FINANCIAL MANAGEMENT UNIT-I FOUNDATIONS OF FINANCE Lesson 1 Financial Management : An Overview INTRODUCTION Financial Management is an appendage of the Finance

function. With the creation of a complex industrial structure, finance function has grown so much that it has which given birth to a separate subject financial management, is today recognized as the most important branch of business administration. One cannot think of any business activity in isolation from its financial implications. The management may accept or reject a business proposition on the basis of its financial viabilities. In other words, financial considerations reign supreme, particularly for line executives who are directly involved in the decision-making process. In this connection, it is observed that "Financial Management involves the application of general management principles to a particular financial operation". LEARNING OBJECTIVES On this lesson, you will be conversant with The meaning of finance and financial management The objectives of financial management Advantages and criticisms on the objective of financial management Scope and functions of the finance manager Finance and other related subjects The functional areas of financial management The process of financial management The process of financial decisions


SECTION TITLE Meaning Financial management is that part of management which is concerned mainly with raising funds in the most economic and suitable manner; using these funds as profitably (for a given risk level) as possible; planning future operations; and controlling current performances and future developments through financial accounting, cost accounting, budgeting, statistics and other means. It guides investment where opportunity is the greatest, producing relatively uniform yardsticks for judging most of the firm’s operations and projects, and is continually concerned with achieving an adequate rate of return on investment, as this is necessary for survival and attracting new capital. Financial management provides the best guide-ship for present and future resource allocation of a firm. It provides relatively uniform yardsticks for judging most of the operations and projects. Financial management implies the designing and implementation of a certain plan. Financial plans aim at an effective utilization of funds. The term ‘Financial management’ connotes that the fund flow is directed according to some plan. Financial management connotes responsibility for obtaining and effectively utilizing funds necessary for the efficient operation of an enterprise. The finance function centres round the management of funds raising and using them effectively. But the dimensions of financial management are much broader than mere procurement of funds. Planning is one of the most important activities of the financial manager. It makes it possible for the financial manager to obtain funds at the best time in relation to their cost and the conditions under which they can be obtained and their effective use by the business firm. Financial management is dynamic, in the making of day- to-day financial decisions in a business of any size. The old concept of finance as treasurer-ship has broadened to include the new, meaningful concept of controllership. While the treasurer keeps track of the money, the controller’s duties extend to planning analysis and the improvement of every phase of the company’s operations, which are measured with a financial yardstick. Financial management is important because it has an impact on all the activities of a firm. Its primary responsibility is to discharge the finance function successfully. It touches all the other


business functions. All business decisions have financial implications, and a single decision may financially affect different departments of an organization. Financial management, however, should not be taken to be a profit-extracting device. No doubt finances have to be so planned as to contribute the profit-making activities. Financial management implies a more comprehensive concept than the simple objective of profit making or efficiency. Its broader mission is to maximize the value of the firm so that the interests of different sections of the community remain protected. It should be noted, therefore, that financial management does not mean management of a business organization with a view to maximizing profits. Financial management applies to every organization, irrespective of its size, nature of ownership and control - whether it is a manufacturing or service organization. It applies to any activity of an organization which has financial implications. To say that it applies to private profit-making organizations alone is to narrow the scope of the subject. Moreover, financial management does not handle merely routine day-to-day matters. It has to handle more complex problems such as mergers, reorganizations and the like. It plays two distinct roles. Firstly, it safeguards interests of the corporation, which is a separate legal entity. Secondly, this separate legal entity has no meaning unless the interests of owners and other sections of the community, which are directly concerned with the corporation, are properly protected. Financial management is thus an integrated and composite subject. It welds together much of the material that is found in Accounting, Economics, Mathematics, Systems analysis and Behavioral sciences, and uses other disciplines as its tool. For a long time, finance has been considered as a rather sterile function concerned with a certain necessary recording of activities alone. financial management makes a significant contribution to the management revolution that is taking place. Financial management’s central role is concerned with the same objectives as those of th e management; with the way in which the resources of the business are employed and how the business is financed. Financial management has been divided into three main areas - decisions on the capital structure; allocation of available funds to specific uses and analysis and appraisal of


problems. Financial management includes planning or finance, cash budgets and source of finance. Definitions "Financial management is the operational activity of a business that is responsible for obtaining and effectively utilizing the funds necessary for efficient operations". - Joseph and Massie. "Financial management is an area of financial decision-making, harmonizing individual motives and enterprise goals". -Weston and Brigham. "Financial management is the area of business management devoted to a judicious used of capital and a careful selection of sources of capital in order to enable a business firm to move in the direction of reaching its goals".-J.F.Bradlery. ‘Financial management is the application of the planning and control Functions to the finance function". - Archer and Ambrosia. "Financial management may be defined as that area or set of administrative functions in an organization which relate with arrangement of cash and credit so that the organization may have the means to carry out its objective as satisfactorily as possible." - Howard and ? Objective of Financial Management Financial management evaluates how funds are procured and used. In all cases, it involves a sound judgement, combined with a logical approach to decision-making. The core of a financial policy is to maximize earnings in the long run and to optimize them in the short-run. This calls for an evaluation of the conditions of alternative uses of funds and allocation of resources after consideration of production and marketing inter-relationships. Financial management is concerned with the efficient use of an improved resource, mainly capital funds. Profit maximization should serve as the basic criterion for decisions arrived at by financial managers of privately owned and controlled firms. Different alternatives are available to a


business enterprise in the process of decisions- making. Each alternative has its own implications. Different courses of actions have to be evaluated on the basis of some analytical framework and for this purpose, commercial strategies of an enterprise have to be taken into consideration. The availability of funds depend upon the kind of commercial strategies adopted by a firm during a particular period of time. Various different theories of financial management provides an analytical framework for an evaluation of courses of action. Maximization of profits is often considered to be a goal or an alternative goal of a firm. However, this is somewhat narrow in concept than the goal of maximizing the value of the firm because of the following reasons: (a) The maximization of profits, as reflected in the earnings per share, is not an adequate goal in the first place because it does not take into consideration time value of money. (b) The concept of maximization of earnings per share does not include the risk of streams of alternative earnings. A project may have an earning steam that will attain the goal of maximum earnings per share; but when compared with the risk involved in it, it may be totally unacceptable to a stockholder, who is generally hostile to risk-bearing activities. (c) This concept of maximization of earnings per share does not take into account the impact of dividend policy upon market price or value of the firm. Theoretically, a firm would never pay a dividend if the objective is to maximize earnings per share. Rather, it would reinvest all its earnings so as to generate greater earnings in the future. Financial management techniques, are applicable to decisions of individuals, nonprofit organizations and of business firms. Also, it is applicable to different situations in different organizations. Financial managers are interested in providing answers to the following questions: 1. Given a firm’s market position, the market demand for its products, its productive capacity and investment opportunities, what specific assets should it purchase? This Indirectly emphasizes the approach to capital budgeting.


2. Given a firm’s market position and investment opportunities, what is the total volume of funds that it should commit? This indirectly emphasizes the composition of a firm’s assets. 3. Given a firm’s market position and investment opportunities, how should it acquire the funds which are necessary for the implementation of its investment decisions? This underscores the approach to capital financing. PROFIT MAXIMIZATION Vs WEALTH MAXIMIZATION Although in general profit maximization is the prime goal of financial management, there are arguments against the same. The following table presents points in favour as well as against profit maximization.


Wealth Maximization: The goals of financial management may be such that they should be beneficial to owners, management, employees and customers. These goals may be achieved only by maximizing the value of the firm. The elements involved in the maximization of the wealth of a firm is as below:

Increase in Profits: A firm should increase its revenues in order to maximize its value. For this purpose, the volume of sales or any other activities should be stepped up. It is a normal practice for a firm to formulate and implement all possible plans of expansion and take every opportunity to maximize its profits. In theory, profits are maximized when a firm is in equilibrium. At this stage, the average cost is minimum and the marginal cost and marginal revenue are equal. A word of caution, however, should be sounded here. An increase in sales will not necessarily result in a rise in profits unless there is a market for increased supply of goods and unless overhead costs are properly controlled. Reduction in Cost: Capital and equity funds are factor inputs in production. A firm has to make every effort to reduce cost of capital and launch economy drive in all its operations. Sources of Funds: A firm has to make a judicious choice of funds so that they maximize its value. The sources of funds are not risk-free. A firm will have to assess risks involved in each source of funds. While issuing equity stock, it will have to increase ownership funds into the corporation. While issuing debentures and preferred stock, it will have to accept fixed and recurring obligauons. The advantages of leverage, too, will have to be weighed properly. Minimum Risks: Different types of risks confront a firm. "No risk, no gain" - is a common adage. However, in the world of business uncertainties, a corporate manager will have to calculate business risks, financial risks or any other risk that may work to the disadvantage of the firm before embarking on any particular course of action. While keeping the goal of maximization of the value of the firm, the management will have to consider the interest of pure or equity stockholders as the central focus of financial policies.


Long-run Value: The goal of financial management should be to maximize long run value of the firm. It may be worthwhile for a firm to maximize profits by pricing its products high, or by pushing an inferior quality into the market, or by ignoring interests of employees, or, to be precise, by resorting to cheap and "get-rich- quick" methods. Such tactics, however, are bound to affect the prospects of a firm rather adversely over a period of time. For permanent progress and sound reputation, it will have to adopt an approach which is consistent with the goals of financial management in the long-run. Advantages of Wealth Maximization v Wealth maximization is a clear term. Here, the present value of cash flow is taken into consideration. The net effect of investment and benefits can be measured clearly. (Quantitatively) v It considers the concept of time value of money. The present values of cash inflows and outflows helps the management to achieve the overall objectives of a company. v The concept of wealth maximization is universally accepted, because, it takes care of interests of financial institution, owners, employees and society at large. v Wealth maximization guide the management in framing consistent strong dividend policy, to earn maximum returns to the equity holders. v The concept of wealth maximization considers the impact of risk factor, while calculating the Net Present Value at a particular discount rate, adjustment is made to cover the risk that is associated with the investments. Criticisms of Wealth Maximization The concept of wealth maximization is being criticized on the following grounds: The objective of wealth maximization is not descriptive. The concept of increasing the wealth of the stockholders differs from one business entity to another. It also leads to confusion in, and


misinterpretation of financial policy because different yardsticks may be used by different interests in a company. As corporations have grown bigger and more powerful, their influence has become more pervasive; they have created an imbalance which is widely believed to have been instrumental in generating a movement to promote more socially conscious business behaviour. Academicians and corporate officers alike have urged the advisability of more socially conscious business management. Financial management will then have to rise equal to the acceptance of social responsibility of business. Financial management should not only maintain the financial health of a business,but should also help to produce a rate of earning which will reward the owners adequately for the use of the capital they have provided. To the creditors, the management must ensure administration, which will keep the business liquid and solvent. Moreover, financial management will have to ensure that expectations raised by the corporation are fulfilled with a proper use of several tools at is disposal. In other words, it should ensure an effective management of finance so that it may bear the desired fruits for the organization. If it is properly supported and nurtured by efficient activities at all stages, it will positively ensure desired results. Financial management should take into account the enterprise’s legal obligations to its employees. It should try to have a healthy concern which can maintain regular employment under favourable working conditions. However, a good financial management alone cannot guarantee that a business will succeed. But it is a necessary condition for business success, though not the only one. It may, however, be described as a pre-requisite of a successful business. In other words, there are various other factors which may support or frustrate financial management by supportive or non- supportive policies. Wealth maximization is as important objective as profit maximization. The operating objective for Financial Management is to maximize wealth or the net present worth of a firm. Wealth maximization is an objective which has to be achieved by those who supply loan capital, employees, society and management. The objective finds its place in these segments of the


corporate sector, although the immediate objectives of Financial Management may be to maintain liquidity and improve profitability. The wealth of owners of a firm is maximized by raising the price of the common stock. This is achieved when the management of a firm operates efficiently and makes optimal decisions in areas of capital investments, financing, dividends and current assets management. If this is done, the aggregate value of the common stock will be maximized. DIMENSIONS OF FINANCIAL MANAGEMENT The different dimensions of financial management are dealt below: Anticipating Financial Needs: The financial manager has to forecast expected events in business and note their financial implications. Financial Manager anticipates financial needs by consulting an array of documents such as the cash budget, the pro-forma income statement, the pro-forma balance sheet, the statement of the sources and uses of funds, etc. Financial needs can be anticipated by forecasting expected funds in a business and their financial implications. Acquiring Financial Resources: This implies knowing when, where and how to obtain the funds which a business needs. Funds should be acquired well before the need for them is actually felt. The financial manager should know how to tap the different sources of funds. He may require short-term and long-term funds. The terms and conditions of the different financial sources may vary significantly at a given point of time. Much will also depend upon the size and strength of the borrowing firm. The financial image of a corporation has to be improved in appropriate financial circles which are primarily responsible for supplying finance. Allocating Funds in Business: Allocating funds in a business means investing them in the best plans of assets. Assets are balanced by weighing their profitability against their liquidity. Profitability refers to the earning of profits and liquidity means closeness to money. The financial manager should steer a prudent course between over-financing and under-financing. He should preserve a proper balance among the various assets. He may adopt the famous marginal


principle which states that the last rupee invested in each kind of an asset should have the same usefulness as the last rupee invested in any other kind of an asset. He should, moreover, allocate funds according to their profitability, liquidity and leverage. So, while the primary financial responsibility from the owner’s viewpoint may be to maximize value, the financial executive’s primary managerial responsibility is to preserve the continuity of the flow of funds so that no essential decision of the top management is frustrated for lack of corporate purchasing power. Administering the Allocation of Funds: Once the funds are allocated to various investment opportunities it is the basic responsibility of the finance manager to watch the performance of each rupee that has been invested. He has to adopt close supervision and marking of flow of funds. This will ensure continuous flow of funds as per the requirements of the organisation. This helps the management to increase efficiency by reducing the cost of operations & earn fair amount of profits out of investments. Analysing the performance of finance: Once the funds are administered, it is very comfortable for the finance manager to take decisions. Through the budgeting, he will be able to compare the actuals with standards. The returns on the investments must be continuous and consistent. The cost of each financial decision and returns of each investment must be analysed. Where ever the deviations are found, necessary steps or strategies are to be adopted to overcome such events. This helps in achieving ‘Liquidity’ of a business unit. Accounting and Reporting to Management: Now, the role of the finance manager is changing. The department of finance has gained substantial recognition. He not only acts as line executive but also as staff. He has to advise and supply information about the performance of finance to top management. He is also responsible for maintaining upto date records of the peformance of financial decisions. If need arises, he has to offer his suggestion to improve the overall functioning of the organisation. The financial manager will have to keep the assets intact, which enable a firm to conduct its business. Asset management has assumed an important role in Financial Management. It is also necessary for the finance manager to ensure that sufficient funds are available for smooth conduct of the business. In this connection, it may be pointed out that management of funds has both liquidity and profitability aspects. Financial Management is concered with the many responsibilities which are the main thrust of a business enterprise.


Scope and Functions of Financial Management A priori definition of the scope of financial management fall into three groups. One view is that finance is concerned with cash. At the other extreme is the relatively narrow definition that financial management is concerned with raising and administering of funds to an enterprise. The third approach is that it is an integral part of overall management rather than a staff specialty concerned with fundraising operations. In this connection. Financial Management plays two significant roles: v To participate in the process of putting funds to work within the business and to control their productivity; and v To identify the need for funds and select sources from which they may be obtained. The functions of financial management may be classified on the basis of liquidity, profitability and management. (1) Liquidity: Liquidity is ascertained on the basis of three important considerations: (a) Forecasting cash flows, that is, matching the inflows against cash outflows; (b) Raising funds, that is, financial management will have to ascertain the sources from which funds may be raised and the time when these funds are needed; (c) Managing the flow of internal funds, that is, keeping its accounts, with a number of banks to ensure a high degree of liquidity with minimum external borrowing. (2) Profitability: While ascertaining profitability, the following factors are taken into account: (a) Cost Control: Expenditure in the different operational areas of an enterprise can be analysed with the help of an appropriate cost accounting system to enable the financial manager to bring costs under control.


(b) Pricing: Pricing is of great significance in the company’s marketing effort, image and sales level. The formulation of pricing policies should lead to profitability, keeping, of course, the image of the organization intact. (c) Forecasting Future Profits: Expected profits are determined and evaluated. Profit levels have to be forecasted from time to time in order to strengthen the organization. (d) Measuring Cost of Capital: Each source of funds has a different cost of capital which must be measured because cost of capital is linked with profitability of an enterprise. (3) Management: The financial manager will have to keep assets intact, for assets are resources which enable a firm to conduct its business. Asset management has assumed an important role in financial management. It is also necessary for the financial manager to ensure that sufficient funds are available for smooth conduct of the business. In this connection, it may be pointed out that management of funds has both liquidity and profitability aspects. Financial management is concerned with the many responsibilities which are thrust on it by a business enterprise. Although a business failure may not always be the result of financial failures, financial failures do positively lead to business failures. The responsibility of financial management is enhanced because of this peculiar situation. Financial management may be divided into two broad areas of responsibilities, which are not by any means independent of each other. Each, however, may be regarded as a different kind of responsibility; and each necessitates very different considerations. These two areas are: v The management of long-term funds, which is associated with plans for development and expansion, and which involves land, buildings, machinery, equipment, transport facilities, research project, and so on; v The management of short-term funds, which is associated with the overall cycle of activities of an enterprise. These are the needs which may be described, as working capital needs.


One of the functions of financial management is co-ordination of different activities of a business house. A business depends upon availability of funds which, in turn, depends upon the extent to which a firm is able to effect cash sales. Financial management must offer a solution for decisions in areas of capital structure, investment, dividend distribution, and retention of surplus inter-alia. The investment decision involves current cash outlay in anticipation of benefits to be realised in the future. The uncertain nature of future benefits necessitates evaluation of investment proposals in relation to their expected rate of return and risk. Once the investment proposals are evaluated and combined into a capital expenditure programme or planned capital budget, the next decision involves finalisation of sources for a given capital outlay. In other words, the financing decision involves the determination of the ideal financing mix or capital structure. For deciding the dividend policy, the percentage of earnings paid to shareholders becomes an important consideration. It is obvious that the percentage of dividend policy paid affects the quantum of retained earnings. The dividend policy is thus instrumental for changes in market price of shares in the capital market. A prudent financial management policy calls for an optimal mix of different decisions in line with organizational objectives. Today, financial management extends itself to the broad subject of international money management which refers to the problem of collecting, utilising and protecting the financial assets of internationally involved companies. This includes both — operating responsibilities of a multi-national corporation and providing the array of techniques and tools available to co-ordinate that task. This task is already difficult in domestic companies. But the task becomes more onerous on account of grated structural and environmental impediments confronting multi-national companies. New problems in managing and administering finances of companies have emerged following the increasing international financing of domestic companies and the entry of foreign collaborations, problems of dealings between parents and subsidiaries speaking in multiple languages, heavy reliance on communication environments, following diverse legal practices, different tax umbrellas and exchange, control system among others. It has become imperative to have reporting systems and optimal use of financial institutions attempting to forecast liquidity and foreign exchange risks of companies.


International cash management deals with more mechanical areas of cash collection, holding and disbursement. International cash management involves longer distances, exchange controls different currency units and multiple financial institutions. A variety of instruments exist for effecting international transfer of funds. There may be payment instructions in written or documentary form incorporating some form of credit. The standard method of transferring funds internationally is by mail payment order, which is a lengthy process. Cable transfers reduce remittance time appreciably. Other international modes of payment include bank drafts, cheques and trade bills. Sight and time drafts, acceptances and letters of credit are termed as documentary credits. The international liquidity management is regulated by exchange control and other barriers which usually prohibit the flow of funds in desired directions. Funds held by individual subsidiaries in different countries cannot be considered fungible and there is little or no chance of international pooling of funds. Even intra-country liquidity management may be affected by weak capital markets which offer few investment media or banking systems which delay transfers. This area is also affected by impediments in banking and mail systems. Role and Functions of the Financial Manager The financial manager performs important activities in connection with each of the general functions of the management. He groups activities in such a way that areas of responsibility and accountability are cleared defined. The profit centre is a technique by which activities are decentralised for the development of strategic control points. The determination of the nature and extent of staffing is aided by financial budget programme. Direction is based, to a considerable extent, on instruments of financial reporting. Planning involves heavy reliance on financial tools and analysis. Control requires the use of the techniques of financial ratios and standards. Briefly, an informed and enlightened use of financial information is necessary for the purpose of coordinating the activities of an enterprise. Every business, irrespective of its size, should, therefore, have a financial manager who has to take key decisions on the allocation and use of money by various departments. Specifically the financial manager should anticipate financial needs; acquire financial resources; and allocate funds to various departments of the business. If


the financial manager handles each of these tasks well, his firm is on the road to good financial health. The financial manager’s concern is to: v Determine the total amount of funds to be employed by a firm; v Allocate these funds efficiently to various assets; v Obtain the best mix of financing in relation to the overall evaluation of the firm. Since the financial manager is an integral part of the top management, he should so shape his decisions and recommendations as to contribute to the overall progress of the business, on which depends the value of the firing. That is his primary objective is to maximise the value of the firm to its stockholders. Although, decisions are the end product of the financial manager’s task, his day-to-day work consists of more than just decision-making. A great deal of his time is spent on financial planning, which may be described as the co-ordination of a series of inter-dependent decisions over an extended period. Of the many environments in which the firm operates, the one closest to the financial manager is the financial market, which ultimately determines whether a firm’s policies are a success or a failure. In a fundamental sense, financial management is nothing more or less than a continuing two-way interaction between a firm and its financial environment. It has been explained earlier that financial management is related to the environment, which is external to a firm. This environment is the macro-economic environment, which includes the study of the financial market. The logic here is very simple. A firm is a part of the entire business activity, which is reflected in the financial market. The financial market is sensitive to the reactions of firms to the supply of, and demand for, its securities. No firm can, therefore, exempt itself from undertaking a study of the financial market. It is in this sense that financial management makes a kind of an integrated approach to the external environment. The financial manager should: v Supervise the overall working of an organization instead of confining himself to technical matters as a top management executive


v Make sure that funds have been acquired in sufficient, but not excessive amounts v Ensure that disbursements do not create shortage of funds v Analyse, plan and control the use of funds v Maintain liquidity while retaining the acceptable level of profits v Economise on the acquisition of funds and hold down their cost v Make allowances for uncertainties that exist in the business world v Administer effectively cash, receivables, inventory and other components of working capital v Analyse financial aspects of external growth v Develop the means to rejuvenate and revitalise the enterprise or to assist in liquidity and distribution of its assets to the various claimants. A financial manager is often up against a dilemma. He has to choose between profitability and liquidity. Although both are desirable, sometimes one has to be sacrificed for the other. Since cash earns no return, a firm increases its liquidity at the cost of its profitability. The financial manager does something more than co-ordinate business activities in a mechanical way. His central role requires that he understands the nature of problems so that he may take proper decisions. In several situations, he faces a challenge: should he choose profitability or liquidity? Despite the knowledge that a particular investment is quite profitable, he is forced to sacrifice this option, if the investment is going to lock up funds for an unreasonable period; the longer the period, the greater is the risk. Most financial managers are, therefore, tempted to compromise between profitability and liquidity, and select projects which are reasonably profitable and, at the same time, sound from the liquidity point of view. Financial Manage and Economics Knowledge of economics is necessary for the understanding of financial environment and the decision theories which underline contemporary financial management. Macro-economics gives


an insight into the policies of the government and private institutions through which money flows, credit flows and general economic activity are controlled. In recent years, a significant change has taken place in the study of financial management, as it has in all other aspects of business and public administration. A considerable progress has been made in the development of theoretical structures for the solution of business problems. The model-building approach to financial management has been developed from two separate branches of study - economics and operations research, aided by computer science. The link between economics and financial management is close. A study of financial management is likely to be barren if it is divorced from the study of economics. Financial management has, in fact, evolved over the years as an autonomous branch of economics. Financial Management and Accounting It is of greater managerial interest to think of financial management as something of which accounting is a part, which is concerned mainly with the raising of funds, in the most economic and suitable manner; using the funds as profitably as possible (for a given risk level); planning future operations and controlling current performance and future developments through financial accounting, cost accounting, budgeting, statistics and other means. Effective planning and direction depends on adequate accounting information available to a management on the financial condition of an enterprise. This includes: Decisions which affect external, legal and financial relationships of funds; decisions on methods of financing, fixed and working capital in general Financial structure, credit policy, payment of dividends, creation of reserves Decisions which are mainly internal and refer to the deployment of funds on different projects Quasi-financial decisions which arise from marketing; personnel, production or any other discipline and other problems which have financial aspects Decisions for which accounting records and reports are widely used. Accounting is a tool for handling only the financial aspects of business operations. It is geared to the financial ends of a business only because these are measurable on the scale of money values.


The distinction between financial management and management accounting is a semantic one, but the gap between the two is rapidly closing. Financial management, however, has the broader meaning of planning and control of all activities by financial means, while management accounting originally meant the internal management of finance in industry. The accountant devotes his attention to the collection and presentation of financial data. The financial officer evaluates the accountant’s statements, develops additional data and arrives at decisions based on his analysis. Evolution of Financial Management The main stream of academic writing and teaching followed the scope and pattern suggested by the narrower and by now traditional definition of the finance function. Financial management, as it was then more generally called, emerged as a separate branch of economics. The traditional approach to the entire subject of finance was from the point of view of the investment banker rather than that of the financial decision-maker in an enterprise. The traditional treatment placed altogether too much emphasis on corporation finance and too little on the financing problems of non-corporate enterprises. The sequence of treatment was built too closely around the episodic phases during the life cycle of a hypothetical corporation in which external financial relations happened to be dominant. Matters like promotion, incorporation, merger, consolidation, recapitalization and reorganization left too little room for problems of a normal growing company. Finally, it placed heavy emphasis on long-term financial instruments and problems and corresponding lack of emphasis on problems of working capital management. The basic contents of the traditional approach may now be summarised. The emphasis in the traditional approach is on raising of funds The traditional approach circumscribes episodic financial function The traditional approach places great emphasis on long-term problems It pays hardly any attention to financing problems of non-corporate enterprises. It is difficult to say at what stage the traditional approach was replaced by modern approach. It is clear, however, that Ezra Solomon, Thomas L. Rein, Edward S. Meade and Arthur Stone Dewing


among others were profoundly impressed by subjects like promotion, securities, floatations, reorganization, consolidations, liquidation, etc. Their works laid emphasis on these topics. They did not consider routine managerial problems relating to financing of a firm, problems of profit planning and control, budgeting, finance and cost control, and working capital management which constitute the crux of the financial problems of modern financial management. The central issue of financial policies is a wise use of funds and the central process involved is a rational matching of advantages of potential uses against the caution of advantages of potential uses against the caution of alternative potential sources so as to achieve broad financial goals which an enterprise sets for itself. The new or modern approach is an analytical way of looking at the financial problems of a firm. Financial problems are a vital and an integral part of overall management. In this connection, Ezra Solomon observes: If the scope of financial management is re-defined to cover decisions about both the use and the acquisition of funds, it is clear that the principal content of the subject should be concerned with how financial management should make judgements about whether an enterprise should hold, reduce, or increase its investments in all forms of assets that require company funds. With the advent of industrial combination the financial manager of corporation was confronted with the complexities of budgeting and financial operations. The size and composition of the capital structure was of particular importance. The major concern of financial management was survival. Its attitude to long-term trade was hostile. It looked upon dividend as a residual payment. The discipline of financial management was conditioned by changes in the socioeconomic and legal environment. Its emphasis shifted from profitability analysis to cash flow generation; and it developed an interest in internal management procedures and control. In the circumstances, cost, budget forecasting, aging of accounts receivable and monetary management assured considerable importance. With technological progress, financial management was almost forced to improve its methodology. Such things as cost of capital, optimal capital structure, effects of capital structure upon cost of capital and market value of a firm were incorporated in the subject. Moreover, financial management laid emphasis on international business and finance, and showed a serious concern for the effects of multi-nationals upon price level movements. The concern for liquidity


and profit margins was indeed tremendous throughout the several phases of financial management. Modern financial management, however, is basically concerned with optimal matching of uses and sources of corporate funds that lead to the maximisation of a firm’s market value. Functional Areas of Financial Management It would indeed be an extremely difficult task to delineate functions of modern financial management. The subject management has been stretched to such a limit that a finance manager today has to be conversant with a large variety of subjects, while the traditional finance manager concerned him with such macroeconomic areas of finance as long-term financing, short-term financing, study of financial institutions, capital market (more particularly, the stock exchange), promotion, planning of corporations, underwriting of securities, and so on. A lot of literature on the subject of Financial Management seems to be devoted to these and similar matters. These areas, to be precise, belong to corporation finance. Modern Financial Management should hence forward concentrate on micro- economic areas with which a business enterprise has to deal during its day-to-day operations. A Large number of empirical studies on the subject have already been conducted on different portfolios of Financial Management, some of which have been tested, while others, which were not tested, were rejected by corporate decision-makers. For example, capital structure and, more particularly, the cost of different sources of funds, dividend policies, depreciation policies, retention of surpluses, liquidity, profit planning and control - these are among the subjects which have captured the attention of different schools of thoughts from time to time. The functional areas of financial management is elaborated below. Determining Financial Needs: One of the most important functions of the financial manager is to ensure availability of adequate funds. Financial needs have to be assessed for different purposes. Money may be required for initial promotional expenses, fixed capital and working capital needs. Promotional expenditure includes expenditure incurred in the process of company formation. Fixed assets needs depend upon the nature of the business enterprise - whether It is a


manufacturing, non-manufacturing or merchandising enterprise. Current asset needs depend upon the size of the working capital required by an enterprise.

Figure: 1 Functional areas of financial management Determining the Sources of Funds: The financial manager has to choose the various sources of funds. He may issue different types of securities. He may borrow from a number of financial institutions and the public. When a firm is new and small and little known in financial circles, the financial manager faces a great challenge in raising funds. Even when he has a choice in selecting sources of funds, he should exercise it with great care and caution. A firm is committed to the lenders of finance and has to meet various terms and conditions on which they offer credit. To be precise, the financial manager must definitely know what he is doing. Financial Analysis: It is the evaluation and interpretation of a firm’s financial position and operations, and involves the comparison and interpretation of accounting data. The financial manager has to interpret different statements. He has to use a large number of ratios to analyse the financial status and activities of his firm. He is required to measure its liquidity, determine its profitability and assets and overall performance in financial terms. This is often a challenging task, because he must understand the importance of each one of these aspects to the firm and he should be crystal clear in his mind about the purposes for which liquidity, profitability and performance are to be measured. Optimal Capital Structure: The financial manager has to establish an optimum capital structure and ensure the maximum rate of return on investment. The ratio between equity and other


liabilities carrying fixed charges has to be defined. In the process, he has to consider the operating and financial leverages of his firm. The operating leverage exists because of operating expenses, while financial leverage exists because of the amount of debt involved in a firm’s capital structure. The financial manager should have adequate knowledge of different empirical studies on the optimum capital structure and find out whether, and to what extent, he can apply their findings to the advantage of the firm. Cost-Volume-Profit Analysis: This is popularly known as the ‘CVP relationship’. For this purpose, fixed costs, variable costs and semi-variable costs have to be analysed. Fixed costs are more or less constant for varying sales volumes. Variable costs vary according to sales volume. Semi-variable costs are either fixed or variable in the short run. The finance manager has to ensure that the income for the firm will cover its variable costs, for there is no point in being in business, if this is not accomplished. Moreover, a firm will have to generate an adequate income to cover its fixed costs as well. The finance manager has to find out the break- even-point (i.e), the point at which total costs are matched by total sales or total revenue. He has to try to shift the activity of the firm as far as possible from the break-ever point to ensure company’s survival against seasonal fluctuations. Profit Planning and Control: Profit planning and control have assumed great importance in the financial activities of modern business. Economists have long before considered the importance of profit maximization in influencing business decisions. Profit planning ensures attainment of stability and growth. In view of the fact that earnings are the most important measure of corporate performance, the profit test is constantly used to gauge success of a firm’s activities. Profit planning is an important responsibility of the finance manager. Profit is the surplus which accrues to a firm after its total expenses are deducted from its total revenue. It is necessary to determine profits properly, for they measure the economic viability of a business. The first element in profit is revenue or income. This revenue may be from sales or it may be operating revenue, investment income or income from other sources. The second element in profit calculation is expenditure. This expenditure may include manufacturing costs, trading costs, selling costs, general administrative costs and finance costs.


Profit planning and control is a dual function which enables management to determine costs it has incurred, and revenues it has earned, during a particular period, and provides shareholders and potential investors with information about the earning strength of the corporation. It should be remembered that though the measurement of profit is not the only step in the process of evaluating the success or failure of a company, it is nevertheless important and needs careful assessment and recognition of its relationship to the company’s progress. Profit planning and control are very important. In actual practice, they are directly related to taxation. Moreover, they lay the foundation for policies, which determine dividends, and retention of profits and surpluses of the company. Profit planning and control are inescapable responsibilities of the management. The break-even analysis and the CVP relationship are important tools of profit planning and control. Fixed Assets Management: A firm’s fixed assets include tangibles such as land, building, machinery and equipment, furniture and also intangibles such as patents, copyrights, goodwill, and so on. The acquisition of fixed assets involves capital expenditure decisions and long-term commitments of funds. These fixed assets are justified to the extent of their utility and/or their productive capacity. Because of this long-term commitment of funds, decisions governing their purchase, replacement, etc., should be taken with great care and caution. Often, these fixed assets are financed by issuing stock, debentures, long-term borrowings and deposits from public. When it is not worthwhile to purchase fixed assets, the financial manager may lease them and use assets on a rental basis. To facilitate replacement of fixed assets, appropriate depreciation on fixed assets has to be formulated. It is because of these facts that management decisions on the acquisition of fixed assets are vital. If they are ill-designed, they may lead to over-capitalisation. Moreover, in view of the fact that fixed assets are maintained over a long period of time, these assets are exposed to changes in their value, and these changes may adversely affect the position of a firm. Project Planning and Evaluation: A substantial portion of the initial capital is sunk in longterm assets of a firm. The error of judgment in project planning and evaluation should be minimized. Decisions are taken on the basis of feasibility and project reports, containing analysis of economic, commercial, technical, financial and organizational viabilities. Essentiality of a project is ensured by technical analysis. The economic and commercial analysis study demand


position for the product. The economy of size, choice of technology and availability of factors favouring a particular industrial site are all considerations which merit attention in technical analysis. Financial analysis is perhaps the most important and includes forecasting of cash inflows and total outlay which will keep down cost of capital and maximize the rate of return on investment. The organizational and manpower analysis ensures that a firm will have the requisite manpower to run the project. In this connection, it should be remembered that a project is exposed to different types of uncertainties and risks. It is, therefore, necessary for a firm to gauge the sensitivity of the project to the world of uncertainties and risks and its capacity to withstand them. It would be unjustifiable to accept even the most profitable project if it is likely to be the riskiest. Capital Budgeting: Capital budgeting decisions are most crucial; for they have long-term implications. They relate to judicious allocation of capital. Current funds have to be invested in long-term activities in anticipation of an expected flow of future benefits spread over a long period of time. Capital budgeting forecasts returns on proposed long-term investments and compares profitability of different investments and their cost of capital. It results in capital expenditure investments. The various proposal assets ranked on the basis of such criteria as urgency, liquidity, profitability and risk sensitivity. The financial analyser should be thoroughly familiar with such financial techniques as pay back, internal rate of return, discounted cash flow and net present value among others because risk increases when investment is stretched over a long period of time. The financial analyst should be able to blend risk with returns so as to get current evaluation of potential investments. Working Capital Management: Working capital is rightly an adjunct of fixed capital investment. It is a financial lubricant which keeps business operations going. It is the life-blood of a firm. Cash, accounts receivable and inventory are the important components of working capital, which is rotating in its nature. Cash is the central reservoir of a firm that ensures liquidity. Accounts receivables and inventory form the principal of production and sales; they also represent liquid funds in the ultimate analysis. The financial manager should weigh the advantage of customer trade credit, such as increase in volume of sales, against limitations of costs and risks involved therein. He should match inventory trends with level of sales. The uncertainties of inventory planning should be dealt within a rational manner. There are several


costs and risks which are related to inventory management. The risks are there when inventory is inadequate or in excess of requirements. The former may hold up production, while the latter would result in an unjustified locking up of funds and increase the cost of capital. Inventory management entails decisions about the timing and size of purchases purely on a cost basis. The financial manager should determine the economic order quantities after considering the relationships of different cost elements involved in purchases. Firms cannot avoid making investments in inventory because production and deliveries involve time lags and discontinuities. Moreover, the demand for sales may vary substantially. In the circumstances, safety levels of stocks should be maintained. Inventory management thus includes purchase management and material management as well as financial management. Its close association with financial management primarily arises out of the fact that it is a simple cash asset. Dividend Policies: Dividend policies constitute a crucial area of minancial management. While owners are interested in getting the highest dividend from a corporation, the board of directors may be interested in maintaining its financial health by retaining the surplus to be used when contingencies arise. A firm may try to improve its internal financing so that it may avail itself of benefits of future expansion. However, the interests of a firm and its stockholders are complementary, f or the ginancial management is interested in maximising the value of the firm, and the real interest of stockholders always lies in the maximisation of this value of the firm; and this is the ultimate goal of financial management. The dividend policy of a firm depends on a number of financial considerations, the most critical among them being profitability. Thus, there are different dividend policy patters which a firm may choose to adopt, depending upon their suitability for the firm and its stockholders. Acquisitions and Mergers: Firms may expand externally through co-operative arrangements, by acquiring other concerns or by entering into mergers. Acquisitions consist of either the purchase or lease of a smaller firm by a bigger organization. Mergers may be accomplished with a minimum cash outlay, though these involve major problems of valuation and control. The process of valuing a firm and its securities is difficult, complex and prone to errors. The financial manager should, therefore, go through the valuation process very carefully. The most difficult interest to value in a corporation is that of the equity stockholder because he is the residual owner.


Corporate Taxation: Corporate taxation is an important function of the financial management, for the former has a serious impact on the financial planning of a firm. Since the corporation is a separate legal entity, it is subject to an income- tax structure which is distinct from that which is applied to personal income. The traditional notion that the finance function is simply a process of ‘managing cash and capital’ or planning and controlling profits, fails to cover the scope of modern financial management. Today’s finance manager is engaged in such activities for the construction of models as to direct the search for new information, set performance standards, rationalise operating rules, and establish operating control. It is, in brief, an all-encompassing function. Its objective is first to select the items of financial information which are relevant to a particular problem, and second, to fit these items into a coherent picture of the problem in relation to the firm’s aims and financial resources. The final objective of financial management is to suggest alternative solutions to problems. However, in actual practice, the modern executive, who is buried in a maze of seemingly endless statistics and voluminous reports, is constantly struggling to gain real financial control, The financial controller is often behaviorally more concerned with expenditure than with profits. He tends to become a person who wants to keep his financial resources intact, spends nothing, and completely avoids undertaking risk. Infact, the management of finance should have the optimal use of funds as its focal point. The auditing approach should give place to a decision-making approach. The new demands on the finance manager call for a basic transformation in his approach because he plays a crucial role in the future success of the organisation. And this is a challenge which he has to face. An analysis of financial data with the help of scientific tools and techniques to improve performance of an undertaking (and to achieve better operating results and better quality of products) is essential n0wdays a day. It is necessary to take a fresh look at finance management in most Indian industries. The management of capital in Indian industries is generally anchored to traditional legacies and practices. This is true for both private and public sectors. The modern tools of management, including capital management, performance budgeting, cost control, organizational development and R & D, have not yet become popular with the captains of our industry. There is an absence of data on the marginal efficiency of capital, input-output


analysis, technical co-efficient, etc., which render current evaluation of issues somewhat difficult. The preponderance of proprietary, partnership and private companies has made industrial units something like closed shops. The management of these sectors is rested in family complexes about which there is no adequate information. Moreover, social obligations, growth potents, technical feasibility of financial planning and flow, and physical productivity - these need a better re-orientation and gearing up of capital management practices. The vagaries of government policy on dividend payments and tax rates and limits on share capital floatation have resulted in a low and uncertain supply of funds to the equity market. As a consequence, business houses are forced to look for their borrowings elsewhere as the only reliable method of finance, even when the cost of these borrowing is relatively high. The present behaviour of financial management is a result of government policy, in an uncertain capital market. Financial Decisions Financial decisions are the decisions relating to financial matters of a corporate entity. Financial requirement, Investment, Financing and Dividend Decisions are the most important areas of financial management, which facilitate a business firm to achieve wealth maximisation. Financial decisions have been considered as the means to achieve long-term objective of the corporates.

Funds Requirement Decision: Financial requirement decision is one of the most important decisions of finance manager. This decision is considered with estimation of the total funds required by a business unit. The total amount of capital and revenue expenditure of a company facilitates the financial manager in finding the total funds requirement. Capital expenditure consists of acquiring fixed assets. Revenue expenditure consists of maintaining the day-to-day


activities of a business unit. Hence the total of this expenditure helps the finance manager in determining the total funds requirement. Investment Decision: Investment decision is concerned with allocation of funds to both capital and current assets. Capital assets are financed through long-term funds and current assets are financed through short-term funds. The financial manager has to carefully allocate the available funds to recover not only the cost of funds but also must earn sufficient returns on the investments. Capital budgeting, CVP analysis are the techniques generally used fir the process of investment decisions. Financing Decisions: Financing decision is concerned with identification of various sources of funds. Funds are available through primary market, financial institution and through the commercial banks. Cost associated with each of the instrument or source is different. The overall cost of that capital composition must be kept at minimum proper debt. Equity ratio should be maintained to maximize the returns to the shareholders. This decision will be made by considering the different factors. viz., inflation, size of the organisation, government policies, etc. Dividend Decisions: Regular and assured percentage of dividend and capital gains are the basic desires of equity shareholders. The overall objective of a corporation is to fulfill the desires of the shareholders and attain wealth maximization in the long run. This decision has been considered as the barometer through which a business firm’s performance is measured. The suppliers of materials, bankers, creditors, shareholders and the government will measure and understand the soundness of the company through dividend decisions. Therefore, dividend decision has been considered as another important decision of the finance function. HAVE YOU UNDERSTOOD? 1. "Financial management is the appendage of the finance function". - Comment. 2. State the objectives of financial management. 3. Indicate the possible areas of conflict between management and stockholders. 4. Discuss briefly the scope and functions of financial management. 5. State the role of the financial manager and explain his functions in an organization.


6. Describe the evolution of financial management. 7. Discuss briefly different functional areas of financial management. 8. Distinguish between: a. Financial management and economics; b. Financial management and accounting. 9. Discuss briefly the problems of international financial management. Lesson 2 Time Value of Money Introduction A project is an activity that involves investing a sum of money now in anticipation of benefits spread over a period of time in the future. How do we determine whether the project is financially viable or not? Our immediate response to this question will be to sum up the benefits accruing over the future period and compare the total value of the benefits with the initial investment. If the aggregate value of the benefits exceeds the initial investment, we will consider the project to the financially viable. While this approach prima facia appears to be satisfactory, we must be aware of an important assumption that underlies our approach. We have assumed that irrespective of the time when money is invested or received, the value of money remains the same. We know intuitively that this assumption is incorrect because money has time value. How do we define this value of money and build it into the cash flow of a project? The answer to this question forms the subject matter of this lesson. Learning Objectives On reading this lesson, you will be conversant with the: Meaning of time value of money Future value of a single cash flow Future value of an annuity Present value of single cash flow


Present value of an annuity Money has time value. A rupee today is more valuable than a rupee a year hence. Why? There are several reasons: Individuals, in general, prefer current consumption to future consumption. Capital can be employed productively to generate positive returns. An investment of one rupee today would grow to (1+r) a year hence (r is the rate of return earned on the investment). In an inflationary period, a rupee today represents a greater real purchasing power than a rupee a year hence. SECTION TITLE Reasons for time value of money Many financial problems involve cash flows occurring at different points of time. For evaluating such cash flows an explicit consideration of time value of money is required. This chapter, discussing the methods for dealing with time value of money, is divided into four sections as follows: Future value of a single cash flow Future value of an annuity Present value of a single cash flow Present value of an annuity Future value of a single cash flow Suppose you have Rs. 1,000 today and you deposit it with a financial institution, which pays 10 per cent interest compounded annually, for a period of 3 years. The deposit would grow as follows: Rs.


Formula The general formula for the future value of a single cash flow is: FVn = PV (I + k) n FVn= future value n years hence PV= cash flow today (present value) k = interest rate per year n = number of years for which compounding is done. The growth of future value is shown in the following Table:1 Table: 1 Future Value of a Single Cash Flow


Equation (1) is a basic equation in compounding analysis. The factor (1 + k)n is referred to as the compounding factor or the future value interest factor (FVIFk,n). It is very tedious to calculate (1 + k)’. To reduce the tedium, published tables are available showing the value of (1 + k) n for various combinations of k and n. Table 2 shows some typical values of (I + k) n. Table: 2 Value of FVIFk,n for Various combinations of k and n For example, if you deposit Rs. 1,000 today in a bank which pays 10 per interest interest compounded annually, how much will the deposit grow to after 8 years and 12 years? The future value, 8 years hence will be: Rs. 1,000 (1.10) 8 = Rs. 1,000 (2.144) = Rs. 2,144 The future value, 12 years hence, will be: Rs. 1,000 (1.1W12 = Rs. 1,000 (3.138) = Rs. 3.138 Graphic View It shows graphically how one rupee would grow over time for different interest rates. Naturally, the higher the interest rate, the faster the growth rate. We have plotted the growth curves for three interest rates: 0 per cent, 6 per cent and 12 per cent. Growth curves can be readily plotted for other interest rates. Doubling Period Investors commonly ask the question: How long would it take to double the amount at a given rate of interest? To answer this question we may look at the future interest factor table. Looking at the above table we find that when the interest rate is 12 percent it takes about 6 years to double the amount, when the interest rate is 6 percent it takes about 12 years to double the amount, so on and so forth. Is there a rule of thumb which dispenses with the use of the future value interest


factor table? Yes, there is one and it is called rule of 72. According to this rule of thumb the doubling period is obtained by dividing 72 by the interest rate. For example, if the interest rate is 8 percent, the doubling period is about 9 years (72/8). Likewise, if the interest rate is 4 percent the doubling period is about 18 years (72/4). Though somewhat crude, it is a handy and useful rule of thumb. If you are inclined to do a slightly more involved calculation, a more accurate rule of thumb is the rule of 69. According to this rule of thumb, the doubling period is equal to:

As an illustration of this rule of thumb, the doubling period is calculated for two interest rates, 10 percent and 15 percent.

Finding the Growth Rate To calculate the compound rate of growth of some series, say the sales series or the profit series, over a period of time, we may employ the future value interest factor table. The process may be demonstrated with the help of the following sales data for Alpha Limited.

What has been the compound rate of growth in the sales of Alpha for the period 1981-87, a sixyear period? This question may be answered in two steps: Step 1: Find the ratio of sales of 1987 to 1981. This is simply: 99/50 = 1.98.


Step 2: Consult the FVIFk, n table and look at the row for 6 years, till you find a value which is closest to 1.98 and then read the interest rate corresponding to that value. In this case, the value closest to 1.98 is 1.974 and the interest rate corresponding to is 12 per cent. Hence, the compound rate of growth is 12 per cent. Shorter Compounding Period So far, we assumed that compounding is done annually. Now, we consider the case where compounding is done more frequently. Suppose, you depoit Rs. 1,000 with a finance company which advertises that it pays 12 per cent interest semi-annually— this means that interest is paid every six months. Your deposit (if interest is not withdrawn) grows as follows:

Note that, if compounding is done annually the principal at the end of one year would be Rs. 1,000 (1.12) = Rs. 1.120.0. The difference of Rs. 3.6 (between Rs.1,123.60 under semi-annual compounding and Rs. 1,120.0 under annual compounding represents interest on interest for the second 6 months. The general formula value of a single cash flow when compounding is done more frequently than annually is:

Where FVn = future value after n years PV= cash flow today (present value)


k = nominal annual rate of interest m = number of times compounding is done during a year n = number of years for which compounding is done. Example: How much does a deposit of Rs. 5,000 grow to at the end of 6 years, if the nominal rate of interest is 12 per cent and the frequency is 4 times a year? The amount after 6 years will be: Rs. 5,000 (1 ÷0.12) 4.6 = Rs. 5,000 (1.03) 24 = Rs. 5,000 x 2.0328 = Rs. 10,164 Effective versus Nominal Rate We have seen above that Rs. 1,000 grows to Rs. 1,123.6 at the end of a year if the nominal rate of interest is 12 per cent and compounding is done semi-annually. This means that Rs. 1,000 grows at the rate of 12.36 per cent per annum. The figure of 12.36 per cent is called the effective rate of interest—the rate of interest under annual compounding which produces the same result as that produced by an interest rate of 12 per cent under semi-annual compounding. The general relationship between the effective rate of interest and the nominal rate of interest is as follows:

Where r = effective rate of interest k = nominal rate of interest m = frequency of compounding per year Example a bank offers 8 per cent nominal rate of interest with quarterly compounding.


What is the effective rate of interest? The effective rate of interest is:

Table 5 gives the relationship between the nominal and effective rates of interest for different compounding periods. In general, the effect of increasing the frequency of compounding is not as dramatic as some would believe it to be—the additional gains dwindle as the frequency of compounding increases.

Future value of an annuity An annuity is a series of periodic cash flows (payments or receipts) of equal amounts. The premium payments of a life insurance policy, for example, are an annuity. When the cash flows occur at the end of each period the annuity is called a regular annuity or a deferred annuity. When the cash flows occur at the beginning of each period the annuity is called an annuity due. Our discussion here will focus on a regular annuity—the formulae of course can be applied, with some modification, to an annuity due. Suppose you deposit Rs. 1,000 annually in a bank for 5 years and your deposits earn a compound interest rate of 10 per cent, what will be the value of this series of deposits (an annuity) at the end of 5 years? Assuming that each deposit occurs at the end of the year, the future value of this annuity will be: Rs. 1,000(1.l0) + Rs. 1,000(1.10) 3 + Rs. 1,000 (1.10) 2 + Rs. 1,000 (1.10) + Rs. 1,000 = Rs. 1,000 (1.4641) + Rs. 1.000 (1.3310) + Rs. 1,000 (1.2100) + Rs. 1,000 (1.10) + Rs. 1,000= Rs. 6,105 The time line for this annuity is shown in the following.


Formula: In general terms the future value of an annuity is given by the following formula: FVAn = A (1+k)n + A (1+k)n-2 +A

Where FVAn= future value of an annuity which has a duration of n periods A= consant periodic flow k= interest rate per period n= duration of the annuity

The term

is referred to as the future value interest factor for an annuity

(FVIFA k, n). The value of this factor for several combinations of k and a is in following table. Table 6 Value of FVIVA k, n for various Combinations of k and n


Example: Four equal annual payments of Rs. 2,000 are made into a deposit account that pays 8 per cent interest per year. What is the future value of this annuity at the end of 4 years? The future value of this annuity is: Rs. 2,000 (FVIFA8%, 4) = Rs. 2,000 (4.507)= Rs. 9,014 Sinking Fund Factor Equation (4) shows the relationship between FI’A A, Ic and a. Juggling it a bit, we get:

In Eq. (5), the inverse of FVIFA ,, is called the sinking (1+ky-’fund factor.


Equation (5) helps in answering the question: How much should be deposited periodically to accumulate a certain sum at the end of a given period? The periodic deposit is simply A and it is obtained by dividing FVAn by FV1FA.k,n Example: How much should you save annually to accumulate Rs. 20,000 by the end of 10 years, if the saving earns an interest of 12 per cent?

Finding the Interest Rate Given the relationship between FVAn, A, k, and n, the interest rate (k) can be easily figured out if the values of the other three—FVn, A, and. n,—are known. Example: A finance company advertises that it will pay a lumpsum of Rs. 8,000 at the end of 6 years to investors who deposit annually Rs. 1,000 for 6 years. What interest rate is implicit in this offer? The interest rate may be calculated in two steps: 1. Find the FVIFAA6 for this contract as follows: Rs. 8,000 = Rs. 1,000 x FV1FA,k,6

2. Look at the FVIFAk,n table and read the mw corresponding to 6 years until you find a value close to 8,000. Doing so, we find that


FVIFA12%,6 is 8.115 So, we conclude that the interest rate is slightly below 12 per cent. Present value of a single cash flow Suppose, someone promises to give you Rs. 1,000 three years hence. What is the present value of this amount if the interest rate is 10 per cent? The present value can be calculated by discounting Rs. 1,000, to the present point of time, as follows:

Formula The process of discounting, used for calculating the present value, is simply the inverse of compounding. The present value formula can be readily obtained by manipulating the compounding formula:

Dividing both the sides of Eq. (4.1) by (l+k)n, we get,


The factor in Eq. (4.6) is called the discounting factor or the present value interest factor (PV1F j. Table 7 gives the value of PVIFk,n for several combinations of k and n. A more detailed table of PVIF, is given in Appendix at the end of this book. Example: Find the present value of Rs. 1,000 receivable 6 years hence if the rate of discount is 10 per cent. The present value is: Rs. 1,000 x PVIF10%,6 = Rs. 1,000 (0.5645) = Rs. 564.5 Example: 1 Find the present value of Rs. 1,000 receivable 20 years hence if the discount rate is 8 per cent. Since Table 7 does not have the value of PVIF we obtain the answer as follows:

Table 7 Value of PVIF k,n for Various Combinations of k and n

Graphic View of Discounting


The following figure shows graphically, how the present value interest factor varies in response to changes in interest rate and time. The present value interest factor declines as the interest rate rises and as the length of time increases.

Present Value of an Uneven Series In financial analysis, we often come across uneven cash flow streams. For example, the cash flow stream associated with a capital investment project is typically uneven. Likewise, the dividend stream associated with an equity share is usually uneven and perhaps growing. The present value of a cash flow stream--uneven or even--may be calculated with the help of the following formula:


where PVn, = present value of a cash flow stream At = cash flow occurring at the end of year t k = discount rate n = duration of the cash flow stream Table 8 shows the calculation of the present value of an uneven flow stream, using a

Shorter Discounting Periods Sometimes, cash flows may have to he discounted more frequently than once a year, semiannually, quarterly monthly, or daily. As in the case of intra-year compounding, the shorter discounting period implies that (i) the number of periods in the analysis increases and (ii) the discount rate applicable per period decreases. The general formula for calculating the present value in the case of shorter discounting period is:


Where PV = present value FVn = cash flow after n years m = number of times per year discounting is done k = annual discount rate To illustrate, consider a cash flow of Rs. 10,000 to be received at the end of four years. The present value of this cash flow when the discount rate is 12 per cent (k = 12 per cent) and discounting is done quarterly (m = 4) and it is determined as follows: PV = Rs. 10,000 x PVJFk/m, mxn = Rs. 10,000 x PVIF3%, 16 = Rs. 10,000 x 0.623 = Rs. 6,230 Present value of an annuity Suppose, you expect to receive Rs. 1,000 annually for 3 years, each receipt occurring at the end of the year. What is the present value of this stream of benefits if the discount rate is 10 per cent? The present value of this annuity is simply the sum of the present values of all the inflows of this annuity:

The time line for this problem is shown in following figure


Formula In general terms the present value of an annuity may be expressed as follows PVAn

Where PVAn = present value of annuity which has a duration of n periods A = constant periodic flow k = discount rate


It is referred to as the present value interest factor for an annuity (PVIFAk,n). It is, as can be seen clearly, simply equal to the product of the future value interest factor for an annuity (PVIFAk, n) and the present value interest factor (PVIFAk, n). Table 9 shows the value of PVIFAL for several combinations of k and it A more detailed table of PVIFAk, n values is found in Appendix A at the end of this book. Table 9 Value of PVIFA k, n for Different Combinations of k and n

Example: What is the present value of a 4-year annuity of Rs. 10,000 discounted at 10 percent? The PVIFA10%, 4 is 3.170 Hence, PVAn = Rs. 10,000 (3.170) = Rs. 31,700 Example: A 10-payment annuity of Rs. 5,000 will begin 7 years hence. (The first occurs at the end of 7 years.) What is the value of this annuity now if the discount rate is 12 per cent? This problem may be solved in two steps. Step 1 Determine the value of this annuity a year before the first payment begins, i.e., 6 years from now. This is equal to Rs. 5,000 (PVJFA124 = Rs. 5,000 (5.650) = Rs. 28,250.


Step 2 Compute the present value of the amount obtained in Step 1. Rs. 28,250 (PV1F1 6) = Rs. 28,250 (0.507) = Rs. 14,323. Capital Recovery Factor Equation (4.9) shows the relationship between PVAn A, k, and n. Manipulating it a bit, we get:

In Eq. (4.10), the inverse of PVIFAk, n is called the capital recovery factor. Example: Your father deposits Rs. 1,00,000 on retirement in a bank which pays 10 per cent annual interest. How much can he withdraw annually for a period of 10 years?

Finding the interest rate Suppose, someone offers you the following financial contract ie., if you deposit Rs. 10,000 with him he promises to pay Rs. 2,500 annually for 6 years. What interest rate do you earn on this deposit? The interest rate may be calculated in two steps: Step1. Find the P VIFA6 for this contract by dividing Rs. 10,000 by Rs. 2,500


Step 2. Look at the PVIFA table and read the row corresponding to 6 years until you find a value close to 4,000. Doing so, you find that

Since, 4,000 lies in the middle of these values the interest rate lies (approximately) in the middle. So, the interest rate is 13 per cent. Present value of perpetuity Perpetuity is an annuity of infinite duration. Hence, the present value of perpetuity may be expressed as follows:

Where = present value of a perpetuity A = constant annual payment PVIFAk,oo = present value interest factor for a perpetuity (an annuity of infinite duration) What is the value of PVIFAk, oo it is simply:

Putting in words, it means that the present value interest factor of a perpetuity is simply I divided by the interest rate expressed in decimal form. Hence, the present value of perpetuity is simply


equal to the constant annual payment divided by the interest rate. For example, the present value of a perpetuity of Rs. 10,000 if the interest rate is 10 per cent is equal to: Rs. 10,000/0.10 = Rs. 1,00,000. Intuitively, this is quite convincing because an initial sum of Rs. 1,00,000 would, if invested at a rate of interest of 10 per cent, provide a constant annual income of Rs.10,000 forever, without any impairment of the capital value. HAVE YOU UNDERSTOOD? 1. Why does money have time value? 2. State the general formula for the future value of a single cash flow. 3. What is the relationship between effective rate of interest and nominal rate of interest? 4. What is an annuity? 5. State the formula for the future value of an annuity. 6. What is a sinking fund factor? Illustrate it with an example. 7. State the general formula for calculating the present value of a single cash flow. 8. What is the general formula for calculating the present value of a cash flow series? Lesson 3 Risk and Return Introduction The value of a firm is affected by two key factors: risk and return. Higher the risk, other things being equal, lower the value; higher the return, other things being equal, higher the value. While intuitively the meaning of risk and return is grasped by almost every person who reflects on his experiences, the financial manager needs an explicit and quantitative understanding of these concepts, and, more importantly, the nature of relationship between them, this chapter, exploring these issues, is divided into three sections as follows: Risk and return concepts Risk in a portfolio context


Relationship between risk and return Learning objectives On reading this lesson, you will he conversant with: Ø The concepts of risk and return Ø Risk in a portfolio context Ø Meaning of diversifiable and non-diversifiable risks Ø Calculation of beta Ø Relationship between risk and return Ø Risk and return: Implications on investment SECTION TITLE Risk and Return: Concepts Risk and return may be defined in relation to a single investment or a portfolio of investments. We will first look at risk and return of a single investment held in isolation and then discuss risk and return of a portfolio of investments. Risk Risk refers to the dispersion of a probability distribution: How much do individual outcomes deviate from the expected value? A simple measure of dispersion is the range of possible outcomes, which is simply the difference between the highest and lowest outcomes. A more sophisticated measure of risk, employed commonly in finance, is standard deviation’. How is standard deviation calculated? The standard deviation of a variable (which for our purposes represents the rate of return) is calculated using the following formula:



= standard deviation

pi= probability associated with the occurrence of I th rate of return ki= I th possible rate of return k= excepted rate of return n= number of possible out comes possible out comes The calculation of the standard deviation of rates of return of Bharath Food and Oriental Shipping is shown in Table 2. Looking at the calculation of standard deviation, we find that it has the following features: 1. The differences between the various possible values and the expected value it squared. This means that values which are far away from the expected value have much more effect on standard deviation than values which are close to the expected value. 2. The squared differences are multiplied by the probabilities associated with the respective values. This means that the smaller the probability that a particular value will occur, the lesser its effect on standard deviation. 3. The standard deviation is obtained as the square root of the sum of squared differences (multiplied by their probabilities). This means that the standard deviation and expected value is measured in the same units and hence the two can be directly compared.











Risks in a Portfolio Context Most investors (individuals as well as institutions) hold portfolios of securities. Hence, a very pertinent question is: What happens when two or more securities are combined in a portfolio? To answer this question, let us consider an example. Suppose you have Rs. 1,00,000 to invest and you are considering two equity stocks, Alpha Company and Beta Industries. The returns on the equity stocks of Alpha and Beta for the preceding five years are shown in Table 2 and you expect the future returns on these stocks to be equal to their past returns. This means that on your investment of Rs. 1,00,000 you expect to earn Rs. 12,000 per annum (because the mean return in the preceding five years was 12 per cent) on either of the securities individually or on a portfolio consisting of these securities. What happens if you invest in a portfolio consisting of the equity stocks of Alpha Company and Beta Industries in equal proportions? While the expected return remains at 12 per cent the same as either company individually, the standard deviation is only 4.73 per cent, much less than the standard deviation of either stock individually. As shown In Fig. 3.1 the variability in the


portfolio rate of return is much less than the variability of individual security rates of return. Why? This happens because the rates of return on the two securities tend to move in opposite directions. In general, if the rates of return of individual securities are not perfectly positively correlated, diversification results in risk reduction. Table 2 Return and Risk: Individual Securities and Portfolio

@When historical return data, rather than the probability distribution of return, is used, the formulae used for calculating the mean return and the standard deviation are as follows:


figure 3.1 Diversifiable and Non-diversifiable Risk What happens when more and more securities are added to a portfolio? In general, the portfolio risk decreases and approaches a limit. Empirical studies have suggested that the bulk of the benefit from diversification, in the form of risk reduction, can be achieved by forming a portfolio of 10-15 securities - thereafter the gains from diversification are negligible or even nil. Figure 5.2 represents graphically the effect of diversification on portfolio risk.

figure 3.2 portfolio risk


Diversifiable risk (also referred to as unsystematic risk or non-market risk) of a security stems from firm-specific factors like emergence of a new competitor, plant breakdown, lawsuit, nonavailability of raw materials, etc. Events of this kind affect primarily a specific firm and not all firms in general. Hence, risks arising from them can be diversified away by including several securities in a portfolio. Non-diversifiable risk (also referred to as systematic risk or market risk) of a security stems from the influence of certain economy-wide factors like money supply, inflation, level of government spending, and industrial policy, which have a bearing on the fortune of almost every firm. Since, these factors affect returns on all firms, investors cannot avoid the risk arising from them, however, diversified their portfolios may be. Put differently such risk cannot be diversified away. Hence, it is referred to as non-diversifiable risk or market risk (as it is applicable to all the securities in the market place) or systematic risk (as it systematically affects all securities). Beta Rational investors hold diversified portfolios from which the diversifiable risk is more or less eliminated. Hence, the relevant measure of risk of an investment is its no diversifiable risk (or systematic risk). Do all securities have the same degree of non- diversifiable risk? All securities do not have the same degree of non-diversifiable risk because the magnitude of influence of economy-wide factors tends to vary from one firm to another. Different securities have differing sensitivities to variations in market returns. This is illustrated graphically in the above figure. It shows the returns on the market portfolio (km) over time along with the returns on two other securities, a risky security (whose return is denoted by kr) and a conservation security (whose return is denoted by k,). It is evident that the return on the risky security (kr) is more volatile than the return on the market portfolio (km) whereas, the return on the conservative security (kc) is less volatile than turn on the market portfolio (km). Return The return from an investment is the realisable cash flow earned by its owner during a given period of time. Typically, it is expressed as a percentage of the beginning of period value of the investment. To illustrate, suppose you buy a share of the equity stock of Olympic Limited for Rs.


80 today. After a year you expect that (i) a dividend of Rs. 2 per share will be received and (ii) the price per share will rise to Rs. 90. The expected return, given this information, is simply:

In general, terms, the rate of return is defined as:

k = actual, expected, or required rate of return Pt = price of the security at time Pt-1= price of the security at time t-1 Dt= income receivable from the security at time t ( It may be noted that the period over which the rate of return is calculated is normally one year. However, it can be defined as any other interval, six months, one month, one week, one day, or any other). Probability When you buy an equity stock you are aware that the rate of return from it is likely to vary-and often vary widely. For example, if you buy a share of Olympic Limited for Rs. 80 today, you may be confronted with the following possible outcomes as far as the price after a year is concerned:


All the three outcomes may not be equally likely. The first outcome, for example, may be more likely than the others. In more formal terms we say that the probability associated with outcome A is greater than the probability associated with the other outcomes. The probability of an event represents the chance of its occurrence. For example, suppose an investor says that there is a 4 to I chance that the market price of a certain stock will rise during the next fortnight. This implies that there is an 80 per cent chance that the price of the stock will increase and a 20 per cent chance that it will not increase during the next fortnight. This judgment can be represented in the form of a probability distribution as follows:

One more example may be given to illustrate the notion of probability distribution. Consider investment in two equity stocks. The first stock, Bharath Foods, may provide a rate of return of 15 percent, 20 per cent, or 25 per cent with certain probabilities associated with them based on the state of the economy as shown in Table 3. The second stock, Oriental Shipping, being more volatile, may earn a rate of rate return of —20 per cent, 10 per cent, or 40 per cent with the same probabilities, based on the state of the economy as shown in Table 3. Table 3 Rates of Return and their Probabilities for Bharath Foods and Oriental Shipping


In defining the probability distribution, the following points should be noted: The possible outcomes must be mutually exclusive and collectively exhaustive. The sum of the probabilities assigned to various possible outcomes is. Expected Rate of Return When the rate of return can take several possible values because of the investment risk, it is common to calculate the expected rate of return, a measure of central tendency. The expected rate of return is defined as:

Where k = expected rate of return pi = probability associated with the D possible outcome ki = the possible outcome n = number of possible outcomes.


From Eq. (2) it is clear that k is the weighted arithmetic average of possible outcomes—each outcome is weighted by the probability associated with it. The expected rate of return for Bharath Foods is: kb= (0.30) (25%) + (0.50) (20%) + (0.20) (15%) = 20.5% Similarly, the expected rate of return for Oriental Shipping is: k0 = (0.30) (40%) + (0.5) (10%) + (0.20) (-20%) = 13.0% = 13.0% Returns

figure 3.3 How is non-diversifiable risk measured? It is generally measured by beta,. Though not perfect, beta represents the most widely accepted measure of the extent to which the return on a financial set fluctuates with the return on the market portfolio. By definition, the beta for the market portfolio is 1. A security which has a beta of say, 1.5, experiences greater fluctuation than the market portfolio. More precisely, if the return on market portfolio is expected to increase by 10 per cent, the return on the security with a beta of 1.5 is expected to increase by 15 per cent (1.5 x 10 per cent). On the other hand, a security which has a beta of, say, 0.8 fluctuates lesser than the market portfolio. If the return on the market portfolio is expected to rise by 10 per cent, the return on the security with a beta of 0.8 is expected to rise by 8 per cent (0.8 x 10 per cent).


Individual security betas generally fall in the range 0.60 to 1.80 and rarely, if ever, assume a negative value. Calculation of Beta For calculating the beta of a security the following market model developed by William F. Sharpe is employed: k1=+ where km++ej kj= return on security j = Intercept term alpha = Regression coefficient, beta km = return on market portfolio ej = random error term Beta reflects the slope of the above regression relationship. It is equal to:

Where Coy (kj, km) = covariance between the return on security j and the return on market portfolio.

= Variance of return on the market portfolio


= Correlation coefficient between the return on jth security and the return on the market portfolio

= Standard deviation of return jth market security

= Standard deviation of return on the market portfolio An example will help in understanding what R is and how to calculate it. The returns on security j and the market portfolio for a 10-year period are given below: Table 4

The beta for security j, 3, is calculated in Table 5. Given the values of (3 (0.76) and cx, (2.12 percent) the regression relationship between the return on security j (Ic) and the return on market portfolio (k.,) is shown graphically in Fig. 5. The graphic presentation is commonly referred to as the characteristic line. Since security j has a beta of 0.76 we infer that its return is less volatile than the return on the market portfolio. If the return on the market portfolio rises/falls by 10 per cent, the return on security j would he expected to increase/decrease by 7.6 percent (0.76 x 10%). The intercept term for security j (a.,) is equal to 2.12 percent. It represents the expected return on security j when the return on the market portfolio is zero. Table 5 Calculation of Beta


Relationship between Risk and Return Capital Asset Pricing Model What is the relationship between the risk of a security measured by its beta and its required rate of return? According to the capital asset pricing model (CAPM) the following equation represents the relationship between risk and return.

As per the above equation the required rate of return of a security consists of two components: (1) the risk-free rate of return (Rf) and (ii) the risk premium (km-Rf). The risk premium, it may be noted, is the product of the level of risk () and the compensation per unit of risk (km-Rf). Thus, for a risky security j, if Rf is 8 per cent, is 1.4, and kM is 14 per cent, the required rate of return is:


It is evident that, ceteris paribus, the higher the beta, the greater the required rate of return, and vice versa. Security Market Line The graphical version of the CAPM is called the security market lines (SML), which shows the relationship between beta and the required rate of return. The figure below shows the SML for the basic data given above. In this figure, the required rate of return for three securities, A. B and C, is shown. Security A is a defensive security with a beta of 0.5.

figure 3.4 Security market line


Its required rate of return is 11 per cent. Security B is a neutral security with a beta of 1. Its required rate of return is equal to the rate of return on the market portfolio. Security C is an aggressive security with a beta of 1.5. Its required rate return is 17 per cent. (In general, if the beta of a security is less than 1 it is characterised as defensive, if the beta of a security is equal to I it is characterised as neutral; and if the beta of a security is more than 1 it is characterised as aggressive.) Changes in Security Market Line The two parameters defining the security market line are the intercept (R1) and the slope (k M R1). The intercept represents the nominal rate of return on the risk-free security. It is expected to be equal to: risk-free security real rate of return plus inflation rate. For example, if the risk-free real rate of return is 2 per cent and the inflation rate is 8 per cent the nominal rate of return on the risk-free security is expected to be 10 per cent. The slope represents the price per unit of risk and is a function of the risk-aversion of investors. If the real risk-free rate of return and/or the inflation rate change, the intercept of the security market line changes. If the risk-aversion of investors changes the slope of the security market line changes. Figure 3.5 below shows the change in the security market line when the inflation rate increases and Figure 3.6 shows the change in the security market line when the risk-aversion of investors decreases


figure 3.5 change in the security market line caused by an increase in inflation Change In the Security Market Line caused by an Increase in Inflation Security Market Equilibrium Suppose the required return on stock A is 15 per cent, calculated as follows:


Change in the Security Market Line caused by a a decrese in Risk Aversion FIGURE 3.6 Change in the Security Market Line caused by a a decrese in Risk Aversion The investors, after analyzing the prospects of stock A, conclude that its earnings, dividends, and price will continue to grow at the rate of 6 per cent annum. The previous dividend per share, D0, was Rs. 1.70. The dividend per share expected a year hence is: D1= Rs. 1.70 (1.06) = Rs. 1.80 The market price per share happens to be Rs. 22. What would investors, in general, do? Investors would calculate the expected return from stock A as follows:


Finding that the expected return is less than the required rate, investors, in general, would like to sell the stock. However, as there would be no demand for the stock at Rs. 22 per share, existing owners will have to lower the price to such a level that it fetches a return of 15 per cent, its required return. That price, its equilibrium price, is the value of P in the following equation:

Solving Eq., for P4, we find that the equilibrium price is Rs. 20,00 If the market price initially had been lower than Rs. 20.00, investors, finding its return to be greater than its required return, seek to buy it. In this process, the price will be pushed up to Rs. 20.00, its equilibrium price. Changes in Equilibrium Stock Prices Stock market prices tend to change in response to changes in the underlying factors. To illustrate, let us assume that stock A, described above, is in equilibrium and sells at a price of Rs. 20.00 per share. If the expectations with respect to this stock are fulfilled, its equilibrium price a year hence will be Rs. 21.20,6 per cent higher than the current price. However, several factors could change in the course of a year and alter its equilibrium price. Suppose the values of underlying factors change as follows: Table: 6


The changes in the first three factors cause kAto change from 15 per cent to 13 cent.

The change in expected growth rate, along with the change in the required rate return, causes the equilibrium price to increase from Rs: 20.00 to Rs. 36.80.

Have you understood? 1. Why is standard deviation regarded as the most important measure of risk in financial theory? 2. What happens to risk when we add more and more securities to a portfolio? 3. Distinguish between non-diversifiable risk and diversifiable risk. 4. How is the systematic risk of a security measured? 5. What is the relationship between the risk of a security measured by its beta and its required rate of return? 6. What is a defensive security? Neutral security? Aggressive security? 7. What is the effect of change in risk aversion on the security market line? 8. "The increase in the risk-premium of all stocks, irrespective of their beta, is the - same, when risk-aversion increases". Comment. 9. The following information is available about two securities, A and B.


(i) Which of the two securities is more risky? Why? 10. What is the empirical evidence on CAPM? Lesson 4 Valuation of Securities Introduction The goal of investors and investment managers is to maximize their rate of return, or in other words, market value of their investments. Thus, investment management is an ongoing process that calls for continuous monitoring of information that may affect the value of securities or rate of return of such securities. Therefore, in making valuation judgements about securities, the analyst applies consistently a process which will achieve a true picture of a company over a representative time span, an estimate of current normal earning power and dividend pay-out; estimate of future profitability; growth and reliability of such expectations and the translation of all these estimates into valuation of the company and its securities. Learning objectives On learning this lesson, you will be conversant with: Valuation concept Valuation of bonds The concept and calculation of YTM. Valuation of equity under dividend capitalization approach; and


Valuation of equity under Ratio approach This chapter, presenting such a framework, is divided into four sections as follows: Valuation concept Bond valuation Equity valuation: dividend capitalization approach Equity valuation: ratio approach SECTION TITLE Valuation Concept From a financial point of view, the value of an asset is equal to the present value of the benefits associated with it. Symbolically,

Where V0 = value of the asset at time zero Ct = expected cash flow at the end of period r k = discount rate applicable to the cash flows n = expected life of the asset For example, if an investor expects an investment to provide an annual cash inflow of Rs. 1,000 per year for the next 10 years and the appropriate discount rate is 16 per cent, the value of the asset can be calculated as follows:


Bond Valuation a) Terminology A bond or debenture (hereafter referred to as only bond), akin to a promissory note, is an instrument of debt issued by a business or governmental unit. In order to understand the valuation of bonds, we need familiarity with certain bond-related terms. Par Value: This is the value stated on the face of the bond. It represents the amount the firm borrows and promises to repay at the time of maturity. Usually, the par or face value of bonds issued by business Finns is Rs. 100. Sometimes it is Rs 1,000. Coupon Rate and Interest A bond carries a specific interest rate which is called the coupon rate. The interest payable to the bondholder is simply, par value of the bond x coupon rate. For example, the annual interest payable on a bond which has a par value of Rs. 100 and a coupon rate of 13.5 percent is Rs. 13.5 (Rs. 100 x 13.5 per cent). Maturity Period: Typically corporate bonds have a maturity period of 7 to 10 years, whereas government bonds have maturity periods extending up to 20-25 years. At the time of maturity the par (face) value plus, perhaps a nominal premium, is payable to the bondholder. b) Basic Bond Valuation Model As noted above. the holder of a bond receives a fixed annual interest-payment for a certain number of years and a fixed principal repayment (equal to par value) at the time of maturity. Hence, the value of a bond is:


Where V = value of the bond I = annual interest payable on the bond F = principal amount (par value) of the bond repayable at the time of maturity n = maturity period of the bond. Example: A Rs. 100 par value bond, bearing a coupon rate of 12 per cent, will mature after 8 years. The required rate of return on this bond is 14 per cent. What is the value of this bond? Since, the annual interest payment will be Rs. 12 for 8 years and the principal repayment will be Rs. 100 at the end of 8 years, the value of the bond will be:

Example: A Rs. 1,000 par value bond, bearing a coupon rate of 14 per cent, will mature after 5 years. The required rate of return on this bond is 13 per cent. What is the value of this bond? Since, the annual interest payment will be Rs. 140 for 5 years and the principal repayment will be Rs. 1,000 at the end of 5 years, the value of the bond will be:

c) Bond Value Theorems Based on the bond valuation model, several bond value theorems have been derived. They state the effect of the following factors on bond values: 1. Relationship between the required rate of return and the coupon rate. 2. Number of years to maturity.


The following theorem show how bond values are influenced by the relationship between the required rate of return and the coupon rate. Ia When the required rate of return is equal to the coupon rate, the value of a bond is equal to its par value. lb When the required rate of return is greater than the coupon rate, the value of a bond is less than its par value. Ic When the required rate of return is less than the coupon rate, the value of a bond is more than its par value. To illustrate the above theorems let us consider a bond of Magnum Limited, which has the following features:

What happens to the value of Magnum’s bond when the required rate of return is 14 per cent? 16 per cent? 12 per cent? If the required rate of return is 14 per cent (which is the same as the coupon rate), the bond value is:

If the required rate of return is 16 per cent (which is higher than the coupon rate), the bond value is:


If the required rate of return is 12 per cent (which is lower than the coupon rate), the bond value is:

The following theorems express the effect of the number of years to maturity on bond values. IIa When the required rate of return is greater than the coupon rate, the discount on the bond declines as maturity approaches. IIb When the required rate of return is less than the coupon rate, the premium on the bond declines as maturity approaches. IIc The longer the maturity of a bond, the greater its price change in response to a given change in the required rate of return. To illustrate the above theorems, let us consider a bond of Sharath Limited which has the following features:

If the required rate of return on this bond is 15 per cent, it will have a value of:

One year from now, when the matuirty period will be 7 years, the bond will have a value of:


Given the required rate of return of 15 per cent, the bond will increase in value with the passage of time, until it matures, as follows:

The lower curve in the following figure represents how the bond value will behave as a function of years to maturity.

figure 4.1 Bond Value as a Function of Years to Maturity If the required rate of return on the bond of Bharath Limited is 11 percent it will have a value of:


One year from now, when the maturity period will be 7 years, the bond will have a value of:

Given the required rate of return of II percent, the bond value will decrease with the passage of time, until it matures, as follows:

The upper curve in Fig 4.1 above represents how the bond value will behave as a function of years to maturity. To show that the longer the maturity of a bond, the greater is its price change in response to a given change in the required rate of return, we may refer to Fig. 4.1 When the required return decreases from 15 per cent to 11 per cent, given a maturity period of 7 years, the value of the bond increases from Rs. 916.8 to Rs. 1,094.6, an increase of 19A percent. However, if the same change in the required rate of return occurs with only 2 years to maturity, the bond value would rise from Rs. 967.4 to Rs. 1,034.7—an increase of only 7.0 per cent. To further illustrate the theorem , consider two bonds A and B, which are alike in all respects except their period of maturity.


What happens if the required rate of return on these two bonds rises to 14 per cent, or falls to 10 percent? The prices of these bonds will behave as follows:

From the above data, it is clear that the percentage price change in bond B (the bond with longer maturity) is higher compared to the percentage price change in bond A (the bond with shorter maturity) for given changes in the required rate of return. d) Yield to Maturity (YTM) Suppose the market price of a Rs. 1,000 par value bond, carrying a coupon rate of 9 percent and maturing after 8 years, is Rs. 800. What rate of return would an investor earn if he buys this bond and holds it till its maturity? The rate of return that he earns, called the yield to maturity (YTM hereafter), is the value of led in the following equation:

To find the value of led which satisfies the above equation, we may have to try several values of led till we ‘hit’ on the right value. Let us begin, with a discount rate of 12 percent. Putting a value of 12 percent for led we find that the right-hand side of the above expression becomes equal to:

Since, this value is greater than Rs. 800, we have to try a higher value for led. Let us try led = 14 percent. This makes the right-hand side equal to:


Since, this value is less than Rs. 800, we try a lower value for k, Let us k d = 13 percent. This makes the right-hand side equal to:

Thus, d lies between 13 percent and 14 percent. Using a linear interpolation in the range 13 percent to 14 percent, we find that Ic is equal to 13.2 per cent.

In approximation if you are not inclined to follow the trial-and-error approach described above, you can employ the following formula to find the approximate YTM n a bond:

Example: The price per bond of Zion Limited is Rs. 90. The bond has a par value of Rs. 100, a coupon rate of 14 per cent, and a maturity period of 6 years. What is he yield to maturity? Using the approximate formula the yield to maturity on the bond of Zion works out to:


e) Bond Values with Semi-annual Interest Most of the bonds pay interest semi-annually. To value such bonds, we have to work with a unit period of six months, and not one year. This means that the bond valuation equation has to be modified along the following lines: The annual interest payment, 1, must be divided by two to obtain the semi-annual interest payment. The number of years to maturity must be multiplied by two to get the number of half-yearly periods. The discount rate has to be divided by two to get the discount rate applicable to half-yearly periods. With the above modifications, the basic bond valuation equation becomes: The procedure for linear interpolation is as follows: (a) Find the difference between the present values for the two rates, which in this case is Rs. 39.9 (Rs. 808—Rs. 768.1). (b) Find the difference between the present value corresponding to the lower rate (Rs. 808 at 13 per cent) and the target value (Rs. 800). which in this case is Rs. 8.0. (c) Divide the outcome of (b) with the outcome of (a), which is 8.0139.9 or 0.2. Add this fraction to the lower rate, i.e., 13 percent. This gives the YTM of 13.2 percent.

Where V = value of the bond 1/2 = semi-annual interest payment


kd/2 = discount rate applicable to a half-year period F = par value of the bond repayable at maturity 2n = maturity period expressed in terms of half-yearly periods. Example: A Rs. 100 par value bond carries a coupon rate of 12 per cent and a maturity period of 8 years. Interest is payable semi-annually. Compute the value of the bond if the required rate of return is 14 per cent. Applying Eq. (6.4), the value of the bond is:

Equity Valuation: Divided Capitalization approach According to the dividend capitalization approach, a conceptually very sound approach, the value of an equity share is equal to the present value of dividends expected from its ownership plus the present value of the resale price expected when the equity share is sold. For applying the dividend capitalisation approach to equity stock valuation, we will make the following assumptions: (i) dividends are paid annually—this seems to be a common practice for business firms in India; and (ii) the first dividend is received one year after the equity share is bought. Single-Period Valuation Model Let us begin with the case where the investor expects to hold the equity share for one year. The price of the equity share will be:

Where P0 = current price of the equity share


D1= dividend expected a year hence P1 = price of the share expected a year hence ks= rate of return required on the equity share. Example: Prestige’s equity share is expected to provide a dividend of Rs. 2.00 and fetch a price of Rs. 18.00 a year hence. What price would it sell for now if investors’ required rate of return is 12 per cent 7 The current price will be

What happens if the price of the equity share is expected to grow at a rate of g percent annually 7 If the current price. F0, becomes P0 (1+g) a year hence, we get:

Simplifying Eq. We get,

Example: The expected dividend per share on the equity share of Road king Limited is Rs. 2.00. The dividend per share of Road king Limited has grown over the past five years at the rate of 5 percent per year. This growth rate will continue in future. Further, the market price of the equity share of Road king Limited, too, is expected to grow at the same rate. What is a fair estimate of the intrinsic value of the equity share of Road king Limited if the required rate is 15 percent? Applying Eq. we get the following estimate:


Expected Rate of Return In the preceding discussion we calculated the intrinsic value of an equity share, given information about (i) the forecast values of dividend and share price, and (ii) the required rate of return. Now, we look at a different question: What rate of return can the investor expect, given the current market price and forecast values of dividend and sham price? The expected rate of return is equal to:

Example: The expected dividend per share of Vaibhav Limited is Rs. 5.00. The dividend is expected to grow at the rate of 6 percent per year. If the price per share now is Rs. 50.00, what is the expected rate of return? Applying Eq. the expected rate of return is:

Multi-Period Valuation Model Having learnt the basics of equity share valuation in a single-period frame-work, we now, discuss the more realistic, and also the most complex, case of multiperiod valuation. Since, equity shares have no maturity period, they may be expected to bring a dividend stream of infinite duration. Hence, the value of an equity share may be put as:

‘The steps in simplification are:


P0 = where Po = price of the equity share today D1= dividend expected a year hence D2= dividend expected two years hence Doo = dividend expected at the end of infinity. Equation above represents the valuation model for an infinite horizon. Is it applicable to a finite horizon? Yes. To demonstrate this consider how an equity share would be valued by an investor who plans to hold it for n years, and sell it thereafter for a price of P. The value of the equity share to him is:

Now, what is the value of Pn, in Eq. Applying the dividend capitalization principle, the value of F, would be the present value of the dividend stream beyond the nth period, evaluated as at the end of the nth year. This means:


Substituting this value of P in Eq. (6.10) we get:

We discuss below three cases: (i) Constant dividends, (ii) constant growth of dividends, and (iii) changing growth rates of dividends. Valuation with Constant Dividends If we assume that the dividend per share remains constant year after year at a value of 1), the Eq. becomes:

Equation on simplification, becomes

Valuation with Constant Growth of Dividends


Most stock valuation models are based on the assumption that dividends tend to increase over time. This is a reasonable hypothesis because business firms typically grow over time. If we assume that dividends grow at a constant compound rate, we get:

The dividend 5 years hence will be: Example: The current dividend (D0) for an equity share is Rs. 3.00. If the constant compound growth rate is 6 percent, what will be the dividend 5 years hence? It will be:

When the dividend increases at a constant compound rate, the share valuation equation becomes:

Eq. simplifies to:

Example: Ramesh Engineering Limited is expected to grow at the rate of 6 percent per annum. The dividend expected on Ramesh’s equity share a year hence is Rs.2.00. What price will you put on it if your required rate of return for this share is 14 percent? The price of Ramesh’s equity share would be:

Changing Growth rates of Dividends


Many firms enjoy a period of super normal growth which is followed by a normal rate of growth. Assuming that the dividends move in line with the growth rate, the price of the equity share of such a firm is:

where P0 =price of the equity share D1 = dividend expected a year hence ga = super-normal growth rate of dividend. gn = normal growth rate of dividends. To compute the value of P0 in Eq. (6.18), the following procedure may be employed. Step 1. Specify the dividend stream expected during the initial period of supernormal growth. Find the present value of this dividend stream. Using the symbols presented earlier, this can be represented as: Step 2. Calculate the value of the share at the end of the initial growth period,

(As per the constant growth model), and discount this value to the present. In terms of our symbols, this discounted value is:

Step 3. Add the above two present-value components to find the value of the share, P0. as given below:


Present value Present value of the of the dividend value of the share at stream during the end of the initial the initial period period

To illustrate the above procedure let us consider the equity share of Vertigo Limited: D0= current dividend per share = Rs. 2.00 n = duration of the period of super-normal growth = 4 years = growth rate during the period of super-normal growth = 20 per cent ga= normal growth rate after the super-normal growth period is over = 5 per cent gn = equity investors required rate of return = 12 per cent Step 1. The dividend stream during the supernormal growth period will be:

Step 2. The price of the share at the end of 4 years, applying the constant growth model at that point of time, will be:


Step 3. The sum of the above components is: P0 = Rs. 9.54 + Rs. 39.53 = Rs. 49.07 The following figure presents a graphic view, in terms of a time line diagram, of the above procedure.

figure 4.2 Time line diagram Impact of Growth on Price, Returns, and P/E Ratio The expected growth rates of companies differ widely. Some companies are expected to remain virtually stagnant; other companies are expected to show normal growth; still others are expected to achieve super-normal growth rate. Assuming a constant total required return, differing expected growth rates mean differing stock prices, dividend yields, capital gains yields, and price-earnings ratios. To illustrate, consider three cases:


The expected earnings per share and dividend per share of each of the three firms are Rs. 3.00 and Rs. 2.00 respectively. Investors’ required total return from equity investments is 15 per cent. Given the above information, we may calculate the stock price, dividend yield, capital gains yield, and price-earnings ratio for the three cases as shown in Table 1. Table 1 Price, Dividend yield, Capital gains yield, and Price-earnings ratio under Differing growth assumptions for 15 percent return

The results in Table 1 suggest the following points: 1. As the expected growth in dividend increases, other things being equal, the expected return’ depends more on the capital gains yield and less on the dividend yield. 2. As the expected growth rate in dividend increases, other things being equal, the priceearnings ratio increases. 3. High dividend yield and low price-earnings ratio imply limited growth prospects. 4. Low dividend yield and high price-earnings ratio imply considerable growth prospects. Equity Valuation: Ratio Approach


While conceptually the dividend capitalization approach is unassailable, it is often not as widely practised as it should be. Practitioners seem to prefer the ratio approach, largely because of its simplicity. The kinds of ratios employed in the context of valuation are discussed below. Book Value The book value per share is simply the net worth of the company (which is equal to paid up equity capital plus reserves and surplus) divided by the number of outstanding equity shares. For example, if the net worth of Zenith Limited is Rs. 37 million and the number of outstanding equity shares of Zenith is 2 million, the book value per share works out to Rs. 18.50 Qts. 37 mitlion divided by 2 million). How relevant and useful is the book value per share as a measure of investment value? The book value per sham is firmly rooted in financial accounting and hence can be established relatively easily. Due to this, its proponents argue that it represents. It may be noted that total return is the sum of the dividend yield and capital gains yield:

Total return = Dividend yield + Capital gains yield an ‘objective’ measure of value. A closer examination, however, quickly reveals that what is regarded as ‘objective’ is based on accounting conventions and policies which are characterised by a great deal of subjectivity and arbitrariness. An allied, and a more powerful, criticism against the book value measure is that the historical balance sheet figures on which it is based are often very divergent from current economic values. Balance sheet figures rarely reflect earnings power and hence the book value per share cannot be regarded as a good proxy for true investment value. Liquidation Value The liquidation value per share is equal to


To illustrate, assume that Pioneer Industries would realise Rs. 45 million from the liquidation of its assets and pay Rs. 18 million to its creditors and preference shareholders in full settlement of their claims. If the number of outstanding equity shares of Pioneer is 1.5 million, the liquidation value per share works out to:

While the liquidation value appears more realistic than the book value, there are two serious problems in applying it. First, it is very difficult to estimate what amounts would be realised from the liquidation of various assets. Second, the liquidation value does not reflect earnings capacity. Given these problems, the measure of liquidation value seems to make sense only for firms which are ‘better dead than alive’ — such firms are not viable and economic values cannot be established for them. Price/Earnings Ratio Traditionally, financial analysts have employed price-earnings ratio models more than dividend capitalization models. According to the price-earnings ratio approach, the intrinsic value of a share is expressed as: Expected earnings per share x appropriate price-earnings ratio The expected earnings per share is defined as:

While the preference dividend and the number of outstanding equity shares can be defined in certain near terms, the expected profit after tax is rather difficult to estimate. To get a reasonable handle over it the following factors, inter alia, need to be examined: sales, gross profit margin,


depreciation, interest burden, and tax rate. Some financial analysts, instead of working with the expected earnings per share for next year, use an estimate of normal earnings per share This represents what earnings per share would be under normal circumstances. To establish the appropriate price-earnings ratio for a given share, one may, to begin with, consider the price-earnings ratio for the market as a whole and also for the industrial grouping to which the share belongs. The next step would be to judge the price-earnings ratio applicable to the particular share under consideration. In forming this judgment the following factors may be taken into account: 1. Growth rate 2. Stability of earnings 3. Size of the company 4. Quality of management 5. Dividend payout ratio While it is difficult to quantify the impact of these factors on the price-earnings ratio, the following qualitative observations may be made: the higher the growth rate, the higher the priceearnings ratio; the greater the stability of earnings, the higher the price-earnings ratio; the larger the size of the company, the higher the price- earnings ratio; the higher the dividend payout ratio, the higher the price-earning ratio. The popularity of the price-earnings ratio approach seems to stem from two main advantages: (i) Since the price-earnings ratio reflects the price per rupee of earnings, it provides a convenient measure for comparing the prices of shares which have different levels of earnings per share. (ii) The estimates required for using the price-earnings ratio approach are fewer in comparison to the estimates required for applying the dividend capitalization approach. While these advantages make the price-earnings approach attractive to the practitioner, it must be emphasised that this approach, as it is practised, does not have a sound conceptual basis — the estimate of the priceearnings ratio does not have a firm theoretical underpinning. Should an attempt be made to develop a sound conceptual basis for this approach, it becomes identical to the dividend capitalization approach.


Have you understood? 1. Discuss the basic bond valuation model. 2. When the required rate of return is equal to/greater than/less than the coupon rate, the value of a bond is equal to/less than/more than its par value.’ Illustrate this with a numerical example. 3. "When the required rate of return is greater than/less than the coupon rate the discount/premium on the bond declines as maturity approaches." Illustrate this with a numerical example. 4. "The longer the maturity of a bond, the greater its price change in response to a given change in the required rate of return." Illustrate this with a numerical example. 5. Explain and illustrate the concept of yield to maturity. 6. State the formula for valuing a bond which pays interest semi-annually and which is redeemable. 7. What is the expected rate of return on an equity share when dividends are expected to grow at a constant annual rate? 8. Discuss the valuation of an equity share with variable growth in dividends. 9. Discuss the impact of growth on price, dividend yield, capital gains yield, and priceearnings ratio. 10. How relevant and useful is the book value per share as a measure of investment value? 11. What are the limitations of the liquidation value approach? 12. What factors are relevant in establishing an appropriate price-earnings ratio for a given share? What is the likely effect of these factors on the price-earnings ratio? 13. What are the advantages and limitation of the price-earnings ratio approach?


UNIT – II INVESTMENT DECISIONS INTRODUCTION Capital budgeting is budgeting for capital projects. The exercise involves ascertaining and estimating cash inflows and outflows, matching the cash inflows with outflows appropriately and evaluation of the desirability of the project, under consideration. Learning Objectives: after reading this lesson, you will be conversant with: 1. The nature of investment decisions 2. Scanning and identification of investment opportunities 3. Criteria for preliminary screening 4. Preparation of cash flow projections for projects 5. Assessing the financial viability of projects using the various appraisal criteria. SECTION TITLE Capital Projects Businesses investments in capital projects are of different nature. These capital projects involve investment in physical assets, as opposed to financial assets like shares, bonds or funds. Capital projects necessarily involve processing, manufacturing or service works. These require investments with a longer time horizon. The initial investment is heavy in fixed assets and investment in permanent working capital is also heavy. The benefits from the projects last for few to many years. Capital projects may be new ones, expansion of existing ones, diversification of existing ones, renovation or rehabilitation of projects, R&D activities, or captive service projects. An enterprise may put up a new subsidiary, increase stake in existing subsidiary or acquire a running firm. All these are considered as capital projects.


Capital projects involve huge outlay and it will last for years. Hence, these are riskier than investments in financial assets. Capital projects have technological dimensions and environmental dimensions. So, careful analysis is needed. Decisions once taken cannot be easily reversed in respect of capital projects and therefore thorough evaluation of costs and benefits is needed. Significance of Capital Budgeting Every business has to commit funds in fixed assets and permanent working capital. The type of fixed assets that a firm owns influences i) the pattern of its cost (i.e. high or low fixed cost per unit given a certain volume of production), ii) the minimum price the firm has to charge per unit of production iii) the break-even position of the company, iv) the operating leverage of the business and so on. These are all very vital issues shaping the profitability and risk complexion of the business. Capital budgeting is significant because it deals with the right kind of evaluation of projects. A project must be scientifically evaluated, so that no undue favor or dis-favor is shown. A good project must not be rejected and a bad project must not be selected. Capital investment proposals involve i) longer gestation period, ii). huge capital outlay, iii) technological considerations needing technological forecasting, iv) environmental issues too, which require the extension of the scope of evaluation to go beyond economic costs and benefits, v) irreversible decision once committed, vi) considerable peep into the future which is normally very difficult, vii) measuring of and dealing with project risks which is a daunting task in deed and so on. All these make capital budgeting a significant task. Capital budgeting involves capital rationing. That is, the available funds must be allocated to competing project in the order of project potentials. Usually, the indivisibility of project poses the problem of capital rationing because required funds and available funds may not be the same. A slightly high return projects involving higher outlay may have to be skipped to choose one with slightly lower return but requiring less outlay. This type of trade-off has to be skillfully made.


The building blocks of capital budgeting exercise are mostly estimates of price and variable cost per unit output, quantity of output that can be sold, the tax rate, the cost of capital, the useful life of the project, etc. over a period of years. A clear system of forecasting is also needed. What should be the discount rate? Should it be the pre-tax overall cost of capital? Or the post-tax overall cost of capital? The choice is very crucial in making capital budgeting exercises a significant one. Finally, which is the appropriate method of evaluation of projects. There are over a dozen or more methods. The choice of method is important. And different methods might rank projects differently leading to a complex picture of project desirability ranks. A clear thinking is needed so that confusion is not descending on the choice of projects. Appraisal of Capital Projects Appraisal means examination and evaluation. Capital projects need to be thoroughly appraised as to costs and benefits. The costs of capital projects include the initial investment at the inception of the project. Initial investment made in land, building, machinery, plant, equipment, furniture,fixtures, etc. generally, gives the installed capacity. Investment in these fixed assets is one time. Further, a one-time investment in working capital is needed in the beginning, which is fully salvaged at the end of the life of the project. Against this committed returns in the form of net cash earnings are expected. These are computed as follows. Let ‘P’ stand for price per unit, ‘V’ for variable cost per unit, ‘Q’ for quantity produced and sold, ‘F’ stand for total fixed expenses exclusive of depreciation, ‘0’ stand for depreciation on fixed assets, ‘I’ for interest on borrowed capital id ‘T’ for tax rate). Then, cash earnings = [(P-V) Q-F-D-I](1-T)+D These cash earnings have to be estimated throughout the economic life of the investment. That is, all the variables in the equation have to be forecasted well over a period of years.


Now, that we have the benefits from the investment estimated, the same may be compared with costs of the capital project and ‘netted’ to find out whether costs exceed benefits or benefits exceed costs. This process of estimation of costs and benefits and comparison of the same is called appraisal. Payback period, accounting rate of return, net present value, rate of return, decision tree technique, sensitivity analysis, simulation and capital asset pricing model (CAPM) are certain methods of appraisal. Requisites for Appraisal of Capital Projects The computation of profit after tax and cash flow is relevant in evaluation of projects. Hence, this is presented here as a prelude to the better understanding of the whole process. Say in fixed assets at time zero, you are investing Rs.20 lakhs. You have estimated the following for the next 4 years. Table 1

With this information, we can estimate profit after tax for the business. For that, apart from the given variable expenses and fixed expenses, depreciation on the fixed assets also is to be considered. The annual depreciation is given by the cost of fixed assets divided by number of


years of economic life of the respective asset. In our case, the figure comes to Rs. 20,00,000/4 = Rs.5 lakhs per annum. The calculations are given in three stages, viz. computation of profit before tax (PBT), profit after tax (PAT) and cash flow. The profit before tax (PBT) for a period is given by: (selling price per unit - variable cost per unit) * (No. of units sold) - Fixed expenses - Depreciation. So, for the 1st year PBT = (200-100) (30000) - 12,00,000 - 5,00,000 = 30,00,000 - 47,00,000 = 13,00,000. Table gives the working and results. Table 2

Profit after tax (PAT) for the different years is obtained by subtracting tax from the PBT. Profit after tax = PAT = PBT (1-Tax Rate). So, for the first year PAT = 13,00,000 (1-30%) = 13,00,000 (0.7) = 9,10,000. Similarly, for the other years the profit figures can be obtained as in table 3 Table 3


Cash flow from business is equal to PAT plus depreciation. Table 3 gives cash flow from business. TABLE 4

Methods used for Projects Appraisal A. Payback Period (PBP) Method Pay back period refers to the number of years one has to wait to setback the capital invested in fixed assets in the beginning. For this, we have to get cash flow from business. We have invested Rs. 20,00,000 at time zero. After one year, a sum of Rs.14, 10,000 is returned. By next year, a sum of Rs. 19,70,000 is returned. But we have to get back only Rs. 5,90,000 (i.e.,


20,00,000 - 14,10,000). So, in the second year we have to wait only for part of the year to get back Rs. 5,90,000. The part of the year = 5.90,000/ 19,70,000 = 0.30 that is, pay back period is 1.30 years or 1 year, 3 months and 19 days. In general payback period is given by ‘n’ in the equation

Where ‘t’ 1 to n, I = initial investment, CF = cash flow at time ‘t’ and t = time measured in years. Normally, businesses are want projects that have lower pay back period, because the invested money is got back very soon. As future is risky, the earlier one gets back the money invested, the better for the business. Some businesses fix a maximum limit on pay back period. This is the cutoff pay back period, serving as the decision criterion. Accordingly, a pay back period ceiling of 3 years means, only projects with payback period equal to or less than 3 years will be accepted and others will be rejected. Merits of payback period 1. It is cash flow based which is a definite concept 2. Liquidity aspect is taken care of well 3. Risky projects are avoided by going for low gestation period projects 4. It is simple and common sense oriented Demerits of payback period 1. Time value of money is not considered as earnings of all years are simply added together 2. Explicit consideration for risk is not involved 3. Post-payback period profitability is ignored totally. B. Accounting Rate of Return (ARR) Method


Here, the accounting rate of return (ARR) on an investment is calculated. It is also called as the average rate of return. To compute ARR, average annual profit is calculated. From the PBT for different years, average annual PBT can be calculated. The average annual PBT = Total PBT I No. of years Average annual PBT = 46,00,000/4 = Rs.11, 50,000 ARR = AAPBT / Investment = 11,50,000/20,00,000 = 0.574 = 57.4% The denominator can be an average investment, i.e., (original value plus terminal value)/2.Here it is 10 lakhs. Then the ARR will be Rs.11, 50,000/ Rs.l0,00,000 = 1.15% ARR can also be computed on the basis of Profit After Tax (PAT). The Average Annual PAT / Original investment. Average Annual PAT = Total PAT/ No. of years = 31,00,000 / 4 = 7,75,000 So, ARR = 7,75,000 / 20,00,00 = 0.3875 = 38.75% The denominator can be the average investment, instead of actual investment, then ARR is = Rs.7, 75,000 / Rs. 10,00,000=0.775 or 77.5%. Merits of ARR 1. It is simple and common sense oriented. 2. Profits of all years are taken into account. Demerits of ARR


i. ii. iii.

Time value of money is not considered. Risk involved in the project is not considered. Annual average profits might be the same for different projects but accrual of profits might differ having significant implications on risk and liquidity.


The ARR has several variants and it lacks uniformity.

A minimum ARR is fixed as the benchmark rate or cut-off rate. The estimated ARR for an investment must be equal to or more than this benchmark or cut-off rate so that the investment or project is chosen. C. Net Present Value (NPV) Method Net present value is computed given the original investment, annual cash flows (PAT + Depreciation) and required rate of return which is equal to cost of capital. Given these, NPV is calculated as follows

I = Original or initial investment CFt = annual cash flows K = cost of capital and t= time measured in years. For the problem, we have done under the pay back period method, we can get the NPV, taking k = say 10% or 0.1,then the NPV= -I + CF1 /(1+k) 1 + CF2 /(1+k) 2 + CF3 I (1+k) 3 + CF4 (l+k) 4 = -20,00,000 + 14, l0, 000/l.l + 19,70000 / 1.12 + l 1,60,000 / 1.13+


5,60,000 / 1.14 = -20,00,000 + 14,10,000 x 0 .909 + 19,70,000 x 0.826 + 11,60,000 x 0.751 + 5,60,000 x 0.683 = - 20,00,000 + 12,81,818 + 16,28,099 + 8,71,525 + 3,79,042 = - 20,00,000 + 41,60,484 = Rs. 21,60,484 If it is required that k= 10%, 11%, 12% and 13% respectively, for years 1 through year 4, the formula is written as follows. NPV = -I+CFt/(l+kt) t = - I + CF1 / (1+k1) 1 + CF2 / (l+k2) 2 + CF3 /(1+k3) 3 + CF4/(1+k4) 4 In the above example, NPV = -20,00,000+14,10,000/1.1+19,70,000/1.112+1 1,60,000/1. 123+ 5,60,000/1.134 =-20,00,000 +14,10,000 x 0.909+19,70,000 x 0.817 + 11,60,000 x 0.712 + 5,60,00 x 0.635 = - 20,00,000 + 40,49,482 = Rs. 20,49,482 If the NPV = 0’ or greater than zero, the project can be taken. Incase, there are several mutually exclusive projects with NPV >0, we will select the one with highest NPV. In the case of mutually inclusive projects you first take up the one with the highest NPV and next the project with next highest NPV, and so on as long as your funds for investment lasts. The factor "k" need not be same for all projects. It can be high for projects whose cash flows suffer greater fluctuations due to risk, and lower for projects with lower fluctuations risk. D. Internal Rate of Return (IRR) Method


Internal Rate of Return (IRR) is the value of ‘k" in the equation, I + Z CF / (l+k) t = 0. In other words, IRR is that value of "k" for which aggregated discounted value of cash flows from the project is equal to original investment in the project. When manually computed, "k" i.e., IRR is got through trial and error. Suppose for a particular value of I +E CF1 I (l+k) t >0, we have to use a higher ‘k’ in our trial and if the value is <0, a lower ‘k’ has to employed next time. Then, you can interpolate k. The value of ‘k’ thus got is the IRR. Decision Tree Approach Decision tree approach is a versatile tool used for decision-making under conditions of risk. The features of this approach are: (1) it takes into account the results of all expected outcomes, (ii) it is suitable where decisions are to be made in sequential parts - that is, if this has happened already, what will happen next and what decision has to follow, (iii) every possible outcome is weighed using joint probability model and expected outcome worked out, (iv) a tree-form pictorial presentation of all possible outcomes is presented here and hence, the term decision-tree is used. An example, will make understanding easier. An entrepreneur is interested in a project, say introduction of a fashion product for which a 2 year market span is foreseen, after which the product turns fade and that within the two years all money invested must be realised back in full. The project costs Rs. 4,00,000 at the time of inception. During the 1st year, three possible market outcomes are foreseen. Low penetration, moderate penetration and high penetration are the three outcomes, whose probability values, respectively, are 0.3, (i.e., 30% chance), 0.4 and 03 and the cash flows after tax under the three possible outcomes are respectively estimated to be Rs. 1,60,000, Rs. 2,20,000 and Rs. 3,00,000. The level of penetration during the 2nd year is influenced by the level of penetration in the first year. The probability values of different penetration levels in the 2nd year, given the level of penetration in the 1st year and respective cash flows are estimated as follows: TABLE 5


If low penetration resulted in 1st year, low penetration in 2nd year with probability of 0.2 and cash flow of Rs.80, 000, moderate penetration in 2 year with probability of 0.6 and cash flow of Rs.2, 00,000 and high penetration in 2" year with probability of 0.2 and cash flow of Rs.3, 00,000 are possible. Similarly, you can follow for other cases. Combining 1st and 2nd year penetration levels together, 9 outcomes are possible. These are: TABLE 6


At this stage, we may go for present value evaluation of these sets of outcomes. And this is done below. For this, we require a discounting rate. Let us take a 10% discount rate. Then the present value of Rs.1 receivable at 1st year end is Rs.0.909 (i.e. 1/1.1) and at 2nd 1 year end it Rs.0.826 (i.e., 1/1.12). Now, the present values of the 9 cash flow streams can be worked out. These values, the NPV relevant to each stream (i.e., the aggregate of the present value of the two cash flows of each stream minus investment of Rs.4,00,000), joint probability (i.e., product of probabilities of the two cash flows of each stream) and expected value of NPV (i.e., joint probability times NPV of each stream) are given below in table 7.

The expected NPV of the project is negative at Rs.12269, if low penetration prevailed both in the 1st and 2nd years and this has a probability of 6 out of 100 or .06. The expected NPV is negative at Rs.16085, if low penetration in 1st year and moderate penetration in 2nd year have prevailed and the probability of this happening is 18%. Outcome 8 shows that NPV of Rs.48, 744 with


probability of 24% is possible when high penetration in 1st year and moderate penetration in the 2nd year result. The expected NPV of the project is the aggregate of the expected NPV of the different streams = Rs.47395. Since, it is positive, the project may be taken up. Capital Asset Pricing Model (CAPM) Capital Asset Pricing Model (CAPM) is one of the premier methods of evaluation of capital investment proposals. CAPM gives a mechanism by which the required rate of return for a diversified portfolio of projects can be calculated given the risk. According to CAPM, the required rate of return comprises of two parts: first, a risk-free rate of return and second a risk premium for the amount of systematic risk of the portfolio. The formula is: Required rate of return = Rf + (Rm -Rf) Bi, where R1- risk free rate of return Rm- return on market portfolio Bi- Beta or risk coefficient of the evaluated portfolio given market portfolio beta = 1 CAPM, therefore, gives a risk-return relationship for the portfolio of various projects. CAM technique for evaluating capital projects We have to calculate the required rate of return for the capital project given its beta coefficient, risk free return and market return. Then, get the estimated return for the project. If the estimated return for the project is greater than or equal to the required rate of return, accept the project. Otherwise, reject the project. The risk-free return is the rate of return obtainable on risk free investments, like investment in any government securities. Simulation Analysis


When uncertainty haunts the estimation of variables in a capital budgeting exercise, simulation technique may be used with respect to a few of the variables, taking the other variables at their best estimates. P, V, F, Q, T, K, I, D and N are the important variables. (P -Price per unit of output, V -. Variable cost per unit of output, F - Fixed cost of operation, Q - Quantity of output, T - Tax rate, K - Discount rate or cost of capital, I - Original investment, D - Annual depreciation and N Number of years of the project’s life). Suppose, in a project, P, V, F, Q, N and I arc fairly predictable but k and ‘T’ are playing truant. In such cases, the K and T will be dealt through simulation while others are take at given values. Suppose, that P = Rs.300/unit, V = Rs. 150/unit, F = l5,00,000/p.a,

Q = 2O,000/p.a, N = 3 years and I = Rs.18,00,000. Then rural profit before tax = [(P-V) Q] - F D = [(300-I 50)*200001 - 15,00.000 - 000 = Rs. 9,00,000/p.a. The profit after tax and hence cash flow cannot be computed as tax rate, T is not predictable. Further, as ‘k’ is also redictable, present value cannot be computed as well. So, we use simulation here. Simulation process gives a probability distribution to each of the truant playing variables. Let the probability distribution for ‘T’ and ‘K’ be as follows:

Next, we construct cumulative probability and assign number ranges, separately for T and K. Two digit random n ranges are used. We start with 00 and end with 99, thus using 100 numbers.


For the different values of the variable in question, as many random numbers as are equal to the probability values of respective values are used. Thus, for variable T, 20% of random numbers aggregated for its first 30% and 50% of random number for its next value 35% and 40%.

For the first value of the unpredictable variable, we assign random numbers 00 to 19. For the second value we assign random numbers 20—69 and for the third value random numbers 70 - 99 are assigned. Similarly, for the variable ‘K’ also random numbers are assigned as given in table 6. Simulation process now involves reading from random number table, random number pairs (one for ‘T’ and another for ‘K’). The values of ‘T’ and ‘K’ corresponding to the random numbers read are taken from the above table. Suppose the random numbers read are: 48 and 80. Then ‘T’ is 35% and the random number 48 falls in the random number range 20-69 corresponding to 35% and ‘K’ is 12% as the random number 80 fails in the random number range 80 -99 corresponding to 12%. Now taking the T = 35% and K = 12%. the NPV of the project can be worked out. We know that the project gives a PAT of Rs.9,00,000 p/a for 3 years. So, the PAT = 9,00,000 – Tax @ 35% = Rs.9,00,000 - 3,15,000 Rs.5,85,000 pa. To this, we have to add depreciation of Rs.6,00,000 (i.e. Rs.18,00,000 / 3 years) to get the cash flow. So, the cash flow= 5,85,000 + 6,00,000= Rs. 11,85,000 p.a.


= (11,85,000 /1.12 + 11,85,000/1.122 + 11,85,000 / 1, 123) -18,00,000 = 11,85,000 [1/1.12 + 1/1.122 + 1/1.12] - 18,00,000 = 1l, 85,000 x 2.4018 - 18,00,000 = 28,56,798 - 18,00,000 = Rs. 10,56,798 We have just taken one pair of random numbers from the table and calculated the NPV as Rs.l0, 56,798. This process must be repeated at least 20 times, reading 20 pairs of random numbers and getting the NPV for values of T and K corresponding to each pair of random numbers read. Suppose the next pair of random numbers are 28 and 49: Corresponding ‘T’ = 35% and ‘K’ = 11%. Then the PAT = PBT - T = Rs.9, 00,000 – Rs.3, 15,000 =Rs. 5,85,000. The cash flow = Rs 5,85,000 + Rs.6, 00,000 = Rs. 11,85,000.

=(Rs.11, 85,000/1.11+Rs.11, 85,000/1.112+Rs.11, 85,000/1.113)- Rs.18, 00,000 = (Rs.10, 67,598 +Rs. 9,6 1,773 +Rs. 8,66,462) –Rs. 18,00,000 = Rs.28, 95,803 –Rs. 18,00,000 = Rs.10, 95,803 Similarly, the NPV for other simulations can be obtained. NPVs may be averaged if the same is positive. Sensitivity Analysis Sensitivity analysis attempts to study the level of sensitivity of the project say the NPV, for changes in a key influencing factor, keeping the influence of all other influencing factors at constant level.


Sensitivity analysis presumes uncertainty of the values of all or some of the influencing factors. For such factors, the range of their values and most likely values are given. Other factors are taken at constant values. We know, that NPV of a project is influenced by P, V, Q, F, 1, N, T and K. Let F, 1, N, D and K be constant at Rs.15, 00,000, Rs.18, 00,000, 3 years, Rs.6, 00,000 and 15% respectively P, V, Q and T and let the uncertain variables. Let their range of values and most likely values be as follows: P: Rs.200-Rs.350; Most Likely value is Rs.300 V Rs.100-Rs.250; Most Likely value is Rs.150 Q: 15000-22000; Most Likely quantity is 20,000 T: 30%-40%; Most Likely rate is 35% Suppose, we want to study the sensitivity of NW with respect to ‘T’. then other uncertain variables, namely, V and Q will be assigned their most likely values. Needless to say, the variables taking constant values will take their fixed values. The variable T’ will be taking different values within the range of its values for each such values of T. The NPV will be worked out and sensitivity of the NPV to that factor also be analysed. Accordingly, for our purpose: I = Rs. 18,00,000, N = 3 years, D = Rs.6, 00,000, F = Rs.15, 00,000, k = 15%. P, V and Q at their most likely values are Rs.300, Rs. 150 and 20,000 units. ‘T’ shall take different values within its range; say 30%, 32.5%, 35%, 37.5% and 40%. For each of these 5 values of T, NPV will be worked out and sensitivity of NW be analysed. First let T be 30%. The annual cash flow is: = [(P-V) Q - F - D] (J-T) + D = [(Rs.300-Rs.150) 20000units-Rs.15, 00,000–Rs.6, 00,000](1-30%) + Rs.6, 00,000 = [Rs.30, 00,000 –Rs. 21,00,000] (0.70) +Rs. 6,00,000


= Rs.9, 00,000(0.70) +Rs. 6,00,000 = Rs. 12,30,000 pa NPV = (Rs.12,30,000 / 1.15 +Rs.12,30,000/1.152 +Rs.12,30,000 / l.153) –Rs.18,00,000 = Rs. 28,08,369 -Rs. 18,00,000= Rs. 10,08,369 Let T be 32.5%. The annual cash flow is: = [(P-V) Q - F - D] (I-D) +D = [(Rs.300-Rs.150) 20000 units-Rs. 15,00,000 –Rs.6, 00,000] (1-32.5%) + Rs.6, 00,000 = [Rs.30, 00,000 -Rs. 21,00,000] (0.675) +Rs. 6,00,000 = Rs.9, 00,000(0.675) +Rs. 6,00,000 = Rs. 12,07,500 p.a NPV = (Rs.12,07,500/1.15 + Rs.12, 07,500/1.152 + Rs.12,07,500/1.153) – Rs.18,00,000 = Rs.27, 56,994 – Rs.18,00,000 = Rs. 9,56,994 Let T be 35% the annual cash flow is: = [(P-V) Q - F - D] (I-D) +D = [(300-150) 20000— 15,00,000 — 6,00,000] (1-35%) + 6,00,000 = [30,00,000 — 21,00,000] (0.65) ÷ 6,00,000 = 9,00,000(0.65) + 6,00,000 = Rs. 11,85,000 p.a NPV = (Rs.11, 85,000/1.15+Rs.11, 85,000/1.152+Rs.11, 85,000/1.15)-


Rs.18, 00,000 = Rs. 27,05,622 – Rs.18, 00,000 = Rs. 9,05,622 Let T be 37.5%. The annual cash flow is: = [(P-V) Q - F - D] (I-D) +D = [(Rs.300-Rs.150) 20000 units-Rs.15, 00,000 –Rs. 6,00,00] (1- 37.5%) +Rs. 6,00,000 NPV = (Rs.l2, 30,00 + Rs.12, 30,000/1.152 + Rs.12, 30,000/l.l5)-Rs.18, 00,000 = Rs. 28,08,369 –Rs. 18,00,000= Rs. 10,08,369 Let T be 32%. The annual cash flow is: = [(P-V) Q - F - D] (I-D) +D = [(Rs.300-Rs.150) 20000 units-Rs.15, 00,000 –Rs.6,00,000] (1- 32.5%) +Rs. 6,00,000 = [Rs.30, 00,000 –Rs.21, 00,000] (0.675) + Rs.6, 00,000 = 9,00,000(0.675) + 6,00,000 = Rs. 12,07,500 p.a NPV = (Rs.12, 07,500/1.15+Rs.12, 07,500/1.12+Rs. 12,07,500/1.15) - Rs.18, 00,000 = Rs.27, 56,994 – Rs.18, 00,000 = Rs. 9,56,994………. Let T be 35% the annual cash flow is: = [(P-V)Q - F - D] (I-D) +D = [(300-150) 20000— 15,00,000 — 6,00,000] (1-35%) + 6,00,000 = [30,00,000 — 21,00,000] (0.65) ÷ 6,00,000


= 9,00,000(0.65) + 6,00,000 = Rs. 11,85,000 p.a NPV = (11,85,000/1.15 + 11,85,000/1.152 + 11,85,000/1.15)— 18,00,000 = 27,05,622 - 18,00,000 = Rs. 9,05,622 Let T be 37.5%. The annual cash flow is: = [(P-V)Q - F - D] (I-D) +D = [(300-150) 20000 — 15,00,000 — 6,00,O0’’] (1-37.5%) + 6,00,000 = [30,00,000—21,00,000] (0.625) + 6,00,000 = Rs. 11,62,500 p.a NPV = (11,62,500/1.15 + 11,62,500/1.152 + 1 1,62,500/1.153)— 18,00,000 = 26,54,249 18,00,000 = Rs. 8,54,249 = [30,00,000 - 21,00,000] (0.60) + 6,00,000 = 9,00,000 (0.60) + 6,00,000 = Rs. 11,40,000 p.a NPV = (Rs.11, 40,000/1.15+Rs11, 40,000/1.152+Rs.11,40,000/l.153)-18,00,000 = Rs.26, 02,876 – Rs.18,00,000 = Rs. 8,02,876 You might have noted that as T rises, npv falls. Rate of change in NPV for a given change in T. When T rises to 32.5% (i.e. (0.325) from 30% (i.e. 0.3) NPV falls to Rs.9,56,994 from Rs.10,08,369.


Rate of change =

When T rises to 35% (i.e. (0.35) from 32.5% (i.e. 0.325) NPV falls to Rs.9, 05,622 from Rs.9, 56,994.

Rate of change =

When T rises to 37.5% from 35% NPV falls to Rs.8,54,249 from Rs. 9,05,622

Rate of change =

When T rises to 40% from 37.5% NPV falls to Rs.3,02,816 falls to Rs. 8,02,816 from Rs. 8,54,249

Rate of change =


The rate of MI in NT’V is rising with the rise in tax rate. Hence, NPV is highly negatively sensitive with tax rate. We can study the sensitivity of NPV to ‘T’ in the form of a graph, taking NPV on the Y axis and ‘T’ on the X-axis also. We can do the sensitivity analysis of NPV with respect to another uncertain variable, say ‘P,’ keeping V, Q and T at their most likely values, other variables at their fixed values and changing the value of P within its given range of values. Similarly, we can do the sensitivity analysis of NPV with respect to V, keeping P. Q and T at their most likely values, other variables at their fixed values and changing the value of V within its given range of values. So, also we can replicate the sensitivity with respect to ‘Q’. Now, of the 4 uncertain variables, namely, P, V, Q and T, with respect to which variable the NPV is most sensitive, can be seen. Knowledge of the same will help in monitoring the project with respect to those variables very ably. Hence, the utility of sensitivity analysis. Illustration A firm is currently using a machine purchased two years ago for Rs.l4,00,000. It has further 5 years of life. It is considering replacing the machine with a new one which will cost Rs.28, 00,000 Cost of installation is Rs.2, 00,000. Increase in working capital is Rs.4, 00,000. The profits before tax and depreciation are as follows for the two machines:

The firm adopts fixed installment method of depreciation. Tax rate and capital gain tax is 10% on inflation un-adjusted capital gain.


Is it desirable to replace the current machine by the new one, taking the resale value of old machine at Rs. 16,00,000 at present and using, PBP, ARR, NPV and IRR? (For NPV method take 10% as discount rate, for ARR shod cutoff rate is 15% and for PBP method cutoff period is 3.5 years). Solution First, we have to calculate the size of investment needed. This includes, purchase cost of new machine, cost of installation and working capital addition needed, reduced by net sale proceeds (after capital gain tax) of old machine. The old machine’s original cost =Rs.14,00,000 Depreciation for the past 2 years

Rs.2, 00,000 [14,00,000 + life 7 years]

It is sold for This gain has two components, capital gain and revenue Capital gain = Rs. Sale value - original cost = Rs.16,00,000 - Rs.14,00,000 = Rs.2,00,000. Revenue gain Total gain-capital gain= Rs.6,00,000 - Rs.4,00,000 = Rs.2,00,000. Tax on revenue gain = Rs.4,00,000 x 40% = Rs.1,60,000. Tax on capital gain = 200000 x 10% = 20,000. Therefore, after adjustment, net sales proceeds of old machine = Rs. 16,00,000 - Rs.20,00,000 - Rs.1,60,000 = Rs. 14,20,000. Now, we can compute net investment at time zero, i.e., at beginning as follows:


Now, we have to calculate the change or increment in cash flow because of the firm going for replacement of old machine by new one. For this purpose, what is the cash flow from new machine and what would be the cash flow from old machine had the firm continued with that must be computed. The difference of former over the latter is the change in cash flow.



A company bought a machine 2 years earlier at a cost of Rs.60, 000 and estimated its useful life as 12 years in all. Its current market price is Rs.25, 000. The management considers replacing this machine with a new one with life of 10 years and price at a Rs. 1,00,000. The new machine can produce 15 units more per hour. The annual operating hours are 1000 both for new and old machines. Selling price per unit is Rs.3. The new machine will involve add. Material cost by Rs.6,000 and labour by RS.6,000 p.a. But savings in cost of consumable stores of Rs.1000 and repairs of Rs.l000 p.a. will result. The corporate tax rate is 40%. Advice on the replacement assuming additional working capital of Rs.10000 introduced now, can be redeemed at 10 years later, cost of capital as 10% and SLM of depreciation, using NPV method.

ii) Cash Flow Computation


Since, uniform cash flow is found throughout l to 9th years, the NPV formulate can be slightly modified as: NPV = [ACF S 1 / (I+k) t +CF10 X 1 (1+k) 10] - I = Rs.23000 [l / 1.1 + 1 / 1.12 + ………1 / 1.19] + 33000 x 1 / 1.110 - Rs.75000 = (Rs.23000 x 5.759) + (Rs.33000 x 0.386)-75000 = Rs.145195 – Rs.75000 = Rs. 70195 The replacement is advised. Illustration


A company has 3 investment proposals. The expected PV of cash flows and the amount of investment needed are as below:

If projects 1 and 2 are jointly taken, there will be no economies or diseconomies. If projects 1 and 3 are undertaken, economies result in investment and combined investment will be Rs.4.4 lakhs. If 2 and 3 are combined, combined PV of cash flow will be Rs.6.2 lakhs. If all the 3 projects are combined, all the above economies will result but diseconomy in the form of additional investment of Rs. 1.25 lakhs will be needed. Find which projects are to be taken. Solution

Projects 1 & 3 will be chosen as NPV is higher Risk Analysis in the Case of Single Project Project risk refers to fluctuation in its payback period, ARR, IRR, and NPV or so higher the fluctuation, higher is the risk and vice versa. Let us take NPV based risk.


If NPV from year to year fluctuates, there is risk. This can be measured through standard deviation of the NPV figures. Suppose, the expected NPV of a project is Rs.18 lakhs, and standard deviation of Rs.6 lakhs, the coefficient of variation C.V is given by sm. Deviation divided by NPV. C.V = Rs.6, 00,000 / Rs 18,00,000=0.33. Risk Return Analysis for Multi Projects When multiple projects are considered together, what is the overall risk of all projects put together? Is it the aggregate average of standard deviation of NPV of all projects? No, it is not. Then what? Now another variable has to be brought in to the scene. That is the correlation coefficient between NPVs of pairs of projects. When two projects are considered together, the variation in the combined NPV is influenced by the extent of correlation between NPVs of the projects in question. A high correlation results in high risk and vice versa. So, the risk of all projects put together in the form of combined standard deviation is given by the formula:

Where, sp = combined portfolio standard deviation Pij = correlation between NPVs of pairs of projects (i and j) si, sj = standard deviation of iin and jth projects, i.e., any pair of projects taken at a time. Illustration Three projects have their standard deviations as follows: Rs.4000, Rs.6000 and Rs.10000. The correlation coefficients are l&2 0.6, 1&3 0.78 and 2&3: -0.5. What is the overall standard deviation of the portfolio of projects? sp = [SPij si sj ] ½ = [s12+s22+s32+2P12s1s2+2P23s2s3+2P13s1s3] ½


= [40002 + 60002 + 100002 + 2x0.6x4000x6000 -i- 2x0.78x6000xl0000 + 2x(-0. 5) x 10000x4000] ½ = [16000000+36000000+ 100000000+28800000+93600000-400000000] ½ = [234400000] ½ = Rs. 15,310 What is the return from these multiple projects? This is simple. It is the aggregate NPVs. Suppose, the three projects have NPVs of Rs.16, 000, Rs.20, 000 and Rs.44, 000. The combined NPV = 16000 + 20000 + 44000 = Rs.80000. The combined coefficient of variation = combined standard deviation I and combined NPV = Rs.15340/Rs.80000 = 0.19 = 19% If we take the correlation factor, unadjusted figures of combined standard deviations and combined NPVs, the coefficient of variation would have been: 20000/80000 = 0.25 = 25%. The correlation factor has resulted in reducing overall portfolio risk from 25% to 19%. This results essentially when there is low degree of correlation among the projects. More so, if there is higher negative correlation among the projects. Illustration Three projects involve an outlay of Rs.2, 00,000, Rs.3, 00,000 and Rs.5, 00,000 respectively. The estimated return from the projects are 14%, 16% and 20%. The standard deviation of returns are 5%, 10% and 10%. The correlation coefficients are 1&2: 0.4, 2&3: 0.6 and 1&3: 0.2. Find the portfolio return and risk. Solution The portfolio or combined return is simply the weighted return of the projects. This is given by: Swi Ri where wi - is the weight (0.2, 0.3 and 0.5 for the three projects respectively) and Ri - is the respective project return. Portfolio return = (wi Ri) = 0.2x14% + 0.3x16% + 0.5x20%


= 2.8% + 4.8% -‘-10% = 176% p = Portfolio risk = [(wi wj pij (i (j]112 = [wlwl(l (1 + w2w2(2(2 + w3w3(3(3 + 2w1w2(12 (1(2 + 2w2w3(23 (2(3 + 2w1w3(13 (1(3]1/2 Putting the given values, we get that, sp, = [0.2+0.9+2.5+2A+18+2] ½ = [26] ½ = 5.099% Have you understood? 1. bring out the meaning and significance of capital projects. 2. Calculate payback period, ARR, NPV (at k=10%) and given IRR. UNIT – III FINANCING AND DIVIDEND DECISION Lesson 1 Financial an Operating Leverages INTRODUCTION Leverage has been defined as ‘the action of a lever, and the mechanical advantage gained by it’ A lever is a rigid item that transmits and modifies force or motion where forces are applied at two points and it turns around a third. It is the principle that permits the magnification of force when a lever is applied to a fulcrum. The term leverage refers to an increased means of accomplishing some purpose. With leverage, it is possible to lift objects, which is otherwise impossible. The term refers generally to circumstances which bring about an increase in income volatility. In business, leverage is the means of increasing profits. It may be favourable or unfavourable. The former reduces profit, while the latter increases it. The leverage of a firm is


essentially related to a measure, which may be a return on investment or on earnings before taxes. It is an important tool of financial planning because it is related to profits. LEARNING OBJECTIVES On reading this lesson, you will be conversant with, 1. The meaning and types of leverages 2. Steps involved in simulation procedure 3. Advantages and limitations of financial leverage 4. Managerial analysis of leverages SECTION TITLE Leverage Calculation Christy and Rodent define leverage as the tendency for profits to change at a faster rate than sales. Leverage is an advantage or disadvantage which is derived from earning a return on total investment (total assets) and which is different from the return on owner’s equity. It is a relationship between equity share capital and debt securities, and creates fixed interest and dividend charges. It is also known as gearing. The term capital gearing is used to describe the ratio between the ordinary share capital and the fixed interest bearing securities of a company. Capital gearing reveals the suitability or otherwise of a company’s capitalization. However, it is a double-edged weapon, and emphasises the effects of deterioration as well as of improvement.



Return on Investment Leverage


The return on investment is a very important indicator of a firm’s performance. It is an index of operational efficiency. It should be remembered that the return on investment is the result of asset turnover and profit margin. Asset turnover is the ratio of sales to total assets, while the profit margin is the ratio of EBIT to sales. This may be expressed as follows: Return on Investment Leverage = Asset Turnover x Profit Margin

This leverage is popularly known as ‘ROI leverage. Asset Leverage The asset turnover aspect of the ROI leverage is often referred to as asset leverage. A firm with a relatively high turnover is said to have a high degree of asset leverage. There is nothing like an absolute high or low asset leverage. In other words, it is a relative term which is used to compare inter- firm performance. The profit margin may be increased with a careful cost control - by reducing production costs, selling expenses, distribution expenses and administrative overheads. Operating Leverage The operating leverage takes place when a change in revenue produces a greater change in EBIT. It indicates the impact of changes in sales on operating income. A firm with a high operating leverage has a relatively greater effect on EBIT for small changes in sales. A small rise in sales may enhance profits considerably, while a small decline in sales may reduce and even wipe out the EBIT. Naturally, no firm likes to operate under conditions of a high operating leverage because that creates a high-risk situation. It is always safe for a firm to operate sufficiently above the break-even point to avoid dangerous fluctuations in sales and profits. The operating leverage is related to fixed costs. A firm with relatively high fixed costs uses much of its marginal contribution to cover fixed costs. It is interesting to note that beyond the break-even point, the marginal contribution is converted into EBIT. The operating leverage is the highest near the


break-even point. After a firm reaches this point, even a small increase in sales results in a big increase in EBIT. The extent of the operating leverage at any single sales volume is calculated as follows:

The change in the rate of earnings is based on the operating leverage resulting from the fact that some costs do not move proportionally with changes in production. This leverage operates both positively and negatively, increasing profits at a rapid rate when sales are expanding and reducing them or causing losses when operations decline. If all the costs were variable, the rate of profit would show fewer changes at different operating levels. The operating leverage, then, is the process by which profits are raised or lowered in greater proportion than the changes in the volume of production because of the inflexibility of some costs. The higher the fixed costs, the greater the leverage and the more frequent the changes in the rate of profit (or loss) with alternations in the volume of activity. Illustration

The operating leverage decreases with an increase in sales above the break- even point. The reason is that fixed costs become relatively smaller than the revenues and the variable costs once the break-even point is reached. The extent of the operating leverage depends on the employment


of fixed assets in the production process. The higher the fixed costs a firm employs in the production process, the greater is its operating leverage. This operating leverage is measured with the help of following formula:

Capital Gearing Affects It is a company’s capacity to maintain an even distribution policy in the face of difficult trading periods, which may occur due to Dividend policies and the building up of reserves and Capital structure management. A firm’s capital structure is the relation between debt and equity securities. It, therefore, shows the effects of borrowing on equity stockholders. Financial Leverage It is generally accepted that investors seek to maximize their return on investments, subject to given risk constraints, and that they demand a higher return for the greater risk involved in an investment. The proportion of debt in the capital structure of a company is limited by two factors: 1. Investors risk preference 2. Business risk associated with the nature of a company’s operations. The determination of this limit, which is known as the corporate debt capacity, is an important aspect of the financial policy of a company to get the maximum benefit from debt financing. While the investors’ risk preference is difficult to assess because it varies from individual to individual, business risk can be determined objectively. A highly geared capital structure, or what is known as high leverage, distorts the profit earning capacity. Frank H. Jones rightly says that the profit earning capacity of ordinary shares in a wellfinanced company is not always fully appreciated. Leverage is thus the utilisation of fixed costs to effect disproportionate changes in income. It may be defined as the employment of an asset or


funds for which a firm pays a fixed cost or fixed return. David Francis observes that a fixed cost or return may be looked upon as the fulcrum of leverage. Financial leverage occurs when a corporation earns a bigger return on fixed cost funds than it pays for the use of such funds. It refers to typical situation in which a firm has fixed charges, securities, such as preferred stock and debentures, and its return on investment must not be equal to fixed charges. It exits in both these conditions. If these conditions are not present, financial leverage is absent. The reason is that, if a firm earns exactly as much as it pays for the use of its capital, there is no use making any borrowings. In other words, there is no financial leverage in this situation. If the ROT (return on investment exceeds the rate of interest, a firm has a favourable financial leverage) and is in a position to pass part of this advantage to its equity stockholders by resorting to borrowings. Charles Ellis observes that there seems to exist a general management preference for equity and retained earnings rather than for debt and preferred capital. However, the financial leverage is favourable when it is worthwhile for a firm to borrow. In other words, when the ROl exceeds interest rate, the financial leverage is favourable, or the firm is said to be trading on equity. It also means that, when there is a favourable financial leverage, the advantage is passed on to equity stockholders. On the other hand, when the ROI is less than the interest rate, the firm loses money by its borrowings. In other words, borrowings place it in an embarrassing position. It is not then worthwhile for it to borrow and have an unfavourable financial leverage. The phrase trading equity is a financial jargon which indicates the utilisation of non-equity sources of funds in the capital structure of an enterprise. At a high debt-equity ratio, a firm may not be able to borrow funds at a cheaper rate of interest it may not able to borrow funds at all. This is so because creditors lose confidence in the company which has a high debt-equity ratio. How can creditors have confidence in the company which has only creditors and no equity stockholders? The company will, therefore, have to strive hard to regain a reasonable debt-equity ratio so that the expectations of the market may be satisfied. In fact, equity financing by way of a public sale of stock offers real value of a firm. Traditionally, it has served as a spearhead for expansion of resources and productive capacity involving risk.


Merwin Waterman states that the term trading on equity is seldom heard among the practitioners of business finance. It is, however, a term full of an academic flavour, and textbooks use it in discussions of the financial structures. On the ‘street’, a synonym for this academic phraseology is financial leverage. Trading on equity is defined as the increase in profit /return resulting from borrowing capital at a lower rate and employing it in a business yielding a higher rate. The capital obtained from debt securities is used in a project which produces a rate of return which is higher than its cost. This allows the difference to be distributed to holders of equity securities. In other words, it is possible to lever the return on investment through a tighter management. Doing business partly on borrowed capital is known as trading on equity, which, however, includes all forms of business with funds (or properties) obtained on contracts calling for limited payments to those who supply funds. The expectation is that these funds will produce a larger revenue than the limited payments call for. Thus, trading on equity may be based upon bonds, non-participating preferred stock, and/or limited rental leases. When a corporation earns more on its borrowed capital than the interest it has to pay on bonds, trading on equity is profitable. But in times of poor business, when the interest on bonds amounts to more than the company makes from the use of these funds, trading on equity is unprofitable. For these reasons, it is said that trading on equity magnifies profits and losses. Most companies benefit from an objective review of their borrowings. In recent years, borrowings have increased as a percentage of net tangible assets, either by force of circumstances or as the result of the doctrine of gearing or leverage. Companies have tended to borrow at different times in circumstances which often bear little relationship to their present size and financial position. Extent of Financial Leverage Financial leverage depends upon the ratio of debt and preferred stock together to common stock equity. There are three ratios which the degree of financial leverage implies.


The effect of financial leverage in a firm’s capital structure may be analysed from the following information given below llustration

When the firm P issued no debt, the shareholders received a 6 percent after - tax return. In spite of the firm Q issuing a debt of Rs. 30,000, it had no leverage, for the ROI (10 per cent) was equal to the


interest (10 per cent). The firm issued a similar debt and enjoyed a favourable leverage, for its ROI (9 per cent) was higher than its interest (7 per cent). However, the firm S suffered from an adverse or unfavourable leverage, for its ROI (7 per cent) was less than its interest rate (8 per cent). The principle of capital structure management is then simple. It is logical for a firm to borrow reasonable amounts; If it earns higher rate than it pays for its borrowings. Similarly, when ROl is high, the firms with a favourable financial leverage are bound to enjoy high earnings. Advantages of Financial Leverage 1. The advantage of trading on equity is that it makes it possible for a company to distribute higher dividends per share than it would have, if it has been financed by stock alone. 2. The advantages and attractiveness of trading on equity for the owners of equity capital are all too apparent. Some of these have already been explained while discussing the requirements for trading on equity. Limitations of Financial Leverage 1. It may cause dividends to disappear altogether and, indeed, may be responsible for the insolvency and even bankruptcy of a corporation. 2. Companies enjoying a fairly regular income can employ borrowed funds more safely than those with widely fluctuating incomes. 3. Beyond a certain point, additional capital cannot be employed to produce a return in excess of the payments which must be made for its use or sufficiently in excess thereof to justify its employment. 4. The bigger the amount of funds borrowed, the higher the interest rate the corporation may be forced to pay in order to market its successive issues of bonds. Such increase in interest rates, if carried far off, may offset all the advantages of trading on equity. But such a general principle does not inevitably follow. A growing company which is progressively increasing its net


earnings through trading on equity may present such an earning exhibit as to make it possible for further trading on equity at low or lower rates. Moreover, money rates may fall. Total Leverage Operating and financial leverages are inter-dependent. At any given level of a firm’s operations, the total extent of leverage may be measured by the following formula: Degree of Total Leverage = Degree of Operating Leverage x Degree of Financial Leverage or

Fixed Charges Leverage

It takes place when a firm has such sources of funds as preferred stock and debentures which carry fixed charges. This leverage indicates the extent to which changes in operating income affect the EBT. It may be calculated by the following formula: Illustration It is evident that if a firm has fixed interest charges amounting to Rs. 20,000, its fixed charges leverage at a sales volume of 20,000 units would be:


In other words, it means that any increase in EBIT would be accompanied by a 1.29 times increase in EBT. If the EBIT gets trebled, say Rs. 2,70,000, the EBT would be Rs. 2,50,000 (2,70,000 - 20,000). The new level of fixed charges leverage would then be:

In other words, like the operating leverage, the fixed charges leverage also decreases with an increase in EBIT. In Financial Management, fixed charges leverage is also referred to as financial leverage. However, as different leverage concepts are associated with the term financial leverage, it would be better to refer to fixed charges leverage separately as the ratio of EBIT to EBT. This would probably make it distinct from financial leverage which is more popularly associated with trading on equity. Marginal Analysis It is clear from the above discussion that the operating leverage, the fixed charges leverage and the combined leverage are techniques of marginal analysis. The fixed charges leverage isolates costs and compares changes in revenues with changes in EBIT. The fixed charges leverage isolates interest and compares changes in EBIT with changes in EBT. Combined leverage isolates both fixed costs and interest and compares changes in revenues with changes in EBT. It has already been stated that operating and combined leverage uses the marginal contribution of sales. The reason is that each additional unit of sales produces a


unit of marginal contribution. Moreover, the leverage works only when sales decrease or increase. If, for example, the operating leverage is a drop of 50 percent in sales may wipe off the EBIT. Illustration

Now, if sales drops by 50 percent, the same will be reduced to Rs. 2,00,000.

It is clear that the EBIT has been wiped off. Illustration 1. From the following Information, you are required to compute the return on investment leverage. Sales 1,50,000 units at Rs. 1.20 per unit. Total Assets = Rs. 3,00,000 Earnings before interest and taxes = Rs. 30,000 Solution


Financial Analysis Through Leverages 1. From the following information, you are required to find out the asset of a firm. Sales Rs. 1,80,000 Total Assets Rs. 3,00,000 Solution

(Note: It should be remembered that the asset leverage is a part of the ROI Leverage). 2. From the following information, compute operating leverage of a firm. Sales 1,50,000 units @ Ps. 1.20 per unit.


Varilable Cost 40 paise per unit Fixed Cost Rs. 36,000 Solution

3. From the following Information, you are required to find out the extent of operating leuerage in the year 1989. EBIT (1988) Rs. 30,000 EBIT (1989) Rs. 35,000 Sales (1988) 1,50,000 units Sales (1989) 1,80,000 units Solution

4. A company is thinking of expansion and financing it by issuing equity stock of Rs. 50,000 shares of Rs. 100 per share or by Issuing 12% debentures of the same amount. The tax rate is 50% and the current equity capital structure amounts to 1,00,000 shares of Rs. 100 each. The earnings before interest and taxes are Rs. 50,00,000. You are required to explain the financial leverage underlying the second proposition.


Solution To find out the financial leverage, it would be necessary to prepare a table as below:

It is clear from the above table that when the debt is issued for Rs. 50,00,000 instead of equity stock, the earnings per share has arisen from Rs. 16.67 to Rs.22. This explains the financial leverage which the equity stockholders enjoy when the proportion of equity stock to the debt is increased in the capital structure. 5. The installed capacity of a factory is 700 units. The actual exploited capacity Is 500 units. Selling price per unit is Rs. 10 and Variable cost Is Rs. 6 per unit. Calculate the operating leverage in each of the following situations: I when fixed costs are Rs. 500 II when fixed costs are Rs. 1,100 III when fixed costs are Rs. 1,500 Solution Statement showing the details of costs under different situations:


Since, there is no interest component, EBIT Itself will be treated as EBT. Operating Leverage:

Have you understood? 1. Explain the following terms (a) ROI Leverage (b) Asset Leverage (c) Operating Leverage (d) Financial Leverage (e) Total Leverage (f) Fixed Charges Leverage


(g) Combined Leverage (h) Marginal Leverage 2. As a financial analyst how would you analyze each leverage from the point of view of financial decisions? Lesson 2 Cost of Capital Introduction Now that, we are familiar with the different sources of long-term finance, let us find out what it costs the company to raise these various types of finance. The cost of capital to a company is the minimum rate of return that it must earn on its investments in order to satisfy the various categories of investors who have made investments in the form of shares, debentures of term loans. Unless the company earns this minimum rate, the investors will be tempted to pull out of the company, leave alone participate in any further capital investment in that company. For example, equity investors expect a minimum return as dividend based on their perception of the risk they are undertaking, on the company’s past performance, or on the returns they are getting risk from shares of other companies they have invested in. Learning objective On reading this lesson, you will be conversant with: The meaning of cost of capital costs associated with the principal sources of long-term finances concept of weighted average cost of capital method of calculating specific cost of discounts sources of capital. SECTION TITLE Costs of Different Sources of Finance


Cost of Debentures The cost of a debenture is defined as:

Where kd = post-tax cost of debenture capital = annual interest payment per debenture capital t = corporate tax rate = redemption price per debenture F = redemption price per debenture P = net amount realised per debenture and n = maturity, period The interest payment (I) is multiplied by the factor (t-t) because interest on debt is a taxdeductible expense and only post-tax costs are considered. The following example illustrates the application of this formula. Example Ajax Limited has recently made an issue of non-convertible debentures for Rs.400 lakhs. The terms of the issue are as follows: each debenture has a face value of Rs.100 and carries a rate of interest of 14 per cent. The interest is payable annually and the debenture is redeemable at a premium of 5 per cent after 10 years.If Ajax Limited realises Rs.97 per debenture and the corporate tax rate is 50 per cent, what is the cost of the debenture to the company? Solution Given I = Rs.14, t = 0.5, P = Rs.97 and n = 10 years, F Ps.105. The cost per debenture (kd) will be:


= 7.7 percent Cost of Term Loans The cost of the term loans will be simply equal to the interest rate multiplied by (1- tax rate). The interest rate to be used here will be the interest rate applicable to the new term loan. The interest is multiplied by I (1 - tax rate) as interest on term loans is also tax deductible. Cost of Preference Capital The cost of a redeemable preference share (kp) is defined as:

kp = cost of preference capital D = preference dividend per share payable annually F = redemption price P = net amount realised per share and n = maturity period Example The terms of the preference share issue made by Colour-Dye-Chem are as follows: Each preference share has a face value of Rs.100 and carries a rate of dividend of 14 per cent payable


annually. The share is redeemable after 12 years at par. If the net amount realised per share is Rs.95, what is the cost of the preference capital? Solution Given that D = 14, F = 100, P = 95 and n = 12

= 0.148 or 14.8 per cent 2 Cost of Equity Capital Measuring the rate of return required by the equity shareholders is a difficult and complex exercise because the dividend stream receivable by the equity shareholders is not specified by any legal contract (unlike in the case of debenture holders). Several approaches are adopted for estimating this rate of return like the dividend forecast approach, capital asset pricing approach, realised yield approach, earnings-price ratio approach, and the bond yield plus risk premium approach. For our purposes. we shall consider only the dividend forecast approach. According to the dividend forecast approach’ the intrinsic value of an equity stock is equal to the sum of the present values of the dividends associated with it,

Where a = price per equity share = expected dividend per share at the end of year t and ke = rate of return required by the equity shareholders.


If we know the current market price (Pe) and can forecast the future stream of dividends, we can determine the rate of return required by the equity shareholders (k8) from equation (1), which is nothing but the cOSI of equity capital. In practice, the model suggested by equation (1) cannot be used in its present form because it is not possible to forecast the dividend stream completely and accurately over the life of the company. Therefore to apply this model in practice, the typical approach is to forecast the dividend per share (OPS) expected at the end of the first year (D1) and assume a constant growth rate (g) in DPS thereafter. Assuming a constant growth rate in dividends, the equation (1) can be simplified as follows:

If the current market price of the share is given (Pe), and the values of D1 and g are known, then the equation (2) can be. rewritten as

The following example illustrates the application of this formula: Example The market price per share of Mobile Glycois Limited is Rs.125, dividend per share expected a year hence is Rs.12 per share and the DPS is expected to grow at a constant rate of 8 per cent per annum. What is the cost of the equity capital to the company? Solution The cost of equity capital (ke) will be:


Cost of Retained Earnings and Cost of External Equity The cost of retained earnings or internal accruals is generally taken to be the same as the cost of equity. i.e., kr (representing cost of retained earnings) = ke But when for raising external equity, the company has certain floatation costs (costs incurred during public issue, like brokerage, underwriting commission, fees to managers of issue, legal charges, advertisement and printing expenses etc.). The formula for ke in this will be as follows:

Where f = floatation costs. For example, Gamma Asbestos Limited has got Rs.100 lakhs of retained earnings and Rs.100 lakhs of external equity through a issue, in its capital structure. The equity investors expect a rate of return of 18%. The cost of issuing external equity is 5%. The cost of retained earnings and the cost of external equity can be determined as follows: Cost of retained earnings kr = ke i.e., 18% Cost of external equity raised by the company Now k0 = 1 - 0.05 = 18.95% Weighted Average Cost of Capital


To illustrate the calculation of the weighted average cost of capital, let us consider the following example: Example

The market price per equity share is Rs.25. The next expected dividend per share (DPS) is Rs.2.00 and the DPS is expected to grow at a rate of 8 per cent. The preference shares are redeemable after 7 years at par and are currently quoted at IRs.75 per share in the stock exchange. The debentures are redeemable after 6 years at par and their current market quotation is Rs.90 per share. The tax rate applicable to the firm is 50 per cent. Calculate the weighted average cost of capital. Solution We will adopt a three-step procedure to solve this problem. Step 1: Determine the costs of the various sources of finance., We shall define the symbols ke, kr, kp, kd and ki to denote the costs of equity, retained earnings, preference capital, debentures. And term loans respectively.


Step 2. Determine the weights associated with the various sources of finance. We shall define the symbols We, Wr, Wp, Wd and Wi to denote the weight of the various sources of finance.


Step 3. Multiply the costs of the various sources of finance with lh corresponding weights and add these weighted costs to determine the weighted average cost of capital (WAC). Therefore, WAC = Wake + Wrkr ÷ Wkp + Wdkd + Wiki = (0.25 x 0.16) + (0.30 x 0.16) + (0.025 x 0.1780) + (0.175 x 0.0912) +(0.25 x 0.07) = 0.1259 or 12.59 per cent. System of Weighting One issue to be resolved before concluding this section relates to the system of weighting that must be adopted for determining the weighted average cost of capital. The weights can be used on (i) book values of sources of finance included in the present capital structure (ii) present value weights of the sources of finance included in the capital 5picture (iii) proportions of financing planned for the capital budget to be adopted for the forthcoming period. There are pros and cons associated with each of these systems of weighting. On the balance, we, however, recommend the use of market value weights provided the values are available and reliable.


Have you understood? 1. What is cost of capital? What is the significance in capital structure planning? 2. How do you calculate cost of debenture capital? 3. Explain the method of calculating the cost of preference capital and equity capital. 4. How do you calculate cost of retained earnings? 5. What is weighted average cost of capital? How do you calculate WACC? Lesson 3 Capital Structure INTRODUCTION Finance is an important input for any type of business and is needed for working capital and for permanent investment. The total funds employed in a business are obtained from various sources. A part of the funds are brought in by the owners and the rest is borrowed from others— individuals and institutions. While some of the funds are permanently held in business, such as share capital and reserves (owned funds), some others are held for a long period such as longterm borrowings or debentures, and still some other funds are in the nature of short-term borrowings. The entire composition of these funds constitute the overall financial structure of the firm. As such the proportion of various sources for short-term funds cannot perhaps be rigidly laid down. The firm has to follow a flexible approach. A more definite policy is often laid down for the composition of long-term funds, known as capital structure. More significant aspects of the policy are the debt equity ratio and the dividend decision. The latter affects the building up of retained earnings which is an important component of long-term owned funds. Since, the permanent or long-term funds often occupy a large portion of total funds and involve long-term policy decision, the term financial structure is often used to mean the capital structure of the firm.


There are certain sources of long-term funds which are generally available to the corporate enterprises. The main sources are: share capital (owners’ funds) and long-term debt including debentures (creditors’ funds). The profits earned from operations are owners’ funds—which may be retained in the business or distributed to the owners (shareholders) as dividend. The portion of profits retained in the business is a reinvestment of owners’ funds. Hence, it is also a source of long-term funds. All these sources together are the main constituents of the capital of the business, that is, its capital structure. LEARNING OBJECTIVES: After reading this chapter you would be able to understand capital structure and its features, determinants of capital structure, cost of capital and related aspects. SECTION TITLE What is Capital Structure? The term ‘capital structure’ represents the total long-term investment in a business firm. It includes funds raised through ordinary and preference shares, bonds, debentures, term loans from financial institutions, etc. Any earned revenue and capital surpluses are included: Capital Structure Planning Decision regarding what type of capital structure a company should have is of critical importance because of its potential impact on profitability and solvency. Small companies often do not plan their capital structure. These companies may do well in the short-run. However, sooner or later they face considerable difficulties. The unplanned capital structure does not permit an economical use of funds for the company. A company should therefore plan its capital structure in such a way that it derives maximum advantage out of it and is able to adjust more easily to the changing conditions. Instead of following any scientific procedure to find an appropriate proportion of different types of capital which will minimize the cost of capital and maximize the market value, a company


may just either follow what other comparable companies do regarding capital structure or may consult some institutional leader and follow its practice. Theoretically, a company should plan an optimum capital structure in such a way that the market value of its shares is maximized. The value will be maximized when the marginal real cost of each source of fund is the same. In general, the discussion on the issue of optimum capital structure is highly theoretical. The determination of an optimum capital structure in practice is a formidable task. That is why, perhaps, significant variations among industries and among different companies within the same industry regarding capital structure are found. A number of factors influence the capital structure decision of a company. The judgement of the person or group of persons making the capital structure decision plays a crucial role. Two similar companies can have different capital structures if the decision makers differ in their judgement about the significance of various factors. These factors are highly psychological, complex and qualitative and do not always follow the accepted theory. Capital markets are not perfect and the decision has to be taken with imperfect knowledge and consequent risk. Features of An Appropriate Capital Structure Capital structure is usually planned keeping in view the interests of the ordinary shareholders. The ordinary shareholders are the ultimate owners of the company and have the right to elect the directors. While developing an appropriate capital structure for his company, a finance manager should aim at maximizing the long-term market price of equity shares. In practice, for most companies within an industry, there will be a range of an appropriate capital structures within which there are no great differences in the market values of shares. A capital structure in this context can be determined empirically. For example, a company may be in an industry that has an average debt to total capital ratio of 60 percent. It may be empirically found that the shareholders in general do not mind the company operating within a 15 percent range of the industry’s average capital structure. Thus, the appropriate capital structure for the company ranges between 45 percent to 75 percent debt to total capital ratio. The management of the company should try to seek the capital structure near the top of this range in order to make


maximum use of favourable leverage, subject to other requirements such as flexibility, solvency, etc. A sound or appropriate capital structure should have the following features: Profitability: The capital structure of the company should be most advantageous. Within the constraints, maximum use of leverage at a minimum cost should be made. Solvency: The use of excessive debt threatens the solvency of the company. Debt should be used judiciously. Flexibility: The capital structure should be flexible to meet the changing conditions. It should be possible for a company to adapt its capital structure with minimum cost and delay if warranted by a changed situation. It should also be possible for the company to provide funds whenever needed to finance its profitable activities. In other words, from the solvency point of view, we need to approach capital structuring with due conservatism. The debt capacity of the company which depends on its ability to generate future cash flows should not be exceeded. It should have enough cash to pay periodic fixed charges to creditors and the principal sum on maturity. The above are the general features of an appropriate capital structure. The particular characteristics of a company may reflect some additional specific features. Further, the emphasis given to each of these features may differ from company to company. For example, a company may give more importance to flexibility than to retaining the control which could be another desired feature, while another company may be more concerned about solvency than about any other requirement. Furthermore, the relative importance of these requirements may change with changing conditions. Determinants of Capital Structure Capital structure has to be determined at the time a company is promoted. The initial capital structure should be designed very carefully. The management of the company should set a target capital structure and the subsequent financing decisions should be made with a view to achieve


the target capital structure. Once a company has been formed and it has been in existence for some years, the Finance Manager then has to deal with the existing capital structure. The company may need funds to finance its activities continuously. Every time the funds have to be procured, the Finance Manager weighs the pros and cons of various sources of finance and selects most advantageous sources keeping in view the target capital structure. Thus, the capital structure decision is a continuous one and has to be taken whenever a firm needs additional finances. Generally, the factors to be considered whenever a capital structure decision is taken are: (i) Leverage or Trading on equity, (ii) Cost of capital, (iii) Cash flow, (iv) Control, (v) Flexibility, (vi) Size of the company, (vii) Marketability, and (viii) Floatation costs. Let us briefly explain these factors. Leverage or Trading on Equity The use of sources of finance with a fixed cost, such as debt and preference share capital, to finance the assets of the company is known as financial leverage or trading on equity. If the assets which are financed by debt yield a return greater than the cost of the debt, the earnings per share will increase without an increase in the owners’ investment. Similarly, the earnings per share will also increase if preference share capital is used to acquire assets. But the leverage impact is felt more in case of debt because (i) the cost of debt is usually lower than the cost of preference share capital, and (ii) the interest paid on debt is a deductible charge from profits for calculating the taxable income while dividend on preference shares is not. Because of its effect on the earnings per share, financial leverage is one of the important considerations in planning the capital structure of a company. The companies with high level of the Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of leverage to increase return on the shareholders’ equity. One common method of examining the impact of leverage is to analyse the relationship between Earnings Per Share (EPS) at various possible levels of EBIT under alternative methods of financing. The EBIT-EPS analysis is one important tool in the hands of the Finance Manager to get an insight into the firm’s capital


structure management. He can consider the possible fluctuations in EBIT and examine their impact on EPS under different financing plans. Illustration Plan A No debt, all equity shares Plan B 50% debt (10%), 30% preference shares (12%), 200/c equity shares Plan C 80% debt (10%), 200/c equity shares The face value of equity shares is Rs. 10. The rates in parentheses indicate the fixed return on debt and preference shares. The total amount of capital required to be raised is Rs. 2,00,000. The company estimates its earnings before interest and taxes (EBIT) at Rs. 50,000 annually.

The effect of financial leverage (trading on equity) is presented in Table1. It will be seen that Plan C is the most attractive, from shareholders’ point of view as the EPS of Rs. 4.25 is the highest under this plan. The lowest EPs are when the company does not use any debt or fixed return securities. You will note that the proportion of fixed return securities under plans B and C


is the same (80%). However, plan C gives a higher EPS for the reason that dividend on preference share is not deductible for income tax purposes while interest is a deductible charge. Assuming that the estimates about EBIT turn out to be correct, the shareholders would be benefited to the maximum if plan C is adopted. The shares of the company will command a high premium in the market and would be greatly in demand. The managements of companies sometimes intentionally want to make their equity shares very attractive and prized possessions. This they can achieve by the practice of trading on equity. The secret of the advantage in financial leverage lies in the fact that whereas the overall return (before tax) on capital employed is 25% the return on preference share and debt is only 12% and 10% respectively. The savings resulting from this difference enable the management to enhance the return on equity shares. Although leverage increases BPS under favourable conditions, it can also increase financial risk to the shareholders. Financial risk increases with the use of debt because of (a) the increased variability in the shareholder’s earnings and (b) the threat of insolvency. A firm can avoid financial risk altogether if it does not employ any debt in its capital structure. But when no debt is employed in the capital structure, the shareholders will be deprived of the benefit of increases in BPS arising from financial leverage. Therefore, a firm should employ debt to the extent the financial risk perceived by the shareholders does not exceed the benefit of increased BPS. Cost of Capital Measuring the costs of various sources of funds is a complex subject and needs a separate treatment. Needless to say that it is desirable to minimize the cost of capital. Hence, cheaper sources should be preferred, other things remaining the same. The cost of a source of finance is the minimum return expected by its suppliers. The expected return depends on the degree of risk assumed by investors. A high degree of risk is assumed by equity shareholders than debt-holders. In the case of debt-holders, the rate of interest is fixed and the company is legally bound to pay interest, whether it makes profits or not. For equity shareholders the rate of dividend is not fixed and the Board of Directors has no legal obligation


to pay dividends even if the profits have been made by the company. The loan of debt-holders is returned within prescribed period, while shareholders can get back their capital only when the company is wound up. This leads one to conclude that debt is a cheaper source of funds than equity. The tax deductibility of interest charges further reduces the cost of debt. The preference share capital is cheaper than equity capital, but is not as cheap as debt is. Thus, in order to minimise the overall cost of capital, a company should employ a large amount of debt. However, it should be realised that a company cannot go on minimising its overall cost of capital by employing debt. A point is reached beyond which debt becomes more expensive because of the increased risk of excessive debt to creditors as well as to shareholders. When the degree of leverage increases, the risk to creditors also increases. They may demand a higher interest rate and may not further provide funds loan to the company once the debt has reached a particular level. Furthermore, the excessive amount of debt makes the shareholders’ position very risky. This has the -effect of increasing the cost of equity. Thus, up to a point the overall cost of capital decreases with debt, but beyond that point the cost of capital would start increasing and, therefore, it would not be advantageous to employ debt further. So, there is a combination of debt and equity which minimizes that firm’s average cost of capital and maximizes the market value per share. The cost of equity includes the cast of new issue of shares and the cost of retained earnings. The cost of debt is cheaper than the cost of both these sources of equity funds. Between the cost of new issue and retained earnings, the latter is cheap. The cost of retained earnings is less than the cost of new issue because the company does not have to pay personal taxes which have to be paid by shareholders on distributed earnings, and also because, unlike new issues, no floatation costs are incurred if the earnings are retained. As a result, between these two sources, retained earnings are preferable. Thus, when we consider the leverage and the cost of capital factors, it appears reasonable that a firm should employ a large amount of debt provided its earnings do not fluctuate very widely. In fact, debt can be used to the point where the average cost of capital is minimum. These two factors taken together set the maximum limit to the use of debt. However, other factors should also be evaluated to determine the appropriate capital structure for a company.


Theoretically, a company should have such a mix of debt and equity that its overall cost of capital is minimum. Let us understand this concept by taking an illustration. Illustration A company is considering a most desirable capital structure. The cost of debt (after tax) and of equity capital at various levels of debt equity mix are estimated as follows:

Determine the optimal mix of debt and equity for the company by calculating composite cost of capital: For determining the optimal debt equity mix, we have to calculate the composite cost of capital i.e., Ko which is equal to Kipl+Kep2 Where Ki = Cost of debt P1 = Relative proportion of debt in the total capital of the firm Ke = Cost of equity P2 = Relative proportion of equity in the total capital of the firm Before we arrive at any conclusion, it would be desirable to prepare a table showing all necessary information and calculations.


Cost of Capital Calculations

The optimal debt equity mix for the company is at a point where the composite cost of capital is minimum. From the table, it is evident that a mix of 20% debt and 80% equity gives the minimum composite cost of capital of 14%. Any other mix of debt and equity gives a higher overall cost of capital. The closest to the minimum cost of capital is a mix of 40% debt and 60% equity where Ko is 14.4%. It can therefore be concluded that a mix of 20% debt and 80% equity will make the capital structure optimal. Cash Flow One of the features of a sound capital structure is conservatism. Conservatism does not mean employing no debt or a small amount of debt. Conservatism is related to the assessment of the liability for fixed charges, created by the use of debt or preference capital in the capital structure in the context of the firm’s ability to generate cash to meet these fixed chares. The fixed charges of a company include payment of interest, preference dividend and principal. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital. Whenever, a company thinks of raising additional debt, it should analyze its expected future cash flows to meet the fixed charges. It is obligatory to pay interest and return the principal amount of debt. If a company is not able to generate enough cash to meet its fixed obligations, it may have to face financial insolvency. The companies which expect large and stable cash inflows can employ a large amount of debt in their capital structure. It is somewhat risky to employ sources of capital with fixed charges for companies whose cash inflows are unstable or unpredictable.


Control In designing the capital structure, sometimes the existing management is governed by its desire to continue control over the company. The existing management team may not only want to be elected to the Board of Directors but may also dispute to manage the company without any outside interference. The ordinary shareholders have the legal right to elect the directors of the company. If the company issues new shares, there is a risk of loss of control. This is not a very important consideration in case of a widely held company. The shares of such a company are widely scattered. Most of the shareholders are not interested in taking active part in the company’s management. They do not have the time and urge to attend the meetings. They are simply interested in dividends and appreciation in the price of shares. The risk of loss of control can almost be avoided by distributing shares widely and in small lots. Maintaining control however, could be a significant question in the case of a closely held company. A shareholder or a group of shareholders could purchase all or most of the new shares and thus control the company. Fear of having to share control and thus being interfered by others often delays the decision of the closely held companies to go public. To avoid the risk of loss of control the companies may issue preference shares or raise debt capital. Since, holders of debt do not have voting right, it is often suggested that a company should use debt to avoid the loss of control. However, when a company uses large amounts of debt, lot of restrictions are imposed on it by the debt-holders to protect their interests. These restrictions curtail the freedom of the management to run the business. An excessive amount of debt may also cause bankruptcy, which means a complete loss of control. Flexibility Flexibility means the firm’s ability to adapt its capital structure to the needs of the changing conditions. The capital structure of a firm is flexible if it has no difficulty in changing its capitalization or sources of funds. Whenever needed, the company should be able to raise funds without undue delay and cost to finance the profitable investments. The company should also be


in a position to redeem its preference capital or debt whenever warranted by future conditions. The financial plan of the company should be flexible enough to change the composition of the capital structure. It should keep itself in a position to substitute one form of financing for another to economies on the use of funds. Size of the Company The size of a company greatly influences the availability of funds from different sources. A small company may often find it difficult to raise long-term loans. If somehow it manages to obtain a long-term loan, it is available at a high rate of interest and on inconvenient terms. The highly restrictive covenants in loan agreements of small companies make their capital structure quite inflexible. The management thus cannot run business freely. Small companies, therefore, have to depend on owned capital and retained earnings for their long-term funds. A large company has a greater degree of flexibility in designing its capital structure. It can obtain loans at easy terms and can also issue ordinary shares, preference shares and debentures to the public. A company should make the best use of its size in planning the capital structure. Marketability Marketability here means the ability of the company to sell or market a particular type of security in a particular period of time which in turn depends upon the readiness of the investors to buy that security. Marketability may not influence the initial capital structure very much but it is an important consideration in deciding the appropriate timing of security issues. At one time, the market favours debenture issues and at another time, it may readily accept ordinary share issues. Due to the changing market sentiments, the company has to decide whether to raise funds through common shares or debt. If the share market is depressed, the company should not issue ordinary shares but issue debt and wait to issue ordinary shares till the share market revives. During boom period in the share market, it may not be possible for the company to issue debentures successfully. Therefore, it should keep its debt capacity unutilised and issue ordinary shares to raise finances.


Floatation Costs Floatation costs are incurred when the funds are raised. Generally, the cost of floating a debt is less than the cost of floating an equity issue. This may encourage a company to use debt rather than issue ordinary shares. If the owner’s capital is increased by retaining the earnings, no floatation costs are incurred. Floatation cost generally is not a very important factor influencing the capital structure of a company except in the case of small companies. HAVE YOU UNDERSTOOD? 1. What are the factors effecting capital structure of the company? 2. Explain the features of an optimal capital structure? Lesson 4 Dividend Policy INTRODUCTION A business organization always aims at earning profits. The utilisation of profits earned is a significant financial decision. The main issue here is whether the profits should be used by the owner(s) or be retained and reinvested in the business itself. This decision does not involve any problem is so far as the sole proprietory business is concerned. In case of a partnership the agreement often provides for the basis of distribution of profits among partners. The decisionmaking is somewhat complex in the case of joint stock companies. Since a company is an artificial person, the decision regarding utilisation of profits rests with a group of people, namely the board of directors. As in any other type of organization, the disposal of net earnings of a company involves either their retention in the business or their distribution to the owners (i.e., shareholders) in the form of dividend, or both. The decision regarding distribution of disposable earnings to the shareholders is a significant one. The decision may mean a higher income, lower income or no income at all to the shareholders. Besides affecting the mood of the present shareholders, dividend may also


influence the mood, behavior and responses of prospective investors, stock exchanges and financial institutions because of its relationship with the worth of the company which in turn affects the market value of its shares. The decision regarding dividend is taken by the Board of Directors and is then recommended to the shareholders for their formal approval in the annual general body meeting of the company. Disposal of profits in the form of dividends can become a controversial issue because of conflicting interests of various parties like the directors, employees, shareholders, debenture holders, lending institutions, etc. Even among the shareholders there may be conflicts as they may belong to different income groups. While some may be interested in regular income, others may be interested in capital appreciation and capital gains. Hence, formulation of dividend policy is a complex decision. It needs careful consideration of various factors. Learning Objectives The objectives of this unit are: To acquaint with the meaning, types and purpose of dividend To highlight the various factors, which influence the determination of dividend policy. SECTION TITLE Forms of Dividend Dividend ordinarily is a distribution of profits earned by a joint stock company among its shareholders. Mostly dividends are paid in cash, but there are also other forms of dividends such as Scrip dividends, Debenture dividends, Stock dividends, and, in unusual circumstances, Property dividends. These are briefly described below: Scrip Dividends Dividends can be paid only out of profits earned in the particular year or in the past reflected in the company’s accumulated reserves. Profits do not necessarily mean adequate cash to enable payment of cash dividends. In case the company does not have a comfortable cash position it


may issue promissory notes payable in a few months. It may also issue convertible dividend warrants redeemable in a few years. Debenture Dividends Companies may also issue debentures in lieu of dividends to their shareholders. These debentures bare interest and are payable after a prescribed period. It is just like creating a longterm debt. Such a practice is not common. Bonus Shares or Stock Dividends Instead of paying dividends out of accumulated reserves, the latter may be capitalized by issue of bonus shares to the shareholders. Thus, while the funds continue to remain with the company, the shareholders acquire the right and this way their marketable equity increases. They can either retain their bonus shares and thus be entitled to increase total dividend or can sell their bonus shares and realise cash. Ordinarily, bonus shares are not issued in lieu of dividends. They are periodically issued by prosperous companies in addition to usual dividends. Certain guidelines, as laid down by the government, are applicable for issue of bonus shares in India. Property Dividends This form of dividend is unusual. Such dividend may be in the form of inventory or securities in lieu of cash payment. A company sometimes may hold shares of other companies, eg., its subsidiaries which it may like to distribute among its own shareholders, instead of paying dividend in cash. In case the company sells these shares it may have to pay capital gains which may be subject to taxation. If these shares are transferred to its shareholders, there is no tax liability. Dividend Policy The objective of corporate management usually is the maximization of the market value of the enterprise i.e., its wealth. The market value of common stock of a company is influenced by its policy regarding allocation of net earnings into ‘plough back’ and ‘payout’. While maximizing the market value of shares, the dividend policy should be so oriented as to satisfy the interests of


the existing shareholders as well as to attract the potential investors. Thus, the aim should be to maximize the present value of future dividends and the appreciation in the market price of shares. Policy Options Dividend policy options refer to the policy options that the management formulates in regard to earnings for distribution as dividend among shareholders. It is not merely concerned with dividends to be paid in one year, but is concerned with the continuous course of action to be followed over a period of several years. Dividend decision involves dealing with several questions, such as: Whether dividend should be paid right from the initial year of operation i.e., regular dividends. Whether equal amount or a fixed percentage of dividend be paid every year, Irrespective of the quantum of earnings as in case of preference shares, i.e., stable dividends. Whether a fixed percentage of total earnings be paid as dividend which would mean varying amount of dividend per share every year, depending on the quantum of earnings and number of ordinary shares in that year, i.e., a fixed payout ratio. Whether the dividend be paid in cash or in the form of shares of other companies held by it or by converting (accumulated) retained earnings into bonus shares, i.e., property dividend or bonus dividend. Dividend Policy Goals There are several factors which influence the determination of the dividend policy. As such no two companies may follow exactly similar dividend policies. The dividend policy has to be tailored to the particular circumstances of the company. However, the following aspects have general applicability: Dividend policy should be analysed in terms of its effect on the value of the company. Investment by the company in new profitable opportunities creates value and when a company foregoes an attractive investment, shareholders opportunity loss. Dividend, investment and financing decisions are interdependent and a trade off.


Dividend decision should not be treated, as a short run residual decision because variability of annual earnings may cause even a zero dividend in a particular year. This may have serious repercussions for the company and may exult in the delisting of its shares for the purpose of dealings on any approved stock exchange. A workable compromise is to treat dividends as a long-term residual to avoid undesirable variations in payout. This needs financial planning over a tawny long time horizon. Whatever dividend policy is adopted by the company, the general principles guiding the dividend policy should, as far as possible, be communicated clearly to investors who may then take their decisions in terms of their own preferences and needs. Erratic and frequent changes in dividends should be avoided. Reduction in the rate of dividend is a painful thing for the shareholders to bear. The management will find it hard to convince the shareholders of the desirability of a lower dividend for the sake of preserving their future interests. Role of the Finance Manager The disposal of the earnings, retention in business or distribution among shareholders, is an issue of fundamental importance in financial management. The Finance Manager plays an important role in advising the management i.e., Board of Directors regarding the decision. It is the latter whose privilege it is to take the decision. The retention of profits in business helps the company in mobilizing funds for expansion. Economists, however, believe that the entire earnings of a business should be paid to its owners who should then decide where to reinvest them. That, all of them may decide to reinvest the distributed earnings in the same company is another thing. In case the company has more favorable reinvestment opportunities within it as compared to those offered outside, it would be more profitable for the company to retain earnings than to pay them out as dividends. The shareholders can later be compensated by issue of bonus shares. Let us illustrate this point by taking an example. Suppose the net profit after taxes of a company is Rs. 1 lakh and is totally distributed as dividend to shareholders. The relevant figures would then appears as follows:


It is clear from the above example that if dividends are not paid, Rs. 1 lakh of income is available to the company for reinvestment in business. In case dividends are paid, it is likely that not more than Rs. 54,000would be available for reinvestment (in the same or any other business), assuming that the stockholders are willing to reinvest their entire dividend income. lf better outside investment opportunities are available to the shareholders, depending upon the environment prevalent in the capital market, they may not appreciate the recommendation (or action) of the Board of Directors for retention of larger amounts in the business, as they might perceive it to their detriment. As such they would be interested in receiving larger dividends. The dividend policy, particularly the timing of the declaration of dividend, influences the market value of a company’s shares. The Finance Manager, therefore, should be well-informed about the capital market trends and the tax policies of the government, besides the rationale behind the investment programme of the company. Role of the Board of Directors The Board of Directors has the power to determine whether and at what rate dividend shall be paid to the shareholders. The payment of dividend is not obligatory. Even a majority of shareholders have no right to interfere with the authority of the Board. So long as the Board acts in good faith, acts on the basis of a reasonable policy, and it does not flagrantly abuse its fiduciary responsibility, its decision cannot be challenged and there is no way to force a dividend by direct legal action. However, there are some restrictions, dictated by law or prudence, on the discretion of the Board of Directors which are as follows:


Dividends may be declared out of any inappropriate surplus. If there is a loss, it should be absorbed first before dividends can be declared. Dividend declarations which impair the capital strength of a corporation must be discouraged. Dividend declarations which might lead to insolvency should be discouraged. A due provision for depreciation, depletion, etc. should be made prior to dividend declaration. Directors can be used by shareholders, if they have declared any unlawful dividends or have grossly neglected their interests. The rights of creditors should be taken care of while taking a decision on dividend. The corporate management is an elective management. The power of recommending a dividend is delegated by the shareholders to the Board of Directors. The Board declares a dividend in its duly convened meeting by a resolution which sets forth the rate of dividend, the class of stockholders to whom dividend is payable, and the date and mode of dividend payment. At times, the interest of the shareholders may come into conflict with those of the company. The Board is expected to act judiciously in taking a decision on dividends. The decision has two dimensions. First, the corporate management must satisfy the shareholders by offering them a fair return on their investment by way of dividends. Second, the management has a commitment to ensure the financial stability of the corporation by withholding dividends (i.e., by not declaring dividends), if it feels this course is necessary, in order to enable the company to stand on a firm ground. The dividend decision thus is a difficult one because of conflicting objectives and also because of lack of specific decision-making techniques. It is not easy to lay down an optimum dividend policy which would maximize the long-run wealth of the shareholders. There are certain factors that impinge upon the dividend decision and, therefore, should be taken into consideration while deciding a policy in this respect. Factors Affecting Dividend Decision It is possible to group the factors affecting dividend policy into two broad categories:


Ownership considerations Firm-oriented considerations. Ownership Considerations: Where ownership is concentrated in few people, there are no problems in identifying ownership interests. Where, however, ownership is decentralized on a wide spectrum the identification of their interests becomes difficult. Further, the influence of stockholders’ interests on dividend decision becomes uncertain because: (a) the status or preferences of stockholders relating to their position, capital gains, current income, etc. cannot be precisely ascertained; (b) a conflict in shareholders’ interests may arise. Inspite of these difficulties, efforts should be made to ascertain the following interests of shareholders to encourage market acceptance of the stock: Current income requirements of stockholders Alternative uses of funds in the hands of stockholders Tax matters affecting stockholders. Since, various groups of shareholders may have different desires’ and objectives, understandably, investors gravitate to those companies, which combine the mix of growth and desired dividends. Since companies generally do not have a singular group of shareholders, the objective of the maximization of the market value of shares requires that the dividend policy be geared to investors in general. Firm-oriented Considerations Ownership interests alone may not determine the dividend policy. A firm’s needs are also an important consideration, which include the following: Contractual and legal restrictions Liquidity, credit-standing and working capital Needs of funds for immediate or future expansion Availability of external capital Risk of losing control of organization Relative cost of external funds


Business cycles Post dividend policies and stockholder relationships. The following factors affect the shaping of a dividend policy. Nature of Business This is an important determinant of the dividend policy of a company. Companies with unstable earnings adopt dividend policies which are different from those which have steady earnings. Consumer goods industries usually suffer less from uncertainties of income and, therefore, pay dividends with greater regularity than the capital goods industries. Industries with stable income are in a position to formulate consistent dividend policies. Thus, public utilities may be able to establish a relatively fixed dividend rate. Mining companies, on the other hand, with long gestation period and multiplicity of hazards, may not be able to declare dividends for years. But once they get established, they might afford to make liberal dividend payments. If earnings fluctuate and losses are caused during depression, the continued payment of dividends may become a risky proposition. A company with ‘wasting’ assets—such as timber, oil or mines—which get depleted over time, may well pursue a policy of gradually returning capital to its owners because its resources are going to be exhausted. Such a company may offer dividends, which include, in part, a return of the owner’s investment. Generally speaking, large and mature companies pay a reasonably good but not an excessive rate of dividend. Excessive dividends may be paid only by ‘mushroom’ companies; a heal thy company with an eye on future follows a somewhat cautious policy and builds up reserves. A company which believes in publicity gimmicks may follow a more liberal dividend policy to its future detriment. A firm with a head programme of investment in research and development would see to it-that adequate reserves are built up for the purpose. Attitude and Objectives of Management


While some organizations may be niggardly in dividend payments,’ some others may be liberal. A large number of firms may be found within these two extremes. Niggardly organizations prefer to conserve cash. Though such an approach may easily meet their future needs for funds, it deprives the stockholders of a legitimate return on their investment. Liberal organizations, on the other hand, feel that stockholders are entitled to an established rate of dividend as long as their financial condition is reasonably sound. Within these two extremes, a number of corporations adopt several venations. The attitude of the management affects the dividend policies of a corporation in another way. The stockholders who control the management of the company may be interested in ‘empirebuilding’ They may consider ploughing back of earnings as the most effective technique for achieving their objective of building up the corporate as perhaps the largest in the field. Composition of Shareholding There may be marked variations in dividend policies on account of the variations in the composition of the shareholding. In the case of a closely held company, the personal objectives of the directors and of a majority of shareholders may govern the decision. Widely held companies have scattered shareholders. Such companies may take the dividend decision with a greater sense of responsibility by adopting a more formal and scientific approach. The tax burden on business corporations is a determining factor in formulation of their dividend policies. The directors of a closely held company may take into consideration the effect of dividends upon the tax position of their important shareholders. Those in the high-income brackets may be willing to sacrifice additional income in the form of dividends in favour of appreciation in the value of shares and capital gains. However, when the stock is widely held, stockholders are enthusiastic about collecting their dividends regularly, and do not attach much importance to tax considerations. Thus, a company which is closely held by a few shareholders in the high income-tax brackets, is likely to payout a relatively low dividend. The shareholders in such a company are interested in taking their income in the form of capital gains rather than in the form of dividends which arc


subject to higher personal income taxes. On the other hand, the shareholders of a large and widely held company may be interested in high dividend payout. Investment Opportunities Many companies retain the earnings to facilitate planned expansion. Companies with low credit ratings may feel that they may not be able to sell their securities for raising necessary finance they would need for future expansion. So, they may adopt a policy for retaining larger portion of earnings. In the context of opportunities for expansion and growth, it is wise to adopt a conservative dividend policy if the cost of capital involved in external financing is greater than the cost of internally generated funds. Similarly, if a company has lucrative opportunities for investing its funds and can earn a rate which is higher than its cost of capital, it may adopt a conservative dividend policy. Desire for Financial Solvency and Liquidity Companies may desire to build up reserves by retaining their earnings which would enable them to weather deficit years or the down-swings of a business cycle. They may, therefore, consider it necessary to conserve their cash resources to face future emergencies, Cash credit limits, and working capital needs, capital expenditure commitments, repayment of long-term debt, etc. influence the dividend decision. Companies sometimes prune dividends when their liquidity declines. Regularity A company may decide about dividends on the basis of its current earnings which according to its thinking may provide the best index of what a company can pay, even though large variations in earnings and consequently in dividends may be observed from year to year. Other companies may consider regularity in payment of dividends as more important than anything else. They may use past profits to pay dividends regularly, irrespective of whether they have enough current profits or not. The past record of a company in payment of dividends regularly builds up the


morale of the stockholders who may adopt a helpful attitude towards it in periods of emergency or financial crisis. Regularity in dividends cultivates an investment attitude rather than a speculative one towards the shares of the company. Restrictions by Financial Institutions Sometimes, financial institutions which grant, long-term loans to corporations put a clause restricting dividend payment till the loan or a substantial part of it is repaid. Inflation Inflation is also a factor which may affect a firm’s dividend decision. In the period of inflation, funds generated from depreciation may not be adequate to replace worn out equipment’. Under these circumstances, the firm has to depend upon retained earnings as a source of funds to make up for the shortfall. This is of particular relevance if the assets have to be replaced in near future. Consequently, the dividend payout ratio will tend to be low. On account of inflation often the profits of most of the companies are inflated. A higher payout ratio based on overstated profits may eventually lead to the liquidation of the company. Inflation has another dimension. In an inflationary situation, current income becomes more important and shareholders in general attach more value to current yield than to distant capital appreciation. They would thus expect a higher payout ratio. Other Factors Age of the company has some effect on the dividend decision. Established companies often find it easier to distribute higher earnings without causing an adverse effect on the financial position of the company than a comparatively younger corporation which has yet to establish itself. The demand for capital expenditure, money supply, etc. undergo great oscillations during the different stages of a business cycle. As a result, dividend policies may fluctuate from time to time.


Have you Understood? 1. What is dividend and why is dividend decision important? 2. "While formulating a dividend policy the management has to reconcile its own needs for funds with the expectations of shareholders". Explain the statement. What policy goals might be considered by management in taking a decision on dividends? 3. Discuss the role of a Finance Manager in the matter of dividend policy. What alternatives he might consider and what factors should he take into consideration before finalising his views on dividend policy? 4. "Dividend can be paid only out of profits". Explain the statement. Will a company be justified in paying dividends when it has unwritten-of accumulated losses of the past? 5. What factors a company would in general consider before it takes a decision on dividends?


UNIT – IV WORKING CAPITAL MANAGEMENT Lesson 1 Working Capital INTRODUCTION Effective Financial Management is the outcome, among other things, of proper management of investment of funds in business. Funds can be invested for permanent or long-term purposes such as acquisition of fixed assets, diversification and expansion of business, renovation or modernization of plant and machinery, and research and development. Funds are also needed for short-tem purposes, that is, for current operations of the business. For example, if you are managing a manufacturing unit you will have to arrange for procurement of raw material, payment of wages to your workmen and for meeting routine expenses. All the goods which are manufactured in a given time period may not be sold in that period. Hence, some goods remain in stock, eg., raw material, semi-finished (manufacturing-in-process) goods and finished marketable goods. Funds are thus blocked in different types of inventory. Again, the whole of the stock of finished goods may not be sold against ready cash, some of it may be sold on credit. The credit sales also involve blocking of funds with debtors till cash is received or the bills are cleared. Working Capital refers to a firm’s investment in short-term assets: viz., cash, short-term securities, amount receivables (debtors) and inventories of raw materials, work-in-process and finished goods. It can also be regarded as that portion of the firm’s total capital which is employed in short-term operations. It refers to all aspects of current assets and current liabilities. In simple words, we can say that working capital is the investment needed for carrying out dayto-day operations of the business smoothly. The management of working capital is no less important than the management of long-term financial investment. Learning Objectives


The objectives of this unit are to familiarize you with the: Concepts and components of working capital Significance of and need for working capital Determinants of the size of working capital Criteria for efficiency in managing working capital SECTION TITLE Significance of Working Capital One will hardly find an operating business firm which does not require some amount of working capital. Even a fully equipped manufacturing firm is sure to collapse without (a) an adequate supply of raw materials to process, (b) cash to meet the wage bill, (c) the capacity to wait for the market for its finished products, and (d) the ability to grant credit to its customers. Similarly, a commercial enterprise is virtually good for nothing without merchandise to sell. Working capital, thus, is the life-blood of a business. As a matter of fact, any organization, whether profit-oriented or otherwise, will not be able to carry on day-to-day activities without adequate working capital. Operating Cycle The time between purchase of inventory items (raw material or merchandise) and their conversion into cash is known as operating cycle or working capital cycle. The successive events which are typically involved in an operating cycle are depicted in Figure I. A perusal of the operating’ cycle would reveal that the funds invested in operations are re-cycled back into cash. The cycle, of course, takes some time to complete. The longer the period of this conversion the longer is the operating cycle. A standard operating cycle may be for any time period but does not generally exceed a financial year. Obviously, the shorter the operating cycle, the larger will be the turnover of funds invested for various purposes. The channels of the investment are called current assets. Sometimes the available funds may be in excess of the needs for investment in these assets, eg., inventory, receivables and minimum essential cash balance. Any surplus may be invested in government securities rather than being retained as idle cash balance.


Concepts of Working Capital There are two types of working capital, namely Gross and Net working capital. Gross Working Capital According to this concept, working capital refers to the firm’s investment in current assets. The amount of current liabilities is not deducted from the total of current assets. This concept views Working Capital and aggregate of Current Assets as two interchangeable terms. This concept is also referred to as ‘Current Capital’ or ‘Circulating Capital’. The proponents of the gross working capital concept advocate this for the following reasons: 1. Profits are earned with the help of assets which are partly fixed and partly current. To a certain degree, similarity can be observed in fixed and current assets so far as both are partly financed by borrowed funds, and are expected to yield earnings over and above the


interest costs. Logic then demands that the aggregate of current assets should be taken to mean the working capital. 2. Management is more concerned with the total current assets as they constitute the total funds available for operating purposes than with the sources from which the funds come. 3. An increase in the overall investment in the enterprise also brings about an increase in the working capital. Net Working Capital The net working capital refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors’ dues, bills payable, bank overdraft and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed current liabilities. A negative net working capital occurs when current liabilities are in excess of current assets. "Whenever working capital is mentioned it brings to mind, current assets and current liabilities with a general understanding that working capital is the difference between the two". ‘Net working capital’ is a qualitative concept which indicates the liquidity position of the firm and indicates the extent to which working capital needs may be financed by permanent sources of funds. This needs some explanation. Current assets should be sufficiently in excess of current liabilities to constitute a margin or buffer for obligations maturing within the ordinary operating cycle of a business. A weak liquidity position poses a threat to the solvency of the company and makes it unsafe. Excessive liquidity is also bad. It may be due to mismanagement of current assets. Therefore, prompt and timely action should be taken by management to improve and correct the imbalance in the liquidity position of the firm. The net working capital concept also covers the question of a judicious mix of long-term and short-term funds for financing current assets. Every firm has a minimum amount of net working capital which is permanent. Therefore, this portion of the working capital should be financed


with permanent sources of funds such as owners’ capital, debentures, long-term debt, preference capital and retained earnings. Management must decide the extent to which current assets should be financed with equity capital and/or borrowed capital. Several economists uphold the net working capital concept. In support of their stand, they state that: In the long run what matters is the surplus of current assets over current liabilities. It is this concept which helps creditors and investors to judge the financial soundness of the enterprise. It is the excess of current assets over current liabilities which can be relied upon to meet contingencies since this amount is not liable to be returned. It helps to ascertain the correct comparative financial position of companies having the same amount of current assets. It may be stated that gross and net concepts of working capital are two important facets of working capital management. Both the concepts have operational significance for the management and therefore neither can be ignored. While the net concept of working capital emphasizes the qualitative aspect, the gross concept underscores the quantitative. Kinds of Working Capital Ordinarily, working capital is classified into two categories: Fixed, Regular or Permanent Working Capital; and Variable, Fluctuating, Seasonal, Temporary or Special Working Capital. Fixed Working Capital The need for current assets is associated with the operating cycle is a continuous process. As such, the need for current assets is felt constantly. The magnitude of investment in current assets however may not always be the same. The need for investment in current assets may increase or decrease over a period of time according to the level of production. Nevertheless, there is always a certain minimum level of current assets which is essential for the firm to carry on its business


irrespective of the level of operations. This is the irreducible minimum amount necessary for maintaining the circulation of the current assets. This minimum level of investment in current assets is permanently locked up in business and is therefore referred to as permanent or fixed or regular working capital. It is permanent in the same way as investment in the firm’s fixed assets is. Fluctuating Working Capital Depending upon the changes in production and sales, the need for working capital, over and above the permanent working capital, will fluctuate. The need for working capital may also vary on account of seasonal changes or abnormal or unanticipated conditions. For example, a rise in the price level may lead to an increase in the amount of funds invested in stock of raw materials as well as finished goods. Additional doses of working capital may be required to face cutthroat competition in the market or other contingencies like strikes and lockouts. Any special advertising campaigns organized for increasing sales or other promotional activities may have to be financed by additional working capital. The extra working capital needed to support the changing business activities is called as fluctuating (variable, seasonal, temporary or special) working capital. Figures II and III give an idea about fixed and fluctuating working capital.


figure II. fixed working capital remaining constant over time It is shown in Figure II that fixed working capital is stable overtime, while variable Working capital is fluctuating—sometimes increasing and sometimes decreasing. The permanent working capital line, however, may not always be horizontal. For a growing firm, permanent working capital may also keep on increasing over time as has been shown in Figure III. Both these kinds of working capital—permanent and temporary—are required to facilitate production and sales through the operating cycle, but temporary working capital is arranged by the firm to meet liquidity requirements that are expected to be temporary. Components of Working Capital It is already noted that working capital has two components: Current assets and Current liabilities. Current assets comprise several items. The typical items are: Cash to meet expenses as and when they occur.


Accounts receivables or sundry trade debtors. Inventory of raw materials, stores, supplies and spares, work-in-process, and finished goods. Advance payments towards expenses or purchases, and other short-term advances, which are recoverable. Temporary investment of surplus funds which could be converted into cash whenever needed. Apart from these, the need for funds to finance the current assets may be met from supply of goods on credit, and deferment, on account of custom, usage or arrangement, of payment for expenses. The remaining part of the need for working capital may be met from short-term borrowing from financiers like banks. These items arc collectively called current liabilities. Typical items of current liabilities are: Goods purchased on credit Expenses incurred in the course of the business of the organization (eg., wages or salaries, rent, electricity bills, interest etc.) which are not yet paid for. Temporary or short-term borrowings from banks, financial institutions or other parties. Advances received from parties against goods to be sold or delivered, or as short-term deposits. Other current liabilities such as tax and dividends payable. Importance of Working Capital Management Because of its close relationship with day-to-day operations of a business, a study of working capital and its management is of major importance to internal, as well as external analysts. It is being increasingly realised that inadequacy or mismanagement of working capital is the leading cause of business failures. We must not lose sight of the fact that management of working capital is an integral part of the overall Financial Management and, ultimately, of the overall corporate management. Working capital management thus throws a challenge and should be a welcome opportunity for a finance manager who is ready to play a pivotal role in his organization. Neglect of management of working capital may result in technical insolvency and even liquidation of a business unit. With receivables and inventories tending to grow and with increasing demand for bank credit in the wake of strict regulation of credit in India by the


Central Bank, managers need to develop a long-term perspective for managing working capital. Inefficient working capital management may cause either inadequate or excessive working capital which is dangerous. A firm may have to face the following adverse consequences from inadequate working capital: 4. Growth may be stunted. It may become difficult for the firm to undertake profitable projects due to non-availability of funds. 5. Implementation of operating plans may become difficult and consequently the firm’s profit goals may not be achieved. 6. Operating inefficiencies may creep in due to difficulties in meeting even day-to-day commitments. 7. Fixed assets may not be efficiently utilised due to lack of working funds, thus lowering the rate of return on investments in the process. 8. Attractive credit opportunities may have to be lost due to paucity of working capital. 9. The firm loses its reputation when it is not in a position to honour its short-term obligations. As a result, the firm is likely to face tight credit terms. On the other hand, excessive working capital may pose the following dangers: 10. Excess of working capital may result in unnecessary accumulation of inventories, increasing the chances of inventory mishandling, waste, and theft. 11. It may provide an undue incentive for adopting too liberal a credit policy and slackening of collection of receivables, causing a higher incidence of bad debts. This has an adverse effect on profits. 12. Excessive working capital may make management complacent, leading eventually to managerial inefficiency. 13. It may encourage the tendency to accumulate inventories for making speculative profits, causing a liberal dividend policy which becomes difficult to maintain when the firm is unable to make speculative profits.


An enlightened management, therefore, should maintain the right amount of working capital on a continuous basis. Financial and statistical techniques can be helpful in predicting the quantum of working capital needed at different points of time. Determinants of Working Capital Needs There are no set rules or formulas to determine the working capital requirements of a firm. The corporate management has to consider a number of factors to determine the level of working capital. The amount of working capital that a firm would need is affected not only by the factors associated when the firm itself but is also affected with economic, monetary and general business environment. Among the various factors the following are important ones. Nature and Size of Business The working capital needs of a firm are basically influenced by the nature of its business. Trading and financial firms generally have a low investment in fixed assets, but require a large investment in working capital. Retail stores, for example, must carry large stocks of a variety of merchandise to satisfy the varied demand of their customers. Some manufacturing businesses like tobacco, and construction firms also have to invest substantially in working capital but only a nominal amount in fixed assets. In contrast, public utilities have a limited need for working capital and have to invest abundantly in fixed assets. Their working capital requirements are nominal because they have cash sales only and they supply services, not products. Thus, the amount of funds tied up with debtors or in stocks is either nil or very small. The working capital needs of most of the manufacturing concerns fall between the two extreme requirements of trading firms and public utilities. The size of business also has an important impact on its working capital needs. Size may be measured in terms of the scale of operations. A firm with larger scale of operations will need more working capital than a small firm. The hazards and contingencies inherent in a particular type of business also have an influence in deciding the magnitude of working capital in terms of keeping liquid resources. Manufacturing Cycle


The manufacturing cycle starts with the purchase of raw materials and is completed with the production of finished goods. If the manufacturing cycle involves a longer period the need for working capital will be more, because an extended manufacturing time span means a larger tieup of funds in inventories. Any delay at any stage of manufacturing process will result in accumulation of work-in-process and will enhance the requirement of working capital. You may have observed that firms making heavy machinery or other such products, involving long manufacturing cycle, attempt to minimise their investment in inventories (and thereby in working capital) by seeking advance or periodic payments from customers. Business Fluctuations Seasonal and cyclical fluctuations in demand for a product affect the working capital requirement considerably, especially temporary working capital requirements of the firm. An upward swing in the economy leads to increased sales, resulting in an increase in the firm’s investment in inventory and receivables or book debts. On the other hand, a decline in the economy may register a fall in sales and, consequently, a fall in the levels of stocks and book debts. Seasonal fluctuations may also create production problems. Increase in production level may be expensive during peak periods. A firm may follow a policy of steady production in all seasons to utilise its resources to the fullest extent. This will mean accumulation of inventories in off-season and their quick disposal in peak season. Therefore, financial arrangements for seasonal working capital requirement should be made in advance. The financial plan should be flexible enough to take care of any seasonal fluctuations. Production Policy If a firm follows steady production policy, even when the demand is seasonal, inventory will accumulate during off-season periods and there will be higher inventory costs and risks. If the costs and risks of maintaining a constant production schedule are high, the firm may adopt the policy of varying its production schedule in accordance with the changes in demand. Firms whose physical facilities can be utilised for manufacturing a variety of products can have the advantage of diversified activities. Such firms manufacture their main products during the season


and other products during off-season. Thus, production policies may differ from firm to firm, depending upon the circumstances. Accordingly, the need for working capital will also vary. Turnover of Circulating Capital The speed with which the operating cycle completes its round raw materials finished product accounts receivables cash plays a decisive role in influencing the working capital needs. (Refer to Figure 1 on operating cycle). Credit Terms The credit policy of the firm affects the size of working capital by influencing the level of book debts. Though the credit terms granted to customers in a large measure depend upon the norms and practices of the industry or trade to which the firm belongs, yet it may endeavour to shape its credit policy within such constrains. A long collection period will generally mean tying of larger funds in book debts. Slave collection procedures may even increase the chances of bad debts. The working capital requirements of a firm are also affected by credit terms granted by its creditors. A firm enjoying liberal credit terms will need less working capital. Growth and Expansion Activities As a company grows, logically, larger amount of working capital will be needed, Though it is difficult to state any firm rules regarding the relationship between growth in the volume-of a firm’s business and its working capital needs. The fact to be recognised is that the need for increased working capital funds may precede the growth in business activities, rather than following it. The shift in composition of working capital in a company may be observed with changes in economic circumstances and corporate practices. Growing industries require more working capital than those that are static. Operating Efficiency


Operating efficiency means optimum utilisation of resources. The firm can minimise its need for working capital by efficiently controlling its operating costs. With increased operating efficiency application use of working capital is improved Price Level Changes Generally, rising price level requires a higher investment in working capital. Increasing prices for the same levels of current assets need enhanced investment. However, firms which can immediately revise prices of their products upwards may not face a severe working capital problem in periods of rising price levels. The effects of increasing price level may, however, be felt differently by different firms. It is possible that some companies may not be affected by the rising prices, whereas others may be badly hit by it. Other Factors There are some other factors which affect the determination of the need for working capital. A high net profit margin contributes towards the working capital. The net profit is a source of working capital to the extent it has been earned. The cash inflow can be calculated by adjusting non-cash items such as depreciation. Outstanding expenses, losses written off, etc. from the net profit. The firm’s appropriation policy, that is, the policy to retain or distribute profit has a bearing on working capital. Payment of dividend consumes cash resourse and reduces the firm’s working capital to that extent. If the profits are retained in the business, the firm’s working capital position will be strengthened. Approaches to Managing Working Capital Two approaches are generally followed for the management of working carpet (i) the conventional approach and (ii) the operating cycle approach. The Conventional Approach


This approach implies managing the individual components of working capital (ii) the inventory, receivables, payables, etc. efficiently and economically so that there are neither idle funds nor paucity of funds. Techniques have been evolved for the management of each of these components. In India, more emphasis is given to the management of debtors because they generally constitute the largest share of the investment in working capital. On the other hand, inventory control has not yet been practiced on a wide scale perhaps due to scarcity of goods (or commodities) and ever rising prices. The Operating Cycle Approach This approach views working capital as a function of the volume of operating expenses. Under this approach the working capital is determined by the duration of the operating cycle and the operating expenses needed for completing the cycle. The duration of the operating cycle is the number of days involved in the various stages, commencing with acquisition of raw materials to the realisation of proceeds from debtors. The credit period allowed by creditors will have to be set off in the process. The optimum level of working capital will be the requirement of operating expenses for an operating cycle, calculated on the basis of operating expenses required for a year. In India, most of the organizations used to follow the conventional approach earlier, but now the practice is shifting in favour of the operating cycle approach. The banks - usually apply this approach while granting credit facilities to their clients. Measuring of Working Capital Measurement of working capital is dealt in the following illustration. Illustration Determine the magnitude of working capital (with the help of the following particulars) for Gujarat Tricycles Limited, a newly set up enterprise: a) The proforma cost sheet shows that the various elements of cost bear the undermentioned relationship to the selling price:


Materials, parts and components 40% Labour 30% Overhead 10% b) Production in 19x 8 is estimated to be 6,000 tricycles. c) Raw material, parts and components are expected to remain in the stores for an average period of one month before issue to production. d) Finished goods are likely to stay in the warehouse for two months on an average before being sold and delivered to customers. e) Each unit of production will be in process for half a month on an average: f) Half of the sales are likely to be on credit. The debtors will be allowed two months credit from the date of sale. g) Credit period allowed by suppliers of raw material, parts and components is one month. h) The lag of payment to labor is one month.50% of the overhead consists of salaries of nonproduction staff. i) Selling price will be Rs 200 per tricycle j) Assume that sales and production follow a consistent pattern. k) Allow 20% to computed figure for buffer cash and contingencies. Before attempting to calculate the working capital, it will be helpful to work out the following basic data a) The yearly production is 6,000 tricycles. Hence, monthly production will be 500 tricycles.


b) The selling price per tricycle is Rs. 200. The various elements of cost (i.e., raw material, parts and components, labour and overheads) comprise 80% (40%+30%+ 10%) of the selling price. Hence, cost of production is Rs. 160 i.e., (200x).


Working Capital Management Under Inflation It is desirable to check the increasing demand for capital for maintaining the existing level of activity. Such a control acquires even more significance in times of inflation. In order to control working capital needs in periods of inflation, the following measures may be applied. Greater disciplines in all segments of the production front may be attempted as under: 14. The possibility of using substitute raw materials without affecting quality must be explored in all seriousness. Research activities in this regard may be undertaken, with financial assistance provided by the Government and the corporate sector, if any. 15. Attempts must be made to increase the productivity of the work force by proper motivational strategies. Before going in for any incentive scheme, the cost involved must


be weighed against the benefit to be derived. Though wages in accounting are considered a variable cost, they have tended to become partly fixed in nature due to the influence of various legislative measures adopted by the Central or State Governments in recent times. Increased productivity results in an increase in value added and this has the effect of reducing labour cost per unit. The managed costs should be properly scrutinised in terms of their costs and benefits. Such costs include office decorating expenses, advertising, managerial salaries and payments, etc. Managed costs are more or less fixed costs and once committed they are difficult to retreat. In order to minimise the cost impact of such items, the maximum possible use of facilities already created must be ensured. Further, the management should be vigilant in sanctioning any new expenditure belonging to this cost area. The increasing pressure to augment working capital will, to some extent, be neutralised if the span of the operating cycle can be i-educed. Greater turnover with shorter intervals and quicker realisation of debtors will go a long way in easing the situation. Only when there is a pressure on working capital does the management become conscious of the existence of slow-moving and obsolete stock. The management tends to adopt ad hoc measures which are grossly inadequate. . Therefore, a clear-cut policy regarding the disposal of slowmoving and obsolete stocks must be formulated and adhered to. In addition to this, there should be an efficient management information system reflecting the stock position from various standpoints. The payment to creditors in time leads to building up of good reputation and consequently it increases the bargaining power of the firm regarding period of credit for payment and other conditions. Projections of cash flows should be made to see that cash inflows and outflows match with each other. If they do not, either some payments have to be postponed or purchase of some avoidable items has to be deferred. Efficiency Criteria


Improved profitability of firm, to a great extent, depends on its efficiency in managing working capital. A single criterion would not be sufficient to judge or evaluate the efficiency in a dynamic area like working capital. Some of the parameters for judging the efficiency in managing working capital are: p. Whether there is enough assurance for the creditors about the ability of the company to meet its short-term commitments on time. Hence, a reliable index is whether a company can settle the bills on due dates. The finance department has to plan in advance to maintain sufficient liquidity to meet maturing liabilities. q. Whether maximum possible inventory turnover is achieved. The adverse effect of ineffective inventory management may not be offset even by the most efficient management of other components of working capital. r. Whether reasonable credit is extended to customers. This powerful instrument to promote sales should not be misused. The other side of the same coin is receiving credit. Both depend upon a company’s strength as a seller and as a buyer. s. Whether adequate credit is obtained from suppliers. It depends upon the company’s position in relation to its suppliers and the nature of supply market i.e. whether there is a single supplier or an oligarchy or a large number of suppliers. With coordination of efforts buyers can be in a position to negotiate competitive credit terms even if there is a single supplier and his ability to control the market. At times the supplier imposes the credit terms as 100% advance i.e., negative trade credit. t. Whether there are adequate safeguards to ensure that neither overtrading nor undertrading takes place. The following indices can be used for measuring the efficiency in managing working capital: Current Ratio (CR) CR =Current Assets/Current Liabilities It indicates the ability of a company to manage the current affairs of business. It is useful to study the trend of working capital over a period of time.


Though the current ratio of 2:1 is considered ideal, this may have to be modified depending on the peculiar conditions prevailing in a particular trade or industry. It is not only the quantum of current ratio that is important but also its quality. i.e., extent to which assets and liabilities are really current. Quick Ratio (QR) QR=Liquid Assets/Current Liabilities Liquid assets mean current assets minus those which are not quickly realisable. Inventory and sticky debts are generally treated as non-quick assets. The relationship of 1:1 between quick assets and current liabilities is considered ideal, but, like current ratio, it also varies from industry to industry, depending on the peculiar conditions of a particular industry. Cash to Current Assets If cash alone is a major item of current assets then it may be a good indicator of the profitability of the organization, as cash by itself does not earn any profit, the proportion should usually be kept low. Sales to Cash Ratio Sales to Cash Ratio=Sales/Average cash balance during the period. Cash should be turned over as many times as possible, in order to achieve maximum sales with minimum cash on hand. Average Collection Period (Debtors/Credit Sales) X 365 This ratio explains how many days of credit a company is allowing to its customers to settle their bills.


Average Payment Period Average payment period=(Creditors/Credit purchases) x 365 It indicates how many days of credit is being enjoyed by the company from its suppliers. Inventory Turnover Ratio (ITR) ITR=Sales/Average Inventory It shows how many times inventory has turned over to achieve the sales. Inventory should be maintained at a level which balances production facilities and sales needs. Working Capital to Sales Usually expressed in terms of percentage, it signifies that for any amount of sales a relative amount of working capital is needed. If any increase in sales is contemplated it has to be seen that working capital is adequate. Therefore, this ratio helps management in maintaining working capital which is adequate for the planned growth in sales. Working Capital to Net Worth This ratio shows the relationship between working capital and the funds belonging to the owners. When this ratio is not carefully watched, it may lead to: a) Over trading when the conditions are in the upswing. Its symptoms being (I) High Inventory Turnover Ratio (ii) Low Current Ratio; or b) Undertrading when the conditions of market are not good. Its major symptoms are: i) Low Inventory Turnover Ratio ii) High Current Ratio. Efficient working capital management should, therefore, avoid both over-trading and undertrading.


Sources of Working Capital Sources of working capital are many. There are both external or internal sources. The external sources are both short-term and long-term. Trade credit, commercial banks, finance companies, indigenous bankers, public deposits, advances from customers, accrual accounts, loans and advances from directors are external short-term sources. Companies can also issue debentures and invite public deposits for working capital which are external long-term sources. Equity funds may also be used for working capital. Trade credit Trade credit is a short-term credit facility extended by suppliers of raw materials and other suppliers. It is a common source. It is an important source. Either open account credit or acceptance credit may be adopted. In the former as per business custom credit is extended to the buyer. The buyer is not giving any debt instrument as such. The invoice is the basic document. In the credit system a bill of exchange is drawn on the buyer who accepts and returns the same. The bill of exchange evidences the debt. Trade credit is an informal and readily available credit facility. It is unsecured. It is flexible too; that is advance retirement or extension of credit period can be negotiated. Trade credit might be costlier as the supplier may inflate the price to account for the loss of interest for delayed payment. Commercial banks are the next important source of working capital finance. Commercial banking system in the country is broad based and fairly developed. Straight loans, cash credits, hypothecation loans, pledge loans, overdrafts and bill purchase and discounting are the principal forms of working capital finance provided by commercial banks. Straight loans are given with or without security. A onetime lump-sum payment is made, while repayments may be periodical or one time. Cash credit is an arrangement by which the customers (business concerns) are given borrowing facility upto a certain limit, the limit being subjected to examination and revision year after year. Interest is charged on actual borrowings, though a commitment charge for utilization may be charged. Hypothecation advance is granted on the hypothecation of stock or other asset. It is a secured loan. The borrower can deal with the goods. Pledge loans are made against physical deposit of security in the bank’s custody. Here the borrower cannot deal with the goods


until the loan is settled. Overdraft facility is given to current account holding customers to overdraw the account upto certain limit. It is a very common form of extending working capital assistance. Bill financing by purchasing or discounting bills of exchange is another common form of financing. Here, the seller of goods on credit draws a bill on the buyer and the latter accepts the same. The bill is discounted for cash with the banker. This is a popular form. Finance companies in the country About 50000 companies exist at present. They provide services almost similar to banks. They provide need-based loans and sometimes arrange loans from others for customers. Interest rate is higher. But timely assistance may be obtained. Indigenous bankers also provide financial assistance to small business and trades. They charge exorbitant rates of interest by very much understanding. Public deposits are unsecured deposits raised by businesses for periods exceeding a year but not more than 3 years by manufacturing concerns and not more than 5 years by non-banking finance companies. The RBI is regulating deposit taking by these companies in order to protect the depositors. Quantity restriction is placed at 25% of paid up capital + free services for deposits solicited from public is prescribed for non-banking manufacturing concerns. The rate of interest ceiling is also fixed. This form of working capital financing is resorted to by well-established companies. Advances from customers are normally demanded by producers of costly goods at the time of accepting orders for supply of goods. Contractors might also demand advance from customers. Where sellers market prevails, advances from customers may be insisted. In certain cases, to ensure performance of contract an advance may be insisted. Accrual accounts are simply outstanding suppliers of overhead service requirements. Loans from directors, loans from group companies etc. constitute another source of working capital. Cash rich companies lend to liquidity companies under liquidity crunch. Commercial papers are usance promissory notes negotiable by endorsement and delivery. Since 1990 CPs came into existence. There are restrictive conditions as to the issue of commercial


paper. CPs are privately placed after RBI’s approval with any firm, incorporated or not, any bank or financial institution. Big and sound companies generally float CPs. Debentures and equity fund can be issued to finance working capital so that the permanent working capital can be matchingly financed through long term funds. Tandon Committee Recommendations Tandon committee was appointed by RBI in July 1974 under the Chairpersonship of Shri. P.LTandon who was the Chairman of Punjab National Bank then. The terms of references of the committee were: 21. To suggest guidelines for commercial banks to follow up and supervise credit from the point of view of ensuring proper use of funds and keeping a watch on the safety of advances. 22. To suggest the type of operational data and other information that may be obtained by banks periodically from the borrowers and by the Reserve bank from the lending banks. 23. To make suggestions for prescribing inventory norms for different industries both in the private and public sectors and indicate the broad criteria for deviating from these norms. 24. To suggest criteria regarding satisfactory capital structure and sound financial basis in relation to borrowing. 25. To make recommendations regarding resources for financing the minimum working capital requirements. 26. To suggest whether the existing pattern of financing working capital requirements by cash credit overdraft requires to be modified. If so, Suggest suitable modification. Findings of the committee: The committee studied the existing system of extending working capital finance to industry and identified the following as its major weaknesses: 27. It is the borrower who decides how much he would borrow. The banker cannot do any credit planning since he does not decide how much he would lend. 28. Bank credit, instead of being taken as a supplementary to other sources of finance, is treated as the first source of finance.


29. Bank credit is extended on the account of security available and not according to the level of operations of the borrower, 30. There is a wrong notion that security by itself ensures the safety of bank funds. As a matter of fact, safety essentially lies in efficient follow-up of the industrial operations of the borrower. Commitee Recommendations: The report submitted by the Tandon committee introduced major changes in the financing of working capital by commercial banks in India. The report was submitted on 9th August 1975. Fixation of norms. An important feature of the Tandon Committee’s recommendations relate to fixation of norms for bank lending to industry. Working Capital Gap 31. In order to reduce the dependence of businesses on banks for working capital, ceiling on bank credit to individual firms has been prescribed. Accordingly, businesses have to compute the current assets requirement on the basis of stipulations as to size. So, flabby inventory, speculative inventory cannot be carried on with bank finance. Normal current liabilities, other than bank finance, are also worked out considering industry and geographical features and factors. Working capital gap is the excess of current assets as per stipulations over normal current liabilities (other than bank assistance). Bank assistance for working capital shall be based on the working capital gap, instead of the current assets need of a business. This type of financing assistance by banks was introduced on the basis of recommendations of Tandon Committee. 32. Inventory and Receivables norms: The committee has suggested norms for 15 major industries. The norms proposed represent the maximum level for holding ventures and receivables. They pertain to the following: gg. Raw materials including stores and other items used in the process of manufacture hh. Stock in process


ii. Finished goods jj. Receivables and bills discounted and purchased. Raw materials are expressed as so many months’ cost of production. Stock in process is expressed as so many months’ cost of production. Finished goods and receivables are expressed as so many months cost of sales and sales respectively. iii) Lending norms: The lending norms have been suggested in view of the realization that the banker’s role as a lender is only to supplement the borrower’s resources. The committee has suggested three alternative methods for working out the maximum permissible level of bank borrowings. Each successive method reduces the involvement of short-term credit to finance the current assets, and increases the use of long-term funds. The first method provided for a maximum 75% of bank funding of the working capital gap. That is, at least 25% of working capital gap must be financed through long-term funds. The second method provided for full bank financing of working capital gap based on 75% of current assets only. That is,25% of current assets should be financed through long-term funds. 25% of current assets are greater than 25% of working capital gap. Hence 2nd method meant more non-bank finance for working capital. The third method provided for long-term fund financing of whole permanent current assets and 25% of varying current assets. That is bank financing will be limited to working capital gap computed taking 75% of varying current assets only. The three methods are discussed below to show permitted bank funding of working capital:


Today, Tandon committee recommendations are not relevant. Now, banks are flush with funds. But good borrowers aren’t many. Tandon committee recommendations were relevant when controlled economy prepared. Today, it opens economy. Besides, these recommendations were relevant in those years when money market was tight and capital rationing was needed. Today, the whole environment has changed. Now banks want to provide long-term loans well. Actually from April 15, 1997, all instructions relating to maximum permissible bank finance (MPBF) were withdrawn.


Chore Committee Recommendations Following the Tandon Committee the Chore Committee under the Chairmanship of Shri. IC.B.Chore, of RBI, was constituted in April 1979. The terms of reference were: 37. To review the working of cash credit system 38. To study the gap between sanctioned and utilized cash credit levels 39. To suggest measures to ensure better credit discipline 40. To suggest measures to enable banks to relate credit limits with output levels. The recommendations of the committee were: 41. To continue the present system of working capital financing, viz., credit, bill finance and loan 42. If possible supplement cash credit system by bill and loan financing 43. To periodically review cash credit levels 44. No need to bifurcate cash credit accounts into demand loan and cash credit components. 45. To fix peak level and non-peak level limits of bank assistance wherever, seasonal factors significantly affect level of business activity. 46. Borrowers to indicate before commencement requirement of bank credit within peak and sanctioned. A variation of 10% is to be tolerated. 47. Excess or under utilization beyond 10% tolerance level is to be considered as irregularity and corrective actions are to be taken up. 48. Quarterly statements of budget and performance be submitted by all borrowers having Rs.50 lakh working capital limit from the whole of banking system. 49. To discourage borrowers depending on adhoc assistances over and above sanctioned levels. 50. The second method of financing of working capital as suggested by the Tandon committee be uniformly adopted by banks. 51. To treat as working capital term loan the excess of bank funding when the switch over to the second method bank financing is adopted and the borrower is not able to repay the excess loan.


Marathe Committee Recommendations Later Marathe Committee was appointed to suggest meaningful credit management function of the RBI. The recommendations of the committee include: 52. The second method of financing Tandon committee should be followed. 53. Fast-track system of advance releasing upto 50% of additional credit required by borrowers pending RBI’s approval of such enhanced credit authorization. 54. The bank should ensure the reasonableness of projections as to sales, current assets, current liability, net working capital by looking into past performance and assumptions of the future trend. 55. The current assets and liabilities to be classified in conformity with the guidelines issued by the RBI. For instance current liability should include any liability that needs to be retired within 12 months from the date of previous balance sheet. 56. A minimum of 1.33 current ratio should be maintained. That is, 25% current assets should be financed from long-term funds. 57. A quarterly information system (QIS) giving details as to projected level of current assets and current liabilities be evolved such that the information is given to the banker in the week preceding the commencement of the quarter to which the data is related and adopted. 58. A quarterly performance reporting system giving data on performance within 6 weeks following the end of the quarter to which the data is related and adopted. 59. A half yearly operating and fund flow statement to be submitted with in 2 months from the close of the half-year 60. The banker should review the borrower’s accounts at least once a year HAVE YOU UNDERSTOOD? 61. Discuss the concept of working capital. Are the gross and net concepts of working capital exclusive? Explain. 62. Distinguish between fixed and fluctuating working capitals. What is the significance of such distinction in financing working needs of an enterprise?


63. Discuss the significance of working capital management in a business enterprise. What shall be the repercussions if a firm has (a) shortage of working capital and (b) excess working capital? 64. A firm desires to finance its current assets entirely with short-term loans. Do you think this pattern of financing would be in the interest of the firm? Support your answer with a cogent argument. 65. What factors a Finance Manager would ordinarily take into consideration while estimating working capital needs of his firm? 66. What is an operating cycle and how a close study of the operating cycle is helpful? 67. How would you as a Finance Manager control the need of increased working capital on account of inflationary pressures? Narrate some real-life examples you might have come across. 68. How would you judge the efficiency of the management of working capital in a business enterprise? Explain with the help of hypothetical data. 69. Define working capital and describe its components 70. Bring out the kinds and concepts of working capital and the nature and significance of each type of working capital 71. What do you mean by working capital management? What approaches would you adopt to ensure effectiveness? 72. Discuss clearly the factors affecting the size and composition of working capital. 73. How would you plan the working capital requirements of a manufacturing undertaking. 74. What is operating cycle? Explain its significance in the context of estimation of working capital and ensuring efficient management of working capital. 75. Explain the different sources of working capital finance. 76. Discuss the terms of reference and recommendations of the Tandon Committee. Give the impact on financing of working capital. 77. What are the recommendations of Chore Committee? Explain them. Lesson 2 Accounts Receivables Management


Introduction When the finished goods are sold on credit, the entire sales (both on cash and credit bases) are recorded as sales in the profit and loss account. But, while the cash sales get represented in terms of cash in hand or in bank or some assets purchased on cash basis, etc, the credit sales are reflected in the value of sundry debtors (SDs) (as referred to in India),are also known as Trade Debtors (TDs). Accounts Receivable (ARs), Bills Receivable (BRs) on the assets side of the balance sheet. This is what happens in the books of the seller. But, in the books of the buyer, the purchases made on credit basis are accounted for as sundry creditors (SCs) also known as Trade Creditors (TCs), Accounts Payables (APs) and Bills Payable (BPs). Further, with a view to fully understand and appreciate the high need for effective monitoring and follow-up of sundry debtors, it may be very pertinent to mention here that generally speaking, after the company’s investment in plant and machinery, and stocks of inventory (mostly in that order), the sundry debtors constitute the third largest and most important item of assets of the company. Therefore, the imperative need of effective monitoring and control of all the items of Sundry Debtors assume a highly important and strategic position in the area of Corporate Financial Management. Learning objectives After reading this lesson, you will be conversant with: Meaning and computation of receivables Credit policy of organization Purpose and cost of maintaining receivables Causes for high sundry debtors Caridecations for formulation credit policy Education of credit worthiness of customers Decision tree for credit granting Monitoring of receivables


SECTION TITLE Credit Policy While formulating credit policies, we should vary the quantum and period of credit, party-wise. For this purpose, we may broadly classify our parties (customers, clilentele) under four different categories, on the basis of their integrity and ability (both intention and strength) to pay in full and in due time. Accordingly, these may be classified as under: Category Degree of Risk A No risk B Little risk C Some risk D High risk But, such an exercise should not be taken as just a onetime exercise. Such classifications must, instead, be reviewed periodically, and revised upward or downward, as the case may be. That is, if the performance of a particular party in category A seems to be declining, in terms of promptness in payment, it could well be brought down from Category A to say, Category B. And, similarly, based upon the past performance, as per the company’s records, if so me perceptible improvement is observed in some category B, or even category C parties, these could as well be promoted to Category A and B respectively, as the case be. I am saying so, such that all the sundry debtors of the company may remain under continuous observation and scrutiny, and some urgent remedial measures (of applying some restrictions or liberalization) could be affected, before it becomes too late. We would now discuss, in detail, about the various ways and means, steps and strategies that can be adopted to achieve the desired goal of keeping the sundry debtors at the minimal level. Steps and Strategies


Step 1 Prompt despatch of goods and invoice: The very first step towards effective supervision and follow-up of sundry debtors is that the goods must be despatched promptly, as also the relative invoice. Because, the 15th day or 60th, whatever, can be counted only after the day one begins, i.e., when the goods invoice have been despatched. Thus, a slight delay of even a day or two delays the payment of the sundry debtors at least by so many day(s). Step 2 Correct and unambiguous invoicing: It is of crucial importance that the order number, particulars (quality and quantity) of goods, and such other details are incorporated in the invoice correctly, so as to facilitate the buyer company to connect the matter appropriately. Any error in these particulars, howsoever all, may result in a significant financial loss, sometimes, due to the avoidable correspondence and the resultant delay in payment. Step 3 Avoid disputes: Extra care and due precaution must be taken by and at all times, in despatching the goods of the agreed quality only, (not even a shade less or more), so that may keep all the possible disputes avoided, ways. Step 4 Standard (printed) invoice porforma with a tear-off portion: With a view to ensuring that all the relevant particulars have been incorporated in the invoice, (of course, meticulously and correctly), it would augur well if the company takes care to evolve an all - comprehensive proforma of its invoices, such that no relevant particulars may be lost sight


of. Besides, with a view to ensuring that the invoice, along with the relative bill of exchange and such other documents, have been duly received by the party, an acknowledgement slip could also be provided as a tear off portion of the relative forwarding letter itself, wherein all the relevant particulars details of the various documents, etc., as also the full and correct postal address of the seller company, are computer-printed at the appropriate place. This way, the buyer company, at the receiving end, would have to just put its rubber stamp (not even signature) on the acknowledgement slip, and to slip the (acknowledgement) slip in the window envelop and post it. And, that is it. A specimen proforma of the suggested forwarding letter along with the tear off portion containing the acknowledgement slip, is placed in Annexure 5.1 at the end of the Chapter. When the efforts of typing acknowledgement letter are involved, mostly the buyer companies are found to be adopting the easiest course of action. That is, they just do not send any acknowledgement, whatsoever. Step 5 Entries in the (i) Master Register (all comprehensive) and (ii) Ledger Accounts (partywise): With a view to exercising effective control on all the Working Capital Management sales effected, on a day-to-day basis, the companies may maintain a Master Register; wherein all the particulars of all the sales effected on a particular day may be entered, in serial order. To facilitate calculation of the due dates of payment, separate sections in the register (or separate files in the computer) should be maintained for parties enjoying the credit for different periods, viz. 15 days, 30 days, 45 days, 60 days, 75 days, 90 days, 180 days, and so on.It will be better still, if separate sub-sections are also maintained for parties falling under different categories like A, B and C (presuming that the parties falling under the category "D" being the high risk will not be given any credit, whatsoever). So, because this may facilitate the company’s effective follow up programme in a scientific and systematic manner, on the basis of the ABC analysis, whereby the quantum of pressure and frequency and rigour of monitoring could be gradually increased in the cases of B (as compared to A) and C (as compared to B) categories of sundry debtors.


That is, in case of category A, too much of close follow-up may not be required until their payment pattern calls for their degradation from category A to category B, and so on. Similarly, the parties under category B may require somewhat closer follow-up, while those under category C may require a still closer and more frequent follow-up measures as also a constant watch and vigil over the payment pattern, so as to decide whether some restrictions are required to be imposed on their credit terms, such that the situation may not get worsened and go out of control, beyond any remedy. A General Pattern of Follow-up Measures A general pattern of follow-up of sundry debtors are discussed hereafter, followed by some special strategies to be evolved for some special and specific cases, desiring special attention and specific treatment. The idea behind having different sections or registers (or different folios in the computer) is that the actual due date can easily be calculated from the date of sale, as the same section / file will have the same due date for the same date of sale. That is, in a section / file of 30 days credit period, the due date will be 30 days after the date of sale and so on. Step 1 By way of a general follow-up, usually a week before the due date of payment, a routine type of computer printed reminder could be sent. Step 2 Further, if the bill does not appear to have been paid even after a week or a fortnight, of the stipulated due date, a second reminder may be sent with a slightly firm language used, and a copy thereof may be endorsed to the Sales Officer/Sales Representative for necessary follow-up action. Step 3


If, even such reminder does not evoke the desired results, a third strict reminder may have to be sent, with a copy thereof endorsed to the Sales Officer/Sales Manager concerned, to personally follow-up the matter with the party concerned, during their immediately next visit to the area, so as to obtain the payment, at the earliest. And, in the mean time, the goods despatch section may be instructed to suspend the supply of goods to such party , till further fuctions, so as to avoid the situation of accumulation of some huge over- amounts. Step 4 And, if even such strict and firm dealings do not bestir (activate) the parties, legal notice(s) may have to be served on some of them, just as test cases, so that they (and even other buyers) may not get an impression that they may go scot free so easily. Step 5 Similarly, in some cases, just by way of setting an example, and creating some sense of fear, even civil suits may be filed, though not with the intention of bringing it to its logical conclusion, but only as a demonstration of strong will that mean business. As has already been stated earlier, along with the master register, the companies must also maintain a separate ledger account for each party, wherein the date of sale, particulars of sale, date of payment or return of the bills, etc. would be incorporated. This way, you will be able to form an opinion regarding each party which may, in turn, facilitate the review and revision of the categorization of each party periodically, and adopting specific strategies for the continuation of the terms of the credit sales or otherwise, depending upon the review data, revealed by the ledger account of the party concerned. Streamlined Enquiry Systems Due care must be taken by the companies to identify one specific official to attend to all the enquiries pertaining to sundry debtors, and all the other officials of the company, including the telephone operators, must know it and know it well. Thus, any call coming for such enquiries may invariably be put through to the right person, and even if, by chance, it gets connected to


some wrong number, the person concerned would be able to transfer the call to the right person, in one go, instead of the call being tossed over from one person to the other. Now, in almost all the companies, all the relevant particulars will be available to the person, with the press of a button on the computer, for clarification of any doubt or for replying to any query pertaining to the bills with great ease. Further, the official concerend would do well if he could note down all the queries made by various sundry debtors so that when all these are listed category-wise, the study and analysis may throw-up some light on how to streamline the proforma invoice or such other systems, so that much of the queries could be eliminated. Incidentally, it may be mentioned here that such enlisting of various complaints received on different counts, may also be used to enable us to take some suitable remedial measures pertaining to after-sales service, quality control, delayed despatch, etc. We should, therefore, treat all the complaints as a free and frank feed back, an opportunity to introspect and improve upon. Besides, this will also enable the official of the company to raise some of his own queries or else to seek some clarification or even to remind of some long over-due payments, etc. But, care must be taken that you praise your query only after all the queries of the caller have been answered to his entire satisfaction. Main Causes High Sundry Debtors [A] Internal Causes (IC) IC-l Ambiguous/Incorrect invoicing regarding quantity, price, etc. IC-2 Delay in the despatch of the documents / goods. IC-3 Lack of effective monitoring of Sundry Debtors like, Age-wise/Party-wise analysis and vigorous follow-up, etc.


IC-4 Lacunae in the Monitoring Mechanism! Credit Policy, (regarding credit period/cash discount, etc.). IC-5 Goods despatched with insufficient documents, e.g. valid purchase Order, etc. IC-6 Defective supplies, e.g. sub-standard quality/quantity, insufficient after-sales services, etc. IC-7 Relevant documents and/or information not readily available for vigorous follow-up, IC-8 Ambiguity/deficiency in the terms and conditions, fixation/re-fixation of prices, and such unresolved issues, causing further delays. IC-9 Overbilling regarding excise duty/sales tax etc., due to the changes in the Acts, noncompliance of the terms and conditions of the purchase order, especially regarding excise duty/sales tax, etc. IC-10 Holding back of 5 to 10 per cent of the amount of the bill, pending installation and commissioning, completion of the project, expiry of the warranty period and such other mutually agreed terms and conditions. IC.11 Any other internal cause (s); please specify). [B] External Causes (EC) (S); (please specify) EC- 1 Damage/Loss during transit EC-2 Lack of co-ordination in the buyers’ organizations EC-3 Lack of liquidity with the buyers EC-4 Buyer’s insolvency/liquidation EC-5 Buyers’ reluctance- to take delivery of the documents from the bank


EC-6 Instalments due but not collected by the collecting agent EC- 7 Instalments collected but not remitted by the collecting agent forcredit of the company’s account EC-8 Any other external cause (s); (please specify). [C] Dispute Being the Cause (DC) DC-1 Buyers’ unreasonable rejections on untenable grounds of deficiency in the quality/quantity of goods supplied DC-2 Buyers unduly delaying the inspection of finished goods, before despatch DC-3 Charges like freight, insurance, postage, demmurages, bank charges, etc.

disallowed/deducted by the buyers, and are being contested by DC-4 Litigation [D] General Comments Sundry Debtors may be dividend into four categories. 78. Internal causes (IC 1 to 11) where the reasons could be the negligence or slackness on the part of some in-house staff 79. External causes (EC 1 to 8) where the reasons lie somewhere outside the company and its staff. 80. Dispute being the cause (DC 1 to 5) where the dispute regarding quality and/or quantity or such other factors may be the main causes. 81. Miscellaneous causes (MC 1 to 3) where the causes are such which do not fall under any of the aforesaid three categories. The added advantage of the listing of the causes, with code numbers given in the parentheses, would be, to facilitate all the different departments to submit the periodical performance reports


in regard to the sundry debtors, with the specific reasons, quoted at the appropriate places, by way of the code numbers only, like 1C3, EC5, DC2 etc. or MC1. Besides, such list may force the departmental heads concerned to identify the specific reasons to be quoted in their periodical reports, instead of the usual practice of giving some causes or the other, mostly in general terms, which did not convey much sense. But, this practice may facilitate the analyses of the various causes of high sundry debtors, which, in turn, may go a long way in evolving some appropriate remedial measures, promptly and well in time. Formulation of Credit Policy Credit policies need to be formulated by the top management, of course, in consultation with the lower levels of management, as they are expected to have the real feel and first-hand experience and information about the market trends as also about the traders and the competitors. Cash Discount Cash discount is a very common mechanism of effecting and encouraging speedy payments but of course, at a price. Therefore, before taking a decision about the period and quantum of giving cash discount, we must first try to understand and appreciate the financial implications of such a stand taken, mainly in terms of the quantum of interest gained or lost. This can be best understood by taking some illustrative examples. Day’s Sales Outstanding (DSO) There is yet another method of monitoring and follow-up of sundry debtors, commonly known as "Day’s Sales Outstanding" (DSO). The ‘day’s sales outstanding’ at a given time "t" may be said to be the ratio of sundry debtors outstanding at the material time to the average daily (credit) sales [not total sales] during the preceding month or two months period or quarter, or say 30 days, 60 days and 90 days, or such other suitable period. It may be represented as under:


DSOt = Sundry Debtors at time "t" I Average daily (Credit) Sales. Let us try to understand this method / tool better with the help of an illustrative example. DECISION - MAKING Sundry debtors management requires a lot of decision-making exercises, in several areas, by the personnel at different levels: top level, middle level and junior level. Credit Policy Formulation of credit policy comes within the purview of the top management. It comprises various aspects of credit policy, which are discussed hereafter, one by one. A. Assessment of credit-worthiness of the sundry debtors This decision is the most crucial one to make, as it is the starting point of the whole chain of events, right from the point of sales on credit to the point of final realization of the proceeds of the credit sales. Here, also the main problem area is to take a decision while selecting a new party for dealings for the first time. This may involve various facets of enquiries and studies, with a view to assessing and evaluating the credit-worthiness and financial stability and strength of each company under consideration. While assessing the extent and quantum of credit risks involved, which differ from case to case, one must guard against some usual types of errors of judgement that may take place sometimes. They are: (i) Either a class A category of customer may be classified as category B or even C. (i) Or vice versa, i.e., a category B (or even category C) customer may be erroneously classified as A category one.


And, both these errors may prove a little costly in that either a good business may be lost, (and the financial gains therewith), or the company may accumulate some more bad debts, eating into its profitability. Such errors may take place but only in some cases, and not in general, provided due care is taken at the time of the evaluation of the credit-worthiness of the parties. In such cases, the periodical review of the payment pattern of the respective parties may be helpful in reclassification of some parties, and thereby rectifying the error, if any, hopefully well in time. Types of Credit Policy Different dimensions of the credit policy may vary in different degrees and shades. It may be categorised under three broad types: (i) Liberal Credit Policy: A credit policy may be termed as liberal wherein some other concessions and facilities are granted to the buyers, with the expectation that this way the sales may pick up, and thereby, the cost of extra concessions granted can well be taken care of, by the additional yield, resulting from the extra sales achieved therewith. But then, such liberalization may as well lead to some additional quantum of bad debts, related with the extra sales effected, as also the resultant higher blockage of funds in sundry debtors, and a higher cost of collection, too. Therefore, all such inter-related facts and factors must be duly considered while taking a decision regarding adoption and execution of a specific credit policy, most suited under the given circumstances. (ii) Strict Credit Policy: Under such credit policy, as against the liberal one, the minimum possible concessions and relaxations are granted to the customers. And, as a result thereof, the sales may get somewhat adversely affected. But, at the same time, the risk of bad debts may as well be minirnized, and so will be the extent of blockage of funds in sundry debtors and the collection efforts and expenses, too. Thus, the decision should be based on the trade-off position of the positive and negative factors. (iii) Medium (Moderate) Credit Policy: Such credit policy adopts the middle of the road approach whereby a balance is tried to be struck in such a way that both the quantum of


additional sales and the resultant risk of bad debts may be kept at the optimal levels, i.e., neither too high nor too low, but in about just the right measure. Parameters of Credit Policy The various dimensions on the basis of which a company may be said to be adopting a rather liberal, strict or medium (moderate) credit policy may broadly be classified under four different parameters. They are: (i) Standard of credit, (ii) Period of credit, (iii) Cash discount, and (iv) Effective monitoring and follow-up {i.e., Collection Efforts}. Let us discuss all these four different parameters of credit policy one after the other. A. Standard of Credit The main and most important question that may arise, while arriving at the credit policy decision, is what standard could be considered as the most appropriate and optimal one, with a view to accepting or rejecting a customer for credit sales. Here, the company has a variety of choices, of offering credit sales, ranging from ‘none’ to ‘all’ and to "some only". The first two options, obviously, do not seem to be right, as these may either adversely affect the volume and value of the sales, or else may run the high risk of the quantum of bad debts. Thus, both these steps are generally not advisable unless either the company enjoys the envious privilege of being in the sellers’ market or else it is in such a disparate situation that its sales may drastically drop down unless a very liberal credit policy is adopted. (B) Period of Credit The duration of time (say 30 days, 45 days. 60 days, etc.) allowed to the customers, to make the payment of the bill, representing the cost of the goods, supplied on credit, is referred to as the


credit period. It has generally been seen that the credit period ranges from 15 days to 60 days or even more. And, in the case of government departments, it may be even 90 days, 180 days, or even more. The credit period, however, varies mainly on two considerations: (i) The trade practices in the particular line of business, and (ii) The degree of trust and credit-worthiness on the part of the customers concerned (C) Cash Discount Cash discount is given by some companies with a view to giving some financial incentive to the customers so as to reduce them to pay the bills well before the usual credit period granted. Under such arrangement, the term of payment will be such that the buyer will get a cash discount at a certain percentage (say 2%), if he makes the payment well before the usual credit period granted, (eg., if he pays within 10 days, while the usual credit period granted is say, 30 days). If such would be the stipulation, it is usually represented, as per the prevailing practice, as "2/10 net 30." To say it again, it means that the buyer will get a discount of 2 per cent, if he makes the payment within 10 days from the date of the bill, or else he will have to pay the full amount of the bill, if the payment is made after 10 days but within 30 days. We must, therefore, appreciate that to obtain an early payment of the bill, some discount is being given, which means that there is a price to be paid to obtain an early payment. Now, let us compute the price, (or the rate of interest, as it, in effect, is the interest only), that is being paid by the seller, to the buyer, for making an early payment. We are here, presuming that all the buyers are prudent enough to pay the bill, only on the 10th day (and not earlier) so as to reap the maximum benefit out of the cash discount offered. And, if they were to decide, not to avail of the cash discount, they would, invariably, pay the bill on the very last day, i.e., on the 30th day only. Example (A) From the point of view of the seller:


(i) 2/10 Net 30 In effect, it means that a discount of 2 per cent is to be given if the bill is paid earlier, just by 20 days only (i.e., 30 less 10 = 20 days). That is, the loss, by way of interest, to the seller (on Rs. 100) for 20 days is 2 per cent. Thus, the rate of interest per annum (presuming 360 days to a year) would come to: (2 x 360) / [100 (30-10)1 = 720/2000 = 0.36 or 36 % (ii) Similarly, in the case of "1/15 net 45", the cost, (to the seller) by way of interest, will be: (1 x 360) / [100 x (45-15)1 = 360/3000 = 0.12 or 12 % (iii) And, in the case of "2/9 net 45", the cost, (to the seller) by way of interest, would be: (2 x 360) / [100 (45-9)] = 720/3600 = 0.20 or 20% (iv) And, "1.5/15 net 60" would mean: (1.5 x 360) / [100 (60-15)] = 540/4500 = 0.12 or 12 % (B) From the point of view of the buyer: But, does it mean that the percentage of savings made by the buyer is also the same (as the percentage of the cost incurred by the seller), or else it is a little more or less? Let us, find it out, based upon the very first illustrative example, given above. That is, "2/10 net 30". Here, from the point of view of the buyer, he stands to gain Rs. 2 when he has to actually pay (Rs. 100 - Rs. 2/-) = Rs. 98/- only (instead of Rs. 100). That is, on an investment or payment of Rs. 98/- only, he stands to gain Rs. 2/- in 20 days period. So, on an annualized basis, he stands to gain(2 x 360) / 98 x 20 = 36.666 percent or say, 36.67 percent. Thus, we see that the buyer is a gainer by a slightly higher percentage, as compared to the seller, because, the buyer gains the same amount by investing or paying a little lesser amount than Rs.


100)- (i.e. Rs. 981- only). But, the loss of the seller is on the full Rs. 100/- i.e., instead of getting Rs. 100/-, he gets a little less, i.e., Rs. 98/-, in the example under consideration. Management of Sundry Debtors (Bills Receivable or Accounts Receivable) in India We have so far discussed about the various principles of management and control of sundry debtors. Now, we would like to critically examine as to what are the actual practices and policies that are, generally being followed by the various companies in India. For the purpose of the study we shall take up the issues under three broad categories: (A) Credit Policy (B) Assessment of Credit-worthiness of the customers (present and prospective), and (C) Monitoring and Control of Sundry Debtors. (A) Credit Policy (i) Very few companies have been found to have systematically formulated and documented their credit policies. In most of the cases these are made on an ad hoc basis and mostly remain as unwritten conventions and practices. (ii) In some of the companies, the credit policy and philosophy have been stated, in too general terms, which do not signify any specific stand or standard, to be followed by the operating staff. For example, if a company states its credit policy, in general terms, like "Our credit policy aims at maximising the growth of sales with the minimal bad debt risks", it does not convey much as a guideline or guiding principle of any practical use and utility. (iii) The credit period offered by various companies differs to a very great extent, ranging from 0 day to 60 days or even 90 days. For example, a company, which is privileged to be in the seller’s market, may not give a single day’s credit, i.e., may insist on cash down payments, while the companies like Premier Motors or Daewoo Motors may offer a much longer credit period, to boost up the sales. Further, while some of the companies, manufacturing consumer products (with the exception of textile and garment manufacturing companies) may give nil or a limited


credit period, other companies may have to give a much longer credit period, to be able to sell their products. (iv) Besides, the practice of offering cash discount (with a view to ensuring early payments) does not seem to be very popular in Indian business scenario. (B) Assessment of Credit-Worthiness of Customers 82. There does not seem to be any systematic and scientific study made, by using different tools and techhiques, to determine the creditworthiness or financial strength and stability of the customers - both present and prospective. In fact, the financial position of the present customers should also be reviewed and revised on a regular basis, based upon out: own experiences of their past performance and dealings with us. But this seldom seems to have been resorted to, in most of the companies. 83. No serious and sincere effort seems to have been made to meticulously analyse the balance sheet and profit and loss account of the companies, with a view to making a realistic assessment and appraisal of their financial position. It has hardly been observed that some companies have asked for some break-ups of certain items (say, of inventories or bad debts), to see through the elements of window dressing, if any. 84. Prospective customers are required to give, at least, two or three references, but no serious attempt seems to have been made by most of the companies to verify the position from such references. 85. Independent credit rating agencies have, of late, appeared on the scene like CRISIL, ICRA, etc., but the credibility and dependability of their credit ratings may be a little doubtful. The credit rating agencies had given satisfactory credit rating to ‘MS Shoes’ and ‘CRB Finance Company’, but their assessment had proved to be totally wrong and contrary to facts. Besides, the practice of seeking professional help from such credit rating companies to ascertain and assess the financial position of the prospective customers does not seem to be very common, as opposed to the conditions prevailing in the USA, and other developed countries. 86. Some companies attempt to get the opinion of the bankers on the prospective customers from the letters’ bank, but, as has already been observed earlier, their opinions, though


given in strict confidence and without any obligation, are written in such general and vague terms that these do not seem to be of much help and practical utility. (C) Effective Monitoring and Control of Sundry Debtors Though the various tools and techniques, systems and strategies, of effective monitoring of sundry debtors, are very well known to the executives of most of the companies, very few companies have been found to have evolved some systematic mechanism of effective monitoring and follow-up of sundry debtors on some sound, systematic and scientific lines. A lot seems to have been left to be desired. Some companies have been found to be working out the average collection period, but not party-wise. They may do the ageing analysis but only in absolute terms and not in terms of percentage, etc. Factoring Factoring is a unique financial innovation. It is both a financial as well as a management support to a client. It is a method of converting a non-productive, inactive asset (i.e., hook debts) into a productive asset (viz., cash) by selling book debts (receivables) to a company that specialises in their collection and administration.’ For a number of companies, cash may become a scarce resource if it takes a long time to receive payment for goods and services supplied by them. Such a current asset in the balance sheet is, in fact, illiquid and serves no business purpose; it is much better to sell that asset for cash which can be immediately employed in the business. A "facto?’ makes the conversion of receivables into cash possible. The term factor has its origin in the Latin word ‘facere’, meaning to make or do, or to get things done. Originally, factors acted as selling agents. They facilitated the flow of merchandise from the manufacturers to customers. The functions of a factor included finding out customers for the manufacturer’s products, stock his goods, sell them and finally collect sales proceeds and remit them to the manufacturer. Thus, the function of factors in olden days included stocking, marketing and distribution as well as administration and financing of credit. The modem factor has specialized in credit collection and financial services, leaving the marketing and distribution functions to the manufacturer.


Factoring Services While purchase of book debts is fundamental to the functioning of factoring, the factor provides the following three basic services to clients: 87. Sales ledger administration and credit management. 88. Credit collection and protection against default and bad-debt losses. 89. Financial accommodation against the assigned book debts. Credit administration A factor provides full credit administration services to his clients. He helps and advises them from the stage of deciding credit extension to customers to the final stage of book debt collection. The factor maintains an account for all customers of all items owing to them, so that collections could be made on due date or before. He helps clients to decide whether or not and how much credits to extend to customers. He provides clients with information about market trends, competition and customers and helps them to determine the credit worthiness of customers. He makes a systematic analysis of the information regarding credit for its proper monitoring and management. He prepares a number of reports regarding credit and collection, and supplies them to clients for their perusal and action. Credit collection and protection When individual book debts become due from the customer, the factor undertakes all collection activity that is necessary. He also provides full or partial protection against bad debts. Because of his dealings with the variety of customers and defaults with different paying habits, he is better position to develop appropriate strategy to guard against possible defaults. Financial assistance Often factors provide financial assistance to the client by extending advance cash against book debts. Customers of "clients" become debtors of a factor and have to pay to him directly in order to settle their obligations. Factoring thus involves an outright purchase of debts, allowing full credit protection against any bad debts and providing financial accommodation against the firm’s


book debts. In the U.S.A., the maximum advance a factor provides is equal to the amount of factored receivables less the sum of (i) the factoring commission, (ii) interest on advance, and (iii) reserve that the factor requires covering bad-debts losses. The amount of reserve depends on the quality of factored receivables and usually ranges between 5 to 20 per cent in the U.S.A. In view of the services provided by a factor, factoring involved the purchase of a client’s book debts with the purpose of facilitating credit administration, collection and protection. It is also a means of short-term financing. It provides protection against the default in -paying for book debts. For these services, the factor, however, charges a fee from the client. Thus factoring has a cost. Other services In developed countries like the U.S.A factors provide many other services. They include: (i) providing information on prospective buyers; (ii) providing financial counselling; (iii) assisting the client in managing its liquidity and preventing sickness; (iv) financing acquisition of inventories; (v) providing facilities for opening letters of credit by the client etc. Factoring and Short-Term Financing Although, factoring provides short-term financial accommodation to the client, it differs from other types of short-term credit in the following manner: Factoring involves sale of book debts. Thus the client obtains advance cash against the expected debt collection and does not incur a debt. Factoring provides flexibility as regards credit facility to the client. He can obtain cash either immediately or on due date or from time to time, as and when he needs cash such flexibility is not available from formal sources of credit. Factoring is a unique mechanism, which not only provides credit to the client but also undertakes the total management of client’s book debts. Factoring and Bills Discounting


Factoring should be distinguished from bill discounting. Bill discounting or invoice discounting consists of the client discounting bills of exchange for goods and services on buyers, and then discounted it with bank for a charge. Thus, like factoring, bill discounting is a method of financing. However, it falls short of factoring in many respects. Factoring is of bills discounting plus much more. Bills discounting has the following limitations in comparison with factoring: Bills discounting is a sort of borrowing while factoring is the efficient and specialized management of book debts along with enhancement of the client’s liquidity. The client has to undertake the collection of book debts. Bill discounting is always ‘with recourse, and as such the client is not protected from bad debts. Bills discounting is not a convenient method for companies having large number of buyers with small amounts since it is quite inconvenient to draw a large number of bills. Types of Factoring The factoring facilities available worldwide can be broadly classified into four main groups 90. Full service non-recourse (old line) 91. Full service recourse factoring 92. Bulk/agency factoring 93. Non-notification factoring HAVE YOU UNDERSTOOD? 94. There are several terms of payment prevalent in the business world. Name the major terms of payment in practice and briefly describe each of them separately. 95. What are the ramifications of enhancing and reducing the credit period? Explain, by citing some illustrative examples. 96. Distinguish between (i) liberal and (ii) strict credit standards by citing suitable examples in each case. Explain the effects of liberal and strict credit terms, in each of the cases separately. 97. What do you mean by (i) liberalizing and (ii) restricting the credit policies, in terms of the following: -


a. Period of credit b. Cash discount c. Credit standards, and d. Collection efforts. 98. Proper assessment of credit risks is considered to be one of the most crucial factors in the area of management of credit. Do you agree? Give reasons for your answer. 99. What are the two main types of error that may creep in, while assessing the credit risks? Explain each of them by citing suitable illustrative examples. 100. a. Bank reference is considered to be one of the major factors for assessing the credit-worthiness of a prospective customer. Do you agree? Give reasons for your answer. b. What are the main shortcomings and limitations connected with obtaining bank references and what are the pragmatic approaches for overcoming them? 101. a. Credit management practices, in Indian Companies, suffer from several deficiencies. What are these and what are the adverse effects of each of them in actual practice? b. What are the specific suggestions that you would like to make with a view to streamlining and strengthening the present practices of management of credit (Sundry Debtors) by the industries in India? 102. "Ageing Analysis" is an effective tool for monitoring and follow-up of sundry

debtors. However, for better results, it is desirable to do the ageing analysis: i. ii. Not only "Period-wise", but also "Party-wise", and Not only in "absolute terms" (of Rs.) but also in "percentage terms".

Explain and illustrate, by using suitable examples. 103. Explain the objective of credit policy? ‘What is an optimum credit policy?

Discuss. 104. Is the credit policy that maximizes expected operating profit an optimum credit

policy? Explain.


105. 106. 107. 108. 109.

What benefits and costs are associated with the extension of credit? How should they be combined to obtain an appropriate credit policy? What is the role of credit terms and credit standards in the credit policy of a firm? What are the objectives of the collection policy? How should it be established? What shall be the effect of the following changes on the level of the finn’s

receivables: . a. b. c. 110. Interest rate increases. The general economic conditions slacken. Production and selling costs increase. The firm changes its credit terms from "2/10, net 30" to "3/10, net 30." ‘The credit policy of a company is criticised because the bad debt losses have

increased considerably and the collection period has also increased.’ Discuss under what conditions thiscriticism may not be justified. 111. What credit and collection procedures should be adopted in case of individual

accounts? Discuss. 112. How would you monitor book debts? Explain the pros and cons of various

methods. 113. 114. 115. What is factoring? What functions does it perform? Explain the features of various types of factoring. Define factoring. How does it differ from bills discounting and short-term

financing? Lesson 3 Inventory Management INTRODUCTION The importance and imperative need for effectively managing and controlling all the items of inventory in a company can be judged from the fact that generally these comprise the largest component of the total assets of a company, second only to the items of plant and machinery. In terms of percentage of the total assets of a manufacturing company, all the three components of


inventory, taken together, generally account for around 25 to 30 per cent of the total assets of the company. Thus, the importance of effectively managing and controlling the inventory of a company can hardly be over-emphasised. Learning objectives After reading this lesson, you will be conversant with: The nature of inventory and its role in working capital management Purpose and compenents of inventories Types of inventories and costs associated with it. Determination of EOQ and Economic production quantity. Inventory planning Various methods of pricing inventories Special techniques like ABC analysis and VED analysis Section Title Components of Inventories The term ‘inventory’ comprises three components. They are: 116. 117. 118. Raw materials (also consumable stores and spares), Work-in-process (also known as stock-in-process, process), and Finished goods.

Let us now discuss all these three items, one by one. 119. Raw Materials are those basic inputs, which are used to manufacture the finished

products. 120. Work-in-process, however, is the intermediary stage that comes after the stage of

raw materials, but just before the stage of finished goods. 121. The finished goods, in turn, comprise the end products, that is, the goods at their

final stage of production, ready for sale in the market.


Supposing, a company is in the business of production of breads. In this case, the wheat flour, baking powder, etc., would comprise the raw materials. And, when the flour is put in the relative moulds, which in turn, are placed in the furnace, this stage is known as the work-in-process stage. And, when the bread is fully baked and is ready for sale, of course, after being wrapped in the packing paper, it comprises the finished goods of the company. It may be noted that in the case of manufacturing companies, inventory comprises raw materials, work-in-process and finished goods, while in the case of trading concerns or trade merchants or retail traders, the inventory comprises only the finished goods. Thus, while all the three components, as aforesaid, comprise the items of inventory for the manufacturing concerns, only the finished goods, like the breads alone, comprise the inventory for a retail trader, selling breads. Here, it may be pertinent to mention that the task of inventory management and control is the joint responsibility of the purchase department, materials department, production department and marketing department. Further, while the policy pertaining to the raw materials is to be formulated by the purchase department, in coordination with the materials and production departments, the policy in regard to the inventory of finished goods is to be formulated by the production department in coordination with the marketing department. The policy in regard to the work-in-process, however, is finalised by the production department alone. And, as we have already seen earlier, keeping in view the vital importance of inventory management and control, in financial terms, the role of finance manager can be said to be the central coordinating role, among all the aforesaid four different departments, with a view to ensuring that the inventory management and control are being exercised effectively at the various stages and departments, on the desired lines. Here, the main responsibility of the finance manager comprises apprising the non-finance executives so as to, at least, understand the basis of the mechanism and its overall implication in regard to the control of various items of inventory, as these have direct effect on the financial gains of the company. That is why it is said that the management of inventory, and for that matter, the management of working capital as a whole, is not the responsibility of the finance manager alone, but also of the purchase department, materials department, production department, and marketing department.


Process Inventories These inventories comprise the various items of raw materials, lying at the various stages of production, till these reach the final stage, to become the finished goods. Supposing, a company is manufacturing iron nails, and its basic raw material is iron rods. In the drawing machine, these rods may be drawn total time required for completing all the involved processes (stretched) and, thus, these may become thinner and thinner in three to four processes, when these may come to the required diameter. Then, these thinner n rods will be cut into pieces of the required length of the nails. And then, while one end may be made pointed, the other end may be flattened to become the head of the nail. And, after all these required processes are completed in full, the stocks of finished goods are ready for transportation (movement) to the godown(s) or to the company’s sales outlets. Thus, as the production process involves several stages of production, the aggregate quantum and value of the raw materials, lying at the different stages of production, all taken together, comprise the stocks of process inventory. And, thus, if the entire process (from the raw material stage till the stage immediately preceding the finished goods stage) takes say, ten days, and the average production of the item is 1000 units per day, the average quantity of such process inventories would be equal to: Average stocks-in-process, multiplied by the time days required to complete all the processes, i.e., 1000 x 10 days = 10,000 units. Movement Inventories Movement inventories are usually referred to the inventories of finished goods, to be transferred from the factory to the company’s godowns, warehouses, or sales depots. Thus, if the average daily sales at the company’s sales depot are 250 units and the transit time (for transporting the finished goods from the factory to the sales depots) is 10 days, the average movement inventories, as per the aforesaid formula, would be: 250 units x 10 days = 2500 units, or


250 units x Rs. 5/- x 10 days = Rs. 12,500/Organization Inventories Organization inventories, on the other hand, comprise the items of raw materials and finished goods stored and stocked in the company’s godowns, to be supplied to the factory or to the sales depots, as and when they would requisition for the required number, weight, volume, etc., of the specific items of raw materials and finished goods, respectively. Here, it may be mentioned that the moment the stocks of raw materials and finished goods are issued from the company’s godown(s), these items are excluded from the organisation inventories and these, in turn, are included in the Working Capital process inventories (though these raw materials may actually be put into the production process a little later), or in the movement inventories (even if the stocks of the finished goods may be lying in the company’s show-rooms, unsold). Now, a natural question, that may arise, could be that if the inventory carrying cost is so huge and material to affect the profitability of the company, favourably or unfavourably, why should the companies, at all, have organization inventories, too, inaddition to the process inventories and movement inventories. And, the answer, too, is very simple and logical. That is, to make the decision-making process of planning (of purchases of raw materials and level of stocking of various items of finished goods) and scheduling of successive operations of production, even more free and flexible. This also facilitates bifurcation of the functions of purchase of raw materials and production plan into two separate departments, to be managed by the respective experts in each department. Thus, while the production department may just give its production schedule to the purchase department, it would be the sole responsibility of the purchase department to decide about the quantum of such purchases and the stockists to purchase them from. That is, if the stocks sometimes are available at a cheaper price during the harvesting seasons of the respective agricultural products, etc., the purchase department may even purchase the materials in much larger quantity than required by the production department (just for a fortnight or a month). Decision could as well be taken by the purchase department whether to go in for such purchases


to avail of the bulk discount, or to avail of the cash discount, etc., whenever offered. Similarly, the purchase department may make purchases for a week only locally, to meet the immediate demands of production, if, by that time, bulk purchases may be made available at a much cheaper rate. Similarly, in an inflationary condition, the purchase people may exercise their prudence and expertise to make the purchases of a larger quantity than required, if such purchases are going to be sufficiently cheaper today, taking into account the quantum of inflation, etc. That is, it would augur well if the purchase people could as well know the fundamentals of cost-benefit analysis, to be made in this regard, as also as to what factors should be taken into consideration (like time-value of money, rate of inflation and the total inventory carrying costs, etc.). This much about the rationale behind keeping the organisation inventory of stocks of raw materials, and delinking the purchase functions and the production functions. Now, let us discuss about the rationale behind keeping organization inventories of finished goods. It is a well known fact that, in order to have some edge over the competitors, companies have to keep some items in ready stock so as to be able to supply these to the customers from the shelf, at least to meet their immediate requirements, and the balance to be supplied in a week’s time or so. This is important because keeping huge numbers of items in ready stock is fraught with grave risks of obsolescence, expiry of shelf life, etc. Further, by virtue of having some organisation inventory of finished foods, the companies are able to delink the production schedule from marketing activities. Thus, we can very well appreciate that by delinking the purchase activities and production activities, as also production activities from marketing activities, companies may be able to optimise their profitability, by enabling the experts different departments, to plan things in such a way that the profitability of the company could be optimized and each departmental experts can concentrate on their respective work, of course, keeping the overall interests and requirements if the other departments, too, in the fore front, inasmuch as all the departments inter-dependent with each other.


At this stage, it may be quite pertinent to examine the rationale behind keeping the in-process inventory, too, (though these do not constitute a part of organization inventory, as such). Let us, at the very outset, clarify that though the in-process inventory refers to work-in-process inventory only, it is different from the process or movement inventory, discussed earlier, even though a part of the work-in-process inventory may represent process or movement inventory, too. Now, as regards the rationale behind keeping the in-process inventory, it may be mentioned here that it provides some flexibility and latitude in the scheduling of production, so as to ensure efficient production schedule and higher capacity utilisation of plant and machinery. Further, in case there is no stock of in-process inventory, some bottlenecks may be caused sometime somewhere in the production process, which may ultimately result in delay in production and non utilisation of the installed capacity at the optimum possible level. These factors, naturally, will culminate in adversely affecting the financial gains of the company. Economic Order Quantity (EOQ) In regard to the management of inventories (specially the inventories of raw materials) two primary questions naturally arise. They are: (a) Order size, i.e., what should be the ideal size of the order? (b) Order Level, i.e., at what level of the stocks should the next order be placed? But, before deliberating to find out the answers to the above questions, let us first try to understand the distinguishing features of the three types of costs involved in the management of inventories: (i) Ordering costs, (ii) (Inventory) carrying costs, and (iii) Shortage costs.


Let us now discuss these costs, in detail, one by one. These include the expenses in respect of the following items: (i) Cost of requisitioning items(s) 1.Ordering Costs Ordering costs pertain to placing an order for the purchase of certain items of raw. These include the expenses in respect of the following items: (i) Cost of requisitioning the items(s) (ii) Cost of preparation of purchase order (i.e. drafting, typing, despatch, postage, etc) (iii) Cost of sending reminders to get the dispatch of the items(s) expedited (iv) Cost of transportation of goods (v) Cost of receiving and verifying the goods (vi) Cost of unloading of the item(s) of goods (vii) Storage and stacking charges, etc. However, in case of items manufactured in-house (i.e., by the same company), the ordering costs would comprise the following costs: (i) Requisitioning cost (ii) Set-up cost (iii) Cost of receiving and verifying the items (iv) Cost of placing and arranging/stacking of the items in the store, etc. 2. Carrying Costs (of inventories)


Inventory carrying costs include the expenses incurred on the following items: (i) Capital cost (i.e., interest on capital locked up in inventories) (ii) Storage cost (iii) Cost of insurance (fire and theft insurance of stocks) (iv) Obsolescence cost (v) Taxes, etc. It may, however, be mentioned here that the carrying costs usually constitute around 25 per cent of the value of inventories held. 3. Shortage Costs (or costs of stock out) Shortage costs or costs of stock out are such costs which the company would incur in case of shortage of certain items of raw materials required for production, or the shortage of certain items of finished goods to meet the immediate demands of the customers. Shortage of inventories of raw materials may affect the company in one or more of the following ways: (i) The company may have to pay somewhat higher price, connected with immediate (crash) procurements. (ii) The company may have to compulsorily resort to some different production schedules, which may not be as efficient and economical. Stock out of finished goods, however, may result in the dissatisfaction of the customers and the resultant loss of sales. It, however, is relatively very difficult to actually measure the shortage cost when it results due to the failure to meet the demands of the customers instantaneously, out of the existing stocks.


This is so because such costs may have ramifications, both in the short-term as also in the long term. Besides, these costs are somewhat intangible in nature, and consequently difficult to assess quantitatively. It has also been observed that some of the companies, with a view to reducing total ordering costs, prefer to order larger quantities. But, this way the level of inventory becomes higher, and thereby the inventory carrying costs also go up. Further, if the company decides to carry a safety stock of inventory so as to mitigate or reduce the stock out costs, or shortage costs, its carrying costs, in turn, would go up further. Thus, with a view to keeping the total costs, pertaining to management of inventory, at the minimum level, we may have to arrive at the optimal level where the total costs, i.e., total ordering costs plus total inventory carrying costs, are minimal. To achieve this end result, we may have to work out the Economic Order Quantity (EOQ). Basic Economic Order Quantity (EOQ) Model At the very outset, it is to clarify here that we are going to discuss only the basic EOQ model, one of the simplest inventory models. There are, in fact, a large number of other inventory models, depending upon various variables and assumptions. Assumptions of the Basic EOQ Model It may further be clarified here that the basic EOQ model is based on various assumptions, which are given hereunder: 122. The estimate of usage (demand or consumption) of the item of inventory for a

given period (usually one year) is known accurately. 123. The usage (demand or consumption of the various items of inventory) is equal

(even), throughout the period. 124. There is no lead time involved. That is, the item of inventory can be supplied

immediately on the receipt of the order itself; there being virtually no time lag between placing of an order and the receipt of the goods. Consequently, there is no likelihood of


stock out, at any stage. Therefore, the shortage cost (or stock out cost) is not being taken into account, as if it is nil. 125. Thus, there remain only two distinct costs involved in computing the total

costs, pertaining to inventory, viz., a) Ordering cost, and (b) Inventory carrying cost. 126. Further, the cost of every order remains uniformly the same, irrespective of the

size of the order. 127. And, finally, that the inventory carrying cost is a fixed percentage of the average

value of inventory. Eoq Formula vs Trial and Error Method It may be observed that the EOQ can be ascertained in two distinct ways: (i) By trial and error method (discussed immediately hereafter), and (ii) By use of a definite formula (discussed thereafter). Trial and Error Method Let us understand the "trial and error" method with the help of an illustrative example. Economic Order Quantity (EOQ) and Optimum Order Quantity (OOQ) The standard EOQ analysis is based on the assumption that no discount is given, howsoever large the order size be. But, in most of the cases, some discount is given by way of an incentive to the buyers to order for a larger quantity so as to avail of some bulk discount. Thus, we should try to modify the standard EOQ formula so as to find out the EOQ as also to assess whether it would be economical to avail of the bulk discount or not. Economic Order Quantity (EOQ)and Inflation The EOQ analysis presumes that the cost price per unit is constant. This implies that the incidence of inflation has not been taken into account. In order to account for inflation, what we have to do is, to first substract the rate of inflation from C (the annual inventory carrying cost,


expressed as a percentage) and apply the standard EOQ formula with this simple modification only. But, you may ask, and rightly so, that why at all do we substract the rate of inflation from C? The reason is simple enough. In an inflationary condition, the purchase price of inventory will also go up and this will, to some extent, offset the inventory carrying cost. Components of Inventory Carrying Costs Inventory carrying costs comprise various items, some of which are given hereunder: (i) Storage Costs That is, the rental payable will be proportionately higher as more space would be required to store higher level of inventory. (ii) Handling Charges That is, when higher stocks will be stored, handling charges like unloading and stacking charges, at the time of receipt of the goods, etc., involving man power, may also go up. (iii) Insurance Premium Similarly, the amount of insurance premium payable, for fire insurance, theft insurance, flood and such other natural calamity insurance, etc., will also be higher. (iv) Wastages It has generally been observed that if more than sufficient stocks of inventory are stored, there is a usual tendency to consume more than what is actually required, resulting in extra avoidable wastages. To bring home the point, let us take a common place example. Supposing there is a huge stock of medical bills proforma, these may, at times, be used even as paper plates, etc. But, if these proforma were in short supply, people may take care not to waste a single form.


(v) Damage and Deterioration In the event of storing more than required level of stocks of raw materials and finished goods, there is every chance that the goods may deteriorate in quality, like the whiteness of papers gets diminished (it turns yellowish) with the passage of time. Some chemicals or medicines also have limited shelf-life, where after these may turn useless. Stocks of cement, in rainy season, are fraught with grave risk of turning into stones, and, thus, becoming useless. (vi) Technical Obsolescence In the modern age of technological advancements, the pace of goods and commodities becoming obsolete has become fast enough. Thus, more than necessary stocks run the risk of becoming obsolete and consequently of much lesser value and use. (vii) Blockage of Funds And, above all, more than necessary funds, blocked in inventory, may pose liquidity problems to the companies. It may as well involve some loss by way of payment of interest as also opportunity costs. Advantages of High Inventories But, at the same time, it may be argued that there are several reasons which may justify stocking of higher level of inventories of raw materials and finished goods. Bulk Purchase For example, you may get bulk discount, making the average costs of the stocks much cheaper. But then, one should not lose sight of the fact that, in such a case, there are several inventory carrying costs involved (like wastages, damages and deterioration, loss of interest and opportunity cost, etc.) which may offset the advantages of bulk purchases. Lead Time What is meant by lead-time?


Lead-time is the time lag that takes place between the placement of an order and the actual supply/delivery made in the company’s godown. Supposing, an order is processed at our end and is placed to the supplier today. The supplier’s office will also take its own time in processing the order plus loading, transportation and unloading, etc. And, supposing it takes say, around 15 days in completing all these processes and the goods are delivered and stored in our godown(s) on the 16th day. Thus, in the instant case, the lead-time would be said to be 16 days. But, as seen earlier, the standard EOQ model presumes as if there is no lead-time involved. And thus, the order can well be placed when the inventory level comes to zero. But, the factual position is otherwise. Therefore, we should decidedly take into account the lead-time, too, while computing EOQ. This can well be done by introducing a slight modification in the standard EOQ analysis to arrive at a realistic ordering point, so as to take care of the lead time involved and thereby to mitigate the risk of shortage of stocks, involving stock out costs. Order Point This can well be done by ensuring that the order is placed when sufficient balance of stock is still left to take care of the lead-time. But, for doing so accurately, we may have to know the rate of usage of materials as also the lead-time, exactly and in definite terms. In that case the ordering level would simply be as under: Lead time (in number of days for procurement) multiplied by average usage per day. i.e. Order Point = Lead time (in days) x Daily Usage. Safety Stock But then, in actual practice, one can neither estimate the lead time nor the daily usage so accurately and exactly. We can, at best, make some reasonable estimates. But, in that case, the possibility of some error, howsoever small, can hardly be eliminated completely. And, therefore, we should, to be on the safer side, take into account the element of such uncertainty, too. Accordingly, we should always keep some safety stock with us to meet such eventualities.


And, as such, the order point should be computed by adding the quantum of sufficient safety stocks, too. Thus, the order point can well be computed as: EOQ + [lead time (in days) x daily usage] + safety stock But, how to compute the safety stock? In fact, it is a managerial decision and, therefore, it largely depends upon the inventory policy as also the organisational culture of the company. It may, accordingly, be high or low, or even medium. This, however, does not mean that we should try to cut it too fine, either. Otherwise, a lot of the valuable time of the Materials Manager and the Purchase Department would get wasted in the fire-fighting operations in procuring the materials, in the nick of time, and incur the avoidable expenses relating to such crash purchases. The best policy, in regard to keeping the safety stock, would ideally be - neither "too much", nor "too little", but "just right". But, it is easy said than done. However, the considered opinion that, by some trial and error method, we may be able to arrive at a nearly optimal level of safety stocks, in due course of time. Other Variable Factors Affecting EOQ In finding out the EOQ or order level or safety stock, etc., we have, in the preceding pages, made certain assumptions that some other factors do not vary, though in the real world they do. Therefore, it would always be prudent enough to consider the following variable factors, too, while taking a particular decision. They are: 1. Restrictions Imposed by the Reserve Bank of India (RBI) and the Government: The Reserve Bank of India (RBI), and the Government of India, with a view to arresting inflation or steep rise in the prices of certain essential commodities, like food grains (rice, wheat, maize, etc.), onion, etc., may resort to some changes in their Selective Credit Control Policies, instructing the banks to retain higher percentage as margin on the stocks advanced against, as also by fixing some ceiling on the maximum amount that could be advanced against the security


of some commodities specified, to a single borrower, as also to fix a lower ceiling on the holding of such stocks by a single party, so as to restrict hoarding, and consequently the steep rise in the price. Such statutory restrictions exercise limitation on the companies in formulating their inventory policy. 2. Expected Scarcity: In case certain material is expected to be in short supply in the near future, it would be a prudent policy to stock a larger quantity of such material so as to avoid the stock-out risk, as far as possible. 3. Fluctuating Prices: Sometimes the price of certain commodity is expected to rise or fall, in the near future. And, accordingly, the stocks of inventory of such items should be kept flexible, and adjusted accordingly, i.e., retaining higher or lower levels of such inventory, respectively. 4. Risk of Obsolescence: Certain items of raw materials may become obsolete with the passage of time. For example, jute packing has since been replaced by polythene matting in the carpet industries. The risk of obsolescence may be even higher and costlier in the cases of the finished goods, in the modern age of technological advancements and stiff global competition. Such stocks should naturally be kept at the minimal possible level. Here, it may be emphasised that even if the policy of meeting the customers’ demand immediately is taken to be the company’s marketing strategy, instead of having a huge ready stocks of such finished goods, it would augur well if only a percentage of the market requirements could be kept in the ready stock, to be supplied to the customers immediately, and the balance quantity could be produced on an emergency basis and supplied in a week’s time or so. This way, the company may meet the competitive challenges, as also avoid the risk of obsolescence. Abcanalysis (or Ved Analysis) ABC analysis is a very effective and useful tool for monitoring and control of inventories. As you must have observed, generally speaking, a very small percentage of the total number of items of inventory (say 10%) may account for a much larger percentage (say 65%) in terms of value. As against this, in cases of certain other items of inventory, a very large percentage of the


total number of items of inventory (say 70%) may account for a much smaller percentage (say 10%) in terms of their total value. And, likewise, a medium percentage of some items (say 20%) may account for a medium percentage (say 25%) in terms of their total value. These are classified as category A, B and C respectively. ABC analysis is also referred to as VED (Vital, Essential and Desirable) analysis. We may put the aforesaid statements in a tabular form as under:

The main (or even sole) purpose of classifying the inventories into these three categories, A, B, and C, is to vary the pressure and intensity of control, in terms of the value of the items of inventory. To put it differently, while the entire stocks (say 100%), of the items in category "A" must be very closely monitored and controlled, the monitoring and control of say, 10% of the items of category "C", could be considered enough to serve the purpose. And, in the case of "B" category of items, the monitoring and control of say 25% of the item alone may be taken as sufficient. Categorization of Items for Abc Analysis Now, let us see how do we usually proceed to classify the various items of inventories into the three categories viz., A, B, and C. The procedure involves the following steps, in a sequential order: Step 1 Rank all the items of inventory, in a descending order, based upon their annual usage value, and serially number them, from I to n.


Step 2 Record the totals of annual consumption values of all the items separately and store them as a percentage of the total value of consumption. Step 3 a) Observe the percentage column and find out the cut off point where the difference between the two successive percentages is rather significant and marked. b) At the same time, please do bear in mind that the cut off point so arrived at, comprises a reasonable number of items of inventory, too. Step 4 We may finalise the classification of the items of inventory into A, B, and C categories, giving the number of units of inventory and their values in percentage terms, under all the three categories, with the laid down principles and objectives of the ABC analysis (or VED analysis), in the desired manner. Basic EOQ Model It is based on the following assumptions: (i) The quantum of the usual annual usage of the items of inventories is known, in accurate term. (ii) The usage is usually uniform throughout the year. (ii) The lead-time (i.e, time gap between ordering and receiving) is NIL. (iv) Therefore, there is no risk of stock-out, either. That is, the stock-out cost is NIL. (v) Thus, only two costs are involved: (a) Ordering Cost, and


(b) Inventory Carrying Cost. (vi) Further, (a) Ordering Cost is uniform, irrespective of the order size, and (b) The Inventory Carrying Cost is a fixed percentage of the average value of Inventories. EOQ Formula vs. Trial and Error Method: Trial and Error Method is a very cumbersome and time-consuming process. The formula, however, makes the procedure rather simple enough.

In Practice: There is no single Economic Order Point (EOP). There is, instead, an Economic Order Range (EOR). EOQ Vs. 000 (Optimal Order Quantity): [That is, when bulk (quantity) discount is available]. (a) When the quantity discount is available at a lower level than the EOQ, then EOQ itself will be the 000, too. (b) But, if it is higher than EOQ, 000 will be the EOQ or the quantity eligible for bulk discount, depending upon which one of these two will be beneficial [i.e., when the resultant difference will be a positive (+ve) figure]. A New Clue to EOQ:


That is, after finding out the EOQ in terms of the nearest integer figure, we should find out the number of orders. And, this again, should be converted into the nearest integer number. Based on this figure as the number of orders, we should calculate the EOQ, which will be the EOQ in real terms. Besides, we should bear in mind the concepts of EOP and EOR, too, at this stage. Components of Inventory Carrying Costs: (i) Storage Cost (ii) Handling Charges (iii) Insurance Charges (iv) Wastages (v) Damage/Deterioration (vi) Technical Obsolescence, Blockage of funds and cost of capital, and opportunity cost connected therewith. Advantages of High Inventory: (a) High Stocks of Raw Materials (i) Bulk purchase at cheaper rate with quantity discount. [Better, if bulk annual purchase is ordered, but the delivery and payments are to be made in phases, to the mutual advantages of both the parties. It is an optimal strategy). (ii) Seasonal purchases, being cheaper and sure. (iii) No Stock-out cost and risk. (iv) In inflationary economy, it may be gainful. (v) Savings of ordering cost and the connected hazels of loading and unloading, etc.


(b) High Stocks of Finished Goods: (i) It may facilitate instant delivery, out of the shelf, and, thus, to have an edge over the competitors. [But, better to have only a small ready stock and the rest to be produced on receipt of the order, on priority basis]. (ii) Thus, the "Golden Mean" is the most basic management mantra, pertaining to the management of inventory, too. 15. Lead Time It represents the time lag between placement of order and the actual receipt of goods. This could as well be taken into account by modifying the EOQ formula, just slightly. 16. Order Point Thus, as a prudent manager, we should place the next order well in advance, at the point in time, when there is some stock left, being sufficient enough to take care of the lead time. 17. Safety Stock And, it would be a better business sense to have some safety stock, too, so as to take care of some possible fluctuations in both (i) the lead-time, and accordingly; (ii) the order point. Thus, Order Point will be = EOQ + [Lead-time (in days) x Daily Usage] + Safety Stock. Estimating and ascertaining the safety stock is a managerial judgement— decision & discretion. But, the safety stock should not be too high, nor too low. It should be sufficient enough, just about right. Have you understood? 1. (a) Name the three main components of inventory.


(b) Whether bond papers, ceiling fans, woollen suit lengths and Maruti 800 cars are raw materials or finished goods? Give specific reasons for your answer, citing illustrative examples to bring home your points of view. 2. Why, at all, are we required to keep stocks of inventories of (a) Raw materials, and (b) finished goods? 3. (a) Distinguish between, "process or movement" inventories, and "organization" inventories. (b) What is the rationale behind keeping stocks of "organization" inventories of both raw materials and finished goods? 4. The basic EOQ model is based on several assumptions. What are they? 5. Write down the formula for EOQ. Explain, how the formula has been derived? 6. The basic EOQ model does not take into account the elements of inflation. What adjustments of modifications, in your considered view, need to be made in the basic EOQ model to take care of the elements of inflation? 7. What do you understand by the terms? (a) Ordering cost. (b) Inventory carrying costs. (c) Shortage costs or stock-out costs? Clarify your points, by citing suitable illustrative examples, in each case. 8. What are the various factors) elements involved in the inventory carrying costs? Explain with the help of some illustrative examples. 9. (a) Explain the following terms with the help of some illustrative examples:


(i) Lead time, (ii) order point, and (iii) safety stock. (b) How is the reorder level ascertained? Explain with the help of an illustrative example. 10. (a) What do you understand by the term "ABC Analysis"? Explain with the help of illustrative examples, the procedure adopted for doing the ABC analysis. (b) What purpose does ABC Analysis serve in the context of inventory policy, monitoring, management and control? Explain, with the help of some suitable illustrative examples. (c) In what other two areas (other than the area of inventory management) can the ABC Analysis be used with immense advantage? Name them and explain each of them with the help of some illustrative examples. 11. The state of affairs in the area of management of inventory in most of the Indian companies leaves a lot to be desired. (a) What are the various factors responsible for such dismal state of affairs? (b) What corrective steps would you suggest to streamline and improve the system of inventory management and control in India? 12. Distinguish between EOQ and OOQ (Optimum Order Quantity) when quantity discount is available. Elucidate your point by citing suitable illustrative examples. 13. Distinguish between JIT (Just In Time) and JIC (Just In Case) approaches towards inventory management and control. (i) Cite suitable illustrative examples to clarify your point. (ii) Which one of the above noted two approaches, in your considered opinion, should be adopted by any company? Give reasons for your answer. 14. (a) What are the comparative advantages and disadvantages of carrying too high or too low stocks of inventories of:


(i) Raw materials, and (ii) finished goods? Explain, with the help of some illustrative examples. (b) What, in your considered view, would be the right approach in this area? Give convincing reasons for your answer. Lesson 4 Cash Management INTRODUCTION In the previous unit, various issues regarding management of working capital were discussed. It was explained that current assets form an important aspect of working capital management. In fact, each current asset requires a detailed treatment to understand the issues related to the need and method of its management. In this unit we shall discuss the planning and managing of cash. Cash to business is like blood stream in human body. Cash denotes the liquidity of a business enterprise and plays an important role in nurturing and improving the profitability of an organization. It is, therefore, essential to make a proper estimate of the cash needs and plan for it so as to avoid technical or legal insolvency. Hence, effective management ensuring adequate cash is necessary. The cash available with the organization should neither be short nor too excessive. learning Objectives The objectives of this unit are to acquaint you with the: Importance of maintaining adequate liquidity Concept of optimum cash balance Importance of cash management and the usefulness of cash budgeting as a technique of liquidity planning SECTION TITLE


Why is Cash Needed? The demand for liquid assets like cash, whether by individuals or firms, is normally attributed to three behavioral motives, viz., the transaction motive, the precautionary motive and the speculative motive. The transaction motive for holding cash is helpful in the conduct of everyday ordinary business such as making of purchases and sales. The amount of cash needed, however, differs from business to business and from firm to firm depending on the frequency of cash transactions. Retail trade, for example, requires a higher ratio of cash to sales and of cash to total assets. Firms having seasonal business will need greater amount of cash during the season. The precautionary motive is concerned with predictability of cash inflows and outflows. Higher the predictability of cash, lower is the amount needed against emergencies or contingencies. This motive for holding cash is also influenced by the ability of the firm to obtain additional cash on short notice through short-term borrowings. A minimum reservoir of cash must always be kept in hand to meet the unexpected payments and other contingencies. The speculative motive for holding cash is concerned with availing the opportunities arising from unexpected developments, e.g. an abnormal increase in prices. However, keeping additional cash for speculative purpose is not common in business. Determining Optimal Cash Balance Holding of excessive cash is a non-profitable proposition, as idle cash does not earn any income. Similarly shortage of cash may deprive the business unit of availing the benefits of cash discounts, and of taking advantage of other favorable opportunities. It may even lead to loss of credit-worthiness on account of default in paying liabilities when the same becomes due. Hence, every organization, irrespective of its size and nature, has to determine the appropriate or optimum cash balance that it would need.


A firm’s cash balance, generally, may not be constant overtime. It would therefore be worthwhile to investigate the maximum, minimum and average cash needs over a designated period of time. You are aware that cash is needed for various transactions of the organization. Maintenance of a cash balance however has an opportunity cost in the following ways: a) Cash can be invested in acquiring assets such as inventory, or for purchasing securities. Opportunities for such investments may be lost if a certain minimum cash balance is held. b) Holding of cash means that it cannot be used to offset financial risks from the short-term debts. c) Excessive reliance on internally generated liquidity can isolate the firm from the short-term financial market. Now the Finance Manager should understand the benefits and the opportunity costs for holding cash. Thereafter, he must proceed to work out a model for determining the optimal amount of cash. First of all, Critical minimum cash balance should be conceived below which the firm would incur definite and measurable costs. Apart from risk aversion, the existence of the minimum balance is justified by institutional requirements such as credit ratings, checking accounts and lines of credit. The violation of maintaining a minimum cash balance will create shortage costs, which will be determined by the actions of creditors on account of postponing their payments or non-availing of cash discounts. At any point of time a firm’s (ending) cash balance can be represented as follows: Ending balance=Beginning Balance + Receipts — Disbursements If receipts and disbursements are equal for any unit of time, no problem is involved. Ordinarily, however, receipts may be more than disbursements or vice versa. Hence, the ending balance will


keep on fluctuating. In actual practice, receipts and disbursements do vary, particularly in case of firms having seasonal activities. Suppose, the receipts and disbursements are not synchronized but the variation is predictable, then the main problem will be that of minimizing total costs. Cash Management Cash, being a sensitive asset, has to be regulated according to needs. Any deficits (or inadequacies) should be rectified and any excess amount be gainfully invested. Cash management involves two main questions 128. 129. How should the collection and disbursement of cash balances be managed? How should the appropriate cash balance be determined, and how should any

temporary idle cash be invested in interest earning assets? Managing Collections and Disbursements The Cash Cycle In order to deal with the problem of cash management, we must have an idea about the flow of cash through a firm’s account. The entire process of this cash flow is known as Cash Cycle. This has been illustrated in Figures III and IV. Cash is used to purchase materials from which goods are produced. Production of these goods involves use of funds for paying wages and meeting other expenses. Goods produced are sold either on cash or credit. In the latter case the pending bills are received at a later date. The firm thus receives cash immediately or later for the goods sold by it. The cycle continues repeating itself.


The diagram in above figure only gives a general idea about the channels of flow of cash Managing Cash in a business. The magnitude of the flow in terms of time is depicted in the diagram given in Figure IV. The following information is reflected by Figure IV: zzzzz. aaaaaa. to E. bbbbbb. The payment for material purchased can be deferred to 17 days (15+2) after it is Raw material for production is received 10 days after placement of order. The material is converted into goods for sale in 37 days (15+2+20) from point B

received (i.e. the distance of time between points B to D), assuming that it takes 2 days for collection of payment of the cheque. cccccc. The amount of the bill for goods sold is received 36 days (32+2+2) after the sale

of goods as is depicted by duration of time between point F to H. dddddd. The recovery of cash spent till point D is made after 56 days (20+30+2+2+2) as

shown between points D to H. Speeding up Collections In order to minimize the size of cash holding, the time gap between sale of goods and their cash collection should be reduced and the flow be controlled. Normally, certain factors creating time lags are beyond the control of management. Yet, in order to improve the efficiency, attention should be paid to the following. All cash collected should be directly deposited in one account. If there are more than one collection centers, all cash receipts should be remitted to the main account with, top speed. Compared to a single collection center, the aggregate requirement for cash will be more when


there are several centers. Concentration of collections at one place will thus permit the firm to store its cash more efficiently. The time lag between the dispatch of cheque by the customer and its credit to our account with the bank should be reduced. Some firms with large collection transactions introduce lock box system. In this system the post boxes are hired at different centers where cash/cheques can be dropped in. The local banker can daily collect the same from the lockers. The collecting bank is paid service charges. In order to minimize time front banks may be asked to devise methods for speeding up the collection of cash. Recovering Dues After sale of goods on credit, either on account of convention or for promoting sales, receivables are created. It may however be useful to reduce the amount blocked in receivables by seeing to it that they do not become overdue accounts. Incentive in the form of discounts for early payment may be given. More important than anything else, is a constant follow-up action for the recovery of dues. This will improve position of cash balance. Controlling Disbursements Needless to assert that speeding up of collections helps conversion of receivables into cash and thus reduces the financing requirements of the firm. Similar kind of benefit can be derived by delaying disbursements. Trade credit is a costless source of funds for it allows us to pay the creditors only after the period of credit agreed upon. The dues can be withheld till the last date. This will reduce the requirement for holding large cash balances. Some firms may like to take advantage of cheque book float which is the time gap between the date of issue of a cheque and the actual date when it is presented for payment directly or through the bank. Investment of Idle Cash Balances Two other important aspects in cash management are how to determine appropriate cash balance and how to invest temporarily idle cash in interest earning assets or securities. The first part relating to the theory of determining appropriate cash balance has already been discussed earlier.


Now we shall discuss the investment of idle cash balances on temporary basis. Cash by itself yields no income. If we know that some cash will be in excess of our need for a short period of time, we must invest it for earning income without depriving ourselves of the benefit of liquidity of funds. While doing this, we must weigh the advantages of carrying extra cash (i.e. more than the normal requirement) and the disadvantages of not carrying it. The carrying of extra cash may be necessitated due to its requirement in future, whether predictable or unpredictable. The experience indicates that cash flows cannot be predicted with complete accuracy. Competition, technological changes, unexpected failure of products, strikes and variations in economic conditions make it difficult to predict cash needs accurately. Investment Criteria When it is realized that the excess cash will remain idle, it should be invested in such a way that it would generate income and at the same time ensure quick re-conversion of investment in cash. While choosing the channels for investment of any idle cash balance for a short period, it should be seen that (i) the investment is free from default risk, that is, the risk involved due to the possibility of default in timely payment of interest and repayment of principal amount; (ii) the investment shall mature in a short span of time; and (iii) the investment has adequate marketability. Marketability refers to the ease with which an asset can be converted back into cash. Marketability has two dimensions price and time-which are inter-related. If an asset can be sold quickly in large amounts at a price determinable in advance, the asset will be regarded as highly marketable and highly liquid. The assets, which largely satisfy the aforesaid criteria, are: Government Securities, Bankers’ Acceptances and Commercial Paper. Cash Budgeting Planning cash and controlling its use are very important tasks. If the future cash flows are not properly anticipated, it is likely that idle cash balances may be created which may result in unnecessary losses. It may also result in cash deficits and consequent problems. The Finance Manager should therefore, plan the cash needs and uses. Cash budget is a useful device for this purpose.


Cash budget basically incorporates estimates of future inflows and outflows of cash over a projected short period of time which may usually be a year, a quarter or a half-year. Effective cash management is facilitated if the cash budget is further broken down into monthly, weekly or even daily basis. Preparing a Cash Budget There are two components of a cash budget—cash inflows and cash outflows. In both these components there are two types of flows, viz. operating cash flows and financial cash flows. Some common elements of each are as follows: Cash Inflows - (a) Operating: cash sales, receivable collections. (b) Financial: interest receipts, sale of marketable securities, issue of new securities. Cash Outflows -(a) Operating: wage payments, payments of bills and accounts payable, and capital expenditure (b) Financial: dividend payments, interest payments, redemption of securities, loan repayments, purchase of marketable securities and tax payments. Sales Work Sheet Sales bring in a major part of cash inflows. All sales may not be against cash; credit sales are quite common. Each business establishment has its own credit policy for promoting sales. Even when care is taken to ensure that credit sales do not exceed the permitted percentage of total sales and that debtors do not default in paying bills in time, it is a common experience that the total amount of sales is recovered over a period of time. Have you understood? 135. 136. What are the three motivations behind holding cash? Explain briefly. "In managing cash, the Finance Manager faces the problem of compromising the

conflicting goals of liquidity and profitability". Comment. What strategy should the Finance Managers develop to solve this problem? 137. 138. What is optimum cash balance and how can it be arrived at? What is cash cycle and how can it be reduced?



If a firm estimates that it will have some idle cash balances from time to time,

what advice would you render to the firm? 140. 141. What is a cash budget and in what way can it be helpful in liquidity planning? How would you judge the efficiency of cash management of a company?


LONG TERM SOURCES OF FINANCE Lesson I Indian Capital and Stock Market INTRODUCTION Capital markets are a sub-part of the financial system. Conceptually, the financial system includes a complex of institutions and mechanisms which affects the generation of savings and their transfer to those who will invest. It may be said to be made of all those channels through which savings become available for investments. The main elements of the financial system are a variety of (i) financial instruments/assets/securities, (ii) financial intermediaries/institutions and (iii) financial markets. Learning Objectives on going through this lesson, you will be conversant with: The nature of financial assets. The rate of financial intermediaries. The functioning of financial market.


The relationship between new issue markets and stock exchange. The functions of stock exchange. The issue mechanism followed in Indian markets. SECTION TITLE Financial Assets A financial asset/Instrument/security is a claim against another economic unit and is held as a store of value and for the return that is expected. While the value of a tangible/physical asset depends on its physical properties such as buildings, machines, furniture vehicles and so on, a financial asset represents a claim to future cash flows in the form of interest, dividends and so on. They are a claim on a stream of income and/or particular assets. The entity/economic unit that offers the future cash flows is the issuer of the financial instrument’ and the owner of the security is the investor’. Depending upon the nature of claim/return, an instrument may be (i) debt (security) such as bonds, debentures, term loans, (ii) equity (security) shares and (iii) hybrid security such as preference shares and convertibles, Based on the type of issuer, the security may be (1) direct (2) indirect and (3) derivative. The securities issued by manufacturing companies are direct assets (e.g. shares/debentures). Indirect assets are claims against financial intermediaries (e.g. units of mutual funds). The derivative instruments include options and futures. The prevalence of a variety of securities to suit the investment requirements of heterogeneous investors, offers differentiated investment choice to them and is an important element in the maturity and sophistication of the financial system. Financial Intermediaries Financial Intermediaries are institutions that channelise the savings of investors into investments/loans. As institutional source of finance, they act as a link between the savers and the investors, which results in institutionalisation of personal savings. Their main function is to convert direct financial assets into indirect securities. The indirect securities offer to the individual investor better investment alternative than the direct/primary security by pooling


which it is created, for example, units of mutual funds. The main consideration underlying the attractiveness of indirect securities is that the pooling of funds by the financial intermediary leads to a number of benefits to the investors. The services/benefits that tailor indirect financial assets to the requirements of the investors are (i) convenience, (ii) lower risk, (iii) expert management and (iv) lower cost. Convenience Financial intermediaries convert direct/primary securities into a more convenient vehicle of investment. They divide primary securities of higher denomination into indirect securities of lower denomination. They also transform a primary security of certain maturity into an, indirect security of a different maturity. For instance, as a result of the redemption/repurchase facility available to unitholders of mutual funds, maturities on units would conform more with the desires of the investors than those on primary securities. Lower Risk The lower risk associated with indirect securities results from the benefits of diversification of investments. In effect, the financial intermediaries transform the small investors in matters of diversification into large institutional investors as the former shares proportionate beneficiary interest in the total portfolio of the latter. Expert Management Indirect securities give to the investors the benefits of trained, experienced and specialised management together with continuous supervision. In effect, financial intermediaries place the individual investors in the same position in the matter of expert management as large institutional investors. Low Cost Low cost is the benefits of investment through financial intermediaries are available to the individual investors at relatively lower cost due to the economies of scale.


The major financial intermediaries are banks, insurance organisations, both life and non-life/ general, mutual funds, non-banking financial companies and so on. Financial Markets Financial markets perform a crucial function in the financial system as facilitating organisations. Unlike financial intermediaries, they are not a source of funds but are a link and provide a forum in which suppliers of funds and demanders of loans/investments can transact business directly. While the loans and investments of financial intermediaries are made without the direct knowledge of the suppliers of funds (i.e. investors), suppliers in the financial market know where their funds are being lent/invested. The two key financial markets are the money market and the capital market. Money Market The money market is created by a financial relationship between suppliers and demanders of short-term funds which have maturities of one year or less. It exists because investors (i.e. individuals, business entities, government and financial institutions) have temporarily idle funds that they wish to place in some type of liquid asset or short-term interest-earning instrument. At the same time, other entities/ organisations find themselves in need of seasonal/ temporary financing. The money market brings together these suppliers and demanders of short- term liquid funds. The broad objectives of money market are three-fold: An equilibrating mechanism for evening out short-term surplus and deficiencies in the financial system; A focal point of intervention by the central bank (e.g. Reserve Bank of India) intervention for influencing liquidity in the economy; and A reasonable access to the users of short-term funds to meet their requirements at realistic/ reasonable cost and temporary deployment of funds for earning returns to the suppliers of funds. Capital Market


The capital market is a financial relationship created by a number of institutions and arrangements that allows suppliers and demanders of long-term funds (i.e. funds with maturities exceeding one year) to make transactions. It is a market for long-term funds. Included among long-term funds are securities issues of business and Government. The backbone of the capital market is formed by the various securities exchanges that provide a forum for equity (equity market) and debt (debt market) transactions. Mechanisms for efficiently offering and trading securities contribute to the functioning of capital markets which is important to the long-term growth of business. Thus, the capital market comprises of (I) stock/security exchanges/markets (secondary markets) and (2) new issue/primary market [initial public offering (IPO) market]. Relationship Between New Issue Market (NIM) and Stock Exchange The industrial securities market is divided into two parts, namely, NIM and stock market. The relationship between these parts of the market provides an insight into its organisation. One aspect of their relationship is that they differ from each other organisationally as well as in the nature of functions performed by them. They have some similarities also. Differences The differences between NIM and stock exchanges pertain to (i) Types of securities dealt, (ii) Nature of financing and (iii) Organisation. New vs Old Securities The NIM deals with new securities, that is, securities which were not previously available and are, therefore, offered to the investing public for the first time. The market, therefore, derives its name from the fact that it makes available a new block of securities for public subscription. The stock market, on the other hand, is a market for old securities which may be defined as securities which have been issued already and granted stock exchange quotation. The stock exchanges, therefore, provide a regular and continuous market for buying and selling of securities. The usual procedure is that when an enterprise is in need of funds, it approaches the investing public, both individuals and institutions, to subscribe to its issue of capital. The securities thus floated are subsequently purchased and sold among the individual and institutional investors. There are, in


other words, two stages involved in the purchase and sale of securities. In the first stage, the securities are acquired from the issuing companies themselves and these are, in the second stage, purchased and sold continuously among the investors without any involvement of the companies whose securities constitute the stock-intrude except in the strictly limited sense of registering the transfer of ownership of the securities. The section of the industrial securities market dealing with the first stage is referred to as the NIM, while secondary market covers the second stage of the dealings in securities. Nature of Financing Another aspect related to the separate functions of these two parts of the securities market is the nature of their contribution to industrial financing. Since the primary market is concerned with new securities, it provides additional funds to the issuing companies either for starting a new enterprise or for the expansion or diversification of the existing one and, therefore, its contribution to company financing is direct. In contrast, the secondary markets can in no circumstance supply additional funds since the company is not involved in the transaction. This, however, does not mean that the stock markets have no relevance in the process of transfer of resources from savers to investors. Their role regarding the supply of capital is indirect. The usual course in the development of industrial enterprise seems to be that those who bar the initial burden of financing a new enterprise, pass it on to others when the enterprise becomes well established. The existence of secondary markets which provide, institutional facilities for the continuous purchase and sale of securities and, to that extent, lend liquidity and marketability, play an important part in the process. Organisational Differences The two parts of the market have organisational differences also. The stock exchanges have, organisationally speaking, physical existence and are located in a particular geographical area. The NIM is not rooted in any particular spot and has no geographical existence. The NIM has neither any tangible form any administrative organisational set up like that of stock exchanges, nor is it subjected to any centralised control and administration for the consummation of its business. It is recognised only by the services that it renders to the lenders and borrowers of


capital funds at the time of any particular operation. The precise nature of the specialised institutional facilities provided by the NIM is described in a subsequent section. Similarities Nevertheless, in spite of organisational and functional differences, the NIM and the stock exchanges are inseparably connected. Stock Exchange Listing One aspect of this inseparable connection between them is that the securities issued in the NIM are invariably listed on a recognised stock exchange for dealings in them. In India, for instance, one of the conditions to which a prospectus is to conform is that it should contain a stipulation that the application has been made, or will be made in due course for admitting the securities to dealings on the stock exchange. The practice of listing of new issues on the stock market is of immense utility to the potential investors who can be sure that should they receive an allotment of new issues, they will subsequently be able to dispose them off any time. The absence of such facilities would act as some sort of psychological barrier to investments in new securities. The facilities provided by the secondary markets, therefore, encourage holdings of new securities and, thus, widen the initial/primary market for them. Control The stock exchanges exercise considerable control over the organisation of new issues. In terms of regulatory framework related to dealings in securities, the new issues of securities which seek stock quotation/listing have to comply with statutory rules as well as regulations framed by the stock exchanges with the object of ensuring fair dealings in them. If the new issues do not conform to the prescribed stipulations, the stock exchanges would refuse listing facilities to them. This requirement obviously enables the stock exchange to exercise considerable control over the new issues market and is indicative of close relationship between the two. Economic Interdependence


The markets for new and old securities are, economically, an integral part of a single market — the industrial securities market. Their mutual interdependence from the economic point of view has two dimensions. One, the behavior of the stock exchanges has a significant bearing on the level of activity in the NIM and, therefore, its responses to capital issues: Activity in the new issues market and the movement in the prices of stock exchange securities are broadly related: new Issues increase when share values are rising and vice versa.1 This is because the two parts of the industrial securities market are susceptible to common influences and they act and react upon each other. The stock exchanges are usually the first to feel a change in the economic outlook and the effect is quickly transmitted to the new issue section of the market. The second dimension of the mutual interdependence of the two parts of the market is that the prices of new issues are influenced by the price movements on the stock market. The securities market represents an important case where the stock-demand-and-supply curves, as distinguished from flow-demand-and-supply curves, exert a dominant influence on price determination. The quantitative predominance of old securities in the market usually ensures that it is these which set the tone of the market as a whole and govern the prices and acceptability of the new issues. Thus, the flow of new savings into new securities is profoundly influenced by the conditions prevailing in the old securities market—the stock exchange. Functions of Stock Exchanges (Secondary Markets Stock exchanges discharge three vital functions in the orderly growth of capital formation: (i) Nexus between savings and investments, (ii) Market place and (iii) Continuous price formation. Nexus between Savings and Investment First and foremost, they are the nexus between the savings and the investments of the community. The savings of the community are mobilised and channelled by stock exchanges for investment into those sectors and units which are favoured by the community at large, on the basis of such criteria as good return, appreciation of capital, and so on. It is the preference of investors for individual units as well as industry groups, which is reflected in the share price, that


decides the mode of investment. Stock exchanges render this service by arranging for the preliminary distribution of new issues of capital, offered through prospectus, as also offers for sale of existing securities, in an orderly and systematic manner. They themselves administer the same, by ensuring that the various requisites of listing (such as offering at least the prescribed minimum percentage of capital to the public, keeping the subscription list open for a minimum period of days, making provision for receiving applications at least at the prescribed centres, allotting the shares against applications on a fair and unconditional basis) are duly complied with Members of stock. Exchanges also assist in the flotation of new issues by acting (i) as brokers, in which capacity they, inter alia, try to procure subscription from investors spread all over the country, and (ii) as underwriters. This quite often results in their being required to nurse new issues till a time when the new ventures start making profits and reward their shareholders by declaring reasonable dividends when their shares command premiums in the market. Stock companies also provide a forum for trading in rights shares of companies already listed, thereby enabling a new class of investors to take up a part of the rights in the place of existing shareholders who renounce their rights for monetary considerations. Market Place The second important function discharged by stock markets/exchanges is that they provide a marker place for the purchase and sale of securities, thereby enabling their free transferability through several successive stages from the original subscriber to the neverending stream of buyers, who may be buying them today to sell them at a later date for a variety of considerations like meeting their own needs of liquidity, shuffling their investment portfolios to gear up for the ever changing market situations, and so on. Since the point of aggregate sale and purchase is centralised, with a multiplicity of buyers and sellers at any point of time, by and large, a seller has a ready purchaser and a purchaser has a ready seller at a price which can he said to be competitive. This guarantees saleability to one who has already invested and surety of purchase to the other who desires to invest. Continuous Price Formation


The third major function, closely related to the second, discharged by the stock exchanges is the process of continuous price formation. The collective judgement of many people operating simultaneously in the market, resulting in the emergence of a large number of buyers and sellers at any point of time, has the effect of bringing about changes in the levels of security prices in small graduations, thereby evening out wide swings in prices. The ever changing demand and supply conditions result in a continuous revaluation of assets, with today’s prices being yesterday’s prices, altered, corrected, and adjusted, and tomorrow’s values being again today’s values altered, corrected and adjusted. The process is an unending one. Stock exchanges thus act as a barometer of ‘the state of health of the nations economy, by constantly measuring its progress or otherwise. An investor can always have his eyes turned towards the stock exchanges to know, at any point of time, the value of the investments and plan his personal needs accordingly. Functions of New Issues/Primary Market The main function of NIM is to facilitate the transfer of resources from savers to entrepreneurs seeking to establish new enterprise or to expand/diversify existing ones. Such facilities are of crucial importance in the context of the dichotomy of funds available for capital uses from those in whose hands they accumulate, and those by whom they are applied to productive uses. Conceptually, the NIM should not, however, be conceived as exclusively serving the purpose of raising finance for new capital expenditure. In fact, the organisation and facilities of the market are also utilised for selling concerns to the public as going concerns through the conversion of existing proprietary enterprises or private companies into public companies. The NIM is a complex of institutions through which funds can be obtained directly or indirectly by those who require them from investors who have savings. New issues can be classified in various ways. The first of new issues are by new companies and old companies. This classification was first suggested by R.F. Henderson. The distinction between new also called initial and old also known as further, does not bear any relation to the age of the company. The securities issued by companies for the first time either after the incorporation or conversion from private to public companies are designated as initial issues,


while those issued by companies which already have stock exchange quotation, either by public issue or by rights to existing shareholders, are referred to as further or old. The new issues by corporate enterprise can also be classified on the basis of companies seeking quotation, namely, new money issues and no new money issues. The term new money issues refers to the issues of capital involving newly created shares; no new money issues represent the sale of securities already in existence and sold by their holders. The new money issues provide funds to enterprises for additional capital investment. According to Merrett and others,5 new money refers to the sum of money equivalent to the number of newly created shares multiplied by the price per share minus all the administrative cost associated with the issue. This money may not be used for additional capital investment; it may be used wholly or partly to repay debt. Henderson uses the term in a rather limited sense so that it is the net of repayment of long-term debt and sums paid to vendors of existing securities. The differences in the approaches by Merrett and others, on the one hand, and Henderson, on the other, arise because of the fact that while the concern of the former is with both flow of funds into the market as well as flow of money, Henderson was interested only in the latter. However, two types of issues are excluded from the category of new issues. First, bonus/ capitalisation issues which represent only book-keeping entries, and, second, exchange issues by which shares in one company are exchanged for securities of another. The general function of the NIM, namely, the channelling of investible funds into industrial enterprises, can be split from the operational stand-point, into three services (i) Origination,(ii) Underwriting, and (iii) Distribution. The institutional set-up dealing with these can be said to constitute the NIM organisation. In other words, the NIM facilitates the transfer of resources by providing specialist institutional facilities to perform the triple-service function. Origination The term origination refers to the work of investigation and analysis and processing of new proposals. These two functions8 are performed by the specialist agencies which act as the sponsors of issues. One aspect is the preliminary investigation which entails a careful study of technical, economic, financial, and legal aspects of the issuing companies. This is to ensure that


it warrants the backing of the issue houses in the sense of lending their name to the company and, thus, give the issue the stamp of respectability, to satisfy themselves that the company is strongly based, has good market prospects, is well-managed and is worthy of stock exchange quotation. In the process of origination, the sponsoring institutions render, as a second function, some services of an advisory nature that go to improve the quality of capital issues. These services include advice on such aspects of capital issues as: (i) determination of the class of security to be issued and price of the issues in the light of market conditions, (ii) the timing and magnitude of issues, (iii) methods of Rotation, and (iv) technique of selling, and so on. The importance of the specialised services provided by the NIM organisation in this respect can hardly be overstressed in view of its pivotal position in the process of flotation of capital in the NIM. On the thoroughness of investigation and soundness of judgement of the sponsoring institutions depends, to a large extent, the allocative efficiency of the market. Underwriting The origination howsoever thoroughly done, will not, by itself, guarantee the success of an issue. To ensure success of an issue, therefore, the second specialist service—underwriting—provided by the institutional setup of the NIM takes the form of a guarantee that the issues would be sold by eliminating the risk arising from uncertainty of public response. That adequate institutional arrangement for the provision of underwriting is of crucial significance both to the issuing companies as well as the investing public cannot be overstressed. Distribution Underwriting, however, is only a stopgap arrangement to guarantee the success of an issue, in the ultimate analysis, depends on the issues being acquired by the investing public. The sale of securities to the ultimate investors is referred to as distribution. It is a specialist job, which can best be performed by brokers and dealers in securities, who maintain regular and direct contact with the ultimate investors. Thus, the NIM is a complex of institutions through which funds can be obtained by those who require them from investors who have savings. The ability of the NIM to cope with the growing requirements of the expanding corporate sector would depend on the presence of specialist


agencies to perform the triple-service-function of origination, underwriting and distribution. While the nature of the services provided by an organised NIM is the same in all developed countries,the degree of development and specialisation of market organisation, the type of institutions found and the actual procedures followed differ from country to country, as they are determined partly by history and partly by the particular legal, social, political, and economic environment. Issue Mechanism The success of an issue depends, partly, on the issue mechanism. The methods by which new issues are made are: (i) Public issue through prospectus, (ii) Tender/Book building, (iii) Offer for sale (iv) Placement and (v) Rights issue. Public Issue through Prospectus A common method followed by corporate enterprises to raise capital through the issue of securities is by means of a prospectus inviting subscription from the investing public. Under this method, the issuing companies themselves offer directly to the general public a fixed number of shares at a stated price, which in the case of new companies is invariably the face value of the securities, and in the case of existing companies, it may sometimes include a premium amount, if any. Another feature of public issue method is that generally the issues are underwritten to ensure success arising out of unsatisfactory public response. The foundation of the public issue method is a prospectus, the minimum contents of which are prescribed by the Companies Act, 1956. It also provides both civil and criminal liability for any misstatement in the prospectus. Additional disclosure requirements are also mandated by the SEBI. The contents of the prospectus, inter alia, include: (i) Name and registered office of the issuing company; (ii) Existing and proposed activities; (iii) Board of directors; (iv) Location of the industry; (v) Authorised, subscribed and proposed issue of capital to public; (vi) Dates of opening and closing of subscription list; (vii) Name of broker, underwriters, and others, from whom application forms along with copies of prospectus can be obtained; (viii) Minimum subscription; (ix) Names of underwriters, if any, along with a statement that in the opinion of the directors, the resources of the underwriters are sufficient to meet the underwriting obligations;


and (x) A statement that the company will make an application to stock exchange(s) for the permission to deal in or for a quotation of its shares and so on. The public issue method through prospectus has the advantage that the transaction is carried on in the full light of publicity coupled with approach to the entire investing public. Moreover, a fixed quantity of stock has to be allotted among applicants on a non-discriminatory basis. The issues are, thus, widely distributed and the danger of an artificial restriction on the quantity of shares available is avoided. It would ensure that the share ownership is widely diffused, thereby contributing to the prevention of concentration of wealth and economic power. A serious drawback of public issue, as a method to raise capital through the sale of securities, is that it is a highly expensive method. The cost of flotation involves underwriting expenses, brokerage, and other administrative expenses. The administrative cost includes printing charges of prospectus, advertisement/publicity charges, accountancy charges, legal charges, bank charges, stamp duty, listing fee, registration charges, travelling expenses, filling of document charges, mortgage deed registration fee and postage and so on). In view of the high cost involved in raising capital, the public issue method is suitable for large issues and it cannot he availed of in case of small issues. Tender/Book Building Method The essence of the tender/book building method is that the pricing of the issues is left to the investors. The issuing company incorporates all the details of the issue proposal in the offer document on the lines of the public issue method including the reserve/minimum price. The investors are required to quote the number of securities and the price at which they wish to acquire. Offer for Sale Another method by which securities can be issued is by means of an offer for sale. Under this method, instead of the issuing company itself offering its shares directly to the public, it offers through the intermediary of issue houses/merchant banks/investment banks or firms of stockbrokers. The modus operandi of the offer of sale is akin to the public issue method in that


the prospectus with strictly prescribed minimum contents which constitutes the foundation for the sale of securities, and a known quantity of shares are distributed to the applicants in a nondiscriminatory manner. Moreover, the issues are underwritten to avoid the possibility of the issue being left largely in the hands of the issuing houses. But the mechanism adopted is different. The sale of securities with an offer for sale method is done in two stages. In the first stage, the issuing company sells the securities to the issuing houses or stockbrokers at an agreed fixed price and the securities, thus acquired by the sponsoring institutions, are resold, in the second stage, by the issuing houses to the ultimate investors. The securities are offered to the public at a price higher than the price at which they were acquired from the company. The difference between the sale and the purchase price, technically called as turn, represents the remuneration of the issuing houses. In the case of public method, the issuing houses receive a fee based upon the size and the complications involved in supervision as they act as agents of the issuing companies. Although this is theoretically possible, but usually the issuing houses’ remuneration in offer for sale is the turn’ out of which they also meet subsidiary expenses such as underwriting commission, the cost of advertisement and prospectus, and so on, whereas these are borne by the companies themselves in the case of public issue method. The offer for sale method shares the advantage available to public issue method. One additional advantage of this method is that the issuing company is saved from the cost and trouble of selling the shares to the public. Apart from being expensive, like the public issue method, it suffers from another serious shortcoming. The securities are sold to the investing public usually at a premium. The margin between the amount received by the company and the price paid by the public does not become additional funds, but it is pocketed by the issuing houses or the existing shareholders. Placement Method Yet another method to float new issues of capital is the placing method defined by London Stock Exchange as "sale by an issue house or broker to their own clients of securities which have been previously purchased or subscribed". Under this method, securities are acquired by the issue houses, as in offer for sale method, but instead of being subsequently offered to the public, they


are placed with the clients of the issue houses, both individual and institutional investors. Each issue house has a list of large private and institutional investors who are always prepared to subscribe to any securities which are issued in this manner. Thus, the flotation of the securities involves two stages: In the first stage, shares are acquired by the issuing houses and in the second stage, they are made available to their investor-clients. The issue houses usually place the securities at a higher price than the price they pay and the difference, that is, the turn is their remuneration. Alternatively, though rarely, they may arrange the placing in return for a fee and act merely as an agent and not principal. Another feature of placing is that, the placing letter and the other documents, when taken together, constitute a prospectus/offer document and the information concerning the issue has to be published. In this method, no formal underwriting of the issue is required as the placement itself amounts to underwriting since the issue houses agree to place the issue with their clients. They endeavour to ensure the success of the issue by carefully vetting the issuing company concerned and offering generous subscription terms. Placing of securities Securities that are unquoted is known as private placing. The securities are usually in small companies but these may occasionally be in large companies. When the securities to be placed are newly quoted, the method is officially known as stock exchange placing. The main advantage of placing, as a method of issuing new securities, is its relative cheapness. This is partly because, many of the items of expenses in public issue and offer for sale methods like underwriting commission, expense relating to applications and allotment of shares, and so on are avoided. Moreover, the stock exchange requirements relating to contents of the prospectus and its advertisement are less onerous in the case of placing. Its weakness arises from the point of view of distribution of securities. As the securities are offered only to a select group of investors, it may lead to the concentration of shares into a few hands who may create artificial scarcity of scrips in times of hectic dealings in such shares in the market.


The placement method is advantageous to the issuing companies but it is not favorably received by the investing public. The method is suitable in case of small issues which cannot bear the high expenses entailed in a public issue, and also in such issues which are unlikely to arouse much interest among the general investing public. Thus, with the placement method, new issues can be floated by small companies which suffer from a financial disadvantage in the form of prohibitively high cost of capital in the case of other methods of flotation as well as at times when conditions in the market may not be favorable as it does not depend for its success on public response. This underscores the relevance of this method from the viewpoint of the market. Rights Issue The methods discussed above can be used both by new companies as well as by established companies. In the case of companies whose shares are already listed and widely held, shares can be offered to the existing shareholders. This is called rights issue. Under this method, the existing shareholders are offered the right to subscribe to new shares in proportion to the number of shares they already hold. This offer is made by circular to ‘existing shareholders’ only. In India, Section 81 of the Companies Act, 1956 provides that where a company increases its subscribed capital by the issue of new shares, either after two years of its formation or after one year of first issue of shares whichever is earlier, these have to be first offered to the existing shareholders with a right to renounce them in favour of a nominee. A company can, however, dispense with this requirement by passing a special resolution to the same effect. Rights issues are not normally underwritten but to ensure full subscription and as a measure of abundant precaution, a few companies have resorted to underwriting of rights shares. The experience of these companies has been that underwriters were not called upon to take up shares in terms of their obligations. It is, therefore, observed that such underwriting serves little economically useful purpose in that "it represents insurance against a risk which is (i) readily avoidable and (ii) of extremely rare occurrence even where no special steps are taken to avoid it. The chief merit of rights issue is that it is an inexpensive method. The usual expenses like underwriting commission, brokerage and other administrative expenses are either non-existent or are very small. Advertising expenses have to be incurred only for sending a letter of rights to


shareholders. The management of applications and allotment is less cumbersome because the number is limited. As already mentioned, this method can be used only by existing companies and the general investing public has no opportunity to participate in the new companies. The preemptive right of existing shareholders may conflict with the broader objective of wider diffusion of share-ownership. The above discussion shows that the available methods of flotation of new issues are suitable in different circumstances and for different types of enterprises. The issue mechanism would vary from market to market. HAVE YOU UNDERSTOOD? 1. Discuss the main elements of the financial system. 2. Explain briefly financial assets/instruments. 3. Describe briefly the functions of financial intermediaries. 4. Explain briefly the two key financial markets. 5. Write a brief note on the differences between the new issue market and the stock exchanges. 6. What are the similarities between the NIM and the stock market? 7. What are the functions of the stock exchanges? 8. Briefly discuss the functions of the NIM. 9. What are the different methods of flotation of issues in the primary market? Lesson 2 Long - Term Sources of Finance

INTRODUCTION Long-term capital is capital with maturity exceeding one year. Long-term capital is used to fund the acquisition of fixed assets and part of current assets. Public limited companies meet their long-term financial requirements by issuing shares and debentures and through borrowing and


public deposits. The required fund is to be mobilized and utilized systematically by the companies. LEARNING Objectives On going through this lesson, you will be conversant with: The various sources of long term capital The different types for long term capital instruments Merits and demerits of equity and preference share capital Different types of debentures and their merits and demerits. Different modes of capital issues SEBI Guidelines on public issues. SECTION TITLE Sources of Capital Broadly speaking, a company can have two main sources of funds. Internal and external, Internal sources refer to sources from within the company External sources refer to outside sources. Internal sources consist of depreciation provision, general reserve fund or free reserve — retained earnings or the saving of the company. External sources consists of share capital, debenture capital, loans and advances (short term loans from commercial banks and other creditors, long term loans from finance corporations and other creditors). Share capital is considered as ownership or equity capital whereas debentures and loans constitute borrowed or debt capital. Raising capital through issue of shares, debentures or bonds is known as primary capital sourcing. Otherwise it is called new issues market. Long-term sources of finance consist of ownership securities y shares and preference shares) and creditor-ship securities (debentures, towing from the financing institutions and lease finance). Short-term sources of finance consists of trade credit, short-term loans from banks and financial institutions and public deposits.


Long-Term Capital Instruments Corporate securities also known as company securities are said to be the documentary media of raising capital by the joint stock companies. These are of two classes: Ownership securities; and Creditor-ship securities. Ownership Securities Ownership securities consist of shares issued to the intending investors with the right to participate in the profit and management of the company. The capital raised in this way is called ‘owned capital’. Equity shares and securities like the irredeemable preference shares are called ownership securities. Retained earnings also constitute owned capital. Creditor-ship Securities Creditor-ship securities consist of various types of debentures which are acknowledgements of corporate debts to the respective holders with a right to receive interest at specified rate and refund of the principal sum at the expiry of the agreed term. Capital raised through creditor-ship securities is known as ‘borrowed capital’. Debentures, bonds, notes, commercial papers etc. are instruments of debt or borrowed capital. Equity Shares Equity shares are instruments to raise equity capital. The equity share capital is the backbone of any company’s financial structure. Equity capital represents ownership capital. Equity shareholders collectively own the company. They enjoy the reward of ownership and bear the risk of ownership. The equity share capital is also termed as the venture capital on account of the risk involved in it. The equity shareholders’ liability, unlike the liability of the owner in a proprietary concern and the partners in a partnership concern, is limited to their capital subscription and contribution. Advantages of Equity Share Capital


1. Equity share capital constitutes the ‘corpus’ of the company. It is the ‘heart’ to the business. 2. It represents permanent capital. Hence, there is no problem of refunding the capital. It is repayable only in the event of company’s winding up and that too only after the claims of preference shareholders have been met in full. 3. Equity share capital does not involve any fixed obligation for payment of dividend. Payment of dividend to equity shareholders depends on the availability of profit and the discretion of the Board of Directors. 4. Equity shares do not create any charge on the assets of the company and the assets may be used as security for further financing. 5. Equity capital is the risk-bearing capital, unlike debt capital which is risk-burdening. 6. Equity share capital strengthens the credit worthiness and borrowing or debt capacity of the company. In general, other things being equal, the larger the equity base, the higher the ability of the company to secure debt capital. 7. Equity capital market is now expanding and the global capital market can be accessed. Disadvantages of Equity Shares capital 1. Cost of issue of equity shares is high, as the limited group of risk- seeking investors need to be attracted and targeted. Equity shares attract only those classes of investors who can take risk. Conservative and cautious investors do not subscribe for equity issues, underwriting commission, brokerage costs and other issue expense’ are high for equity capital, rising up issue cost. 2. The cost of servicing equity capital is generally higher than the cost of issuing preference shares or debenture since on account of higher rise, the expectation of the equity shareholders is also high as compared preference shares or debentures. 3. Equity dividend is payable from post-tax earnings. Unlike interest" paid on debt capital, dividend is not deductible as an expense from the profit for taxation purposes. Hence cost of equity is high Sometimes, dividend tax is paid, further rising cost of equity share capital.


4. The issuing of equity capital causes dilution of control of the equity holders.In times of depression, dividends on equity shares reach low be which leads to drastic fall in their market values. 5. Excessive reliance on financing through equity shares reduces the capacity of the company to trade on equity. The excessive use of equity shares is likely to result in over capitalization of the company. Preference Shares Preference shares are those which catty priority rights in regard to the payment of dividend and return of capital and at the same time are subject to certain limitations with regard to voting rights. The preference shareholders are entitled to receive the fixed rate of dividend out of the net profit of the company. Only after the payment of dividend at a fixed rate is made to the preference shareholders, the balance of it will be used for paying dividend to ordinary shares. The rate of dividend preference shares is mentioned in the prospectus. Similarly in the event of liquidation the assets remaining after payment of all debts of the company are first used for returning the capital contributed by the preference shareholders. Types of Preference Shares There are many forms of preference shares. These are: 1. Cumulative preference shares 2. Non-Cumulative preference shares 3. Participating preference shares 4. Non-participating preference shares 5. Convertible preference shares 6. Non-convertible preference shares 7. Redeemable preference shares 8. Ir-redeemable preference shares 9. Cumulative convertible preference shares


Merits of Preference shares 1. The preference shares have the merits of equity shares without their limitations. 2. Issue of preference shares does not create any charge against the assets of the company. 3. The promoters of the company can retain control over the company by issuing preference shares, since the preference shareholders have only limited voting rights. 4. In the case of redeemable preference shares, there is the advantage that the amount can be repaid as soon as the company is in possession of funds flowing out of profits. 5. Preference shares are entitled to a fixed rate of dividend and the company may declare higher rates of dividend for the equity shareholders by trading on equity and enhance market value. 6. If the assets of the company are not of high value, debenture holders will not accept them as collateral securities. Hence the company prefers to tap market with preference shares. 7. The public deposit of companies in excess of the maximum limit stipulated by the Reserve Bank can be liquidated by issuing preference shares. 8. Preference shares are particularly useful for those investors who want higher rate of return with comparatively lower risk. 9. Preference shares add to the equity base of the company and they strengthen the financial position of it. Additional equity base increases the ability of the company to borrow in future. 10. Preference shares have variety and diversity, unlike equity shares; Companies thus have flexibility in choice. Demerits of Preference Shares 1. Usually preference shares carry higher rate of dividend than the rate of interest on debentures. 2. Compared to debt capital, preference share capital is a very expensive source of financing because the dividend paid to preference shareholders is not, unlike debt interest, a taxdeductible expense. 3. In the case of cumulative preference shares, arrears of dividend accumulate. It is a permanent burden on the profits of the company.


4. From the investor’s point of view, preference shares may be disadvantageous because they do not carry voting rights. Their interest may be damaged by equity shareholders in whose hands the control is vested. 5. Preference shares have to attraction. Not even 1% of total corporate capital is raised in this form. 6. Instead of combining the benefits of equity and debt, preference share capital, perhaps combines the benefits of equity and debt. Debentures A debenture is a document issued by a company as an evidence of a debt due from the company with or without a charge on the assets of the company. It is an acknowledgement of the company’s indebtedness to its debenture-holders. Debentures are instruments for raising longterm debt capital. Debenture holders are the creditors of the company. In India, according to the Companies Act, 1956, the term debenture includes "debenture stock, bonds and any other securities of company whether constituting a charge on the assets of the company or not" Debenture-holders are entitled to periodical payment of interest agreed rate. They are also entitled to redemption of their capital as per the terms. No voting rights are given to debentureholders. Under section 117 of the companies Act, 1956, debentures with voting rights cannot be issued. Usually debentures are secured by charge on or mortgage of the assets of the company. Types of debentures Debentures can be various types. They are: 1. Registered debentures 2. Bearer debentures or unregistered debentures 3. Secured debentures 4. Unsecured debentures 5. Redeemable debentures


6. Irredeemable debentures 7. Fully convertible debentures 8. Non-convertible debentures 9. Partly convertible debentures 10. Equitable debentures 11. Legal debentures 12. Preferred debentures 13. Fixed rate debentures 14. Floating rate debentures 15. Zero coupon debentures 16. Foreign currency convertible debentures Registered debentures: Registered debentures are recorded in a register of debenture-holders with full details about the number, value and types of debentures held by the debenture-holders. The payment of interest and repayment of capital is made to the debenture-holders whose names are entered duly in the register of debenture-holders. Registered debentures are not negotiable. Transfer of ownership of these types of debentures cannot be valid unless the regular instrument of transfer is sanctioned by the Directors. Registered debentures are not transferable by mere delivery. Bearer or Unregistered debentures: The debentures which are payable to the bearer are called bearer debentures. The names of the debenture-holders are not recorded in the register of debenture-holders. Bearer debentures are negotiable. They are transferable by mere delivery and registration of transfer is not necessary. Secured debentures: The debentures which are secured by a mortgage or change on the whole or a part of the assets of the company are called secure debentures. Unsecured debentures: Unsecured debentures are those, which do not have charge on the assets of the company.


Redeemable debentures: The debentures which are repayable after a certain period are called redeemable debentures. Redeemable debentures may be bullet repayment debentures (i.e. one time be payment) or periodic repayment debentures. Irredeemable debentures: The debentures which are not repayable during lifetime of the company are called irredeemable debentures. They are al known as perpetual debentures. Irredeemable debentures can be redeemed in the event of the company’s winding up. Fully convertible debentures: Convertible debentures can be converted into equity shares of the company as per the terms of their issue. Convertible debenture-holders get an opportunity to become shareholders and to take part the company management at a later stage. Convertibility adds a ‘sweetner’ to debentures and enhances their appeal to risk seeking investors. Non–convertible debentures: Non-convertible debentures are not convertible They remain as debt capital instruments. Partly convertible debentures: Partly convertible debentures appeal to investors who want the benefits of convertibility and non-convertibility in one instrument. Equitable debentures: Equitable debentures are those which are secured by deposit of title deeds of the property with a memorandum in writing to create a charge. Legal Debentures: Legal debentures are those in which the legal ownership of property of the corporation is transferred by a deed to the debenture holders, security for the loans. Preferred debentures: Preferred debentures are those which are paid first in the L time of winding up of the company. The debentures have priority over other debentures Fixed rate debentures: Fixed rate debentures carry a fixed rate of interest Now a days this class is not desired by both investors and issuing institutions. Floating rate debentures: Floating rate debentures carry floating interest rate coupons. The rates float over some benchmark rates like bank rate, LIBOR etc.


Zero-coupon debentures: Zero-coupon debentures are merest coupons. Interest on these is paid on maturity called as deep-discount debentures. Foreign Currency convertible debentures: Foreign currency convertible debentures are issued in overseas market in the currency of the country where the flotation takes place. Later these are converted into equity, either GDR. ADR or plain equity. Merits of debentures 1. Debentures provide funds to the company for a long period without diluting its control, since debenture holders are not entitled to vote. 2. Interest paid to debenture-holders is a charge on income of the company and is deductible from computable income for income tax purpose whereas dividends paid on shares are regarded as income and are liable to corporate income tax. The post-tax cost of debt is thus lowered. 3. Debentures provide funds to the company for a specific period. Hence, the company can appropriately adjust its financial plan to suit its requirements. 4. Since debentures are generally issued on redeemable basis, the company can avoid overcapitalisation by refunding the debt when the financial needs are no longer felt. 5. In a period of rising prices, debenture issue is advantageous. The burden of servicing debentures, which entail a fixed monetary commitment for interest and principal repayment, decreases in real terms as the price level increases. 6. Debentures enable company to take advantage of trading on equity and thus pay to the equity shareholders a dividend at a rate higher than overall return on investment. 7. Debentures are suitable to the investors who are cautious and who particularly prefer a stable rate of return with no risk. Even institutional investors prefer debentures for this reason. Demerits of Debentures 1. Debenture interest and capital repayment are obligatory payments. Failure to meet these payment jeopardizes the solvency of the firm.


2. In the case of debentures, interest has to be paid to the debenture holders irrespective of the fact whether the company earns profit or not. It becomes a great burden on the finances of the company. 3. Debenture financing enhances the financial risk associated with the firm. This may increase the cost of equity capital. 4. When assets of the company get tagged to the debenture holders the result is that the credit rating of the company in the market comes down and financial institutions and banks refuse loans to that company. 5. Debentures are particularly not suitable for companies whose earnings fluctuate considerably. In case of such company raising funds through debentures, may lead to considerable fluctuations in the rate of dividend payable to the equity shareholders. Financing Through Equity Shares and Debentures Comparison A company may prefer equity finance (i) if long gestation period is involved, (ii) if equity is preferred by the market forces, (iii) if financial risk perception is high, (iv) if debt capacity is low and (v) dilution of control isn’t a problem or does not rise. A company may prefer debenture financing compared to equity shares financing for the following reasons: i. Generally the debenture-holders cannot interfere in the management of the company, since they do not have voting rights. ii. iii. Interest on debentures is allowed as a business expense and it is tax- deductible. Debenture financing is cheaper since the rate of interest payable on it is lower than the dividend rate of preference shares. iv. Debentures can be redeemed in case the company does not need the funds raised through this source. This is done by placing call option in the debentures. v. vi. Generally a company cannot buy its own shares but it can buy its own debentures. Debentures offer variety and in dull market conditions only debentures help gaining access to capital market. Convertible Issues


A convertible issue is a bond or a share of preferred stock that can be converted at the option of the holder into common stock of the same company. Once converted into common stock, the stock cannot be estranged again for bonds or preferred stock. Issue of convertible preference shares and convertible debentures are called convertible issues. The convertible preference shares and convertible debentures are converted into equity shares. The ratio of exchange between the convertible issues and the equity shares can be stated in terms of either a conversion price or a conversion ratio. Significance of convertible issues: The convertible security provides the investor with a fixed return from a bond (debenture) or with a specified dividend from preferred stock (preference shares). In addition, the investor gets an option to convert the security (convertible debentures or preference shares) into equity shares and thereby participates in the possibility of capital gains associated with, being a residual claimant of the company. At the time of issue, the convertible security will be priced higher than its conversion value. The difference between the issue price and the conversion value is known as conversion premium. The convertible facility provides a measure of flexibility to the capital structure of the company to company which wants a debt capital to start with, but market wants equity. So, convertible issues add sweeteners to sell debt securities to the market which want equity issues. Convertible preference shares: The preference shares which carry the right of conversion into equity shares within a specified period, are called convertible preference shares. The issue of convertible preference shares must be duly authorized by the articles of association of the company. Convertible debentures: Convertible debentures provide an option to their holders to convert them into equity shares during a specified period at a particular price. The convertible debentures are not likely to have a good investment appeal, as the rate of interest for convertible debentures is lesser than the non-convertible debentures. Convertible debentures help a company to sell future issue of equity shares at a price higher than the price at which the company’s equity shares may be selling when the convertible, debentures are issue. By convertible debentures, a company


gets relatively cheaper financial resource for business growth. Debenture interest constitutes tax deductible expenses. So, till the debentures are converted, the company gets a tax advantage. From the investors’ point of view, convertible debentures prove an ideal combination of high yield, low risk and potential capital appreciation. Different Modes of Capital Issues Capital instruments, namely, shares and debentures can be issued to the market by adopting any of the four modes: Public issues, Private placement, Rights issues and Bonus issues. Let us briefly explain these different modes of issues. Public Issues Only public limited companies can adopt this issue when it wants to raise capital from the general public. The company has to issue a prospectus as per requirements of the corporate laws in force inviting the public to subscribe to the securities issued, may be equity shares, preference shares or debentures/bonds. A private company cannot adopt this route to raise capital. The prospectus shall give an account of the prospects of investment in the company. Convinced public apply to the company for specified number of shares/debentures paying the application money, i.e., money payable at the time of application for the shares/debentures usually 20 to 30% of the issue price of the shares/debentures. A company must receive subscription for at least 95% of the shares/bonds offered within the specified days. Otherwise, the issue has to be scrapped. If the public applies for more than the number of shares/debentures offered, the situation is called over subscription. In under subscription public subscribes for less number of shares/debentures offered by the company. For good companies coupled with better market conditions, over —subscription results. Prior to issue of shares/debentures and until the subscription list is open, the company goes on promoting the issue. In the western countries such kind of promoting the issue is called ‘road-show’. When there is over-subscription a part of the excess subscription, usually upto 15% of the offer, can be retained and allotment proceeded with. This is called as green-shoe option. When there is over-subscription, pro-rata allotment (proportionate basis allotment, i.e., say when there is 200% subscription, for every 200 share applied 100 shares allotted) may be adopted.


Alternatively, pro-rata allotment for some applicants, fill scale allotment for some applicants and nil allotment for rest of applicants can also be followed. Usually the company co-opts authorities from stock-exchange where listing is done, from securities regulatory bodies (SEI3J in Indian, SEC in USA and so on) etc. in finalizing mode of allotment. Public issues enable broad-based share-holding. General public’s savings directed into corporate investment. Economy, company and individual investors benefit. The company management does not face the challenge of dilution of control over the affairs of the company. And good price for the share’ and competitive interest rate on debentures are quite possible. Right Shares Whenever an existing company wants to issue new equity shares, the existing shareholders will be potential buyers of these shares. Gentrally the Articles or Memorandum of Association of the Company gives the right to existing shareholders to participate in the new equity issues of the company. This right is known as ‘pre-emptive right’ and such offered shares are called ‘Right shares’ or ‘Right issue’. A right issue involves selling securities in the primary market by issuing rights to the existing shareholders. When a company issues additional share capital, it has to be offered in the first instance to the existing shareholders on a pro-rata basis. This is required in India under section 81 of the Companies Act, 1956. However, the shareholders may by a special resolution forfeit this right, partially or fully, to enable the company to issue additional capital to public. Under section 81 of the Companies Act 1956, where at any time after the expiry of two years from the formation of a company, or at any time after the expiry of one year from the allotment of shares being made for the first lime after its formation, whichever is earlier, it is proposed to increase the subscribed capital of the company by allotment of further shares, then such further shares shall be offered to the persons who, at the date of the offer, are holders of the equity shares of the company, in proportion as nearly as circumstances admit, to the capital paid on those shares at that date. Thus the existing shareholders have a pre-emptive right to subscribe to


the new issues made by a company. This right has at its root in the doctrine that each shareholder is entitled to participate in any further issue of capital by the company equally, so that his interest in the company is not diluted. Significance of rights issue 1. The number of rights that a shareholder gets is equal to the number of shares held by him. 2. The number rights required to subscribe to an additional share is determined by the issuing company. 3. Rights are negotiable. The holder of rights can sell them fully or partially. 4. Rights can be exercised only during a fixed period which is usually less than thirty days. 5. The price of rights issues is generally quite lower than market price and that a capital gain is quite certain for the share holders. 6. Rights issue gives the existing shareholders an opportunity for the protection of their prorata share in the earning and surplus of the company. 7. There is more certainty of the shares being sold to the existing shareholders. If a rights issue is successful it is equal to favourable image and evaluation of the company’s goodwill in the minds of the existing shareholders. Bonus Issues Bonus issues are capital issues by companies to existing shareholders whereby no fresh capital is raised but capitalization of accumulated earnings is done. The shares capital increases, but accumulated earnings fall. A company shall, while issuing bonus shares, ensure the following: 1. The bonus issue is made out of free reserves built out of the genuine profits and shares premium collected in cash only. 2. Reserves created by revaluation of fixed assets are not capitalized 3. The development rebate reserves or the investment allowance reserve is considered as free reserve for the purpose of calculation of residual reserves only. 4. All contingent liabilities disclosed in the audited accounts which have bearing on the net profits, shall be taken into account in the calculation of the residual reserve.


5. The residual reserves after the proposed capitalisation shall be at least 40 per cent of the increased paid up capital. 6. 30 percent of the average profits before tax of the company for the previous three years should yield a rate of dividend on the exp capital base of the company at 10 percent. 7. The capital reserves appearing in the balance sheet of the company as a result of revaluation of assets or without accrual of cash resources are capitalized nor taken into account in the computation of the residual reserves of 40 percent for the purpose of bonus issues. 8. The declaration of bonus issue, in lieu of dividend is not made. 9. The bonus issue is not made unless the partly paid shares, if any existing, are made fully paid-up. 10. The company — a) has not defaulted in payment of interest or principal in respect of fixed deposits and interest on existing debentures or principal on redemption thereof and (b) has sufficient reason to believe that it has not defaulted in respect of the payment of statutory dues of the employees such as contribution to provident fund, gratuity or bonus. 11. A company which announces its bonus issue after the approval of the board of directors must implement the proposals within a period of six months from the date of such approval and shall not have the option of changing the decision. 12. There should be a provision in the Articles of Association of the Company for capitalisation of reserves, etc. and if not the company shall pass a resolution at its general body meeting making decisions in the Articles of Association for capitalisation. 13. Consequent to the issue of bonus shares if the subscribed and paid-up capital exceed the authorized share capital, a resolution shall be passed by the company at its general body meeting for increasing the authorized capital. 14. The company shall get a resolution passed at its generating for bonus issue and in the said resolution the management’s intention regarding the rate of dividend to be declared in the year immediately after the bonus issue should be indicated. 15. No bonus shall be made which will dilute the value or rights of the holders of debentures, convertible fully or partly. Sebi General Guidelines for Public Issues


1. Subscription list for public issues should be kept open for at least 3 working days and disclosed in the prospectus. 2. Rights issues shall not be kept open for more than 60 days. 3. The quantum of issue, whether through a right or public issue, shall not exceed the amount specified in the prospectus/letter of offer. No retention of over subscription is permissible under any circumstances, except the special case of exercise of green-shoe option. 4. Within 45 days of the closures of an issue a report in a prescribed form with certificate from the chartered accountant should be forwarded to SEBI to the lead managers. 5. The gap between the closure dates of various issues eg., Rights and Indian public should not exceed 30 days. 6. SEBI will have right to prescribe further guidelines for modifying the existing norms to bring about adequate investor protection, enhance the quality of disclosures and to bring about transparency in the primary market. 7. SEBI shall have right to issue necessary clarification to these guidelines to remove any difficulty in its implementation. 8. Any violation of the guidelines by the issuers/intermediaries will be punishable by prosecution by SEBI under the SEBI Act 9. The provisions in the Companies Act, 1956 and other applicable laws shall be complied in connection with the issue of shares and debentures. Have you understood? 1. Discuss the sources of long-term finance of a company. 2. Critically evaluate equity shares a source of finance both the point of (i) the company and (ii) investing public. 3. Discuss the features of preference shares and evaluate preference share capital from the company’s point of view. 4. What are right shares? Explain the significance of the same from the company’s and investors’ view point. 5. Define ‘debenture’ and bring out its salient features as an instrument of corporate financing.


6. Explain the different types of debentures that may be issued by a company. 7. What are the advantages and disadvantages of debenture finance to a company? 8. List out the SEBI guidelines for issuing bonus shares. Lesson 3 Lending Procedures of the Term Lending Financial Institutions INTRODUCTION Under this head we shall see the lending procedure practiced by long-term finance Learning Objectives After reading this lesson, you will be conversant with: The different types of appraisal used by term lending institution for financing The conditions for financial assistance The various schemes of assistance of financial institutions The concept, merits and demerits of public deposits The regulations of RBI regarding public deposits. SECTION TITLE Essential Requirements: The essential requirements insisted upon by the financial institutions before taking up a request for financial assistance for consideration are: 1. The applicant concerned include the following should have obtained industrial license or should have made some kind of commitment, where necessary 2. The applicant should have obtained/applied for permission of the Securities and Exchange Board of India to issue capital, wherever necessary 3. The applicant should have obtained the approval of the Government regarding the terms of technical and/or financial collaboration agreement, if any.


4. The applicant should have a clearance from the Capital Goods Committee in respect of the machinery proposed to be imported 5. The applicant should have selected a site for the location of the factory and has prepared a detailed ‘project report’. After the receipt of the filled up application in triplicate in the case of non-corporate units and quadruplicate in the case of corporate bodies, the project is appraised by a team of technical, financial and economic officers of the Corporation from several angles — technical, financial, economic, managerial and social. Appraisal by Financial Institution: 1.Technical Appraisal The technical appraisal of the project involves a critical analysis of the following: 1. Feasibility of the selected technical project and its suitability in Indian conditions. 2. Location of the project in relation to the sources and availability of inputs — raw materials, water, power, transport, skilled and unskilled labour and in relation to the market to be served by the product/service. 3. Adequacy of the plant and machinery and their specifications 4. Adequacy of the plant layout 5. Arrangements for securing technical know-how, if necessary 6. Availability of skilled and unskilled labour and arrangements for training for the labourers. 7. Provision for the disposal of factory effluents and utilisation of byproducts if any. 8. Whether the process proposed for selection is technically sound up-to-date etc. Another important feature of technical appraisal relates to the technology to be adopted for the project. In case of new technical processes adopted from abroad, attention is to be paid to the terms and conditions. 2.Economic Appraisal


The economic appraisal of a project involves: 1. Consideration of natural and industrial property of the project and contribution to the national economy of the country in terms of contribution to GDP, down stream and upstream projects. 2. Savings in foreign exchange or prospects of exports. 3. Employment potential, direct and indirect 4. A critical study of the existing and future demand for the products proposed to be manufactured, the licensed and installed capacity, the level of competition etc. 5. Scrutiny of the project in relation to the import and export policies of the Government and various other factors like regulatory controls, if any, in regard to production, prices and raw materials. 3.Financial Appraisal Financial appraisal of the existing concern deals with an analysis of its working results, balance sheets and cash flow for the past years/projected future years and an examination of the following aspects in all cases. 1. Estimated cost of the project 2. Financial plan with reference to capital structure, promoter’s contribution, debt-equity ratio and the availability of other resources. 3. Crucial examination of the investments made outside the business and justification therefore. 4. Projections of cash flow, both during the construction and the operation periods. 5. Projects break-even level of operation and time required to reach that level of operation. 6. Estimation of future profitability in the light of competition and product service obsolescence. 7. Internal rate of return, debt-service coverage and projected dividends on share capital, payback period, abandonment value at the end of different levels of milestones or years of operation. 4.Managerial Appraisal


The confidence of the lending institution in the repayment prospects of a loan is largely conditioned by its opinion of the borrowing unit’s management. Therefore, it has been remarked that appraisal of management is the touch stone of term credit analysis. Where the technical competence, administrative ability, integrity and resourcefulness of the management are well established, the loan application gets the most favourable consideration. The expertise, experience and earnestness of the management tells in the efficiency, effectiveness and excellence of the project. 5.Social Appraisal The social objectives of the project are considered keeping in view the interest of the general public. The projects, which provide large employment opportunities and canalize the income of the agricultural sector for productive use, projects located in totally less developed areas and projects that stimulated small scale industries are considered to serve the society well. The social benefits are more. The social cost of pollution consumption of scarce resources, etc. is also to be weighed. Conditions for Assistance from Financial Institutions Different financial institutions stipulate different kinds of conditions depending on the nature of the project, the borrower etc. The main conditions of a term loan are as follows: 1. The borrower (applicant) has to obtain all relevant Government clearances such as licensing, capital goods clearance for imported machines, import license, clearance from pollution control board, etc. 2. For consortium loan, the borrower has to satisfy all the institutions participating in lending 3. Concurrence of the financial institution is necessary for repayment of any existing loan or long-term liabilities. 4. The term loan agreement may stipulate the debt-equity ratio to be followed by the company. 5. As long as the loan is outstanding, the declaration of dividend is made subject to the institution’s approval.


6. The term lending institution reserves the right to nominate one or more directors in the management of the company. 7. Once the loan agreement is signed, any major commercial agreements such as orders for equipment, consultancy, collaboration agreement, selling agency agreement etc. and further expansion need the concurrence of the term lending institution. 8. The borrower is not permitted to create any additional charge on the assets without the knowledge of the financial institutions. 9. The financial institutions may appoint suitable personnel in the areas of marketing, research and development, depending upon the nature of the project. 10. The promoters cannot dispose their shareholders without the consent of the lending institutions. This is stipulated for keeping the promoters involved as long as the institutions are involved in the business. Puplic Deposits Deposits with companies have come into prominence in r cent years. Of these the more important one are the deposits accepted by trading and manufacturing companies. The Indian Central Banking Enquiry Committee in 1931 recognized the importance of public deposits in the financing of cotton textile industry in India in general and at Ahmedabad in particular. The growth of public deposits has been considerable. From the company’s point of view, public deposits are a major source of finance to meet the working capital needs. Due to the credit squeeze imposed by the Research Bank of India on bank loans the corporate sector during 1970s 1980s and also due to the recommendations of the Tandon Committee, restricting credit, many companies were not getting as much money in the 1980s as they are used to getting in the past, from the banks. So, public deposits came handy as working capital funds for the businesses. While to the depositor the rate offered is higher than that offered by banks, the cost of deposits to the company is less than the cost of borrowings from bank. Moreover, the availability and volume of bank credit are restricted by considerations of margin, security offered, periodical submission of statements etc. The credit available to companies through public deposits is not affected by such consideration. There is no problem of margin or security. Since, the fixed deposits from the public are unsecured, the borrowing company need not mortgage or


hypothecate any of its assets to raise loans in this form. These deposits are available for comparatively longer terms than bank credit. Merits of Public Deposits The merits of public deposits are as follows: 1. There is no need of creation of any charge against any of the assets of the company for raising funds through public deposits. 2. The company can get advantage of trading on equity since the rate of interest and the period for which the public deposits have been accepted are fixed. 3. Public deposit is a less costly method for raising short-term as well as medium term funds required by the companies, because of less restrictive covenants governing this as against bank credits. 4. No questions are asked about the uses of public deposits. 5. Tax leverage is available as interest on public deposits is a charge on revenue. Demerits of Public Deposits The main demerits of the public deposits are as follows: i. This mode of financing, sometimes, puts the company into serious financial difficulties. Even a slight rumour about the inefficiency of the company may result in a rush of the public to the company for getting premature payments of the deposits made by them. ii. iii. Easy availability of fund encourages lavish spending. Public deposits are unsecured deposits and in the event of a failure of the company, depositors have no assurance of getting their money back. RBI Regulations for Public Deposit The RBI regulation of public deposits has six main aspects: i. There is a ceiling on the quantum of deposits in terms of paid-up capital and reserves by the company because undue accumulation of short-term liabilities in the form of deposits


can lead a company into financial difficulties. In the beginning the definition of deposits was quite narrow and excluded unsecured loans accepted from the public and guaranteed by the directors. Now the term deposit covers "an money received by a non-banking company by way of deposit or loan or in any other form but excludes money raised by way of share capital or contributed as capital by proprietors". ii. The second aspect of the Reserve Bank’s regulation is the limit on the period of such deposit. Formerly, in order to avoid direct competition with short-term public deposits, companies were prohibited from accepting deposits for a period of less than 12 months. But the 1973 amendment reduced the period to less than 6 months. The short-term deposit is now pegged down to 10 per cent of the garagate of the paid-up capital and free reserves of the company while secured and unsecured deposits shall not exceed 15 per cent and 25 per cent, respectively, of the paid-up capital and free reserves. iii. The Reserve Bank has made obligatory on the part of the companies accepting deposits to regularly file the returns, giving detailed information about them, their repayment, etc. so that the Reserve Bank can verify whether the companies adhere to the restrictions. However such statements are not filed and the Reserve Bank’s action to prevent a defaulting company from accepting any deposit fails to afford any protection to the existing depositors. iv. The Reserve Bank has stipulated that while issuing newspaper advertisements (or even the application forms) soliciting such deposits, certain specified information regarding the financial position and the working of the company must accompany. This clause is often mis-ued as much advertisement often carried words like "as per Reserve Bank directive", thereby giving a wrong impression that these deposits are actually governed by the Reserve Bank. Now such advertisements would be illegal and attract penal provision prescribed in this behalf. Similarly, the catalogues and handouts issued by brokers stating that the companies mentioned therein had complied with Reserve Bank directives would also attract the penal provision. v. The Reserve Bank has entrusted the auditors of the companies with additional responsibilities of reporting to it that the provision under the Act has been strictly followed by the company.



The Reserve Bank has issued a broad "RBI Directives on Company Deposit in order to clarify its role in protecting the depositors. The bank has reiterated that the deposits or loans are fully protected or are absolutely safe merely because the companies claimed to have complied with the RBI directives and that they should not presume that the Reserve Bank can come to their rescue in the event of failure of a company to meet its obligations.

Have you understood? 1. What do you mean by Public Deposits? Explain their merits and demerits. 2. Explain the types of appraisal to be made in sanctioning project finance. Lesson 4 Venture capital Financing INTRODUCTION In present day economy, finance is defined as the provision of money at the time when it is required. Finance is required for all types of project and non-profit organizations, to carry out their regular activities to achieve their objectives. Hence, it is considered as lifeblood of economic activities. The success of any organization mainly depends on how well financial resources are being used. The financial services in India have undergone drastic changes in the last 50 years. In the early 60s both primary and secondary market were functioning on traditional basis and were inactive and unorganised. Later FERA Act, 1973, Nationalization of commercial bank, establishment of IDBI have contributed greatly to the growth of primary and secondary markets. From 1970 on wards an uninterrupted rise in the industrial, agricultural and service sector growth was found. The same trend continued even in the 80s. This led to the introduction of different types of financial instruments in the market. But during the 90s the country faced severe balance of payments crisis, high inflationary pressures and set back in industrial and finance sector. In the year 1991, Sri P.V. Narasimha Rao’s government with a view to bring inflation under control and to restore normalcy. In the economy introduced the new industrial policy was introduced.


Liberalization in industrial licensing, foreign investment, foreign technology agreements, disinvestment of public sector units and MRTP Act amendments were introduced. The new import and export policy brought series of changes in the economic environment. All these attracted the financial sector. Both primary and secondary markets started functioning as per the requirements of the market. New financial products were introduced. Technology in banks and customer service have improved. Competitive financial market was created focusing on needs of customers. This resulted in the witnessing of new financial instruments in the market Viz., Leasing, Hire-purchase Factoring, Forfeiting, Global Depository Receipts, Venture capital etc., Learning objectives On going through this lesson, you will be conversant with Definition and meaning of venture capital Characteristic features of venture fund Venture capital investment process Stages of financing Types of organizations Venture capital financing in India Guidelines on venture funds capital Present scenario of venture capital financing The new financial instrument ‘Venture Capital’ is discussed in detail. SECTION TITLE Definition Venture Capital It is defined as long-term funds in equity or semi-equity form to finance hi-tech projects involving high risk and yet having strong potential of high profitability.


The term ‘Venture Capital’ refers to capital investment made in a business or industrial enterprise, which carries elements of risk and insecurity and the probability of business hazards. Capital investment may assume the form of either equity or debt or both as a derivative instrument, The risk associated with the enterprise could be so high as to entail total loss or be so insignificant as to lead high gains. Generally, the investment is made in the form of equity with the prime objective being capital gains as the business prospers. Equity investment enables the investor to the investment into cash when required. Meaning Venture Capital means many things to many people Jane Koloski Morris, editor of the well known industry publication, Venture Economics, defines Venture capital as ‘providing seed, start-up and first stage financing’ and also funding the expansion of companies that have already demonstrated their business potential but do not yet have access to the public securities market or to credit oriented institutional funding sources Venture capital also provides management in leveraged buy out financing". The European venture capital association describes it as risk finance for entrepreneurial growth oriented companies. It is investment for the medium or long-term seeking to maximize medium or long-term return for both parties. It is a partnership with the entrepreneur in which the investor can add value to the company because of his knowledge experience and contract base. Steven James Lee, defines it as actual or potential equity investments in companies through the purchase of stock, warrants, options or convertible securities. Venture capital is a long-term investment discipline that often requires the venture capitalist to wait five or more years before realising a significant return on the capital resource. The 1995 Finance Bill, defines Venture capital as long-term equity investment in novel technology, based projects which display potential for significant growth and financial returns. Hence, venture capital implies an investment in the form of equity for high risk projects with the expectation of higher returns. The investment is made through the private placement with the expectation of risk of total loss or huge returris. Risk is associated with such capital investment and as such it is termed as venture capital. High technology industry is more attractive to venture


capital because of high returns. The main object of investing equity is to get high capital profits at saturation stage. Characteristic Features · Investments are made in equity in high tech. Industry and wait for 5- 7 years to reap the benefit of capital gains. · Investments are made in innovative projects with new technology with a view to commercialise the know how through new products\services · The claim over the management is decided on the basis of proportion to investments. · Venture capital investor does not interfere in the day-to-day business affairs but closely watch the performance of the business unit. · Venture capital funds need not be repaid in the course of business units, but they are realised through exist route, (stock exchange). Venture Capital Investment Process Financing of a High tech., project under venture capital has following steps. They are: 1. Establishment of contact between the entrepreneur and the venture capitalist: The Prospective entrepreneur, with his know how prepares a project report establishing there in the possibility of marketing a commercial product. This can be done with the help of auditor, professional or a merchant banker. The business consists of five important feasibility reports namely, Technical, Financial, Managerial, Marketing and Socio-economic feasibility. The formal application in duplicate will be submitted to venture capital investor. 2. Preliminary Evaluation: After the preliminary evaluation of the report is completed, venture capital investor normally discusses the investment plan for the project with the banker. During this stage close net work is expected from the management team, to implement the project. 3. Detailed Approval: In addition to the close discussion with the management team, a detailed appraléal of project is undertaken. Techno-economic feasibility will be examined by involving


the executives of the Venture capital Investor and the management professional. If required they may even consult the experts In the similar field to take a decision. 4. Sensitivity Analysis: The Forecasted results of sales and profits are tested and analysed. The risks and threats will be evaluated by using sensitivity analysis. Sensitivity analysis helps the evaluators to predict the probable risks and returns associated with the project. This formally clears the project for investment. 5. Investment in the project: The terms and conditions of venture capital assistance will be finalised according to the requirement of the project. The amount of funds required, profile of the business, the life time technology and the possible competition in the business will be looked into. A formal agreement is entered between the technocrat and investor stating therein the role of and share of management in the new project. 6. Monitoring the Project and post investment support: The venture capitalist role begins with financing the project. It is a general practice of the Investor to appoint an executive director to have closer look in to the project. The executive director assists the project in developing strategies, decision-making and planning. The process of interaction with the technocrat increases the healthy environment in carrying the day-to-day business affairs. Stages of Venture Capital Financing The financing of high-tech., project in the form of venture capital financing is done in several stages. They may ‘be in the form of: 1. Early-stage financing 2. Later stage financing (1) Early-stage financing This stage of financing is done to the new project or to the new technocrat who wishes to commercialize his research talents. As the technocrat is well versed only with know how and not


with capital, going for debt at this stage increases the risk of entrepreneur and affect the health of the business unit. In, other means of financing, the obligation to repay the loans along with interest starts immediately with lending. Hence, it is not advisable for young entrepreneurs to go in for such loans. They have depend mainly on equity stoke so that the risk of repayment does not arise equity financing permits the young entrepreneurs to commercialize and earns profits out of the investment. The main instruments used for such financial assistance would be in the form of equity contribution, unsecured loans and optionally convertible securities. Once the financing is done, venture capitalists assists the firm in general administrative activities and allow the technocrat to concentrate on production and marketing. This stage of venture capital financing consists of seed capital, start-ups and second round financing. (a) Seed capital: Seed capital financing includes the implementation of research project, starting from all initial conceptual stage. This stage requires more time to complete the process. Because the entrepreneur made an effort to the maximum to meet the market potentiality. Therefore external equity in preferred. The key factors that influence equity financing at this stage are: The technology used in the project, possible threats of new technology in the near future. Different aspects of the product life cycle. The total investment required commercializing the product and time required to get suitable returns etc., (b) Start-up stage financing: At this stage innovator requires finance to commercialize the product. This stage is not simple to execute, it requires more time in getting different elements ie., (patent rights, trade marks, design and copy rights) which are very essential to bring the product in the market. All these components are very essentially needed to launch the product effectively. Hence, time and finance is needed. On the other hand, the research must also be done to evaluate the probable opportunities to exploit the market. Therefore, venture capital investor evaluates the projects carefully and negotiate the terms and conditions with the entrepreneur with regard to sharing the management. (c) Second round of financing: This type of financing is required when the project incurs loss or inability to yield sufficient profits. The reasons could be due to internal or external factors. At


this stage, if the venture capitalists is fully aware of the genuine reasons for the loss, he should decide on second round financing, or he may seek the support of new investor. This is a complex process as the original investor may express his inability to further finance the project or entrepreneur must have lost the confidence with the original investor or he may wishes to broad base the investment pattern. Lot of bargaining has be done to coordinate the financing with original investor and with the technocrat or promoter. (2) Later Stage Financing Later stage financing is considered to be the easy means of assistance. The reason being, the product launched has not only reached the boom period but also indicator further expansion and growth. Hence it is a easy means of financing with low risk profile. The real problem associated at this stage is entrepreneur not be willing to give majority of his stake to the venture capitalists but may accept for more number of executive directors in the board. This means of is also known as expansion finance, replacement capital, management buy out and turn around capital. (a) Expansion finance: Later stage financing is executed to expand the market, production or to establish warehouses etc., Export trade activities may also be considered for financing the project. (b) Replacement capital): Under this stage, the promoter may prefer to buy the entire equity stake of the project by approaching some other financiers. He may also wish to increase his holding by buying more number of equity shares. Replacement capital) is normally preferred at the time of public issues. If the company is unlisted, getting capital gains on the fresh issues needs more time, tilt then replacement capital can be obtained in the form of convertible preference shares from the second financier. (c) Management Buy out (MBO): This may be offered in two ways namely. ‘Management buy out’ or ‘Management buy int. In management buy out, venture capitalist help the management of a company to buy or take over the ownership of the business. This would help the management to reshuffle or reengineer the entire project.


In management buy in strategies, outsides prefers to buy the existing business. This means of financing is less risky, it is not considered as venture capital and has wide criticism. (d) Rescue Capital: Rescue capital is also known as turnaround capital offered with a view to help the technocrat or the business unit to come out of difficulties. This means of financing is risky in nature and the investor may ask for major changes in the management. In India, venture capital financing for MBO and turnout are rarely seen, as the majority of the investor prefers to invest only in later stages. Types of Venture Capital Organizations On the basis of ownership, management and rising of funds, venture capital organization are categorised on the following groups: Captive Venture Capital Funds: These organizations are wholly owned by financial institutions and are operated as subsidiaries. The parental institutions supply funds for venture capital assistance e.g.. 1DBI used captive funds to assist venture capital, TDIC uses the funds for venture capital which is supplied by UTI and ICICI. RCTC used the funds of UTI and IFCI. All these venture capital investors perform their activities independently.

Independent Venture Capital Funds: All these funds are raised by group individuals venture capitalists. These funds are close-ended with minimum capital base and equity oriented instruments. The investor in such contribution expects huge capital gains, rather than regular income of dividends. The amount invested in the project will be realised through the exist route. (Promoter and venture capitalists prefers to go for primary market to sell the shares and distributes the realised amount as per the terms and conditions of the agreement.) Government Funds: These venture capital organizations are wholly owned by the government. The assistance will be given to promoter at the initial stages to complete research and developmental activities. To avail such benefits the product innovated should be of national importance. Government of Karnataka through the Central Government scheme, provides Rs. 25,000 for the technocrat who commercializes his know how by obtaining a patent right, the Commissioner of industrial development is authorised to release this fund through Karnataka Council of Technological upgradation scheme.


Exit Route of Venture Capital The main aim of venture capitalist is to realise the investment with huge profit after the completion of successful efforts with the promoter in launching or commercialising the product. The exit route will be well thought by the investor at the stage of marking investments. Exit means realization of investment through the issue of equity shares to the public. The main motto of venture capitalist is find exit at ‘maximum profit or if it is unavoidable with ‘minimum loss’. There are alternative routes of disinvestment practiced in a real life situation. They are: Going public Sale of shares to entrepreneurs Sale of the company to another company Finding a new investor Liquidation (a) Going Public: Most of the venture capital assisted firms prefers to go in for public issue to recover their investments with profits. This process not only help the entrepreneur but also the investor in different ways. The main benefit of going public increases the liquidity of the business firm. This liquidity will increase the percentage returns over the private placements. (If it were sold through private placements). The public issues provides another opportunity for the business firm to list its shares in the stock market. Once the shares are listed, it increases the image of the organization. In addition to this, it increases and attracts efficient persons to work in the organization. In addition to this, the commercial banks and financial institutors will forward to offer different types of loans. If the firm wishes to raise additional capital for expansion and growth, it could be done easily through the public issue. However, going public is not an easy route to exit or venture capital assisted units because, it has to observes several legal for’ of stock exchange. The company must also disclose part a considerable ar1t of information at the time of issuing the shares; this could be a sales threat with the global competition. Employees may ask for better comfort with huge hike in the salaries and perks. The expenditure incurred during the course of the issue in also substantially high, which may affect the profitability. As the company is going for public issue, its social responsibility


increases and they have to be accountable to all the organs of the society, which burdens the financial affairs of the company. With all these demerits or bottlenecks going public for exit route is widely used in seal life situations. (b) Sale of shares to entrepreneur: Some times, promoter may prefers to have exit route through, Over The Counter Exchange by entering into bought out deals with the member of O.T.C. He may purchase the shares with a view of entering in to the primary market at the later stage. In certain circumstances, an entrepreneur himself prefers to buy the entire shares. He may even buy the shares with the help of his own group-even the employees are allowed to do so at an agreed price for buying such shares. If necessary, the entrepreneur may approach financial institutions for loans. The price at which the stake of the V. C. assisted may be done as several methods. Viz., (i) Book value method: According to this method, the price is fixed on the basis of book value method or a predetermined multiple applied to determine the book value (ii) Price-earning ratio: This method is widely in practice. The price of the share is determined as the basis of multiplying the price earning ratio to earning per share. (iii) Percentage of sales method: Pricing under P/E ratio is popular only when the earnings are low or the company anticipated losses in the coming years PIE ratio is not suitable. On such circumstance, percentage of sale method is used. If the sales figures are highly volatile, the total average sale of the industry is taken into consideration. (iv) Multiple of cash flow method: According to this method, the value of the business is determined by multiplying the cash flow of the business by a multiplies which is similar to the industry. Hence it is considered to be a better method when compared to PIE ratio and percentage on sales method.


(v) Independent Valuation: Sometimes, the task of determining the value of business is assigned to professionals like CAs or Merchant Bankers. They may use either p/eratio method or a traditional method for assessing the value of the assets. (Realisable value) (vi) Agreed to this method: Venture capitalist and the entrepreneur follow the price that was determined mutually at the time of launching business. This is a traditional and simple method. (c) Sale of a company to another company: On many occasions, venture capitalist and the entrepreneur may agree together to sell the business unit to some other company. The reasons could be many viz., the entrepreneurs may prefer to undertake some other new company. He may find it difficult to operate the business profitably. At the time of managerial difficulties he may search for a new company which is having similar line of business. The modalities of such a sale will be made on the basis of level of operations and, the nature of venture, which may be acceptable to both the parties. (d) Finding a new investor: Under this method, the venture capitalists and the investor may decide to sell the unit to another new investor who may be a venture capitalist or a corporate who is having similar line of business. But buying venture from others and buying company may increase their operation and profitability. This provides an opportunity to exploit and can have economies of large scale operations (e) Liquidation: This is a lender of last resort, when a firm performs very badly, in other words if it incurs continuous cash loss over the years, venture capitalist and the entrepreneur decides to close down the operations. Hence, it takes the firm to liquidation. The reason for such a exercises would be many viz., stiff competition, technological failure, poor management by the entrepreneur etc., HAVE YOU UNDERSTOOD? 1. Define the term ‘Venture Capital’ 2. Explain the process Venture Capital investment. 3. Mention the different characteristic features of Venture Capital 4. What is early stage financing? Explain.


5. What is later stage financing? Explain.


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