an unknown outcome. The
proverb says that the things you already own are far more valuable to you than things you
hope to get because you may never actually get them.
This applies to financial transactions too. Say, someone borrowed a certain amount from
you and it is due. Just as you are expecting the money to be credited to your account, you
get a call from the borrower saying that he will pay you after 3 months. You are not happy
about this. This is because you are aware of time value of money or TVM.

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There is no reason for any rational person to delay taking an amount owed to him or her.
More than financial principles, this is basic instinct. The money you have in hand at the
moment is worth more than the same amount you ‘may’ get in future. One reason for this is
inflation and another is possible earning capacity.
The fundamental code of finance maintains that, given money can generate interest; the value
of a certain sum is more if you receive it sooner. This is why it is called as the present value.
Basically, the time value of money validates that it is more beneficial to have cash now than
later. Say, if you invest a Rs. 100 today – the returns will be more compared to the same
investment made 2 months from now. Moreover, there is always a risk that the borrower
might delay even more or not pay at all in the future.
CONCEPT OF TIME VALUE OF MONEY:

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MEANING OF TVM:-
The term “Time Value of Money” refers to the Money’s worth varies according to the time
period in which it is received.
REASONS FOR THE TIME PREFERENCE FOR MONEY:-
1. Uncertainty and loss.
2. To satisfy present needs.
3. Investment opportunities.
4. Inflation.
5. Consumption.
NEED/ APPLICATION/ IMPORTANCE OF TVM:-
1. In Investment Decision.
2. In Capital Budgeting Decision.
3. It helps in personal decisions like savings for children, buying a house etc.,
4. It helps in accepting or rejecting project proposal.
5. Assessment of credit policies.
6. Determining the magnitude of risk & Uncertainty.
TECHNIQUES OF TIME VALUE OF MONEY:-
Techniques
of TVM
Compounding
Technique
*Future value of Single cash flow
*Future Value of even cash flow
*Future Value of Uneven cash flow
*Future value of Annuity
Discounting
Technique
*Present value of Single cash flow
*Present Value of even cash flow
*Present Value of Uneven cash flow
*Present value of Annuity

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MEANING OF PRESENT VALUE:-
It refers to the current worth of a future sum of money or stream of cash flows given a
specified rate of return.
MEANING OF FUTURE VALUE:-
It refers to the value of an asset or cash at a specified date in the future that is equivalent in
value to a specified sum today.
MEANING OF ANNUITY:-
It is a sum of money or an investment that is paid at regular intervals.
A. COMPOUNDING TECHNIQUE.
i) Future value of Single cash flow
FVn = PV (1+r) n
Where,
FVn = Future value
PV = Present value
r = rate of Interest
n = No. of years
Problem- 01
Calculate the future value of a sum of Rs.1000 if it is invested at 8% interest for a period of 1 year.
Solution:-

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Problem- 02
Calculate the future value of a sum of Rs. 5000 if it is invested at 12% interest for a period of
3 years.
Solution:-
Problem- 03
Mr. X invests Rs.1000 for a period of 5 years in a Bank. The rate of interest is 10%. Find the
Future value.
Solution:-

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Multiple Compounding Periods
If a sum of Money is compounded for 1 year at a particular rate of interest then above
illustration help us to find the future Value.
But if the compounding period differs, interest earned will also differ if the interest is
compounded Semi annually, Quarterly or monthly; such future value is calculated by using
the following formula:
FV = PV [1 + r/m]mn
Where,
FV = Future Value
PV = Present Value i.e., cash flow
r = Rate of Interest
n = Total no. of years
m = No. of times interest is compounded in a year
Problem-04
Calculate the future value of a sum of Rs.1000 if it is invested for a year with an interest
compound period of Semi-annually, Quarterly and Monthly at 10%.
Solution:-

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Problem-05
Calculate the future value of a sum of Rs.5000 if it is invested for 2 years with
an interest compounding Semi-annually, Quarterly and Monthly at 12%.
Solution:-

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ii) Future Value of even cash flow
FVn = PV (1+r) n-1
+ PV (1+r) n-2
+ PV (1+r) n-3
+ PV (1+r) n-4
………+ PV
Or
FVA = PCF (1+r) n
– 1
r
Problem-06
Mr. Ajay deposits Rs. 6,000 at the end of each year for 5 years in his saving account. Paying
9% interest compounded annually. He wants to determine how much sum of money he will
have at the end of 5th
year.

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Problem-07
Compute the Future value for the following payments made over a period of 5 years at 12%
rate of interest.
Year 1 2 3 4 5
Payments 3000 3000 3000 3000 3000

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PROBLEM-08
Mr. Sushanth deposits Rs.12, 000 at the end of each year for 6 years and deposits earns
compound interest at 12% p.a. Determine how much sum of money he will have at the end of
6 years.

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iii) Future Value of Uneven cash flow
FVUECF = R1 (1+r) n-1
+ R2 (1+r) n-2
+ R3 (1+r) n-3
+ R4 (1+r) n-4
……
Where,
FVUECF = Future value of Uneven cash flow
R1, R2 ,R3 = Uneven cash flow
r = rate of Interest
n = No. of years
PROBLEM-09
Calculate the Future value at the end of 5 year of the following series of payment at 9% rate
of interest, Rs.2000 at the end of 1st
year, Rs.4000 at the end of 2nd
year, Rs.6000 at the end
of 3rd
year, Rs.8000 at the end of 4th
year, Rs.10000 at the end of 5th
year.

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PROBLEM-10
Calculate the Future value of the following cash flow if it is invested at 8%
interest p.a.
At the end of
the year
Amount Deposited
1 1000
2 2000
3 3000
4 4000

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iv) Future value of Annuity
PROBLEM-11
Mr. Naveen deposited Rs.1000 annually in a bank for 5 years at 10% interest
compounded. Calculate future value at the end of 5 years.
PROBLEM-12
Mr. Anand deposited Rs.5000 annually in a bank for 5 years at 10% interest
compounded. Calculate future value at the end of 4 years.

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B. DISCOUNTING TECHNIQUES.
i) Present value of Single cash flow
PV = __FV____
(1+r) n
Where,
PV = Present value
FV = Future Value
r = Rate of Interest / Discounting rate
n = No. of years
PROBLEM-13
Mr. Mohan receive Rs.30, 000 after 5 years from now his time preference for
money is 10% p.a. Find Present value.
PROBLEM-14
Calculate the present value of sum of Rs.25, 000 received after 2 years if the
discount rate is 8% p.a.

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PROBLEM-15
Calculate present value of Rs.5000 received at the end of a year if the discount
rate is 9% p.a.
ii) Present Value of even cash flow
PV = F1____ + F2____ + F3____ + F4____ + - - - - - - - - + F____
(1+r) 1
(1+r) 2
(1+r) 3
(1+r) 4
(1+r) n
Where,
F = Future cash flow
PV = Present Value
n = No. of years

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PROBLEM-16
Find out the present value of Annuity receipt of Rs.8, 000 received for 5 years
at the rate of 8% discount.
PROBLEM-17
What is the present value of Annuity of Rs.9, 000 received at the end of 5th
year.
If it is invested at 10%.

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18
iii) Present Value of Uneven cash flow
PV = F1____ + F2____ + F3____ + F4____ + - - - - - - - - + F____
(1+r) 1
(1+r) 2
(1+r) 3
(1+r) 4
(1+r) n
Where,
F = Future cash flow
PV = Present Value
n = No. of years
PROBLEM-18
Calculate the Present value of the following series of payments made at the end
of each year for the period of 5 years at 8% interest rate.
Rs. 8, 000 at the end of 1st
year
Rs.10, 000 at the end of 2nd
year
Rs.12, 000 at the end of 3rd
year
Rs.14, 000 at the end of 4th
year
Rs.16, 000 at the end of 5th
year

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PROBLEM-19
Compute the present value of cash inflows at 10% discount rate using formula
method as well as table method.
Year 1 2 3 4 5
Expected cash Flow 1000 2000 3000 4000 5000

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iv) Present value of Annuity
PROBLEM-20
Mr. Arun receives Rs. 1000 dividend annually for 3 years. Calculate present
value of this stream of dividend at a discount of 10%?

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PROBLEM-21
Mr. Darshan receives Rs. 3000 dividend annually for 3 years. Calculate present
value at a discount of 10%?

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DOUBLING PERIOD
It refers to the method in which a particular sum of money is double in a
definite period of time at a specified rate of interest.
This is calculated by using the formula:-
1. Rule 72 = Doubling Period = 72
Rate of Interest
2. Rule 69 = Doubling Period = 0.35 + 69
Rate of Interest
PROBLEM-22
Calculate the doubling period for a sum of Rs.8, 000 at 6% rate of Interest per
annum.
PROBLEM-23
Calculate the doubling period if an investor invests his deposit at 12% interest
by using rule 69 and 72.

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VALUATION
Valuation is the process of estimating the worth of something having economic
or monetary value. It is usually expressed as a price/ earnings ratio.
METHODS OF VALUATION:
1. Book Value
2. Market Value
3. Liquidation Value
4. Replacement Value
5. Going concern Value
A. VALUATION OF BOND/ DEBENTURE:
1. Redeemable Bond/ Debenture
PV of Debenture = I1____ + I2____ + I3____ + M3____
(1+r) 1
(1+r) 2
(1+r) 3
(1+r) 3
Where,
PVB = Present Value of Bond
I = Interest amount received
r = Discounting rate/ Capitalization rate
M = Maturity value
PROBLEM-24
A Debenture is available for Rs.1000. It has interest amount of Rs.80 per year
for a period of 5 years with the capitalization rate of 12%. The bond has the
maturity value of Rs.1140. Advice the investor in his buying decision.

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PROBLEM-25
A Debenture is available in the market for Rs.1000 with Rs.80 as interest for a
year for a period of 4 years with the maturity value of Rs.1120. The debentures
capitalization rate is 10%. Advice Mr.Pavan in his buying decision of this
debenture.
-

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2. Irredeemable Bond/ Debenture
PV of Debenture = I____
r
Where,
PVB = Present Value of Bond
I = Interest amount received
PROBLEM-26
What is the value of Irredeemable debentures which as Rs.60 as the interest for
infinite period with the discount rate at 9%.
PROBLEM-27
How much an investor has to pay for the following debt instrument whose
interest per year is Rs.70. Its capitalization rate is 11%.

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B. VALUATION OF PREFERENCE SHARE:
1. Redeemable Preference share
PV of Preference share = D1____ + D2____ + D3____ + M3____
(1+r) 1
(1+r) 2
(1+r) 3
(1+r) 3
Where,
PVPS = Present Value Redeemable Preference share
D = Dividend of the year
M = Maturity value
PROBLEM-28
How much an investor has to pay for the redeemable preference shares which
has dividend of Rs.70 per year for next 4 year with maturity value of Rs.1150.
The capitalization rate is 8%.

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PROBLEM-29
A preference share is available in the stock market with the following
information:
a. Maturity value of preference share Rs.1120.
b. Dividend amount of Rs.50 per year.
c. Maturity period is 4 years.
d. Discount rate is 8%.

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2. Irredeemable Preference share
PVIPS = D____
r
Where,
PVIPS = Present Value Irredeemable Preference share
D = Dividend of the year
PROBLEM-30
A company issued 8% irredeemable preference share of Rs.100 each. The
capitalization rate is 6%. Compute present value of preference shares.
PROBLEM-31
Compute the present value of 7% Irredeemable preference shares of Rs.100
each. If the capitalization rate is 11%.

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C. VALUATION OF EQUITY SHARE:
1. Dividend Capitalization Model
a. Single Period Valuation Model
PVES = D1____ + P1____
(1+r) 1
(1+r) 1
Where,
PVES = Present Value Equity share
D1 = Dividend paid in the 1st year
P1 = Sale price of equity share at the end of the year
PROBLEM-32
Mr. Raghu holds an equity share which has the features of getting Rs.20 as
dividend for the First year. He aspects to sell the same share for Rs.190 at the
end of the year. What is the value today if the capitalization rate is 11%.

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PROBLEM-33
Mr. Anand is planning to buy an equity share hold it for 1 year and then sells it.
The expected dividend at the end of the year is Rs.8 and expected rates is
Rs.220 at the final year.
Determine the value of equity share if the capitalization rate is 14%.
b. Two period Valuation Model
PVES = D1____ + D2____ + P1____
(1+r) 1
(1+r) 2
(1+r) 2
Where,
D1 & D2 = Dividend paid in the 1st
& 2nd
year
P1 = Sale price of equity share at the end of 2nd
year

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PROBLEM-34
Mr. Raj is holding the equity share of a company which has the following
features.
The dividend of 1st
and 2nd
year is Rs.8 and Rs.10.
The discount rate is 9%.
The sale price of equity share at the end of 2nd
year is Rs.160.
Calculate the present value of equity share.

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PROBLEM-35
Mr. Ashok is planning to buy an equity share hold it for two years then sale it.
The expected dividend at the end of 1st
year and 2nd
year is Rs.10 and Rs.12.
expected selling price of share at the end of 2nd
year is Rs.280. Discount rate is
16%.

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c. When dividend rate is constant
PVES = D1____
r
Where,
D1 = Dividend
PROBLEM-36
XYZ Co., ltd currently paying a dividend of Rs.30 per share. It is expected that
the company will pay the same dividend in the future. The current capitalization
rate is 16%. What is the present value of equity share.
PROBLEM-37
Calculate the present value of equity share. If the dividend is Rs.20 per share for
an infinite period with the capitalization rate is 16%.

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d. When the dividend is growing at constant rate
PVES = D1____
r - g
Where,
D1 = Dividend
g = Growth rate
PROBLEM-38
A Company is expected to pay dividend of Rs.8 per share by next year. The
dividends are expected to grow continuously at the rate of 10%. What is the
value of equity share, if the required rate of return is 12%.
PROBLEM-39
An investor is planning to purchase a equity share which has the following
features:
The current dividend is Rs.30. The discount rate is 16%. The growth rate is 8%.

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e. When the dividend rate is growing at variable rate
Procedure:
Step 1: Calculate the present value of Dividend
Step 2: Find out the present value of equity share at the end of year with constant growth in dividend.
Step 3: Find out present value of equity share today
PROBLEM-40
A Company is expected to pay a dividend of Rs.5 per share. After a year its
dividends are expected to grow 14% for next 5 years and then at the rate of 7%
indefinitely. Find out the PVES if the capitalization rate is 11%.

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PROBLEM-41
A Company is currently paying a dividend of Rs.4 per share. The dividend is
expected to grow at 16% for next 5 years and at 11% forever. What is the
present value of the share? If the capitalization rate is 14%.

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2. Earning Capitalization Model
PVES = E___
r
Where,
E = Earning per share
PROBLEM-42
Calculate the present value of equity share of a company which earns
Rs.1, 00,000 which is to be distributed among 10,000 shareholders with the
capitalization rate is 12%.
PROBLEM-43
Calculate the price of equity share according to earning capitalization model.
When earning per share is Rs.22 with the capitalization rate is 13%.
e capitalization rate is 13%.

Chethan. S
Asst Prof., Department of Management
1
CORPORATE FINANCIAL MANAGEMENT
III SEMESTER BBA
UNIT-3
FINANCING DECISION AND DIVIDEND DECISION
A. FINANCING DECISION
FINANCING DECISION:
Financing decision involves determining different sources of finance from which funds may
be raised and proportion of each source finance. Financial manager can raise funds from both
debt and equity sources of finance keeping in mind the cost, control and risk of each source
of finance. However, he has to ensure the best debt-equity mix to maximize the wealth of the
shareholders. The mix of debt and equity is known as capital structure.
CAPITALISATION
Capitalization means all the money received by that business in exchange for long - term debt and
equity
Capitalization is the total value of a company’s outstanding shares. It is calculated by multiplying
the number of shares by their current price.
The market capitalization formula is:
MC = N x P
Where
MC stands for market capitalization
N stands for the number of outstanding shares
P is the closing price per share
Depending on their size, companies are generally classified as large-cap (typically $10 billion+),
mid-cap ($2 billion to $10 billion) or small-cap (typically $300 million to $2 billion).

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MEANING OF CAPITAL STRUCTURE OR FINANCING DECISION
Capital Structure is the mix of different sources of long-term funds such as equity shares,
preference shares, long-term loans or debts like debentures or bonds, retained earnings etc., in
the total capitalization of the company. In simple words, capital structure refers to the mix of
debt and equity.
For example, if company has equity shares of Rs.1,00,000, debentures of Rs.1,00,000,
preference shares of Rs.1,00,000 and retained earnings of Rs.50,000. The capital structure of
the firm is said to be Rs.3,50,000.
CAPITAL STRUCTURE AND FINANCIAL STRUCTURE
The term capital structure differs from financial structure. Capital structure refers to the mix
of different sources of long-term funds only whereas financial structure refers to the mix of
both long-term funds as well as short-term funds. Thus, a company’s capital structure is only
a part of its financial structure.
Patterns of Capital Structure
In case of a new company the capital structure may be of any of the following four patterns.
i) Capital structure with equity shares only.
ii) Capital structure with both equity and preference shares.
iii) Capital structure with equity shares and debentures.
iv) Capital structure with equity shares, preference shares and debentures.

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The choice of an appropriate capital structure depends on a number of factors such as
the nature of the company’s business, regularity of earnings, conditions of the money market,
attitude of the investors, etc.
Since the capital structure is the mix of debt and equity, it is better to understand the
basic difference between these two:
Debt is a liability on which interest has to be paid irrespective of the company’s profits, while
equity consists of shareholders’ or owners’ funds on which payment of dividend depends
upon the company’s profits. A high proportion of the debt content in the capital structure
increases the risk and may lead to financial insolvency of the company in adverse times.
However, raising funds through debt is cheaper as compared to raising funds through shares.
This is because of two reasons:
i) Interest payable on debt is allowed as an expense for tax purpose whereas dividend is
considered to be an appropriation of profits hence payment of dividend does not result in any
tax benefit to the company.
(ii) Cost of debt is less than cost of equity.
For example, if a company is in 50% tax bracket, pays interest at 12% on its debentures, the
effective to it comes only to 6%. While if the amount is raised by issue of 12% preference
shares, the cost of raising the amount would be 12%. Thus, raising funds by debt is cheaper
resulting in higher availability of profits for shareholders. This increases the earnings per
equity share of the company which is the basic objective of a finance manager.

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OPTIMAL CAPITAL STRUCTURE
The optimum capital structure may be defined as the relationship of debt and equity
securities, which minimizes the firm’s cost of capital and thereby maximizes the value of the
firm.
The optimum capital structure is the combination of debt and equity which maximizes the
value of the firm. Optimum capital structure maximizes the value of the company and hence
the wealth of its owners and minimizes the company’s cost of capital. Thus, the optimum
capital structure is obtained when the market value per equity share is the maximum. Thus,
the objective of the firm should, therefore, be to select debt-equity mix which leads to
maximum value of the firm.
Principles of Capital structure decisions:-
a) Cost Principle
Cost Principle: this principle deals with the ideal capital structure which should minimize
cost of financing and maximize the earnings per share. The cheaper form of capital structure
is debt capital.
b) Risk Principle
Risk Principle: this principle deals with the capital structure which should not accept high
risk. If company issue large amount of preference shares out of the earnings of the company
then less amount will be left out for equity shareholders as dividend is paid after the
preference shares.
c) Control Principle
Control Principle: this principle deals with the capital structure which is keeping the
controlling position of owners. Preference shareholders possesses no voting rights and don't
disturb positions.
d) Flexibility Principle
Flexibility Principle: this principle deals with capital structure which can have additional
requirements of funds in future.
e) Timing Principle
Timing Principle: this principle deals with capital structure which should be able to have
market opportunities and which should be able to minimize cost of raising funds and obtain
the savings.

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FEATURES OF CAPITAL STRUCTURE
1. Profitability.
2. Solvency.
3. Flexibility.
4. Control.
5. Simplicity.
6. Liquidity.
FACTORS DETERMINING THE CAPITAL STRUCTURE
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. The use of long-term debt increases magnifies the earnings per share if
the firm yields a return higher than the cost of debt. The earnings per share also increase with
the use of preference share capital but due to the fact that interest is allowed to be deducted
while computing tax, the leverage impact of debt is much more.
2. Growth and stability of sales: The capital structure of a firm is highly influenced by the
growth and stability of its sales. If the sales of a firm are expected to remain fairly stable, it
can raise a higher level of debt. Stability of sales ensures that the firm will not face any
difficulty in meeting its fixed commitments of interest payment and repayments of debt.
Similarly, the rate of growth in sales also affects the capital structure decision.
3. Cash flow ability to service debt: A firm which shall be able to generate larger and stable
cash inflows can employ more debt in its capital structure as compared to the one which has
unstable and lesser ability to generate cash inflows. Debt financing implies burden of fixed
charge sue to the fixed payment of interest and the principal.
4. Nature and size of the firm
Nature and size of a firm also influences its capital structure. A public utility concern has
different capital structure as compared to other manufacturing concern. Public utility
concerns may employ more of debt because of stability and regularity of their earnings. On
the other hand, a concern which cannot provide stable earnings due to the nature of its
business will have to rely mainly on equity capital.
5. Control
Whenever additional funds are required by a firm, the management of the firm wants to raise
the funds without any loss of control over the firm. In case the funds are raised through the
issue of equity shares, the control of the existing shareholders is diluted.

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Hence, they might raise the additional funds by way of fixed interest bearing debt and
preference share capital. Preference shareholders and debenture holders do not have the
voting right. Hence, from the point of view of control, debt financing is recommended.
6. Cost of Capital: Every rupee invested in a firm has a cost. Cost of capital refers to the
minimum return expected by its suppliers. The capital structure should provide for the
minimum cost of capital. The main sources of finance for a firm are equity, preference share
capital and debt capital. The return expected by the suppliers of capital depends upon the risk
they have to undertake. Usually, debt is a cheaper source of finance compared to preference
and equity capital due to (i) fixed rate of interest of debt; (ii) legal obligation to pay interest;
(iii) repayment of loan and priority in payment at the time of winding up of the company.
7. Flexibility: Capital structure of a firm should be flexible, i.e., it should be such as to be
capable of being adjusted according to the needs of the changing conditions. It should be
possible to raise additional funds, whenever the need be, without much of difficulty and
delay. A firm should arrange its capital structure in such a manner that it can substitute one
form of financing by another. Redeemable preference shares and convertible debentures may
be preferred on account of flexibility. Preference shares and debentures which can be
redeemed at the discretion of the firm offer the highest flexibility in the capital structure.
8. Requirements of investors: The requirements of investors are another factor that
influences the capital structure of a firm. It is necessary to meet the requirements of both
institutional as well as private investors when debt financing is used. Investors are generally
classified under three kinds, i.e. bold investors, cautious investors and less cautious investors.
Bold investors are willing to take all types of risk, are enterprising in nature, and prefer
capital gains and control and hence equity share capital is best suited to them.
9. Capital Market Conditions: Capital market conditions do not remain the same for ever.
Sometimes there may be depression while at other times there may be boom in the market.
The choice of the securities is also influenced by the market conditions. If the share market is
depressed and there are pessimistic business conditions, the company should not issue equity
shares as investors would prefer safety. But in case there is boom period, it would be
advisable to issue equity shares.
10. Assets structure: The liquidity and the composition of assets should also be kept in mind
while selecting the capital structure. If fixed assets constitute a major portion of the total
assets of the company, it may be possible for the company to raise more of long term debts.
11. Purpose of financing: If funds are required for a productive purpose, debt financing is
suitable and the company should issue debentures as interest can be paid out of the profits
generated from the investments. However, if the funds are required for unproductive purpose
or general development on permanent basis, we should prefer equity capital.
12. Period of Finance: The period for which the finances are required is also an important
factor to be kept in mind while selecting an appropriate capital mix. If the finances are
required for a limited period of, say, seven years, debentures should be preferred to shares.
Redeemable preference shares may also be used for a limited period finance, if found suitable
otherwise. However, in case funds are needed on permanent basis, equity share capital is
more appropriate.

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13. Costs of floatation: Although not very significant, yet costs of floatation of various
kinds of securities should also be considered while raising funds. The cost of floating a debt
is generally less than the cost of floating equity and hence it may persuade the management to
raise debt financing. The costs of floating as a percentage of total funds decrease with the
increase in size of the issue.
14. Personal considerations: The personal considerations and abilities of the management
will have the final say on the capital structure of a firm. Managements which are experienced
and are very enterprising do not hesitate to use more of debt in their financing as compared to
the less experienced and conservative management.
15. Corporate tax rate: High rate of corporate taxes on profits compel the companies to
prefer debt financing, because interest is allowed to be deducted while computing taxable
profits. On the other hand, dividend on shares is not an allowable expense for that purpose.
16. Legal requirements: The government has also issued certain guidelines for the issue of
shares and debentures. The legal restrictions are very significant as these lay down a
framework within which capital structure decision has to be made. For example, the
controller of capital issues, now SEBI grants his consent for capital issue when (i) the debt-
equity ratio does not exceed 2:1 (ii) the ratio of preference capital to equity does not exceed
1:3 and (iii) promoters hold at least 25% of the equity capital.
EPS (Earning Per Share)
Earnings per share can be defined as that share of a company’s profit that is distributed to
each share of stocks. Further, it is considered to be a significant financial parameter as it
helps to gauge a company’s financial health. To elaborate, higher EPS reflects greater
profitability from the company and its overall ventures.
A company with a steadily increasing EPS is often considered to be a reliable investment
option.
Generally, EPS is divided into 3 broad categories, namely –
Trailing EPS: It is entirely based on the previous year’s figures.
Current EPS: Mostly based on the current projections and available figures.
Forward EPS: Depends on anticipated future projections and estimated figures.

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Calculation of Earnings per Share
EPS = Net Profit available to Equity shareholder
No. of equity share
Preparation of Income Statement / Income Table/
Profitability Statement
Particulars Amount
Net Sales XXXX
( - ) Variable Cost XXX
Contribution XXXX
( - ) Fixed Cost XXX
Earning Before Interest & Tax (EBIT) XXXX
( - ) Interest on Debenture XXX
Earning Before Tax (EBT) XXXX
( - ) Corporate Tax XXX
Earning After Tax (EAT) XXXX
( - ) Preference Dividend XXX
Net Profit available to Equity shareholder XXXX

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PROBLEMS ON EPS (Earning Per Share)
PROBLEM 01
A Company has equity share capital of ₹5, 00,000 divided into share of ₹100 each.
Company wishes to raise ₹3, 00,000 for Expansion and Modernization purpose.
The company has following alternatives.
i) All are equity shares (common stock).
ii) ₹1, 00,000 in equity share and ₹2, 00,000 in Debentures at 10% Interest.
iii) All are debentures at 10% Interest.
iv) ₹1, 00,000 in equity share and ₹2, 00,000 in preference share capital at 8% Dividend
rate.
The corporate tax is 50%
The company EBIT is ₹1, 50,000
Calculate EPS for each case and comment which capital structure the company has to choose.
Solution:-

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PROBLEM 02
PENTA FOUR Ltd. has currently an all equity structure consisting of 15,000 equity shares
of Rs.100 each. The management is planning to raise another Rs. 25 lakhs to finance a major
programme of expansion and is considering three alternative methods of financing:
i) To issue 25,000 equity shares of Rs.100 each.
ii) To issue 25,000, 8% debentures of Rs.100 each.
iii) To issue 25,000, 8% preference shares of Rs.100 each.
The company’s expected earnings before interest and taxes will be Rs.8 lakhs.
Assuming a corporate tax rate of 46%, determine the earnings per share (EPS), in each
alternative and comment which alternative is best and why?
Solution:-

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PROBLEM 03
AB Ltd., is capitalized with Rs.10,00,000 divided into shares of Rs.100 each. It plans to raise
further Rs.5,00,000 for expansion plans. The company plans the following schemes:
a) All equity shares.
b) Rs.2,00,000 in equity shares and Rs.3,00,000 in debentures at 10%.
c) All debentures at 10%.
The company has estimated its EBIT at Rs.3,00,000. Tax rate is 50%. Suggest which
scheme is to be selected.
Solution:-

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PROBLEM 04
ABC Ltd., has a share capital of Rs.1,00,000 divided into shares of Rs.10 each. It has a
major expansion programme requiring an investment of another Rs.50,000. The management
is considering the following three alternatives:
i) Issue 5,000 shares of Rs.10 each
ii) Issue 5,000, 12% preference shares of Rs.10 each.
iii) Issue of 10% debentures of Rs.50,000
The company’s present EBIT is Rs.30,000 p.a. Calculate the EPS for the above three
alternatives presuming,
a) EBIT continues to be the same.
b) EBIT increases by Rs.10,000
Assume the tax rate at 50%.
Solution:-

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PROBLEM 05
A company needs Rs.12,00,000 for the installation of a new factory which would yield an annual
EBIT of Rs.2,40,000. The company has the objective of maximizing the EPS. It is considering
the possibility of issuing equity shares of Rs.10 each plus raising a debt of Rs.2,00,000,
Rs.6,00,000, or Rs.10,00,000. The current market price per share is Rs.40 which is expected to
drop to Rs.25 per share of the market borrowings were to exceed Rs.7,50,000. Cost of
borrowings is as follows:
• Upto Rs.2,50,000 at 10% p.a.
• Between Rs.2,50,000 and Rs.6,50,000 at 14% p.a.
• Between Rs.6,50,000 and Rs.10,00,000 at 16% p.a.
Assume tax rate of 50%, calculate the EPS and the scheme which would meet the objective of the
management.
Solution:-

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PROBLEM 06 2019 QP Question
A Company has EBIT of Rs.4,80,000 and its capital structure consist of the
following Securities.
Particulars Amount
Equity share Capital (10 Each) 4,00,000
12% Preference shares 6,00,000
14.5% Debentures 10,00,000
The Company is facing fluctuations in its sales what would be the change in
EPS.
a) If the EBIT of the Company Increased by 25%.
b) If the EBIT of the Company Decreased by 25%.
The corporate Tax is 35%.
Solution:-

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PROBLEM 07 2018 QP Question
Sun Limited and Moon Limited are identical except that former is not Levered
while the latter it has levered. The particulars are as follows:
Particulars Sun Limited Moon Limited
Equity Share Capital (Rs.10 each) 10,00,000 5,00,000
8% debt Capital - 5,00,000
Assets 10,00,000 10,00,000
Return on Assets 20% 20%
Calculate the EPS assuming the tax rate of 30% and would it be advantageous
to the moon limited to raise the level of debt to 70%?
Solution:-

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PROBLEM 08
KR Limited is capitalized with Rs.5,00,000 divided into 50,000 equity shares of
Rs.10 each. The management desires to raise another Rs.5,00,000 to finance some
expansion programme.
There are four possible financing plans:
i) All equity Shares.
ii) Rs.2,50,000 in equity and the balance in debentures carrying 10% Interest.
iii) Rs.2,50,000 in Equity and Rs.2,50,000 in preference shares carrying 10%
Dividend.
iv) All debentures carrying 10% Interest.
The existing EBIT amounts to Rs.60,000 p.a.
Calculate EPS in all the above four plans.
Solution:-
Particulars Plan I Plan II Plan III Plan IV
EBIT 60,000 60,000 60,000 60,000
Less: Interest on
debentures @ 10 %
Nil 25,000 nil 50,000
Earnings Before Tax
(EBT)
60,000 35,000 60,000 10000
Less: Tax @ 50% 30,000 17,500 30,000 5,000
Earnings After Tax (EAT) 30,000 17,500 30,000 5,000
Less: Preference Dividend nil nil 25000 nil
Earnings Available to
equity shares
30,000 17,500 5,000 5,000
No. of Equity shares 100,000 75,000 75,000 50,000
EPS 0.3 0.23 0.06 0.1
(Note:- If tax information is not given in the problem we should
assume 30% or 50% and we should give Note below the Solution)

Practice Questions
Year - 2016
Solution:-
a. When the EBIT is 80,000
CALCULATION OF EPS
Particulars
EBIT/operating profit
Less: Interest on Debt. @10 %
Earnings Before Tax (EBT)
Less: Tax @ 50 %
Earnings After Tax (EAT)
Less: Dividend on Pref. Share
Earnings Available to equity shares
No. of Equity shares
EPS
Practice Questions
a. When the EBIT is 80,000
CALCULATION OF EPS
Equity Pref+Deb Debenture
Plan I Plan II Plan III
80000 80000 80000
@10 % nil 5,000 10,000
(EBT) 80000 75000 70000
40,000 37,500 35,000
40,000 37,500 35,000
Share @10% nil 5000 nil
Earnings Available to equity shares 40,000 32,500 35,000
20,000 10,000 10,000
2 3.25 3.5
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Debenture
Plan III
80000
10,000
70000
35,000
35,000
nil
35,000
10,000
3.5

b. When the EBIT is increased to 1,00,000
Particulars
Less: Interest on debentures @10 %
Less: Tax @ 50 %
Less: Dividend on Preference capital
@10%
EPS
Year - 2015
b. When the EBIT is increased to 1,00,000
Equity Pref+Deb Debenture
Plan I Plan II Plan III
100000 100000 100000
Interest on debentures @10 % nil 5,000 10,000
(EBT) 100000 95000 90000
50,000 47,500 45,000
50,000 47,500 45,000
Dividend on Preference capital nil 5000 nil
Earnings Available to equity shares 50,000 42,500 45,000
20,000 10,000 10,000
2.5 4.25 4.5
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Debenture
Plan III
100000
10,000
90000
45,000
45,000
nil
45,000
10,000
4.5

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Solution:-
A. The Company may issue 50,000 equity shares of Rs.100 per share.
Particulars EBIT - I EBIT - II EBIT - III
EBIT 1,00,000 2,00,000 4,00,000
Less: Interest on Debt. Nil Nil Nil
Earnings Before Tax
(EBT)
1,00,000 2,00,000 4,00,000
Less: Tax @ 50% 50,000 1,00,000 2,00,000
Earnings After Tax (EAT) 50,000 1,00,000 2,00,000
Less: Preference Dividend Nil Nil Nil
equity shares
50,000 1,00,000 2,00,000
No. of Equity shares 50,000 50,000 50,000
EPS Rs.1 Rs.2 Rs.4
B. The Company issue 50,000 equity shares of Rs.100 each and
25,000 debentures of Rs.100each at 8% Interest.
Particulars EBIT - I EBIT - II EBIT - III
EBIT 1,00,000 2,00,000 4,00,000
Less: Interest on Debt. 2,00,000 2,00,000 2,00,000
Earnings Before Tax -1,00,000 0 2,00,000
Less: Tax @ 50% -50,000 0 1,00,000
Earnings After Tax (EAT) -1,50,000 0 1,00,000
Less: Preference Dividend Nil Nil Nil
equity shares
-1,50,000 0 1,00,000
No. of Equity shares 25,000 25,000 25,000
EPS Rs.-6 Rs.0 Rs.4

C. The Company issue 50,000 equity shares of
25,000 preference share of Rs.100each at 8% Dividend.
Particulars
EBIT
Less: Interest on Debt.
Earnings Before Tax
Less: Tax @ 50%
Less: Preference Dividend
equity shares
EPS
Year - 2014
C. The Company issue 50,000 equity shares of Rs.100 each and
25,000 preference share of Rs.100each at 8% Dividend.
EBIT - I EBIT - II EBIT
1,00,000 2,00,000 4,0
Nil Nil Nil
1,00,000 2,00,000 4,0
50,000 1,00,000 2,0
(EAT) 50,000 1,00,000 2,0
Preference Dividend 2,00,000 2,00,000 2,0
-1,50,000 -1,00,000 0
25,000 25,000 25
Rs.-6 Rs.-4 Rs.0
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Rs.100 each and
EBIT - III
4,00,000
Nil
4,00,000
2,00,000
2,00,000
2,00,000
25,000
Rs.0

LEVERAGE
Leverage is an investment strategy of using borrowed money
various financial instruments or
investment. Leverage can also refer to the amount of
Companies use leverage to finance their assets
companies can use debt to invest in business operations in an attempt to increase shareholder
value.
An automaker, for example, could borrow money to build a new factory. The new factory
would enable the automaker to increase the number of cars it produces and increase
Concept:
To gain Higher Financial Benefits compared to the fixed charges
Types of leverages
There are three types of leverages:
i) Operating leverage
ii) Financial leverage and
iii) Combined leverage
i) Operating leverage
Operating leverage refers to the extent to which the firm has fixed operating costs. If firm
has high degree of operating leverage, it will have relatively high fixed costs in comparison
with a firm with low operating leverage. Operating leverage can be calculated by the
following formula:
LEVERAGES
Leverage is an investment strategy of using borrowed money—specifically, the use of
various financial instruments or borrowed capital—to increase the potential return of an
Leverage can also refer to the amount of debt a firm uses to finance assets.
Companies use leverage to finance their assets—instead of issuing stock to raise capital,
could borrow money to build a new factory. The new factory
would enable the automaker to increase the number of cars it produces and increase
Concept: - “How to do more with less”
To gain Higher Financial Benefits compared to the fixed charges Payable
There are three types of leverages:
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specifically, the use of
to increase the potential return of an
a firm uses to finance assets.
instead of issuing stock to raise capital,
could borrow money to build a new factory. The new factory
would enable the automaker to increase the number of cars it produces and increase profits.
Payable

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Contribution
Operating leverage = ----------------
EBIT
Degree of operating leverage
% of change in EBIT
DOL = ---------------------------
% of change in Sales
ii) Financial leverage
Financial leverage refers to the extent to which the firm has fixed financing costs arising from
the use of debt capital. If firm has high financial leverage, it will have relatively high fixed
financing costs compared to the firm with low financial leverage.
Financial leverage can be calculated by the following formula:
EBIT
Financial leverage = ----------
EBT
Note: If dividend payable on preference shares available in the problem the formula for
Financial Leverage is:
EBIT
Financial leverage = ----------
EBT – Dp
-------
1-T
Where; Dp = Dividend on preference shares.
Degree of financial leverage
% of change in EPS
DFL = ---------------------------
% of change in EBIT
iii) Combined leverage or Total leverage
Combined leverage refers to the extent to which a firm has fixed operating costs as well as
financing costs. Combined leverage can be calculated by the following formula:
Contribution
Combined leverage = ---------------
EBT
Or
=Operating Leverage x Financial Leverage

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Note: If dividend payable on preference shares available in the problem the formula for
Combined Leverage is :
Contribution
Combined leverage = -------------------
EBT – Dp
-------
1-T
Where; Dp = Dividend on preference shares.
Degree of combined leverage
% of change in EPS
DCL = ------------------------
% of change in Sales
Combinations of Operating and Financial leverage
Operating
Leverage
Financial
Leverage
Combined effect
High
Low
Low
High
High
Low
High
Low
It is very dangerous policy which should be avoided it is called as
risky situation.(Very risky)
It is very cautious policy and not assumed any risk.( Conservative)
This is an ideal policy. The company can follow aggressive debt
policy which is known as ideal situation.(Moderate)
Adverse effects of operating leverage were taken care of by having
low financial leverage. (Moderate)

PROFORMA OF INCOME STATEMENT
Particulars
Net Sales
Less: Variable Cost
Contribution
Less: Fixed Cost
Less: Interest on debentures
Less: Tax
Less: Dividend on Preference capital
EPS
DIFFERENCE BETWEEN OPERATING AND FINANCIAL LEVERAGE
PROFORMA OF INCOME STATEMENT
Amount
(₹)
XXXX
XXX
XXXX
XXX
XXXX
Interest on debentures XXX
(EBT) XXXX
XXX
XXXX
Dividend on Preference capital XXX
Earnings Available to equity shares XXXX
XXX
XX
Operating
Leverage
Financial
Leverage
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Combined
Leverage

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PROBLEM 09
Calculate operating leverage:
Interest Rs.5, 000; Sales Rs.50, 000; Variable cost Rs.25, 000 and
Fixed cost Rs.15, 000
Solution:-

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PROBLEM 10
Calculate operating, financial, combined leverages from Interest Rs.5, 000;
Sales Rs.50, 000; Variable cost Rs.25, 000; Fixed cost Rs.15,000.
Solution:-

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PROBLEM 11
A firm has sales of Rs.5, 00,000, variable cost Rs. 3, 50,000 and fixed cost
Rs.1, 00,000 and debt of Rs.2,50,000 at 10 per cent interest. Calculate the
operating, financial and combined leverage.
Solution:-

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PROBLEM 12
XYZ Ltd., has an average selling price of Rs.10 per unit. Its variable unit cost
is Rs.7 and fixed costs amount to Rs.1,70,000. it pays 50% tax on its income.
It finances all its assets by equity capital. ABC Ltd., is identical to XYZ Ltd.,
except in respect of the pattern of financing. ABC Ltd., finances its assets by
equity for 50% and by debt for 50%, the interest on which amounts to
Rs.20,000. Determine operating and financial leverages at sales level of
Rs.7,00,000 for both companies and interpret the results.
Solution:-

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Interpretation
A company should try to have a balance of the two leverages because they have
got tremendous effect on EBIT and EPS. It may be noted that a right
combination of these leverages is a very big challenge for the management. A
proper combination of both operating and financial leverage is a blessing for the
firm’s growth while an improper combination may prove to be a curse.

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PROBLEM 13 2019 QP Question (6 Marks)
A firm has sales of Rs.10,00,000, variable cost of Rs.5,00,000, fixed cost of
Rs.2,00,000 and debt of Rs.5,00,000 at 10% interest. Calculate operating,
financial and combined leverage.
Solution:-

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A firm has sales of Rs.20,00,000, variable cost of Rs.14,00,000, fixed cost of
Rs.4,00,000 and debt of Rs.10,00,000 at 10% interest. Calculate operating,
financial and combined leverage.
Solution:-

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Determine the three types of leverages from the following information:-
Selling price per unit Rs.10
Variable cost per unit Rs.5
Fixed Cost Rs.1,20,000
10% debt capital Rs.3,00,000
Number of units sold 90,000
Solution:-

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Determine the three types of leverages from the following information:-
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.1,25,000
Interpret the Results of the firm.
Solution:-

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Practice Questions
Year - 2015
Year - 2014
Practice Questions
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B. DIVIDEND DECISION
MEANING OF DIVIDEND:
Dividend is a after tax profit which is distributed to the shareholders.
The term dividend refers to that part of the profits of a company which is
distributed amongst its shareholders.
DEFINITION: Dividend refers to a reward, cash or otherwise, that a company
gives to its shareholders. Dividends can be issued in various forms, such as cash
payment, stocks or any other form. A company’s dividend is decided by its
board of directors and it requires the shareholders’ approval. However, it is not
obligatory for a company to pay dividend. Dividend is usually a part of the
profit that the company shares with its shareholders.
DIVIDEND PROCESS
DIVIDEND DECISION
MEANING OF DIVIDEND:-
after tax profit which is distributed to the shareholders.
distributed amongst its shareholders.
Dividend refers to a reward, cash or otherwise, that a company
to its shareholders. Dividends can be issued in various forms, such as cash
to pay dividend. Dividend is usually a part of the
profit that the company shares with its shareholders.
DIVIDEND PROCESS
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after tax profit which is distributed to the shareholders.
Dividend refers to a reward, cash or otherwise, that a company
to its shareholders. Dividends can be issued in various forms, such as cash
to pay dividend. Dividend is usually a part of the

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DIVIDEND POLICY
The term dividend policy refers to the policy concerning how much profits to be
distributed as dividend and how much to be retained in the business.
TYPES OF DIVIDEND POLICY
1. Stable dividend policy
2. Regular dividend policy
3. Irregular Dividend Policy
4. No dividend Policy
1. Stable dividend policy
The term ‘stability of dividend’ means consistency or lack of variability
in the stream of dividend payment. In more precise terms, it means payment of
certain minimum amount of dividend regularly. A stable dividend policy may
be established in any of the following forms:
a. Constant dividend per share: Some companies follow a policy of paying
fixed dividend per share irrespective of the level of earnings year after year.
Such firms, usually, create a ‘Dividend Equalization Reserve’ to enable them
pay the fixed dividend even in the year when the earnings are not sufficient or
when there are losses. A policy of constant dividend per share is most suitable
to concerns whose earnings are expected to remain stable over a number of
years.
b. Constant payout ratio: It means payment of a fixed percentage of net
earnings as dividends every year. The amount of dividend in such a policy
fluctuates in direct proportion to the earnings of the company. This type of
policy is suitable to concerns whose profits are expected to increase over a
number of years.
c. Stable rupee dividend plus extra dividend: Some companies follow a
policy of paying constant low dividend per share plus an extra dividend in the
years of high profits. Such a policy is most suitable to the firms having
fluctuating earnings from year to year.

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2. Regular dividend policy
• Payment of dividend at the usual rate is termed as regular dividend. The
investors such as retired persons, widows and other economically weaker
persons prefer to get regular dividends. A regular dividend policy offers the
following advantages:
• It establishes a profitable record of the company.
• It created confidence amongst the shareholders.
• It aids in long-term financing and renders financing easier.
• It stabilizes the market value of shares.
• The shareholders view dividends as a source of funds to meet their day-to-
day living expenses.
3. Irregular Dividend Policy
• Some companies follow irregular dividend payments on account of the
following:
• Uncertainty of earnings.
• Unsuccessful business operations.
• Lack of liquid resources.
• Fear of adverse effects of regular dividends on the financial standing of the
company.
4. No dividend Policy
A company may follow a policy of paying no dividends presently because of its
un favorable working capital position or on account of requirements of funds for
future expansion and growth.
FORMS OF DIVIDEND
• Cash dividend
• Property dividend
• Stock dividend or Bonus shares
• Scrip or Bond dividend
Dividends can be classified in various forms. They are:

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• Cash dividend: A cash dividend is a usual method of paying dividend.
Payment of dividends in cash results in outflow of funds from the firm.
The firm should, therefore, have adequate cash resources at it disposal so
that its liquidity position is not adversely affected due to cash dividend.
• Scrip or Bond dividend: In case the company does not have sufficient
cash to pay dividend it may issue bonds for the amount due to the
shareholders by way of dividends. The purpose of bond dividend is to
postpone the payment of immediate dividend in cash. The bond holders
get regular interest on their bonds besides payment of the bond money on
the due date. Bond dividend is not popular in India.
• Property dividend: In case of property dividend the company pay
dividend in the form of assets which are not required by the company or
in the form of company’s products. This type of dividend is also not
popular in India.
• Stock dividend or Bonus shares: In case of this dividend, the company
issues its own shares to the existing shareholders in lieu or in addition to
cash dividend. Payment of stock dividend is popularly termed as “issue
of bonus shares” in India.
FACTORS AFFECTING DIVIDEND POLICY
External factors
1. General state of economy
2. State of capital market
3. Legal restrictions
4. Contractual restrictions
5. Tax policy

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Internal factors
1. Desire of the shareholders
2. Financial needs of the company
3. Nature of earnings
4. Desire of control
5. Liquidity position
The factors affecting the dividend policy are classified into external and
internal:
External factors
Following are the external factors which affect the dividend policy of a firm:
1. General state of economy: The general state of economy affects to a great
extent the management’s decision to retain or distribute earnings of the firm.
In case of uncertain economic and business conditions - the management
may like to retain the whole or a part of the firm’s earnings to build up reserves
to absorb shock in the future.
In periods of depression - the management may also like to retain a large part
of its earnings to preserve the firm’s liquidity position.
In periods of prosperity - the management may not be liberal in dividend
payments though the earning power of a company warrants it because of
availability of larger profitable investment opportunities.
In periods of inflation - the management retain larger proportion of the
earnings for replacement of worn-out assets.

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2. State of capital market: In case a firm has an easy access to the capital
market either because it is financially strong or because favourable conditions
prevail in the capital market, it can follow a liberal dividend policy (retains
less and distributes more). However, if the firm has no easy access to capital
market because either of weak financial position or because of unfavourable
conditions in the capital market. It is likely to adopt a more conservative
dividend policy (retain more and distribute less profits to equity shareholders).
3. Legal restrictions: In India Companies Act 1956 has put several restrictions
regarding payment and declaration of dividends.
i) Dividends can only be paid out of current profits or past profits or money
provided by the central government or state government. Payment of dividend
out of capital is illegal.
ii) Dividend should be paid only out of profits after providing for depreciation
and transferring to reserves not less than 10%.
4. Contractual restrictions: Lenders of the firm generally put restrictions on
dividend payment to protect their interest and capital repayment in periods
when the firm is experiencing liquidity or profitability problems. For example
it may be provided in a loan agreement that the firm shall not pay dividend of
more than 12% so long the firm does not clear the loan.
5. Tax policy: The tax policy followed by the Government also affects the
dividend policy. For example the Government gives tax incentives to
companies retaining larger share of their earnings.

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Internal factors
1. Desire of the shareholders: Of course, the directors of the company have
considerable freedom in declaring the dividend but the shareholders are the real
owners of the company and therefore, their desires should not be overlooked by
the directors while deciding about the divided policy.
2. Financial needs of the company: Shareholders’ desire and financial needs
of the company are two conflict issues while determining the dividend policy.
If company retains more profits, it may not meet the desires of the shareholders.
3. Nature of earnings: A firm having stable income may follow higher
dividend payout ratio. For example Public Utility Companies like Electricity
Boards and Air lines carrying business purely on cash system may pay higher
dividends. Similarly Liquor Companies can follow liberal dividend policy since
people used to drink liquor both in boom as well as in recession. But the
companies which are engaged in Luxury Goods may follow conservative
dividend policy because of stiff competition and low profits.
4. Desire of control: The company which follows low dividend payout ratio
does not dilute the control of the existing shareholders whereas the company
following high dividend payout ratio dilutes the control of the existing
shareholders as it issues new shares to acquire funds to finance future finance
requirements.
5. Liquidity position: The payment of dividends results in cash outflow from
the firm. A firm may have adequate earnings but it may not have sufficient cash
to pay dividends. It is therefore important for the management to take into
account the cash position and the overall liquidity position of the firm before
and after payment of dividends while making dividend decision.

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BONUS SHARE
Bonus shares are the additional shares given to the current shareholders of the
company free of cost, in proportion to their existing shareholding. Such an event
is called a Bonus Issue. Bonus shares are given to the current shareholders in
lieu of a dividend pay-out.
ADVANTAGES OF BONUS SHARE
Issue of bonus shares is beneficial both to the company as well as to the
shareholders.
To the company
1. Conservation of Cash: Issue of bonus shares makes possible for the
company to declare a dividend without using the cash resources that may be
needed for operation or expansion. The company can thus retain earnings as
well as satisfy the desire of the shareholders to receive dividend.
2. Keeps EPS at a Reasonable Level: A company having a high EPS may
have to face problems both from the workers and consumers. Workers may feel
that they are underpaid while consumers think that they are overcharged for the
company’s products. Issue of bonus shares results in increasing the number of
shares and reducing the earning per share. Thus, EPS can be brought down to a
reasonable level without affecting the interest of the shareholders.
3. Wider Marketability of shares: Issue of bonus shares reduces the market
price of the company’s shares and thus even it reaches to the small investors
who cannot afford for bigger price shares.

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To the investors
1. Tax Benefits: When dividend is received in cash, it is included in his income
and taxed at usual income rates. However, stock dividend is not so taxable.
The profit made on the sale of shares will be deemed as a capital gain and will
be subject to lower rate of income tax.
2. Indication of Higher Future Profits: Issue of bonus shares is generally an
indication of higher future profits. This is because a company declares a bonus
issue only when its earnings are expected to increase.
3. Increase in Future Dividends: The shareholders will get extra dividends in
future even if the existing cash dividend per share is continued.
4. High psychological Value: Issue of bonus shares is usually received
positively in the market. This tends to create greater demand for the company’s
shares. As a matter of fact, the share prices of the company may rise on the
stock exchange after bonus issue in place of falling.
DISADVANTAGES OF BONUS SHARE
To the company
1. Issue of bonus shares leads to an increase in the capitalization of the company
2. Issue of bonus shares results in more liability on the company in respect of
future dividends.
3. It prevents new investors from becoming the shareholders of the company.
4. Control of the existing shareholders is not diluted and the present
management may misuse its position.
To the investors
1. Shareholders who prefer cash dividend may disappoint.
2. Issue of bonus shares lowers the market value of existing shares too.

Mr.CHETHAN.S
Asst. Prof, Department of Management, AIGS.
1
UNIT-4
INVESTMENT DECISION
INTRODUCTION:-
Investment decision it relates to as how the funds of a firm are to be invested into different
assets, so that the firm is able to earn highest possible return for the investors.
Investment decision can be long-term, also known as capital budgeting where the funds are
committed into long-term basis.
Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this context, capital
expenditure is the spending of funds for large expenditures like purchasing fixed assets and
equipment, repairs to fixed assets or equipment, research and development, expansion and the
like. Budgeting is setting targets for projects to ensure maximum profitability.
Capital budgeting is the process of making investment decisions in long term assets. It is the
process of deciding whether or not to invest in a particular project as all the investment
possibilities may not be rewarding.
MEANING OF CAPITAL BUDGETING:-
Capital Budgeting is the process of selecting the asset or an investment proposal that will
yield returns over a long period.
Thus, the manager has to choose a project that gives a rate of return more than the cost
financing such a project. That is why he has to value a project in terms of cost and benefit.

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Thus, capital budgeting is the most important responsibility undertaken by a financial manager.
This is because:
1. It involves the purchase of long term assets and such decisions may determine the future
success of the firm.
2. These decisions help in maximizing shareholder’s value.
3. Principles applicable to capital budgeting process also apply to other corporate decisions like
working capital management.
Following are the categories of projects that can be examined using capital budgeting process:
 The decision to buy new machinery
 Expansion of business in other geographical areas
 Replacement of an obsolete equipment
 New product or market development etc
PROCESS OF CAPITAL BUDGETING:-
 Step 1: Idea Generation
The most important step of the capital budgeting process is generating good investment ideas.
These investment ideas can come from a number of sources like the senior management, any
department or functional area, employees, or sources outside the company.
 Step 2: Analyzing Individual Proposals
A manager must gather information to forecast cash flows for each project in order to
determine its expected profitability. This is because the decision to accept or reject a capital
investment is based on such an investment’s future expected cash flows.
 Step 3: Planning Capital Budget
An entity must give priority to profitable projects as per the timing of the project’s cash
flows, available company resources, and a company’s overall strategies.
 Step 4: Project Execution
In this stage finance manager must take necessary step for immediate execution of selected
project.
 Step 5: Monitoring and Conducting a Post Audit
It is important for a manager to follow up or track all the capital budgeting decisions. He
should compare actual with projected results and give reasons as to why projections did not
match with actual performance. Therefore, a systematic post-audit is essential in order to find
out systematic errors in the forecasting process and hence enhance company operations.

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OBJECTIVES OF CAPITAL BUDGETING:-
1. Selecting profitable projects
An organization comes across various profitable projects frequently. But due to capital
restrictions, an organization needs to select the right mix of profitable projects that will
increase its shareholders’ wealth.
2. Capital expenditure control
Selecting the most profitable investment is the main objective of capital budgeting. However,
controlling capital costs is also an important objective. Forecasting capital expenditure
requirements and budgeting for it, and ensuring no investment opportunities are lost is the
crux of budgeting.
3. Finding the Right sources for funds
Determining the quantum of funds and the sources for procuring them is another important
objective of capital budgeting. Finding the balance between the cost of borrowing and returns
on investment is an important goal of Capital Budgeting.
IMPORTANCE [OR] ADVANTAGES OF CAPITAL BUDGETING
1. It encourages large Investment.
2. It increases earning capacity of the Business.
3. It increases Reputation of the Business.
4. It helps in better utilization of resources in organization.
5. It creates right decision for right investment.
6. It acts as a basis to forecast the future trends of the project.
7. It acts as a supporting element for the organization to achieve the objectives.
8. It provides large no of business opportunities.

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DISADVANTAGES OF CAPITAL BUDGETING
1. It is irreversible in nature.
2. It is based on Assumption not reality.
3. It is not adopted by small business concerns because a total investment is small in size.
4. It is difficult to anticipate immediate returns.
5. It is influenced by various factors such as political, social, economical, technological
factors etc., and it is very difficult to predict the changes in various factors.
CAPITAL BUDGETING TECHNIQUES:-
To assist the organization in selecting the best investment there are various techniques
available based on the comparison of cash inflows and outflows.
Techniques / Methods of
Capital Budgeting
Traditional Methods
1. Payback Period (PBP).
2. Accounting Rate of
return method (ARR).
Discount Cash Flow
Methods / Modern
Methods
1. Net Present Value (NPV).
2. Internal Rate of Return method (IRR).
3. Profitability Index (PI).

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TRADITIONAL METHODS:-
1. PAYBACK PERIOD METHOD
MEANING: - In this technique, the entity calculates the time period required to
earn the initial investment of the project or investment. The project or
investment with the shortest duration is opted for.
Types of Payback Period:-
A. Pay Back Period
B. Post Pay Back Period & Post Pay back Profitability
C. Discounted Pay Back Period
FORMULAS:-
A. When the cash flow are even or uniformed
B. When the cash flow are Uneven
Accept & Reject Criteria:-
Shorter the payback period Project is Accepted
Longer the payback period the Project is Rejected

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PROBLEM 01 (When the cash flow are even or uniformed)
From the Following information calculate the Pay Back Period and
Suggest?
Particulars Project A Project B
Project Cost 5,50,000 6,50,000
Cash Flows:
Year 1 1,00,000 1,50,000
Year 2 1,00,000 1,50,000
Year 3 1,00,000 1,50,000
Year 4 1,00,000 1,50,000
Year 5 1,00,000 1,50,000
SOLUTION:-

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PROBLEM 02 (When the cash flow are Uneven)
Calculate the Payback period from the Following Particulars and
suggest suitable Projects.
Particulars Project X Project Y
Investment 1,00,000 50,000
Cash Flows:
Year 1 10,000 10,000
Year 2 30,000 7,500
Year 3 40,000 20,000
Year 4 25,000 20,000
Year 5 15,000 15,000
SOLUTION:-

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PROBLEM 03 (When the cash flow are Uneven)
From the following information. Calculate the payback period and
suggest which project is suitable to invest.
Project - P Project - Q
Project Cost 50,000 50,000
Year Cash Inflow (Rs.) Cash Inflow (Rs.)
1 12,000 5,000
2 26,000 15,000
3 10,000 20,000
4 8,000 20,000
5 8,000 10,000
SOLUTION:-

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PROBLEM 04 (Problem on Post Payback Period & Post
pay back Profitability)
Rajesh and Company ltd is considering a purchase of 2 Assets namely
A&B. Each costing Rs. 5, 00,000. Cash Flow is as Follows.
Calculate Post payback period and Post payback profitability?
Years Asset -A Asset - B
Year 1 1,50,000 50,000
Year 2 2,00,000 1,50,000
Year 3 2,50,000 2,00,000
Year 4 1,50,000 3,00,000
Year 5 1,00,000 2,00,000
SOLUTION:-

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PROBLEM 05 (Problem on Discounted Payback period)
Alexa Company ltd is considering a purchase of 2 Assets namely
M&N. Each costing Rs. 4,000. Cash Flow is as Follows.
Years Asset - M Asset - N
Year 1 3,000 0
Year 2 1,000 4,000
Year 3 1,000 1,000
Year 4 1,000 2,000
The present value factors at 10%.
(Discount Factors 0.909, 0.826, 0.751, 0.683)
Calculate the discounted payback period.
SOLUTION:-

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PROBLEM 06 (Problem when cash flow has not given)
A company is considering expanding its production. It can go in
either for an automatic machine costing Rs. 2,24,000 with an
estimated life of 5 ½ years or an ordinary machine costing Rs.60,000
having an estimated life of 8 years. The annual sales and costs are
estimated as follows:
Particulars Automatic Machine
(Rs.)
Ordinary Machine
(Rs.)
Sales 1,50,000 1,50,000
Costs:-
Material 50,000 50,000
Labour 12,000 60,000
Variable Overheads 24,000 20,000
Calculate the Payback period and advice the Management
SOLUTION:-
Particulars Amount
(Automatic)
Amount
(Ordinary)
Sales
Less: Operating costs (Variable + Fixed cost)
EBDT (Earnings Before Depreciation and Tax)
Less: Depreciation
EBT (Earnings Before Taxes)
Less: Taxes @ 50%
EAT (Earnings After Taxes)
Add: Depreciation
Cash Inflow
(Earnings After Taxes But Before Depreciation)

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PROBLEM 07 (Problem when cash flow has not given)
A project costs Rs.20,00,000 and yields annually a profit of
Rs.3,00,000 after depreciation at 12 ½ % but before tax at 50%.
Calculate payback period.
SOLUTION:-
Particulars Amount
EBT (Earnings Before Taxes)
Less: Taxes @ 50%
Add: Depreciation
Cash Inflow
(Earnings After Taxes But Before Depreciation)

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2. ACCOUNTING RATE OF RETURN:-
MEANING: - Accounting Rate of Return (ARR) is the percentage rate of
return that is expected from an investment or asset compared to the initial cost
of investment. In this technique, the total net income of the investment is
divided by the initial or average investment to derive at the most profitable
investment.
Accounting rate of return, also known as the Average rate of return, or ARR is a
financial ratio used in capital budgeting.
FORMULA:-

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PROBLEM 08
Determine the Accounting rate of return from the following Data of 2
Machines A and B
Particulars Machine A Machine B
Cost 56,125 56,125
Additional Investment 5,000 6,000
Annual Income after Depreciation & Tax
Year 1 3,375 11,375
Year 2 5,375 9,375
Year 3 7,375 7,375
Year 4 9,375 5,375
Year 5 11,375 3,375
36,875 36,875
Life of the Project 5 Years 5 Years
Salvage Value/Scrap value 3,000 3,000
Tax Rate is 55%
SOLUTION:-

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PROBLEM 09
A company is requiring a machine which requires an Investment of
Rs. 1,60, 000. The Net Income before Tax & Depreciation is
estimated as follows:
Year 1 2 3 4 5
Cash Inflow 56,000 48,000 30,000 64,000 80,000
Depreciation charged on Straight line basis. The tax rate is 40%.
Calculate ARR?
SOLUTION:-
Particulars Amount
EBDT (Earnings Before Depreciation and Tax)
Less: Depreciation
EBT (Earnings Before Tax)
Less: Taxes

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PROBLEM 10
Calculate the accounting rate of return for Project A & B from the
following information:
Particulars Project A Project B
Original Investment 20,000 30,000
Expected life 4 Years 5 Years
Year Cash Inflow Cash Inflow
Year 1 2,000 3,000
Year 2 1,500 3,000
Year 3 1,500 2,000
Year 4 1,000 1,000
Year 5 **** 1,000
6,000 10,000
If the required rate of return is 12% Which Project should be
undertaken
SOLUTION:-

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MODERN METHODS OF CAPITAL BUDGETING:-
A. Net Present Value (NPV)
B. Internal rate of return(IRR)
C. Profitability Index (PI)
1. NET PRESENT VALUE (NPV)
MEANING: - Net present value (NPV) is the difference between the present
value of cash inflows and the present value of cash outflows over a period of
time. NPV is used in capital budgeting and investment planning to analyze the
profitability of a projected investment or project.
Net present value (NPV) is a financial metric that seeks to capture the total
value of a potential investment opportunity.
FORMULA:-

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PROBLEM 11
X Limited is considering to Purchase a Machine. It has 2 Machines
before hand. Calculate the NPV of the Machines at 10% Cost of
capital from the details given below:
Particulars Machine A Machine B
Original Cost 1,00,000 1,00,000
Estimated life 5 Years 5 Years
Cash Inflows
Year 1 10,000 10,000
Year 2 30,000 25,000
Year 3 40,000 30,000
Year 4 25,000 30,000
Year 5 20,000 25,000
36,875 36,875
Suggest which Machine is Profitable, Present Value of Rs. 1 for 5
Years at 10% Discount Rate
SOLUTION:-

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PROBLEM 12
From the following information, Calculate Net Present Value of the
two Projects and suggest which of the two projects should be
accepted:
Particulars Project X Project Y
Initial Investment 20,000 30,000
Estimated life 5 Years 5 Years
Scrap Value 1,000 2,000
The Expected cash Inflows are as follows:-
Year Cash Inflow 'X' Cash Inflow 'Y'
1 5,000 20,000
2 10,000 10,000
3 10,000 5,000
4 3,000 3,000
5 2,000 2,000
The following are the Present Value factors @ 10% p.a
1st Year 0.909
2nd Year 0.826
3rd Year 0.751
4th Year 0.683
5th Year 0.621
SOLUTION:-

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PROBLEM 13
ABC Ltd is considering an Investment Decision to install a new
machine. The Project will cost Rs. 5,00,000 with a life of 5 Years and
no salvage value. The Companies tax rate is 50%. The estimated
Income before depreciation and taxes is as follows:-
Years Income
1 1,00,000
2 1,10,000
3 1,40,000
4 1,50,000
5 2,50,000
Compute NPV at 10%?
SOLUTION:-
Calculation of Cash Inflow
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
EBDT
(-) Depreciation
EBT
(-) Tax @ 50%
EAT
(+) Depreciation
Cash Inflow

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2. INTERNAL RATE OF RETURN (IRR)
MEANING: - The internal rate of return is a metric used in financial analysis to
estimate the profitability of potential investments. The internal rate of return is
the discounting rate where the total of initial cash outlay and discounted cash
inflows are equal to zero.
There are several formulas and concepts that can be used when seeking to
identify an expected return. The IRR is generally most ideal for analyzing the
potential return of a new project that a company is considering undertaking.
FORMULA:-
PROBLEM 14
From the following particulars relating to a project calculate the IRR.
The cost of the project is Rs. 50,000. The life of the project is 5 years
and following are the expected cash inflows of the project.
Year Cash Inflow PV Factor at 10% PV Factor at 15%
1 20,000 0.909 0.869
2 15,000 0.826 0.756
3 10,000 0.751 0.657
4 15,000 0.683 0.571
5 8,000 0.621 0.497

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SOLUTION:-

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PROBLEM 15
A Company has to select one of the following machines. Under IRR
Method Suggest which machine is preferable?
Particulars Year Machine X Machine Y
Cost 25,000 23,000
Life 4 Years 4 Years
Annual Cash Inflow 1 7000 3000
2 3000 2000
3 2000 1000
4 4000 4000
Present Value of Discount Factor is as follows:-
Year 1 2 3 4
Discount Factor @ 10% 0.909 0.826 0.751 0.683
Discount Factor @ 12% 0.893 0.797 0.712 0.636
SOLUTION:-

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3. PROFITABILITY INDEX (PI)
MEANING: - Profitability Index is a capital budgeting tool used to rank
projects based on their profitability. It is calculated by dividing the present
value of all cash inflows by the initial investment. Projects with higher
profitability index are better. The profitability index is the value we get for each
invested unit of money:
The profitability index (PI), alternatively referred to as value investment ratio
(VIR) or profit investment ratio (PIR), describes an index that represents the
relationship between the costs and benefits of a proposed project.
FORMULA:-

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PROBLEM 16
A Project will cost Rs. 10,00,000 and will have a life of 5 years and
no salvage value assume 50% tax rate. And depreciation under
reducing balance method at 20%. The estimated cash inflows before
depreciation and tax from the proposed investment or as follows:-
Years EBDT
1 3,20,000
2 3,50,000
3 3,90,000
4 5,00,000
5 5,40,000
Evaluate the project according to NPV at 12%, PBP, PI & ARR
SOLUTION:-
EBDT
(-) Depreciation
EBT
(-) Tax @ 50%
EAT
(+) Depreciation
Cash Inflow

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PROBLEM 17
SOLUTION:-
EBDT
(-) Depreciation
EBT
(-) Tax @ 30%
EAT
(+) Depreciation
Cash Inflow

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PROBLEM 188
SOLUTION:-

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Practice Questions8
PROBLEM 198
PROBLEM 208

WORKING CAPITA
MEANING OF WORKING CAPITAL:
The capital of a business which is used in its day
Working capital. It is calculated as the current assets minus the current liabilities.
EXAMPLE:-
DEPARTMENT OF MANAGEMENT, AIGS
FINANCIAL MANAGEMENT
UNIT - 5
WORKING CAPITAL MANAGEMENT
MEANING OF WORKING CAPITAL:-
e capital of a business which is used in its day-to-day trading operations
calculated as the current assets minus the current liabilities.
CHETHAN.S
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FINANCIAL MANAGEMENT
L MANAGEMENT
day trading operations is called
calculated as the current assets minus the current liabilities.

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CONCEPTS OF WORKING CAPITAL:-
There are two concepts of working capital:
(i) Gross concept, and
(ii) Net concept.
(i) Gross Concept of Working Capital:
The gross working capital refers to the total fund invested in current assets.
Current assets are those assets which are easily converted into cash within a
time period of one year. It includes cash in hand and at bank, short term
securities, debtors, bills receivable, prepaid expenses, accrued expenses and
inventories like raw materials, work-in-progress, stores and spare parts, finished
goods.
(ii) Net Concept of Working Capital:
The term net working capital refers to the excess of current assets over current
liabilities. In other words, the amount of current assets that would remain in a
firm after all its current liabilities are paid.

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Current liabilities are those claims of outsiders to the business enterprise which
are payable within a period of one year, and include sundry creditors, bills
payable, outstanding expenses, short-term loans, advances and deposits, bank
overdraft, proposed dividend, provision for taxation etc.
OPERATING CYCLE OF A BUSINESS:-
Working Capital Cycle or popularly known as operating cycle, is the length of
time between the outflow and inflow of cash during the business operation. It is
the time taken by the firm, for the payment of materials, wages and other
expenses, entering into stock and realizing cash from the sale of the finished
good.
In short, the working capital cycle is the average time required to invest cash in
assets and reconverting it into cash by selling the assets produced.
The working capital cycle may vary from enterprise to enterprise depending on
various factors, such as nature and size of business, production policies,
manufacturing process, fluctuations in trade cycle, credit policy, terms and
conditions for purchase and sales, etc.

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IMPORTANCE OF WORKING CAPITAL:
A concern requires adequate working capital to carry on its day-to-day
operations smoothly and efficiently. Lack of adequate working capital not only
impairs firm’s profitability but also results in stoppage in production and
efficiency in payment of its current obligations.
Thus working capital is considered the life-blood of the business.
The advantages of having adequate working capital may be summarized:
1. Smooth Flow of Production:
To maintain a smooth flow of production, it is necessary that adequate working
capital is available for paying trade suppliers, hiring labour and incurring other
operating expenses.
2. Increase in Liquidity and Solvency Position:
It enhances the liquidity and solvency position of the business concern.
3. Goodwill:
A firm with sound working capital position can make timely payment of its
outstanding bills. This enhances the reputation of the firm.
4. Advantages of Cash Discount:
It enables the firm to avail itself of the facilities like cash discount by making
prompt payments.
5. Easy Loan:
Adequate amount of working capital builds a sound credit-worthiness of the
firm. As a result it becomes easier for the firm to obtain additional loans in
favorable terms and conditions in order to meet seasonal increase in demand or
to finance the increased working capital resulting from expansion.
6. Regular Payment of Wages and Salaries:
The firm can make regular and timely payment of wages and salaries to its
employees. This increases the morale and efficiency of employees.

CHETHAN.S
5
7. Security and Confidence:
It creates a sense of security and confidence in the mind of management or
officials of the firm.
8. Efficient Use of Fixed Assets:
Adequate amount of working capital enables the firm to use its fixed assets
more efficiently and extensively. If the fixed assets remain idle due to paucity of
working capital, depreciation of fixed assets and interest on borrowed capital
invested in fixed assets will have to be incurred unnecessarily.
9. Meeting of Contingencies:
It can meet unforeseen contingencies of the firm. Unforeseen contingencies like
business depression, financial crisis due to huge losses etc. can easily be
overcome, if adequate working capital is maintained by a firm.
10. Completing operating cycle:
A sound management of working capital helps in completing the operating
cycle quickly. This enables a firm to increase its profitability.
COMPONENTS OR COMPOSITION OF WORKING CAPITAL:
There are two components of working capital viz., current assets and current
liabilities.
Current Assets:
Current assets generally mean those assets which, in the normal and ordinary
course of business, will be or are likely to be converted into cash within a year.
Examples of current assets are:
1. Inventories like raw materials, work-in-progress, stores and spare parts,
finished goods
2. Sundry Debtors (net of provision)
3. Short-term investment or marketable securities
4. Short-term loans and advances
5. Bills receivable or accounts receivable
6. Pre-paid expenses

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7. Accrued Income
8. Cash in hand and bank balances.
Current Liabilities:
Current liabilities mean those liabilities repayable within the same period, i.e., a
year. In other words, current liabilities are those which are to be repaid in the
ordinary course of the business within a year.
Examples of current liabilities are:
1. Sundry creditors
2. Bills payable
3. Outstanding expenses
4. Short-term loans, advances and deposits
5. Provision for tax
6. Proposed dividend
7. Bank overdraft.
DIFFERENT SOURCES OF WORKING CAPITAL:
A firm can use two types of sources to finance its working capital, namely:
(i) Long-term source, and
(ii) Short-term source.
(i) Long-Term Sources:
Every business organization is required to maintain a minimum balance of cash
and other current assets at all the times—irrespective of the ups and downs in
the level of activity. The portion of working capital which is continuously
maintained by the business at all times to carry on its minimum level of
activities is called permanent working capital.
This type of working capital should be arranged from long-term sources of
fund.
The following are the long-term sources of financing permanent working
capital:

CHETHAN.S
7
(a) Issue of Equity shares
(b) Issue of Preference shares
(c) Retained earnings (ploughed-back profits)
(d) Issue of Debentures and other long-term bonds
(e) Long-term loans taken from financial institutions etc.
(ii) Short-Term Sources:
The short-term financing of working capital is generally used to support the
temporary working capital which is usually needed to meet the seasonal
increase or sudden spurt in demand.
Various short-term sources of financing of temporary working capital are:
(a) Bank credit
(b) Public deposits
(c) Trade credit
(d) Outstanding expenses
(e) Provision for depreciation
(f) Provision for taxation
(g) Advances from customers
(h) Loans from directors
(i) Security money received from employees

CFM Full Notes (BCU)

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