3rd Term-Finance Management

UNIT ONE
CORE CONCEPTS OF FINANCIALMANAGEMENT
Introduction ???
After reading this lesson you will be able to understand the following: -
 Concept of „Finance‟ under different approaches.
 Significance of „Finance‟.
 Nature of financial management.
 Relationship between finance and other important functions of the organization.
 Role of a Finance Manager in an organization.
 New challenges faced by the finance manager.
A very warm welcome to all my students in Third Trimester of PGPACM course at NICMAR,
Hyderabad Campus. I will be teaching you FINANCIAL MANAGEMENT; I must tell you
that I find this subject as the most interesting subject and all my efforts will be to make it very
interesting for you as well. Let’s discuss
Almost every firm, government agency, and organization has one or more financial
managers who oversee the preparation of financial reports, direct investment activities, and
implement cash management strategies. As computers are increasingly used to record and
organize data, many financial managers are spending more time developing strategies and
implementing the long- term goals of their organization.
The duties of financial managers vary with their specific titles, which include controller,
treasurer or finance officer, credit manager, cash manager, and risk and insurance
manager.Controllers direct the preparation of financial reports that summarize and forecast
the organization‟s financial position, such as income statements, balance sheets, and
analyses of future earnings or expenses. Regulatory authorities also in charge of preparing
special reports require controllers. Often, controllers oversee the accounting, audit, and
budget departments. Treasurers and finance officers direct the organization‟s financial goals,
objectives, and budgets. They oversee the investment of funds and manage associated
risks, supervise cash management activities, execute capital-raising strategies to support a
firm‟s expansion, and deal with mergers and acquisitions. Credit managers oversee the
firm‟s issuance of credit. They establish credit- rating criteria, determine credit ceilings, and
monitor the collections of past-due accounts.
Managers specializing in international finance develop financial and accounting
systems for the banking transactions of multinational organizations.
Cash managers monitor and control the flow of cash receipts and disbursements to
meet the
S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 1

business and investment needs of the firm. For example, cash flow projections are needed
to determine whether loans must be obtained to meet cash requirements or whether surplus
cash should be invested in interest-bearing instruments. Risk and insurance managers
oversee programs to minimize risks and losses that might arise from financial transactions
and business operations undertaken by the institution. They also manage the organization‟s
insurance budget.
Financial institutions, such as commercial banks, savings and loan associations, credit
unions, and mortgage and finance companies, employ additional financial managers who
oversee various functions, such as lending, trusts, mortgages, and investments, or
programs, including sales, operations, or electronic financial services. These managers may
be required to solicit business, authorize loans, and direct the investment of funds, always
adhering to Federal and State laws and regulations.
Branch managers of financial institutions administer and manage all of the functions of
a branch office, which may include hiring personnel, approving loans and lines of credit,
establishing a rapport with the community to attract business, and assisting customers with
account problems. Financial managers who work for financial institutions must keep abreast
of the rapidly growing array of financial services and products. In addition to the general
duties described above, all financial managers perform tasks unique to their organization or
industry. For example, government financial managers must be experts on the government
appropriations and budgeting processes, whereas healthcare financial managers must be
knowledgeable about issues surrounding healthcare financing. Moreover, financial
managers must be aware of special tax laws and regulations that affect their industry.
Financial managers play an increasingly important role in mergers and consolidations,

and in global expansion and related financing. These areas require extensive, specialized
knowledge on the part of the financial manager to reduce risks and maximize profit.
Financial managers increasingly are hired on a temporary basis to advise senior managers
on these and other matters.
In fact, some small firms contract out all accounting and financial functions to
companies that provide these services.
The role of the financial manager, particularly in business, is changing in response to

technological advances that have significantly reduced the amount of time it takes to
produce financial reports. Financial managers now perform more data analysis and use it to
offer senior managers ideas on how to maximize profits. They often work on teams, acting
as business advisors to top management. Financial managers need to keep abreast of the
latest computer technology in order to increase the efficiency of their firm‟s financial
operations.

We all have heard about the term finance, let us discuss on what does it mean and
why do you as a student of PGPACM want to study it?
Finance can be defined as the art and science of managing money. Virtually all individuals
and organizations earn or raise money and spend or invest money. Finance is concerned
with the process, institutions, markets, and instruments involved in the transfer of money
among and between individuals, businesses, and governments.
Why study finance?

An understanding of the concepts, techniques, and practices presented in this course will
fully acquaint you with the financial manager's activities. Because most business decisions
are measured in financial terms, the financial manager plays a key role in the operation of
the firm. People in all areas of responsibility accounting, information systems, management,
marketing, and operations- need a basic understanding of the managerial finance function.
All managers in the firm, regardless of their job descriptions, work with financial personnel to
justify personnel requirements, negotiate operating budgets, deal with financial performance
appraisals, and sell proposals based at least in part on their financial' merits. Clearly, those
managers who understand the financial decision-
making process will be better able to address financial concerns, and will therefore more
often get the resources they need to accomplish their own goals.
To make informed decisions about where to get and put money in order to maximize
value in
both personal and business decisions.
I know you want to ask the following question: -
If I have no intention of becoming a financial manger, why do I need to understand

financial management?
One good reason is “to prepare yourself for the workplace of the future”. More and more
businesses are reducing management jobs and squeezing together the various layers of the
corporate pyramid. This is being done to reduce costs and boost productivity. As a result,
the responsibilities of the remaining management positions are being broadened. The
successful manager will need to be much more of a team player that has the knowledge and
ability to move not just vertically within an organization but horizontally as well. Developing
cross-functional capabilities will be the rule, not the exception. Thus, a mastery of
basic financial management skills is key ingredient that will be required in the work place of
your not too distant future.

Finance is the study of money management, the acquiring of funds (cash) and the
directing of these funds to meet particular objectives. Good financial management helps
businesses to
maximize returns while simultaneously minimizing risks.
Hardly anybody wants to work in a field where there is no room for experience, creativity,
judgment and a pinch of luck but study of finance is not so. There are many reasons that the
manager’s job is challenging and interesting. Here are four important ones.
I. -Securities Markets
II. -Understanding Values
III. -Time and uncertainty
IV. -Understanding People.
I. Securities Markets include Money Markets and Capital Markets.

Money Markets includes:
 Markets for short-term claims with original maturity of one year or less.
 High-grade securities with little or no risk of default.
* Examples:
1. Treasury Bills.
2. Commercial Paper.
3. Certificates of Deposit.
Capital markets include:

* Market for long-term securities with original maturity of more than one year.
*Securities may be of considerable risk.
*Example:
1.Stocks 2.Corporate bonds 3.Government bonds.
Primary Markets
A primary market is a market for newly created securities. The proceeds from the sale of
securities in primary markets go to the issuing entity. A security can trade only once in the
primary market.
Secondary Markets
A secondary market is a market for previously issued securities. The issuing firm is not
directly affected by transactions in the secondary markets. A security can trade an unlimited
number of times in secondary markets. The volume of trade in secondary markets is such
higher than in primary markets.
Investment Bankers:::An investment banker specializes in marketing new securities in the

primary market. Examples of Investment bankers are: Merrill Lynch, Sigma Manufactures
Merchant Bank, etc.

Brokers and Dealers
These generally participate in the secondary markets. A broker helps investors in buying or
selling securities. A broker charges commissions, but never takes title to the security. A
dealer buys securities from sellers, and sells them to buyers.
Financial Intermediaries
These are institutions that assist in the financing of firms. Example include; commercial
banks and pension funds. These institutions invest in securities of other firms, but they are
themselves financed by other financial claims. On the other hand, it is a sort of indirect
financing in which savers deposit funds with the banks and financial institutions rather than
directly buying bonds or shares and the financial institutions, in turn lend the money to
ultimate borrowers. The Commercial Banks, Financial Institutions, Finance and Investment
Companies, Insurance Companies, Unit Trust, Pension Funds etc., are examples of financial
intermediaries.
II. Understanding Value

Understanding how capital markets work amounts to understanding how financial assets are
valued. This is a subject on which there has been remarkable progress over the past 10 to
20 years. New theories have been developed to explain the prices of bonds and stocks.
And, when put to the test, these theories have worked well. I, therefore, would like to give
more stress in this area because the implication of this is applying in almost all parts of the
corporate finance.
III. Time and Uncertainty

The financial manager cannot avoid coping with time and uncertainty. Firms often have the
opportunity to invest in assets which cannot pay their way in the short run and which expose
the firm and its stockholders to considerable risk. The investment, if undertaken, may have
to be financed by debt, which cannot be fully repaid for many years. The firm cannot walk
away from such choices- someone has to decide whether the opportunity is worth more than
it costs and whether the additional debt burden can be safely borne.
IV. Understanding People

The financial manager needs the opinions and cooperation of many people. For instance,
many new investment ideas come from plant managers. The financial manager wants these
ideas to be presented fairly; therefore, the proposers should have no personal incentives to
be either overconfident or overcautious. Take another example. In some firms the plant
manager needs permissions from the head office to buy a company car but not to lease it,
and the line of least resistance may be to lease the car. In other firms the plant manager
needs permission from the head office to buy or lease, and the line of least resistance may

be to travel everywhere by cab. The financial manager has to be aware of these effects and
has to devise procedures that will avoid as far as possible any conflicts of interest.
These are not the only reasons that financial management is interesting and also
challenging.
Concept of Finance
Different finance scholars have interpreted the term „finance‟ in real world variably. More
significantly, as noted at the very outset of this chapter, the concept of finance has changed
markedly with change in times and circumstances. For convenience of analysis different
viewpoints on finance can be categorized into following three major groups:
F.1. The first category incorporates the views of all those who contend that finance concerns
with acquiring funds on reasonable terms and conditions to pay bills promptly. This approach
covers study of financial institutions and instruments from which funds can be secured, the
types and duration of obligations to be issued, the timing of the borrowing or sale of stocks,
the amounts required, urgency of the need and cost. The approach has the virtue of
shedding light on the very heart of finance function. However, the approach is too restrictive.
It lays stress on only one aspect of finance. The traditional scholars hold this approach of
finance
F.2. The second approach holds that finance is concerned with cash. Since almost all
business transactions are expressed ultimately in terms of cash, every activity within the
enterprise is the primary concern of a finance manager. Thus, according to this approach,
finance manager is required to go into details of every functional area of business activity, be
it concerned with purchasing, production, marketing, personnel, administration, research or
other associated activities. Obviously, such a definition is too broad to be meaningful.
F.3. A third approach to finance, held by modern scholars, looks at finance as being
concerned with procurement of funds and wise application of these funds. Protagonists of
this approach opine t hat responsibility of a finance manager is not only limited to acquisition
of adequate cash to satisfy business requirements but extends beyond this to optimal
utilisation of funds. Since money involves cost, the central task of a finance manager while
allocating resources is to match the benefits of potential uses against the cost of alternative
sources so as to maximise value of the enterprise. This is the managerial approach of
finance which is also known as problem- centered approach, since it emphasizes that
finance manager in his endeavor to maximise value of the enterprise has to deal with vital
problems of the enterprise, viz., what capital expenditures should the enterprise make?
What volume of the funds should the enterprise invest? How should the desired funds be
obtained?

Let us move on to financial management, you all being students of management know
the
meaning of management. So let us discuss financial management now.
Nature of Financial Management

Financial management is an integral part of overall management and not merely a staff
function. It is not only confined to fund raising operations but extends beyond it to cover
utilisation of funds and monitoring its uses. These functions influence the operations of other
crucial functional areas of the firm such as production, marketing and human resources.
Hence, decisions in regard to financial matters must be taken after giving thoughtful
consideration to interests of various business activities. Finance manager has to see things
as a part of a whole and make financial decisions within the framework of overall corporate
objectives and policies.
The financial management of a firm affect its very survival because the survival of the
firm depends on strategic decisions made in such important matters such as product
development, market development, entry in new product line, retrenchment of a product,
expansion of the plant, change in location, etc. In all these matters assessment of financial
implications is inescapable.
Another striking feature of financial management that explains its generic nature is the
imperativeness of the continuous review of the financial decisions. As a matter of fact,
financial decision-making is a continuous decision-making process, which goes on
throughout the corporate life. Since a firm has to operate in an environment that is dynamic,
it has, therefore, to interact constantly with various environmental forces in addition to
changing conditions of the firm and adapt and adjust its objectives and strategies including
financial policies and strategies. A one-time financial plan not subjected to periodic review
and modifications in the context of changed conditions will be a fiasco because conditions
may change to such an extent that the plan is no longer relevant and acts as a hindrance
rather than help. Financial planning should, therefore, not be static. It has to be continuously
adapted to changing conditions. As you all are MBA students it is essential for you to know
the interface between finance and other functions let us discuss. You all are studying other
management subjects also let us relate those with finance.
Interface between finance and other functions

Till now you might have understood about the pervasive nature of finance. Let us discuss in
greater detail the reasons why knowledge of the financial implications of their decisions is
important for the non-finance managers. One common factor among all managers is that
they use resources and since resources are obtained in exchange for money, they are in
effect making the investment decision and in the process of ensuring that the investment is
effectively utilized they are also performing the control function.

Marketing-Finance Interface
There are many decisions, which the Marketing Manager takes which have a significant
impact on the profitability impact on the profitability of the firm. For example, he should have
a clear understanding of the impact the credit extended to the customers is going to have
on the profits of the company. Otherwise in his eagerness to meet the sales targets he is
liable to extend liberal terms of credit, which is likely to put the profit plans out of gear.
Similarly, he should weigh the benefits of keeping a large inventory of finished goods in
anticipation of sales against the costs of maintaining that inventory. Other key decisions of
the Marketing Manager, which have financial implications, are:
> Pricing
> Product promotion and advertisement
> Choice of product mix
> Distribution policy.
Production-Finance Interface
As we all know in any manufacturing firm, the Production Manager controls a major part of
the investment in the form of equipment, materials and men. He should so organize his
department that the equipments under his control are used most productively, the inventory
of work-in- process or unfinished goods and stores and spares is optimized and the idle time
and work stoppages are minimized. If the production manager can achieve this, he would be
holding the cost of the output under control and thereby help in maximizing profits. He has to
appreciate the fact that whereas the price at which the output can be sold is largely
determined by factors external to the firm like competition, government regulations, etc. the
cost of production is more amenable to his control. Similarly, he would have to make
decisions regarding make or buy, buy or lease etc. for which he has to evaluate the financial
implications before arriving at a decision.
Top Management-Finance Interface

The top management, which is interested in ensuring that the firm's long-term goals are met,
finds it convenient to use the financial statements as a means for keeping itself informed of
the overall effectiveness of the organization. We have so far briefly reviewed the interface of
finance with the non-finance functional disciplines like production, marketing etc. Besides
these, the finance function also has a strong linkage with the functions of the top
management. Strategic planning and management control are two important functions of the
top management. Finance function provides the basic inputs needed for undertaking these
activities.
Economics - Finance Interface

The field of finance is closely related to economics. Financial managers must understand the
economic framework and be alert to the consequences of varying levels of economic activity
and changes in economic policy. They must also be able to use economic theories as
guidelines for efficient business operation. The primary economic principle used in

managerial finance is marginal analysis, the principle that financial decisions should be
made and actions taken only when the added benefits exceed the added costs. Nearly all-
financial decisions ultimately come down to an assessment of their marginal benefits and
marginal costs.
Accounting - Finance Interface

The firm's finance (treasurer) and accounting (controller) activities are typically within the
control of the financial vice president (CFO). These functions are closely related and
generally overlap; indeed, managerial finance and accounting are often not easily
distinguishable. In small firms the controller often carries out the finance function, and in
large firms many accountants are closely involved in various finance activities. However,
there are two basic differences between finance and accounting; one relates to the
emphasis on cash flows and the other to decision making. complex and diverse
responsibilities.
„
We all know it very well that environment keeps changing and thus brings in new challenges
every time, let us discuss on the new challenges been faced by manager.
Managers are presently facing some new challenges as indicated below:
 TREASURY OPERATIONS: Short-term fund management must be more sophisticated.

 Finance managers could make speculative gains by anticipating interest rate
movements.
 FOREIGN EXCHANGE: Finance Managers will have to weigh the costs and benefits of
 playing with foreign exchange particularly now that the Indian economy is going global
and the future value of the rupee visa a vis foreign currency has become difficult to
predict.
 FINANCIAL STRUCTURING: An optimum mix between debt and equity will be essential.
 Firms will have to tailor financial instruments to suit their and investors' needs.
 Pricing of newissues is an important task in the Finance Manager‟s portfolio now.
 MAINTAINING SHARE PRICES: In the premium equity era, firms must ensure that share
 prices stay healthy. Finance managers will have to devise appropriate dividend and
bonus
 policies.
 ENSURING MANAGEMENT CONTROL: Equity issues at premium means
managements
 may lose control if they are unable to take up their share entitlements. Strategies to
prevent this are vital.

TIME VALUE OF MONEY
 Understand what is meant by "the time value of money.
 Describe how the interest rate can be used to adjust the value of cash flows to a
single point
 in time.
 Calculate the future value of an amount invested today.
 Calculate the present value of a single future cash flow.
 Understand the relationship between present and future values.
 Understand in what period of time money doubles
 Understand shorter compounding periods
 Calculate & understand the relationship between effective & nominal interest rate.
 Use the interest factor tables and understand how they provide a short cut to
calculating
 present and future values.
You all instinctively know that money loses its value with time. Why does this happen?
What does a Financial Manager have to do to accommodate this loss in the value of money
with time? In this section, we will take a look at this very interesting issue.
Why should financial managers be familiar with the time value of money?
The time value of money shows mathematically how the timing of cash flows,
combined with the opportunity costs of capital, affect financial asset values. A
thorough understanding of these concepts gives a financial manager powerful tool to
maximize wealth.
What is the time value of money?
 The time value of money serves as the foundation for all other notions in finance. It
impacts business finance, consumer finance and government finance. Time value of
money results from the concept of interest.
 This overview covers an introduction to simple interest and compound interest,
illustrates the use of time value of money tables, shows a approach to solving time
value of money problems and introduces the concepts of intra year compounding,
annuities due, and perpetuities. A simple introduction to working time value of money
problems on a financial calculator is included as well as additional resources to help
understand time value of money.

Time value of money
The universal preference for a rupee today over a rupee at some future time is
because of the following reasons: -
 Alternative uses/ Opportunity cost
 Inflation
 Uncertainty
The manner in which these three determinants combine to determine the rate of
interest
can be represented symbolically as:
Nominal or market rate of interest rate = Real rate of interest + Expected rate of
Inflation + Risk of premiums to compensate uncertainty.
Basics
Evaluating financial transactions requires valuing uncertain future cash flows.
Translating a value to the present is referred to as discounting.
Translating a value to the future is referred to as compounding.
The principal is the amount borrowed. Interest is the compensation for the
opportunity cost of funds and the uncertainty of repayment of the amount borrowed;
that is, it represents both the price of time and the price of risk. The price of time is
compensation for the opportunity cost of funds and the price of risk is compensation
for bearing risk.
 Interest is compound interest if interest is paid on both the principal and any
accumulated interest. Most financial transactions involve compound interest, though
there are a few consumer transactions that use simple interest that is, interest paid
only on the principal or amount borrowed).
 Under the method of compounding, we find the future values (FV) of all the cash
flows at the end of the time horizon at a particular rate of interest. Therefore, in this
case we will be comparing the future value of the initial outflow of Rs. 1,000 as at the
end of year 4 with the sum of the future values of the yearly cash inflows at the end
of year 4. This process can be schematically represented as follows:
PROCESS OF DISCOUNTING
Under the method of discounting, we reckon the time value of money now, i.e. at time
0 on the time line. So, we will be comparing the initial outflow with the sum of the
present values (PV) of the future inflows at a given rate of interest.

Translating a value back in time -- referred to as discounting -- requires determining
what a future amount or cash flow is worth today. Discounting is used in valuation
because we often want to determine the value today of future value or cash flows.
The equation for the present value is:
Present value = PV = FV / (1 + i)n

Where:
PV = present value (today's value), [(1 + i) ] is the compound factor.
FV = future value (a value or cash flow sometime in And
the future), We can also represent the equation a number of
i = interest rate per period, and different, yet equivalent ways:
n n
n = number of compounding periods Present Value = PV = FV/ (1+i) = FV * 1/ (1+i) =
n
n FV * (1/1+i)
=FV (Discount factor for i & n) = FV (PVIF i, n )
Where PVIFi,n is the present value interest factor, or discount factor.

In other words future value is the sum of the present value and interest:
Future value = Present value + interest
From the formula for the present value you can see that as the number of discount
periods, n,
becomes larger, the discount factor becomes smaller and the present value becomes
less, and as the interest rate per period, i, becomes larger, the discount factor
becomes smaller and the present value becomes less.
Therefore, the present value is influenced by both the interest rate (i.e., the discount
rate) and the numbers of discount periods.
Example 1
Suppose you invest 1,000 in an account that pays 6% interest, compounded annually.
How much will you have in the account at the end of 5 years if you make no
withdrawals? After 10 years?
Answer:
FV5 = Rs 1,000 (1 + 0.06) 5 = Rs 1,000 (1.3382) 5 = Rs 1,338.23
FV10 = Rs 1,000 (1 + 0.06)10 = Rs 1,000 (1.7908) 10 = Rs 1,790.85
What if interest was not compounded interest? Then we would have a lower balance
in the account:
FV5 = Rs 1,000 + [Rs 1,000(0.06) (5)] = Rs 1,300
FV10 = Rs 1,000 + [Rs 1,000 (0.06) (10)] = Rs 1,600

Example 2
Suppose you are faced with a choice between two accounts, Account A and Account
B. Account A provides 5% interest, compounded annually and Account B provides
5.25% simple interest. Consider a deposit of Rs 10,000 today. Which account
provides the highest balance at the end of 4 years?
Answer:
Account A: FV 4 = Rs 10,000 (1 + 0.05) 4 = Rs 12,155.06
Account B: FV4 = Rs 10,000 + (Rs 10,000 (0.0525) (4)] = Rs 12,100.00
Account A provides the greater future value.
Example 3
Suppose that you wish to have Rs 20,000 saved by the end of five years. And
suppose you deposit funds today in account that pays 4% interest, compounded
annually. How much must you deposit today to meet your goal?
Answer:
Given: FV 5= Rs 20,000; n = 5; i = 4%
PV = Rs 20,000/ (1 + 0.04) = Rs 20,000/1.21665
PV = Rs 16,438.54
1. You invest Rs 5,000 today. You will earn 8% interest. How much will you have in 4
Years? (Pick the closest answer) Rs 6,802.50 Rs 6,843.00 Rs 3,675
2. You have Rs 450,000 to invest. If you think you can earn 7%, how much could you
accumulate in 10 years?(Pick the closest answer)
Rs 25,415 Rs 722,610 Rs 722,610
3. If a commodity costs Rs500 now and inflation is expected to go up at the rate of
10% per year, how much will the commodity cost in 5 years?
Rs 805.25 Rs 3,052.55 Cannot tell from this information
In what period of time money will be doubled?

Investor most of the times want to know that in what period of time his money will be
doubled. For this the “rule of 72” is used.
Suppose the rate of interest is 12%, the doubling period will be 72/12=6 yrs.
Apart from this rule we do use another rule, which gives better results, is the “rule of
69”
= .35 + 69/int rate
= .35 + 69/12
= .35 + 5.75 = 6.1 yrs

Practice Problems
What is the balance in an account at the end of 10 years if Rs 2,500 is deposited
today and the account earns 4% interest, compounded annually? Quarterly?
If you deposit Rs10 in an account that pays 5% interest, compounded annually, how
much will you have at the end of 10 years? 50 years? 100 years?
How much will be in an account at the end of five years the amount deposited today is
Rs10, 000 and interest is 8% per year, compounded semi-annually?
Answers
1. Annual compounding: FV = Rs 2,500 (1 + 0.04) 10 = Rs 2,500 (1.4802) = Rs
3,700.61
Quarterly compounding: FV = Rs 2,500 (1 + 0.01) 40 = Rs 2,500 (1.4889) = Rs3,
722.16
2. 10 years: FV = Rs10 (1+0.05) 10 = Rs10 (1.6289) = Rs16.29

50 years: = Rs10 (11.4674) = Rs114.67
FV = Rs10 (1 + 0.05)
100 years: FV = Rs10 (1 + 0.05) 100 = Rs10 (131.50) = Rs 1,315.01
3. FV = Rs 10,000 (1+0.04) 10 = Rs10, 000 (1.4802) = Rs14, 802.44
For example, assume you deposit Rs. 10,000 in a bank, which offers 10% interest per
annum
compounded semi-annually which means that interest is paid every six months.
Now, amount in the beginning = Rs. 10,000
Interest @ 10% P.A for first six months 10,000*0.1/2 = 500

Amount at the end of six months = 10,500
Interest @ 10% P.A for next six months 10,500 * 0.1/2 = 525
Amount at the end of the year = 11,025
Instead, if the compounding is done annually, the amount at the end of the year will be
10,000 (1 + 0.1) = Rs, 11000. This difference of Rs. 25 is because under semi-annual
compounding, the interest for first 6 moths earns interest in the second 6 months.
The generalized formula for these shorter compounding periods is

MN FVn = PV (1+ K/M)
Where
FVn= future value after „n‟ years M = Number of times compounding
PV = cash flow today is done during a year
K = Nominal Interest rate per annum N = Number of years for which
compounding is done.
Effective vs. Nominal Rate of interest
We have seen above that the accumulation under the semi-annual compounding
scheme exceeds the accumulation under the annual compounding scheme
compounding scheme, the nominal rate of interest is 10% per annum, under the
scheme where compounding is done semi annually, the principal amount grows at the
rate of 10.25 percent per annum.
This 10.25 percent is called the effective rate of interest which is the rate of interest
per annum under
annual compounding that produces the same effect as that produced by an interest
rate of 10 percent
under semi – annual compounding.
The general relationship between the effective a nominal rates of interest is as follows:
= (1+k/m)m – 1
r = Effective rate of interest

k = Nominal Rate of interest
m = Frequency of Compounding per year
Example
Find out the effective rate of interest, if the nominal rate of interest is 12% and is
quarterly
compounded?
Answer:
Effective rate of interest = (1 + K/m m) – 1
= (1 + 0.12/4)4 – 1
= 0.126 = 12.6% p.a compounded quarterly
By now you should have clear understanding of
 Compounding Discounting
 Doubling period (Rule of 72)
 Doubling period (Rule of 69)
 Shorter compounding periods E
 ffective vs. Nominal Rate of interest
By now you should be an expert in using the following two tables:
A-1 The Compound Sum of one rupee FVIF
A-3 The Present Value of one rupee PVIF

Concept and measurement of cost of capital
After reading this lesson you will be able to: -

 Understand the concept, importance & significance of cost of capital
 Understand the types of capital Calculate the specific costs of debt
 Calculate the specific cost of preferred stock
 Calculate the specific cost of common equity using dividends model.
Students we discussed Capital budgeting decision in which there were basically twoinputs
i.e.,
(i) The cash flows emanating from the projects, and

(ii) The discount rate.
First input has already been discussed; the present lesson focuses attention on the second
input. This discount rates has been denoted as the cut-off rate, the minimum required rate of
return, rate of interest, target rate etc., Technically speaking, this discount rate is known as
the cost of capital. The concept of cost of capital is an important and fundamental concept
of theory financial management.
We know that the main objective of the business firm is to maximize the wealth of
shareholders in the long run. So, keeping in mind this major point, what managers require is
to invest only in those projects, which give return in excess of cost of funds invested in the
projects of the business? Here my point is that we have to determine of cost of funds, if it is
raised from different sources and at different quantum. The various sources of funds to the
company are in the form of equity and debt.
CONCEPT OF COST OF CAPITAL
The concept of cost of capital has been used in capital budgeting as the discount rate or the
minimum required rate of return. In the NPV and PI techniques, the cash flows have been
discounted at this cost of capital to find out the desirability of the proposal. In the IRR
method, although this cost of capital is not directly used, still it was required to make the
accept-reject decisions. If a project's IRR is more than the cost of capital of the firm then the
proposal is considered to be acceptable, otherwise it should be rejected. So, the concept of
cost of capital has been used quite often without providing a good deal of explanation about
how it is obtained.
Theoretically speaking, the cost of capital is the minimum required rate of return; a
project must earn in order to cover the cost of raising funds being used by the firm in
financing of the proposal.

This can be substantiated as follows; if a firm accepts an investment proposal, it will
also need funds for it‟s financing. These funds can be procured from different types of
investor i.e., equity share holders, preference share holders, debt holders, depositors etc.,
These investor while providing the funds to the firm will have, an expectation of receiving a
minimum return from the firm. The minimum return expected by the investors depends upon
the risk perception of the investor as well as on the risk-return characteristics of the firm.
Therefore, in order to procure funds, the firm must pay this return to the investors.
Obviously, this return payable to investors would be earned out of the revenues enerated by
the proposal wherein the funds are being used. So, the proposal must earn at least that
much, which is sufficient to pay to the investors of the firm. This return payable to investor is
therefore; the minimum return the proposal must earn other-wise, the firm need not take up
the proposal. In nutshell, therefore, the cost of raising funds is the minimum required rate of
return of the firm i.e., the cost of capital is the minimum return which the firm must earn on
the proposals in order to break-even..
Thus, the minimum rate of return that a firm must earn in order to satisfy the
expectations of its investor is called the cost of capital of the firm. In other words, the cost of
capital is the rate of return; a firm must earn in order to attract the supplier of funds to make
available the funds to the firm.
IMPORTANCE AND SIGNIFICANCE OF COST OF CAPITAL
The importance and significance of the concept of cost of capital can be stated in terms of
the contribution it makes towards the achievement of the objective of maximization of the
wealth of the shareholders.
a) If a firm's actual rate of return exceeds its cost of capital and if this return is earned
without of course, increasing the risk characteristics of the firm, then the wealth
maximization goal will be achieved. The reason for this is obvious.
b) If the firm's return is more than its cost of capital, then the investor will no doubt be
receiving their expected rate of return from the firm. The excess portion of the return
will however be available to the firm and can be used in several ways
E.g. (i) for distribution among the shareholders in the form of higher than expected
dividends, and
(ii) For reinvestment within the firm for increasing further the subsequent returns. In
both the cases, the market price of the share of the firm will tend to increase &
consequently will result in increase in the shareholders wealth.
In capital budgeting decision it helps accepting those proposals whose rate of return is
more than the cost of capital of the firm and hence results in increasing the value of the firm.
Similarly, the firm's value is reduced when the rate of return on the proposal falls below the

cost of capital. Thus, the concept of cost of capital is consistent with the goal of maximization
of shareholders wealth and it works as a tool to achieve this goal.
Further, the cost of capital has a useful role to play in deciding the financial plan or
capital structure of the firm. It may be noted that in order to maximize the value of the firm,
the cost of all the different sources of funds must be minimized. The cost of capital of different
sources usually varied and the firm will like to have a combination of these sources in such a
way so as to minimize the overall cost of capital of the firm.
What impacts the cost of capital?
The Cost of Capital becomes a guideline for measuring the profitability of

different investments.
Remember that: The goal of the corporation is to maximize the value of

shareholders’ equity!
Therefore cost needs to come down.

TYPES OF COST OF CAPITAL
1.Explicit cost & implicit cost

The explicit cost of capital of a particular source may be defined in terms of the
interest or dividend that the firm has to pay to the suppliers of funds. There is an explicit flow
of return payable by the firm to the supplier of fund. For example, the firm has to pay interest
on debentures, dividend at fixed rate on preference share capital and also some expected
dividend on equity shares. These payments refer to the explicit cost of capital.
There is one source of funds, which does not involve any payment or flow i.e., the
retained earnings of the firm. The profits earned by the firm but not distributed along the
equity shareholders are ploughed back and reinvested within the firm. These profits
gradually result in a substantial source of funds to the firm. Had these profits been
distributed to equity shareholders, they could have invested these funds (return for them)
elsewhere and would have earned some return. The investors forego this return when the
profits are ploughed back. Therefore, the firm has an implicit cost of these retained earnings
and this implicit cost is the opportunity cost of investors. Thus, the, implicit cost of retained
earning is the return which could have been earned by the investor, had the profit been
distributed to them. This is also called opportunity cost of capital. Except the retained
earnings, all other sources of funds have explicit cost of capital.
2.Specific cost & overall cost
 We know that a company obtains capital from various sources. The cost of capital of
each source differs because of the risk differences and the contractual agreements. The
cost of capital of each, source of capital is known as component or specific cost of
capital. And when we take combined cost of all the components it is called overall cost of
capital. The components are assigned certain weights & then the weighted average cost
of capital is determined.
 The advantage of using the overall cost of capital is its simplicity. Once it is computed,
projects can be evaluated using a single rate that does not change unless underlying
business and financial market condition change.
 The overall cost of capital of a firm is a proportionate average of the costs of the various
components of firm‟s financing. The cost of equity capital is the most difficult to measure.
Our concern will be with the marginal or specific cost of capital. We will determine
specific costs first & then will move our attention to overall cost of capital.

MEASUREMENT OF COST OF CAPITAL
As discussed for measuring firm‟s overall cost of capital specific cost of capital need to
be determined component wise.
Component of Cost of capital
I. Cost of Debt (K D)
II. Cost of Preferred Capital (KP)
III. Cost of Equity (KE)
IV. Cost of Retained Earnings (KR)
I. Cost of Debt (K D)
 We know it very well that the capital structure of a firm normally includes the debt
component also. Debt may be in the form of Debentures, Bonds; Term Loans form
Financial Institutions and Banks etc. The debt is carried a fixed rate of interest payable to
them, irrespective of the profitability of the company since the coupon rate is fixed. The
firm increases its earnings through debt financing. Then after payment of fixed interest
charges more surpluses is available for equity shareholders, and hence EPS will
increase.
 An important point to be remembered that dividends payable to equity shareholders and
preference shareholders is an appropriation of profit, whereas the interest payable on
debt it is a charge against profit.
 Therefore, any payment towards interest will reduce the profit and ultimately the
company‟s tax liability would decrease. This phenomenon is called “ Tax shield”. The tax
shield is viewed as a benefit accruing to the company, which is geared. Geared, here
means inclusion of debt capital to the total capital requirement of the form/company.
 To gain the full tax shield the following condition apply:
 The company must be able to show a taxable profit every year to take full advantage of the tax
shield.
 If the company makes loss, the tax shield goes down and cost of borrowing increases.
Example
Harappa Ltd. has earned a profit before interest and tax of Rs. 6,00,000 for the year
ended
31 st March 2001. Calculate its profit after tax in the following situation: The company
has entirely financed its project through issue of 3,00,000 equity shares of Rs 10
each.
The company has financed its project through issue of 1,00,000 equity shares of Rs
10 each and 20,000 14% debentures of Rs 100 each.
The company‟s applicable corporate tax rate is 40%.
Solution

You can calculate the profit as:
By using the tax shield and advantage of fixed interest bearing funds in the capital structure,
the EPS of the owners i.e. equity shareholders is increase by Re.0.72 (i.e. Rs 1.92-Rs 1.20)
In a situation of loss making, the advantage of tax shield and gearing cannot be gained. It
will further increase the cost of debt.
The explicit cost of debt can be derived by solving for the discount rate that equates the
market price of the debt issue with the present value of interest payments and then be
adjusting the explicit cost obtained for the tax deductibility of interest payments.
To apply the formulation of cost of debt what kind of information do we need?

 Inflows (Net cash proceeds by issue of debentures)
 Outflows (In terms of interest & principal repayment whether in installments orin lump
sum)

(a) Cost of Perpetual Debt
The cost of perpetual debt is calculated with the following formula:

K D = I (1-T) / D
Where,
KD = Cost of debt D = Net proceeds of issue of Debentures,
I = Annual interest payment Bonds, Terms loans etc.
T = Company‟s effective corporate tax rate
Example:Vishwanath Steel Ltd. has issued 30,000 irredeemable 14% debentures of Rs 150
each.
The cost of floatation of debentures is 55 of the total issued amount. The company‟s
taxation rate is 40%. Calculate the cost of debt.
Here, you see:
Net proceeds from debenture issue
Annual interest charge:

(Rs 45,00,000 x 14/ 100) = Rs. 6,30,000
KD = I (1-T)/D
= Rs. 6,30,000 (1- 0.40)/ (Rs.42,75,000)
= 3,78,000/42,75,000 = 0.0884 or 8.84%
Please note Net proceeds will change if debentures are issued at discount or at premium.
(b) Cost of Redeemable Debt
The cost of capital of redeemable debt may be ascertained with the help of following
equation
Where I = Annual Interest Payment

Bo = Net Proceeds
COPi= Regular Cash Outflow on account of amortization
COPn = Cash Outflow on account of repayment at maturity
K d = After tax cost of capital of debt.

In case, the debt is repayable only at the time of maturity and there is no annual
amortization then the Equation above will not contain the second element i.e.,
i
The Equation is to be solved for the value of k , which will be after tax cost of capital for debt.
This equation is to be solved by trail and error procedure (as the IRR equation was solved
earlier).
Example :ABC Ltd. issues 15% debentures of face value of Rs.100 each, redeemable at the
end of 7 years. The debentures are issued at a discount of 5% and the flotation cost is
estimated to be 1%. Find out the cost of capital of debentures given that the firm has 50%
tax rate.
Solution
The value of right hand side of the equation is to be made equal to the amount of Rs.94 and
can be derived by trail and error procedure as follows:
Since the amount is less than Rs.94, the rate of discount may be reduced to 8% and
therefore,
By interpolating between 8% and 9%, the value of kd comes to 8.68%. So, the cost ofcapital
(after tax) of debenture is 8.68%.
In order to avoid the cumbersome procedure of trial and error we can use an approximation
to after tax cost of capital of debt.

Where RV = Redemption Value of debenture
Kd= After Tax Cost of Debt
t = Tax rate ,
N = Life of debenture ,
Now, applying the same
II. Cost of Preference Share Capital (Kp )
Preferred Stock has a higher return than bonds, but is less costly than common
stock. WHY?
In case of default, preferred stockholders get paid before common stock holders. However,
in the case of bankruptcy, the holders of preferred stock get paid only after short and long-
term debt holder claims are satisfied. Preferred stock holders receive a fixed dividend and
usually cannot vote on the firm‟s affairs.
(a) Cost of Perpetual Preference shares
Example:If Cowboy Energy Services is issuing preferred stock at $100 per share, with a
stated
dividend of $12, and a flotation cost of 3%, then:
Solution
Unlike the situation with bonds, no adjustment is made for taxes, because preferred
stock dividends are paid after a corporation pays income taxes. Consequently, a firm
assumes the full market cost of financing by issuing preferred stock. In other words,
the firm cannot deduct dividends paid as an expense, like they can for interest
expenses.

(b) Cost of Redeemable Debt
The cost of redeemable preference share is defined as that discount rate which equates the
proceeds from preference share capital issue to the payment associated with the same i.e.
dividend payment and principal payment. It is calculated as follows: Where
Kp = cost of preference capital
D = preference dividend per share payable annually
F = redemption price
P = net amount realized per share And n = maturity
period
An approximation formula as given below can also be used.
Example :The terms of the preference share issue made by Color-Dye-Chem are as
follows: Each preference share has a face value of Rs.100 and carries a rate of
dividend of 14 percent payable annually. The share is redeemable after 12 years at
par. If the net amount realized is Rs.95, what is the cost of the preference capital?
Solution
Given that D = 14, F = 100, P = 95 and n = 12
Example :ABC Ltd issues 15% preference shares of the face value of Rs. 100 each at
a flotation cost of 4%. Find out the cost of capital of preference share if

i. The preference shares are irredeemable and
ii. If the preference shares are redeemable after 10 years at a premium of 10%
Solution
III. Cost of Equity (KE)

 Equity capital is that capital, which we generate from the owners of the company.
These funds are not repaid during the lifetime of the organization; hence are also
called permanent source of funds.
 The equity shareholders are the owners of the company and we know it very well that
the main objective of the firm is maximization of wealth of the equity shareholders.
 Equity share capital is treated as the risk capital of the company. Because of the
following reasons:
1. If the company is doing well then the ultimate beneficiaries are the equity
shareholders who will get the return in the form of dividends from the company, and
the capital appreciation for their investment
2. If the company is liquidated due to losses, the ultimate and worst sufferers are the
equity shareholders.
3. Sometimes they may not even get their investment back during the liquidation
process.
The profits after taxation, less dividends paid out to the shareholders, are funds that belong
to the equity shareholders. These funds are reinvested in the company and therefore, you
should note that those retained funds should be included in the category of equity. These
funds are known as „retained earnings’.
The cost of equity is defined as the minimum rate of return that a company must earn on
the equity. You should remember that you have to earn this minimum rate on your

investment in any project so that market price of the shares remains unchanged. Now I will
explain the various methods, which are used in calculation of Cost of Equity.
o
 The cost of equity capital is by far the most difficult cost to measure. In the case of equity
share, the cost has to be viewed in the opportunity framework. The investor has provided
funds to the firm expecting to receive the combined return of dividends and the
appreciation in market value. The investment was made, presumably on a logical basis,
because the type of risk embodied in the firm reasonably matched with the investor‟s on
risk preference and because the expectations about earnings, dividends and market
appreciation were satisfactory. The investor made this choice by foregoing other
investment opportunities.
 The problem of measuring, the cost of equity capital to a firm arises from the need to
measure the investor‟s expectations about the risk and return in relation to the firm. There
are various models that we use for determining cost of equity.
Let us discuss these models one by one.
Ways to Calculate
1. Dividend discount models

2. CAPM
3. Price earning method
4. Bond yield – plus – risk premium
1. DIVIDEND DISCOUNT MODELS
Dividend discount models are designed to compute the intrinsic value of a share of
common stock under specific assumption as to the expected growth pattern of future
dividends and the appropriate discount rate to employ. Merrill Lynch, CS First Boston, and a
number of other investment banks routinely make such calculations based on their own
particular models and estimates. What follows is an examination of such models, beginning
with the simplest one.
The value of a share of common stock can be viewed as the discounted value of all
expected cash dividends provided by the issuing firm until the end of the time. In other
words,

Constant Growth
Future dividends of a company could jump all over the place; but, if dividends are
expected to grow at a constant rate, what implication does this hold for our basic stock
valuation approach? If this constant rate is g, then Equation written above will become
Where Do is the present dividend per share. Thus, the dividend expected at the end of
period n is equal to the most recent dividend times the compound growth factor, (1 +
g)n is greater than g (a reasonable assumption because a dividend growth
Assuming that ke rate that is always greater than the capitalization rate would imply an
infinite stock value), Equation can be reduced to
Rearranging, the investor‟s required return can be expressed as
The critical assumption in this valuation model is that

dividends per share are expected to grow perpetually at a compound rate of g. For
many companies this assumption may be a fair approximation of reality.
An allowance for future growth in dividend is to add to the current dividend yield. It is
recognized that the current market price of a share reflects expected future dividends.
This dividend growth model is also called as Gordon‟s dividend growth model‟.
Let us do some questions to understand the concept better.
Example:LKN, Inc.‟s dividend per share at t = 1 is expected to be $4, that it is expected to

grow at a 6 percent rate forever, and that the appropriate discount rate is 14 percent. What
will be the value of one share of LKN stock?
Solution:The value of one share of LKN stock would be
V = $4/(.14 - .06) = $50

For companies in the mature stage of their life cycle, the perpetual growth model is often
reasonable.
Where, D 1 = current dividend per Equity share

PE = Market price per equity share
g = Growth in expected dividend
Example:The equity of Survy limited is traded in the market at Rs. 90 each. The current year
dividend per share is Rs 18.The subsequent growth in dividend is expected at the rate of
6%. Calculate the cost of equity capital.
Solution:
Example :Sunlight Ltd. has its share of Rs. 10.each quoted on the stock exchange; the
current price
per share is Rs. 24. The gross dividends per share over
the last year have been Rs.1.20, Rs1.45 and Rs 1.60.
Calculate the cost of equity shares.
Solution Expected current year dividend:
The dividends are growing @ 10 % and are expected to continue to grow at this rate.

Some times the dividend growth model formula for calculation of cost of equity
share capital is also written as follows:
Example :Full moon Ltd. has its equity share of Rs. 10 each quoted in a stock exchange
has market price of RS. 56. A constant expected annual growth rate of 6%, and dividend of
Rs.3.60 per share has been paid for the current year. Calculate the cost of capital.
Solution
Example:ABC ltd has just declared & paid a dividend at the rate 15% on the equity share of
Rs. 100 each. The expected future growth rate in dividends is 12%. Find out the cost of
capital of equity shares given that the present value of share is Rs. 168.
Solution:The cost of equity capital in this case will be ascertained as follows

No growth
A special case of the constant growth model calls for an expected growth rate, g, of zero.
Here the assumption is that dividends will be maintained at their current level forever. The
dividend per share is expected on the current market price per share. As per this method,
the cost of capital is defined as “the discount rate that equates the present value of all
expected future dividends per share with the net proceeds of the share.” Not many stocks
are expected to maintain a constant dividend forever. However, when a stable dividend is
expected to be maintained for a long period of time this equation does provide a good
approximation of value.
Example :Hindustan Manufacturing Ltd. has distributed a dividend of Rs. 30 on each Equity
share
of Rs 10. The current market price of share is Rs. 80. Calculate the cost of equity
Solution Applying the above formula:

Example :FMD Ltd issued 10,000 equality of Rs. 10 each at a premium of Rs. 2 each. The
company has incurred issue expenses of Rs 5,000. The equity shareholders expect the rate
of dividend to 18% p.a. Calculate the cost of equity share capital. Will your answer be
different if the current market price of the share is Rs 21.1?
Solution Since the Equity share are newly issued, the cost of capital of it can be calculated
as
follows:
P
NET Proceeds per share:
But in case of the existing equity share, market price is to be taken as basis for
calculation
of cost of equity capital as follows:

Varying Growth Rate in Dividends:
Dividends may also be assumed to grow at different rates for different years. For
example, for first 5 years the growth rate may be 10% per annum, then for the next 5 years
the growth rate may be 15% per annum and thereafter the dividends may grow at 20% per
annum infinitely. This means that the dividend will grow at 10% per annum for year 1 to 5,
and at 15% for years 6 to 10 and at 20% for the year 11 and thereafter. Equation can be
modified to take care of such situations of dividend stream and the cost of capital may
therefore be calculated with the help of following Equation.
=24%
In may be observed that the Ke has increased from 22%

to 24% as a result of inclusion of Corporation Dividend
Tax.
Zero Dividends:
It may also be assumed that the firm may not pay any dividend and instead reinvests
its entire earnings. The investors, even if no dividend is expected, will not change their
required rate of return. Instead, the investor must be expecting a capital gain in the
form of increase in market price. Thus, the required rate of return accrues to the
investors in the form of capital gain, which they receive when they sell their shares at
a later date at a , against the current price, Pn . In such a case, the cost of capital, k e,
may be price say, Po
calculated with the help of following equation.
An important assumption in Equation above is that P n>P0. The value of k in Equation

can be derived as
The main problem in applying this equation is that it is difficult, if not impossible to estimate
value of Pn i.e.,, the expected market price at the end of year n.
Criticism of dividend discount models
The dividend growth model is criticized on the following reason:
 The future growth pattern is impossible to predict because it will be inconsistent and
uneven.
 Due to uncertainty of future and imperfect information, only historic growth is to be
used for prediction for future growth.
 Calculating only cost of equity capital, and ignoring the cost of other forms of capital
may not be valid The dividend growth depends on retained earnings of the company,
and the growth is difficult to assume.

2. Capital Asset Pricing Model Approach (CAPM)
Another technique that can be used to estimate the cost of equity is the capital asset pricing
model (CAPM) approach. The CAPM explains the behaviour of security prices and provides
a mechanism whereby investors could assess the impact of proposed security investment
on their overall portfolio risk and return. In other words, it formally describes the risk-return
trade-off for securities. It is based on certain assumptions.
The basic assumptions of CAPM relates to
(a) The efficiency of the security markets and
(b) Investor preferences.
(a) The efficient market assumption implies that

(i) All investors have common (homogeneous) expectations regarding the expected
returns, variances and correlation of returns among all securities;
(ii) All investors have the same information about securities;
(iii) There are no restrictions on investments;
(iv) There are no taxes;
(v) There are no transaction costs; and
(vi) No single investor can affect market price significantly.
(b) The implication of investors' preference assumption is that all investors prefer the
security that provides the highest return for a given level of risk or the lowest amount of risk
for a given level of return, that is, the investors are risk averse.
There are two types of risks to which security investment is exposed:
(i) Diversifiable/unsystematic risk:

It represents that portion of the total risk of an investment that can be
eliminated/minimised through diversification. The events/factors that cause such risks
vary from firm to firm. The sources of such risks include management capabilities and
decisions, strikes, unique government regulations, availability or otherwise of raw
materials, competition, level of operating and financial leverage of the firm, and so on.
(ii) Non-diversifiable/systematic risk:

a) The systematic/non-diversifiable risk is attributable to factors that affect all firms.
Illustrative sources of such risks are interest rate changes, inflation or purchasing power
change, changes in investor expectations about the overall performance of the
economy and political changes, and so on.

b) As an investor through diversification can eliminate unsystematic risk, the systematic
risk is the only relevant risk. Therefore, an investor (firm) should be concerned,
according to CAPM, solely with the non-diversifiable (systematic) risk.
c) Systematic risk can be measured in relation to the risk of a diversified portfolio, which is
commonly referred to as the market portfolio or the market.
d) According to CAPM, the non-diversifiable risk of an investment/security/ asset is
assessed in terms of the beta coefficient. Beta is a measure of the volatility of a
security's return relative to the returns of a broad-based market portfolio.
e) Alternatively, it is an index of the degree of responsiveness or co-movement of return
on an investment with the market return.
f) The beta for the market portfolio as measured by the broad-based market index equals
one. Beta coefficient of 1 would imply that the risk of the specified security is equal to
the market; the interpretation of zero coefficient is that there is no market-related risk to
the investment.
g) A negative coefficient would indicate a relationship in the opposite direction. The 'going'
required rate of return in the market for a given amount of systematic risk is called the
Security Market Line (SML).
With reference to the cost of capital perspective, the CAPM describes the relationship
between 'the required rate of return, or the cost of equity capital, and the non-diversifiable or
relevant risk, of the firm as reflected in its index of non-diversifiable risk, that is, beta.
Symbolically,
Ke = Rj + b (Km - Rj)
Where Ke = cost of equity capital can be viewed as the average rate

Rf = the rate of return required on a of return on all assets.
risk-free asset/security/investment b = the beta coefficient
Km = the required rate of return on
the market portfolio of assets that
Example: “Cowboy Energy Services has a B = 1.6. The risk free rate on T-bills is
currently 4% and the
market return has
averaged 15%.
Solution
Ke = Rj + b (Km - Rj)
= 4 + 1.6 (15 – 4) =
21.6 %

3. PRICE EARNING METHOD
This method takes into consideration the earnings per share (EPS) and the market
price of the share. It is based on the assumption that the investors the stream of future
earning of the share and the earnings of the share need not be in the form of dividend and
also it need not be disbursed to the shareholders. It based on the argument that even if the
earnings are not disbursed as dividends, it is kept in the retained earnings and its causes
future growth in the earnings of the company as well as the increase in the market price of
the share. In calculation of cost equity share capital, the
earnings per share are divided by the current market price.
Where,
M = Market price per share.
E = Current earning per share.
Example:MATA SANTOSHI LTD. has 50,000. Equity shares of Rs 10 each and its current
market
value is Rs 45 each. The after tax profit of the company for the year ended 31 march, 2001
is Rs 9,60,000.Calculate the cost of capital based on price/earning method.
Solution: EPS here will be as
= Rs. 9,60,000/50,000 equity shares = Rs. 19.20
KE = E/M
= Rs. 19.20/ Rs. 45 = 0.4267 or 42.67

DEF :A company‟s value under the Price/Earnings business valuation method is based on
the assumption that the company value should be similar to companies whose shares are
traded in the stock market. The company‟s value is calculated according to the future profit
of the business and the industry average P/E ratio or the P/E ratio of another firm with a
similar business profile.
The Formula:
Company Value = [Profit in year i]*[Comparative P/E] / (1+r)
Business Valuation - Price/Earnings Method
Where: Profit in Year i = Net profit in any chosen year (I)
Comparative P/E = P/E of any public company or industry average
r = Discount Rate
This Value is discounted to the beginning of the forecast period.
4. BOND YIELD PLUS RISK PREMIUM APPROACH
The logic behind this approach is that the return required the investors is directly based on
the risk profile of the company. This risk profile is adequately reflected in the return earned
by the bondholders. Yet, since the risk borne by the equity investors is higher than that of
bondholders, the return earned by them should also be higher. Hence this return is
calculated as:
Yield on the long-term bonds of the company + Risk premium
 This risk premium is a very subjective figure, which is arrived at after considering the
various operating and financial risks faced by the firm. Though these risks are already
factored in the bond yield, since by nature equity investment is riskier than
investments in bonds and is exposed to a higher degree of the firm's risks, these also
have an impact on the risk-premium. For example, let us take two companies A and B,
A having a net profit margin of 5% and B of 10% with other things being equal. Since
company B faces less downside risk compared to company A, it will have to pay less
interest to its bondholders. Hence, the risk of company is already accounted for in the
bondholders‟ return.
o Yet, when it comes to estimating the equity holders' risk premium, these risks are
considered all over again because the equity holders are going to bear a larger part of
these risks. In fact, these risks being taken into account for fixing the bondholders
return will result in a multiple increase in the equity holders' risk. Hence, the equity
holders of company A will receive a higher risk premium than those of company B.

Cost of Retained Earnings (KR)
As we discussed in the previous class the cost of equity capital, now I will continue our
discussion to the retained earnings. This is one of the major sources of finance available for
the well-established companies to finance its expansion and diversification programmes.
These are the funds accumulated over years of the company by keeping part of the funds
generated without distribution. The equity shareholders of the company are entitled to these
funds and sometimes; these funds are also taken into account while calculating the cost of
equity. But so long as the retained profits are not distributed to the shareholders, the
company can use these funds within the company for further profitable investment
opportunities.
Hence, you can say that cost of equity includes retained earning. But in practice, retained
earnings are a slightly cheaper source of capital as compared to the cost of equity capital.
That is why, we deal the cost of retained earnings separately form the cost of equity capital.
To be very clear the cost of retained earnings to the shareholders is basically an

opportunity cost of such funds to them. It is basically equal to the income that they would
otherwise obtain by placing these funds in alternative investment.
Say, suppose, the company earns Rs. 100 by using your money but distributed only Rs. 60
as dividend. That means the company has retained Rs. 40 of your money. If you could
invest it in the stock market this money at the end of the year you would earn at least few
amount. That possible earning is your opportunity cost of retained earning.
The cost of retained earnings, is often taken as equal to the cost of equity share capital,
since the retained earnings are viewed as the fresh subscription to the equity share capital.

5.Weighted Average Cost of Capital (WACC)
Now that we have specific cost of capital of each of the long-term sources i.e., the debt, the
preference share capital, the equity share capital and the retained earnings, next step is to
calculate the overall cost of capital.
Cost of capital is the overall composite cost of capital and may be defined as the average of
the cost of its specific fund.
Weighted average cost of capital (WACC) is define as the weighted average of the cost of
various sources of finance, weight being the market value of each source of finance
outstanding. Cost of various sources of finance refers to the returns expected by the
respective investor.
The CIMA defines the weighted average cost of capital “ as the average cost of company‟s
finance (equity, debentures, bank loans) weighted according to the proportion each
elements bears to the total pool of capital, weighting is usually based on market valuation
current yields and costs after tax.
The argument in favor of using WACC stems from the concept that capital from
various sources are generated by the business and then finally invested in number of
projects. Hence cost of capital should be weighted cost of capital. Financing decision, which
determines the optimal capital mix, is traditionally made without making any reference to the
acceptance or otherwise of a pacific project. Similarly a specific project is evaluated without
considering the mode of financing of that project. Traditionally, optimal capital structure
occurs at a point where WACC is minimum. We thus call
WACC as the minimum rate of return requires from project to pay off the expected
return the investors and as such WACC is generally referred to as the required rate of
return. According, the relative worth of a project is determined using this require rate of
return as the discounting rate. Thus, WACC gets much importance in both decisions.
This overall cost of capital of the firm is of utmost importance as this rate is to be used
as the discount rate or the cut-off rate evaluating the capital budgeting proposals. The
overall cost of capital may be defined as the rate of return that must be earned by the firm in
order to satisfy the requirements of the different investors.
The overall cost of capital is thus, the minimum required rate of return on the assets of the
firm.

This overall cost of capital should take care of the relative proportion of different sources in
the capital structure of the firm. Therefore, this overall cost of capital should be calculated as
the weighted average rather than simple average of different specific cost of capital.
WACC = (Cost of equity X % equity) + (cost of debt X % debt) + (Cost of equity X %

equity)
Example:ABC Ltd. has a gearing ratio of 40%. Its cost of equity is 21% and the cost of debt
is 15%. Let‟s calculate the company‟s WACC.
Solution:WACC = (21% X 60%) + (15% X 14%)

= 12.6% + 6% = 18.6%
Now the question is what weights to use?
Weights can be
I. Historical or existing weights

1. Book value
2. Market value
II. Marginal weights
I. Historical or existing weights
Historical or existing weights are the weights based on the actual or existing proportions of
different sources in the overall capital structure. Such weighing system is based on the
actual proportions at the time when the W ACC is being calculated. In other words, the
weighing system is the proportions in which the funds have already been raised by the firm.
The use of historical weights is based on two important assumptions namely

(i) That the firm would raise the additional resources required for financing the
investment proposals, in the same proportions in which they are appearing at present
in the capital structure, and
(ii) That the present capital structure is optimal and therefore the firm wants to
continue with the same pattern in future also.

However, there may be some problems in applying the historical weights. The firm may not
be able to raise additional finance in the same proportion as existing one because of
prevailing economic and capital market conditions, legal constraints or other factors.
Further, the assumption of existing capital structure being the optimal one may not always
hold good.
1.Book Value Weights:

 The weights are said to be book value weights if the proportions of different sources
are ascertained on the basis of the face values i.e., the accounting values. The book
value weights can be easily calculated by taking the relevant information from the
capital structure as given in the balance sheet of the firm.
 The book value weights are considered as a sound weighing system as it is
operational in nature and a firm may design its capital structure in terms of as it
appears in the balance sheet. However, the book value weights system does not truly
reflect the economic values. In fact, the weighing system should be market
determined. The book value weights system is not consistent with the definition of the
overall cost of capital, which is defined as the minimum rate of return needed to
maintain the firm's market value. The book value weights ignore the market values.
2.Market Value Weights:

The weights may also be calculated on the basis of the market value of different
sources i.e., the proportion of each source at its market value. In order to calculate the
market value weights, the firm has to find out the current market price of the securities
in each category. However, a problem may arise if there is no market value available
for a particular type of security.
The advantages of using the market value weights may be

1) The market value weights are consistent with the concept of maintaining market
value in the definition of the overall cost of capital.
2) The market value weights provide current estimate of the investor's required rate of
return.
3) The market Value weights yield good estimate of the cost of capital that would be
incurred should the firm require additional funds from the market.
However, the market values weights suffer from some limitations, as follows:
 Not only that the market values of all types of securities issue have to
beobtained but also that the market value of equity share is to be segregated
into capital and retained earrings.
 The market values are subject to change from time to time and so the concept
of optimal capital structure in terms of market values does not remain relevant
any longer.

 External factors, which affect the market value, will affect the cost of capital also
and therefore, the investment decision process will be influenced by the
external factors.
The weights be assigned to different sources of funds are clearly going to be different if the
financial analyst choose to apply current market value weights as against the book values as
stated in the balance sheet. He must be guided by the purpose of the analysis in deciding
which value is relevant. If he is deriving a criterion against which to judge the expected
return from future investment, he should use the current market values of different sources.
The investors, certainly, do not invest in the book values of the equity shares, which may
differ significantly from the market values. The book values are static and not responsive to
changing performance. The choice of market values also complements the use of
incremental funding in that both are expressed in the market terms. It may be noted that the
market value of equity shares automatically includes retained earnings as reported in the
balance sheet.
With respect to the choice between the book value and market value weights, the following
points are to be noted It is argued that the book value is more reliable than market value
because it is not
as volatile. Although it is true that book value does not change as often as market value, this
is more a reflection of the weakness than of strength, since the true value of the firm
changes over time as both the firm specific and the market related information is revealed.
The WACC based on market value will generally be greater than the WACC based on book
values. The reason being that the equity capital having higher specific cost of capital usually
has market value above the book value. However, this is not the rule.
II. Marginal Weights:
The other system of assigning weights is the marginal weights system. The marginal
weights refer to the proportions in which the firm wants or intends to raise funds from
different sources. In other words, the proportions in which additional funds required to
finance the investment proposals will be raised are known as marginal weights. So, in case
of marginal weights, the firm in fact, calculates the actual WACC of the incremental funds.
Theoretically, the system of marginal weights seems to be good enough as the return from
investment will be compared with the actual cost of funds. Moreover, if a particular source
which has been used in the past but is not being used now to raise
additional funds, or cannot be used now for one or the other reason then why should it be
allowed to enter the decision process even through the weighing system.
However, there are some shortcomings of the marginal weights system. In particular, the
capital budgeting decision process requires the long-term perspective whereas the marginal
weights ignore this. In the short run, the firm may be tempted to raise funds only from

cheaper sources and thereby accepting more & more proposals. However, later on when
other sources will have to be resorted to, some projects, which should have been accepted
otherwise, will be rejected because of higher cost of capital.
Example: The require rate of return on equity is 16% and cost of debt is 12%. The firm has
a capital
structure mix of 60% of Equity and 40% Debt. What is the overall rate of the return of
the firm
should
earn?
Solution:
This means suppose the total cost or investments made by the firm is Rs. 10,00,000
(Rs.6,00,000 equity and Rs 4,00,000 debt). Company must earn 14.4% on its overall;
investments i.e., Rs.1, 44,000 which will be just sufficient to give equity holders a rate of
return of 16%. This can be further explained as follows:
So now it must be clear to you that WACC is the discount rate that can be used to
evaluate the company‟s new investments, provided that they have the same risk
profile as the company as whole and provided that they used the same combination of
debt and equity to finance the purposed investment, or financed it by company
reserves.
Example : The following information is available from the Balance Sheet of a Company:
Equity Share Capital20,000 shares of Rs. 10 each Rs. 2,00,000
Reserves and Surplus Rs. 1,30,000
8% Debentures Rs. 1,70,000
The rate of tax for the company is 50%. Current level of Equity Dividend is 12%.

Calculate weighted average cost of capital.
Solution:
1. As the current market price of equity share is not given, the cost of capital of equity
share has been taken with reference to the rate of dividend and the face value of the
share.
So, ke = 12/100 = 12%.
The opportunity cost of retained earnings is the dividends foregone by shareholders.

Therefore, the firm must earn the same rate of return on retained earnings as on the
Equity Share Capital.
Thus, the minimum cost of retained earnings in the cost of equity capital
i.e., Kr=Ke
Example :In considering the most desirable capital structure of a company, the following
estimates
of the cost of debt capital (after tax) have been made at various levels of debt-equity mix:

You are required to find out the weighted average cost of capital of the firm for
different proportions of debt.
Solution:The optimal capital structure may be ascertained in terms of the cost of capital of
the firm
as that level at which the WACC is lowest. The WACC of the firm may be ascertained as
follows:
Out of different debt proportions, the firm has the minimum WACC when the debt proportion is 40%.
Therefore, the optimal capital structure for the firm is consisting of 40% debt and 60% equity and its WACC
would be 13.4%
Example: PQR & Co. has the following capital structure as on Dec. 31, 2000.
Equity Share Capital (5000 share of 100 each) Rs. 5,00,000
9% Preference Shares Rs. 2,00,000
10% Debentures Rs. 3,00,000
The equity shares of the company are quoted at Rs. 102 and the company is expected to
declare a dividend of Rs. 9 per share for the next year. The company has registered a
dividend growth rate of 5%, which is expected to be maintained.

i). Assuming the tax rate applicable to the company at 50%, calculate the weighted average
cost of capital, and
ii). Assuming that the company can raise additional term loan at 12% for Rs 5,00,000 to
finance its expansion, calculate the revised WACC. The company‟s expectation is that the
business risk associated with new financing may bring down the market price from Rs. 102
to Rs. 96 per share.
Solution: The present WACC may be calculated as follows:
If the company decides to raise Rs. 5,00,000 by the issue of 12% loan and the
market
price of the share is expected to go down to Rs. 96, then the WACC may be
calculated as
follows:

2. What is capital budgeting? Enumerate various methods for evaluation of capital
expenditure projects?
Capital budgetry (or investment appraisal) is the planning process used to determine whether a
firm's long term investments such as new machinery, replacement machinery, new plants, new
products, and research development projects are worth pursuing. It is budget for major capital, or
investment, expenditures
Many formal methods are used in capital budgeting, including the techniques such as
 Accounting rate of return

 Net present value
 Profitability index
 Internal rate of return
 Modified internal rate of return
 Equivalent annuity
These methods use the incremental cash flows from each potential investment, or project
Techniques based on accounting earnings and accounting rules are sometimes used - though
economists consider this to be improper - such as the accounting rate of return, and "return on
investment." Simplified and hybrid methods are used as well, such as payback period and
discounted payback period.
What is capital rationing? What are the factors leading to capital rationing?
Capital rationing has to do with the acquisition of new investments. More to the point, capital
rationing is all about the acquisition of new investments based on such factors as the recent
performance of other capital investments, the amount of disposable resources that are free to
acquire a new asset, and the anticipated performance of the asset. In short, capital rationing is a
strategy employed by companies to make investments based on the current relevant circumstances
of the company.
Generally, capital rationing is utilized as a means of putting a limit or cap on the portion of the
existing budget that may be used in acquiring a new asset. As part of this process, the investor will
also want to consider the use of a high cost of capital when thinking in terms of the outcome of the
act of acquiring a particular asset. Obviously, any responsible company will choose to employ
strategies that support the productive use of disposable funds built within a capital budget. At the
same time, it is important to understand what benefits can reasonably be expected from owing the
asset in question.
Since capital rationing is all about setting criteria that any investment opportunity must meet before
the company will seriously entertain the purchase, many businesses choose this strategy as their
guiding process for any acquisitions. Using the basic principles of the technique, a company can
develop a list of standards that must be addressed before any capital purchase. If the standards are
drafted in a manner that accurately reflects the current condition of the company, then there is a
good chance the right types of investments will be considered.
Some of the more important factors to consider as part of a productive capital rationing approach
are the financial condition of the company, the long and short term goals of the business, and proper
attention to daily operations. One of the benefits of capital rationing is that the approach helps to

ensure that funds for basic operations are not diverted in order to take advantage of a so-called
“can‟t fail” opportunity, which helps to maintain the stability of the business.
Discounted Cashflow (Dcf) Mode
Discounted cash flow is an approach to valuation that is useful in determining just how attractive a
particular investment opportunity is likely to be for a given investor. The idea behind this type of
calculation is to help an investor choose stocks, bonds, and other securities that will provide the
amount of return desired within a specified period of time. By using this model to evaluate each
investment opportunity, the investor stands a better chance of arranging the portfolio so that it
moves the investor closer to his or her personal goals.
While there are different approaches to developing a workable discounted cash flow model, the
purpose is to assess not only how much of a return can be reasonably expected from the
investment, but how long it would take to earn that amount of return. As part of the process, the
investor also allows for the weighted average cost of return as the means of discounting the cash
flow. This is compared to the circumstances of the investor, and his or her need for a minimum
amount of return within the period under consideration. If the projection of the discounted cash flow
indicates that the investor will recoup the investment and begin to see a return within a reasonable
period of time, then the investment is likely to be a good option.
This process of identifying the time value of money earned from the investment can be especially
important if the idea is to create a steady flow of income. Choosing investments that are highly likely
to produce returns that can be counted upon for receipt within a given time frame may be very
important to the investor, especially if those returns are slated for use in meeting basic living
expenses. Thus, the process of assessing the discounted cash flow associated with a given
investment becomes crucial to the creation and the maintenance of a workable budget.
Depending on the complexity and range of circumstances associated with a given investor,
determining the discounted cash flow may be a very simple process, or one that must allow for a
number of different factors. In situations where the investors is a large corporation, the process of
calculation may be somewhat more involved, while an investor who is simply looking to project the
return that can be used for income over the next six months will have fewer factors to consider. In
any event, the calculation of the discounted cash flow can help investors avoid committing to
investments that are less likely to help them achieve their goals, and identify investments that
demonstrate a high level of potential to aid them in reaching the desired results.
Nominal interest rate
In finance and economics nominal interest rate or nominal rate of interest refers to the rate of
interest before adjustment for inflation (in contrast with the real interest rate); or, for interest rates
"as stated" without adjustment for the full effect of compounding (also referred to as the nominal
annual rate). An interest rate is called nominal if the frequency of compounding (e.g. a month) is not
identical to the basic time unit (normally a year).
Real interest rate:The "real interest rate" is approximately the nominal interest rate minus the
inflation rate (see Fisher equation and below for exact equation). Since the inflation rate over
the course of a loan is not known initially, volatility in inflation represents a risk to both the
lender and the borrower.

Nominal versus real interest rate
The nominal interest rate includes both inflation and the real rate of interest. In the case of a loan,
this real interest the lender receives as income. If lender is receiving 8 percent from a loan and
inflation is 8 percent, then the real rate of interest is zero because nominal interest and inflation are
equal. A lender would not have no net benefit from such a loan because inflation fully diminishes the
value of the loan's profit.
The relationship between real and nominal interest rates can be described in the equation:
(1 + r)(1 + i) = (1 + R) where r is the real interest rate, i is the inflation rate, and R is the nominal
interest rate.[1]
A common approximation for the real interest rate is:
real interest rate = nominal interest rate - expected inflation
In this analysis, the nominal rate is the stated rate, and the real interest rate is the interest after the
expected losses due to inflation. Since the future inflation rate can only be estimated, the ex ante
and ex post (before and after the fact) real interest rates may be different; the premium paid to
actual inflation may be higher or lower. In contrast, the nominal interest rate is known in advance.
Management of Working Capital
After reading this lesson you will be able to: -

• Understand Concept, need and determinants of working capital
• Understand the concept of operating cycle
• Computation of operating cycle
I will start this lesson with a question:
Why should managers be familiar with working capital management?

When we work in any organization, we find that most of the time managers are concerned with
working capital management.
What I mean is: -

 # Ensuring that enough cash exists to pay bills;
 # Ensuring that enough inventory exists to make and sell products;
 # Ensuring that any excess cash is invested in interest-bearing securities;
 # Ensuring that accounts receivable are at a level that maximizes earnings,
 # Ensuring that short-term borrowings such as salaries payable and trade credit are used
efficiently and at the lowest cost possible.

What is Working capital management?
You see, working capital management involves the relationship between a firm's short-term
assets and its short-term liabilities. The basic goal of working capital management is to
ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy
both maturing short-term debt and upcoming operational expenses. The management of
working capital involves managing inventories, accounts receivable, accounts payable and
cash.
This Topic extends the discussion to the management of the firm‟s working capital needed. There is
a trade-off between the risk of having too little working capital on hand and the reduced profitability
that results from having excess working capital.
What is Working capital?

• You can understand working capital in two different but interlinked senses. In the first
sense,working capital refers to gross working capital and in second sense it is understood in
terms of net working capital. We can explain both in following paragraphs: -
CONCEPTS OF WORKING CAPITAL

GROSS WORKING CAPITAL: It refers to the firm‟s investment in current assets. Current assets are
the assets, which can be converted into cash within an accounting year or within an operating cycle.
You can include here cash, short-term securities, debtors (accounts receivable & book debts), bills
receivable and stock.
NET WORKING CAPITAL: But the net working capital refers to the difference between current
assets and current liabilities. Current liabilities are those claims of outsider, which are expected to
mature for payment within an 1accounting year & include creditors, bills payable & the outstanding
expenses. In other words you can say that this is the excess of current assets over current liabilities.
CURRENT ASSETS constitute the following:

1. Inventories: Inventories represent raw materials and components, work-in-progress and
finished goods.
2. Trade Debtors: Trade Debtors comprise credit sales to customers.
3. Prepaid Expenses: These are those expenses, which have been paid for goods and
services whose benefits have yet to be received.
4. Loan and Advances: They represent loans and advances given by the firm to other firms for
a short period of time.
5. Investment: These assets comprise short-term surplus funds invested in government
securities,shares and short-terms bonds.
6. Cash and Bank Balance: These assets represent cash in hand and at bank, which are used
for meeting operational requirements. One thing you can see here is that this current asset is
purely liquid but non-productive.
Current liabilities form part of working capital that represent obligations which the firm has to clear
to the outside parties in a short-period, generally within a year.
CURRENT LIABILITIES comprise the following:

1. Sundry Creditors: These liabilities stem out of purchase of raw materials on credit terms
usually for a period of one to two months.
2. Bank Overdrafts: These include withdrawals in excess of credit balance standing in the
firm‟s
current accounts with banks
3. Short-term Loans: Short-terms borrowings by the firm from banks and others form part of
current liabilities as short-term loans.
4. Provisions: These include provisions for taxation, proposed dividends and contingencies.
Working capital

Current assets Current liabilities
Cash Accounts payable
Accounts receivable Notes payable
Notes receivable Accrued expenses
Marketable securities Taxes payable
Inventory
Prepaid expenses
Total current assets Total current liabilities
A low liquidity measure would indicate either that the company is having financial problems, or that the
company is poorly managed; hence, a fairly high liquidity ratio is good. However, it shouldn’t be too high,
because excess funds incur an opportunity cost and can probably be invested for a higher return. The 2 main
measures of liquidity are net working capital and the current ratio.
Net Working Capital
Working capital is used to run the business and to pay its current liabilities. The sources of working capital
include:
 internal sources
o retained earnings
o a shorter earnings cycle, which is the time from investing the cash to receiving cash for the finished
product or service
o cash flow from depreciation or deferred taxes
 external sources
o loans
o trade credit
o debt and equity financing used for working capital
Net working capital is what remains after subtracting current liabilities from current assets; hence, it is
money to run the business.
Net Working Capital = Current Assets – Current Liabilities
Gross working capital concept focuses on two aspects:

1. How to optimize investment in current assets?
2. How should current assets be financed?
The planning should be done keeping in mind two danger points i.e. excessive and inadequate
investment in current assets. Investment in current assets needs to be adequate as it affects the
profitability, solvency and liquidity. Why this issue comes up because it ultimately affects the
objectives of financial management.
Danger points to be kept in mind while planning

1. Excessive investment (Profitability)
a) It results in unnecessary accumulation of inventories. Thus, chances of inventory is
handling,waste, theft & losses increase.
b) It is an indication of defective credit policy & slack collection period.
c) Excessive WC makes management complacent, which degenerates into managerial
inefficiency.
d) Tendencies of accumulating inventories tend to make speculative profits grow.
2. Inadequate investment (Liquidity)

a) It stagnates growth.
b) It becomes difficult to implement operating plans and achieve the firm‟s operating profit
target.
c) Operating inefficiencies creep in when it becomes difficult even to meet day-to-day
commitments.
d) Fixed assets are not efficiently utilized for the lack of working capital funds. Thus, the firm‟s
e) profitability would deteriorate.
f) Paucity of WC funds render the firm unable to avail attractive credit opportunities.
g) The firm loses its reputation when it is not in a position to honour its short-term obligations.
Kinds of Working Capital

1.Permanent working capital:
1. This component represents the value of the current assets required on a continuing basis over
the entire year, and for several years. Permanent working capital is the minimum amount of current
assets, which is needed to conduct a business even during the dullest season of the year. The
minimum level of current assets is called permanent or fixed working capital as this part is
permanently blocked in current assets.
2.This amount varies from year to year, depending upon the growth of the company and the stage of
the business cycle in which it operates. It is the amount of funds required to produce the goods and
services, which are necessary to satisfy demand at a particular point of time. It represents the
current assets, which are required on a continuing basis over the entire year. It is maintained as the
medium as to continue the operations at any time.
Characteristics of Permanent working capital

• •It is classified on the basis of the time period
• •It constantly changes from one asset to another and continues to remain in the business
process.
• •Its size increase with the growth of business operations.
2. Temporary working capital:

 Contrary to the above you will find that temporary working capital represents a certain amount of
fluctuations in the total current assets during a short period.
 These fluctuations are increased or decreased and are generally cyclical in nature. Additional
current assets are required at different times during the operating year.
 Variable working capital is the amount of additional current asset that are required to meet the
seasonal needs of a firm, so is also called as the seasonal working capital.
 For example: additional inventory will be required for meeting the demand during the period of
high sales When the peak period is over variable working capital starts decreasing or very little
during the normal period. It is temporarily invested in current assets. Say for an example a
shopkeeper invests more money during winter season because he/ she requires to keep more
amount of stock of woolen cloths. The same happens in a sugar factory how: the factory
manager buys more quantity of sugarcane during the harvesting season and they continuously
stops for some time.
Characteristics of Temporary working capital
 It is not always gainfully employed, though it may change from one asset to another asset, as
permanent working capital does.
 It is particularly suited to business of a seasonal or cyclical nature.
Determinants of Working Capital

We can explain the determinants of working capital as follows:
1. Nature of business:
The working capital requirements of an enterprise are basically related to the conduct of the
business.Public utility undertakings like Electricity, Water supply, Railways, etc. need very
limited working capital because they offer cash sales only and supply services, not products
and as such no funds are ties up in inventories and receivables. But at the same time have
to invest fewer amounts in fixed assets. The manufacturing concerns on the other hand
require sizable working capital along with fixed investments, as they have to build up the
inventories.
2. Terms of sales and purchases:

Credit sales granted by the concerns too its customers as well as credit terms granted by the
suppliers also affect the working capital. If the credit terms of the purchases are more
favorable and at the same time those of sales less liberal, less cash will be invested in the
inventory. With more favorable credit terms, working capital requirements can be reduced.
3. Manufacturing cycle:
The length of manufacturing cycle influences the quantum of working capital needed.
Manufacturing process always involves a time lag between the time when raw materials are
fed into the production line and finished goods are finally turned out by it. The length of the
period of manufacture in turn depends on the nature of product as well as production
technology used by a concern. Shorter the manufacturing cycle; lesser the working capital
required.
4.
5. Rapidity of turnover:

If the inventory turnover is high, the working capital requirements will be low. With a better
inventory control, a firm is able to reduce its working capital requirements. When a firm has to
carry on a large slow moving stock, it needs a larger working capital as against another
whose turnover is rapid. A firm should determine the minimum level of stock, which it will
have to maintain throughout the period of its operation.
6. Business cycle:
Cyclical changes in the economy also influence quantum of working capital. In a period of
boom i.e., when the business ism prosperous, there is s need of larger amount of working
capital due to increases in sales, rise in price etc and vice-a-versa during period of
depression.
7. Changes in technology:
Changes in technology may lead to improvements in processing of raw materials, savings in
wastage,greater productivity, and more speedy production. All these improvements may
enable the firm to reduce investments in inventory.
8. Seasonal variation: The inventory of raw materials, spares and stores depends on the
condition of supply. If the supply is prompt and adequate the firm can manage with small
inventory. However, if the supply were unpredictable and scant then the firm, to ensure the
continuity of production, would have to acquire stocks as and when they are available and
carry larger inventory on an average.
9. Market conditions:
The degree of competition prevailing in the market place has an important bearing on working
capital needs. When competition is keen, a larger inventory of finished goods is required to
promptly serve customers who may not be inclined to wait because other manufacturers are
ready to meet their needs.
10. Seasonality of operation:

Firms, which have marked seasonality in their operations usually, have highly fluctuating
working requirements. Let us take an example to illustrate this point. Consider firm
manufacturing fans. The sale of fans reaches a peak during the summer months and drops
sharply during the winter period. The working capital need of such a firm is likely to increase
considerably in summer months and decrease significantly during winter season.
11. Dividend policy:
It has a dominant influence on the working capital position of a firm. If the firm is following a
conservative dividend policy, the need for working capital can be met with retained earnings.
12. Working capital cycle:
Larger the working capital cycle, more is the requirement of working capital.
CASH MANAGEMENT
Involves :
 Cash flows into and out of the firm
 Cash flows within the firm
 Cash balances held by the firm by borrowing for financing deficit or by investing
surplus
Managing Cash Flows in Services (Banking/Telecom) Sector :
Accelerating Cash Collections
• By reducing mailing, processing and collection times

• By developing decentralised collection centres and concentration banking
• By introducing drop-box system
• Pre-paid cards
• On-line payment (a) thru credit card or (b) by direct debit of a/c
• Bill discounting
Controlling Disbursements
• Availing maximum credit period in procurement

• Payment through credit card
• Investing payment float
CASH MANAGEMENT – in the power sector
Raising of bills :
- instantaneous preparation & delivery of bill
- delivery of bill through Email or text messages on mobiles
- online viewing of bills
- introducing pre-paid card system with rate advantages
- allowing certain graded discount scheme for payment within specified time, say 10
days, 15 days etc. (early bird scheme)
Collection of payments :
 numerous and wide-spread cash collection centres
 several drop boxes for cheques
 online payment schemes through the internet
 penalty for late payment
Cash Disbursements :
o ensuring timely payments of statutory charges e.g. loan
o interest, income tax, excise duty,sales tax.
o timely payment of employee salary
o timely payments to suppliers and contractors
Investments / Borrowings:

- ensuring and maintaining consortium of banks & financial institutions for investing surplus
cash and for borrowing short-term cash.
INVENTORY MANAGEMENT
Inventory :
- Raw Materials
- Work-in-process or semi-finished goods
- Finished goods
Effective inventory management :
 Ensures continuous supply of raw materials for uninterrupted production
 Maintains sufficient stocks of raw materials in times of scarcity & rising prices in the market
 Maintains sufficient stocks of finished goods for meeting sales needs of customers
 Minimises inventory cost and time.
 Controls investment in inventory & maintains it at optimum levels
Inventory Control Techniques :
 Economic Order Quantity (EOQ) - the quantity which minimises the total cost i.e.
ordering cost + carrying cost
EOQ = 2AO where A is the annual demand

C O is the cost per order, and
C is the carrying cost/unit
EOQ applied to regular use items like raw materials, consumables, stock items based
on their consumption pattern.
 Reorder Level : the inventory level at which an order should be placed to replenish
stock.
 Safety stock : safety level always maintained for critical items.
Reordering done before safety stock level is reached.
RECEIVABLES MANAGEMENT
Investment in accounts receivables is governed by :

 Credit Sales : qty. depends on firm‟s market share product quality, competition, economic
condition, nature of business, industry norms, etc.
 Collection period : depends on credit policy & efficiency of collection machinery
Credit policy is determined by :
• Credit standards : client analysis
• Credit terms : duration, payment term

• Collection effort ability
Firms use credit policy :
 As a marketing tool to expand sales
 To create new customers
 To maintain market share in recession
Some salient features
 All sales are on credit
 Customers are very large in no., very widely dispersed and belonging to different groups like
agricultural farmers, industrial consumers and general public
 State govt.‟s interference
 Rampant theft of electricity
 Poor maintenance of transformers, substation equipment, transmission lines
 No meters, defective meters
Remedial Measures
 Reforms leading to restructuring of SEBs, setting up of Regulators – CERC & SERC for tariff
fixation
APDRP for creating consumer awareness regarding commercial orientation in the power sector
Ex. Working Capital for New Project
Estimated cost per unit of production Rs.
Raw materials 80
Direct labour 30
Factory overheads 60
Total 170
Selling price - Rs.200 / unit
Level of activity - 1,04,000 units of production p.a. [carried out evenly throughout
the year (52 weeks); wages & O/H accrue similarly]
Raw materials in stock - average 4 weeks
Work in process - average 2 weeks (assume 50% completion i.r.o. conversion

costs & 100% i.r.o. materials)
Finished goods in stock - average 4 weeks

Credit allowed by suppliers - average 4 weeks
Credit allowed to debtors - average 8 weeks (all sales on credit)
Lag in payment of wages - average 1.5 weeks
Cash expected to be at bank - average Rs.25,000/-
Add 10% to computed figure to allow for contingencies
Ex. From the following data prepare the annual working capital requirements of Anonymous Ltd. :
Production during previous year :- 60,000 units. It is planned to maintain this level of activity during
the current year also.
Expected ratios of various costs/expenses to selling price :- raw materials - 60%, direct wages –
10% & direct overheads – 20%.
Raw materials are expected to remain in stores for an average of 2 months before issue to
production. Each unit is expected to be in process for 1 month. Feeding of raw material into the
production line and the labour & overhead costs are expected to accrue evenly during the month.
Finished goods will stay in the warehouse awaiting despatch to customers for approximately 3
months. Credit allowed by suppliers is 2 months from the date of delivery of raw materials. Credit
allowed to customers is 3 months from the date of despatch.
Selling price is Rs.5/unit. There is a regular production & sales cycle.
Wages and overheads are paid on the 1st of every month for the previous month. The company
normally keeps cash in hand to the extent of Rs.20,000/-.
External Sources of Finance

• Long Term – may be paid back after many years or not at all!
• Short Term – used to cover fluctuations in cash flow

• ‘Inorganic Growth’ – growth generated by acquisition
Long Term
EXTERNALSOURCE
• Shares (Shareholders are part owners of a company)
a. Ordinary Shares (Equities):

i. Ordinary shareholders have voting rights
ii. Dividend can vary
iii. Last to be paid back in event of collapse
iv. Share price varies with trade on stock exchange
b. Preference Shares:
i. Paid before ordinary shareholders
ii. Fixed rate of return
iii. Cumulative preference shareholders – have right to dividend carried over to next year in
event of non-payment
c. New Share Issues – arranged by merchant or investment banks
d. Rights Issue – existing shareholders given right to buy new shares at discounted rate
e. Bonus or Scrip Issue – change to the share structure – increases number of shares and reduces
value but market capitalisation stays the same
• Loans (Represent creditors to the company – not owners)

– Debentures – fixed rate of return, first to be paid
– Bank loans and mortgages – suitable for small to medium sized firms where property or some
other asset acts as security for the loan
– Merchant or Investment Banks – act on behalf of clients to organise and underwrite raising
finance
– Government/EU – may offer loans in certain circumstances
• Grants
Internal sources
1. Use retained profit

2. Use the provision kept under the heads of deprication.
Sources of long term finance
The main sources of long term finance are as follows:
1. Shares:These are issued to the general public. These may be of two types:
(i) Equity and (ii) Preference. The holders of shares are the ownersof the business.
2. Debentures:These are also issued to the general public. The holders ofdebentures are the creditors of the
company.
3. Public Deposits :General public also like to deposit their savings with a popularand well established
company which can pay interest periodicallyand pay-back the deposit when due.

4. Retained earnings:The company may not distribute the whole of its profits among itsshareholders. It may
retain a part of the profits and utilize it ascapital.
5. Term loans from banks:Many industrial development banks, cooperative banks and commercial banks
grant medium term loans for a period of threeto five years.
6. Loan from financial institutions:There are many specialised financial institutions established by the
Central and State governments which give long term loans at reasonable rate of interest. Some of these
institutions are: Industrial Finance Corporation of India ( IFCI), IndustrialDevelopment Bank of India (IDBI),
Industrial Credit and InvestmentCorporation of India (ICICI), Unit Trust of India ( UTI ), StateFinance
Corporations etc. These sources of long term finance willbe discussed in the next lesson.
Short Term Sources of Finance

Short Term Financing ( External source)
The repayment term of short term financing is usually shorter than one year.
Creditworthiness is an important aspect which the entrepreneur or the venture must
satisfy before any short term financing will be granted. The following aspects are
considered when assessing creditworthiness.
Different Aspects of Short Term Finance
1) Trade creditors
This the basic source of finance and many entrepreneurs do not realise that by
acquiring items on credit they are obtaining short term finance. Credit just like any
other source of finance has interest element hidden which most are not able to
recognise. The discount may be offered to encourage early payment and the receiving
company may not advantage of the discount the cost arise.
Assume that a discount of 5% is offered for payment within 30 days. The cost of capital
for credit taken over these 30 days is:
2) Factoring
Factoring involves raising funds on the security of the company’s debts, so that cash is
received earlier than if the company waited for the debtors to pay. Most factoring
companies offer these three services:
 Sales ledger accounting, despatching invoices and making sure bills are paid.
 Credit management, including guarantees against bad debts.
 The provision of finance, advancing clients up to 80% of the value of the debts
that they are collecting.
3) Invoice Discounting
This is purely a financial arrangement which benefits the liquidity position of the
enterprise. Invoice discounting is the transferring of invoice to a finance house in
exchange with immediate cash. The company makes an offer to the finance house by
sending it the respective invoices and agreeing to guarantee payment of any debts that

are purchased. If the finance house accepts the offer, it makes immediate cash
payment of about 75%, which means that at a specified future date, say 90 days, the
loan must be repaid. The company is responsible for collecting the debt and for
returning the amount advanced, whenever the debt is collected.
4) Bank Overdraft
One of the most common used sources of short term of finance because of its cost and
flexibility. When borrowed funds are no longer required they can quickly and easily be
paid. It is also comparatively cheap because the risks to the lender are less than on the
long-term loans, and all the loan interests are allowable tax expenses. The bank issue
overdrafts with the right to call them in at short notice. Bank advances are, in fact
payable on demand. Normally the bank assures the borrower that he can rely on the
overdraft not being recalled for a certain period of time.
The borrower is required to use the overdraft to supplement the working capital
shortfall. As the bank overdraft is payable on demand it is not wise to use the money in
purchasing non current assets like machine. Financing of such assets should be made
using long-term finance such as finance lease and loans. Any plans that involve an
overdraft or short term loan should therefore refer closely to the company’s cash flow
analysis so that it is quite clear how long the funds will be needed and when they can
be repaid.
Another purpose for which bank overdraft might typically be used to iron out seasonal
fluctuations in trade. The banks assist in providing temporary funds to finance
production on the assumption that the goods or products will be sold in a later season.
Agriculture is the obvious example of an industry where this type of borrowing is
needed.
5) Counter Trade
Counter trade is a method of financing trade, but goods rather than money are used to
fund the transaction. It is a form of barter. Goods are exchanged for the other goods.
This form of business for private enterprises is diminishing in local trading but for
international trade is still a popular way of funding the business activities.
Internal sources
1. Conservative dividend policy
2. Spread throughout yearly.
Advantages and Disadvantages of Bill discounting
You have already read that commercial banks provide short-term loans by discounting bills of
exchange or promissory notes. In such cases the banks deduct discount while making payment.
The amount of discount is generally equal to the amount of interest for the remaining period of

payment against the bill. This is known as discounting of bill. The advantages and disadvantages of
obtaining finance from this source are
listed below.
Advantages of Bill discounting
a) Immediate availability of cash: By discounting the bill, the drawer gets cash immediately. He does
not have to wait for the payment until the expiry of credit period stated on the bill.
b) No extra security is to be offered: Banks generally do not ask for any other security while making
payment against the bill discounted. However, if a customer is interested, banks also grant him limit
for discounting of bills. This limit is known as „limit against discounted bills‟. Usually banks ask for
certain security while extending this limit. Such limit is obtained when drawing of bills of exchange is
almost a regular feature in business.
c) Nature of liability for repayment: Repayment of money advanced against discounted bill is the
responsibility of the drawee of bills of exchange. Banks therefore approach the drawee, who is
generally the acceptor of the bill, for payment after the due date on the bill.
In case the drawee does not pay or refuses to pay, the drawer or the person who got payment after
discounting the bill is held responsible for payment
Disadvantages of Bill discounting
(a) Payment of interest in advance: While discounting a bill, bank deducts the discount and balance
is credited in customer‟s account. This discount is equal to the amount of interest for the remaining
period of payment against the bill. Thus, a person receiving money through discounting of bill has to
offer advance interest on the amount of the bill.
(b) Facility is subjected to the creditworthiness of parties involved : Banks generally extend this
facility after being satisfied with the creditworthiness of different parties involved. In case of doubt,
the bank may ask for some security. Thus, it is not a very easily available facility.
(c) Additional burden in case of non-payment : Bills not paid upon maturity are to be certified by
Notary Public and a certain amount in the form of noting charges is paid. Thus, it becomes an
additional burden.
Debentures
Whenever a company wants to borrow a large amount of fund for a long but fixed period, it can
borrow from the general public by issuing loancertificates called Debentures. The total amount to be
borrowed is dividedinto units of fixed amount say of Rs.100 each. These units are called
Debentures.
These are offered to the public to subscribe in the same manner as is done in the case of shares. A
debenture is issued under the common seal of the company. It is a written acknowledgement of
money borrowed. It specifies the terms and conditions, such as rate of interest, time repayment,
security offered,etc.
Characteristics of Debenture
Following are the characteristics of Debentures:
i) Debentureholders are the creditors of the company. They are entitled to periodic payment of
interest at a fixed rate.
ii) Debentures are repayable after a fixed period of time, say five years or seven years as per
agreed terms.
iii) Debentureholders do not carry voting rights.
iv) Ordinarily, debentures are secured. In case the company fails to pay interest on debentures or
repay the principal amount, the debentureholders can recover it from the sale of the assets of the
company.
Types of Debentures :
Debentures may be classified as:
a) Redeemable Debentures and Irredeemable Debentures
b) Convertible Debentures and Non-convertible Debentures.
Redeemable Debentures :
These are debentures repayable on a pre-determined date or at any time prior to their maturity,
provided the company so desires and gives a notice to that effect.
Irredeemable Debentures :
These are also called perpetual debentures. A company is not bound to repay the amount during its
life time. If the issuing company fails to pay the interest, it has to redeem such debentures.
Convertible Debentures :
The holders of these debentures are given the option to convert their debentures into equity shares
at a time and in a ratio as decided by the company.

3rd Term-Finance Management

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3rd Term-Finance Management

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UNIT ONE

CORE CONCEPTS OF FINANCIALMANAGEMENT

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 1

Financial managers play an increasingly important role in mergers and consolidations,

The role of the financial manager, particularly in business, is changing in response to

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 2

Why study finance?

If I have no intention of becoming a financial manger, why do I need to understand

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 3

I. Securities Markets include Money Markets and Capital Markets.

Capital markets include:

Investment Bankers:::An investment banker specializes in marketing new securities in the

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 4

II. Understanding Value

III. Time and Uncertainty

IV. Understanding People

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 5

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 6

Nature of Financial Management

Interface between finance and other functions

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 7

Top Management-Finance Interface

Economics - Finance Interface

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 8

Accounting - Finance Interface

 TREASURY OPERATIONS: Short-term fund management must be more sophisticated.

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 9

What is the time value of money?

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 10

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 11

Present value = PV = FV / (1 + i)n

=FV (Discount factor for i & n) = FV (PVIF i, n )

Where PVIFi,n is the present value interest factor, or discount factor.

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 12

In what period of time money will be doubled?

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 13

2. 10 years: FV = Rs10 (1+0.05) 10 = Rs10 (1.6289) = Rs16.29

100 years: FV = Rs10 (1 + 0.05) 100 = Rs10 (131.50) = Rs 1,315.01

3. FV = Rs 10,000 (1+0.04) 10 = Rs10, 000 (1.4802) = Rs14, 802.44

Interest @ 10% P.A for first six months 10,000*0.1/2 = 500

The generalized formula for these shorter compounding periods is

r = Effective rate of interest

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 15

After reading this lesson you will be able to: -

(i) The cash flows emanating from the projects, and

CONCEPT OF COST OF CAPITAL

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 16

IMPORTANCE AND SIGNIFICANCE OF COST OF CAPITAL

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 17

What impacts the cost of capital?

The Cost of Capital becomes a guideline for measuring the profitability of

Remember that: The goal of the corporation is to maximize the value of

Therefore cost needs to come down.

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 18

1.Explicit cost & implicit cost

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 19

Component of Cost of capital

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 20

To apply the formulation of cost of debt what kind of information do we need?

S.R.P** NICMAR 3RD TERM- FINANCIAL MANAGEMENT Page 21

The cost of perpetual debt is calculated with the following formula:

Annual interest charge:

(b) Cost of Redeemable Debt

Where I = Annual Interest Payment