Module - 1

Module - 1
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Unit 1: Nature and Scope of Financial Management
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Objectives
to give an insight into the Financial Management
To identify major areas of decision making in financial management
To give a overall view of the scope of financial management.
Unit Outline
1.1 Introduction
1.2 Meaning of usiness Finance.
1.! "efinitions of Financial Management
1.# $hich are the major areas of decision making in financial management%
1.& 'cope of financial management
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1.1INTO!U"TION
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Finance is the life(lood of (usiness organisations) without finance the
formation) esta(lishment) production) functioning or operating of (ig) medium or
small (usiness enterprise is not possi(le. Finance may (e defined as the art and
science of managing money. The major areas of finance are 1* financial services
and 2* financial management. Financial Services is concerned with the design
and delivery of products to individuals) (usiness and government within the areas
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of financial institutions) personal financial planning) investments) real estate) and
so on. Financial management is concerned with the duties of the financial
mangers in the (usiness firm. The su(ject of finance is traditionally classified into
two classes
1* +u(lic Finance and 2* +rivate Finance.
+u(lic finance deals with the re,uirements) receipts) and dis(ursement
of funds in the government institutions like states) local self-governments and
central governments. $hereas the private finance deals with the re,uirements)
receipts and dis(ursement of funds (y the individual) a (usiness organisation and
non-(usiness organisation. The private finance from the a(ove we can once again
classified into personal finance and (usiness finance and finance of non-(usiness
organisation.
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1#$ M%&NIN' OF (USIN%SS FIN&N"%
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To understand the meaning of (usiness finance there is a need to
understand the concepts (usiness and finance. usiness may (e understood as the
organised efforts of enterprises to supply consumers with goods and services for
satisfying these needs and wants and in the process. -ll (usinesses share the
same purpose that is to earn profits. roadly speaking) the term (usiness includes
industry) trade and commerce.
Finance refers to provisioning of money at the time when it is re,uired. .ere
finance refers to management of flows of money through an organisation. .ence
(usiness Finance concerned with ac,uisition of funds) use of funds and
distri(ution of profits (y a (usiness firm.
The (usiness finance can (e further classified in to sole proprietary finance)
partnership finance and company or corporate finance. The principle of (usiness
finance can (e applied to any of the forms of (usiness organisations. ut since the
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(usiness in an economy in terms of value in companies is more hence the
emphasis to the financial practices and pro(lems of the incorporated enterprises
are studied much in (usiness finance. 'o most of the authors use corporate
finance interchangea(ly with (usiness finance.
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1#) !%FINITIONS OF FIN&N"I&* M&N&'%M%NT
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Financial management refers to that part of the management activity which
is concerned with the planning and controlling of firm/s financial resources. It deals
with finding out various sources for raising funds for the firm.
-ccoding to Soloman, /Financial Management is concerned with the efficient use
of important economic resource) manely) 0apital Funds./
-ccording to Prather & Wert) 1usiness finance deals primarily with raising
administering and dis(ursing funds (y privately owned (usiness units operating in
non-financial fields of industry.1
Wheeler defines usiness Finance as 1that (usiness activity which is concerned
with the ac,uisition and conservation of capital funds in meeting the financial
needs and administering the funds used in the (usiness.1
-ccording to 2uthmann and "ougall) (usiness finance can (e (roadly defined as
the activity concerned the planning) raising) controlling and administering the
funds used in the (usiness.
-ccording to James C. Van Horne /Financial Management is concerned with the
ac,uisition) financing) and management of assets with some overall goal in mind./
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&%&S OF !%"ISION M&,IN' IN FIN&N"I&* M&N&'%M%NT
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Therefore the decision function of financial management can (e (roken down
into three major areas3 the investment) financing) and asset management
decisions.
Investment !ecision
The investment decision is the most important of the firm/s three major
decisions when it comes to the value creation. Investment decision relates to the
determination of total amount of assets to (e held in the firm) the composition of
these assets like the amount of fi4ed assets) current assets and the e4tent of
(usiness risk involved (y the investors.
The investment decisions can (e classified in to two groups3 51* 6ong-term
investment decision or capital (udgeting and 52* 'hort-term decision or $orking
capital decision.
Financing !ecision
Financing decision follows the Investment decision. The Finance manager
now has to decided how much of finance is re,uired to meet the long-term and
short-term investment decisions) what are the sources of financing these
investment decisions) what is the composition of these finance and what should (e
the financial mi4 and so on.
&sset Management !ecision
The third important decision of the firm is the asset management decision.
7nce assets have (een ac,uired and appropriate financing provided) these assets
must still (e managed efficiently. The finance manager has more responsi(ility in
managing the current assets than fi4ed assets. - large share of the responsi(ility
of managing the fi4ed assets would reside in the hands of operating managers of
the company.
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1#- S"O.% OF FIN&N"I&* M&N&'%M%NT
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Financial management is concerned with ac,uisition) proper utilisation or
allocation of these funds. It is an activity concerned with the planning) raising)
controlling and administering the funds used in the (usiness. .ence the finance
manager have to concentrate on the following areas of finance function.
1. %stimating Financial e/uirements# The finance manager has to
estimate what would (e the short term and long-term financial re,uirement
of his (usiness. For this he has to prepare financial plan for present as well
as for future. .e should make correct estimate of finance for purchasing of
fi4ed assets and current assets. The estimate should (e accurate other wise
it leads to either e4cess of funds or inade,uacy (oth these situations will
have adverse impact on the profita(ility of an organisation.
2. !eciding "apital Structure# The capital structure refers the composition
and proportion of different securities for raising funds. -fter deciding the
estimate of financial re,uirements for fi4ed and current assets of his
(usiness the finance manager must decide what should (e composition of
long-term funds like capital and de(t ratio. Then he has to plan what should
(e its proportion (y taking in to consideration the cost of funds. 'imilarly for
short-term funds.
!. Selecting a Source of Finance# -fter selecting the capital structure the
finance manager must select the sources of finance (y considering the cost
of capital and availa(ility of funds in the market.
#. Selecting a pattern of investment# -fter procurement of funds) he has to
decide the pattern of investment. .e should decide a(out which assets
should (e purchased among fi4ed assets and which is the method of
selecting the fi4ed assets or capital (udgeting techni,ues to (e used and
cost analysis etc.)
&. .roper "as0 Management# +roper cash management is another important
function of finance manager. .e has to asses the cash needs of the
organisation like for purchasing of raw materials) making payment to the
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creditors) wages) rent and other day-today e4penses. .e must identify the
sources of raising cash like from cash sales) collection of de(ts) short-term
loans from (anks and so on. The cash in an organisation neither e4cess nor
shortage. 84cess cash will increase the idle funds in the organisation)
whereas shortage of funds or cash will affect the creditworthiness of the
company) hence it should (e ade,uate.
9. Implementing Financial "ontrols# 8fficient financial management
re,uires implementation of some financial controls like ratio analysis) return
on capital employed) return on assets) (udgetary control) (reak-even
analysis) return of investment) internal audit etc.) to evaluate the
performance of various financial policies of the organisation.
:. .roper use of surpluses# +roper use of profits or surpluses is also
essential for the e4pansion and diversification plans and also protecting the
interests of shareholders. Issue of (onus shares or ploughing (ack of capital
etc.) will increase the value of the shares of the company hence judicious
utilisation of these surpluses is very important.
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UNIT $ O(+%"TI1%S O 'O&*S OF FIN&N"I&*
M&N&'%M%NT
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Objectives
To study the o(jectives of financial management
To analyse the relevance of each o(jective with the present scenario
To know other o(jectives of financial management
Unit outline
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2.1 7(jectives of financial management
2.2 +rofit ma4imisation
2.! -rguments in favour of +rofit ma4imisation
2.# 0riticisms on +rofit ma4imisation o(jective
2.& $ealth ma4imisation
2.9 0riticisms on wealth ma4imisation o(jective
2.: 7ther o(jectives
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$#1 O(+%"TI1%S O 'O&*S OF FIN&N"I&* M&N&'%M%NT
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Financial management is concerned with procurement and use of funds. Its
main aim is to use (usiness funds is such a way that value or earnings of the
firm/s are ma4imised. There are various alternative ways of using (usiness funds.
The organisation should go through the pros and cons of each alternative way of
using these (usiness funds (efore final selection. The financial management
provides a framework for selecting a proper course of action and deciding a via(le
commercial strategy.
The following are the o(jectives of financial management.
1. +rofit Ma4imisation
2. $ealth Ma4imisation) and
!. 7ther o(jectives.
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M&2IMIS&TION
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The main o(jective of a (usiness firm is profit ma4imisation (ecause the (usiness
firm is a profit-seeking organisation. .ence the o(jective of the financial
management of (usiness organisation is profit ma4imisation. There are some
arguments in favour of this o(jective of (usiness. They are.
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a* $hen profit earning is the aim of (usiness then profit ma4imisation should (e
the o(vious o(jective.
(* +rofita(ility is a (arometer for measuring efficiency and economic prosperity of
a (usiness enterprise) therefore) profit ma4imisation is justified on the grounds
of rationality.
c* The economic and (usiness conditions do not remain same at all the times like
recession) depression) cut throat competition and so on. .ence the (usiness
organisations should earn more and more profits when the situations are
favoura(le.
d* 'ince profit is the main source finance for growth and development of a
(usiness organisation hence) keeping profit ma4imisation of profit) as an
o(jective of the (usiness is justifia(le.
e* Through ma4imisation of profita(ility of a (usiness it is possi(le to contri(ute
more and more funds for social activities to meet social goals.
.owever) the concept of profit ma4imisation has (een criticised and rejected as
the o(jective of financial management of a (usiness organissation on account of
the following reasons3
a* It is vague. The term /profit/ is vague and it cannot (e precisely defined. It
means the term profits if different to different people. $hich profits are to (e
ma4imised) short term or long term profit) profits (efore ta4 or after ta4) or
total profits or profit per share and the like.
(* It ignores timings. +rofit ma4imisation o(jective ignores the time value of
money and does not consider the magnitude and timing of earnings.
1. It overlooks quality aspects o uture activities. The (usiness is not solely
run with the o(jective of earning ma4imum profits. 'ome organisations give
more emphasis to sales growth) (y increasing its volume of sales (y decreasing
the profits or gain margin. 'ome organisations make more profits and
contri(ute more amounts to the development of the society.
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M&2IMIS&TION
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$ealth or net worth is the difference (etween gross present worth and the
amount of capital investment re,uired to achieve the (enefits. -ny financial action
which creates wealth or which has a net present worth a(ove ;ero is a desira(le
one and should (e undertaken. The operating o(jective for financial management
is to ma4imise wealth or net present worth. $ealth ma4imisation is) therefore)
considered to (e the main o(jective of financial management. The o(jective of
wealth ma4imisation is to ma4imise the economic welfare of the shareholders of a
company. The value of a company/s shares depends largely on its new worth
which itself depends on earning per share 58+'*. - stockholder/s current wealth in
the firm is the product of the num(er of shares owned) multiplied with the current
stock price per share.
'tockholder/s current wealth in the firm < 5=um(er of shares owned* 4 5current
stock price per share*
It is sym(olically represented
$ o < =+ o
Thus the (usiness organisation should strive for the increase in the current stock
price per share or 8+') so that the current wealth of a firm will increases. This in
turn depends upon the proper financial management.
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"ITI"ISM OF 3%&*T4 M&2IMIS&TION
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The wealth ma4imisation o(jective has (een criticised (y certain financial
theorists mainly on the following grounds.
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a* It is a prescriptive rather than descriptive. The o(jective should tell what the
firm should actually do.
(* The o(jective of wealth ma4imisation is not necessarily socially desira(le.
c* There is controversy as to whether the o(jective of a firm is ma4imise the
stockholders wealth or wealth of the firm) since the firm includes stockholders)
de(enture-holders) preference shareholders etc.
d* 'ince the management and ownership are separated in large corporate form of
organisations) the managers will act in such a manner) which ma4imises the
managerial utility rather than the wealth ma4imisation of stockholders of the
firm. This is a controversial argument.
In spite of all the criticism) we are of the opinion that wealth ma4imisation is
the most appropriate o(jective of a firm.
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O(+%"TI1%S
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esides the a(ove (asic o(jectives) the following are the other o(jectives of
financial management.
5a* 8nsuring fair return to shareholders.
5(* uilding up reserves for growth and e4pansion.
5c*8nsuring ma4imum operational efficiency (y efficient and effective utilisation of
finances.
5d* 8nsuring financial discipline in the organisation.
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Unit ) FIN&N"I&* %N1IONM%NT
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Objectives
To study the environment under which the financial management is studied
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To give a (rief outline of functions of financial manager and organisation of
finance function.
Unit outline
FIN&N"I&* %N1IONM%NT
!.1 Functional areas of Financial Management
!.2 7rganisation of Finance function
!.! Functions of 0ontroller
!.# Functions of Treasurer
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)#1 FUN"TION&* &%&S OF FIN&N"I&* M&N&'%M%NT
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Financial management is an applied field of (usiness administration.
+rinciples developed (y the financial mangers from accounting) economics and
other fields are applied to the pro(lems of managing finances. Moreover) every
(usiness activity re,uires money and hence financial management is closely
related with all other areas of management. The relationship (etween financial
management and other areas of management has (een e4plained (riefly.
!inancial "anagement an# Cost $ccounting
Most of the large companies have a separate cost accounting department to
monitor e4penditures in their operational areas. The cost information is regularly
supplied to the management to control the costs. The finance manager is
concerned with proper utili;ation of funds and therefore he is concerned with the
operational costs of the firm.
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!inancial "anagement an# "arketing
The success or failure of a firm is greatly depends upon the marketing. 7ne
of the important elements of marketing mi4 is price. The fi4ation of price for a
product plays very important role. There are various policies of pricing. The
marketing department must o(serve the (est pricing policy when compared to the
competitors in the industry. .ence he collects the financial information from the
finance department) here the role of finance manager is very important.
!inancial "anagement an# $ssets "anagement
The current assets and the fi4ed assets of the firm constitute the total assets
of a firm. The firm/s assets should (e properly managed. +roper management of
assets refers to systematic ac,uisition and maintenance or (etter utili;ation of
assets. The finance manager plays very important role in the proper maintenance
of composition of these assets.
!inancial "anagement an# Personnel "anagement
+ersonnel management is concerned with selection) recruitment) training
and placement of personnel department. The proper functioning and the a(ove
said functions of personnel departments depend upon the decisions taken in
finance department. .ence the functioning of finance department in an
organisation plays a vital role.
!inancial "anagement an# !inancial $ccounting
Financial management and financial accounting are ,uite distinct from each
other. Financial accounting is concerned with the systematic recording) analysing)
reporting and measuring the (usiness transactions. The o(jective of financial
accounting is measurement of funds and the o(jective of financial management is
to management of funds. The management of funds depends on the measurement
of financial accounting through profit and loss account and (alance sheet.
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)#$ O'&NIS&TION OF T4% FIN&N"% FUN"TION
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- firm must give proper attention to the structure and organisation of its
finance department. If financial data are missing or inaccurate) the firm may not
(e in a position to identify the serious pro(lems confronting the firm at any time
for correcting. The roles of different finance e4ecutives should (e clearly defined in
order to avoid conflict and overlapping of functions.
7rganisation of the finance function differs from company to company
depending on their respective needs and the financial philosophy. The titles used
to designate the key finance official are also different vi;.) vice-president
5Finance*) 0hief 84ecutive 5Finance*) 2eneral Manager 5Finance*) etc. however) in
most companies) the vice-president 5Finance* has under him two officers carrying
out the two important functions - the accounting and the finance functions. The
former is designated as 0ontroller and the latter as the Treasurer.
The controller is concerned with the management and control of the firm/s
assets. .is duties include providing information for formulating the accounting and
financial policies) preparation of financial reports) direction of internal auditing)
(udgeting) inventory control) ta4es) etc. while the treasurer is mainly concerned
with managing the firm/s funds) his duties include the following3
Forecasting the financial needs> administering the flow of cash> managing
credit> floating securities> maintaining relations with financial institutions and
protecting funds and securities.
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)#) FUN"TIONS OF "ONTO**%
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+lanning and control. To esta(lish) coordinate and administer) as part of
management) a plan for the control of operations.
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1. ?eporting and interpreting. To compare performance with operating plans and
standard/s and to report and interpret the results of operations to all levels of
management and to the owners of the (usiness.
2. Ta4 administration. To esta(lish and administer ta4 policies and procedures.
!. 2overnment reporting. To supervise or co-ordinate the preparation of report to
the government.
#. +rotection of assets. To ensure protection of assets for the (usiness through
internal control) internal audit and proper insurance coverage.
&. 8conomic appraisal. To appraise continuously economic and social forces and
2overnment influences) and to interpret their effect upon the (usiness.
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)#5 FUN"TIONS OF T%&SU%
---------------------------------------------------------------------------+rovision of
finance. To esta(lish and e4ecute programmes for the provision of capital re,uired
(y the (usiness.
1. Investor relations. To esta(lish and maintain an ade,uate market for the
company/s securities and to maintain ade,uate contact with the investment
community.
2. 'hort-term financing. To maintain ade,uate sources for the company/s current
(orrowings from the money market.
!. anking and custody. To maintain (anking arrangement) to receive) have
custody of and dis(urse the company/s monies and securities.
#. 0redit and collections. To direct the granting of credit and the collection of
accounts receiva(les of the company.
&. Investments. To achieve the company/s funds as re,uired and to esta(lish and
co-ordinate policies for investment in pension and other similar trusts.
9. Insurance. To provide insurance coverage as may (e re,uired.

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UNIT 5 FIN&N"IN' !%"ISIONS
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Objectives
To study the financing of investment decisions
To have the e4posure of various leverages
To identify how to arrive at optimum leverage for successful investment
decisions.
Unit Outline
#.1 $hat is financing decision%
#.2 Meaning of leverage
#.! Types of leverage
Financial leverage
7perating leverage
0omposite leverage
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5#1 FIN&N"IN' !%"ISIONS
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-fter the Investment decision is taken the firm has to decide upon the (est
means of financing these investment policies. The investment decisions are
continuous in nature (ecause the companies make the new investments in its
regular course of (usiness since the (usiness is ever e4panding. .ence the firms
will make plan continuous its financial needs. The financial decision is not only
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concerned with how (est to finance new assets) (ut also concerned with the (est
overall mi4 of financing for the firm.
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5#$ M%&NIN' OF *%1%&'%
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The term /6everage/ refers to the a(ility of a firm in employing long term
funds having a fi4ed cost) to enhance returns to the owners> i.e. e,uity
shareholders. . In other words /leverage is the employment of fi4ed assets or
funds for which a firm has to meet fi4ed costs or fi4ed rate of interest o(ligation
irrespective of the level of activities attained or the level of operating profit
earned/.
James Horne has defined leverage as 1 the employment of an asset or sources of
funds for which the firm has to pay a fi4ed cost or fi4ed return.)1
The higher the leverage higher is the risk as well as return to the owners. - higher
leverage o(viously implies higher outside (orrowings and hence riskier if the
(usiness activity of the firm suddenly slows down. The leverage can have negative
or reversi(le effect also. It may (e favora(le or unfavora(le.
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5#) T6.%S OF *%1%&'%S
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There are (asically two types of leverages) 1* operating leverage) and 2* financial
leverage. In addition to these two types of leverages there are composite leverage
and working capital leverage. The leverage associated with the employment of
fi4ed cost assets is referred to as operating leverage. $hile the leverage resulting
from the use of fi4ed cost@return source of funds is known as financial leverage.
FIN&N"I&* *%1%&'% O T&!IN' ON %7UIT6
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The company can finance its investments (y de(t and@or e,uity. The company
may also use preference capital. The rate of interest on de(t is fi4ed irrespective
of the company/s rate of return on assets. The rate preference dividend is also
fi4ed> (ut preference dividends are paid when the company earns profits. The
ordinary shareholders are entitled to the residual income. That is) earnings after
interest and ta4es 5less preference dividends* (elongs to them) this dividends also
depends on the dividend policy of the company.
The use of the fi4ed charge sources of funds) such as de(t and preference
capital with the owner/s e,uity in the capital structure) is descri(ed as financial
leverage or trading on e,uity.
The use of long term fi4ed interest (earing de(t and preference share capital
along with e,uity share capital is called financial leverage or trading on e,uity. The
long term fi4ed interest (earing is employed (y a firm to earn more from the use
of these resources than their cost so as to increase the return on owner/s e,uity) it
is called trading on e,uity. $ irm%s earnings are more than &hat #e't &oul#
cost is kno&n as avoura'le leverage an# i the irm%s earnings are less
than the #e't cost then its is kno&n as unavoura'le leverage.
The impact of financial leverage is to magnify the shareholders earnings. It
is (ased on the assumption that the fi4ed charges can (e o(tained at a cost lower
than the firm/s rate of return on its assets.
!%'%% OF FIN&N"I&* *%1%&'%
The degree of financial leverage measures the impact of a change in
operating income 58IT* on change in earning on e,uity capital or share.
The formula to calculate the degree of financial leverage
8arnings (efore Interest and Ta4es 8IT
Financial 6everage < ----------------------------------------- 7? ------
8arnings (efore Ta4es 8T
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1# Operating *everage
The operating leverage occurs when a firm has fi4ed costs which must (e
recovered irrespective of sales volume. The fi4ed costs remaining same) the
percentage change in operating revenue 58IT* will (e more than the percentage
change in sales. This is known as operating leverage. The degree of operating
leverage depends upon the amount of fi4ed elements in the cost structure. The
degree of operating leverage will (e calculated as3
0ontri(ution
7perating 6everage < -------------------
7perating profit
If a firm does not have fi4ed costs then there will (e no operating leverage.
The percentage change in sales will (e e,ual to the percentage change in profit.
$hen fi4ed costs are there) the percentage change in profits will (e more than the
percentage in sales volume. The degree of operating leverage is calculated as3
+ercentage 0hange in +rofits
"egree of operating leverage < -------------------------------
+ercentage 0hange in 'ales
is8 Factor
In a high leveraged situation will magnify the operating profits (ut it (rings
in the risk element too. The percentage change in profits will (e more in a
situation with higher fi4ed costs as compared to that where fi4ed costs are lower.
The higher degree of leverage (rings in more decrease in operating profits.
$# "omposite *everage
The operating leverage measures the degree of operating risk and it is
measured (y percentage change in operating profit due to percentage change in
sales. The financial leverage measures the financial risk (y measuring the
percentage change in ta4a(le profit or 8+' with the percentage change in
operating profit or 8IT. oth these leverages are closely concerned with the
firm/s capacity to meet the fi4ed costs.
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0omposite leverage e4pressed the relationship (etween revenue on account
of sales 50ontri(ution* and the ta4a(le income 5+T* on account of change in
sales. The composite ratio is calculated as follows3
0omposite 6everage < 7perating leverage A Financial leverage

7r
0ontri(ution 8IT 0ontri(ution
< --------------- A -------- < -------------
8IT +T +T
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UNIT - .O(*%MS FIN&N"I&* *%1%&'%S
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Objective
To understand the practical application of various leverages in the firm for
(etter financial decisions
Unit outline
&.1 +ro(lems on3
7perating leverage
Financial leverage
0omposite leverage
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-#1 .O(*%MS OF *%1%&'%S
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1. From the following data calculate the operating leverage) financial leverage and
com(ined leverage3
'ales3 1B)BBB units at ?s 2& per unit as selling price. Caria(le cost < ?s & per
unit
Fi4ed cost < ?s !B)BBB. Interest < ?s 1&)BBB.
Solution:
Ta(le to calculate 76) F6 and 06
'ales 2)&B)BBB
6ess Caria(le
cost
&B)BBB
0ontri(ution 2)BB)BBB
6ess Fi4ed cost !B)BBB
8IT 1):B)BBB
6ess Interest 1&)BBB
8T 1)&&)BBB
0ontri(ution
7perating profit 58IT*
2) BB)BBB
< ------------
1) :B)BBB
< 1.1: times
Financial 6everage < --------------------------------------- 7? ------
1) :B)BBB
< ------------
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1) &&)BBB
< 1.1B times
< 1.1: A 1.1B
< 1.2D times
2. 8valuate two companies firm - and firm in terms of the financial and
operating leverage.
Firm - Firm
'ales ?s 2B)BB)BBB ?s
!B)BB)BBB
Caria(le cost #BE of 'ales !BE of 'ales
Fi4ed cost ?s &)BB)BBB ?s :)BB)BBB
Interest ?s 1)BB)BBB ?s 1)2&)BBB
Solution:
Ta(le to calculate 76) F6 and 06
Firm - Firm
'ales 2B)BB)BBB !B)BB)BBB
Less Caria(le cost F)BB)BBB D)BB)BBB
0ontri(ution 12)BB)BBB 21)BB)BBB
Less Fi4ed cost &)BB)BBB :)BB)BBB
8IT :)BB)BBB 1#)BB)BBB
Less Interest 1)BB)BBB 1)2&)BBB
8T 9)BB)BBB 12):&)BBB
0ontri(ution
Firm & Firm (
12) BB)BBB 21) BB)BBB
< --------------- < ----------------
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:) BB)BBB 1#) BB)BBB
< 1.:1 times < 1.&B times
Financial 6everage < ------------------------------- 7? ---------
Firm & Firm (
:) BB)BBB 1#) BB)BBB
< ---------- ------------
9) BB)BBB 12) :&)BBB
< 1.19 times < 1.1B times
Firm & Firm (
<1.1: A 1.19 < 1.&B A1.1
< 2 times < 1.9! times
!irm $ has more 'usiness an# inancial risk &hen compare# to !irm
(.
!. The following data are availa(le for A 6td.)3
'elling price per unit ?s 12B
Caria(le cost ?s :B
Fi4ed cost ?s 2) BB)BBB
a* $hat is the operating leverage when A 6imited sells 9)BBB units.
(* $hat is the E change that will occur in the 8IT of A limited if output
increases (y &E.
22
Solution:
a* Ta(le to calculate 76) if sales is 9)BBB units
'ales :)2B)BBB
Less varia(le cost #)2B)BBB
0ontri(ution !)BB)BBB
Less Fi4ed cost 2)BB)BBB
8IT 1)BB)BBB
0ontri(ution
!) BB)BBB
< ------------
1) BB)BBB
< ! times
(* $hen the output increases (y &E.
=ow the total output increases to 9)!BB units
Therefore the change in 8IT is
'ales :)&9)BBB
Less varia(le cost #)#1)BBB
0ontri(ution !)1&)BBB
Less Fi4ed cost 2)BB)BBB
8IT 1)1&)BBB
The change in 8IT < 1) 1&)BBB - 1) BB)BBB
< 1&)BBB
Therefore the E change in 8IT < 1&)BBB@1) BB)BBB 4 1BB < 1&E
23
#. 0alculate the Financial leverage and 7perating leverage under situation - and
situation ) under financial plans II and I from the following information relating
to operations and capital structure of -0 6imited.
Installed capacity < 1BBB units. -ctual production and 'ales < FBB units.'elling
price per unit < ?s 2B. Caria(le cost < ?s 1&.
Fi4ed cost3
'ituation - ?s FBB
'ituation ?s 1)&BB.
0apital 'tructure3
+articulars +lan I +lan II
8,uity share
capital
&)BBB :)BBB
"e(t &)BBB 2)BBB
0ost of de(t 1BE 1BE
Solution:
'ituation - +lan I +lan II
'ales 19)BBB 19)BBB
Less Caria(le
cost
12)BBB 12)BBB
0ontri(ution #)BBB #)BBB
Less F. 0 FBB FBB
8IT !)2BB !)2BB
Less interest &BB 2BB
8T 2):BB !)BBB
+lan I +lan II
0ontri(ution
7. 6 < ------------------- <#)BBB@!)2BB #)BBB@!)2BB
24
< 1.2& times < 1.2& times
8IT
F.6 < --------- < !2BB@2:BB < !2BB@!BBB
8T
< 1.1D times < 1.B: times
'ituation +lan I +lan II
'ales 19)BBB 19)BBB
Less Caria(le
cost
12)BBB 12)BBB
0ontri(ution #)BBB #)BBB
Less F. 0 1)&BB 1)&BB
8IT 2)&BB 2)&BB
Less interest &BB 2BB
8T 2)BBB 2)!BB
+lan I +lan II
0ontri(ution
7. 6 < ------------------- <#)BBB@2)&BB <#)BBB@2)&BB
< 1.9B times < 1.9B times
F.6 < 8IT
------- < 2)&BB@2)BBB < 2&BB@2!BB
8T
< 1.2& times < 1.BD times
"onclusion3 It is advisa(le to the management that the 76 should (e less and F6
should (e more in order to ma4imise the returns. Therefore 76 under situation - is
1.2& times and F6 under situation 5+lan I* is 1.2& times) which is considered as
an ideal situation.
25
&. From the following data of -) and 0 companies prepare their income
statement3
.articulars & ( "
C0 as a E of
sales
99 2@! :& &B
Interest ?s 2BB ?s !BB ?s 1)BBB
76 & 3 1 9 3 1 2 3 1
F6 ! 3 1 # 3 1 2 3 1
Income Ta4 rate &B E &B E &B E
Solution:
$e knew)
8IT 8IT
F.6 < --------- < ---------
8T 8IT - Interest
In Company $
! 8IT
--- < -----------
1 8IT-2BB
! 8IT - 9BB < 8IT
2 8IT < 9BB
8IT <?s !BB
In 0ompany
# 8IT
---- < -----------
1 8IT-!BB
# 8IT - 12BB < 8IT
! 8IT < 12BB
8IT < ?s #BB
In 0ompany 0
2 8IT
--- < -----------
1 8IT-1BBB
26
2 8IT - 2BBB < 8IT
8IT < ?s 1BBB
Operating Leverage
0ontri(ution
76 < ----------------
8IT
In 0ompany - In company
0ontri(ution
76 < ----------------
8IT
& 0ontri(ution 9 0ontri(ution
--- <---------------- --- <---------------
1 !BB 1 #BB
0ontri(ution < ?s 1&BB 0ontri(ution < ?s 2#BB
In company 0
2 0ontri(ution
-- < ----------------
1 1BBB
0ontri(ution < ?s 2BBB
Computation o Sales)
0ontri(ution < 'ales - C0
0ompany -
6et 'ales < 1BB
C0 < 99 2@!
Therefore 0ontri(ution < 1BB -2BB@! < 1BB@!
27
< ?s 1)&BB
Therefore 'ales < 1&BB 4 1BB 4 ! @ 1BB
< ?s. #)&BB
Caria(le 0ost < ?s !)BBB
0ompany
6et 'ales < 1BB
C0 < :&E
Therefore 0ontri(ution < 1BB -:& <2&

Therefore 'ales < 2#BB 4 1BB@2& < ?s. D)9BB
Caria(le 0ost < ?s :)2BB
0ompany 0
6et 'ales < 1BB
C0 < &B
Therefore 0ontri(ution < 1BB -&B < &B

Therefore 'ales < 2)BBB 4 1BB@ &B
< ?s. #)BBB
Caria(le 0ost < ?s 2)BBB
9. +G? and 0oHs latest alance 'heet is as follows>

(alance S0eet of .7 9 "o#
*iabilities &mount
:In s#;
&ssets &mount
:In s#;
28
8,uity 0apital
5?s 1B@- each*
1BE 6ong term
de(t
?etained
earnings
0urrent
6ia(ilities
9B)BBB
FB)BBB
2B)BB
B
#B)BB
B
Fi4ed -ssets
0urrent
-ssets
1&B)BB
B
&B)BB
B
Total 2BB)BBB Total 2BB)BB
B
The 0ompanyHs total assets turnover ratio<!) Fi4ed cost<?s1) BB)BBB@-
and Caria(le 0ost<#BE of 'ales) Ta4<&BE. Find 76) F6 and 06.
Solution
Total -ssets Turnover ?atio < 'ales@Total -ssets
! < 'ales@2)BB)BBB
Therefore 'ales < ?s.9) BB)BBB@-
Therefore C.0<#BE of 'ales < #B@1BB 4 9BBBBB
<?s. 2#BBBB
Interest < 1BE6ong term de(t<1B@1BB 4 FBBBB
<?s.#FBBB@-
Income 'tatement
'ales
5-*C.0
0ontri(ution
5-*F0
8IT
5-*Interest
51BEonFB)BBB*
9BBBBB
2#BBBB
!9BBBB
1BBBBB
29BBBB
FBB
B
29
8T
5-*Ta4&BE
8-T
2&2BBB
129BBB
129BBB
7perating 6everage < 0ontri(ution@8IT
< !9BBBB@29BBBB<1.!F times
Financial 6everage < 8IT@8T <29BBBB@2&2BBB<1.B! times
0om(ined 6everage < 76 A F6< 1.!FA1.B!<1.#2 times
:. A 6imited has estimated that for a new product) its 8+ is 2BBB units of the
item is sold for ?s 1#per unit.) the cost accounting department has currently
identified C0 of ?s. D@- per unit. 0alculate 76 for sales volume of 2&BB units and
!BBB units. I8+ < reak 8ven +ointJ. Fi4ed cost not given.
Solution
'elling +rice<?s1#@-per unit
Caria(le cost <?sD@- per unit
0alculation of Fi4ed cost.
'ales 2FBBB
5-*C0 1FBBB
0ontri(ution 1BBBB
5-*F0 - 1BBBB
8IT < B
Therefore 0ontri(ution will (e considered as Fi4ed cost i.e. ?s. 1B)BBB@-
Income Statement
30
+articulars 2&BBKni
ts
!BBBKni
ts
'ales
5-*C0
0ontri(uti
on
5-*F0
8IT
!&BBB
22&BB
#2BBB
2:BBB
12&BB
1BBBB
1&BBB
1BBBB
2&BB &BBB
Therefore 76 52&BBKnits* < 0ontri(ution@8IT< 12&BB@2&BB<& times

76 5!BBBKnits* < 0ontri(ution@8IT<1&BBB@&BBB<! times
If sales volume is increased (y 2& E5from 2BBB to 2&BBKnits* the 8IT
increases unto ?s2&BB@- from 8+. If sales volume increases up to ?s &BBB@-
5dou(led3 2&BB to &BBB*
F. Following information is o(tained from a hypothetical company which has the
three different situations A)L and M and Financial plans I) II and III. Lou are
re,uired to calculate 76) F6 and 06. The total capacity of the project<1BBBB
Knits)
84plored capacity of sales<:&BB Knits
'.+ +er Knit<?s.2B@-
C.0 +er Knit<?s1&@-
Fi4ed 0ost>
A<?s1BBBB
L<?s2BBBB
M<?s2&BBB
Financial +lans>
1* ?s&BBBB@-8,uity and ?s#BBBB@-de(t at 1BE interest
2* ?s9BBBB@- 8,uity and ?s!BBBB@-de(t at 1BE interest
!* ?s!BBBB@- 8,uity and ?s9BBBB@- de(t at 1BE interest
31
'olution
'ituation +lan-I +lan-II +lan-III
'ales
5-*C0
0ontri(ution
5-*F0
8IT
5-*Interest
8T
1)&B)BBB
1)12)&BB
1)&B)BBB
1)12)&BB
1)&B)BBB
1)12)&BB
!:)&BB
1B)BBB
!:)&BB
1B)BBB
!:)&BB
1B)BBB
2:)&BB
#BBB
2:)&BB
!BBB
2:)&BB
9BBB
2!&BB 2#&BB 21&BB
*perating +everages
5I* 76<!:&BB@2:&BB<1.!9 times
5II* 76<!:&BB@2:&BB<1.!9 times
5III* 76<!:&BB@2:&BB<1.!9 times
!inancial +everages
5I* F6<2:&BB@2!&BB< 1.1: times
5II* F6<2:&BB@2#&BB< 1.12 times
5III* F6<2:&BB@21&BB< 1.2F times
0om(ined 6everages
5I* 06<1.!9 4 1.1: < 1.&D times
5II* 06<1.!9 41.12 < 1.&2 times
5III* 06<1.!9 4 1.2F < 1.:# times
'ituation-L +lan-I +lan-II +lan-III
'ales
5-*C0
0ontri(ution
5-*F0
8IT
5-*Interest
1)&B)BBB
1)12)&BB
1)&B)BBB
1)12)&BB
1)&B)BBB
1)12)&BB
!:)&BB
2B)BBB
!:)&BB
2B)BBB
!:)&BB
2B)BBB
1:)&BB
#BBB
1:)&BB
!BBB
1:)&BB
9BBB
32
8T 1!&BB 1#&BB 11&BB
*perating +everages
5I* 76<!:&BB@1:&BB<2.1# times
5II* 76<!:&BB@1:&BB<2.1# times
5III* 76<!:&BB@1:&BB<2.1# times
!inancial +everages
5I* F6<1:&BB@1!&BB<1.!B times
5II* F6<1:&BB@1#&BB<1.21 times
5III* F6<1:&BB@11&BB<1.&2 times
Com'ine# +everages
5I* 06<2.1#A1.!B<2.:F times
5II* 06<2.1#A1.21<2.&D times
5III* 06<2.1#A1.&2<!.2& times
'ituation-M +lan-I +lan-II +lan-III
'ales
5-*C0
0ontri(ution
5-*F0
8IT
5-*Interest
8T
1)&B)BBB
1)12)&BB
1)&B)BBB
1)12)&BB
1)&B)BBB
1)12)&BB
!:)&BB
2&)BBB
!:)&BB
2&)BBB
!:)&BB
2&BBB
12)&BB
#BBB
12)&BB
!BBB
12)&BB
9BBB
F&BB D&BB 9&BB

7perating 6everages>
5I* 76<!:&BB@12&BB<! times
5II* 76<!:&BB@12&BB<! times
5III* 76<!:&BB@12&BB<! times
!inancial +everages,
5I*F6<12&BB@F&BB<1.#: times
5II*F6<12&BB@D&BB<1.!2 times
5III*F6<12&BB@9&BB<1.D2 times
33
Com'ine# +everages,
5I*06<!A1.#:<#.#1 times
5II*06<!A1.!2<!.D9 times
5III*06<!A1.D2<&.:9 times
The 76 is least in situation A 5all plans* and the F6 is highest in situation M
+lan III.
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Unit < "&.IT&* STU"TU%
-------------------------------------------------------
Objectives
To (ring clarity in concepts of capital structure) differentiating with financial
structure and decide a(out the optimum capital structure.
To (ring out the essential features for appropriate capital structure
To identify the factors which determines the capital structure.
Unit Outline
&.1 Introduction
9.2 Meaning of capital structure
9.! "ifference (etween capital and financial structure
9.# 7ptimum 0apital structure
9.& Features of -ppropriate 0apital 'tructure
9.9 Factors determining 0apital 'tructure
--------------------------------------------------
<#1 INTO!U"TION
-------------------------------------------------
34
The funds re,uired (y the (usiness organisation are raised through the
ownership securities i.e.) (y e,uity shares) preference shares and creditorship
securities i.e.) de(entures and (onds. ut the (usiness organisation must raise
these funds (y a proper mi4 of (oth these securities in such a way that the cost
and the risk of (oth these securities should (e minimum. The mi4 of different
securities is disclosed (y the firm/s capital structure.
------------------------------------------------------------------------------
-#$ M%&NIN' OF "&.IT&* STU"TU%
--------------------------------------------------------------------------
In ordinary language it implies the proportion of de(t and e,uity in the total
capital of a company.
-ccording to 'erstenberg 0apital 'tructure refers to the /the make up of a firm/s
capitalisation/. In other words) it represents the mi4 of different sources of long
term funds in the capitalisation of the company.
-------------------------------------------------------------------------------
-#) !IFF%%N"% (%T3%%N "&.IT&* STU"TU% &N! FIN&N"I&*
STU"TU%
--------------------------------------------------------------------------
Financial 'tructure is the entire left hand side of the company/ (alance sheet
i.e.) ownership securities) creditorship securities and current lia(ilities. $hereas
capital structure refers to sources of all long-term funds like ownership securities
like e,uity capital and preference capital and creditorship securities like
de(entures) (onds and long term loans.
--------------------------------------------------------------------------
<#5 O.TIMUM "&.IT&* STU"TU%
--------------------------------------------------------------------------
The optimum capital structure is o(tained when the market value per e,uity
share is the ma4imum. It may (e defined as that relationship of de(t and e,uity
securities which ma4imi;es the value of a company/s share in the stock e4change.
7r /at optimum capital structure) the value of an e,uity shares is the ma4imum
while the average cost of capital is the minimum.
35
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<#- F%&TU%S OF &..O.I&T% "&.IT&* STU"TU%
-------------------------------------------------------------------------
-n appropriate capital structure will posses the following features.
1. .rofitabilit=. The most profita(le capital structure of a company is one that
tends to minimi;e cost of financing and ma4imise earning per e,uity share.
.ence these companies naturally are profita(le.
2. Solvenc=. The pattern of capital structure should (e devised in such a way
that the company does not run into the risk of (ecoming insolvent. 84cess use
of de(t threatens the solvency of the company.
!. Fle>ibilit=. The capital structure should (e in such a way that it should have a
provision of easily switching over to re,uirements of changing conditions (y
easy swap and also there should (e availa(ility of funds for profita(le activities.
#. "onservatism. The capital structure should (e conservative so that the de(t
content in the total capital structure does not e4ceed the limit which the
company can (ear.
&. "ontrol. The capital structure should (e so devised that it involves minimum
risk of loss of control of the company.
--------------------------------------------------------------------------
<#- F&"TOS !%T%MININ' "&.IT&* STU"TU%
--------------------------------------------------------------------------
2reat caution is re,uired at the time of determining the initial capital
structure of a company since it will have long-term implications. .ence the finance
manager should (e careful (ut it can (e changes su(se,uently as per the
re,uirements. This capital structure decision is a continuous one and has to (e
taken whenever a firm needs additional finances.
36
The following are the factors which determines the capital structure of a
company.
1. Trading on equity or Financial Leverage. The use of long-term fi4ed
interest (earing de(t and preference share capital along with e,uity share
capital is called financial leverage or trading on e,uity. Making profit to
shareholders (y using the other funds like de(entures) preference capital
is called trading on e,uity. In other words if the rate of return on the total
capital employed is more than the rate of interest on de(entures or rate
of dividend on preference shares.
2. Retaining control. The capital structure of a company is also affected (y
the e4tent to which the promoters or e4isting management of the
company desire to maintain control over the affairs of the company. if the
e4isting management want maintain the same control over the company
for further funds they will issue only de(entures and preference capital
instead of issuing e,uity shares.
!. Nature of enterprise. The nature of enterprise will determine the capital
structure of the organisation. If the company is a pu(lic utility
organisation or a monopoly organisation in that product then it can earn
sta(le profit. .ence it goes for de(entures or (onds since they will have
ade,uate profits to meet recurring costs.
#. Legal requirements. The promoters of a company must comply with the
legal re,uirements of the organisation. For e4ample the (anking
companies has to raise funds only through e,uity share capital as per the
anking ?egulations -ct.
&. Purpose of financing. The purpose of financing is another factor which
determines the capital structure of the organisation. The purpose of
financing is for productive purposes like purchase of machinery ) payment
of old de(ts (orrowed at high interest are financed through de(entures
37
and (onds. If the purpose of financing is for non productive purposes like
welfare activities etc then it is raised through e,uity capital.
9. Period of finance. The capital structure of a company depends on the
period of finance. For e4ample the funds re,uired for the (usiness is & to
1B years it is raised through de(entures) redeema(le preference shares
and (onds. $hereas if funds are raised for permanently then it is raised
through e,uity shares or preference shares.
:. Government policy. 2overnment policy is an important factor in planning
the company/s capital structure. The controller of capital Issues and
2overnment of India can interfere and dictate the capital structure of the
organisation.
F. Market sentiments of investors. The market sentiments of the investors
will determine the capital structure of the organisation. If company/s
investors e4pect a(solute safety attitude in their investment pattern then
the companies will go for raising the finance re,uired through de(entures.
If the investors want to make high profits through speculation then the
companies raise its capital (y issuing e,uity shares.
----------------------------------------------------------------
UNIT ? "&.IT&* STU"TU% T4%OI%S
---------------------------------------------------------------
Objectives
To give an idea of (asic capital structure theories and to select optimum capital
structure.
To highlight the essential features for a sound capital mi4
Unit outline
38
:.1 0apital 'tructure Theories3
=et Incomes 5=I* -pproach)
=et 7perating Income 5=7I* -pproach)
Modigilani - Miller 5MM* -pproach) and
Traditional -pproach.
:.2 0apital 'tructure Management or +lanning the 0apital 'tructure
:.! 8ssential features of a sound capital mi4
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?#1 "&.IT&* STU"TU% T4%OI%S
---------------------------------------------------------------------------------------------
To achieve the (asic goal of optimum capital structure in the organisation
the finance manager must have the (asic knowledge of capital structure theories.
There are e4treme opinions on the optimum capital structure) hence it calls for
various theories in this. They are3
=et Incomes 5=I* -pproach)
=et 7perating Income 5=7I* -pproach)
Modigilani - Miller 5MM* -pproach) and
Traditional -pproach.
These theories are (ased on the following general assumption. They are3
5a* The firm employs only two types of capital-de(t and e,uity.
5(* The firm pays 1BBE of its earnings as dividend. Thus there are no retained
earnings.
5c*The firm/s total assets given are assumed to (e constant in investment
decisions.
5d* The operating earnings are not e4pected to grow.
5e* The (usiness risk remains constant and is independent of capital structure
and financial risks.
39
5f* The firm has a continuous life.
1# Net Incomes :NI; &pproac0
"urand has suggested this approach. -ccording to this approach) capital
structure decision is relevant to the valuation of the firm (ecause the change in
capital structure decision causes a corresponding change in the overall cost of
capital as well as the total value of the firm. -ccording to this approach a higher
de(t content in the capital structure 5high financial leverage* will result in
decline in the overall or weighted average cost of the capital and increase in the
value of e,uity shares of the company.
This approach is (ased on the following three assumptions.
5i* There are no corporate ta4es.
5ii* The cost of de(t is less than cost of e,uity or e,uity capitalisation rate.
5iii* The de(t content does not change the risk perception of the investors.
7n the (asis of =et Income approach the value of the firm is calculated as3
1@SA(
$here)
C< Calue of Firm.
'< Market value of 8,uity.
< market value of "e(t.
Market value of e,uity < =I@ke) where) =I < 8arnigs availa(e for e,uity
shareholders> ke < cost of e,uity or e,uity capitalisation rate
7verall cost of capital 5No* < 8IT@C
$# Net Operating Income :NOI; &pproac0
This approach has also (een suggested (y "urand. -ccording to this approach
the market value of the firm is not affected (y the change in capital structure.
40
ecause the market value of the firm is ascertained (y capitalising the net
operating income at the overall cost of capital 5k*) which is considered to (e
constant.
-ssumptions of this approach are3
a* The overall cost of capital remains constant for all degrees of de(t-e,uity
mi4.
(* The market capitalises the value of the firm as a whole hence) the split
(etween de(t and e,uity is not relevant.
c* The use of de(t having low cost increases the risk of e,uity shareholders)
this results in increase in e,uity capitalisation rate.
d* There are no corporate ta4es.
-ccording to this approach) the Calue of the firm is calculated with the help
of the following formula.
8IT 51-Ta4 rate*
Calue of Firm 5C* < --------
No
No < 7verall cost of capital
Calue of e,uity < C -
-ccording to =7I -pproach) the total value of the firm remains constant
irrespective of the de(t-e,uity mi4 or the degree of leverage.
7verall cost of capital 5No* < Ne 5'@C* O Nd 5@C*
$hereas Nd< 0ost of de(t or PInterest rate 51-Ta4 rate*Q eg. 1BE51-B.!&*
< Market value of "e(t
C < Calue of firm
' < C -
8IT-1
Ne < ------- A 1BB
C -
41
)# Modigiliani - Miller &pproac0
This approach is similar to the =7I approach. It also states that the value of
the firm is independent of its capital structure. =evertheless) there is a (asic
difference the two is that the =7I approach is purely definitional or conceptual. It
does not provide operational justification for irrelevance of the capital structure in
the valuation of the firm.
-ssumptions of MM Theory
The MM theory is (ased on the following assumptions3
1* +erfect capital markets e4ist where individuals and companies can (orrow
unlimited amounts at the same rate of interest.
2* There are no ta4es or transaction costs.
!* The firm/s investment schedule and cash flows are assumed constant and
perpetual.
#* Firms e4ist with the same (usiness or systematic risk at different levels
of gearing.
&* The stock markets are perfectly competitive.
9* Investors are rational and e4pect other investors to (ehave rationally.
a* MM Theory3 =o ta4ation.
(* MM Theory with 0orporate Ta4
5# Traditional &pproac0 or Beig0ted average cost of capital :3&"";
The traditional approach or intermediate approach is a mid-way (etween the two
approaches. It partly contains features of (oth the approaches as given (elow3
a* The traditional approach is similar to =I -pproach to the e4tent that it accepts
that the capital structure or leverage of the firm affects the cost of capital and
42
its valuation. .owever) it does not su(scri(e to the =I approach that the value
of the firm will necessarily increase with all degree of leverages.
(* It su(scri(es to the =7I approach that (eyond a certain degree of leverage) the
overall cost of capital increases resulting in decrease in the total value of the
firm. .owever) it differs from =7I approach in the sense that the overall cost of
capital will not remain constant for all degree of leverage.
-ccording to Traditional approach the firm through judicious use of de(t-
e,uity mi4 can increase its total value and there(y reduce its overall cost of
capital. This is (ecause de(t is relatively cheaper source of funds as compared to
raising money through shares (ecause of ta4 advantage. .owever) (eyond a point
raising of funds through de(t may (ecome a financial risk and would result in a
higher e,uity capitalisation rate.
Traditionally) optimal capital structure is assumed at a point where weighted
average cost of capital 5$-00* is minimum. For a project evaluation) this $-00 is
considered as the minimum rate of return re,uired from project to pay-off the
e4pected return of the investors and as such $-00 or 0omposite cost of capital is
generally referred to as the re,uired rate of return.
It is calculated as follows3
$-00 < 50ost of 8,uity A E 8,uity* O 50ost of de(t A E de(t*
---------------------------------------------------------------
?#$ .*&NNIN' T4% "&.IT&* STU"TU%
-------------------------------------------------------------
"etermining the capital mi4 and also the estimation of capital re,uirements
for current and future need of a firm are very important for a firm. 8,uity capital
and de(t are the two principle sources of finance of a (usiness. ut it should (e in
what proportion% .ow much of financial leverage a firm should employ% -re the
two important ,uestions comes (efore finance manager. The relationship (etween
financial leverage and cost of capital will answer this ,uestion.
43
The capital structure planning) which aims at the ma4imisation of profits and
the wealth of the shareholders) ensures the ma4imum value of a firm or the
minimum cost of capital. It is very difficult for a finance manager to determine the
proper mi4 of de(t and e,uity for his firm. The financial manager must try to reach
as near as possi(le of the optimum point of de(t and e,uity mi4.
----------------------------------------------------------------
?#) %SS%NTI&* F%&TU%S OF & SOUN! "&.IT&* MI2
----------------------------------------------------------------
The following are the essential features of a sound capital mi4.
1. Ma4imum possi(le use of leverage.
2. The capital structure should (e fle4i(le.
!. The use of de(t should (e within the capacity of a firm.
#. It should involve minimum possi(le risk of loss of control.
&. It must avoid undue restrictions in agreement of de(t.
---------------------------------------------------------------
UNIT C .O(*%MS ON "OST STU"TU% T4%OI%S
--------------------------------------------------------
Objective
To familiarise a(out various cost structure theories for practical applications
Unit outline
F.1 +ro(lems on 0ost 'tructure Theories
44
---------------------------------------------------------------------------
C#1 .O(*%MS ON "OST STU"TU% T4%OI%S
-----------------------------------------------------------------------------------------------
1. 0ompanies + and G are identical in all respects including risk factors e4cept for
de(t @ e,uity) + having issued 1BE de(entures of ?s) D lakhs while G has
issued only e,uity. othe the companies earn 2BE (efore interest and ta4es on
their total assets of ?s. 1& lakhs.
-ssuming ta4 rate of &BE and capitalisation rate of 1&E for an all-e,uity
company) compute the value of companies + and G using 5a* net income approach
and 5(* net operating income approach.
+articulars + G
8IT 5R 2BE on ?s. 1& lakhs*
6ess 3 Interest
8T
6ess 3 Ta4 R &BE
8arnings after Ta4 58-T*
!)BB)BBB
DB)BBB
------------
2)1B)BBB
1.B&)BBB
------------
1)B&)BBB
!)BB)BBB
-
-------------
!)BB)BBB
1)&B)BBB
------------
1)&B)BBB
:a; 1aluation of compan= under Net Income &pproac0
Calculation of value of quity
Calue of 8,uity 5capitalised R 1&E*
+ < 51)B&)BBB 4 1BB @ 1&* < :)BB)BBB
G < 51)&B)BBB 4 1BB @ 1&* <1B)BB)BBB
!alue of "e#t
+ < D)BB)BBB) G < B
Calue of 0ompany < ' O "
+ < :)BB)BBB O D)BB)BBB < 19)BB)BBB
G < 1B)BB)BBB O B < 1B)BB)BBB
-'. Valuation o companies un#er /et *perating Income $pproach
8IT 51 - T*
C < --------
N
45
Calue of e,uity 5'* < C -
Company P
8IT 51 - T*
C 5value of e,uity* < --------
N
!)BB)BBB 51 - B.&B*
C < ---------------------- < 1B)BB)BBB
B.1&
Calue of "e(t < 5D)BB)BBB 4 1 - B.&* < #)&B)BBB
Calue of 8,uity 5'* < C -
< 1B)BB)BBB - #)&B)BBB < &)&B)BBB
$dd value of "e(t < D)BB)BBB
%%%%%%%%%%%%%%%%%%
!alue of company &'()*(***
%%%%%%%%%%%%%%%%%
Company +
8IT 51 - T*
C < --------
N
!)BB)BBB 51 - B.&B*
C < ---------------------- < 1B)BB)BBB
B.1&
Calue of 8,uity 5'* < C -
< 1B)BB)BBB
Calue of "e(t < -
----------------
Calue of company 1B)BB)BBB
---------------
2. The following information is availa(le regarding the two firms - and which are
identical in all respects e4cept the degree of leverage. Firm - has 9E de(t of
?s 9 lakhs while firm has no de(t. oth the firms are earning an 8T of ?s
2)#B)BBB each. The e,uity capitali;ation rte is 1BE and the corporate ta4 is
9BE. 0ompute the value of the two firms on MM Model.
,olution
!alue of unlevered firm -
46
Cu < 8T 51 - T* @ ke
< 2)#B)BBB 51-B.9* @ 1BE
< D9)BBB @ B.1B
< D)9B)BBB
Calue of levered firm -
Ci < Cu O t
< D)9B)BBB O 9)BB)BBB 5B.9*
< D)9B)BBB O !)9B)BBB
< ?s. 1!)2B)BBB
!. The values for two firms A and L in accordance with the traditional theory are
given (elow3
A L
84pected operating income
Total cost of de(t
=et Income
0ost of e,uity 5ke*
Market value of shares 5s*
Market value of de(t
Total value of the firm
-verage cost of capital 5ke*
"e(t e,uity ratio
?s. &B)BBB
B
&B)BBB
B.1B
&)BB)BBB
B
&)BB)BBB
B.1B
B
?s. &B)BBB
1B)BBB
#B)BBB
B.11
!)9B)BBB
2)BB)BBB
&)9B)BBB
5B.BD*
B.&&9
0ompute the values for firms A and L as per the MM theses. -ssume that
5i* 0orporate income ta4es do not e4ist) and
47
5ii* The e,uili(rium value of ke is 12.&E
Solution)
"OM.UT&TION OF T4% 1&*U%S OF FIMS
0ompany A
?s.
0ompany L
?s.
84pected net operating income S4
6ess3 cost of de(t 5"*
=et income for e,uity
8,uili(rium cost of capital 5ko*
Total value of company 5C*< S4 @ ko
Market value of de(t 5*
Market value of e,uity 5C - *
0ost of e,uity 5ke* < S4 - "@ s
&B)BBB
B
------------
&B)BBB
----------
B.12&
#)BB)BBB
-
#)BB)BBB
12.&E
&B)BBB
1B)BBB
----------
#B)BBB
---------
B.12&
#)BB)BBB
2)BB)BBB
2)BB)BBB
2BE
#. In considering the most desira(le capital structure of a company) the following
estimates of the cost of "e(t and 8,uity capital 5after Ta4* have (een made at
various levels of "e(t-8,uity Mi43
"e(t as E of total
capital employed
0ost of "e(t
5E*
0ost of 8,uity
5E*
B
1B
2B
!B
#B
&B
9B
&.B
&.B
&.B
&.&
9.B
9.&
:.B
12.B
12.B
12.&
1!.B
1#.B
19.B
2B.B
48
0alculate the optimal "e(t-8,uity Mi4 for the company (y calculating composite
cost of capital.
Solution)
"alculation of Optimal !ebt-%/uit= Mi>
"e(t as E of
total capital
employed
0ost of
"e(t
5E*
0ost of
8,uity
5E*
$-00
B
1B
2B
!B
#B
&B
9B
&.B
&.B
&.B
&.&
9.B
9.&
:.B
12.B
12.B
12.&
1!.B
1#.B
19.B
2B.B
5& 4 B * O 512 4 1.BB* < 12.BB
5& 4 B.1B* O 512 4 B.DB* < 11.!B
5& 4 B.2B * O 512 4 B.FB* < 11.BB
5&.& 4 B.!B * O 51! 4 B.:B* < 1B.:&
59 4 B.#B * O 51# 4 B.9B* < 1B.FB
59.& 4 B.&B * O 519 4 B.&B* < 11.2&
5: 4 B.9B * O 52B 4 B.#B* < 12.2B
-t optimum de(t-e,uity mi4 !B3 :B) the $-00 is at minimum level of 1B.:&E.
-------------------------------------------------------
UNIT D "OST OF "&.IT&*
-----------------------------------------------------
Objectives
To familiarise a(out the cost of capital
To incorporate the importance of cost of capital in (usiness financial decisions.
Unit outline
D.1 Meaning
D.2 'ignificance or Importance of 0ost of 0apital
D.! 07M+KT-TI7= 7F 07'T 7F 0-+IT-6
49
$. Computation o speciic cost o capital
---------------------------------------------------------------
D#1 M%&NIN' OF "OST OF "&.IT&*
--------------------------------------------------------------
The main goal of (usiness firm is to ma4imise the wealth of shareholders in
the long-run) the management should only invest in projects which give a return in
e4cess of cost of funds invested in the projects of the (usiness. The term cost of
capital refers to the minimum rate of return a firm must earn on its investments so
that the market value of the company/ e,uity shares does not fall. This is intended
to achieve the o(jective of wealth ma4imisation. This is possi(le when the firm
earns a return on the projects financed (y e,uity shareholders/ funds at a rate
which is at least e,ual to the rate of return e4pected (y them.
The cost of capital is the rate of return the company has to pay to various
suppliers of funds in the company.
-ccording to 'olomon 8;ra) 10ost of capital is the minimum re,uired rate of
earnings or the cut-off rate of capital e4penditures.1
.ampton) Tohn T. defines cost of capital as /the rate of return the firm
re,uires from investment in order to increase the value of the firm in the market
place1.
Thus) we can say that cost of capital is that minimum rate of return which a
firm) must and) is e4pected to earn on its investments so as to maintain the
market value of its shares.
-------------------------------------------------------------------------------
D#$ SI'NIFI"&N"% O IM.OT&N"% OF "OST OF "&.IT&*
---------------------------------------------------------------------------
The determination of cost of capital of a firm is important to the
management to take some financial decisions like3
50
a* 0apital udgeting decisions. In capital (udgeting decisions) the cost of capital is
often used as a discount rate on the (asis of which the firm/s future cash flows
are discounted to find out their present values.
(* 0apital structure decisions. The cost of capital is an important consideration in
capital structure decisions. The finance manager must raise capital from
different sources in a way that it optimises the risk and cost factors.
c* asis for evaluating the financial performance. The actual profita(ility of the
project is compared to the projected overall cost of capital and the actual cost
of capital of funds raised to finance the project. if the actual profita(ility of the
project is more than the projected and the actual cost of capital) the
performance may (e said to (e satisfactory.
d* asis for taking other financial decisions. The cost of capital is also used in
making other financial decisions such as dividend policy) capitalisation of
profits) making the right issue and working capital.
------------------------------------------------------------------------
D#) "OM.UT&TION OF "OST OF "&.IT&*
--------------------------------------------------------------------------
(. Computation o speciic cost o capital
0omputation of specific cost of various sources of finance vi;.) de(t) preference
share capital) e,uity share capital and retained earnings is discussed as (elow3
1# "ost of !ebt :,d;. The cost of de(t is the rate of interest paya(le on de(t.
The interest paid on de(ts will have ta4 (enefits i.e.) ta4 is paid on the profits
after allowing de(enture interest.
a. Cost o Irre#eema'le 0e'entures)
I 51 - t*
Nd < ----------
=+
$here)
I < -nnual interest
T < 0ompanies ta4 rate
51
=+ < =et proceeds of loans or de(entures
In case of de(t is raised at premium or discount) we should consider + as the
amount of net proceeds received from the issue and not the face value of
securities. The formula is
I
Nd < ----------
=+
In case of underwriting commission 5K0* paid if any is deducted from =+ 5K0 is
always calculated at par value. Ma4imum permissi(le limit is 2.&E*.
$# "ost of .reference s0ares
a* Irredeema(le +reference shares
Np < +" @ =+
(* ?edeema(le +reference shares
+" O ?C-=+
---------
n
Np < -------------------------
?C O =+
-----------
2
$here +" is preference dividend
"ividend paid on preference shares is an appropriation of profit and hence is does
not get ta4 (enefit.
-ny premium or discount on issue of shares is to (e adjusted with net proceeds.
Knderwriting paid if any is also deducted from the net proceeds 5Ma4. permissi(le
limit &E calculated on par value*
=ote3 there is no difference in calculation of Np whether to (e calculated (efore
ta4 or after ta4 (ecause it doesn/t get ta4 (enefit.
)# "ost of %/uit=
52
0ost of e,uity is assumed to (e nil (ecause of the following reasons3
a* There is no fi4ed rate of dividend paid to e,uity shareholders.
(* There is no legal (inding for declaring dividends to e,uity shareholders.
The following are the approaches to cost of e,uity3
a* "ividend price approach 5"+ approach*
The rate of dividend e4pected (y the e,uity shareholders is considered as
cost of e,uity.
(* 8arning price approach
Ne < "ividend @ Market +rice 4 1BB
c* "+ O 2rowth approach
Ne < "ividend @ Market +rice 4 1BB O 2rowth ?ate
d* ?ealised Lield approach 5past*
=ote3
"ividend
M+ < ---------
Ne - 2?
There is no ta4 effect and always it is irredeema(le.
5# 3eig0ted &verage "ost of "apital :3&"";
It refers to overall cost of capital after taking into consideration the weights
of each source of capital.
$eights can (e of two types3
a* $eights assumed on face value 5(ook price*
(* $eights assumed on market price.
----------------------------------------------------------------
UNIT 1E .O(*%MS ON "OST OF "&.IT&*
53
----------------------------------------------------------------
Objective
To study the costs of various sources of capital for (etter selection of source on
the (asis of cost of capital.
"0apter outline
1B.1 +ro(lems on cost of capital
---------------------------------------------------------------
1E#1 .O(*%MS ON "OST OF "&.IT&*
-------------------------------------------------------------
I 0ost of "e(t
.roblems
1. - company issues ?s. 1B)BB)BBB 19E de(entures of ?s. 1BB each. The
company is in !&E ta4 rate. Lou are re,uired to calculate the cost of de(t after
ta4 if de(entures are issued at
5i* +ar
5ii* 1BE "iscount
5iii* 1BE +remium
5iv* If (rokerage is paid at 2E what will (e the cost of de(enture if issued at
par.
5v* 0alculate Nd (efore ta4 for 5iv* a(ove.
,olution
I 51 - t* 1)9B)BBB 51 -B.!&*
54
5i* Nd 5at +ar* < ---------- < --------------------- < 1B.#E
=+ 1B)BB)BBB
1)9B)BBB 51 - B.!&*
5ii*Nd 5at "iscount* < ---------------------- < 11.&9E
D)BB)BBBB
1)9B)BBBB 51 - B.!&*
5iii* Nd 5at +remium* < ----------------------- < D.#&E
11)BB)BBB
1)9B)BBBB 51 - B.!&*
5iv* Nd 5rokerage at 2E* < -------------------------< 1B.91E
1B)BB)BBB - 2B)BBB
I 1)9B)BBB
5v* Nd 5(efore ta4* < ------ < ---------------------< 19.!!E
=+ 1B)BB)BBB - 2B)BBB
'. Cost o 1e#eema'le #e'entures
Formula
I 51 - t* O 5?C - =+*
------------
n
Nd < ----------------------------------- A 1BB
5?C O =+*
------------
2
$here)
?C < ?edemption value
n < num(er of years
2. - : year ?s 1BB de(enture is availa(le at a net cost of ?s D&. The coupon rate
is 1&E and the (ond will (e redeemed at a premium of 9E on maturity. The
firm/s ta4 rate is #BE. 0alculate the cost of de(enture.
,olution
I 51 - t* O 5?C - =+*
------------
n
Nd < ----------------------------------- A 1BB
55
5?C O =+*
------------
2
1& 51 - B.#* O 51B9 - D&*
------------
:
Nd < ------------------------------- A 1BB < 1B.&2E
51B9 O D&*
-------------
2
!. - 1BE ?s. 1)BBB par (ond of 1B years sold at ?s. D&B and underwriting
commission &E. 0alculate cost of de(t. a* efore ta4 ) and (* -fter ta4
Solution
0alculation of =et proceeds3
+ar value ?s 1)BBB
5-* "iscount &B
-----------
D&B
5-* Knderwriting commission
on 1)BBB at &E &B
----------
=et proceeds DBB
a* efore ta4
I O 5?C - =+*
------------
n
Nd < ----------------------------------- A 1BB
5?C O =+*
------------
2
1BB O 51BBB - DBB*
------------
1B
Nd < ------------------------- A 1BB < 11.&FE
51BBB O DBB*
56
-------------
2
(* -fter ta4
I 51 - t* O 5?C - =+*
------------
n
Nd < ----------------------- A 1BB
5?C O =+*
------------
2
1BB 51 - B.!&* O 51BBB - DBB*
------------
1B
Nd < ------------------------------- A 1BB < :.DE
51BBBO DBB*
-------------
2
#. -0 6td.) issues 2 sets of de(entures. 7ne at discount at 1BE and the other at
a premium of 1&E respectively.
'eries 13 12E) 1)BBB de(entures of ?s 1BB each.
'eries 2 3 : U E 1BBB de(entures of ?s 1B each.
'eries 2 was redeemed after a period of F years at a premium of 1&E.
Knderwriting commission is paid on (oth the series as per the ma4imum limits
specified under company/s act. 0alculate Nd after ta4 and (efore ta4 for (oth the
series.
,olution
'eries 13
I 51 -t* 12)BBB 51 -B.!&*
a* Nd < --------- < --------------------- 4 1BB < F.D1E
=+ F:)&BB
57

Calculation of N P.
+ar value 1)BB)BBB
5-* "iscount 1B)BBB
----------
DB)BBB
5-* Knderwriting
0ommission R 2.&E 2)&BB
51)BB)BBB 4 2.&E* -----------
?s. F:)&BB
-----------------
(* Nd < I@=p < 12)BBB @ F:)&BB 4 1BB
< 1!.:1E
'eries 23
0alculation of =+3
+ar value 1)BBB
5O* +remium 1&B
------
1)1&B
5-* Knderwriting
0ommission 2&
------
1)12&
I 51 - t* O 5?C - =+*
------------
n
a* Nd < ----------------------------------- A 1BB
5?C O =+*
------------
2
:& 51 - B.!&* O 51)1&B - 1)12&*
------------
F
Nd < ----------------------------------- A 1BB
51)1&B - 1)12&*
------------
2
< #.&9 E
58
I O 5?C - =+*
------------
n
(* Nd < ----------------------------------- A 1BB
5?C O =+*
------------
2
:& O 51)1&B - 1)12&*
------------
F
Nd < ----------------------------------- A 1BB < 9.F: E
51)1&B - 1)12&*
------------
2
-------------------------------------------------------------------------------
UNIT 11 .O(*%MS OF "OST OF .%F%%N"% S4&%S
----------------------------------------------------------------
Unit Outline
+ro(lems of 0ost of +reference shares
a/ 0rredeema#le Preference s1ares
Np < +" @ =+
#/ Redeema#le Preference s1ares
+" O ?C-=+
---------
n
Np < -------------------------
?C O =+
-----------
2
c/ Pro#lems on Cost of quity
-pproaches to the cost of e,uity3
59
"ividend price approach 5"+ approach*
8arning price approach
Ne < "ividend @ Market +rice 4 1BB
e* "+ O 2rowth approach
f* ?ealised Lield approach 5past*
=ote3
"ividend
M+ < ---------
Ne - 2?
There is no ta4 effect and always it is irredeema(le.
1. -ssuming that the firm/s ta4 rate is &BE compute after ta4 cost and (efore ta4
0ost of preference shares in the following cases3
a* D E +reference shares sold at par.
(* - 0ompany issues 1#E irredeema(le preference shares) the face value of share
is ?s. 1BB (ut the issue price is ?s D&. $hat is the cost of +reference shares%
$hat is the cost if the issue price is ?s 1B&%
c* - 0ompany +reference shares sold at ?s 1BB with a 1BE dividend and
redemption ?s 112 if the company redeems within & years.
'olution3
a* Np < +" @ =+ < D @ 1BB < DE
(* i* Np < +" @ =+ < 1# @ D& < 1#.:#E
ii* Np < +" @ =+ < 1# @ 1B& < 1!.!!E
+" O ?C-=+
---------
n
60
c* Np < ------------------------- 4 1BB
?C O =+
-----------
2
1B O 112- 1BB
---------------
&
Np < ------------------------- 4 1BB < 11.: E
112 O 1BB
-----------
2
"ost of e/uit= s0ares :,e;
- companies share is ,uoted in market at ?s #B currently. - company pays a
dividend of ?s 2 per share and investors e4pects a growth rate of 1BE compute
a* The 0ompanies cost of e,uity capital.
(* If anticipated growth rate is 11E p.a. 0alculate the indicated growth market
price per share.
c* If companies cost of capital is 19E and anticipated growth rate is 1BE p.a.
0alculate the market price if dividend of Ts 2 per share is to (e maintained.
'olution3
a* Ne < "@M+ 4 1BB O 2?
< 2 @ #B 4 1BB O 1BE
< 1& E
(* M+ < " @NeE - 2?E
< 2 @ 1&E - 11E
< 2 @ #E < ?s. &B.
c* M+ < 2 @ 19 - 1B
< 2 @ 9E < ?s. !!.!!E
----------------------------------------------------------------
61
Unit 1$ .roblems on 3eig0ted &verage cost of "apital :3&"";
----------------------------------------------------------------
Unit outline
.roblems on 3eig0ted &verage cost of "apital :3&"";
1. 0alculate $-00 of - 6td. From the following information3
Sources "apital "ost of capital
"e(t #)BB)BBB 1#E
8,uity share 9)BB)BBB 2BE
-ssume corporate ta4 rate as !&E.
,olution.
Method 13
,ources Capital 2eig1ts Cost of capital 2$CC
"e(t #)BB)BBB B.# B.BD1 B.B!9#
8,uity 9)BB)BBB B.9 B.2 B.12
------------- ----------
1B)BB)BBB B.1&9#
------------- ----------
$-00 < B.1&9# 4 1BB < 1&.9#E
Method 23
'ources 0apital 0ost of capital Total cost of capital
"e(t #)BB)BBB D.1E !9)#BB
62
8,uity 9)BB)BBB 2BE 1)2B)BBB
----------- ----------
1B)BB)BBB 1)&9)BBB
------------- -------------
$-00 < 1)&9)#BB @ 1B)BB)BBB 4 1BB < 1&.9#E
$orking =otes3
0ost of capital3 "e(t < 1# 4 B.9& 5after ta4* < B.BD1 (ecause it gets ta4
(enefit.
2. /M/ 6td) L 6td) and A 6td.) are in the same type of (usiness and hence have
similar operating risks. .owever the capital str&ucture of each of them is different
and the following are the details.
Particulars 3 Ltd4 5 Ltd4 6 Ltd4
8,uity share capital3
5Face value ?s. 1B @ share &)BB)BBB 2)&B)BBB #)BB)BBB
Market Calue per share ?s. 12 2B 1&
"ividend per share 2.FF # 2.:
"e(entures
5Face value ?s.1BB* 2)&B)BBB 1)BB)BBB
Market value
per de(enture ?s FB 12&
Interest rate FE 1BE
-ssume that the current level of dividends are generally e4pected to
continue indefinitely and the income ta4 rate is at &BE. Lou are re,uired to
compute the $-00 of each of the company.
Solution)
"ost of e/uit=:
Formula Ne < " @ M 4 1BB
63
2 ltdF 6 ltdF G ltdF
2.FF @12 4 1BB # @ 2B 4 1BB 2.: @ 1& 4 1BB
< 2#E < 2BE < 1FE
"ost of !ebt:
Formula
Nd < I 51 - T* @ M+
A ltd) L ltd) M ltd)
F 51 - B.&* @FB 1B 51 - B.&* @ 12& BE
< &E < #E
Sources Capital Cost of capital Total COC WACC
X: Debt 2,50,000 5% 12,500 1,32,500
---------- x 100
Equity 5,00,000 24% 1,20,000 7,50,000
----------- -------------
7,50,000 1,32,500 = 17.67%
----------- -------------
Y: Debt 1,00,000 4% 4,000 54,000
--------- x 100
Equity 2,50,000 20% 50,000 3,50,000
------------ ----------
3,50,000 54,000 = 15.43%
----------- ---------
Z: Debt --- 0% --- 72,000
-------- x 100
Equity 4,00,000 18% 72,000 4,00,000
---------- ---------
4,00,000 72,000 = 18%
---------- --------
On Face value:
A 6td.) Ne < 2.FF @1B 41BB < 2F.F E
L 6td.) Ne < # @1B 41BB < #BE
M ltd.) Ne < 2.:@1B 41BB <2:E
64
A ltd.) Nd < I 51 - t* @ FC < F 51 -B.&* @ 1BB < #E
L 6td.) Nd < 1B 51- B.B&*@1BB < &E.
X: Debt 2,50,000 4% 10,000 1,54,000
---------- x 100
Equity 5,00,000 28.8% 1,44,000 7,50,000
----------- -------------
7,50,000 1,54,000 = 20.53%
----------- -------------
Y: Debt 1,00,000 5% 5,000 1,05,000
--------- x 100
Equity 2,50,000 40% 1,00,000 3,50,000
------------ ----------
3,50,000 1,05,000 = 30%
----------- ---------
Z: Debt --- 0% --- 1,08,000
-------- x 100
Equity 4,00,000 27% 1,08,000 4,00,000
---------- ---------
4,00,000 1,08,000 = 27%
---------- --------
-------------------------------------------------------------
Unit 1) .roblems on Marginal cost of capital
-------------------------------------------------------------
"0apter Outline
+ro(lems on Marginal cost of capital
Marginal cost of capital
65
The cost of rising additional finance over and a(ove the e4isting re,uirement
is called as marginal cost of capital.
1. ALM 0ompany provides you with the following information3
'ources -mount after ta4 070
8,uity 2)BB)BBB 12E
"e(entures 2)BB)BBB #E
The company is considering an investment proposal re,uiring an additional
investment of ?s. 1)BB)BBB. It has taken decision to finance this amount (y
taking a loan from financial institution at a cost of 1BE presuming the
corporate ta4 rate at &BE. Find out3
a. Marginal cost of capital
(. $-00 (efore additional financing
c. $-00 after additional financing
d. $hat will (e $-00 if the additional amount of de(t of 1)BB)BBB is raised
proportionately from e,uity and de(t at the e4isting specific cost.
,olution.
a. M00 < I 51-t* @ =+ < 1B 51.B&* @1BB < &E
(. $-00 5(efore -F*
Debt 2,00,000 12% 24,000 32,000
---------- x 100
Equity 2,00,000 4 % 8,000 4,00,000
----------- -------------
4,00,000 32,000 = 8 %
----------- -------------
c. !"" #$%te& !'(
Sources Capital Cost o capital 2otal C*C W$CC
Debt 2,00,000 12% 24,000 37,000
---------- x 100
Equity 2,00,000 4 % 8,000 5,00,000
66
!' 1,00,000 5 % 5,000
------------ ----------
5,00,000 37,000 = 7.4 %
----------- ----------
). !""
Sources Capital Cost o capital 2otal C*C W$CC
Exi*ti+, Equity 2,00,000 12% 24,000
!))iti-+$. Equity 50,000 12 % 6,000 40,000
-------- x 100
5,00,000
Exi*ti+, Debt 2,00,000 4 % 8,000
!))iti-+$. Debt 50,000 4 % 2,000 = 8%
---------- ---------
5,00,000 40,000
---------- ---------
2. The cost of specific sources of capital for harath =igam ltd.) are3
?ate of e,uity 5re* 3 19 E
?ate of +ref. 'hares 5rp*3 1#E
?ate of de(t 5rd* 3 12E
The market value proportions of e,uity) preference and de(t are3-
8@C 58,uity value* < B.9
+@C 5+ref. Calue* < B.B&
"@C 5"e(t value* < B.!&
The corporate ta4 rate is !BE. 0alculate $-00 of harath =igam ltd.)
,olution.
'ources 070 $eights $-00
Ne B.19 B.9 B.BD9
Np B.1# B.B& B.BB:
67
Nd B.BF# B.!& B.B2D
512 4 :BE* Total B.1!22
$-00 < 1!.22 E
Module $
----------------------------------------------------------------
UNIT 1 SOU"%S OF *ON'-T%M FIN&N"%
----------------------------------------------------------------
Objectives
To give an insight into the various long-term finance sources
To get in depth idea of various sources of long-term and what is its relative
advantages and disadvantages.
To give more input to decide which are the (etter source for long-term source
of capital.
Unit outline
$#1 introduction
2.2 0lassification of capital of a (usiness organisation
2.! Carious sources of long-term capital
7wnership securities or 0apital 'tock
68
0reditorship securities or "e(t 0apital
.y(rid Financing@Instruments
$#5 ,inds of OBners0ip securities or S0ares are#
1. 8,uity 'hares
2. +reference 'hares
!. "eferred 'hares
#. =o par 'tock@'hares
&. 'hares with differential ?ights
9. 'weat 8,uity
----------------------------------------------------------------
INTO!U"TION
----------------------------------------------------------------
In the day today (usiness) finance is re,uired (y the (usiness organisations
irrespective of it is (ig) medium or small for its operations and to achieve its
o(jectives. $ithout ade,uate finance) the (usiness enterprise cannot accomplish
its o(jectives.
0apital re,uired for a (usiness enterprise can (e classified under two main
categories vi;.) 1. Fi4ed 0apital) and 2. $orking 0apital. 6ong-term funds are
re,uired to create production facilities (y purchasing fi4ed assets like land)
(uilding) plant) furniture) machinery etc.) any investment of funds on these is
(locked up on a permanent (asis hence it is called fi4ed capital. Funds are
re,uired for short-term purposes for the purchase of raw materials) payment of
wages and other day-to-day e4penses. These funds are known as working capital.
--------------------------------------------------------------------------- T4%
1&IOUS SOU"%S OF &ISIN' *ON'-T%M "&.IT&*
69
---------------------------------------------------------------------------
7wnership securities or 0apital 'tock
0reditorship securities or "e(t 0apital
.y(rid Financing@Instruments
&# OBners0ip securities
It is known as /0apital 'tock/ represents shares. 0ompanies issue different
types of shares to mo(ilise funds from various investors. The 0ompanies -ct of
1D&9 has limited the type of shares are issued from +reference 'hares) 7rdinary
'hares) and "eferred 'hares to only two types of 'hare like +reference shares and
8,uity 'hares.
-------------------------------------------------------------------------------,IN!S OF
O3N%S4I. S%"UITI%S O S4&%S
---------------------------------------------------------------------------
1. 8,uity 'hares
2. +reference 'hares
!. "eferred 'hares
#. =o par 'tock@'hares
&. 'hares with differential ?ights
9. 'weat 8,uity
1# %/uit= S0ares
8,uity shares are also known as 7rdinary shares. It represents the owner/s
capital in a company. These e,uity shareholders are the real owners of the
70
company. They have the voting right and they have control over the working
of the company. 8,uity shareholders do not have preference in paying dividend
of the company. They are eligi(le for dividend only when the company earns
profit and after paying dividend to the preference shareholders. These
shareholders do not have any preferential rights over the dividend and also
capital of the company when it is li,uidated.
"0aracteristics of %/uit= s0are0olders
a* Maturit= period3 The e,uity capital is a permanent source of capital it is
paid (ack only when the company is li,uidated and after paying all the
claims and preference capital. It does not have maturity period.
(* "laims or ig0t to Income. They e,uity shareholders are paid the
earnings only after paying dividend to the preference shares.
c* "laim on &ssets. 8,uity shareholders have a residual right over the
assets of the company. 8,uity shareholders can get (ack their capital
invested in a company after making payment to the creditors of the
company) preference shareholders and if there is any amount left out
after realisation of the assets the remaining amount is paid to the e,uity
shareholders.
d* 1oting ig0ts3 8,uity shareholders are the real owners of the company
hence they enjoy the voting rights in effective control of the working of
the company.
e* *imited liabilit=3 8,uity shareholders will have limited lia(ility in the
company. if the company is running under the loss and li,uidated then
the shareholders are lia(le to the e4tent of paid up capital of the
company.
f* .re-emptive ig0t: shares offered to e4isting shareholders are called
?ight 'hares and their prior right to such is known as pre-emptive right.
71
The shareholders will enjoy this right as per the provisions of the
0ompanies -ct of 1D&9.
$# .reference s0ares
+reference shares are those which have preferential rights over the dividend
and preference capital of the company at the time of li,uidation. These
shareholders enjoy the preference of payment of dividend. The e,uity
shareholders will get dividend only after the payment of dividend to the
preference shareholders similarly the preference share capital is paid (ack to
them prior to the payment of capital of e,uity shareholders (ut only after
paying the creditors of the company when it is li,uidated. These shareholders
are not the owners of the company) hence they do not enjoy the right to vote
and any say in the working of the company. They are eligi(le for fi4ed dividend
even though company earns less profit or incurs loss.
T=pes of preference s0ares
Following are the types of preference shares
a* "umulative .reference S0ares: If the company do not earn profits its
dividend is cumulated till the company earn profit and it is paid to the
preference share holders when the company earns profit.
(* Non-"umulative .reference S0ares: =ormally these preference
shareholders do not have any claim over the arrears of dividend during the
period of incurring loss (y the company.
c* edeemable .reference S0ares: +reference capital is also a permanent
capital of the company hence it is paid (ack only if the company is
li,uidated. ut in the case of redeema(le preference shares) if the articles of
72
association permit the company can pay (ack the capital (efore li,uidation
out of profits or from fresh issue of capital.
d* Irredeemable .reference s0ares: These preference shares cannot (e
redeemed during the lifetime of the company unless it is li,uidated.
e* .articipating .reference S0ares: These preference shares get their fi4ed
rate of dividend out of the profits of the company and also have the right to
participate in the surplus profits of the company.
f* Non-.articipating .reference S0ares: These preference shares get only
their fi4ed rate of dividend and they do not participate in the profits of the
company.
g* "onvertible .reference S0ares: These preference shares have the right to
convert in to e,uity shares after a fi4ed period) if articles of association
permit.
h* Non-"onvertible .reference S0ares: These shares do not enjoy the
(enefit of converting in to e,uity shares forever.
)# !eferred S0ares
These are the shares issued to the promoters or founders for rendering the
service at the time of formation of a company. These shares do not enjoy any
preference over the e,uity shareholders in payment of dividend and return of
capital. 'ince their dividend payment can (e deferred or postponed they are called
deferred shares. The issue of these shares (y the pu(lic limited or its su(sidiaries
is not allowed under the 0ompanies -ct of 1D&9.
5# No .ar Stoc8HS0ares
=o par stock refers to shares which do not have face value. The companies
that are issuing such shares are dividend into a num(er of specified shares without
73
any specific denomination. In the share certificate of the company it simply
mentions the num(er of shares held (y its owner without mentioning any face
value. The value of a share can (e determined (y dividing the real net worth of the
company with the total num(er of shares of the company. The dividend on such
share is paid not on the (asis of face value (ut it is paid per share.
-# S0ares Bit0 differential rig0ts
'hares with differential rights refers to issued of shares with differential
rights as to voting) dividend or other wise su(ject to fulfillment of the conditions
laid down at the time of issue of such e,uity shares) as per the 0ompanies -ct
5Issue of 'hare 0apital with "ifferential Coting ?ights* ?ules) 2BB1. This concept
of differential rights is new to the Indian corporates and it will re,uire e4perience
to ascertain its effectiveness.
<# SBeat %/uit=
It means if the e,uity shares issued (y a company to its employees or
directors at a discount or for consideration other than cash for providing know-how
or making availa(le rights in the nature of intellectual property rights 5like patents
or copyright* or value additions. 'ection :D- of the companies -ct) 1D&9 5inserted
with effect from !1
st
7cto(er 1DDF* allows companies to issued sweat shares
su(ject to some conditions in the -ct.
----------------------------------------------------------------
Unit $ "%!ITOS4I. S%"UITI%S
---------------------------------------------------------------------------
To determine which are the creditorship securities
74
To study relative merits and demerits of each of them
To know a(out new creditorship instruments availa(le in the market
Unit outline
$#$#1"%!ITOS4I. S%"UITI%S
"e(entures or onds
Types of de(entures
2.2.2 .y(rid Financing@Instruments
+reference share capital
0onverti(le de(entures@(onds
$arrants and
7ptions
2.2.! Forms of options.
?ights)
$arrants) and
0alls and puts
8K?7 Issues
2lo(al "epository ?eceipts 52"?s*
Foreign 0urrency 0onverti(le onds 5F00s*
-merican "epository ?eceipts 5-"?s*
-------------------------------------------------------------------
$#$#1"%!ITOS4I. S%"UITI%S
---------------------------------------------------------------------------
75
The term /0reditorship securities/ also know as /de(t capital/ represents
de(entures and (onds. These instruments of finance occupy a very important role
in the financial plan of the company.
1# !ebentures or (onds
The company can raise its long-term loans through issue of "e(entures or
(onds. - de(enture is an acknowledgment of a de(t. Issued (y a company under
its common seal assuring them for the payment of a principal sum at a specified
date and till that at fi4ed rate of interest per cent is paid and it may or may not
hold any charge on the assets of the company. - de(enture holder is a creditor of
a company. - fi4ed rate of interest is paid on de(entures.
T=pes of !ebentures
"e(entures may (e of the following types3
a* (earer !ebentures: These de(entures are easily transfera(le like negotia(le
instruments. The (earer of this de(entures will (ecome lawful owner of the (y
good faith the coupons of interest are attached to the de(entures) he can get
interest from the company/s (ank it (ecomes due.
(* SimpleF Na8ed or Unsecured !ebentures: These de(entures are not given
any security on assets of the company. They have no priority as compared to
other creditors. They are treated along with unsecured creditors at the time of
winding up of the company.
c* Secured or Mortgaged !ebentures: T0e de(enture will have security over
the assets of the company. In case of default in payment of interest or principal
amount the de(enture holders can realise the assets in order to satisfy their
claims.
d* egistered !ebentures: These are de(entures which are paya(le to the
registered holders i.e.) the persons whose names are appear in the register of
76
de(enture holders. These de(entures are transferred in the same way as
shares.
e* .erpetual or Irredeemable !ebentures: The de(entures whose principal
amount is paid only at the time of winding up or any happening of the
contingency or e4piry of a long period of time.
f* edeemable !ebentures: these de(entures are issued for a specified period
of time. 7n the e4piry of that specified time the company has the right to pay
(ack the de(enture holders out of the assets mortgaged. 2enerally the
de(entures are redeema(le.
g* "onvertible !ebentures: These de(entures have option to get convert into a
e,uity share after a lapse of a specified period if the articles of association of
the company permits.
h* Gero Interest (ondsH!ebentures: 7n these ;ero interest (onds interest is
not paid) this loss of interest is compensated (y converting these (onds in to
e,uity shares after a specific period of time.
i* Gero "oupon (onds: these (onds do not carry any interest (ut it is sold (y
the issuing company at deep discount from its eventual maturity value. The
difference (etween the issue price and the maturity value represents the gain
or interest earned (y its investor.
-------------------------------------------------------------------------------4=brid
FinancingHInstruments
---------------------------------------------------------------------------
77
-s hy(rid source of financing has characteristics of (oth straight de(t and
straight e,uity falling (etween. The hy(rid instruments@sources of financing are i*
+reference share capital) ii* 0onverti(le de(entures@(onds) iii* $arrants and iv*
7ptions.
In this chapter the preference shares were already discussed and also
converti(le preference share is also as a type of preference share is mentioned.
The second one is 0onverti(le "e(entures@onds.
"onvertible debenturesHbonds
0onverti(le de(entures give the de(enture-holders the right 5option* to
convert them into e,uity shares on certain terms. The holders are entitled to a
fi4ed income till the conversion option is e4ercised and would share the (enefits
associated with e,uity shares after the conversion.
The converti(le de(entures presently in India can (e of three types3 5i*
compulsory converti(le within 1F months) 5ii* optionally converti(le within !9
months and 5iii* converti(le after !9 months will call an put features. .owever)
only the first two types are popular.
3arrants
- warrant entitles its holders to su(scri(e to the e,uity capital of a company
during a specified period at a stated@particular price. $arrant means it is an
instrument that gives its holder the right to purchase a certain num(er of shares
at a specified price over a certain period of time.
Options
7ption is a derivative security and derives its value from an underlying
security@asset. -n option is an instrument that provides to its holders an
opportunity to purchase@sell a specified security@asset at a stated price on@(efore
a specified e4piration date. The focus in options is on options related to shares.
Thy are traded in India on the ='8 and '8 as securities. There are three (asic
forms of options.
78
-------------------------------------------------------------------------------FOMS OF
O.TIONS
---------------------------------------------------------------------------?ights)
$arrants) and
0alls and puts
a* ig0ts: the option to the shareholders to purchase a specified num(er of
e,uity shares at a stated price during a given period is called rights. It is a legal
right of e4isting shareholders to (e offered (y the company in the first
opportunity to purchase additional e,uity shares in proportion to their current
holdings.
(* "alls and puts: - call option is an option to purchase a specified num(er of
shares on@(efore a specified future date at stated@strike price. The striking price
is the price at which the holder of the option can (uy the shares at any time
prior to the e4piration date of the option. - put option is an option to sell a
given num(er of shares on@(efore a specified future date at a stated striking
price.
%UO Issues
-s a part of new economic policy since 1DD1-D2 India accepted
6i(eralisation) +rivatisation and 2o(alisation has its Industrial policy. Thence the
government undertook two major steps-that of allowing Foreign Institutional
Investors 5FIIs* to invest in the Indian capital market and permitting Indian
0ompanies to float their stocks in foreign markets. Two primary instruments
79
floated (y the Indian 0ompanies in international markets are 2"?s and Foreign
0urrency 0onverti(le onds 5F00s* more commonly known as the /8uro Issues/.
8uro Issued denotes that the Issue is made a(road through instruments
denominated in foreign currency and the securities issued are listed on any
overseas 'tock 84change. 8uro issue is a method of mo(ilising resources re,uired
(y a company in foreign e4change. - 8uro Issue is different from foreign issue. In
case of foreign issue issuer is not incorporated in the country in which the
securities are (eing issued) (ut the securities are denominated in the currency of
the country of issue and are aimed at domestic investors in the country where the
issue is made.
'lobal !epositor= eceipts :'!s;
- 2"? is an instrument which allows Indian 0orporates) anks) =F0s etc.)
to raise finds through e,uity issues a(road to augment their resources for
domestic operations. - 2"? is a dollar denominated instrument of a company)
traded in stock e4changes outside the country of origin. It represents a certain
num(er of underlying e,uity shares. Though the 2"? is ,uoted and traded in
dollar terms) the underlying e,uity shares are denominated in rupees only.
Instead of issuing in the names of individual shareholders) the shares are
issued (y the company to an intermediary called the depository) usually in
7verseas "epository ank in whose name the shares are registered.
Foreign "urrenc= "onvertible (onds :F""(s;
onds issued in accordance with the scheme and su(scri(ed (y a non-
resident in foreign currency and converti(le into ordinary share of the issuing
company in any manner either in whole or in part on the (asis of only e,uity
related warrants attached to de(t instrument. The F00s are like converti(le
de(entures issued in India. The ond has a fi4ed interest or coupon rate and is
80
converti(le into certain num(er of shares at a pre-fi4ed price. The (onds are listed
and traded on one or more stock e4changes a(road.
&merican !epositor= eceipts :&!s;
- foreign company 5eg.)Infosys* might make issue in K ' - (y issuing
securities through appointment of ank as depository. y keeping the securities
issued (y the foreign company) the K ' ank will issue receipts called -"?s to the
investors. It is a negotia(le instrument and also entitled for dividends as and when
declared. The -"? holder can transfer the instrument as in the case of domestic
instrument and also entitled for dividends as and when declared
-------------------------------------------------------------------------------
Unit ) "ividend +olicy
----------------------------------------------------------------
Objective
To give a general idea of "ividend) "ividend policy generally prevailed and
nature of dividend decisions.
To study various dividend theories e4isting and their relative pros and cons.
Unit outline
2.1.1 Meaning
2.1.2 "ividend +olicy
2.1.! =ature of "ividend "ecision
2.1.# Theories on "ividend +olicies
81
The Irrelevance Theory or The Irrelevance 0oncept of "ividend
-* ?esidual -pproach and
* Modigliani and Miller approach.
The ?elevance theory or ?elevance concept of "ividend.
-* $alter/s -pproach and
* 2ordon/s -pproach
--------------------------------------------------
$#)#1M%&NIN' OF !I1I!%N!
---------------------------------------------------------------------------
"ividend refers to that part of the profits of a company which id distri(uted
amongst its shareholders. It is the return that a shareholder gets from the
company for his shareholding) out of its profits. -ccording to the Institute of
0hartered -ccountants of India) dividend is 1a distri(ution to shareholder out of
profits or reserves availa(le for this purpose.
--------------------------------------------------
$#)#$!I1I!%N! .O*I"6
---------------------------------------------------------------------------
The company will not distri(ute entire profits earned as dividend to its
shareholders) (ecause it needs to provide funds to finance its long-term growth.
.ence company will keep some money for its e4pansion and growth otherwise it
has to depend upon entirely on outside resources like issue of new shares or de(t.
7n the other hand it has to look after the ma4imi;ation of wealth of its
82
shareholders) (y declaring more returns to its shareholders. .ence company must
re,uire a dividend policy.
The term dividend policy refers to the policy concerning ,uantum of profits
to (e distri(uted as dividend. The concept of dividend policy implies that
companies through their oard of "irectors evolve a pattern of dividend payments)
which has a (earing on future action.
--------------------------------------------------
$#)#)N&TU% OF !I1I!%N! !%"ISION
---------------------------------------------------------------------------
The dividend decision of the firm is very important to the finance manager.
This dividend decision will determines the amount of profit to (e distri(uted among
shareholders and the amount of profit to (e retained in the (usiness for financing
its long-term growth. There is an indirect relationship (etween (etween the
amount of dividends distri(uted and retained earnings. .igher the amount of
dividend distri(ute lower will (e the retained earnings. This dividend decision will
have its impact on the value of the firm) since the value of the firm depends on
the dividend decision.
--------------------------------------------------
$#)#5T4%OI%S ON !I1I!%N! .O*I"I%S
---------------------------------------------------------------------------
There are conflicting theories regarding impact of dividend decision on the
valuation of a firm. -ccording to one school of thought) dividend decision dose not
affects the shareholders/ wealth and also the valuation of the shares of the firm
5Irrelevance theory*. -ccording to another school of thought) dividend decision
materially affects the shareholders/ wealth and also the valuation of the firm
5?elevance theory*.
1# T0e Irrelevance T0eor= or T0e Irrelevance "oncept of !ividend
83
There are two approaches in the Irrelevance theory they are -* ?esidual -pproach
and
* Modigliani and Miller approach.
&; %SI!U&* &..O&"4
-ccording to this approach or theory) dividend decision has no effect on the wealth
of the shareholders or the value of the shares) and hence it is irrelevant so far as
the valuation of the firm is concerned. This theory says dividend decision merely
as a part of financing decision (ecause the earnings availa(le may (e retained in
the (usiness for re-investment. ut if the funds are not re,uired in the (usiness
they may (e distri(uted as dividends. Thus) the decision to pay dividends or retain
the earnings may (e taken as a residual decision. The firm can retain the earnings
if it has profita(le investment opportunities otherwise it should pay them as
dividends.
(; MO!I'*I&NI &N! MI**% &..O&"4 :MM MO!%*;
Modigliani and Miller have e4pressed in the most comprehensive manner in
support of the theory of irrelevance. This theory maintain that dividend policy has
no effect on the market price of the shares and the value of the firm is determined
(y the earning capacity of the firm or its investment policy. They o(served that
1under conditions of perfect capital markets) rational investors) a(sence of ta4
discrimination (etween dividend income and capital appreciation) given the firm/s
investment policy its dividend policy may have no influence on the market price of
the shares1.
&ssumptions of MM 4=pot0esis#
MM hypothesis of irrelevance of dividends is (ased on the following
assumptions
1. 0apital markets are perfect.
84
2. Investors (ehave rationally
!. They have the knowledge of markets since the Information freely availa(le.
#. There are no transaction costs.
&. The firm has a fi4ed investment policy.
9. =o investor is large enough to influence the market price of shares.
:. There are either no ta4es or there are no differences in the ta4 rates applica(le
to dividends and capital gains.
F. ?isk or uncertainty does not e4ist. In other words) investors are a(le to forecast
future prices and dividends with certainty and one discount rate can (e used for
all securities at all times.
"riticism of MM approac0
MM hypothesis has (een criticised on account of various unrealistic assumptions.
They are.
1. +erfect capital market does not e4ist in reality.
2. Free availa(ility of information is not availa(le to all the investors.
!. The firms will incur transaction cost while issuing securities.
#. Ta4es do e4it and there is normally different ta4 treatment for dividends and
capital gains.
&. The firms do not follow a rigid investment policy.
9. The investors have to pay (rokerage) fees) etc) while doing any transaction.
:. 'ingle "iscount rate for discounting cash flows at different time period in not
correct.
$# elevance t0eor= or elevance concept of !ividend#
This theory of thought advocates that dividend decisions considera(ly affect the
value of the firm. This theory was advocated (y Myron 2ordon) Tone 6inter)
Tames $alter) ?ichardson. -ccording to them dividend decisions will effect the
firm/s position in the stock market. .igher dividends increase the value of stock
85
while low dividends decrease their value. This id (ecause dividends
communicate information to the investors a(out the firm/s profita(ility. There
are two theories which advocate this they are.
* $alter/s -pproach and * 2ordon/s -pproach
&; 3&*T%IS &..O&"4
+rof. Tames 8. $alter strongly supports the doctrine that dividend policy
almost always affects the value of the enterprise. The finance manager can)
therefore) use it to ma4imise the wealth of the e,uity shareholders. The
relationship (etween the internal rate of return earned (y the firm and its cost
of capital is very significant in determining the dividend policy to ma4imise the
wealth of the shareholders. +rof. $alter/s model is (ase on the relationship
(etween the firm/s 5i* return on investment) i.e. r and 5ii* the cost of capital or
the re,uired rate of return) i.e. k.
-ccording to +rof. $alter) it r Vk) i.e.) the firm can earn a higher return than
what the shareholders can earn on their investments) the firm should retain the
earnings. 'uch firms are termed as growth firms and the optimum pay-out
would (e ;ero in their case. This would ma4imise the value of shares.
In case of a firm which does not have profita(le investment opportunities
5i.e.) r W k*) the optimum dividend policy would (e to distri(ute the entire
earnings as dividend. For such firm/s) the optimum pay-out would (e 1BB E
and the firms should distri(ute the entire earnings as dividends.
In case of firms where r < k) it does not matter whether the firm retains or
distri(utes its earnings. In their case the value of the firm/s shares would not
fluctuate with change in the dividend rates. There is) therefore) no optimum
dividend policy for such firms.
&ssumptions
86
$alter/s model is (ased on the following assumptions.
1. The investments of the firm are financed through retained earnings only and
the firm does not use e4ternal sources of funds.
2. The internal rate of return 5r * and the cost of capital 5k* of the firm are
constant.
!. 8arnings per share and dividend per share do not change while determining
the given value.
#. The firm has a very long life.
-ccording to 3alterIs model the formula to determine the value of a share
58 - "*
" O r --------
ke
+ < --------------------
ke
" r58 - "*@ke
or + < ----- O --------------
ke ke
$here) p < market price per share
" < dividend per share
r < internal rate of return
8 <earnings per share
ke < cost of e,uity capital
"riticisms of 3alterIs Model
This model also (ased on the unrealistic assumptions.
87
1. The (asic assumption that investments are financed through retained
earnings only is seldom true in real would. Firms do raise funds (y e4ternal
financing.
2. The assumption of internal rate of return 5 r* will remain con stand does not
remain constant. -s a matter of fact with increased investments) r also
changes.
!. The assumption that /k/ will also remain constant does not also hold good. -
firm/s risk pattern does not always remain constant and as such it is not
correct to presume that /k/ will always remain constant.
(; 'O!ONIS &..O&"4
+rof. 2ordon has also developed a model on the lines of +rof. $alter
suggesting that dividends are relevant and the dividend decision of the firm
affects its value. .is (asis valuation model is (ased on the following
assumptions3
1. The firm is an all e,uity firm.
2. =o e4ternal financing is availa(le or used retained earnings represent the
only source of financing investment programmes.
!. The rate of return on the firm/ investment r) is constant.
#. The retention ratio) () once decided upon is constant. Thus) the growth
rate of the firm g < (r is also constant.
--------------------------------------------------
UNIT 5 T6.%S OF !I1I!%N! .O*I"6
88
---------------------------------------------------------------------------
Objective
To study various dividend policies
To know various factors influencing dividend policy
To highlight the corporate dividend practices in India.
Unit outline
2.#.1 Types of dividend policy
Constant payout 1atio Policy
Constant 0ivi#en# 1ate Policy
"ultiple 0ivi#en# Increase Policy
1egular 0ivi#en# plus 34tra 0ivi#en# Policy
5niorm Cash 0ivi#en# plus (onus Shares Policy
2.#.2 Factors Influencing "ividend +olicy
2.#.! 0orporate dividend practices in India
89
--------------------------------------------------
UNIT $#5#1 T6.%S OF !I1I!%N! .O*I"6
---------------------------------------------------------------------------
There are various types of "ividend +olicies among them are.
6. Constant payout 1atio Policy) This method is known as /sta(ility of
dividends/ which means always paying a fi4ed percentage of the net earnings
every year. Knder this method) if earnings vary) the amount of dividends also
varies from year to year. The dividend policy is entirely (ased on company/s
a(ility to pay) (y following a regular practice of retained earnings. - very few
firms will select this method) since in most firms) earnings are ,uite volatile.
T0e relation betBeen %arnings .er S0are :%.S; and !ividend .er
S0are :!.S; under "onstant !ividend .a=out atio .olic=
7. Constant 0ivi#en# 1ate Policy) It is a most popular kind of dividend policy in
which the payment of dividend is paid at a constant rate) even when earnings
vary from year to year) through the maintenance of /"ividend 8,ualisation
?eserve/. Firms are generally careful to set the dividend at a sustaina(le level
and raise it only when the firm can sustain the higher level and cut dividends in
adverse situations. This constant dividend rate policy is possi(le only when the
earnings pattern of the company does not show wide fluctuations.
T0e relation betBeen %arnings .er S0are :%.S; and !ividend .er
S0are :!.S; under "onstant !ividend .a=out ate .olic=
90
8. "ultiple 0ivi#en# Increase Policy) some firms follow a policy of very
fre,uent and very small dividend increases to give the illusion of movement and
growth. The clear hope (ehind such a policy is that the market rewards
consistent increases.
9. 1egular 0ivi#en# plus 34tra 0ivi#en# Policy) under this type of dividend
policy some firms consciously divide their announced into two portions a regular
dividend and an e4tra dividend. The regular dividend is the dividend that will
continue at the announced level) whereas the e4tra dividend payment will (e
made as circumstances permit.
:. 5niorm Cash 0ivi#en# plus (onus Shares Policy) Knder this method) a
minimum rate of dividend per share is paid in cash plus (onus shares are
issued out of accumulated reserves. ut the issue of (onus shares is not on
annual (asis. It depends upon the amount kept in reserves over a period say !
to & years. This policy is usually adopted in case of companies which have
fluctuating earnings.
--------------------------------------------------
UNIT - F&"TOS INF*U%N"IN' !I1I!%N! .O*I"6
---------------------------------------------------------------------------
O(+%"TI1%S
1. To know various factors influencing dividend policy
91
"4&.T% OUT*IN%
various factors influencing dividend policy
Though there is difference of opinion that the dividend policy will have its
impact on the value of the firm/s e,uity shares in the stock market) it is evident
that the dividend policies do have a significant effect on the value of the firm/s
e,uity share in the stock market. ut there is no uniform dividend policy (ecause
the different firms at different times follow different dividend policy. The following
are the important general factors applica(le to individual firms) which determine
the dividend policy of a firm.
1# *egal estrictions: The company may also (e legally restricted from declaring
and paying dividends. 6egal provisions relating to dividends as laid down in
sections D!) 2B&) 2B&-) 2B9 and 2B: of the 0ompanies -ct) 1D&9 are significant
(ecause they lay down a frame work within which dividend policy is formulated.
These provisions re,uire that dividend can (e paid only out of current profits)
past profits or moneys provided (y the 0entral or 'tate 2overnments for the
payment of dividends in pursuance of the guarantee given (y the 2overnment.
The 0ompanies 5Transfer or +rofits to ?eserves* ?ules) 1D:& re,uire a company
providing more than 1BE dividend to transfer certain percentage of the current
year/s profits to reserves. 0ompanies -ct further provides that dividends cannot
(e paid out of capital) (ecause it will amount to reduction of capital adversely
affecting the security of its creditors.
$# Magnitude of Trend of %arnings: The amount and trend of earnings will
determine the dividend policy. The dividends are paid only out of present or
past year/s profits. The past trend of the company/s profits should (e kept in
consideration while making the dividend decision.
92
)# !esire and T=pe of S0are0olders: The oard of "irectors are appointed (y
the shareholders of the company) hence the desires of the shareholders should
(e kept in mind while declaring dividend. There may (e different types of
shareholders 5investors* like retired persons) widows and other economically
weaker persons their desires also should (e taken care while declaring
dividend.
5# Nature of Industr=: The nature of industry will influences the dividend policy
of a company. 0ertain industries will have a steady and sta(le demand
irrespective of the prevailing economic conditions then this type of industries
can follow a higher dividend payout ratio. The industry with uncertain profits
can follow conservative policy.
-# &ge of t0e "ompan=: The newly esta(lished companies cannot pay higher
dividends though they earn more profits) since they have to reserve these
profits for growth and future developments. $hereas) the old companies need
not reserve more funds for its e4pansion hence) they can follow li(eral dividend
policy for e4ample .ero .onda declared 1BBBE dividend during this current
year 2BB!-B#.
<# Future Financial e/uirements: T0e Future financial needs of the company
are to (e considered (y the management while taking the dividend decision.
Though the management wants to give importance to the shareholders interest)
on the contrast the company should more weight to the financial needs of the
company.
?# %conomic polic= of t0e 'overnment: The dividend policy of the company
must (e adjusta(le to the economic policy of the government. "uring different
economic situations like inflation) depression etc.) the government will insist to
follow the directed state policy in declaration of dividend.
C# Ta> polic=: The ta4 policy followed (y the government also affects the
dividend policy. The government may give ta4 incentives to companies
retaining larger share of their earnings.
93
--------------------------------------------------
UNIT < "O.O&T% !I1I!%N! .&"TI"%S IN IN!I&
---------------------------------------------------------------------------
O(+%"TI1%
1. To highlight the corporate dividend practices in India.

"4&.T% OUT*IN%
To highlight the corporate dividend practices in India.
The main o(jective of ma4imi;ation of wealth of shareholders is mainly
influenced (y the dividend policy of the company. .ence the company must retain
the earnings if it has profita(le investment opportunities) giving a higher rate of
return than the cost of retained earnings) otherwise it should pay them as
94
dividends. It implies that a firm should treat retained earnings as the active
decision varia(le) and the dividends as the passive residual.
Module-)
--------------------------------------------------
UNIT 1 IN1%STM%NT !%"ISIONS
---------------------------------------------------------------------------
Objectives
To identify long term investment decisions
To study the significance of 0apital udgeting
To torch on capital (udgeting process
Unit outline
!.1.1 Introduction
0lassification of investment decisions
6ong-term investment decision or capital (udgeting and
'hort-term decision or $orking capital decision.
84penses comes under capital investment
8.6.7 Meaning of Capital (u#geting

95
!.1.! Importance of 0apital udgeting
!.1.# 0apital udgeting +rocess
--------------------------------------------------
)#1#1INTO!U"TION
---------------------------------------------------------------------------
The investment decision is the most important of the firm/s three major
decisions when it comes to the value creation. Investment decision relates to the
determination of total amount of assets to (e held in the firm) the composition of
these assets like the amount of fi4ed assets) current assets and the e4tent of
(usiness risk involved (y the investors.
The investment decisions can (e classified in to two groups3 51* 6ong-term
investment decision or capital (udgeting and 52* 'hort-term decision or $orking
capital decision.
In this module the long-term investment decision or capital (udgeting is discussed
in detail. The capital (udgeting decisions) re,uire comparison of cost against
(enefits over a long period. The investment made in capital assets cannot (e
recovered in the short run. 'uch assets will generate returns ranging from 2 to 2B
years or more. 'uch investment decision involve a careful consideration of various
factors like profita(ility) safety) li,uidity and solvency etc. a (usiness organisation
has to face ,uite often the pro(lem of capital investment decisions. 0apital
investment refers to the investment in projects whose results would generate
revenue or earnings from alter a year and it will continue for several num(ers of
years. The following are the e4penses which comes under capital investment are3
i* ?eplacements of old technology with new technology
96
ii* 84pansion of production activity
iii* "iversification of products due to competition and for growth
iv* ?esearch and "evelopment e4penditure
v* Miscellaneous e4pensed for installation of e,uipment) pollution control
e,uipment etc.
--------------------------------------------------
)#1#$ M%&NIN' OF "&.IT&* (U!'%TIN'
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0apital (udgeting is the process of making investment decisions in capital
e4penditures. - capital e4penditure refers to an e4penditure whose (enefits are
e4pected (e received over period of time e4ceeding one year.
0harles T. .orngreen has defined capital (udgeting as) 10apital (udgeting is
long term planning for making and financing proposed capital outlays1.
?ichard and 2reenlaw have referred to capital (udgeting as 1ac,uiring inputs
with long-run return1.
6ynch defines it as 10apital (udgeting consists in planning development of
availa(le capital for the purpose of ma4imising the long term profita(ility of the
concern.1
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)#1#) IM.OT&N"% OF "&.IT&* (U!'%TIN'
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- capital (udgeting or investment decision involves huge capital on capital
assets of the concern. -ny wrong decision in capital (udgeting will cost the
organisation through its capital loss and also revenue loss of the company. .ence
97
this decision is so critical and important) the finance manager should take special
care in making these decisions. They are
a. It involves heavy un#s. 0apital (udgeting decisions) generally)
involve large investment of limited funds. These funds are to (e invested
properly. .ence it is important to plan and control these funds.
'. 2hese un#s &ill have long term implications. 'ince the funds are
limited and also involves huge investments for long term or permanent
(asis. .ence it involves more risks) it should (e properly managed.
c. Irreversi'le #ecisions. 7nce the investment is made on capital assets)
it is not possi(le to reverse the decisions without incurring heavy losses.
#. +ong term impact on proita'ility. 0apital (udgeting decisions will
have a long-term and significant effect on the profita(ility of a concern.
-n unwise decision may prove disastrous and greater loss to the
organisation.
e. 0iiculties o Investment #ecisions. The capital (udgeting decisions
re,uire an assessment of future events which are uncertain) hence it is
very difficult to estimate the pro(a(le events it is very difficult to asses
the pro(a(le costs) (enefits accurately in this dynamic environment.
. It is national important. The investment decision taken (y the
individual concern is of national importance (ecause it generates
employment) economic activities and economic growth.
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)#1#5 "&.IT&* (U!'%TIN' .O"%SS
---------------------------------------------------------------------------
98
0apital (udgeting involves comple4 process (ecause it involves investment
of current funds for achieving (enefit in future and the future is always uncertain.
.owever) the following procedure may (e adopted in the process of capital
(udgeting3
&/ 0dentification of 0nvestment proposal. It is first and important stage in the
capital (udgeting process. The proposal or the idea (out potential
investment opportunities may originate from top management or may come
from the any part of organisation structure. The ideas are analysed (y the
departmental head in the light of the corporate o(jectives and strategies.
7/ ,creening t1e proposals. 8ach proposal received (y the department is
screened from various angles to see whether it is technically feasi(le)
amount of e4penditure involved) returns generated) risks involved etc.)
8/ valuation of various proposals# the ne4t stage is to evaluate the various
proposals received from the departments (y using capital (udgeting
techni,ues.
'/ Fi9ing priorities4 -fter evaluating various proposals) the unprofita(le or
uneconomical proposals are rejected. 7ut of selected proposals once again
are listed on the (asis of priorities after considering urgency) risk and
profita(ility of the proposal.
)/ Final approval and preparation of capital e9penditure #udget4 For the
approved proposal in the meeting the capital e4penditure (udget is
prepared. This (udget lays down the amount of estimated e4penditure to (e
incurred on fi4ed assets during the (udget period.
:/ 0mplementing proposal. $hile implementing the project or proposal) it is
(etter to assign responsi(ilities for completing the project within the given
time frame and cost limit so as to avoid unnecessary delays and cost over
runs. =etwork techni,ues used in the project management such as +8?T
99
and 0+M can also (e applied to control and monitor the implementation of
the projects.
;/ Performance revie<. The last stage in the process of capital (udgeting is the
evaluation of the performance of the project. The evaluation is made
through post completion audit (y way of comparison of actual e4penditure
on the project with the (udgeted one. -ny unfavoura(le variances) if any
should (e looked into and the causes of the same (e identified so that
corrective action may (e taken in future.
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UNIT $ M%T4O!S O T%"4NI7U%S OF "&.IT&* (U!'%TIN'
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Objective
To understand the various techni,ues of 0apital udgeting
100
Unit outline
)#$#1 Tec0ni/ue t0at recogniJe .a=bac8 of "apital %mplo=ed:
+ay(ack +eriod Method.
)#$#$ Tec0ni/ues t0at use &ccounting .rofit for .roject
evaluation:
a. -ccounting ?ate of ?eturn method.
(. 8arning +er 'hare.
)#$#) Tec0ni/ues t0at recogniJe Time 1alue of Mone=:
a. =et +resent Calue Method.
(. Internal ?ate of ?eturn Method.
c. =et Terminal Calue Method.
d. +rofita(ility Inde4 Method.
e. "iscounted +ay(ack +eriod Method.
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UNIT $ M%T4O!S O T%"4NI7U%S OF "&.IT&* (U!'%TIN'
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Met0ods or tec0ni/ues of capital budgeting or Investment &ppraisal
Tec0ni/ues
101
The techni,ues availa(le for appraisal of investment proposal are classified three
heads3
I# Tec0ni/ue t0at recogniJe .a=bac8 of "apital %mplo=ed:
+ay(ack +eriod Method.
II# Tec0ni/ues t0at use &ccounting .rofit for .roject evaluation:
c. -ccounting ?ate of ?eturn method.
d. 8arning +er 'hare.
III# Tec0ni/ues t0at recogniJe Time 1alue of Mone=:
f. =et +resent Calue Method.
g. Internal ?ate of ?eturn Method.
h. =et Terminal Calue Method.
i. +rofita(ility Inde4 Method.
j. "iscounted +ay(ack +eriod Method.
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)#$#1 Tec0ni/ue t0at recogniJe .a=bac8 of "apital %mplo=ed
---------------------------------------------------------------------------
.a=bac8 .eriod Met0od#
The term pay(ack refers to the period in which the project will generate the
necessary cash to recover the initial investment. For e4ample) if a project re,uires
102
?s. !B)BBB as initial investment and it will generate an annual cash inflow of ?s.
9)BBB for ten years) the pay (ack period will (e & years) it is calculated as follows3
Initial Investment
+ay (ack period < -------------------
-nnual 0ash Inflow
?s !B)BBB
< ------------
?s 9)BBB
0ash inflow is calculated (y taking into profits from the project (efore
depreciation and after Ta4.
$hen the cash inflow is uneven then the pay(ack period is calculated (u
cumulative cash inflows and (y interpolation) the e4act pay(ack period can (e
calculated. For e4ample) if the project re,uires an initial investment of ?s. #B)BBB
and the annual cash inflows for & years are ?s. 12)BBB) ?s) 1B)BBB) ?s. 1#)BBB)
?s. 11)BBB and ?s. D)BBB respectively) the pay (ack period will (e calculated as
follows3
5ear Cas1 inflo<s
=in Rs/
Cumulative cas1 inflo<s
=in Rs/
1
2
!
#
&
12)BBB
1B)BBB
1#)BBB
11)BBB
D)BBB
12)BBB
22)BBB
!9)BBB
#:)BBB
&9)BBB
103
From the a(ove ta(le we are clear that in ! years ?s. !9)BBB has (een
recovered. ?s. #)BBB is left out of initial investment. In the fourth year the cash
inflow is ?s. 11)BBB. It means the pay (ack period is (etween three to four years
calculated as follows.
-mount to (e recovered
+ay (ack period < ! years O -------------------------------------
-mount availa(le in the ne4t year.
< ! O #)BBB@ 11)BBB
< !.!! years.
&dvantages of .a= bac8 period
a. The main advantage of this method is that it is simple to understand and
easy to calculate.
(. In this method) as a project with a shorter pay (ack period is preferred to
the one having a longer pay (ack period. .ence the project of loss from
,uick o(solescence can (e overcome from this method.
c. This method gives an indication to the prospective investors specifying
when their funds are likely to (e repaid.
d. This method is suita(le when the future is very uncertain.
!isadvantages
a. This method does not take into account the cash inflows earned after the
pay (ack period and the true profita(ility of the projects cannot (e
correctly assessed.
(. This method ignores the time value of money and does not consider the
magnitude and timing of cash in flows.
c. It does not take into consideration the cost of capital which is a very
important factor in making sound investment decisions.
104
d. It treats each asset individually in isolation with other assets which is not
feasi(le in real practice.
e. This method does not consider the salvage value of an investment.
---------------------------------------------------------------------------
)#$#$ Tec0ni/ues t0at use &ccounting .rofit for .roject evaluation
--------------------------------------------------------------------------
&ccounting ate of eturn Met0od
It is also known as return on investment or return on capital employed. This
method applied the normal accounting techni,ue to measure the increase in profit
e4pected to result from an investment (y e4pressing the net accounting profit
arising form the investment as a percentage of the capital investment. That is3
-verage annual profit after ta4
-?? < ----------------------------------- A 1BB
-verage or Initial Investment
Initial investment O 'alvage value
-verage investment < -----------------------------------------
2
Knder this method the project which gives highest rate of return will (e selected.
Merits
1. It is easy to calculate (ecause it makes use of readily availa(le accounting
information.
2. It is concerned with profits availa(le for shareholders rather than cash flows.
!. This method takes into consideration all the years profit throughout its life.
#. Guick decision of capital investment proposals is possi(le.
&. If high profits are re,uired) this is certainly a way of achieving them.
105
!emerits
1. It does not take into account the time value of money.
2. It uses the straight line method of depreciation. 7nce this method is changed
the method will not (e easy to use.
!. It is (iased against short-term projects in the same way that pay(ack is (iased
against longer-term ones.
#. There are different methods for calculating the accounting rate of return due to
diverse concepts of investments as well as earnings. 8ach method gives
different results. This reduces the relia(ility of the method.
-------------------------------------------------------------------------------
)#$#) Tec0ni/ues t0at recogniJe Time 1alue of Mone=
--------------------------------------------------------------------------
Net present 1alue Met0od
This is generally considered to (e the (est method for evaluating the capital
investment proposals. In this method first cash inflows and cash outflows
associated with each project are worked out. The present value of these cash
inflows and outflows are then calculated at the rate of return accepta(le to the
management. This rate of return is considered as the cut-off rate and is generally
determined on the (asis of cost of capital adjusted risk element in the project. T1e
Net Present !alue =NP!/ is t1e difference #et<een t1e total present value of future
cas1 inflo<s and t1e total present value of future cas1 outflo<s.
The =et +resent Calue can (e used as an /accept or reject/ criterion. In case
the =+C is positive the project should (e accepted. If the =+C is negative) the
project should (e rejected.
106
Merits
1. It recognises the time value of money and is suita(le to (e applied ina situation
with uniform or uneven cash inflows even at different periods of time.
2. It takes into account the earnings over the entire life of the project and the true
profita(ility of the profit can (e evaluated.
!. It takes into consideration the o(jective of ma4imum profita(ility.
!emerits
1. -s compared to traditional method) the =+C method is more difficult to
understand and operate.
2. It is not easy to determine an appropriate discount rate.
!. The method is (ased on the presumption that cash inflow can (e invested at
the discounting rate in the new projects. ut this presumption does not always
hold good (ecause it all depends upon the availa(le investment opportunities.
Internal ate of eturn :I;
Internal ?ate of ?eturn is that rate at which the sum of discounted cash
inflows e,uals the sum of discounted cash outflows. In other words) it is the rate
which discounts the cash flows to ;ero. It is also known as time adjusted rate of
return method or trial and error yield method.
Merits
1. It also takes into account the present value of money.
2. It considers the profita(ility of the project for its entire economic life and hence
ena(les evaluation of true profita(ility.
107
!. The determination of cost of capital is not a pre-re,uisite for the use of this
method and hence it is (etter than =+C method where the cost of capital
cannot (e determined easily.
#. It provides for uniform ranking of various proposals due to the percentage rate
of return.
!emerits
1. It is difficult to understand and is the most difficult method of evaluation of
investment proposals.
2. This method is (ased upon the assumption that the earnings are reinvested at
the internal rate of return for the remaining life of the project) which is not a
justified assumption.
!. The results of =+C method and I?? method may differ when the projects under
evaluation differ in their si;e) life and timings of cash flows.
!iscounted .a= bac8 .eriod Met0od#
Knder this method the draw (ack of time value of money not considered in
pay (ack period is considered. .ence this method is improvement over the pay
(ack period method. Knder this method the project which gives the greatest post
pay-(ack period may (e accepted. Knder this method the present values of all
cash outflows and inflows are computed at an appropriate discount rate. The time
period at which the cumulated present value of cash inflows e,uals th present
value of cash outflows is known as discounted pay (ack period.
.rofitabilit= Inde> Met0od or (enefit "ost atio
It is also a time-adjusted method of evaluating the investment proposals.
+rofita(ility inde4 also called as enefit-0ost ?atio or "esira(ility factor is the
relationship (etween present value of cash inflows and present value of cash
outflows. Thus
108
+resent value of cash inflows
+rofita(ility Inde4 < -------------------------
+resent value of cash outflows
The proposal is accepted if the profita(ility inde4 is more than one and is
rejected in case the +I is less than one.
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UNIT ) .O(*%MS ON "&.IT&* (U!'%TIN'
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Objectives
To give practical e4posure to the working of capital (udgeting
To help in decision making process) in selecting a (est method of capital
(udgeting
To know the working knowledge of these methods
Unit outline
!.!.1 +ro(lems on capital (udgeting
+ay(ack period
-ccounting ?ate of ?eturn
=et +resent Calue
Internal ?ate of ?eturn
+rofita(ility inde4
109
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)#)#1 .roblems on capital budgeting
-------------------------------------------------------------------------------
1. 0alculate the cash inflow under pay (ack period with the following information>
+rofit efore Ta4 and efore "epreciation 5+T"* <&BBBB) "epreciation <1B)BBB)
Ta4<!&E
Solution)
+T" &B)BBB
6ess "epreciation 1B)BBB
XXXXX
+T-" #B)BBB
Less3 Ta4 !&E 1#)BBB
XXXXX
+-T-" 29)BBB
5O* "epreciation 1B)BBB
XXXXX
+-T" !9)BBB
XXXXX
To calculate ta4 we have to first change depreciation.
2. 0alculate the +ay ack +eriod 5++* from the following3
6ears InfloBs
I &BBBBB
110
II #BBBBB
III !BBBBB
IC 1BBBBB
Initial Investment < ?s.1B)BB)BBB
Solution)
++ < 2O1)BB)BBB@!)BB)BBB<2.!! years
!. 0alculate ++ form the following> Initial investment 1B) BB)BBB) life of the
project #years) +" and (efore Ta4 5+T"*
I &)BB)BBB
II #)BB)BBB
III !)BB)BBB
IC 1)BB)BBB
'olution3
0alculation of "epreciation>
"8+=< 0ost of asset O Installation charges-'crap value@6ife of -sset
<1B)BB)BBB@#<2)&B)BBB
?ate of ta4 is assumed as !&E.
2iven
Ye$& /010D #-( De2+. /01!D #-( 1$x 35% /!1!D #3(De2. /!10D
4 500000 250000 250000 87500 162500 250000 412500
44 400000 250000 150000 52500 97500 250000 347500
444 300000 250000 50000 17000 32500 250000 282500
111
45 100000 250000 #150000( - #150000( 250000 100000
++<2O2)#B)BBB@2)F2)&BB 52)#B)BBB<1B)BB)BBB-:)9B)BBB*

< 2.F& Lears.
#. - +roject involves the investment of ?s. &BBBBB which yields +-"-T as stated
(elow3
Lears +-T-"
I 2&BBB
II !:&BB
III 92&BB
IC 9&BBB
C #BBBB
-t the end of & years the machinery in the project can (e sold for #B)BBB. The
cut-off rate is FE. 'uggest the management whether or not to accept the
proposal (ased on -??.
Solution
'tep I3 -verage profit< Total cash inflows@life of project
<2!BBBB@&<#9BBB
'tep II> -??<-+@Initial Investment 5I I*
<#9BBB@5&BBBBB-#BBBB* 4 1BB<1BE
Interpretation3 It is advisa(le to accept the project since -?? is a(ove
the cut-off rate.
112
Interpretation of =+C> If =+C is greater than or e,ual to ;ero then accept or else
rejects the project.
&. 0alculate =+C and I?? of a project involving the initial cash outflow of
?s.1)BB)BBB and generating annual cash inflow of ?s.!&)BBB) ?s.#B)BBB)
?s.!B)BBB) and ?s.&B)BBB for # years respectively. -ssume discounting rate of
return at 1&E.
'olution3
0alculation of =+C
Ye$&* "$*6 i+%.-7* Di*c-u+t 815% 91:#13&(+; </5 =$.ue*
1 35000 0.8696 30436
2 40000 0.7561 30244
3 30000 0.6575 19725
4 50000 0.5718 28590
>>>>>>>>
1-t$. Di*c-u+t "$*6 i+%.-7* 1,08,995
?e**@ 4+iti$. 4+=e*tAe+t 1,00,000
>>>>>>
<et </5 8995
Interpretation3 'ince =+C is 2reater than or e,ual to ;ero we accept the project.
113
0alculation of I??
Ye$&* "$*6 4+%.-7* Di*c-u+t 85% Di*c-u+te) ".4 Di*c-u+t 820% Di*c-u+te) ".4.
1 35000 0.9524 33334 0.8333 29165.5
2 40000 0.9070 36280 0.6944 27776
3 30000 0.8638 25914 0.5787 17361
4 50000 0.8227 41135 0.4823 24115
>>>>>>>> >>>>>>>>>>>>>
1-t$. D"4 136663 98418
?e** 4.4 100000 100000
>>>>>>>> >>>>>>>>>
</5 36663 #1582(
O ve =+C
I??< 6??O ------------------------------ 4 difference in rates
5O ve =+C* O 5- ve =+C*

!9)99!
I??< & O ------------------------------ 4 1&
5!9)99!* O 51)&F2*
< 1D.!FE
114
9. - 0ompany has an investment opportunity costing ?s. #B)BBB with the following
e4pected net cash flow 5after ta4 (efore depreciation*.
Lears =et 0ash flow
1 ?s. :)BBB
2 :)BBB
! :)BBB
# :)BBB
& :)BBB
9 F)BBB
: 1B)BBB
F 1&)BBB
D 1B)BBB
1B #)BBB
Ksing 1BE as the cost of capital 5rate of discount* determine the following3
a* +ay (ack period.
(* =et present value at 1BE discount factor.
c* +rofita(ility Inde4 at 1BE discount factor.
d* Internal ?ate of ?eturn with the help of 1BE discount factor and 1&E
discount factor.
Solution)
a* +ay (ack period < & O &BBB@FBBB
< &.92& years.
115
(* =et +resent Calue
Lear 0ash Inflow
?s.
"iscount R
1BE
"iscounted cash
inflow
1
2
!
#
&
9
:
F
D
1B
:)BBB
:)BBB
:)BBB
:)BBB
:)BBB
F)BBB
1B)BBB
1&)BBB
1B)BBB
#)BBB
B.DBD1
B.F29#
B.:&1!
B.9F!B
B.92BD
B.&9#&
B.&1!2
B.#99&
B.#2#1
B.!F&&
5-* Initial Invt.
N.1
9!9#
&:F&
&2&D
#:F1
#!#9
#&19
&1!2
9DDF
#2#1
1&#2
----------
#F)D9!
#B)BBB
---------
CFD<)
c* 2ross +I < "iscounted cash inflow@"iscounted 0ash outflow
< #F)D9!@#B)BBB < 1.2!
=et +I < 2ross +I - 1
< 1.2! - 1 < B.2!
d* Internal ?ate of ?eturn
Lear 0ash Inflow
?s.
"iscount R
1&E
"iscounted cash
inflow
1
2
!
#
&
:)BBB
:)BBB
:)BBB
:)BBB
:)BBB
B.F9D9
B.:&91
B.9&:&
B.&:1F
B.#D:2
9BF:
&2D!
#9B!
#BB!
!#FB
116
9
:
F
D
1B
F)BBB
1B)BBB
1&)BBB
1B)BBB
#)BBB
B.#!2!
B.!:&D
B.!29D
B.2F#!
B.2#:2
Less Initial
Invt.
5-*ve =+C
!#&F
!:&D
#DB#
2F#!
DFD
--------
!D)#1F
#B)BBB
--------
5-* &F2
O ve =+C
5O ve =+C* O 5- ve =+C*
F)D9!
I??< 1B O ------------------------------ 4 51& - 1B*
F)D9! O &F2
< 1#.9D& E
:. The 6 0ompany 6td) is considering the purchase of a new machine. Two
alternative machines 5-YB have (een suggested each costing ?s. #)BB)BBB.
8arnings after ta4ation (ut (efore depreciation are e4pected to (e as follows3

Lear Machine - Machine
1
2
!
#
&
2otal
#B)BBB
1)2B)BBB
1)9B)BBB
2)#B)BBB
1)9B)BBB
;(7*(***
1)2B)BBB
1)9B)BBB
2)BB)BBB
1)2B)BBB
FB)BBB
:(>*(***
117
The company has a target rate return on capital at the rate of 1BE. 7n this (asis
you are re,uired3
1. 0ompare profita(ility of Machines and state which alternative you consider
financially prefera(le.
2. 0ompute +a>y(ack period for each project
!. 0ompute annual rate of return for each project.
Solution:
1. =et +resent Calue.
Lea
r
Machine
-
"iscount
R1BE
"iscount
ed cash
inflow
Machine "iscount
ed cash
inflow
1
2
!
#
&
#B)BBB
1)2B)BBB
1)9B)BBB
2)#B)BBB
1)9B)BBB
B.DBD1
B.F29#
B.:&1!
B.9F!B
B.92BD
;0iscounte#
Cash inlo&
5-* Initial Invt.
=+C
!9)!9#
DD)19F
1)2B)2BF
1)9!)D2B
DD)!##
----------
-
&)1D)BB#
#)BB)BBB
----------
--
1)1D)BB#
1)2B)BBB
1)9B)BBB
2)BB)BBB
1)2B)BBB
FB)BBB
;0iscounte#
Cash inlo&
5-* Initial Invt.
1)BD)BD2
1)!2)22#
1)&B)29B
F1)D9B
#D)9:2
----------
-----
&)2!)2BF
#)BB)BBB
----------
----
1)2!)2BF
Interpretation3 It is advisa(le to accept Machine since =+C is more when
compared to Machine -.
2. +ay (ack period.
Machine - < ! O FB)BBB@2)#B)BBB < !.!! years
Machine < 2 O 1)2B)BBB@2)BB)BBB < 2.9 years
Interpretation3 It is advisa(le to accept Machine as per ++.
118
!. -??.
0alculation of "epreciation3
< 0ost of asset O Installation charges-'crap value@6ife of -sset
< #)BB)BBB@& < FB)BBB p.a.
+-T" of
Machine -
+-T" of
Machine
5-*
"epreciation
+-T-" of
Machine -
+-T-" of
Machine
#B)BBB
1)2B)BBB
1)9B)BBB
2)#B)BBB
1)9B)BBB
1)2B)BBB
1)9B)BBB
2)BB)BBB
1)2B)BBB
FB)BBB
FB)BBB
FB)BBB
FB)BBB
FB)BBB
FB)BBB
- #B)BBB
#B)BBB
FB)BBB
1)9B)BBB
FB)BBB
#B)BBB
FB)BBB
1)2B)BBB
#B)BBB
B
-verage profit 5-* < !)2B)BBB@& < 9#)BBB
-?? < 9#)BBB@#)BB)BBB 4 1BB < 19E
-verage profits 5* < 2)FB)BBB@& < &9)BBB
-?? < &9)BBB@#)BB)BBB 4 1BB < 1#E
0nterpretation. it is advisa(le to accept Machine - as per -??.
119
D# The e4pected cash flows of the project are as follows3
Lears 0ash flows
B - 1)BB)BBB
1 2B)BBB
2 !B)BBB
! #B)BBB
# &B)BBB
& 9B)BBB
The cost of capital is 12E calculate the following.
a* =+C
(* enefit cost ratio 52+I*
c* ++
d* I??
e* "iscounted ++
,olution.
a* =+C
Lear 0ash Inflow "iscount factor
R
12E
"iscounted
0ash inflow
1
2
!
#
&
2B)BBB
!B)BBB
#B)BBB
&B)BBB
9B)BBB
B.FD2D
B.:D:2
B.:11F
B.9!&&
B.&9:#
; Cash inlo&
- Initial invt.
N.1
1:)F&F
2!)D19
2F)#:2
!1)::&
1:)B22
------------
1)1D)B#!
1)BB)BBB
------------
1DFE5)
(* enefit cost ration 52+I*
< "iscounted 0ash inflow @ "iscounted 0ash outflow
120
< 1)1D)B#! @ 1)BB)BBB
< 1.1D
c* +ay ack period
< ! O 1B)BBB @ &B)BBB
< !.2 years
d* I??
Lear 0ash Inflow "iscount factor
R
2BE
"iscounted
0ash inflow
1
2
!
#
&
2B)BBB
!B)BBB
#B)BBB
&B)BBB
9B)BBB
B.F!!!
B.9D##
B.&:F:
B.#F2!
B.#B1D
; Cash inlo&
- Initial invt.
N.1
19)999
2B)F!2
2!)1#F
2#)11&
12)B&:
------------
D9)F1F
1)BB)BBB
------------
- )F1C$
O ve =+C
5O ve =+C* O 5- ve =+C*
1D)B#!
I??< 12 O ------------------------------ 4 51& - 1B*
1D)B#! O !)1F2
< 1F.F&E
e* "iscounted +ay ack period
121
< ! O 2D):&# @ !1)::&
< !.D years
122
-------------------------------------------------------------------------------
Unit 5 is8 and Uncertaint= in "apital (udgeting
-------------------------------------------------------------------------------
Objectives
The o(jectives of this unit are3
To (ring clarity in the concepts of ?isk and Kncertainty
To study the methods of accounting the risk in capital (udgeting
Unit outline
)#5#1 is8 and Uncertaint= in "apital (udgeting
The following methods are suggested for accounting for risk in capital (udgeting.
=i/ General Tec1niques.
5a* ?isk adjusted discount rate>
5(* 0ertainty e,uivalent coefficient.
=ii/ +uantitative Tec1niques.
5a* 'ensitivity analysis
5(* +ro(a(ility assignment
5c*'tandard deviation
5d* 0oefficient of variation
5e* "ecision tree analysis
-------------------------------------------------------------------------------
)#5#1 is8 and Uncertaint= in "apital (udgeting
----------------------------------------------------------------------------
123
-ll the techni,ues of capital (udgeting re,uire the estimation of future cash
inflows and cash outflows. The future cash flows are estimated) (ased on the
following factors3
51* 84pected economic life of the project.
52* 'alvage value of the asset at the end of its life.
5!* 0apacity of the project.
5#* 'elling price of the product.
5&* +roduction cost
59* "epreciation and ta4 rate
5:* Future demand for the product etc.)
ut due to uncertainties a(out the future most of the a(ove factors cannot
(e e4act. For e4ample) the product (ecomes a(solute) technology (ecomes
o(solescence) in these situations taking investment decisions (ecomes difficult.
ut some allowances for the element of risk have to (e provided.
The following methods are suggested for accounting for risk in capital
(udgeting.
=i/ General Tec1niques.
5a* ?isk adjusted discount rate>
5(* 0ertainty e,uivalent coefficient.
=ii/ +uantitative Tec1niques.
5a* 'ensitivity analysis
5(* +ro(a(ility assignment
5c*'tandard deviation
5d* 0oefficient of variation
5e* "ecision tree analysis
is8 adjusted discount rate
124
The risk adjusted discount rate is (ased on the presumption that investors
e4pect a higher rate of return on risky projects as compared to less risky projects.
The rate re,uires is determined (y i* risk free rate and ii* risk premium rate. ?isk
free rate is the rate at which the future cash inflows should (e discounted and
there (een no risk. ?isk premium rate is the e4tra return e4pected (y the investor
over the normal rate on account of the project (eing risky. Therefore risk adjusted
discount rate is a composite discount rate that takes into account (oth the time
and risk factors. - higher discount rate will (e used for more risky projects and
lower rate for less risky projects.
From the following data) state which project is (etterV
Lear 0ash inflows
+roject A +roject L
B -1B)BBB -1B)BBB
1 &)BBB 9)BBB
2 #)BBB 9)BBB
! 2)BBB #)BBB
?iskless discount rate is &E. +roject A is less risky as compared to +roject L.
the management considers risk premium rates at &E and 1BE respectively
appropriate for discounting the cash inflows.
Solution:
+roject ?isk adjusted discount rate
A &E O &E < 1BE
L &E O 1BE < 1&E
Lear "iscounted 0ash inflows
125
+roject A +roject L
B -1B)BBB -1B)BBB
1 #)&#& &)21F
2 !)!2B #)&!9
! 1)&B2 2)9!B
--------- ---------
=+C - 9!! 2)!F#
--------- ---------
+roject L is superior to +roject A. since =+C is positive it may (e accepted.
Sensitivit= anal=sis
$here cash inflows are very sensitive under different circumstances) more
than one forecast of the future cash inflows may (e made. These inflows may (e
regarded as /7ptimistic/) /Most 6ikely/ and /+essimistic/. Further cash inflows may
(e discounted to find out the =+C under these three different situations. If the =+C
under the three situations differ widely it implies that there is a great risk in the
project and the investor/s decision to accept or reject a project will depend upon
his risk (earing a(ilities.
Illustration
Mr. Tanu is considering tow mutually e4clusive projects - and . Lou are
re,uired to advise him a(out the accepta(ility of the projects from the following
information.
+roject -
?s.
+roject
?s.
0ost of the Investment &B)BBB &B)BBB
126
Forecast 0ash Inflows
per annum for & years
7ptimistic
Most 6ikely
+essimistic
5The cut-off rate is 1&E*
!&)BBB
2&)BBB
2B)BBB
#B)BBB
2B)BBB
&)BBB
Solution
"omputation of N.1 of cas0 in floBs at a !iscount ate of 1-K
:&nnuit= of e# 1 for - =ears;
.roject & .roject (
-nnual
cash
inflow
"iscou
nt
factor
R 1&E
+resent
Calue
=+C -nnual
cash
inflow
"iscou
nt
factor
R 1&E
+resent
Calue
=+C
7ptimistic
Most 6ikely
+essimistic
!&)BBB
2&)BBB
2B)BBB
!.!&22
!.!&22
!.!&22
1)1:)!2:
F!)FB&
9:)B##
9:)!2:
!!)FB&
1:)B##
#B)BBB
2B)BBB
&)BBB
!.!&22
!.!&22
!.!&22
1)!#)BFF
9:)B##
19):91
F#)BFF
1:)B##
-!!)2!D
The =+C calculated a(ove indicate that +roject is more risky as compared to
+roject -. at the same time during favora(le conditions) it is more profita(le.
.robabilit= Tec0ni/ue
- pro(a(ility is a relative fre,uency with which an event may occur in the
future. $hen future estimates of cash inflows have different pro(a(ilities the
e4pected monetary values may (e computed (y multiplying cash inflow with the
pro(a(ility assigned.
Illustration:
The -0 company 6imited has given the following possi(le cash inflows fro two of
their projects A and L out of which one they wish to undertake together with their
associated pro(a(ilities. oth the projects will re,uire an e,ual investment of ?s.
&)BBB.
127
Lou are re,uired to give your considered opinion regarding the selection of
the project.
+roject A +roject L
+ossi(le
event
0ash inflows +ro(a(ility 0ash
inflows
+ro(a(ilit
y
-
0
"
8
#)BBB
&)BBB
9)BBB
:)BBB
F)BBB
.1B
.2B
.#B
.2B
.1B
12)BBB
1B)BBB
F)BBB
9)BBB
#)BBB
.1B
.1&
.&B
.1&
.1B
,olution.
"omputation of %>pected Monetar= values for .roject 2 and .roject 6
+roject A +roject L
0ash
inflows
+ro(a(ilit
y
84pecte
d value
0ash
inflows
+ro(a(ili
ty
84pecte
d value
-
0
"
8
#)BBB
&)BBB
9)BBB
:)BBB
F)BBB
Total
.1B
.2B
.#B
.2B
.1B
?s. #BB
1)BBB
2)#BB
1)#BB
FBB
<EEE
12)BBB
1B)BBB
F)BBB
9)BBB
#)BBB
Total
.1B
.1&
.&B
.1&
.1B
1)2BB
1)&BB
#)BBB
DBB
#BB
CFEEE
128
The e4pected monetary value of +roject L is higher than the e4pected
monetary value of +roject A. .ence +roject L is prefera(le to project A.

!ecision Tree &nal=sis
"ecision tree anlysis is another techni,ue which is helpful in tackling risky
capital investment proposals. "ecision tree is a graphic display of relationship
(etween a present decision and possi(le future events) future decisions and their
conse,uences. The se,uence of event is mapped out over time in a format
resem(ling (ranches of a tree. In other words) it is a pictorial representation in
tree form which indicates the magnitude) pro(a(ility and interrelationship of all
possi(le outcomes.
Module -5
---------------------------------------------------------------------------
UNIT 1 3or8ing "apital Management
---------------------------------------------------------------------------
Objectives
1# To familiarise about t0e concept of 3or8ing "apital
$# To 8noB various classifications of Bor8ing capital
Unit outline
129
0lassifications of working capital
a* 2ross working capital and =et working capital
(* +ermanent working capital and Temporary working capital
c* 7perating cycle concept of working capital.
Importance or advantages of ade,uate working capital
-------------------------------------------------------------------------------
5#1#1 INTO!U"TION
-------------------------------------------------------------------------------
$orking capital management is concerned with the pro(lems that arise in
managing the current assets) the current lia(ilities and the interrelationship that
e4ists (etween them. The term current assets refer to those assets which can (e
converted into cash with in one year with out undergoing a decrease in value and
without disrupting the operations of the firm. The major components of current
assets are cash) marketa(le securities) accounts receiva(le and inventory. 0urrent
lia(ilities are those lia(ilities which are to (e paid within a year) out of current
assets or earnings of the firm. The current lia(ilities are accounts paya(le) (ills
paya(le) (ank overdraft) and outstanding e4penses.
The goal of working capital management is to manage the firm/s current
assets and lia(ilities in such a way that a satisfactory level of working capital is
maintained. If the working capital in not kept at satisfactory level) the firm likely
will (ecome insolvent. The current assets should (e large enough to cover its
130
current lia(ilities. 8ach current asset should (e properly managed to maintain
satisfactory level of li,uidity) either e4cess or deficiency of the current assets will
have adverse impact on the firm/s working capital management.
--------------------------------------------------------------------------
5#1#$ "oncepts and !efinitions of 3or8ing "apital
-----------------------------------------------------------------------------
Working capital is defined as the e4cess of current assets over current lia(ilities.
$orking capital is classified in to3
d* 2ross working capital and =et working capital
e* +ermanent working capital and Temporary working capital
f* 7perating cycle concept of working capital.
<ross &orking capital refers to the firm/s investment in current assets. The
constituents of current assets are3
i* 0ash in hand and at (ank. ii* ills receiva(les. iii* 'undry de(tor less provision
of (ad de(ts. iv* 'hort term loans and advances. C* Inventories of stock consists
of raw materials) work in process) stores and spares and finished goods. vi*
Temporary investments of surplus funds. Ci* +repaid e4penses. Cii* -ccrued
incomes
/et &orking capital refers to the e4cess of current assets over current lia(ilities.
The constituents of current lia(ilities are3
i* ills paya(le. Ii* 'undry creditors. Iii* -ccrued e4penses. Iv* 'hort term loans)
advances and deposits. C* "ividends paya(le. Ci* ank overdraft. Cii* +rovision for
ta4ation.
Permanent &orking capital represents the assets re,uired on continuing (asis
over the entire year. 2emporary &orking capital refers to additional assets
re,uired at different items during the operation of the year. *perating Cycle
concept o &orking capital refers to the average time elapses (etween the
131
ac,uisition of raw materials and the final cash realisation. 0ash is used to (uy raw
materials and other stores) so cash is converted into raw materials and stores
inventory) in production process it remains as a work in process) this work in
process is converted into finished product) this finished product are sold on credit
or cash. If it is sold on credit) then it will (e in the form of (ills receiva(le) later on
it is transformed in to the original form of cash.
Thus operating cycle consists of the following cycles
The raw materials and stores inventory stage
The work in process stage
The finished goods inventory stage
The receiva(les stage
--------------------------------------------------------------------------
5#1#) Importance or advantages of ade/uate Bor8ing capital
---------------------------------------------------------------
$orking capital is very important to the (usiness firm to meet its daily running.
The working capital) should not (e either e4cess or shortage) it should (e
ade,uate. The main significance or importance of ade,uate amount of working
capital are3
a* -de,uate working capital helps the (usiness organisation to maintain solvency
(y providing uninterrupted flow of production.
(* The sufficient working capital to make prompt payments will enhance the
goodwill of a concern.
c* The concern can raise easy loans in the financial market (ecause of high
solvency and good credit rating.
d* -de,uate working capital will help the concern to avail cash discounts on
purchases and this in turn reduces the cost of production.
132
e* -de,uate working capital will ensures regular supply of raw material and
continuous production.
f* It ensures regular payment of salaries and other day today e4penses of the
(usiness.
g* The concerns with ade,uate capital will ensure proper e4ploitation of markets
to avail discounts while purchasing their re,uirements in (ulk ,uantities.
h* -de,uacy of working capital creates an environment of security) confidence)
and high morale will create overall efficiency in a (usiness.
133
Unit $ &!%7U&T% 3O,IN' "&.IT&*
Objectives
1. To determine the factors which influences the working capital
re,uirements
2. To diagnose the symptoms of poor working capital management
!. To identify the (asic functions of working capital management
Unit Outline
Factors determining the working capital
'ymptoms of +oor $orking 0apital Management
asic functions of working capital management
-. 8stimating the working capital management.
. Financing of working capital needs) and
0. -nalysis and control of working capital.
---------------------------------------------------------------
134
5#$#1 Factors determining t0e Bor8ing capital
-------------------------------------------------------------------------------
Carious factors will determine the working capital of the company. The important
of them are.
6. /ature o (usiness. The working capital re,uirement of a company depends
(asically on the nature of its (usiness. If the nature of (usiness is Trading and
manufacturing of goods and services re,uire huge amount of working capital. If
the nature of its (usiness is pu(lic utilities) then it re,uires less amount of
working capital.
7. Si=e>scale o pro#uction. The si;e of scale of production will determine the
amount of working capital of a firm. If the si;e of production is small it re,uires
less amount of working capital to purchase raw material) wages and other
e4penses and if the scale of operation is large it re,uires more amount of
working capital.
8. Pro#uction policy. The production policy of the firm will determine the
amount of working capital. If the production policy is to accumulate production
in slack season and keep inventory and to sell in the peak season) then the firm
re,uires more working capital.
9. +ength o pro#uction cycle. In manufacturing concern) the re,uirement of
working capital increase in direct proportion to length of manufacturing process.
:. Working capital cycle. The working capital cycle will determine the amount of
working capital of a (usiness concern. If working capital cycle is short ie.)
without credit sales then the amount re,uirement for working capital will (e
less otherwise it re,uires more.
?. Cre#it policy. The credit policy of a concern in its dealing with de(tors and
creditors will determine the amount of working capital.
@. (usiness cycles. The stage of (usiness cycle of a firm will determine the
amount of working capital. If the concern is in (oom period naturally it re,uire
more working capital or if it is in recession) then it re,uires less amount.
135
A. Inlationary con#ition. The higher the price level re,uires higher the amount
of working capital.
BBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBBB
5#$#$ S=mptoms of .oor 3or8ing "apital Management
---------------------------------------------------------------------------
The following are the symptom to (e seen in the case of poor working capital
management.
6. 84cessive carriage of inventory over the normal levels re,uires for the (usiness
will result in increase in creditor (alance.
7. 'low down in collection of de(tors will result in working capital pro(lems.
8. If the capital goods are purchased from working capital) this will result in the
pro(lem in day to day re,uirement of working capitals.
9. Knplanned production schedules will cause e4cessive stocks of finished goods or
failures in meeting despatch scheduled.
:. 7ver trading will cause shortage of working capital.
?. "ependence in short term sources of finance for financing permanent working
capital causes lesser profita(ility and will increase strain on the management in
managing working capital.
@. Inefficiency in cash management causes em(e;;lement of cash.
A. Ina(ility to get working capital limits will cause serious concern to the company.
- finance manager can achieve ade,uate $orking 0apital Management (y
following these three (asic functions.
". 8stimating the working capital management.
8. Financing of working capital needs) and
F. -nalysis and control of working capital.
-------------------------------------------------------------------------------
5#$#) %stimating t0e Bor8ing capital management#
--------------------------------------------------------------------------
136
In order to determine the amount of working capital needed (y a firm) a
num(er of factors vi;.) production policies) nature of (usiness) length of
manufacturing process) credit policy etc.) are to (e considered (y the finance
manager of a company. The following format can (e uses in estimating the
working capital re,uirement.
Bt$teAe+t -% -&Ci+, "$2it$. Dequi&eAe+t*
-mount
?s
$. Current assets:
1. cash
2. "e(tors or ?eceiva(les
!. 'tocks
i* ?aw materials
ii* $ork in process
iii* 'tores and spares
iv* Finished goods
#. -dvance payment) if any
&. 7thers
(. Current +ia'ilities)
1. 0reditors
2. 7utstanding payments
!. -ny other
$orking 0apital 5--*
-------------------------------------------------------------------------------5#$#5
Financing of Bor8ing capital needs
--------------------------------------------------------------------------
The working capital of a concern can (e classified in to two3
1. +ermanent or Fi4ed working capital re,uirement.
2. Temporary or Caria(le working capital re,uirement.
137
+ermanent or Fi4ed working capital is re,uired to invest permanently in current
assets to ensure minimum ,uantity to maintained for continuous use this
minimum cannot (e reduced) (ecause it is re,uired for day to day operation of the
(usiness. The amount invested on these permanent fi4ed assets is called fi4ed
working capital. 'imilarly some working capital is re,uired for meeting seasonal
demands and some special purchases like increase in prices) strikes) calamities
eta. This is called temporary working capital.
The fi4ed or permanent working capital is generally financed (y the sources like
issue of shares) de(entures) pu(lic deposits) ploughing (ack of profits) loans from
financial institutions etc.
The temporary working capital is financed through the sources like Indigenous
ankers) Trade credit) cash credit or (ank overdraft) advances accounts receiva(le
or Factoring) accrued e4penses) "eferred incomes) +rovision for depreciation)
0ommercial +aper) 0ommercial anks.

Unit ) "&S4 M&N&'%M%NT
Objectives
1# To familiarise about cas0 management
$# To identif= t0e problems in cas0 management
138
Unit outline
Management of different components of working capital
Management of 0ash
Features of 8ffective 0ash Management
Motives for .olding 0ash
asic pro(lems in 0ash Management
1. 0ontrolling level of cash
2. 0ontrolling inflows of cash
!. 0ontrolling outflows of cash and
#. 7ptimum investment of surplus cash
-------------------------------------------------------------------------------
5#)#1 Management of different components of Bor8ing capital
--------------------------------------------------------------------------
$orking capital management of a firm involves its different components like3
1. Management of 0ash
2. Management of inventories
!. Management of receiva(les
#. Management of paya(les etc.)
-------------------------------------------------------------------------------
5#)#$ Management of "as0
--------------------------------------------------
0ash management is rapidly emerging as a vital area in any (usiness
organisation. It is one of the important components of current assets. Cash
"anagement implies making sure that all the (usiness generated revenues are
effectively controlled and utilised in the (est possi(le manner to result in gains for
the organisation.
139
!eatures o 3ective Cash "anagement
8ffective cash management involves the proper management of cash inflows
and outflows which includes3
Improving forecasts of cash flows
'ynchronising cash inflows and outflows.
Ksing floats.
-ccelerating collections.
2etting availa(le funds to where they are needed.
0ontrolling dis(ursements.
-------------------------------------------------------------------------------
5#)#) Motives for 4olding "as0
---------------------------------------------------------------------------
7ne distinguishing feature of cash as an asset) in any of the firm/s is that it does
not earn any su(stantial return for the (usiness. In spite of this fact the firm with
the following motives holds cash.
1. Transaction motive# - firm enters into a variety of (usiness transactions
resulting in (oth inflows and outflows. In order to meet the (usiness o(ligations
in such situations) it is necessary to maintain ade,uate cash (alance. Thus) the
firms keep cash (alance with the motive of meeting routine (usiness payments.
2. .recautionar= motive# - firm keeps cash (alance to meet une4pected cash
needs arising out of une4pected contingencies such as floods) strikes)
une4pected slow down in collection of receiva(les) increase in the prices of raw
materials etc. .igher the possi(ility of contingencies higher will (e the cash
kept (y the firm for meeting them.
!. Speculative motive# - firm keeps cash (alance to take advantage of
une4pected change in the prices of the securities in the stock market. This
motive is a speculative in nature) so that the firm can make profit out of this
cash investment in securities.
140
#. "ompensating motive# - firm keeps cash (alance to compensate (anks for
providing certain services and loans. anks provide a variety of services to
(usiness firms) such as clearance of che,ue) supply of credit information)
transfer of funds) and so on. $hile for some of these services (anks charge a
commission or fee) for others they seek indirect compensation this the (anks
will get from prescri(ing to maintaining minimum (alance from the customers
(ank account) which is not allowed to use of transaction purposes.
---------------------------------------------------------------------------
5#)#5 (asic problems in "as0 Management
------------------------------------------------------------------------------
There are four (asic pro(lems in cash management. They are
1. 0ontrolling level of cash
2. 0ontrolling inflows of cash
!. 0ontrolling outflows of cash and
#. 7ptimum investment of surplus cash
1# "ontrolling level of cas0
7ne of the (asic o(jectives of cash management is to minimise the level of cash
(alance with the firm. This o(jective can (e achieved (y the following ways.
a/ Preparing Cas1 -udget. +reparing cash (udget or cash forecast is the most
significant device for planning and controlling the use of cash. In cash (udget
involves the projection of future receipts and payments of the firm over various
intervals of time. It reveals the amount of e4pected cash inflows and outflows
over a period of time to the finance manager. $ith this the finance manager
will determine the cash needs of the firm) plan for the financing of these needs
and e4ercise control over the cash and li,uidity of the firm.
#/ Providing for unpredicta#le discrepancies. 0ash (udget will help to predict the
cash receipts and dis(ursement over a period of time and (y this it predicts the
discrepancies (etween cash inflows and cash outflows in the normal (usiness
141
activities. y this it is possi(le to predict what will (e the cash re,uirements
during uncertainties like strikes) short term recession) floods etc.)
c/ Consideration of s1ort costs. 'hort cost refers to the cost incurred as a result
of shortage of cash. They are meeting the claims of creditors at the time of
default in making payment) (orrowing at high interest charges.
d/ $vaila#ility of ot1er sources of funds. - firm can avoid holding unnecessary
large (alance of cash for contingencies in case it has to pay a slightly higher
rate of interest than that on a long-term de(t.
2. "ontrolling infloBs of cas0. -fter preparing the cash (udget) the finance
manager should also ensure that there is not significant deviation (etween
projected cash inflows and cash outflows. The finance manager must devise
the techni,ues which are appropriate in prevention of fraudulent diversion of
cash receipts and to speedup the cash collection. The following are the
methods.
a/ Prompt payment #y t1e customers4 To accelerate the prompt payment the firm
must ensure prompt (illing) informing the customers a(out the date and
amount of payment) sending the (ills in self addressed envelop) giving cash
discounts etc.)
#/ +uick conversion of payment into cas14 If the amount is received in che,ue
from the customers it must (e presented for collection immediately.
c/ "ecentralised collections4 If the firm operates in a wide geographical area) the
firm should setup collection centres at various places to speedup its collection
of che,ues and immediately the firm make arrangements to present it for
payments.
d/ Lock #o9 system4 It is sytem or techni,ue of reducing mailing) processing and
collecting time. Knder this system the firm selects some collecting centres at
different places. The places are selected on the (asis of num(er of consumers
and the remittances to (e received from a particular place. The firm hires a
142
post (o4 in a post office and the parties are asked to send the che,ues on that
post (o4 mum(ler. - local (ank is authorised to operate the post (o4 and to
process these che,ues.
)# "ontrolling outfloBs of cas0
- 0ompany can keep cash (y effectively controlling dis(ursements. The
o(jective of controlling cash outflows is to slow down the payments as far as
possi(le. The following methods can (e used to delay dis(ursements3
a/ Paying on last date. The dis(ursements can (e delayed on making payments
on the last due date only. It can help in using the money for short periods
and the firm can make use of cash discount also.
#/ Payments t1roug1 drafts. - company can delay payment (y Kssing drafts to
the suppliers instead giving che,ues. $hen a che,ue is issued then the
company will have to keep a (alance in its account so that the che,ue is
paid whenever it comes. 7n the otherhand a draft is paya(le only on
presentation to the issuer. The receiver will give the draft to its (ank for
presenting it to the (uyer/s (ank. it takes num(er of days (efore it is
actually paid.
c/ Payroll funds. In case of payment of payroll funds the finance manager must
see that the fre,uency of payments are increased. 'econdly the payments
are to (e made through che,ue (y this the employees can not present
che,ues on the same day for clearance and the payment cannot (e made on
the same day) like this the payment can (e delayed.
d/ Tec1nique of ?Paying float?4 Through this techni,ue it is possi(le to ma4imise
the availa(ility of funds. The term /float/ means the amount tied up in
che,ues that have (een drawn (ut have not yet (een presented for
payment.
143
5# Investment of surplus cas0# Following are the two (asic pro(lems regarding
the investment of surplus cash3
5i* "etermination of surplus cash.
5ii* "etermination of the channels of investment.
:i; !etermination of surplus cas0. 'urplus cash refers to the e4cess cash
over the firm/s normal cash re,uirements. $hile determining the amount of
surplus cash) the finance manager should take into account the minimum
cash (alance to (e maintained in the firm to avoid risk of shortage of cash
for the day today needs. In this regard he has to consider two (asic factors
a* desired days of cash and (* average daily cash outflows. y multiplying
these two it is possi(le to determine safety level of cash.
:ii; "etermination of the channels of investment. -fter determining whether
these surplus finds are temporary surplus of cash or temporary the finance
manager has to invest them in the various instruments (ased on the
availa(ility of cash and its type. 'ome of these type of investments are3
Treasury ills
0ertificate of "eposits
?eady Forwards.
Inter corporate deposits
0all deposits
"eposits
Investment in marketa(le securities.
Money market mutual funds etc.
144
Unit 5 IN1%NTO6 M&N&'%M%NT
Objectives
1# To familiarise about t0e concept of Inventor=
$# To 8noB t0e benefits of 0olding inventories
)# To identif= t0e tools and tec0ni/ues of Inventor= Management
Unit outline
Management of inventories
enefits of holding inventories
Tools and techni,ues of Inventory Management
----------------------------------------------------------------
5#5#1# Management of inventories#
Inventories are very important constitutes of working capital management.
For the successful running of any company mainly depends on the availa(ility of
inventory in right ,uantity at right time) at reasona(le price. Inventory constitutes
?aw material) work-in-progress) finished goods) consuma(le stores and spare
parts. Inventory management refers to systematic control over purchasing)
storing and issuing of inventory with an intention of ma4imising the profits.
---------------------------------------------------------------------------
5#5#$ (enefits of 0olding inventories
---------------------------------------------------------------------------
145
The following are the specific (enefits of holding inventories.
1. If a company maintains ade,uate inventory) it avoids losses of sales and loss of
customers due to shortage of finished goods in the market.
2. If a company orders for ade,uate inventory in large ,uantity it can reduce
orderings cost like checking) approving) mailing the order etc.)
!. -dvantage of (argaining power) if company purchases in large ,uantity.
-------------------------------------------------------------------------------
5#5#) Tools and tec0ni/ues of Inventor= Management
--------------------------------------------------------------------------
8ffective Inventory Management re,uires an effective control system for
inventories. The following are the important tools and techni,ues of inventory
management.
1. "etermining of 'tock 6evels like Minimum level) Ma4. level) ?eorder level etc.)
2. 0lassification and 0odification of Inventories.
!. "etermining of 'afety 'tocks.
#. 'electing a proper system of 7rdering for Inventory.
&. "etermining 8conomic 7rder Guantity.
9. +erpetual Inventory 'ystem.
:. -lways etter 0ontrol -nalysis 5-0 -nalysis*
F. Cital 8ssential and "esira(le 5C8"* -nalysis.
D. Inventory Turnover ?atios.
1B. -ging 'chedule of Inventories.
11. +reparation of Inventory ?eports.
Unit - %"%I1&(*% M&N&'%M%NT
Objectives
1# To familiarise about t0e management of receivables
$# To ascertain t0e cost of maintaining receivables
146
)# To determine t0e factors affecting t0e siJe of receivables
Unit outline
Management of receiva(les
0osts of maintaining receiva(les
Factors affecting the si;e of receiva(les
-------------------------------------------------------------------------------
5#-#1# Management of receivables
--------------------------------------------------------------------------
=e4t to Inventories in the current assets of the (usiness firm accounts
receiva(le constitutes a major portion in the current assets. The account
receiva(les arise (ecause of credit sales. Knder this system) when a firm sells
goods or services on credit) the payments are postponed to future dates and
receiva(les are created.
?eceiva(les represent amounts owed to the firm as a result of sale of goods
or services in the ordinary course of (usiness. These are claims of the firm against
its customers and form part of its current assets. ?eceiva(les are also known as
accounts receiva(les) trade receiva(les) or (ook de(ts. The period of credit and
e4tent of receiva(les depends upon the credit policy of the firm.
?eceiva(le is a direct result of credit sale. 0redit sale is resorted to (y a firm
to push up its sales which ultimately result in increasing in profits earned. -t the
same time) selling goods on credit results in (locking of funds in accounts
receiva(le which results in demand for additional funds) increase in (ad de(ts)
maintaining and supervising the accounts of the customers. .ence it all calls for
good receiva(les management. ?eceiva(le management is a process of making
147
decisions relating to the investment of funds in this asset which will result in
ma4imi;ing the overall return on the investment of the firm.
--------------------------------------------------------------------------
5#-#$# "osts of maintaining receivables
---------------------------------------------------------------------------
The major categories of costs associated with the e4tension of credit and
accounts receiva(le are3
1. 0apital costs
2. -dministrative costs
!. 0ollection costs and
#. "efaulting costs.
-------------------------------------------------------------------------------
5#-#) Factors affecting t0e siJe of receivables
---------------------------------------------------------------------------
The si;e of account receiva(les is determined (y a num(er of factors. 'ome
of the important factors are as follows3
1. 6evels of sales
2. 0redit policies
!. Terms of trade like 0redit period and 0ash discount.
148
Unit <
3O,IN' "&.IT&* "ONTO* &N! (&N,IN' .O*I"6
Objective
1# To get insig0t into t0e various committees constituted and
t0eir recommendations Bit0 regard to t0e financing of
Bor8ing capital re/uirements of t0e companies#
149
Unit outline
$orking 0apital 0ontrol and anking +olicy
0ommittees and their findings and recommendations.
1. "ehejia 0ommittee ?eport) 1D9D.
2. Tandon 0ommittee ?eport) 1D:&.
!. 0hore 0ommittee ?eport) 1DFB.
#. Marathe 0ommittee ?eport) 1FF#.
&. 0hakravarty 0ommittee ?eport) 1DF&.
9. Nannan 0ommittee ?eport) 1DD:.
------------------------------------------------------------------------------
5#<#1# 3or8ing "apital "ontrol and (an8ing .olic=
--------------------------------------------------------
The availa(ility of (ank credit to industry has (een a su(ject-matter of regulation
and control in the recent years keeping in view the (asic o(jective of ensuring its
e,uita(le distri(ution to various sectors of the Indian economy. 'ince =ovem(er
1D9&) a Cre#it $uthorisation Scheme has (een in operation as part of the
?eserve ank of India/s credit policy. Knder this scheme all scheduled commercial
(anks are re,uired to o(tain prior authorisation of ?I (efore sanctioning any
fresh credit limits of ?s. 7ne crore or more to any single party or any limit that
would ena(le the party avail ?s one crore or more from the entire (anking system
150
on secured on unsecured (asis. This limit of ?s one crore was su(se,uently raised
to ?s five crores.
To regulate and control (ank finance) the ?I has (een issuing directives
and guidelines to the (anks from time to time on the recommendations of certain
specially constituted committees. The following are the committees and their
findings and recommendations.
:. "ehejia 0ommittee ?eport) 1D9D.
F. Tandon 0ommittee ?eport) 1D:&.
D. 0hore 0ommittee ?eport) 1DFB.
1B. Marathe 0ommittee ?eport) 1FF#.
11. 0hakravarty 0ommittee ?eport) 1DF&.
12. Nannan 0ommittee ?eport) 1DD:.
!%4%+I& "OMMITT%%
In order to determine 1the e4tent to which credit needs of industry) and
trade are likely to (e inflated and how such trends could (e checked1) the =ational
0redit 0ouncil constituted in 1D9F a committee under the chairmanship of 'hri.
C.T. "ehejia. The committee su(mitted its report in 'eptem(er 1D9D.
The committee was of the opinion that there was also a tendency to divert
short-term credit for long-term assets. -lthough committee was of the opinion
that it was difficult to evolve norms for lending to industrial concerns) the
committee recommended that the (anks should finance industry on the (asis of a
study of (orrower/s total operations rather than security (asis alone. The
0ommittee further recommended that the total credit re,uirements of the
(orrower should (e segregated into /.ard 0ore/ and 'hort-term/ component. The
/.ard 0ore/ component which should represent the minimum level of inventories
like raw material) finished product and stores which the industry was re,uired to
151
hold for maintaining a given level of production should (e put on a formal term
loan (asis and su(ject to repayment schedule. The committee was also of the
opinion that generally a customer should (e re,uired to confine his dealings to one
(ank only.
T&N!ON "OMMITT%%
?I set up a committee under the chairmanship of 'hri. +.6. Tandan in Tuly
1D:# to study the following3
1. To suggest guidelines for commercial (anks to follow up and supervise credit
from the point of view of ensuring proper end use of funds and keeping a watch
on the safety of advances.
2. To suggest the type of operational data and other information that may (e
o(tained (y (anks periodically from the (orrowers and (y the ?I fro the
leading (anks.
!. To suggest for prescri(ing inventory norms for the different industries like
pu(lic and private sectors.
#. To make recommendations regarding resources for financing the minimum
working capital re,uirements.
&. To suggest criteria regarding satisfactory capital structure and sound financial
(asis in relation to (orrowing.
9. To suggest whether the e4isting pattern of financing working capital
re,uirements (y cash credit Z overdraft re,uires to (e modified.
Findings of t0e committee. The committed identified the following major
weaknesses3
1. It is the (orrower who decides how much he would (orrow.
2. ank credit) instead of (eing taken as a supplementary to other source of
finance.
152
!. ank credit is e4tended on the amount of security availa(le and not according
to the level of operations of the (orrower.
#. There is a wrong notion that security (y itself ensures the safety of (ank funds
(ut actually it lies in efficient follow-up of the industrial operations of the
(orrower.
ecommendations3 The report was su(mitted on D
th
-ugust) 1D:& with the
following recommendations.
1. - proper financial discipline has to (e o(served (y the (orrower and he must
supply the relevant information should (e provided for proper appraisal of
credit plans.
2. The main function of a (anker as a lender is to supplement the (orrower/s
resources to carry an accepta(le level of current assets.
!. The (ank should know the end-use of (ank credit so that it is used only for
purposes for which it is made availa(le.
The recommendations of the committee regarding lending norms have (een
suggested under three alternatives. -ccording to the first method) the
(orrower will have to contri(ute a minimum of 2&E of the working gap from
long-term funds. Knder the second method the (orrower will have to provide a
minimum of 2&E of the total current assets from long-term funds3 this will
give a minimum current ratio of 1.!!31. In the third method) the (orrower/s
contri(ution from long-term funds will (e to the e4tent of the entire core
current assets and a minimum of 2&E of the (alance current assets.
"4O% "OMMITT%% %.OT
The ?I appointed another committee under the chairmanship of 'hri. N..
0hore in March) 1D:D to review the working of cash credit system in recent years
with particular reference to the gap (etween sanctioned limits and the e4tent of
their utilisation and also to suggest alternative types of credit facilities to ensure
financial discipline.
153
The following are the important recommendations of the committee.
1. The (anks should o(tain ,uarterly statements in the prescri(ed format
from all (orrowers having working capital credit limits of ?s &B lakhs and
a(ove.
2. The (anks should undertake a periodical review of limits of ?s 1B lakhs
and a(ove.
!. The (anks should not (ifurcate cash credit accounts into demand loan and
cash credit components.
#. If a (orrower does not su(mit the ,uarterly returns in time the (anks
may charge penal interest of one per cent on the total amount
outstanding for the period of default.
&. anks should discourage sanction of temporary limits (y charging
additional one percent interest over the normal rate on theses limits.
9. The (anks should fi4 separate credit limits for peak level and non-peak
level) wherever possi(le.
:. anks should take steps to convert cash credit limits into (ill limits for
financing sales.
M&&T4% "OMMITT%% %.OT
The ?I appointed another committee in March) 1D:D under the
chairmanship of Marathe to review the working of 0redit -uthorisation
'cheme and suggest measures for giving meaningful directions to the credit
management function of the ?I. The principle recommendations of the
committee are3
1. The committee has declared the Third Method of 6ending as suggested (y
the Tandon 0ommittee to (e dropped. .ence the (anks should provide
credit for working capital according to the 'econd Method of 6ending.
2. The committee has suggested the introduction of the /Fast Track 'cheme/
to improve the ,uality of credit appraisal in (anks. it recommended that
154
commercial (anks can release without prior approval of the ? &BE of
the additional credit re,uired (y the (orrowers against the following
re,uirements.
a* The estimates@projections in regard to production) sales) chargea(le
current assets) other current assets) current lia(ilities other than (ank
(orrowings) and net working capital are reasona(le in terms of the past
trends and assumptions regarding most likely trends during the future
projected period.
(* The classification of assets and lia(ilities as /current/ and /non-current/ is
in conformity with the guidelines issued (y the ?I.
c* The projected current ratio is not (elow 1.!!31.
d* The (orrower has (een su(mitting ,uarterly information and operating
statements 5Form I)II) and III* for the past si4 months within the
prescri(ed time and undertakes to do the same in future also.
e* The (orrower undertakes to su(mit to the (ank his annual account
regularly and promptly.
"4&,&1&T6 "OMMITT%% %.OT
The ?I appointed another committee under the chairmanship of 'ukhamoy
0hakravarty to review the working of the monetary system of India and it
su(mitted its report in -pril) 1DF&. The following are the two major
recommendations of the committee with regard to working capital finance.
1. The committee has suggested that the government must insist that all
pu(lic sector units) large private sector units and government
departments must include penal interest payment clause in their
contracts for payments delayed (eyond a specified period of 2E higher
than minimum lending rate of the supplier/s (ank.
155
2. The committee further suggested that the total credit limit to (e
sanctioned to a (orrower should (e considered under three different
heads.
a* For 0ash credit portion is ma4imum prevailing lending rate of the
(ank.
(* For ill Finance portion 2E (elow the (asic lending rate of the (ank.
c* For 6oan +ortion the rate may vary (etween the minimum and
ma4imum lending rate of the (ank.
,&NN&N "OMMITT%% %.OT
In view of the ongoing li(eralisation in the financial sector) the I-
constituted a committee headed (y 'hri N. Nannan) to e4amine all the aspects of
working capital finance including assessment of ma4imum permissi(le (ank
finance and this committee su(mitted its report in Fe(ruary) 1DD:. The
recommendations of this committee are3
1. The arithmetical rigidities imposed (y Tandon 0ommittee in the form of
ma4imum permissi(le (ank finance 5M+F* computation in practice till now
should (e scrapped.
2. It suggests that freedom to each (ank (e given in regard to evolving its own
system of working capital finance for a faster credit delivery so as to serve
various (orrowers more effectively.
!. It suggests that line of credit system) as prevalent in many advanced
countries) should replace the e4isting system of assessment@fi4ation of su(-
limits within total working capital re,uirements.
#. The committee proposed to shift emphasis from the li,uidity level lending to
the cash deficit lending called "esira(le ank Finance.
156
Unit ?
.O(*%MS ON %STIM&TIN' 3O,IN' "&.IT&* 9
"&S4 (U!'%T
Objective
1# To 8noB t0e practical determination of Bor8ing capital and
its estimation
"0apter outline
+ro(lems on estimating working 0apital
+ro(lems on cash (udget
157
.roblems on estimating Bor8ing "apital
1. - +roforma cost sheet of a company provides the following particulars3
lements of cost $mount per unit
Materials #BE
"irect la(our 2BE
7verheads 2BE
The following further particulars are availa(le3
a* It is proposed to maintain a level of activity of 2)BB)BBB units.
(* ?aw materials are e4pected to remain in stores for an average period of one
month.
c* Materials will (e in process) on average of half a month.
d* 'elling price per unit ?s. 12.
e* Finished foods are re,uired to (e in stock for an average of one month.
f* 0redit allowed to de(tors is 2 months.
g* 0redit allowed (y suppliers is one month.
Lou may assume that sales and production follow a consistent pattern.
158
Solution)
Statement s0oBing t0e details of calculation of net Bor8ing capital
0urrent -ssets
?aw Materials5one month*3
52)BB)BBA12A#B@1BBA1@12*

$ork in +rogress351@2month*3
?aw Materials
52BBBBBA12A#B@1BBAB.&@12*
6a(our
52BBBBBA12A2B@1BBAB.&@12*
7verheads
52BBBBBA12A2B@1BBAB.&@12*
Finished goods 57ne Month*3
?aw Materials
52BBBBBA12A#B@1BBA1@12*
6a(our
52BBBBBA12A2B@1BBA1@12*
7verheads
"e(tors 52months*
?aw Materials
6a(our
7verheads
Total 0urrent -ssets5-*
0urrent 6ia(ilities3
?aw Materials
Total 0urrent 6ia(ilities5*
=8T $7?NI=2 0-+IT-65--*
FBBBB
#BBBB
2BBBB
2BBBB
FBBBB
#BBBB
#BBBB
19BBBB
FBBBB
FBBBB
9#BBBB
FBBBB
FBBBB
&9BBBB
159
2. - +roforma cost sheet of a company provides the following particulars3
8lements of cost3 -mount +er Knit
Materials &BE
"irect 6a(our 1&E
7verheads 1&E
The following further particulars are availa(le>
5a* It is proposed to maintain a level of activity of !BBBBKnits.
5(* 'elling +rice<?s2B +.K
[ ?aw materials are e4pected to (e in the stores for an average of 2 months.
5d* Materials will (e in process) on average of one month.
5e* Finished goods are re,uired to (e in stock for an average of 2 months.
5f* 0redit allowed to de(tors is 2 months.
5g* 0redit allowed to creditors is 2 months.
Lou may assume that sales and production follow a consistent pattern.
Solution)
'tatement showing the details calculation of net working capital
160
0urrent -ssets3
?aw materials52months*
5!BBBBBA2BA&B@1BBA2@12*
$ork- in- progress
?aw materials
"irect 6a(our
5!BBBBBA2BA1&@1BBA1@12*
7verheads
Finished goods52 months*
?aw materials
"irect 6a(our
7verheads
"e(tors52 months*
?aw materials
"irect 6a(our
7verheads
Total 0urrent -ssets5-*
0urrent 6ia(ilities>
?aw materials
Total 0urrent 6ia(ilities5*
=et $ording 0apital5--*
&BBBBB
2&BBBB
:&BBB
:&BBB
&BBBBB
1&BBBB
1&BBBB
&BBBBB
1&BBBB
1&BBBB
2&BBBBB
&BBBBB
&BBBBB
2BBBBBB
161
!. A and 0. is desirous to purchase a (usiness and has consulted you and one
point on which you are asked to advice them is the average amount of working
capital which will (e re,uired in the first yearHs working.
Lou are given the following estimates and are instructed to add 1BE to your
computed figure to allow for contingencies3
51* -mount (locked up in stocks3 ?s.
'tock of finished goods &BBB
'tock of 'tores materials FBBB
162
52* -verage 0redit 'ales3
Inland sales-9 weeks credit !)12)BBB
84port sales-one and half months :F)BBB
5!* 6ag in payment of wages and other
outgoing>
$ages-one and half weeks 2)9B)BBB
'tock of materials-7ne and half weeks #F)BBB
?ent) ?oyalties-9 months 1B)BBB
0lerical 'taff 92)#BB
Manager-half month #FBB
Miscellaneous e4penses-7ne and half month #F)BBB
5#* +ayment in -dvances>
'undry e4penses5paid Guarterly in advance* FBBB
5&* Kn drawn profit on the average throughout the year ?s 11)BBB
163
Solution)
'tatement shows the details of calculating of net wording capital.

0urrent -ssets
'tock of finished goods
'tock of stores) materials
'undry de(tors>-
Inland5!12BBBA9@&2* !9BBB
84port5:FBBBA1.&@&2* 22&B
+ayment in advance>-
'undry e4penses5FBBBA!@12*
Total 0urrent -ssets
0urrent 6ia(ilities
6ag in payment of wages
529BBBBA1.&@&2*
6ag in payment to materials
5#FBBBA1.&@12*
?ent and royalties
51BBBBA 9@12*
0lerical staff
592#BBAB.&@12*
ManagerHs salary
5#FBBAB.&@12*
Miscellaneous e4penses
5#FBBBA1.&@12*
Total current lia(ilities
2ross working capital5--*
-dd> 1BE contingencies
=et $orking capital
?s
&BBB
FBBB
!F2&B
2BBB
&!2&B
:&BB
9BBB
&BBB
29BB
2BB
9BBB
2:!BB
2&D&B
2&D&
2F&#&
164
#. - proforma cost sheet of a company provides the following particulars>
8lements of cost3 -mount per Knit
Materials &BE
"irect 6a(our 1BE
7verheads 1BE
The following further particulars are availa(le
5a* It is proposed to maintain a level of activity of 1BBBBKnits.
5(* 'elling price<?s.1B p.u.
[ ?aw materials are e4pected to (e in the stores for an average of 2 months.
5d*Materials will (e in process) on average of one month.
5e* Finished goods are re,uired to (e in a stock for an average of 2months.
5f* 0redit allowed to de(tors is !months.
165
5g* 0redit allowed to suppliers is 2months.
'olution3
'T-T8M8=T '.7$I=2 T.8 "8T-I6' 0-60K6-TI7= 7F =8T $7?NI=2 0-+IT-6
166
0urrent -ssets
?aw materials 5one month*
51BBBBBA1BA&B@1BBA2@12*
$ork-in-+rogress5one month*
?aw materials
6a(our
51BBBBBA1BA1B@1BBA1@12*
7verheads
Finished 2oods52months*
?aw materials
6a(our
7verheads
"e(tors5!months*
?aw materials
51BBBBBA1BA&B@1BBA!@12*
6a(our
51BBBBBA1BA1B@1BBA!@12*
7verheads
51BBBBBA1BA1B@1BBA!@12*
0urrent 6ia(ilities3
?aw materials
Total current lia(ilities
=et working capital
F!!!!
#199:
F!!!
F!!!
F!!!!
1999:
1999:
12&BBB
2&BBB
2&BBB
#!!!!!
F!!!!
F!!!!
!&BBBB
&. - proforma cost sheet of a company provides the following particulars>
8lements of c -mount per unit 5?s*
167
Materials FB
"irect la(ours !B
7verheads 9B
Total cost 1:B
5O* profit !B
'elling +rice 2BB
The following further particulars are availa(le>
5a* ?aw materials are in stock on an average for one month
5(* ?aw materials are in process on an average for half a month.
50* Finished goods are in a stock on an average for one month.
5d* 0redit allowed (y suppliers is one month.
5e* 6ag in payment of wages is one and half weeks.
5f* 6ag in payment of overheads is one month
5g* 1@# output is sold against cash.
5h* 0ash in hand and at (ank is e4pected to (e ?s. 2&BBB
5i* 0redit allowed to customers is 2months.
Lou are re,uired to prepare a statement showing the working capital needed
to finance level of activity of 1B#BBBKnits of production.
Lou may assume that production is carried on evenly throughout the year)
wages and overheads accrued similarly and a time period of # weeks is e,uivalent
to a month.
'T-T8M8=T '.7$I=2 T.8 "8T-I6' 0-60K6-TI7=' 7F T.8 =8T $7?NI=2
0-+IT-6
168
0urrent -ssets>
?aw materials
51B#BBBAFBA#@&2*
$ork-in-progress
?aw materials
51B#BBBAFBA2@&2*
6a(our
51B#BBBA!BA2@&2*
7verheads
51B#BBBA9BA2@&2*
Finished goods>
?aw materials
51B#BBBAFBA#@&2*
6a(our
51B#BBBA!BA#@&2*
7verheads
51B#BBBA9BA#@&2*
"e(tors>
?aw materials
51B#BBBAFBAF@&2A!@#*
6a(our
51B#BBBA!BAF@&2A!@#*
7verheads
51B#BBBA9BAF@&2A!@#*
0ash in hand
0urrent 6ia(ilities
0reditors-?awmaterials
51B#BBBAFBA#@&2*
$ages 7@'
51B#BBBA!BA1.&@&2*
6ag in payment of wages
51B#BBBA9BA#@&2*
Total 0urrent lia(ilities
=et working capital5--*
9#BBBB
!2BBBB
12BBBB
2#BBBB
9#BBBB
2#BBBB
#FBBBB
D9BBBB
!9BBBB
:2BBBB
2&BBB
#:#&BBB
9#BBBB
DBBBB
#FBBBB
121BBBB
!&!&BBB

169
.roblem on "as0 (udget
The following information is availa(le in respect of ALM 0ompany ltd.3
1. Materials are purchased and received one month (efore (eing used and
payment is made to supplFers two months after receipt of materials.
2. 0ash is received from customers three months after finished goods are sold
and delivered to them.
!. =o time lag applies to payments of wages and e4penses.
#. The following figures apply to recent and future months3
Month Materials
received
'ales $ages and
e4penses
Tanuary
Fe(ruary
March
-pril
May
Tune
Tuly
-ugust
2B)BBB
22)BBB
2#)BBB
29)BBB
2F)BBB
!B)BBB
!2)BBB
!#)BBB
!B)BBB
!!)BBB
!9)BBB
!D)BBB
#2)BBB
#&)BBB
#F)BBB
&1)BBB
D)&BB
1B)BBB
1B)&BB
11)BBB
11)&BB
12)BBB
12)&BB
1!)BBB
&. 0ash (alance at the (eginning of -pril is ?s. 1B)BBB.
9. -ll products are sold immediately they have (een made and that materials
used and sums spent on wages and e4penses during any particular month
relate strictly to the sales made during that month.
,olution.
0ash udget from -pril to Tuly
+articulars -pril May Tune Tuly
170
7pening alance
0ollections from de(tors

&
+ayments
$ages and e4penses
+ayments to suppliers
(
0losing (alance 5- - *
1B)BBB
!B)BBB
------------
#B)BBB
------------
11)BBB
22)BBB
------------
!!)BBB
------------
:)BBB
:)BBB
!!)BBB
----------
#B)BBB
----------
11)&BB
2#)BBB
----------
!&)&BB
----------
#)&BB
#)&BB
!9)BBB
---------
#B)&BB
---------
12)BBB
29)BBB
---------
!F)BBB
---------
2)&BB
2)&BB
!D)BBB
--------
#1)&BB
--------
12)&BB
2F)BBB
---------
#B)&BB
---------
1)&BB
171

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