This document provides an overview of the nature and scope of financial management. It discusses key topics such as the meaning of business finance, definitions of financial management, major areas of decision making, and the scope of financial management. Specifically, it outlines that the three major areas of decision making are investment decisions, financing decisions, and asset management decisions. Additionally, it notes that the scope of financial management involves estimating financial requirements, deciding capital structure, selecting sources of finance, selecting investment patterns, proper cash management, and implementing financial controls.

1. Module - 1
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Unit 1: Nature and Scope of Financial Management
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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 Outline
1.1 Introduction
1.2 Meaning of Business Finance.
1.3 Definitions of Financial Management
1.4 Which are the major areas of decision making in financial management?
1.5 Scope of financial management
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1.1INTRODUCTION
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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, and
so on. Financial management is concerned with the duties of the financial
mangers in the business firm. The subject of finance is traditionally classified into
two classes
1) Public Finance and 2) Private Finance.
Public finance deals with the requirements, receipts, and disbursement
of funds in the government institutions like states, local self-governments and
central governments. Whereas the private finance deals with the requirements,
receipts and disbursement of funds by the individual, a business organisation and
non-business organisation. The private finance from the above we can once again
classified into personal finance and business finance and finance of non-business
organisation.
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1.2 MEANING OF BUSINESS FINANCE
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To understand the meaning of business finance there is a need to
understand the concepts business and finance. Business may be understood as the
organised efforts of enterprises to supply consumers with goods and services for
satisfying these needs and wants and in the process. All businesses share the
same purpose that is to earn profits. Broadly speaking, the term business includes
industry, trade and commerce.
Finance refers to provisioning of money at the time when it is required. Here
finance refers to management of flows of money through an organisation. Hence
Business Finance concerned with acquisition of funds, use of funds and
distribution 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 business
finance 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 the
emphasis to the financial practices and problems of the incorporated enterprises
are studied much in business finance. So most of the authors use corporate
finance interchangeably with business finance.
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1.3 DEFINITIONS OF FINANCIAL MANAGEMENT
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Financial management refers to that part of the management activity which
is concerned with the planning and controlling of firm's financial resources. It deals
with finding out various sources for raising funds for the firm.
Accoding to Soloman, 'Financial Management is concerned with the efficient use
of important economic resource, manely, Capital Funds.'
According to Prather & Wert, "Business finance deals primarily with raising
administering and disbursing funds by privately owned business units operating in
non-financial fields of industry."
Wheeler defines Business Finance as "that business activity which is concerned
with the acquisition and conservation of capital funds in meeting the financial
needs and administering the funds used in the business."
According to Guthmann and Dougall, business finance can be broadly defined as
the activity concerned the planning, raising, controlling and administering the
funds used in the business.
According to James C. Van Horne 'Financial Management is concerned with the
acquisition, financing, and management of assets with some overall goal in mind.'
------------------------------------------------------------------------------- MAJOR
AREAS OF DECISION MAKING IN FINANCIAL MANAGEMENT
3

4. -------------------------------------------------------------------------------
Therefore the decision function of financial management can be broken down
into three major areas: the investment, financing, and asset management
decisions.
Investment Decision
The investment decision is the most important of the firm's three major
decisions when it comes to the value creation. Investment decision relates to the
determination of total amount of assets to be held in the firm, the composition of
these assets like the amount of fixed assets, current assets and the extent of
business risk involved by the investors.
The investment decisions can be classified in to two groups: (1) Long-term
investment decision or capital budgeting and (2) Short-term decision or Working
capital decision.
Financing Decision
Financing decision follows the Investment decision. The Finance manager
now has to decided how much of finance is required to meet the long-term and
short-term investment decisions, what are the sources of financing these
investment decisions, what is the composition of these finance and what should be
the 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 assets
must still be managed efficiently. The finance manager has more responsibility in
managing the current assets than fixed assets. A large share of the responsibility
of managing the fixed assets would reside in the hands of operating managers of
the company.
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1.5 SCOPE OF FINANCIAL MANAGEMENT
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4

5. Financial management is concerned with acquisition, proper utilisation or
allocation of these funds. It is an activity concerned with the planning, raising,
controlling and administering the funds used in the business. Hence the finance
manager 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.
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UNIT 2 OBJECTIVES OR GOALS OF FINANCIAL
MANAGEMENT
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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 management
Unit outline
6

7. 2.1 Objectives of financial management
2.2 Profit maximisation
2.3 Arguments in favour of Profit maximisation
2.4 Criticisms on Profit maximisation objective
2.5 Wealth maximisation
2.6 Criticisms on wealth maximisation objective
2.7 Other objectives
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2.1 OBJECTIVES OR GOALS OF FINANCIAL MANAGEMENT
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Financial management is concerned with procurement and use of funds. Its
main aim is to use business funds is such a way that value or earnings of the
firm's are maximised. There are various alternative ways of using business funds.
The organisation should go through the pros and cons of each alternative way of
using these business funds before final selection. The financial management
provides a framework for selecting a proper course of action and deciding a viable
commercial strategy.
The following are the objectives of financial management.
1. Profit Maximisation
2. Wealth Maximisation, and
3. Other objectives.
---------------------------------------------------------------------------PROFIT
MAXIMISATION
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The main objective of a business firm is profit maximisation because the business
firm is a profit-seeking organisation. Hence the objective of the financial
management of business organisation is profit maximisation. There are some
arguments 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 as
the objective of financial management of a business organissation on account of
the 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. -------------------------------------------------------------------------------WEALTH
MAXIMISATION
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Wealth or net worth is the difference between gross present worth and the
amount of capital investment required to achieve the benefits. Any financial action
which creates wealth or which has a net present worth above zero is a desirable
one and should be undertaken. The operating objective for financial management
is to maximise wealth or net present worth. Wealth maximisation is, therefore,
considered to be the main objective of financial management. The objective of
wealth maximisation is to maximise the economic welfare of the shareholders of a
company. The value of a company's shares depends largely on its new worth
which itself depends on earning per share (EPS). A stockholder's current wealth in
the firm is the product of the number of shares owned, multiplied with the current
stock price per share.
Stockholder's current wealth in the firm = (Number of shares owned) x (current
stock price per share)
It is symbolically represented
W o = NP o
Thus the business organisation should strive for the increase in the current stock
price per share or EPS, so that the current wealth of a firm will increases. This in
turn depends upon the proper financial management.
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CRITICISM OF WEALTH MAXIMISATION
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The wealth maximisation objective has been criticised by certain financial
theorists 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 is
the most appropriate objective of a firm.
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OBJECTIVES
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Besides the above basic objectives, the following are the other objectives of
financial 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.
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Unit 3 FINANCIAL ENVIRONMENT
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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 outline
FINANCIAL ENVIRONMENT
3.1 Functional areas of Financial Management
3.2 Organisation of Finance function
3.3 Functions of Controller
3.4 Functions of Treasurer
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3.1 FUNCTIONAL AREAS OF FINANCIAL MANAGEMENT
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Financial management is an applied field of business administration.
Principles developed by the financial mangers from accounting, economics and
other fields are applied to the problems of managing finances. Moreover, every
business activity requires money and hence financial management is closely
related with all other areas of management. The relationship between financial
management 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 to
monitor expenditures in their operational areas. The cost information is regularly
supplied to the management to control the costs. The finance manager is
concerned with proper utilization of funds and therefore he is concerned with the
operational costs of the firm.
11

12. Financial Management and Marketing
The success or failure of a firm is greatly depends upon the marketing. One
of the important elements of marketing mix is price. The fixation of price for a
product plays very important role. There are various policies of pricing. The
marketing department must observe the best pricing policy when compared to the
competitors in the industry. Hence he collects the financial information from the
finance 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 assets
of a firm. The firm's assets should be properly managed. Proper management of
assets refers to systematic acquisition and maintenance or better utilization of
assets. The finance manager plays very important role in the proper maintenance
of composition of these assets.
Financial Management and Personnel Management
Personnel management is concerned with selection, recruitment, training
and placement of personnel department. The proper functioning and the above
said functions of personnel departments depend upon the decisions taken in
finance department. Hence the functioning of finance department in an
organisation plays a vital role.
Financial Management and Financial Accounting
Financial management and financial accounting are quite distinct from each
other. Financial accounting is concerned with the systematic recording, analysing,
reporting and measuring the business transactions. The objective of financial
accounting is measurement of funds and the objective of financial management is
to management of funds. The management of funds depends on the measurement
of financial accounting through profit and loss account and balance sheet.
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13. ---------------------------------------------------------------------------
3.2 ORGANISATION OF THE FINANCE FUNCTION
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A firm must give proper attention to the structure and organisation of its
finance department. If financial data are missing or inaccurate, the firm may not
be in a position to identify the serious problems confronting the firm at any time
for correcting. The roles of different finance executives should be clearly defined in
order to avoid conflict and overlapping of functions.
Organisation of the finance function differs from company to company
depending on their respective needs and the financial philosophy. The titles used
to designate the key finance official are also different viz., vice-president
(Finance), Chief Executive (Finance), General Manager (Finance), etc. however, in
most companies, the vice-president (Finance) has under him two officers carrying
out the two important functions - the accounting and the finance functions. The
former is designated as Controller and the latter as the Treasurer.
The controller is concerned with the management and control of the firm's
assets. His duties include providing information for formulating the accounting and
financial policies, preparation of financial reports, direction of internal auditing,
budgeting, inventory control, taxes, etc. while the treasurer is mainly concerned
with managing the firm's funds, his duties include the following:
Forecasting the financial needs; administering the flow of cash; managing
credit; floating securities; maintaining relations with financial institutions and
protecting funds and securities.
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3.3 FUNCTIONS OF CONTROLLER
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Planning and control. To establish, coordinate and administer, as part of
management, a plan for the control of operations.
13

14. 1. Reporting and interpreting. To compare performance with operating plans and
standard's 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.
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3.4 FUNCTIONS OF TREASURER
---------------------------------------------------------------------------Provision of
finance. To establish and execute programmes for the provision of capital required
by the business.
1. Investor relations. To establish and maintain an adequate market for the
company's securities and to maintain adequate contact with the investment
community.
2. Short-term financing. To maintain adequate sources for the company's current
borrowings from the money market.
3. Banking and custody. To maintain banking arrangement, to receive, have
custody of and disburse the company's 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 company's 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.
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15. -------------------------------------------------------------------------------
UNIT 4 FINANCING DECISIONS
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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 Outline
4.1 What is financing decision?
4.2 Meaning of leverage
4.3 Types of leverage
Financial leverage
Operating leverage
Composite leverage
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4.1 FINANCING DECISIONS
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After the Investment decision is taken the firm has to decide upon the best
means of financing these investment policies. The investment decisions are
continuous in nature because the companies make the new investments in its
regular course of business since the business is ever expanding. Hence the firms
will 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 best
overall mix of financing for the firm.
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4.2 MEANING OF LEVERAGE
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The term 'Leverage' refers to the ability of a firm in employing long term
funds having a fixed cost, to enhance returns to the owners; i.e. equity
shareholders. . In other words 'leverage is the employment of fixed assets or
funds for which a firm has to meet fixed costs or fixed rate of interest obligation
irrespective of the level of activities attained or the level of operating profit
earned'.
James Horne has defined leverage as " the employment of an asset or sources of
funds 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 higher
leverage obviously implies higher outside borrowings and hence riskier if the
business activity of the firm suddenly slows down. The leverage can have negative
or reversible effect also. It may be favorable or unfavorable.
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4.3 TYPES OF LEVERAGES
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There are basically two types of leverages, 1) operating leverage, and 2) financial
leverage. In addition to these two types of leverages there are composite leverage
and working capital leverage. The leverage associated with the employment of
fixed cost assets is referred to as operating leverage. While the leverage resulting
from 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 company
may also use preference capital. The rate of interest on debt is fixed irrespective
of the company's rate of return on assets. The rate preference dividend is also
fixed; but preference dividends are paid when the company earns profits. The
ordinary shareholders are entitled to the residual income. That is, earnings after
interest and taxes (less preference dividends) belongs to them, this dividends also
depends on the dividend policy of the company.
The use of the fixed charge sources of funds, such as debt and preference
capital with the owner's equity in the capital structure, is described as financial
leverage or trading on equity.
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
long term fixed interest bearing is employed by a firm to earn more from the use
of these resources than their cost so as to increase the return on owner's equity, it
is called trading on equity. A firm's earnings are more than what debt would
cost is known as favourable leverage and if the firm's earnings are less
than the debt cost then its is known as unfavourable leverage.
The impact of financial leverage is to magnify the shareholders earnings. It
is based on the assumption that the fixed charges can be obtained at a cost lower
than the firm's rate of return on its assets.
DEGREE OF FINANCIAL LEVERAGE
The degree of financial leverage measures the impact of a change in
operating 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 EBIT
Financial Leverage = ----------------------------------------- OR ------
Earnings before Taxes EBT
17

18. 1. Operating Leverage
The operating leverage occurs when a firm has fixed costs which must be
recovered irrespective of sales volume. The fixed costs remaining same, the
percentage change in operating revenue (EBIT) will be more than the percentage
change in sales. This is known as operating leverage. The degree of operating
leverage depends upon the amount of fixed elements in the cost structure. The
degree 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 the
percentage in sales volume. The degree of operating leverage is calculated as:
Percentage Change in Profits
Degree of operating leverage = -------------------------------
Percentage Change in Sales
Risk Factor
In a high leveraged situation will magnify the operating profits but it brings
in the risk element too. The percentage change in profits will be more in a
situation 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 is
measured by percentage change in operating profit due to percentage change in
sales. The financial leverage measures the financial risk by measuring the
percentage change in taxable profit or EPS with the percentage change in
operating profit or EBIT. Both these leverages are closely concerned with the firm's
capacity to meet the fixed costs.
18

19. Composite leverage expressed the relationship between revenue on account
of sales (Contribution) and the taxable income (PBT) on account of change in
sales. The composite ratio is calculated as follows:
Composite Leverage = Operating leverage X Financial leverage
Or
Contribution EBIT Contribution
= --------------- X -------- = -------------
EBIT PBT PBT
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UNIT 5 PROBLEMS FINANCIAL LEVERAGES
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Objective
• To understand the practical application of various leverages in the firm for
better financial decisions
Unit outline
5.1 Problems on:
• Operating leverage
• Financial leverage
• Composite leverage
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5.1 PROBLEMS OF LEVERAGES
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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 EBIT
Financial 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 1,25,000
Solution:
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 EBIT
Financial 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 Firm
B.
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 times
b) When the output increases by 5%.
Now the total output increases to 6,300 units
Therefore 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 1,15,000
The change in EBIT = 1, 15,000 - 1, 00,000
= 15,000
Therefore 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
Contribution
O. L = ------------------- =4,000/3,200 4,000/3,200
Operating profit (EBIT)
24

25. = 1.25 times = 1.25 times
EBIT
F.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
Contribution
O. L = ------------------- =4,000/2,500 =4,000/2,500
Operating profit (EBIT)
= 1.60 times = 1.60 times
F.L = EBIT
------- = 2,500/2,000 = 2500/2300
EBT
= 1.25 times = 1.09 times
Conclusion: It is advisable to the management that the OL should be less and FL
should be more in order to maximise the returns. Therefore OL under situation A is
1.25 times and FL under situation B (Plan I) is 1.25 times, which is considered as
an 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 - Interest
In 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 2000
Computation of Sales:
Contribution = Sales - VC
Company A
Let Sales = 100
VC = 66 2/3
Therefore Contribution = 100 -200/3 = 100/3
27

28. = Rs 1,500
Therefore Sales = 1500 x 100 x 3 / 100
= Rs. 4,500
Variable Cost = Rs 3,000
Computation of Sales:
Contribution = Sales - VC
Company B
Let Sales = 100
VC = 75%
Therefore Contribution = 100 -75 =25
Therefore Sales = 2400 x 100/25 = Rs. 9,600
Variable Cost = Rs 7,200
Computation of Sales:
Contribution = Sales - VC
Company C
Let Sales = 100
VC = 50
Therefore Contribution = 100 -50 = 50
Therefore Sales = 2,000 x 100/ 50
= Rs. 4,000
Variable Cost = Rs 2,000
6. 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.
Solution
Total 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. 240000
Interest = 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
126000
Operating Leverage = Contribution/EBIT
= 360000/260000=1.38 times
Financial Leverage = EBIT/EBT =260000/252000=1.03 times
Combined Leverage = OL X FL= 1.38X1.03=1.42 times
7. X Limited has estimated that for a new product, its BEP is 2000 units of the
item is sold for Rs 14per unit., the cost accounting department has currently
identified VC of Rs. 9/- per unit. Calculate OL for sales volume of 2500 units and
3000 units. [BEP = Break Even Point]. Fixed cost not given.
Solution
Selling Price=Rs14/-per unit
Variable cost =Rs9/- per unit
Calculation of Fixed cost.
Sales 28000
(-)VC 18000
Contribution 10000
(-)FC - 10000
EBIT = 0
Therefore 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
EBIT
Therefore OL (2500Units) = Contribution/EBIT= 12500/2500=5 times
OL (3000Units) = Contribution/EBIT=15000/5000=3 times
If sales volume is increased by 25 %(from 2000 to 2500Units) the EBIT
increases 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 the
three different situations X,Y and Z and Financial plans I, II and III. You are
required to calculate OL, FL and CL. The total capacity of the project=10000
Units,
Explored capacity of sales=7500 Units
S.P Per Unit=Rs.20/-
V.C Per Unit=Rs15/-
Fixed Cost;
X=Rs10000
Y=Rs20000
Z=Rs25000
Financial Plans;
1) Rs50000/-Equity and Rs40000/-debt at 10% interest
2) Rs60000/- Equity and Rs30000/-debt at 10% interest
3) Rs30000/- Equity and Rs60000/- debt at 10% interest
31

32. Solution
Situation 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 10,000 10,000 10,000
EBIT 27,500 27,500 27,500
(-)Interest 4000 3000 6000
EBT 23500 24500 21500
Operating Leverages
(I) OL=37500/27500=1.36 times
(II) OL=37500/27500=1.36 times
(III) OL=37500/27500=1.36 times
Financial Leverages
(I) FL=27500/23500= 1.17 times
(II) FL=27500/24500= 1.12 times
(III) FL=27500/21500= 1.28 times
Combined 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 11500
Operating Leverages
(I) OL=37500/17500=2.14 times
(II) OL=37500/17500=2.14 times
(III) OL=37500/17500=2.14 times
Financial Leverages
(I) FL=17500/13500=1.30 times
(II) FL=17500/14500=1.21 times
(III) FL=17500/11500=1.52 times
Combined Leverages
(I) CL=2.14X1.30=2.78 times
(II) CL=2.14X1.21=2.59 times
(III) CL=2.14X1.52=3.25 times
Situation-Z 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 25,000 25,000 25000
EBIT 12,500 12,500 12,500
(-)Interest 4000 3000 6000
EBT 8500 9500 6500
Operating Leverages;
(I) OL=37500/12500=3 times
(II) OL=37500/12500=3 times
(III) OL=37500/12500=3 times
Financial 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 Z
Plan 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 Outline
5.1 Introduction
6.2 Meaning of capital structure
6.3 Difference between capital and financial structure
6.4 Optimum Capital structure
6.5 Features of Appropriate Capital Structure
6.6 Factors determining Capital Structure
--------------------------------------------------
6.1 INTRODUCTION
-------------------------------------------------
34

35. The funds required by the business organisation are raised through the
ownership securities i.e., by equity shares, preference shares and creditorship
securities i.e., debentures and bonds. But the business organisation must raise
these funds by a proper mix of both these securities in such a way that the cost
and the risk of both these securities should be minimum. The mix of different
securities is disclosed by the firm's capital structure.
------------------------------------------------------------------------------
5.2 MEANING OF CAPITAL STRUCTURE
--------------------------------------------------------------------------
In ordinary language it implies the proportion of debt and equity in the total
capital of a company.
According to Gerstenberg Capital Structure refers to the 'the make up of a firm's
capitalisation'. In other words, it represents the mix of different sources of long
term 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 sheet
i.e., ownership securities, creditorship securities and current liabilities. Whereas
capital structure refers to sources of all long-term funds like ownership securities
like equity capital and preference capital and creditorship securities like
debentures, bonds and long term loans.
--------------------------------------------------------------------------
6.4 OPTIMUM CAPITAL STRUCTURE
--------------------------------------------------------------------------
The optimum capital structure is obtained when the market value per equity
share is the maximum. It may be defined as that relationship of debt and equity
securities which maximizes the value of a company's share in the stock exchange.
Or 'at optimum capital structure, the value of an equity shares is the maximum
while 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 capital
structure of a company since it will have long-term implications. Hence the finance
manager should be careful but it can be changes subsequently as per the
requirements. This capital structure decision is a continuous one and has to be
taken whenever a firm needs additional finances.
36

37. The following are the factors which determines the capital structure of a
company.
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 company's 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 company's
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 mix
Unit 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 Structure
7.3 Essential features of a sound capital mix
------------------------------------------------------------------------------
7.1 CAPITAL STRUCTURE THEORIES
---------------------------------------------------------------------------------------------
To achieve the basic goal of optimum capital structure in the organisation
the finance manager must have the basic knowledge of capital structure theories.
There are extreme opinions on the optimum capital structure, hence it calls for
various 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 firm's 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+B
Where,
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 equity
shareholders; ke = cost of equity or equity capitalisation rate
Overall cost of capital (Ko) = EBIT/V
2. Net Operating Income (NOI) Approach
This approach has also been suggested by Durand. According to this approach
the 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 net
operating income at the overall cost of capital (k), which is considered to be
constant.
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 help
of the following formula.
EBIT (1-Tax rate)
Value of Firm (V) = --------
Ko
Ko = Overall cost of capital
Value of equity = V - B
According to NOI Approach, the total value of the firm remains constant
irrespective 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-1
Ke = ------- X 100
V-B
41

42. 3. Modigiliani - Miller Approach
This approach is similar to the NOI approach. It also states that the value of
the firm is independent of its capital structure. Nevertheless, there is a basic
difference the two is that the NOI approach is purely definitional or conceptual. It
does not provide operational justification for irrelevance of the capital structure in
the 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 firm's 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 Tax
4. Traditional Approach or weighted average cost of capital (WACC)
The traditional approach or intermediate approach is a mid-way between the two
approaches. 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 of
capital. This is because debt is relatively cheaper source of funds as compared to
raising money through shares because of tax advantage. However, beyond a point
raising of funds through debt may become a financial risk and would result in a
higher equity capitalisation rate.
Traditionally, optimal capital structure is assumed at a point where weighted
average cost of capital (WACC) is minimum. For a project evaluation, this WACC is
considered as the minimum rate of return required from project to pay-off the
expected return of the investors and as such WACC or Composite cost of capital is
generally 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 requirements
for current and future need of a firm are very important for a firm. Equity capital
and debt are the two principle sources of finance of a business. But it should be in
what proportion? How much of financial leverage a firm should employ? Are the
two important questions comes before finance manager. The relationship between
financial leverage and cost of capital will answer this question.
43

44. The capital structure planning, which aims at the maximisation of profits and
the wealth of the shareholders, ensures the maximum value of a firm or the
minimum cost of capital. It is very difficult for a finance manager to determine the
proper mix of debt and equity for his firm. The financial manager must try to reach
as 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 applications
Unit outline
8.1 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-equity
company, compute the value of companies P and Q using (a) net income approach
and (b) net operating income approach.
Particulars P Q
EBIT (@ 20% on Rs. 15 lakhs) 3,00,000 3,00,000
Less : Interest 90,000 -
------------ -------------
EBT 2,10,000 3,00,000
Less : 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 Approach
Calculation of value of Equity
Value of Equity (capitalised @ 15%)
P = (1,05,000 x 100 / 15) = 7,00,000
Q = (1,50,000 x 100 / 15) =10,00,000
Value of Debt
P = 9,00,000, Q = 0
Value of Company = S + D
P = 7,00,000 + 9,00,000 = 16,00,000
Q = 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 - B
Company 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.
Solution
Value of unlevered firm B
46

47. Vu = EBT (1 - T) / ke
= 2,40,000 (1-0.6) / 10%
= 96,000 / 0.10
= 9,60,000
Value of levered firm A
Vi = Vu + Bt
= 9,60,000 + 6,00,000 (0.6)
= 9,60,000 + 3,60,000
= Rs. 13,20,000
3. The values for two firms X and Y in accordance with the traditional theory are
given below:
X Y
Expected operating income Rs. 50,000 Rs. 50,000
Total cost of debt 0 10,000
Net Income 50,000 40,000
Cost of equity (ke) 0.10 0.11
Market value of shares (s) 5,00,000 3,60,000
Market value of debt 0 2,00,000
Total value of the firm 5,00,000 5,60,000
Average 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 50,000
Less: cost of debt (D) 0 10,000
------------ ----------
Net income for equity 50,000 40,000
---------- ---------
Equilibrium cost of capital (ko) 0.125 0.125
Total value of company (V)= ¯x / ko 4,00,000 4,00,000
Market value of debt (B) - 2,00,000
Market value of equity (V - B) 4,00,000 2,00,000
Cost 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 composite
cost of capital.
Solution:
Calculation of Optimal Debt-Equity Mix
Debt as % of Cost of Cost of WACC
total capital Debt Equity
employed (%) (%)
0 5.0 12.0 (5 x 0 ) + (12 x 1.00) = 12.00
10 5.0 12.0 (5 x 0.10) + (12 x 0.90) = 11.30
20 5.0 12.5 (5 x 0.20 ) + (12 x 0.80) = 11.00
30 5.5 13.0 (5.5 x 0.30 ) + (13 x 0.70) = 10.75
40 6.0 14.0 (6 x 0.40 ) + (14 x 0.60) = 10.80
50 6.5 16.0 (6.5 x 0.50 ) + (16 x 0.50) = 11.25
60 7.0 20.0 (7 x 0.60 ) + (20 x 0.40) = 12.20
At 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 outline
9.1 Meaning
9.2 Significance or Importance of Cost of Capital
9.3 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 in
the long-run, the management should only invest in projects which give a return in
excess of cost of funds invested in the projects of the business. The term cost of
capital refers to the minimum rate of return a firm must earn on its investments so
that the market value of the company' equity shares does not fall. This is intended
to achieve the objective of wealth maximisation. This is possible when the firm
earns a return on the projects financed by equity shareholders' funds at a rate
which 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 various
suppliers of funds in the company.
According to Solomon Ezra, "Cost of capital is the minimum required rate of
earnings or the cut-off rate of capital expenditures."
Hampton, John J. defines cost of capital as 'the rate of return the firm
requires from investment in order to increase the value of the firm in the market
place".
Thus, we can say that cost of capital is that minimum rate of return which a
firm, must and, is expected to earn on its investments so as to maintain the
market 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 the
management 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 firm's 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 capital
Computation of specific cost of various sources of finance viz., debt, preference
share 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 debentures
In case of debt is raised at premium or discount, we should consider P as the
amount of net proceeds received from the issue and not the face value of
securities. The formula is
I
Kd = ----------
NP
In case of underwriting commission (UC) paid if any is deducted from NP (UC is
always 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
-----------
2
Where PD is preference dividend
Dividend paid on preference shares is an appropriation of profit and hence is does
not 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. permissible
limit 5% calculated on par value)
Note: there is no difference in calculation of Kp whether to be calculated before
tax or after tax because it doesn't 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 outline
10.1 Problems on cost of capital
---------------------------------------------------------------
10.1 PROBLEMS ON COST OF CAPITAL
-------------------------------------------------------------
I Cost of Debt
Problems
1. 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 - 20,000
b) Cost of Redeemable debentures
Formula
I (1 - t) + (RV - NP)
------------
n
Kd = ----------------------------------- X 100
(RV + NP)
------------
2
Where,
RV = Redemption value
n = number of years
2. 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
firm's 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)
-------------
2
3. 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. -------------
2
b) 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)
-------------
2
4. 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 limits
specified under company's act. Calculate Kd after tax and before tax for both the
series.
Solution
Series 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
(-) Underwriting
Commission @ 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
(-) Underwriting
Commission 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 firm's 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
-----------
2
Cost of equity shares (Ke)
A companies share is quoted in market at Rs 40 currently. A company pays a
dividend of Rs 2 per share and investors expects a growth rate of 10% compute
a) 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 tax
benefit.
2. 'Z' Ltd, Y Ltd, and X Ltd., are in the same type of business and hence have
similar operating risks. However the capital str5ucture of each of them is different
and 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 4,00,000
Market Value per share Rs. 12 20 15
Dividend per share 2.88 4 2.7
Debentures
(Face value Rs.100) 2,50,000 1,00,000
Market value
per debenture Rs 80 125
Interest rate 8% 10%
Assume that the current level of dividends are generally expected to
continue indefinitely and the income tax rate is at 50%. You are required to
compute 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:
Formula
Kd = I (1 - T) / MP
X 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 WACC
X: 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 WACC
X: 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. WACC
Sources Capital Cost of capital Total COC WACC
Existing Equity 2,00,000 12% 24,000
Additional Equity 50,000 12 % 6,000 40,000
-------- x 100
5,00,000
Existing Debt 2,00,000 4% 8,000
Additional 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) = 0.6
P/V (Pref. Value) = 0.05
D/V (Debt value) = 0.35
The corporate tax rate is 30%. Calculate WACC of Bharath Nigam ltd.,
Solution:
Sources COC Weights WACC
Ke 0.16 0.6 0.096
Kp 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 outline
2.1 introduction
2.2 Classification of capital of a business organisation
2.3 Various sources of long-term capital
• Ownership securities or Capital Stock
68

69. • Creditorship securities or Debt Capital
• Hybrid Financing/Instruments
2.4 Kinds of Ownership securities or Shares are.
1. Equity Shares
2. Preference Shares
3. Deferred Shares
4. No par Stock/Shares
5. Shares with differential Rights
6. Sweat Equity
----------------------------------------------------------------
INTRODUCTION
----------------------------------------------------------------
In the day today business, finance is required by the business organisations
irrespective of it is big, medium or small for its operations and to achieve its
objectives. Without adequate finance, the business enterprise cannot accomplish
its objectives.
Capital required for a business enterprise can be classified under two main
categories viz., 1. Fixed Capital, and 2. Working Capital. Long-term funds are
required to create production facilities by purchasing fixed assets like land,
building, plant, furniture, machinery etc., any investment of funds on these is
blocked up on a permanent basis hence it is called fixed capital. Funds are
required for short-term purposes for the purchase of raw materials, payment of
wages and other day-to-day expenses. These funds are known as working capital.
--------------------------------------------------------------------------- THE
VARIOUS SOURCES OF RAISING LONG-TERM CAPITAL
69

70. ---------------------------------------------------------------------------
• Ownership securities or Capital Stock
• Creditorship securities or Debt Capital
• Hybrid Financing/Instruments
A. Ownership securities
It is known as 'Capital Stock' represents shares. Companies issue different
types of shares to mobilise funds from various investors. The Companies Act of
1956 has limited the type of shares are issued from Preference Shares, Ordinary
Shares, and Deferred Shares to only two types of Share like Preference shares and
Equity Shares.
-------------------------------------------------------------------------------KINDS OF
OWNERSHIP SECURITIES OR SHARES
---------------------------------------------------------------------------
1. Equity Shares
2. Preference Shares
3. Deferred Shares
4. No par Stock/Shares
5. Shares with differential Rights
6. Sweat Equity
1. Equity Shares
Equity shares are also known as Ordinary shares. It represents the owner's
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 of
the company. Equity shareholders do not have preference in paying dividend of
the company. They are eligible for dividend only when the company earns profit
and after paying dividend to the preference shareholders. These shareholders
do not have any preferential rights over the dividend and also capital of the
company 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 the
service at the time of formation of a company. These shares do not enjoy any
preference over the equity shareholders in payment of dividend and return of
capital. Since their dividend payment can be deferred or postponed they are called
deferred shares. The issue of these shares by the public limited or its subsidiaries
is 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 companies
that 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 simply
mentions the number of shares held by its owner without mentioning any face
value. The value of a share can be determined by dividing the real net worth of the
company with the total number of shares of the company. The dividend on such
share 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 differential
rights as to voting, dividend or other wise subject to fulfillment of the conditions
laid 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 concept
of differential rights is new to the Indian corporates and it will require experience
to ascertain its effectiveness.
6. Sweat Equity
It means if the equity shares issued by a company to its employees or
directors at a discount or for consideration other than cash for providing know-how
or making available rights in the nature of intellectual property rights (like patents
or copyright) or value additions. Section 79A of the companies Act, 1956 (inserted
with effect from 31st October 1998) allows companies to issued sweat shares
subject 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 market
Unit outline
2.2.1 CREDITORSHIP SECURITIES
Debentures or Bonds
• Types of debentures
2.2.2 Hybrid Financing/Instruments
• Preference share capital
• Convertible debentures/bonds
• Warrants and
• Options
2.2.3 Forms of options.
• Rights,
• Warrants, and
• Calls and puts
EURO Issues
Global 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' represents
debentures and bonds. These instruments of finance occupy a very important role
in the financial plan of the company.
1. Debentures or Bonds
The company can raise its long-term loans through issue of Debentures or
bonds. A debenture is an acknowledgment of a debt. Issued by a company under
its common seal assuring them for the payment of a principal sum at a specified
date and till that at fixed rate of interest per cent is paid and it may or may not
hold any charge on the assets of the company. A debenture holder is a creditor of
a company. A fixed rate of interest is paid on debentures.
Types of Debentures
Debentures 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 company's 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.
-------------------------------------------------------------------------------Hybrid
Financing/Instruments
---------------------------------------------------------------------------
77

78. As hybrid source of financing has characteristics of both straight debt and
straight 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 also
convertible 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) to
convert them into equity shares on certain terms. The holders are entitled to a
fixed income till the conversion option is exercised and would share the benefits
associated 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 36
months 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 company
during a specified period at a stated/particular price. Warrant means it is an
instrument that gives its holder the right to purchase a certain number of shares
at a specified price over a certain period of time.
Options
Option is a derivative security and derives its value from an underlying
security/asset. An option is an instrument that provides to its holders an
opportunity to purchase/sell a specified security/asset at a stated price on/before
a 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 basic
forms of options.
78

79. -------------------------------------------------------------------------------FORMS OF
OPTIONS
---------------------------------------------------------------------------Rights,
• Warrants, and
• Calls and puts
a) 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 accepted
Liberalisation, Privatisation and Gobalisation has its Industrial policy. Thence the
government undertook two major steps-that of allowing Foreign Institutional
Investors (FIIs) to invest in the Indian capital market and permitting Indian
Companies to float their stocks in foreign markets. Two primary instruments
79

80. floated by the Indian Companies in international markets are GDRs and Foreign
Currency Convertible Bonds (FCCBs) more commonly known as the 'Euro Issues'.
Euro Issued denotes that the Issue is made abroad through instruments
denominated in foreign currency and the securities issued are listed on any
overseas Stock Exchange. Euro issue is a method of mobilising resources required
by a company in foreign exchange. A Euro Issue is different from foreign issue. In
case of foreign issue issuer is not incorporated in the country in which the
securities are being issued, but the securities are denominated in the currency of
the country of issue and are aimed at domestic investors in the country where the
issue 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 for
domestic operations. A GDR is a dollar denominated instrument of a company,
traded in stock exchanges outside the country of origin. It represents a certain
number of underlying equity shares. Though the GDR is quoted and traded in
dollar terms, the underlying equity shares are denominated in rupees only.
Instead of issuing in the names of individual shareholders, the shares are
issued by the company to an intermediary called the depository, usually in
Overseas 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 issuing
company in any manner either in whole or in part on the basis of only equity
related warrants attached to debt instrument. The FCCBs are like convertible
debentures 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 listed
and 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 issuing
securities through appointment of Bank as depository. By keeping the securities
issued by the foreign company, the U S Bank will issue receipts called ADRs to the
investors. It is a negotiable instrument and also entitled for dividends as and when
declared. The ADR holder can transfer the instrument as in the case of domestic
instrument 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 Dividend
A) Residual Approach and
B) Modigliani and Miller approach.
The Relevance theory or Relevance concept of Dividend.
A) Walter's Approach and
B) Gordon's Approach
--------------------------------------------------
2.3.1 MEANING OF DIVIDEND
---------------------------------------------------------------------------
Dividend refers to that part of the profits of a company which id distributed
amongst its shareholders. It is the return that a shareholder gets from the
company for his shareholding, out of its profits. According to the Institute of
Chartered Accountants of India, dividend is "a distribution to shareholder out of
profits or reserves available for this purpose.
--------------------------------------------------
2.3.2 DIVIDEND POLICY
---------------------------------------------------------------------------
The company will not distribute entire profits earned as dividend to its
shareholders, because it needs to provide funds to finance its long-term growth.
Hence company will keep some money for its expansion and growth otherwise it
has 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 must
require a dividend policy.
The term dividend policy refers to the policy concerning quantum of profits
to be distributed as dividend. The concept of dividend policy implies that
companies 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 among
shareholders and the amount of profit to be retained in the business for financing
its long-term growth. There is an indirect relationship between between the
amount of dividends distributed and retained earnings. Higher the amount of
dividend distribute lower will be the retained earnings. This dividend decision will
have its impact on the value of the firm, since the value of the firm depends on
the dividend decision.
--------------------------------------------------
2.3.4 THEORIES ON DIVIDEND POLICIES
---------------------------------------------------------------------------
There are conflicting theories regarding impact of dividend decision on the
valuation of a firm. According to one school of thought, dividend decision dose not
affects the shareholders' wealth and also the valuation of the shares of the firm
(Irrelevance theory). According to another school of thought, dividend decision
materially 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 Approach
and
B) Modigliani and Miller approach.
A) RESIDUAL APPROACH
According to this approach or theory, dividend decision has no effect on the wealth
of the shareholders or the value of the shares, and hence it is irrelevant so far as
the valuation of the firm is concerned. This theory says dividend decision merely
as a part of financing decision because the earnings available may be retained in
the business for re-investment. But if the funds are not required in the business
they may be distributed as dividends. Thus, the decision to pay dividends or retain
the earnings may be taken as a residual decision. The firm can retain the earnings
if it has profitable investment opportunities otherwise it should pay them as
dividends.
B) MODIGLIANI AND MILLER APPROACH (MM MODEL)
Modigliani and Miller have expressed in the most comprehensive manner in
support of the theory of irrelevance. This theory maintain that dividend policy has
no effect on the market price of the shares and the value of the firm is determined
by the earning capacity of the firm or its investment policy. They observed that
"under conditions of perfect capital markets, rational investors, absence of tax
discrimination between dividend income and capital appreciation, given the firm's
investment policy its dividend policy may have no influence on the market price of
the shares".
Assumptions of MM Hypothesis.
MM hypothesis of irrelevance of dividends is based on the following
assumptions
1. Capital markets are perfect.
84

85. 2. Investors behave rationally
3. 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 approach
MM 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
firm's position in the stock market. Higher dividends increase the value of stock
85

86. while low dividends decrease their value. This id because dividends
communicate information to the investors about the firm's profitability. There
are two theories which advocate this they are.
B) Walter's Approach and B) Gordon's Approach
A) WALTER'S APPROACH
Prof. James E. Walter strongly supports the doctrine that dividend policy
almost always affects the value of the enterprise. The finance manager can,
therefore, use it to maximise the wealth of the equity shareholders. The
relationship between the internal rate of return earned by the firm and its cost
of capital is very significant in determining the dividend policy to maximise the
wealth of the shareholders. Prof. Walter's model is base on the relationship
between the firm's (i) return on investment, i.e. r and (ii) the cost of capital or
the required rate of return, i.e. k.
According to Prof. Walter, it r >k, i.e., the firm can earn a higher return than
what the shareholders can earn on their investments, the firm should retain the
earnings. Such firms are termed as growth firms and the optimum pay-out
would 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 entire
earnings as dividend. For such firm's, 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 or
distributes its earnings. In their case the value of the firm's shares would not
fluctuate with change in the dividend rates. There is, therefore, no optimum
dividend policy for such firms.
Assumptions
86

87. Walter's 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 Walter's model the formula to determine the value of a share
(E - D)
D + r --------
ke
P= --------------------
ke
D r(E - D)/ke
or P = ----- + --------------
ke ke
Where, p = market price per share
D = dividend per share
r = internal rate of return
E =earnings per share
ke = cost of equity capital
Criticisms of Walter's Model
This 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
firm's risk pattern does not always remain constant and as such it is not
correct to presume that 'k' will always remain constant.
B) GORDON'S 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 outline
2.4.1 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 Policy
2.4.2 Factors Influencing Dividend Policy
2.4.3 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 company's
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 Per
Share (DPS) under Constant Dividend Payout Ratio Policy
2. 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 Per
Share (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 its
impact on the value of the firm's equity shares in the stock market, it is evident
that the dividend policies do have a significant effect on the value of the firm's
equity share in the stock market. But there is no uniform dividend policy because
the different firms at different times follow different dividend policy. The following
are the important general factors applicable to individual firms, which determine
the 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
year's 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 year's profits. The past trend of the company's 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
---------------------------------------------------------------------------
OBJECTIVE
1. 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 mainly
influenced by the dividend policy of the company. Hence the company must retain
the earnings if it has profitable investment opportunities, giving a higher rate of
return 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 active
decision 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 process
Unit outline
3.1.1 Introduction
Classification of investment decisions
• Long-term investment decision or capital budgeting and
• Short-term decision or Working capital decision.
Expenses comes under capital investment
3.1.2 Meaning of Capital Budgeting
95

96. 3.1.3 Importance of Capital Budgeting
3.1.4 Capital Budgeting Process
--------------------------------------------------
3.1.1 INTRODUCTION
---------------------------------------------------------------------------
The investment decision is the most important of the firm's three major
decisions when it comes to the value creation. Investment decision relates to the
determination of total amount of assets to be held in the firm, the composition of
these assets like the amount of fixed assets, current assets and the extent of
business risk involved by the investors.
The investment decisions can be classified in to two groups: (1) Long-term
investment decision or capital budgeting and (2) Short-term decision or Working
capital decision.
In this module the long-term investment decision or capital budgeting is discussed
in detail. The capital budgeting decisions, require comparison of cost against
benefits over a long period. The investment made in capital assets cannot be
recovered in the short run. Such assets will generate returns ranging from 2 to 20
years or more. Such investment decision involve a careful consideration of various
factors like profitability, safety, liquidity and solvency etc. a business organisation
has to face quite often the problem of capital investment decisions. Capital
investment refers to the investment in projects whose results would generate
revenue or earnings from alter a year and it will continue for several numbers of
years. 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 activity
iii) Diversification of products due to competition and for growth
iv) Research and Development expenditure
v) Miscellaneous expensed for installation of equipment, pollution control
equipment etc.
--------------------------------------------------
3.1.2 MEANING OF CAPITAL BUDGETING
---------------------------------------------------------------------------
Capital budgeting is the process of making investment decisions in capital
expenditures. A capital expenditure refers to an expenditure whose benefits are
expected be received over period of time exceeding one year.
Charles T. Horngreen has defined capital budgeting as, "Capital budgeting is
long term planning for making and financing proposed capital outlays".
Richard and Greenlaw have referred to capital budgeting as "acquiring inputs
with long-run return".
Lynch defines it as "Capital budgeting consists in planning development of
available capital for the purpose of maximising the long term profitability of the
concern."
--------------------------------------------------
3.1.3 IMPORTANCE OF CAPITAL BUDGETING
---------------------------------------------------------------------------
A capital budgeting or investment decision involves huge capital on capital
assets of the concern. Any wrong decision in capital budgeting will cost the
organisation 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 special
care 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 investment
of current funds for achieving benefit in future and the future is always uncertain.
However, the following procedure may be adopted in the process of capital
budgeting:
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 outline
3.2.1 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 Appraisal
Techniques
101

102. The techniques available for appraisal of investment proposal are classified three
heads:
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 the
necessary 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 before
depreciation and after Tax.
When the cash inflow is uneven then the payback period is calculated bu
cumulative cash inflows and by interpolation, the exact payback period can be
calculated. For example, if the project requires an initial investment of Rs. 40,000
and 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 as
follows:
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 been
recovered. Rs. 4,000 is left out of initial investment. In the fourth year the cash
inflow is Rs. 11,000. It means the pay back period is between three to four years
calculated 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 Method
It is also known as return on investment or return on capital employed. This
method applied the normal accounting technique to measure the increase in profit
expected to result from an investment by expressing the net accounting profit
arising 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 = -----------------------------------------
2
Under this method the project which gives highest rate of return will be selected.
Merits
1. 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. Demerits
1. 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 capital
investment proposals. In this method first cash inflows and cash outflows
associated with each project are worked out. The present value of these cash
inflows and outflows are then calculated at the rate of return acceptable to the
management. This rate of return is considered as the cut-off rate and is generally
determined on the basis of cost of capital adjusted risk element in the project. The
Net Present Value (NPV) is the difference between the total present value of future
cash inflows and the total present value of future cash outflows.
The Net Present Value can be used as an 'accept or reject' criterion. In case
the NPV is positive the project should be accepted. If the NPV is negative, the
project should be rejected.
106

107. Merits
1. 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.
Demerits
1. 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 cash
inflows equals the sum of discounted cash outflows. In other words, it is the rate
which discounts the cash flows to zero. It is also known as time adjusted rate of
return method or trial and error yield method.
Merits
1. 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.
Demerits
1. 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 in
pay back period is considered. Hence this method is improvement over the pay
back period method. Under this method the project which gives the greatest post
pay-back period may be accepted. Under this method the present values of all
cash outflows and inflows are computed at an appropriate discount rate. The time
period at which the cumulated present value of cash inflows equals th present
value of cash outflows is known as discounted pay back period.
Profitability Index Method or Benefit Cost Ratio
It is also a time-adjusted method of evaluating the investment proposals.
Profitability index also called as Benefit-Cost Ratio or Desirability factor is the
relationship between present value of cash inflows and present value of cash
outflows. Thus
108

109. Present value of cash inflows
Profitability Index = -------------------------
Present value of cash outflows
The proposal is accepted if the profitability index is more than one and is
rejected 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 methods
Unit outline
3.3.1 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.10,00,000
Solution:
PBP = 2+1,00,000/3,00,000=2.33 years
3. Calculate PBP form the following; Initial investment 10, 00,000, life of the
project 4years, PBD and before Tax (PBTBD)
I 5,00,000
II 4,00,000
III 3,00,000
IV 1,00,000
Solution:
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 100000
PBP=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 stated
below:
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. The
cut-off rate is 8%. Suggest the management whether or not to accept the
proposal based on ARR.
Solution
Step I: Average profit= Total cash inflows/life of project
=230000/5=46000
Step II; ARR=AP/Initial Investment (I I)
=46000/(500000-40000) x 100=10%
Interpretation: It is advisable to accept the project since ARR is above
the cut-off rate.
112

113. Interpretation of NPV; If NPV is greater than or equal to zero then accept or else
rejects the project.
5. Calculate NPV and IRR of a project involving the initial cash outflow of
Rs.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 of
return at 15%.
Solution:
Calculation of NPV
Years 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 8995
Interpretation: Since NPV is Greater than or equal to zero we accept the project.
113

114. Calculation of IRR
Years Cash Inflows Discount @5% Discounted C.I Discount @20% Discounted C.I.
1 35000 0.9524 33334 0.8333 29165.5
2 40000 0.9070 36280 0.6944 27776
3 30000 0.8638 25914 0.5787 17361
4 50000 0.8227 41135 0.4823 24115
________ _____________
Total DCI 136663 98418
Less I.I 100000 100000
________ _________
NPV 36663 (1582)
+ ve NPV
IRR= LRR+ ------------------------------ x difference in rates
(+ ve NPV) + (- ve NPV)
36,663
IRR= 5 + ------------------------------ x 15
(36,663) + (1,582)
= 19.38%
114

115. 6. A Company has an investment opportunity costing Rs. 40,000 with the following
expected net cash flow (after tax before depreciation).
Years Net Cash flow
1 Rs. 7,000
2 7,000
3 7,000
4 7,000
5 7,000
6 8,000
7 10,000
8 15,000
9 10,000
10 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 8,963
c) Gross PI = Discounted cash inflow/Discounted Cash outflow
= 48,963/40,000 = 1.23
Net PI = Gross PI - 1
= 1.23 - 1 = 0.23
d) 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 NPV
IRR= LRR+ ------------------------------ x difference in rates
(+ ve NPV) + (- ve NPV)
8,963
IRR= 10 + ------------------------------ x (15 - 10)
8,963 + 582
= 14.695 %
7. The L Company Ltd, is considering the purchase of a new machine. Two
alternative 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 B
1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 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 basis
you are required:
1. Compare profitability of Machines and state which alternative you consider
financially preferable.
2. Compute Pa;yback period for each project
3. Compute annual rate of return for each project.
Solution:
1. Net Present Value.
Yea Machine Discount Discount Machine B Discount
r A @10% ed cash ed cash
inflow inflow
1 40,000 0.9091 36,364 1,20,000 1,09,092
2 1,20,000 0.8264 99,168 1,60,000 1,32,224
3 1,60,000 0.7513 1,20,208 2,00,000 1,50,260
4 2,40,000 0.6830 1,63,920 1,20,000 81,960
5 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 1,23,208
Interpretation: It is advisable to accept Machine B since NPV is more when
compared to Machine A.
2. Pay back period.
Machine A = 3 + 80,000/2,40,000 = 3.33 years
Machine B = 2 + 1,20,000/2,00,000 = 2.6 years
Interpretation: 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 of
Machine A Machine B Depreciation Machine A Machine B
40,000 1,20,000 80,000 - 40,000 40,000
1,20,000 1,60,000 80,000 40,000 80,000
1,60,000 2,00,000 80,000 80,000 1,20,000
2,40,000 1,20,000 80,000 1,60,000 40,000
1,60,000 80,000 80,000 80,000 0
Average profit (A) = 3,20,000/5 = 64,000
ARR = 64,000/4,00,000 x 100 = 16%
Average profits (B) = 2,80,000/5 = 56,000
ARR = 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 flows
0 - 1,00,000
1 20,000
2 30,000
3 40,000
4 50,000
5 60,000
The cost of capital is 12% calculate the following.
a) NPV
b) Benefit cost ratio (GPI)
c) PBP
d) IRR
e) Discounted PBP
Solution:
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 19,043
b) Benefit cost ration (GPI)
= Discounted Cash inflow / Discounted Cash outflow
120

121. = 1,19,043 / 1,00,000
= 1.19
c) Pay Back period
= 3 + 10,000 / 50,000
= 3.2 years
d) 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 NPV
IRR= 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
-------------------------------------------------------------------------------
Objectives
The 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 budgeting
Unit outline
3.4.1 Risk and Uncertainty in Capital Budgeting
The 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 cash
inflows and cash outflows. The future cash flows are estimated, based on the
following 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 cannot
be exact. For example, the product becomes absolute, technology becomes
obsolescence, 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 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
Risk adjusted discount rate
124

125. The risk adjusted discount rate is based on the presumption that investors
expect 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. Risk
free rate is the rate at which the future cash inflows should be discounted and
there been no risk. Risk premium rate is the extra return expected by the investor
over the normal rate on account of the project being risky. Therefore risk adjusted
discount rate is a composite discount rate that takes into account both the time
and risk factors. A higher discount rate will be used for more risky projects and
lower 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% respectively
appropriate 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, more
than one forecast of the future cash inflows may be made. These inflows may be
regarded as 'Optimistic', 'Most Likely' and 'Pessimistic'. Further cash inflows may
be discounted to find out the NPV under these three different situations. If the NPV
under the three situations differ widely it implies that there is a great risk in the
project and the investor's decision to accept or reject a project will depend upon
his risk bearing abilities.
Illustration
Mr. Tanu is considering tow mutually exclusive projects A and B. You are
required to advise him about the acceptability of the projects from the following
information.
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 84,088
Most Likely 25,000 3.3522 83,805 33,805 20,000 3.3522 67,044 17,044
Pessimistic 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 of
the 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 .10
Solution:
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 value
A 4,000 .10 Rs. 400 12,000 .10 1,200
B 5,000 .20 1,000 10,000 .15 1,500
C 6,000 .40 2,400 8,000 .50 4,000
D 7,000 .20 1,400 6,000 .15 900
E 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 expected
monetary 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 risky
capital investment proposals. Decision tree is a graphic display of relationship
between a present decision and possible future events, future decisions and their
consequences. The sequence of event is mapped out over time in a format
resembling branches of a tree. In other words, it is a pictorial representation in
tree form which indicates the magnitude, probability and interrelationship of all
possible 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 capital
Unit outline
129

130. Classifications of working capital
a) Gross working capital and Net working capital
b) Permanent working capital and Temporary working capital
c) 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 in
managing the current assets, the current liabilities and the interrelationship that
exists between them. The term current assets refer to those assets which can be
converted into cash with in one year with out undergoing a decrease in value and
without disrupting the operations of the firm. The major components of current
assets are cash, marketable securities, accounts receivable and inventory. Current
liabilities are those liabilities which are to be paid within a year, out of current
assets or earnings of the firm. The current liabilities are accounts payable, bills
payable, bank overdraft, and outstanding expenses.
The goal of working capital management is to manage the firm's current
assets and liabilities in such a way that a satisfactory level of working capital is
maintained. If the working capital in not kept at satisfactory level, the firm likely
will become insolvent. The current assets should be large enough to cover its
130

131. current liabilities. Each current asset should be properly managed to maintain
satisfactory level of liquidity, either excess or deficiency of the current assets will
have adverse impact on the firm's 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 capital
e) Permanent working capital and Temporary working capital
f) Operating cycle concept of working capital.
Gross working capital refers to the firm's investment in current assets. The
constituents of current assets are:
i) Cash in hand and at bank. ii) Bills receivables. iii) Sundry debtor less provision
of bad debts. iv) Short term loans and advances. V) Inventories of stock consists
of raw materials, work in process, stores and spares and finished goods. vi)
Temporary investments of surplus funds. Vi) Prepaid expenses. Vii) Accrued
incomes
Net 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 for
taxation.
Permanent working capital represents the assets required on continuing basis
over the entire year. Temporary working capital refers to additional assets
required at different items during the operation of the year. Operating Cycle
concept 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 raw
materials and other stores, so cash is converted into raw materials and stores
inventory, in production process it remains as a work in process, this work in
process is converted into finished product, this finished product are sold on credit
or cash. If it is sold on credit, then it will be in the form of bills receivable, later on
it 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 be
adequate. The main significance or importance of adequate amount of working
capital 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 CAPITAL
Objectives
1. To determine the factors which influences the working capital
requirements
2. To diagnose the symptoms of poor working capital management
3. To identify the basic functions of working capital management
Unit Outline
Factors determining the working capital
Symptoms of Poor Working Capital Management
Basic 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 important
of 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 capital
management.
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 by
following 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, a
number of factors viz., production policies, nature of business, length of
manufacturing process, credit policy etc., are to be considered by the finance
manager of a company. The following format can be uses in estimating the
working capital requirement.
Statement of Working Capital Requirements
Amount
Rs
A. Current assets:
1. cash
2. Debtors or Receivables
3. Stocks
i) Raw materials
ii) Work in process
iii) Stores and spares
iv) Finished goods
4. Advance payment, if any
5. Others
B. Current Liabilities:
1. Creditors
2. Outstanding payments
3. Any other
Working Capital (A-B)
-------------------------------------------------------------------------------4.2.4
Financing 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 current
assets to ensure minimum quantity to maintained for continuous use this
minimum cannot be reduced, because it is required for day to day operation of the
business. The amount invested on these permanent fixed assets is called fixed
working capital. Similarly some working capital is required for meeting seasonal
demands and some special purchases like increase in prices, strikes, calamities
eta. This is called temporary working capital.
The fixed or permanent working capital is generally financed by the sources like
issue of shares, debentures, public deposits, ploughing back of profits, loans from
financial institutions etc.
The temporary working capital is financed through the sources like Indigenous
Bankers, Trade credit, cash credit or bank overdraft, advances accounts receivable
or Factoring, accrued expenses, Deferred incomes, Provision for depreciation,
Commercial Paper, Commercial Banks.
Unit 3 CASH MANAGEMENT
Objectives
1. To familiarise about cash management
2. To identify the problems in cash management
138

139. Unit outline
Management of different components of working capital
Management of Cash
Features of Effective Cash Management
Motives for Holding Cash
Basic problems in Cash Management
1. Controlling level of cash
2. Controlling inflows of cash
3. Controlling outflows of cash and
4. 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 Cash
2. Management of inventories
3. Management of receivables
4. Management of payables etc.,
-------------------------------------------------------------------------------
4.3.2 Management of Cash
--------------------------------------------------
Cash management is rapidly emerging as a vital area in any business
organisation. It is one of the important components of current assets. Cash
Management implies making sure that all the business generated revenues are
effectively controlled and utilised in the best possible manner to result in gains for
the organisation.
139

140. Features of Effective Cash Management
Effective cash management involves the proper management of cash inflows
and 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 firm's is that it does
not earn any substantial return for the business. In spite of this fact the firm with
the 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 are
1. Controlling level of cash
2. Controlling inflows of cash
3. Controlling outflows of cash and
4. Optimum investment of surplus cash
1. Controlling level of cash
One of the basic objectives of cash management is to minimise the level of cash
balance 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. The
objective of controlling cash outflows is to slow down the payments as far as
possible. 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 buyer's 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 regarding
the 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 firm's 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 MANAGEMENT
Objectives
1. To familiarise about the concept of Inventory
2. To know the benefits of holding inventories
3. To identify the tools and techniques of Inventory Management
Unit outline
Management of inventories
Benefits of holding inventories
Tools 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 of
inventory in right quantity at right time, at reasonable price. Inventory constitutes
Raw material, work-in-progress, finished goods, consumable stores and spare
parts. 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 for
inventories. The following are the important tools and techniques of inventory
management.
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 MANAGEMENT
Objectives
1. To familiarise about the management of receivables
2. To ascertain the cost of maintaining receivables
146

147. 3. To determine the factors affecting the size of receivables
Unit outline
Management of receivables
Costs of maintaining receivables
Factors affecting the size of receivables
-------------------------------------------------------------------------------
4.5.1. Management of receivables
--------------------------------------------------------------------------
Next to Inventories in the current assets of the business firm accounts
receivable constitutes a major portion in the current assets. The account
receivables arise because of credit sales. Under this system, when a firm sells
goods or services on credit, the payments are postponed to future dates and
receivables are created.
Receivables represent amounts owed to the firm as a result of sale of goods
or services in the ordinary course of business. These are claims of the firm against
its customers and form part of its current assets. Receivables are also known as
accounts receivables, trade receivables, or book debts. The period of credit and
extent 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 firm
to push up its sales which ultimately result in increasing in profits earned. At the
same time, selling goods on credit results in blocking of funds in accounts
receivable which results in demand for additional funds, increase in bad debts,
maintaining and supervising the accounts of the customers. Hence it all calls for
good receivables management. Receivable management is a process of making
147

148. decisions relating to the investment of funds in this asset which will result in
maximizing 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 and
accounts receivable are:
1. Capital costs
2. Administrative costs
3. Collection costs and
4. Defaulting costs.
-------------------------------------------------------------------------------
4.5.3 Factors affecting the size of receivables
---------------------------------------------------------------------------
The size of account receivables is determined by a number of factors. Some
of the important factors are as follows:
1. Levels of sales
2. Credit policies
3. Terms of trade like Credit period and Cash discount.
148

149. Unit 6
WORKING CAPITAL CONTROL AND BANKING POLICY
Objective
1. 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 outline
Working Capital Control and Banking Policy
Committees 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 regulation
and control in the recent years keeping in view the basic objective of ensuring its
equitable distribution to various sectors of the Indian economy. Since November
1965, a Credit Authorisation Scheme has been in operation as part of the
Reserve Bank of India's credit policy. Under this scheme all scheduled commercial
banks are required to obtain prior authorisation of RBI before sanctioning any
fresh credit limits of Rs. One crore or more to any single party or any limit that
would 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 raised
to Rs five crores.
To regulate and control bank finance, the RBI has been issuing directives
and guidelines to the banks from time to time on the recommendations of certain
specially constituted committees. The following are the committees and their
findings 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, and
trade are likely to be inflated and how such trends could be checked", the National
Credit 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 divert
short-term credit for long-term assets. Although committee was of the opinion that
it was difficult to evolve norms for lending to industrial concerns, the committee
recommended that the banks should finance industry on the basis of a study of
borrower's total operations rather than security basis alone. The Committee
further recommended that the total credit requirements of the borrower should be
segregated into 'Hard Core' and Short-term' component. The 'Hard Core'
component which should represent the minimum level of inventories like raw
material, 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 basis
and subject to repayment schedule. The committee was also of the opinion that
generally 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 July
1974 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 major
weaknesses:
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 the
following 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 borrower's
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 borrower's
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 years
with particular reference to the gap between sanctioned limits and the extent of
their utilisation and also to suggest alternative types of credit facilities to ensure
financial 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 REPORT
The RBI appointed another committee in March, 1979 under the
chairmanship of Marathe to review the working of Credit Authorisation
Scheme and suggest measures for giving meaningful directions to the credit
management function of the RBI. The principle recommendations of the
committee 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 REPORT
The RBI appointed another committee under the chairmanship of Sukhamoy
Chakravarty to review the working of the monetary system of India and it
submitted its report in April, 1985. The following are the two major
recommendations 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 supplier's 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 IBA
constituted a committee headed by Shri K. Kannan, to examine all the aspects of
working capital finance including assessment of maximum permissible bank
finance and this committee submitted its report in February, 1997. The
recommendations 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 7
PROBLEMS ON ESTIMATING WORKING CAPITAL &
CASH BUDGET
Objective
1. To know the practical determination of working capital and
its estimation
Chapter outline
Problems on estimating working Capital
Problems 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 unit
Materials 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) 560000
2. A Proforma cost sheet of a company provides the following particulars:
159

160. Elements of cost: Amount Per Unit
Materials 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) 250000
Direct 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 one
point on which you are asked to advice them is the average amount of working
capital which will be required in the first year’s working.
You are given the following estimates and are instructed to add 10% to your
computed 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 2,60,000
Stock of materials-One and half weeks 48,000
Rent, Royalties-6 months 10,000
Clerical Staff 62,400
Manager-half month 4800
Miscellaneous 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 Unit
Materials 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 350000
5. A proforma cost sheet of a company provides the following particulars;
Elements of c Amount per unit (Rs)
167

168. Materials 80
Direct labours 30
Overheads 60
Total cost 170
(+) profit 30
Selling Price 200
The 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 needed
to 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 equivalent
to a month.
STATEMENT SHOWING THE DETAILS CALCULATIONS OF THE NET WORKING
CAPITAL
168

169. Current Assets;
Raw materials
(104000X80X4/52) 640000
Work-in-progress
Raw materials
(104000X80X2/52) 320000
Labour
(104000X30X2/52) 120000
Overheads
(104000X60X2/52) 240000
Finished goods;
Raw materials
(104000X80X4/52) 640000
Labour
(104000X30X4/52) 240000
Overheads
(104000X60X4/52) 480000
Debtors;
Raw materials
(104000X80X8/52X3/4) 960000
Labour
(104000X30X8/52X3/4) 360000
Overheads
(104000X60X8/52X3/4) 720000
Cash in hand 25000
Total Current Assets 4745000
Current Liabilities
Creditors-Rawmaterials
(104000X80X4/52) 640000
Wages O/S
(104000X30X1.5/52) 90000
Lag in payment of wages
(104000X60X4/52) 480000
Total Current liabilities 1210000
Net working capital(A-B) 3535000
169

170. Problem on Cash Budget
The 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 July
Particulars April May June July
170

171. Opening Balance 10,000 7,000 4,500 2,500
Collections from debtors 30,000 33,000 36,000 39,000
------------ ---------- --------- --------
40,000 40,000 40,500 41,500
A ------------ ---------- --------- --------
Payments 11,000 11,500 12,000 12,500
Wages and expenses 22,000 24,000 26,000 28,000
Payments to suppliers ------------ ---------- --------- ---------
B 33,000 35,500 38,000 40,500
------------ ---------- --------- ---------
Closing balance (A - B) 7,000 4,500 2,500 1,500
171