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Chapter : Introduction

Q ue st io n : W ha t do y o u mea n by f i na ncia l ma na g e me nt ?
An sw er : M ea ni ng o f F ina nc ia l M a na g e me nt :
Financial management deals with procurement of funds and their effective utilisation in the business..
T he p r i mar y t as k o f a C h ar te r ed Acco u nt a nt i s to d ea l wi t h fu nd s, 'Ma n a ge me n t o f F u nd s ' i s
an i mp o rt a nt a sp ect o f f i na nc ia l ma na g e me n t i n a b u si n es s u nd er ta k i n g o r a n y o t her i n s tit u ti o n l i ke
ho sp i ta l, art so c iet y, a n d so o n. T h e ter m 'F i n an cia l Ma n a ge me n t ' ha s b een d e fi ned d i ffere n tl y b y
d i f fere n t a u t ho fr s.
Ac co rd i n g to So lo mo n " Fi n a nc ial M a na g e me n t is co n cer n ed wi t h t he e ffici e nt u se o f a n
i mp o rt a nt e co no mic r e so ur c e, n a me l y cap it al fu nd s." P hi ll ip p a t us ha s gi v e n a mo re e la b o rate
d ef i ni tio n o f t h e ter m, as , " Fi n a nci al Ma n a ge me n t, i s co n cer ned wi t h t he ma n a ge ria l d e ci s io n s t hat
r es u lt s i n t he acq ui s it i o n a nd fi na n ci n g o f s ho rt a nd lo n g ter m cr ed i t s fo r t he fir m." T h u s, i t d eal s
wi t h t h e si t ua tio n s t ha t r eq u ir e s el ect io n o f sp e ci fi c p ro b le m o f si ze a n d gro wt h o f a n e n terp r i s e. T he
an al ys i s o f t he se d e ci sio n s i s b a sed o n t he e xp e c ted i n flo ws a nd o u t flo ws o f fu nd s a nd t he ir e ffe ct o n
ma n a ger ia l o b j ect i ve s.
Th e mo st a ccep tab le d e f i ni tio n o f fi na nc ia l ma na g e me n t i s t h at gi v e n b y S. C.K u c h ha l
as, " Fi n a nci al ma n a ge m en t d eal s w i t h p ro c ur e me n t o f fu nd s a nd t he i r effe ct i ve ut il is at io n i n t he
b u si n es s." T h u s, t her e a r e 2 b a si c a sp e ct s o f fi n an cia l ma n a ge me n t :
1 ) Pro c ure me nt o f f un d s :
As fu nd s ca n b e o b tai n ed fr o m d i f fere nt so urc es t h u s, t he ir p ro c ure me nt i s a l wa ys c o n si d ered
as a co mp l e x p r o b l e m b y b u si n es s co n cer n s. Th es e fu nd s p ro c ured fro m d i ffer e nt so urc e s ha ve
d i f fere n t c h arac ter is ti cs in ter ms o f r i s k, co s t a nd co n tro l t hat a m an a ger mu s t co n sid er wh i le
p r o cu ri n g fu nd s. T he f u nd s s ho uld b e p ro c ur e d at mi n i mu m co st, at a b al a nced ri s k a nd co nt ro l
fa cto r s.
F u nd s ra is ed b y is s u e o f eq u it y s ha re s a re t he b e st fro m ri s k p o in t o f v ie w fo r t he co m p an y,
as it h as no rep a y me n t l iab i li t y e x cep t o n wi n d i n g up o f t he co mp a n y, b ut fro m co s t p o i n t o f v i e w, it
is mo s t e xp e ns i ve, a s d i vid e nd e xp ect at io n s o f s har e ho ld er s are h i g her th a n p re v ai li n g i nt ere st rate s
and d i v id e nd s are ap p r o p r iat io n o f p r o f it s a nd n o t allo wed a s e xp e n se u nd er t he i nco me ta x ac t. The
is s ue o f ne w eq u it y s har es ma y d i l ut e t h e co n tro l o f t h e e x is ti n g s h are ho ld er s.
Deb e nt ur es ar e co mp ar a ti v el y c heap er s in ce t he i n ter es t i s p a id o ut o f p ro fi ts b e fo r e ta x . B ut,
th e y e n tai l a hi g h d e gr e e o f r is k s i nce t he y ha v e to b e rep a id a s p er t he ter ms o f a gre e me n t; a ls o , t he
in ter es t p a y me n t ha s to b e mad e wh e t her o r no t th e co mp a n y ma k e s p ro fit s.
F u nd s c a n a l so b e p r o c ur ed fr o m b a n k s and fi n a nci al i n st it u tio n s, t he y p ro vid e fu nd s s u b j ect
to ce rta i n r es tri ct i ve co ve n a nt s. T he se co ve na n t s re s tri ct freed o m o f t he b o rro wer to rai s e lo a ns fro m
o th er so ur ce s. T he r e fo r m p r o ce s s i s al so mo vi n g i n d ire ct io n o f a c lo s er mo n ito r i n g o f 'e nd u se ' o f
r eso ur ce s mo b il ized t hr o u g h cap ita l ma r ke ts . S uc h re str ic tio n s are e ss en ti al fo r t he sa fet y o f fu nd s
p r o v id ed b y i n s ti t ut io ns and i n ve sto r s. T h ere ar e o th er fi na nc ia l i n str u me n t s u sed fo r rai s i n g fin a nce
e.g . co m me rci al p ap er , d eep d i sco u n t b o nd s, et c. T he fi n a nce ma n a ger ha s to b ala n ce t h e a va il ab il it y
o f f u nd s a nd t h e r e st r ic t iv e p r o v is io n s t ied wi t h s uc h fu nd s r es u lt i n g i n l ac k o f fle xib il it y.
I n t he g lo b a li sed co mp et it i ve sc e nari o , it is no t e no u g h to d ep e nd o n a va il ab le wa ys o f
f i na nc e b ut re so ur ce mo b ili za tio n i s to b e u nd er ta ke n t hro u g h i n no vat i v e wa ys o r fi n a nci al p ro d uc t s
th at ma y mee t t he n ee d s o f i n ve s to r s. M u lt i p le o p tio n co n ver t ib le b o nd s c a n b e si g h ted as a n
ex a mp l e, fu nd s ca n b e r ai sed i nd i g e no us l y a s al so fro m ab ro ad . Fo r ei g n D irec t I n v es t me n t ( F DI ) a nd
Fo r e i g n I n st it u tio na l I n ve s to r s ( FI I ) ar e t wo maj o r so ur ce s o f fi na nc e fro m ab ro ad alo n g wi t h
A mer ica n Dep o s ito r y R eceip t s ( A D R 's) a nd G l o b al Dep o si to r y R ece ip t s ( GD R 's) . T h e me c ha n i s m o f
p r o cu ri n g fu nd s i s to b e mo d i fi ed i n t h e li g h t o f req u ire me n t s o f fo re i g n i n v es to r s. P ro c ure me nt o f
f u nd s i nter al ia i nc l ud e s :
- I d e nt i fi cat io n o f so ur c es o f fi na n ce
- De ter mi n at io n o f f i na n c e mi x
- R ai si n g o f fu nd s
- Di v i sio n o f p ro fi ts b et we e n d i vid e nd s a nd r ete nt io n o f p ro fi ts i.e . i n ter na l fu nd g e nera tio n.
2 ) Eff ect iv e u se o f s uc h f u nd s :
Th e fi na nc e ma n a ger i s al so r esp o n s ib l e fo r e ffe ct i ve u ti li sa tio n o f fu nd s . He mu s t p o i n t o ut
si t ua tio n s wh ere f u nd s ar e kep t id l e o r ar e us e d i mp ro p e rl y. A ll fu n d s are p ro c ured at a cer ta in co st

Financial Management`

and a ft er e nt ai li n g a ce r tai n a mo u nt o f r i s k. I f th e fu nd s are no t ut il is ed i n t h e ma n ner so t ha t t he y


ge n era te a n i n co me h i g h er t h a n co st o f p r o c u re m en t , t here i s no mea n i n g i n r u n n i n g t h e b u si n es s. It is
an i mp o rt a nt co n sid er at i o n i n d i v id e nd d ec i sio n s also , t h us, it i s cr uc ia l to e mp lo y fu nd s p ro p erl y a nd
p r o f itab l y. T he f u nd s a r e to b e e mp lo yed i n t he ma n n er so t ha t t he co mp a n y ca n p ro d uce a t it s
o p ti mu m l e vel wi t ho u t e nd a n ge r i n g it s fi n a n cia l so l v e nc y. T h u s, fi na n cia l i mp lic at io ns o f eac h
d eci sio n to i n v e st i n fi xed a s se ts ar e to b e p ro p erl y a na l ys ed . Fo r t hi s, t h e fi na n ce ma na g e r mu st
p o s se ss so u nd k no wl ed ge o f tec h n iq ue s o f ca p ita l b ud ge ti n g a nd mu s t keep i n v ie w t he n e ed o f
ad eq uat e wo r ki n g cap i ta l a nd e ns ur e t h at wh i le fir ms e nj o y a n o p ti mu m le ve l o f wo r ki n g cap it a l t h e y
d o no t keep to o mu c h f u nd s b lo c ked i n i n v e nto r i es, b o o k d eb t s, ca s h, etc .
F i xed as s et s a r e to f i na n ced fr o m med i u m o r lo n g ter m fu n d s, a nd no t s ho rt ter m fu nd s, as fi xed
as se ts ca n no t b e so ld i n s ho r t t er m i.e. wi t hi n a year, al so a l ar ge a mo u nt o f fu nd s wo uld b e b l o ck ed
in s to c k i n ha nd a s t h e c o mp a n y ca n no t i m med ia tel y s el l i ts fi n is h ed go o d s.
Q ue st io n : E xp la i n t he sco p e o f f i na n cia l ma n a g e me nt ?
An sw er : S co p e o f f ina nci a l ma na g e me nt :
A so u nd f i na n c ial ma na g e me n t is e s se nt ia l i n a ll t yp e o f fi na nc ia l o r ga n i sat io n s - wh et her
p r o f it o r ie nt ed o r no t, wher e f u nd s ar e i n vo l ved and a l so i n a c e ntr al l y p la n ned e co no m y a s al so in a
cap i tal i st s et - up . Fir ms , a s p er t h e co m mer cia l hi s to r y, h a ve no t l iq uid ated b ec a us e t hei r tec h n o lo g y
wa s o b so let e o r t heir p r o d uc t s h ad no o r lo w d e ma nd o r d u e to a n y o t her fa cto r , b u t d u e to l ac k o f
f i na nc ia l ma n a ge me n t. Ev e n i n b o o m p er io d , whe n a co mp a n y ma k e s h ig h p ro fi t s, t here i s d a n ger o f
liq uid at io n, d ue to b ad f i na nc ia l ma na g e me n t. Th e ma i n ca u se o f liq u id at io n o f s uc h co mp a n ie s i s
o ver - trad i n g o r o v er -e xp and i n g wit h o ut a n ad eq u ate fi na n cia l b a se .
Fi n a nc ial ma na g e me nt o p ti mi s e s t h e o ut p ut fro m t h e gi ve n i np u t o f fu nd s a nd at te mp t s to u s e
th e fu nd s i n a mo s t p r o d uc ti v e ma n n er . I n a co u n tr y li ke I nd i a, wh ere re so ur ce s ar e scar c e a nd
d e ma nd o n fu nd s ar e ma n y, t he ne ed fo r p r o p er fi na nc ia l ma na g e me n t i s e no r mo u s. I f p ro p er
tec h n iq ue s a re u sed mo s t o f t he e nt er p r i se s ca n red u ce t he ir cap i ta l e mp lo yed a nd i mp ro ve r et ur n o n
in v e st me n t. T h us , a s me n a n d mac h i ne ar e p ro p e rl y ma n a ged , fi na nc e s ar e al so to b e we ll ma na g e d .
I n n e wl y sta r ted c o mp a n ie s, it i s i mp o r ta nt to ha v e so u nd fi n a nc ial ma na g e me n t, a s i t e n s ure s
th eir s ur v i val , o fte n s uc h co mp a ni es i g no re s fi n an cia l ma n a ge me n t a t t h eir o wn p eri l. E ve n a s i mp le
act, li ke d ep o s it i n g t h e ch eq ue s o n t he d a y o f t he ir re ceip t i s no t p e r fo r med . S u c h o r ga ni sa tio n s p a y
he a v y i n te re s t c har g es o n b o r r o wed f u nd s, b u t a re tard y i n re al is i n g t h e ir o wn d eb to r s. T h is i s d ue to
th e fac t t he y lac k r e al is atio n o f t h e co ncep t o f ti me v al ue o f mo ne y, it is no t ap p r eci at ed t ha t eac h
va l ue o f r u p ee h as to b e mad e u se o f a nd t hat it ha s a d ir ect co st o f u til i sa tio n. I t mu s t b e re ali sed
th at ke ep i n g r up e e id l e ev e n fo r a d a y, r e s ul ts i nto lo s s es . A no n - p ro fi t o rga n is at io n ma y no t b e ke e n
to ma ke p ro fi t, tr ad it io n all y, b u t it d o e s n eed to cut d o wn it s co s t a nd u se t he fu nd s at i t s d isp o sa l to
th eir o p t i mu m cap aci t y . A so u nd se n se o f fi n an cia l ma na g e me n t ha s to b e c ul ti va ted a mo n g o u r
b ur e a ucra t s, ad mi n i str at o r s, e n gi n eer s, ed uc at io ni s t s and p ub lic a t lar g e . Un le s s t hi s i s d o ne, co lo s sa l
wa s ta g e o f t he c ap i ta l r e so ur c es ca n no t b e arre st ed .
Q ue st io n : W ha t a re t h e o bj ect iv e s o f f ina nc ia l ma na g e me nt ?
An sw er : O bj ect iv e s o f f ina nc ia l ma na g e me nt :
E ffic ie n t f i na nc ia l ma na g e me n t req u ire s e xi s te nce o f so me o b j ecti ve s o r go al s b e ca us e
j ud g me nt as to wh e t he r o r no t a fi na n ci al d e ci sio n i s e f fic ie n t i s t o b e mad e i n li g h t o f so me
o b j ecti ve . T he t wo ma i n o b j ecti v es o f fi n a nc ial ma n a ge me n t are :
1 ) Pro fit M a xi mi sa t io n :
I t is trad it io nal l y b ei n g ar g u ed , t ha t t he o b j ec ti ve o f a co mp a n y is to e arn p ro fit, he n ce t h e o b j ect i ve
o f f i na nc ia l ma n a ge m e n t i s p r o f it ma x i mi s at io n . T h us, ea c h a lter n at i ve , i s to b e see n b y t he fi na n ce
ma n a ger fro m t he v ie w p o i nt o f p r o f it ma x i m is at io n. B ut , i t ca n no t b e t h e o n l y o b j ec ti ve o f a
co mp a n y, it i s a t b e st a li mi ted o b j ect i ve el se a n u mb e r o f p ro b le ms wo uld ar is e. So me o f t he m are :
a ) Th e ter m p r o fi t i s v ag u e a nd d o e s no t c lari f y wh a t e x act l y i t mea n s. It co n v e ys d i ffer e nt me an i n g
to d i ffere n t p eo p le.
b)
P ro fi t ma xi mi s at io n ha s to b e att e mp t ed wi t h a re al is at io n o f ri s k s i n vo l ved . Th ere i s d irec t
r ela tio n b et we e n r is k a n d p r o fi t; h i g her t h e r is k , hi g he r i s t he p ro fit. F o r ma xi mi si n g p ro fi t, ri s k is
alto g et he r i g no r ed , i mp l yi n g t ha t f i na nc e ma n a ger ac cep ts hi g h l y r is k y p ro p o s al s a l so . P ra ct i cal l y,
r is k i s a v er y i mp o r t a nt fa cto r to b e b al a nced wi th p ro fi t o b j ec ti ve .
c) P ro fi t ma x i mi s at io n is a n o b j ec ti ve no t ta k i n g i nto acco u n t t h e t i me p att er n o f r et ur n s.
E.g . P ro p o sa l X g i ve s r e tu r ns h i g her t ha n t h at b y p ro p o sa l Y b u t, t h e ti me p erio d i s s a y, 1 0 yea rs a n d
7 ye ar s re sp e ct i vel y. T h u s, t he o ver al l p r o fit is o nl y co n sid ered no t t h e ti me p er io d , no r t he fl o w o f
p r o f it.
d) P ro fit ma x i mi s at io n a s a n o b j ect i ve i s t o o na rro w, it fai l s to ta ke i nto acco u n t t h e so c ial
co n s id era tio n s a nd o b l i ga tio n s to var io us i n ter es ts o f wo r k ers , co n s u m ers, so cie t y, a s we ll as et hi ca l

CA- IPCC- Financial Management`

tr ad e p rac ti ce s. I g no r i n g t he se f ac to r s, a co mp a n y ca n no t s ur vi ve fo r lo n g. P ro fit ma x i mi sa tio n at t he


co s t o f so c ial a nd mo r al o b li ga tio n s i s a s ho r t si g ht ed p o l ic y.
2 ) Wea lt h ma x i mi sa t io n :
T h e co mp a n ie s ha v i n g p r o fi t ma x i mi sa tio n a s it s o b j ect i ve, ma y ad o p t p o lic ie s yi eld i n g
exo r b it a nt p ro fi ts i n t he s ho r t r u n wh i c h ar e u n he al t h y fo r t he gro wt h , s ur vi v al a nd o ve ral l i nt ere st s
o f t he b u si ne s s. A co m p an y ma y n o t u nd er ta ke p la n n ed a nd p re scr ib ed s h u t -d o wn s o f t he p la n t fo r
ma i nt e na nc e, a nd so o n fo r ma x i mi s i n g p r o fi ts i n t h e s ho r t ru n . T h us , t he o b j ec ti v e o f a fir m s ho u ld
b e to ma x i mi s e it s va l ue o r we al t h.
A cco rd i n g to Va n Ho r ne, " Va l ue o f a fir m i s rep re se n ted b y t he ma r ket p r ice o f t h e
co mp a n y's co m mo n sto c k.. ..... t he mar k e t p ri ce o f a fir m 's sto c k rep re s en t s t he fo ca l j ud g me n t o f al l
ma r ket p a rti cip a nt s a s t o wh at t h e v al ue o f t h e p arti c ul ar fir m i s. I t ta k es i n to acco u n t p re se n t as a lso
p r o sp e cti v e fu t ure ear ni n g s p er s h ar e, t he t i mi n g a nd ri s k o f t he s e ea r ni n g, t he d i vid e nd p o l ic y o f t he
f ir m a nd ma n y o t h er fac to r s ha v i n g a b ea r i n g o n th e mar ke t p ric e o f s to c k. T he ma r ke t p ric e se r v es a s
a p er fo r ma n ce i nd e x o r r ep o r t car d o f t h e fir m's p ro gr e ss . It i nd ica te s h o w we l l ma n a ge me n t i s d o i n g
o n b e hal f o f sto c k ho ld er s." S h ar e p r ice s i n t he s har e ma r ket , a t a g i ve n p o i nt o f ti me, are t he r e s ul t o f
a mi x t ure o f ma n y fac t o r s, a s g e ner a l e co no mi c o u tlo o k , p ar tic u lar o u tlo o k o f t he co mp a ni es u nd er
co n s id era tio n, tec h n ica l fac to r s a nd e ve n ma ss p s yc ho lo g y, b ut , ta ke n o n a lo n g ter m b a s i s, the y
r ef le ct t he v al ue , wh i c h var io u s p ar ti es, p ut o n t he co mp a n y.
No r ma ll y t hi s va l ue i s a f u n ct io n, o f :
- t he li k el y r ate o f e ar ni n g s p er s h ar e o f t he co m p an y; a nd
- t he cap i ta li sa tio n r at e.
T h e li k el y r a te o f ear n i n g s p er s h are (E P S) d ep e nd s up o n t h e as se s s me n t as to t he p ro fi tab l y
a co mp a n y i s go i n g to o p er at e i n t he f ut u re o r wh at i t i s li k el y to ea r n a ga i n st ea c h o f it s o r d in ar y
s har es.
T he cap it al is at i o n r a te r e f lec t s t he li k i n g o f t h e i n ve sto r s o f a c o mp a n y. I f a co mp a n y e arn s a
hi g h r at e o f ear n i n gs p e r s har e t hr o u g h i ts r i s k y o p er at io ns o r r is k y fi na n ci n g p a tt er n, t h e i n v es to rs
wi l l no t lo o k up o n i t s s har e wi t h fa vo ur . To t ha t e x te nt , t he mar ke t va l ue o f t he s hare s o f s uc h a
co mp a n y wi l l b e lo w. A n ea s y wa y to d e ter m i n e t he cap it al i sat io n ra te is to s tart wi t h fi xed d ep o s it
in ter es t r at e o f b a n ks , i n ve sto r wo u ld wa n t a hi g h er re t ur n i f h e i n ve s ts i n s h are s, as t h e ri s k
in cr e as es . Ho w mu c h hi g her r et ur n is e xp ec ted , d ep end s o n t h e ri s k s i n vo l v ed i n t h e p art ic u lar s har e
wh ic h i n t ur n d ep e nd s o n co mp a n y p o li cie s, p a s t reco rd s, t yp e o f b u si n e s s a nd co n fid e n ce co m m and ed
b y t he ma n a ge me n t. T h u s, cap ita li sa tio n r a te i s t he c u mu l a ti ve re s u lt o f th e as s es s me n t o f t he va rio us
s har e ho ld er s r e gar d i n g t he r i s k a nd o t her q ua li t ati v e fac to r s o f a co mp an y. I f a co mp a n y i n v e s ts it s
f u nd s i n ri s k y ve n t ur e s, th e i n v e sto r s wi l l p u t i n t hei r mo ne y i f t h e y ge t hi g h er re t ur n a s co mp ar ed to
th at fro m a lo w ri s k s ha r e.
T he mar ke t va l ue o f a s har e i s t h u s, a fu nc tio n o f ear n i n gs p er s har e a nd c ap it al i sat io n rate.
Si n ce t he p ro fi t ma xi m is at io n cr it er i a ca n no t b e ap p li ed i n real wo r ld si t ua tio n s b eca u se o f i ts
tec h n ica l li mi t at io n t h e f i na nc e ma n a ger o f a co mp a n y h a s to e ns ur e t ha t hi s d ec is io n s a re s uc h t ha t
th e mar k et va l ue o f t he s h ar e s o f t h e co mp a n y is ma x i mu m i n t he lo n g r u n. T h is i mp l ie s t ha t t h e
f i na nc ia l p o lic y ha s to b e s uc h t ha t it o p t i mi s e s t he EP S, ke ep i n g i n vi e w t he ri s k a nd o t her fa cto r s.
Th u s, wea lt h ma x i mi s a t io n i s a b e tt er o b j ect i ve fo r a co m me rci al u nd e r ta ki n g as co m p ar ed to r et ur n
and ri s k.
T her e i s a gr o wi n g e mp h a si s o n so ci a l a nd o t h er o b l i gat io n s o f a n e nte rp ri se. I t ca n no t b e
d en ied t ha t i n t he ca s e o f u nd er ta ki n g s, e sp e cia ll y t ho se i n t he p ub l ic s ecto r, t h e q u es tio n o f weal t h
ma x i mi s at io n i s to b e s e en i n co n te x t o f so c ia l a nd o t her o b li g at io ns o f t he e nt erp ri se .
I t mu s t b e u n d er s to o d t hat fi n a nci al d ec is io n ma k i n g i s r e lat ed to t h e o b j ec ti v es o f t h e
b u si n es s. T he fi na n ce m an a ger h as to e n s ure t ha t t h ere i s a p o s it i ve i mp act o f e ac h fi na nc ia l d e ci sio n
o n t h e furt h era nc e o f t h e b u si n e ss o b j ec ti v es . O ne o f t he ma i n o b j ect i ve o f a n u nd er ta k i n g ma y b e to
" p r o gre ss i ve l y b ui ld up t he c ap ab il it y to u nd er ta ke t he d es i g n a nd d e v elo p me n t o f a ircr a ft e n gi n e s,
he li co p te rs, e tc." A fi na nc e ma na ge r i n s u c h c as es wi l l al lo ca te fu nd s i n a wa y t hat t hi s o b j ect i ve i s
ac hie v ed a lt ho u g h s u c h an al lo ca tio n ma y no t ne ces s ari l y ma x i mi se we al th .
Q ue st io n : W ha t a re t h e f u nct io ns o f a F ina nc e M a na g er ?
An sw er : Fu nc tio n s o f a Fi na n ce M a na g er :
T h e t wi n a sp e ct s, p r o c ur e me nt a nd e ffect i ve ut il i sat io n o f fu n d s are cr uc ial ta s k s fac e d b y a
f i na nc e ma n a ger. T he f in a nc ial ma na g er is req ui red to lo o k i nto t he fin a nc ial i mp li cat io n s o f a n y
d eci sio n i n t h e f ir m. T h u s al l d e ci sio n s i n vo l ve ma n a ge me n t o f fu n d s u nd er t he p u r vie w o f t he
f i na nc e ma na ge r. A l ar ge n u mb er o f d ec is io n s in vo l ve s ub s ta n ti al o r ma ter ia l c ha n ge s i n v al ue o f
f u nd s p ro c ured o r e mp l o yed . Th e fi na n ce ma n a ger , h as to ma na ge fu nd s i n s u c h a wa y so a s to ma k e
th eir o p t i mu m ut il is at io n a nd to e ns u r e t he ir p ro cur e me n t i n a wa y t ha t the r is k , co s t and co n t ro l are
p r o p erl y b al a nced u nd er a g i ve n s it u at io n. He ma y n o t , b e co n cer ned wi t h t h e d eci s io ns , t hat d o no t
af f ec t t h e b a si c fi n a nc ia l ma na g e me n t a nd s tr uc t ure .

CA- IPCC- Financial Management`

T h e nat ur e o f j o b o f a n ac co u nta n t a n d fi n a nce ma n a ge r i s d i ffe re nt , a n ac co u nta n t 's j o b is


p r i mar il y to reco r d t he b us i ne s s tr a n sa ctio n s, p rep are fi n a nci al sta te me n t s s ho wi n g re s ul t s o f t he
o r ga n i sat io n fo r a gi ve n p er io d a nd it s fi n a nc ia l co nd i tio n a t a g i ve n p o in t o f ti me. H e i s to r eco rd
var io u s hap p e n i n g s i n mo ne tar y ter ms to e n s u re t ha t a s set s, li ab i li ti e s, i n co me s a nd e xp e n se s ar e
p r o p erl y gro up ed , c la s s i fied a nd d is clo sed i n t he fi na nc ia l s tat e me n ts . Acco u nt a nt i s no t co n c ern ed
wi t h ma na g e me n t o f f u n d s t h at is a sp ec ial i sed t as k a nd i n mo d e r n t i me s a co mp l e x o ne. T h e fi n an ce
ma n a ger o r co n tro l ler h as a t a s k e n tir el y d i ffer en t fro m t h at o f a n acco u nt a nt, he i s to ma n a ge fu nd s .
So me o f t he i mp o r ta n t d eci sio n s as r e gar d s fi na nc e ar e a s fo llo ws :
1 ) Es ti ma ti ng t he re q u ire me nt s o f f u nd s : A b u si n es s req u ire s fu nd s fo r lo n g t er m p urp o s e s i.e .
in v e st me n t i n fi x ed a s s et s a nd so o n. A ca re fu l e st i ma te o f s uc h fu nd s i s r eq uir ed to b e mad e. A n
as se s s me n t ha s to b e ma d e r e gar d i n g r eq u ire me n ts o f wo r ki n g cap ita l i n vo l v i n g, e s ti ma t io n o f a mo u n t
o f f u nd s b lo c ked i n c ur r en t a s set s a nd t ha t li k el y to b e g e nera ted fo r s ho rt p erio d s t hro u g h c urr e nt
liab il it ie s. Fo r eca st i n g t he r eq u ir e me n t s o f fu nd s is d o ne b y u se o f tec h ni q ue s o f b ud get ar y co nt ro l
and lo n g ra n g e p l a n ni n g. Es ti ma t es o f r eq u ire me n t s o f fu nd s c a n b e mad e o nl y i f al l t he p h ys i cal
act i vi tie s o f t he o r ga n is atio n ar e fo r ec as ted . T h e y ca n b e tr a ns la ted i nto mo n eta r y t er ms .
2 ) Deci s io n reg a rd i ng ca p it a l st ru ct ure : O nc e th e req uir e me n ts o f fu nd s i s es ti ma ted , a d eci sio n
r eg ard i n g var io u s so ur c es fr o m wh e r e t h e fu nd s wo u ld b e ra is ed i s to b e ta ke n. A p ro p er mi x o f t h e
var io u s so urc es i s to b e wo r ked o u t, eac h so u rce o f fu nd s i n vo l ve s d i ffe ren t i ss u es fo r co ns id er atio n.
Th e fi na n ce ma n a ger ha s to c ar e f u ll y lo o k i nto th e e xi s ti n g c ap i ta l s tr u ct ure a nd se e ho w t h e v ario u s
p r o p o sa ls o f ra i si n g f u n d s wi l l a f f ec t i t. He i s to ma i nta i n a p ro p er b a la nce b et we e n lo n g a nd s ho r t
ter m fu n d s a nd to e n s ur e t h at s u f f ic ie n t lo n g -te r m fu nd s ar e r ai sed i n o rd er to fi n a nce fi x ed a s set s
and o t her lo n g - ter m i n ve s t me n ts a nd to p ro vi d e fo r p er ma ne n t need s o f wo r k i n g cap ita l. I n t h e
o ver al l vo l u me o f lo n g - ter m f u nd s, he i s to ma in ta i n a p ro p er b a la nc e b et we e n o wn a nd lo a n fu nd s
and to se e t ha t t he o ver all cap ita li sa tio n o f t h e co mp a n y i s s uc h , t h at t he co mp a n y i s ab le to p ro cu re
f u nd s at mi n i mu m co st and is ab le to to l era te s ho c k s o f l ea n p er io d s . All t he se d e ci sio n s ar e k no wn
as 'fi n a nci n g d ec is io n s '.
3 ) Inv es t me nt dec i sio n : F u nd s p r o c ur ed fro m d i ffere n t so u rce s ha ve to b e i n ve st ed i n vari o us k ind s
o f a s se ts. Lo n g ter m f u nd s ar e u sed i n a p ro j ec t fo r fi xed a nd a lso c urr en t a ss et s. T he i n ve st m en t o f
f u nd s i n a p ro j ect is to b e mad e a f ter car e fu l as se s s me n t o f v ari o u s p ro j ect s t hro u g h c ap it al
b ud ge ti n g. A p ar t o f lo n g t er m f u nd s i s a lso t o b e k ep t fo r fi n a nc i n g wo r ki n g c ap i tal r eq uir e me nt s.
As se t ma n a ge me n t p o l ic ie s ar e to b e l aid d o wn reg ard i n g v ario u s i te m s o f c urr e nt a s se t s, i n ve nto r y
p o lic y i s to b e d e ter m in ed b y t he p r o d uc tio n and fi n a nce ma n a ger, wh il e k eep i n g i n mi n d th e
r eq u ire me n t o f p r o d uc ti o n a n d f ut ur e p r i ce es ti ma te s o f ra w ma teri al s a nd a vai lab il it y o f fu nd s .
4 ) Div i de n d dec i sio n : The fi n a nce ma n a ger is co ncer n ed wi t h t he d ecis io n to p a y o r d ecla re
d iv id e nd . He i s to a s si s t t he to p ma na g e me n t i n d e cid i n g a s to wh at a mo u n t o f d i v id e nd s ho u ld b e
p aid to t he s har e ho ld er s and wh a t a mo u n t b e ret ai ned b y t he co mp a n y, i t i n vo l ve s a l ar ge n u mb er o f
co n s id era tio n s. E co no m ica ll y sp ea k i n g, t h e a m o u n t to b e ret ai n ed o r b e p aid to t h e s h are ho ld er s
s ho uld d ep e nd o n wh e t h er t h e co mp a n y o r s har e ho l d er s c a n ma k e a mo r e p ro fi tab le us e o f re so urc e s,
al so co n sid e rat io n s l i ke tr e nd o f ea r ni n g s, t h e t rend o f s ha re mar k et p r i ces , req ui re me n t o f fu n d s fo r
f u t ure gro wt h, ca s h f lo w si t ua tio n, ta x p o s it io n o f s har e ho ld er s, a nd so o n to b e k ep t i n mi n d .
T he p r i n cip al f u nct io n o f a fi n a nce ma n a ger re lat e s to d eci sio n s re gard i n g p ro c ure me n t,
in v e st me n t a nd d i v id e nd s.
5 ) S u pp ly o f fu n ds t o a ll pa rt s o f t he o rg a ni sa tio n o r ca s h ma na g e me nt : T he fi na n ce ma na g e r h a s
to e n s ure t h at al l sec ti o n s i.e. b r a nc h es , fa ct o rie s, u n it s o r d ep ar t m en t s o f t he o r ga ni s at io n are
s up p l ied wi t h ad eq ua te f u nd s. Sec tio n s ha v i n g ex ce s s fu nd s co n trib u te to t he c e ntra l p o o l fo r u se i n
o th er se ct io n s t h at nee d s f u nd s. A n ad eq u ate s up p l y o f ca s h at a ll p o i nt s o f ti me is ab s o lu te l y
es se n tia l fo r t h e s mo o t h flo w o f b us i ne s s o p er atio n s. E v e n i f o ne o f t he ma n y b ra nc he s is s h o rt o f
f u nd s, t he wh o le b us i n es s ma y b e i n d a n ge r, t h u s, ca s h ma n a ge me n t a nd ca s h d isb u rs e me n t p o lic ie s
ar e i mp o r ta n t wi t h a v i e w to s up p l yi n g ad eq ua te fu nd s at al l t i me s a n d p o in t s i n a n o r g a ni sa t io n . It
s ho uld e n s ure t hat t her e is no e xc es s i ve c a s h.
6 ) Ev a l ua ti ng f i na n cia l pe rf o r ma nce : Ma na g e me n t co ntro l s ys t e ms ar e u s ual l y b as ed o n fi na nc ia l
an al ys i s, e. g. R OI ( r et ur n o n i n ve s t me n t) s ys t e m o f d i vi sio n al co ntro l. A fi n a nce ma na g er h as to
co n s ta nt l y r e vie w t he f in a nc ial p er fo r ma n ce o f v ario u s u n it s o f t h e o rga n i sat io n. A na l ys i s o f t he
f i na nc ia l p er fo r ma nc e he lp s t he ma n a ge me nt fo r a s se ss i n g ho w t he fu nd s are ut ili s ed i n v ario u s
d iv i sio n s a nd wh a t ca n b e d o ne to i mp r o v e i t.
7 ) Fina nc ia l neg o t ia t io ns : Fi n a nce ma n a ger 's maj o r t i me is u ti li sed in carr yi n g o u t ne go ti atio n s
wi t h fi n a nci al i n st it u tio n s, b a n k s a nd p ub l ic d ep o s ito r s. He h as to fu rn is h a lo t o f i n fo r ma t i o n to

CA- IPCC- Financial Management`

th e se i ns ti t ut io n s a nd p er so n s i n o r d er to e n s u re t ha t ra i si n g o f fu nd s is wi t h i n t h e st at ut es .
Ne go t ia tio n s fo r o u t sid e f i na nc i n g o f te n r eq uire s sp ec ia li sed s k il ls .
8 ) K eep ing in to uc h w it h st o c k e xc ha ng e q u o ta tio n s a n d b eha v io r o f sha re pr ic es : It i n vo l v e s
an al ys i s o f maj o r t r e n d s i n t he s to c k mar ke t a nd j ud gi n g t he ir i m p act o n s h are p r ice s o f t he
co mp a n y's s har es .
Q ue st io n : W ha t a re t h e v a rio u s met ho d s a n d to o ls u se d fo r fi na ncia l ma na g e me nt ?
An sw er : Fi n a nce ma na g er us e s v ar io u s to o ls to d i sc h ar ge hi s fu nc tio n s a s re g ard s fi n an cia l
ma n a ge me n t. I n t h e ar e a o f f i na nc i n g t h ere are v ario u s me t ho d s to p ro cur e fu nd s fro m lo n g a s al so
s ho r t ter m so urce s. T h e f i na nc e ma na ger ha s to d ecid e a n o p ti mu m cap it al str u ct ur e t ha t ca n
co n trib u te to t he ma x i m is at io n o f s har e ho ld er 's we a lt h. Fi n a nci al l e ver a ge o r t rad i n g o n eq u it y is a n
i mp o rt a nt me t ho d b y wh ic h a f i na n ce ma n a ger m a y i ncr ea se t he r et ur n to co m mo n s hare h o ld er s.
Fo r e va l uat io n o f cap ita l p r o p o s al s, t he fi na nc e ma na ger u se s cap it al b ud ge ti n g t ec h n iq u e s
as p a yb ac k, i n ter n al r a t e o f r e t ur n, ne t p re se n t va l ue, p ro fitab il it y i nd ex, a vera g e rat e o f ret u rn. I n
th e a rea o f c urr e nt a s s et s ma n a ge me n t, he u s es met ho d s to c hec k e ffici e nt ut il is at io n o f c u rre nt
r eso ur ce s a t t he e nt er p r i se 's d i sp o sal . A n e n terp r is e c a n i ncre as e it s p ro fitab il it y wi t ho u t a ffec ti n g it s
liq uid it y b y a n e f fi ci e nt ma na g e me n t o f wo r k i n g cap it al. Fo r i ns ta nc e, in t he area o f wo r k i n g c ap it al
ma n a ge me n t, c as h ma n a ge me n t ma y b e c e ntr al is ed o r d e -c e ntr al is ed ; c e nt ral i sed me t ho d i s co ns id ered
a b et ter to o l o f ma n a gi n g t h e e nt er p r i s e 's l iq uid reso ur ce s. I n t h e are a o f d iv id e nd d e ci s io ns , a fi r m is
fa ced wi t h t he p r o b le m o f d ec lar at io n o r p o stp o ni n g d ec lar at io n o f d i vid e nd , a p ro b l e m o f i n ter na l
f i na nc i n g.
Fo r e val u at io n o f a n en ter p r i se 's p er fo r ma nce, t h ere ar e var io u s met ho d s, a s rat io a na l ys i s.
Th i s te c h niq u e i s u sed b y a ll co ncer n ed p er so n s. Di ffere nt rat io s s er vi n g d i ffere nt o b j ect i ve s. A n
in v e sto r us e s var io u s r at io s to e va l ua te t he p ro fi tab i li t y o f i n ve st me n t i n a p art ic u lar co mp a n y. Th e y
en ab le t h e i n ve sto r , to j ud ge t h e p r o f itab il it y, s o lv e nc y, l iq uid it y a nd g ro wt h a sp ec ts o f t he fir m. A
s ho r t - ter m cred i to r i s m o r e i nte r e sted i n t he l iq uid it y asp ect o f t h e fir m , and i t i s p o s s ib le b y a st ud y
o f l iq uid it y rat io s - c u r r e nt r at io , q uic k ra tio s , etc. T he ma i n co n cer n o f a fi na nc e ma na ger is to
p r o v id e ad eq ua te f u nd s fr o m b e s t p o ss ib l e so urc e, at t he ri g h t t i me a nd a t mi n i mu m co st and to
en s ur e t ha t t he fu nd s so acq uir ed ar e p ut to b e st p o s sib le u se . F u nd s flo w a nd ca s h flo w s ta te me n t s
and p ro j ect ed fi n a nci a l st ate me nt s h elp a lo t i n th i s re g ard .
Q ue st io n : D is cu s s t he ro le o f a f i na nce ma na g er ?
An sw er : I n t h e mo d e r n e nt er p r i se , a fi n a nce ma n a ger o cc up ie s a ke y p o s it io n, h e b e i n g o n e o f t he
d yna mi c me mb er o f co r p o r ate ma n a ger ial t ea m. His ro l e, i s b eco m i n g mo r e and mo r e p er va si v e and
si g n i fi ca nt i n so l vi n g co mp le x ma na g er i al p ro b l e ms. Tr ad i tio n al l y, t he r o le o f a fi na nc e ma na g e r was
co n f i ned to rai s i n g f u n d s fr o m a n u mb er o f s o urc e s, b ut d ue to r ece nt d e velo p me nt s i n t he so cio eco no mi c a nd p o li ti cal sc e n ar io t hr o u g ho u t t he wo r ld , he i s p l aced i n a ce nt ral p o s it io n in t he
o r ga n i sat io n. He i s r esp o n sib le fo r s hap i n g t h e fo r t u ne s o f t he e nt erp ri s e a nd i s i n vo l ved i n t he mo s t
vi ta l d e ci sio n o f a llo ca tio n o f cap it al li k e mer ger s, acq u i sit io n s, e tc. A fi n a nce m a na g er, as o th er
me mb er s o f t h e co r p o r a t e tea m ca n no t b e a ver s e to t he fa s t d e ve lo p me n t s, aro u nd h i m a nd ha s to ta ke
no t e o f t h e c ha n g es i n o r d er to t a ke r e le v a nt st e p s i n v ie w o f t he d yn a m ic c ha n g e s i n c irc u ms t a nc es .
E.g . i n tro d uc tio n o f E u r o - as a si n g l e c urre nc y o f E uro p e is a n i n ter na tio n al le ve l c h a n ge, ha v i n g
i mp ac t o n t he co r p o r at e f i na nc ia l p l a ns a nd p o l i cie s wo rld - wid e.
Do me st ic d e ve lo p me nt s as e mer ge n ce o f fi na nc ia l s er vi ce s s ec to rs a nd S EB I a s a wa tc h d o g
fo r i n ve sto r p ro te ctio n a n d r e g u la ti n g b o d y o f ca p ita l mar k et s i s co n tr ib u ti n g to t he i mp o rt a nce o f t he
f i na nc e ma n a ger 's j o b . Ba n k s a nd f i na nc ia l i n s t it ut io n s were t h e maj o r so urc es o f fi na nc e, mo n o p o l y
wa s t he s tat e o f a f fa ir s o f I nd ia n b u si ne s s, s h ar eho ld er s s at is fact io n wa s no t t he p ro mo te r 's co nc er n
as mo st o f t he co mp a ni e s, we r e clo se l y held . D u e to t he o p e ni n g o f e co no m y, co mp et it io n i ncr e ased ,
se ller 's ma r ket i s b ei n g co n ver ted i nto b u yer 's mar ke t. De v elo p me n t o f i nt er ne t ha s b ro u g ht n e w
ch al le n ge s b e fo re t he ma n a ger s. I nd i a n co nce rn s no lo n ger ha ve to co mp et e o n l y n at io nal l y, i t i s
fa ci n g i n ter n at io nal co mp e ti tio n . T h us a ne w era i s u s he red d uri n g t he re ce n t year s, i n fi n an cia l
ma n a ge me n t, sp eci al l y, wi t h t he d e velo p me n t o f fi na nc ia l to o l s, tec h n iq ue s, i ns tr u me n t s a nd
p r o d uc t s. Al so d u e to i ncr ea si n g e mp ha s is o n p ub lic s ec to r u nd er ta k i n g s to b e s el f - s up p o r ti n g a nd
th eir d ep e nd e n ce o n c ap it al ma r ket f o r fu nd req u ire me n t s a nd t he in cre as i n g si g ni fic a nc e o f
lib er al is at io n, g lo b al i sat io n a nd d e r e g ul at io n.
Q ue st io n : Dra w a t y p i ca l o rg a ni sa t io n c ha rt hig hl ig hti ng t he f ina nc e fu nct io n o f a co mp a n y ?
An sw er : T h e fi na nc e f u nc tio n i s t he s a me i n all e n terp r is es , d e ta il s ma y d i ffer, b ut maj o r feat ur es
ar e u n i ver sa l i n na t ur e. Th e f i na nc e f u nct io n o c cup ie s a s i g ni fic a nt p o s i tio n i n a n o r ga n is at io n and i s
no t t he re sp o n sib i li t y o f a so le e xe c ut i ve. T he i mp o r ta n t asp ect s o f fi na nc e ma na ger a re to carr i ed o n
b y to p ma n a ge me n t i.e. ma n a gi n g d ir ec to r , c h air ma n , b o ard o f d ir ecto r s. The b o ard o f d ire cto r s ta ke s

CA- IPCC- Financial Management`

d eci sio n s i n vo l v i n g fi na nc ia l co n sid e r at io n s, t h e fi na nc ia l co n tro l ler i s b as ica ll y me a nt fo r a ss is ti n g


th e to p ma na ge me nt a n d ha s an i mp o r t a nt ro le o f co n tr ib ut i n g to go o d d ecis io n ma ki n g o n i s s ue s
in v o l vi n g al l fu n ct io na l ar ea s o f b u si n e ss. He i s to b ri n g o u t fi na n cia l i mp li ca tio n s o f al l d ec is io n s
and ma k e t h e m u nd er st o o d . He ma y b e ca lled as t he fi n a nci al co nt ro l ler, v ic e -p re sid e nt ( fi n a nc e),
ch ie f acco u n ta n t, t r ea s ur e r , o r b y a n y o t he r d es i g na tio n, b u t ha s th e p r i mar y r esp o n s ib i l it y o f
p er fo r mi n g fi na n ce f u n ctio n s. He i s to d i sc h a r ge t he re sp o n sib il it y ke ep i n g i n v ie w t he o ver al l
o ut lo o k o f t he o r ga ni sa t io n .
BO A RD O F D I RE C TO RS
P RE SI DE NT

V.P .(P ro d u ct io n )

V.P .( F i na nc e)

Tr e as u r e r

Cr ed it
Mg mt.

Ca s h
Mg mt.

Ba n k i n g
r ela tio n s

V.P .( Sal e s)

Co nt ro l ler

P o r tfo lio
Mg mt.

Co rp o ra te
Ge ner al &
Co st
Acco u n ti n g

Ta xe s

In ter na l
A ud i t

B ud ge ti n g

O rg a n isa tio n c ha rt o f f ina nc e f u nc t io n


Th e C hi e f fi na n ce e xec u ti ve wo r k s d ir e ct l y u nd e r t he P re sid e n t o r M a na gi n g D ire cto r o f t he co mp a n y.
Be s id e s ro u ti n e wo r k, h e ke ep s t he Bo ar d i n fo r med a b o ut al l p ha se s o f b u si n es s ac ti v it y, i nc l us iv e o f
eco no mi c, so ci al a nd p o lit ic al d e v elo p me n t s a ff ect i n g t he b us i ne s s b e h av io ur a nd fro m t i me to ti me
f ur n is h e s i n fo r mat io n a b o u t t he fi n a nci al s tat u s o f t he co mp a n y . Hi s fu nc tio n s are : (i ) Tre a s ur y
f u nc tio n s a nd (i i) Co n tr o l f u nc tio n s.
Rela t io ns h ip Bet w ee n f ina nc ia l ma na g e me n t a nd o t her a r ea s o f ma na g e me nt : T her e i s clo se
r ela tio n s hip b e t we e n t h e ar e as o f fi n a nc ial a nd o t her ma n a ge me nt l i ke p ro d u ct io n, sa le s, ma r k eti n g,
p er so n n el, etc. Al l a cti v it ie s d ir ec tl y o r i nd i rec tl y i n vo l v e acq ui s it io n a nd u se o f fu nd s.
Det er mi n at io n o f p r o d u ctio n, p r o c ur e me n t a n d ma r ket i n g stra te g ie s ar e th e i mp o r ta n t p rero g at i ve s o f
th e re sp ect i ve d ep ar t me nt head s, b ut f o r i mp l e me nt i n g, t he ir d ec i sio n s fu nd s a re req u ired . Li ke,
r ep la ce me n t o f fi x ed a s s et s fo r i mp r o v i n g p ro d u ctio n cap a ci t y req ui re s fu nd s. Si mi l arl y, t he p ur ch as e
and sal es p ro mo tio n p o l ici es ar e laid d o wn b y t he p urc h as e a nd mar k et i n g d i vi s io ns re sp e ct i ve l y, b ut
ag ai n p ro c u re me n t o f r a w ma ter ial s, ad ver ti si n g a nd o t her sa le s p ro m o tio n req u ire fu nd s. Sa me i s
fo r , recr u it me n t a nd p r o mo tio n o f s ta f f b y t he p erso n n el d ep art me n t wo uld req ui re fu nd s fo r p a y me n t
o f sa lar ie s, wa g e s a nd o th er b e ne f i ts. I t ma y , ma n y t i me s, b e d i ffi cu lt to d e ma rca te wh er e o n e
f u nc tio n e nd s a nd o t he r st ar t s. A lt ho u g h , fi na nc e fu nct io n ha s a si g ni fic a nt i mp ac t o n t h e o th er
f u nc tio n s, it need no t l i mi t o r o b s tr uc t t h e ge ne ral fu nc tio n s o f t he b u s i ne s s. A fir m fac i n g fi na nc ia l
d i f fic u lt ie s, ma y gi v e we i g h t a ge to f i na nc ia l co n s id era tio n s a nd d e vi s e i ts o wn p ro d u ct io n a nd
ma r ket i n g str at e gie s t o s u it t he s it ua tio n . W hi le a fir m h a vi n g s urp l u s fi na n ce, wo uld h a ve
co mp ara ti v el y lo we r r i g id it y a s r e gar d s t he fi n an cia l co ns id er at io ns vi s -a - v i s o t h er fu nc tio n s o f t he
ma n a ge me n t.
Perv a siv e Na t ur e o f F i na n ce F u nct io n : F i na n ce i s t he li fe b lo o d o f o f a n o r ga n is at io n, i t i s t h e
co m mo n t hr ead b i nd i n g all o r ga ni sa tio n al fu n ct i o n s. T h i s i n ter face ca n b e e xp l ai ned a s b e lo w :
* Pro du ctio n - Fi na n ce : P r o d uc tio n fu nc ti o n r eq uir es a lar g e i n ve s t me n t. P ro d uc ti ve u se o f
r eso ur ce s e n s ure s a co s t ad v a nt a ge fo r t he fir m. Op t i mu m i n v es t me n t i n i n ve nto r ie s i mp ro ve s p ro fit
ma r gi n s. Ma n y p ar a me t er s o f p r o d uct io n ha v e an i mp act o n co st a n d ca n p o ss ib l y b e co n t ro lled
th r o u g h i nte r na l ma n a g e me nt, t h us e n ha n ci n g p ro fit s. I mp o rt a nt p ro d uc tio n d e ci sio n s l i ke m ak e o r
b u y ca n b e ta k e n o nl y a f ter t he f i na nc ia l i mp li ca tio n s ar e co n sid ered .
* M a rket ing - F ina nc e : Var io u s a sp e ct s o f mar k et i n g ma na g e me n t ha ve fi na nc ia l i mp lic a tio n s,
d eci sio n s to ho ld i n ve n to r ie s o n lar ge sc al e to p ro v id e o ff t he s hel f s erv ic e to c u s to mer s i n c rea se s
in v e nto r y ho ld i n g co st and a t t he sa me ti me ma y i ncre as e s ale s, si mi la r wi t h e xt e ns io n o f cred it
fa ci li t y to c u sto me r s. M ar k et i n g s tr a te gi e s to i n crea se sal e i n m o st c as e s, ha ve ad d it io na l co st s th at
ar e to b e wei g h ted car e f ul l y a g ai n s t i n cr e me n ta l re ve n ue b e fo re ta k i n g d eci sio n .

CA- IPCC- Financial Management`

* Per so nn el - Fi na n ce : I n t he g lo b a li sed co mp eti ti v e sce n ario , b u si n es s o r g a ni sa tio n s are mo vi n g to


a f la tter o r g a ni sa tio n al str u ct ur e . I n ve st me n t s i n h u ma n r eso u rce d e v el o p me n t s are al so i n crea si n g.
Re s tr uct ur i n g o f r e mu n er at io n str u ct ur e, vo l u nt ar y r et ire me n t sc h e m es, s we at eq ui t y, etc. h a ve
b eco me maj o r fi na n ci al d eci sio n s i n t h e h u ma n r eso ur ce ma n a ge me n t.
Q ue st io n : W ha t is t h e rele v a nc e o f t i me v a lu e o f mo ney i n fi na ncia l dec i sio n ma ki ng ?
An sw er : A fi n a nce ma na g er is r eq u ir ed to ma ke d ec i sio n s o n i n ve s t m en t, fi na n ci n g a nd d i vid end i n
vi e w o f t he c o mp a n y's o b j ecti ve s. T he d ec is io n s a s p u rc ha se o f a s se t s o r p ro c ure me n t o f fu n d s i.e.
th e i n ve s t me n t/ fi na nc i n g d e ci sio n s a f f ect t he cas h flo w i n d i ffere nt ti me p erio d s. Ca s h o ut flo ws
wo u ld b e at o ne p o i n t o f t i me a nd i n f lo w a t so me o t her p o i n t o f t i me , he n ce, t h e y are no t co m p arab l e
d ue to t he c ha n ge i n r up ee va l ue o f mo ne y. T he y ca n b e mad e co mp a ra b le b y i ntro d u ci n g t he i nt ere st
fa cto r. I n t he t heo r y o f f i na nc e, t he i nt er e st fact o r is o ne o f t he c r uci al and e xcl u s i ve co n cep t , k no wn
as t he ti me va l ue o f mo n e y.
Ti me va l ue o f mo ne y mea n s t h at wo rt h o f a r up e e rec ei v ed to d a y i s d i ffer e nt fro m t he sa me
r ece i ved i n fut ur e. T h e p r e fer e n ce fo r mo n e y n o w a s co mp ared to fut u r e i s k no wn a s t i me p r e fere nce
o f mo n e y. T h e co nc ep t i s ap p li cab l e to b o t h i nd i vid u al s a nd b u si ne s s ho u se s.
Rea so n s o f ti me pr ef er enc e o f mo ney :
1 ) Ri s k :
Th ere is u ncer ta i nt y ab o ut t he r ec eip t o f mo n e y in fut ur e.
2 ) Pref ere nc e fo r pr es e nt co n su mp t io n :
Mo s t o f t h e p er so n s a nd co mp a n ie s h a ve a p r e fe ren ce fo r p r es e nt co n s u mp tio n ma y b e d u e to ur ge n c y
o f n eed .
3 ) I nv e st me nt o ppo rt u nit ie s :
Mo s t o f t he p er so n s a n d co mp a n ie s ha ve p re fe ren ce fo r p re se n t mo n e y b ec a us e o f a v ai lab il it ie s o f
o p p o rt u ni tie s o f i n ve s t m en t fo r ear n i n g ad d it io n al c as h flo ws .
I mpo rta n ce o f t i me v a l ue o f mo ney :
Th e co nc ep t o f ti me va l ue o f mo ne y h elp s i n ar ri vi n g at t he co mp arab l e v al u e o f t h e d i ffere n t rup e e
a mo u n t a ri si n g at d i f fer en t p o i n t s o f ti me i n to e q ui v al e nt v al ue s o f a p a rtic u lar p o i nt o f t i me, p res e nt
o r f ut u re. T he c as h f lo ws ar i s i n g at d i f f er e n t p o i nt s o f t i me c a n b e mad e co mp arab le b y us i n g a n y o ne
o f t he fo llo wi n g :
- b y co mp o u nd i n g t he p r ese n t mo n e y to a fut u re d ate i.e. b y fi nd i n g o u t t he v al u e o f p re s e nt mo n e y.
- b y d i sco u n ti n g t h e f u t ur e mo ne y to p r e se n t d a te i.e. b y fi nd i n g o ut t h e p re se n t va l ue(P V) o f f ut u re
mo ne y.

Notes on:- Finance Function


The finance function is most important for all business enterprises. It remains a focus of all activities. It starts with the
setting up of an enterprise. It is concerned with raising of funds, deciding the cheapest source of finance, utilization of
funds raised, making provision for refund when money is not required in the business, deciding the most profitable
investment, managing the funds raised and paying returns to the providers of funds in proportion to the risks undertaken
by them. Therefore, it aims at acquiring sufficient funds, utilizing them properly, increasing the profitability of the
organization and maximizing the value of the organization and ultimately the shareholders wealth.
Notes on:- Inter-relationship between Investment, Financing and Dividend Decisions
The finance functions are divided into three major decisions, viz., investment, financing and dividend decisions.
It is correct to say that these decisions are inter-related because the underlying objective of these three decisions is the
same, i.e. maximisation of shareholders wealth. Since investment, financing and dividend decisions are all interrelated,
one has to consider the joint impact of these decisions on the market price of the companys shares and these decisions
should also be solved jointly. The decision to invest in a new project needs the finance for the investment. The financing
decision, in turn, is influenced by and influences dividend decision because retained earnings used in internal financing
deprive shareholders of their dividends. An efficient financial management can ensure optimal joint decisions. This is
possible by evaluating each decision in relation to its effect on the shareholders wealth.
The above three decisions are briefly examined below in the light of their inter -relationship and to see how they
can help in maximising the shareholders wealth i.e. market price of the companys shares.

CA- IPCC- Financial Management`

Investment decision: The investment of long term funds is made after a careful assessment of the various
projects through capital budgeting and uncertainty analysis. However, only that investment proposal is to be accepted
which is expected to yield at least so much return as is adequate to meet its cost of financing. This have an influence on
the profitability of the company and ultimately on its wealth.
Financing decision: Funds can be raised from various sources. Each source of funds involves different issues.
The finance manager has to maintain a proper balance between long-term and short-term funds. With the total volume of
long-term funds, he has to ensure a proper mix of loan funds and owners funds. The optimum financing mix will
increase return to equity shareholders and thus maximise their wealth.
Dividend decision: The finance manager is also concerned with the decision to pay or declare dividend. He
assists the top management in deciding as to what portion of the profit should be paid to the shareholders by way of
dividends and what portion should be retained in the business. An optimal dividend pay-out ratio maximises
shareholders wealth.
The above discussion makes it clear that investment, financing and dividend decisions are interrelated and are to
be taken jointly keeping in view their joint effect on the shareholders wealth.

Chapter : Estimation of Working Capital


INTRODUCTION
Decisions relating to working capital and short term financing are referred to as Working Capital Management. These involve
managing the relationship between a firm.s short-term assets and its short-term liabilities. The goal of working capital
management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both
maturing short-term debt and upcoming operational expenses.
MEANING AND CONCEPT OF WORKING CAPITAL
There are two concepts of working capital - gross and net. Gross working capital refers to the firm.s investment in current
assets. Current assets are those assets which can be converted into cash within an accounting year. Net working capital refers
to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are
expected to mature for payment within an accounting year.
Current Assets include: Stocks of raw materials, Work-in-progress, Finished goods, Trade debtors, Prepayments, Cash
balances .
Current Liabilities include: Trade creditors, Accruals, Taxation payable, Bills Payables, Outstanding expenses, Dividends
payable, short term
Working capital is also known as operating capital. A most important value, it represents the amount of day-to-day operating
liquidity available to a business. A company can be endowed with assets and profitability, but short of liquidity if these assets
cannot readily be converted into cash. A positive working capital means that the company is able to payoff its short-term
liabilities. A negative working capital means that the company currently is unable to meet its short-term liabilities. From the
point of view of time, the term working capital can be divided into two categories viz., Permanent and temporary.
Permanent working capital refers to the hard core working capital. It is that minimum level of investment in the current assets
that is carried by the business at all times to carry out minimum level of its activities.
Temporary working capital refers to that part of total working capital, which is required by a business over and above
permanent working capital. It is also called variable working capital. Since the volume of temporary working capital keeps on
fluctuating from time to time according to the business activities it may be financed from short-term sources.
Importance of Adequate Working Capital:
The importance of adequate working capital in commercial undertakings can be judged from the fact that a
concern needs funds for its day-to-day running. Adequacy or inadequacy of these funds would determine the efficiency with
which the daily business may be carried on. Management of working capital is an essential task of the finance manager. He has
to ensure that the amount of working capital available with his concern is neither too large nor too small for its requirements.
A large amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to
pay huge amount as interest on such funds. The various studies conducted by the Bureau of Public Enterprises have shown that
one of the reason for the poor performance of public sector undertakings in our country has been the large amount of funds
locked up in working capital This results in over capitalization. Over capitalization implies that a company has too large funds

CA- IPCC- Financial Management`

for its requirements, resulting in a low rate of return a situation which implies a less than optimal use of resources. A firm has,
therefore, to be very careful in estimating its working capital requirements.
If the firm has inadequate working capital, it is said to be under-capitalised. Such a firm runs the risk of
insolvency. This is because, paucity of working capital may lead to a situation where the firm may not be able to meet its
liabilities. It is interesting to note that many firms which are otherwise prosperous (having good demand for their products and
enjoying profitable marketing conditions) may fail because of lack of liquid resources. If a firm has insufficient working
capital and tries to increase sales, it can easily over-stretch the financial resources of the business. This is called overtrading.
Early warning signs of
over trading include:
Pressure on existing cash.
Exceptional cash generating activities e.g., offering high discounts for early cash payment.
Bank overdraft exceeds authorized limit.
Seeking greater overdrafts or lines of credit.
Part-paying suppliers or other creditors.
Paying bills in cash to secure additional supplies.
Management pre-occupation with surviving rather than managing.
Frequent short-term emergency requests to the bank (to help pay wages, pending receipt of a cheque).
needs enough cash to pay wages and salaries as they fall due and to pay creditors if it is to keep its workforce engaged and
ensure its supplies. Maintaining adequate working capital is not just important in the short-term. Sufficient liquidity must be
maintained in order to ensure the survival of the business in the long-term as well. Even a profitable business may fail if it
does not have adequate cash flow to meet its liabilities as they fall due. Therefore, when business make investment decisions
they must not only
consider the financial outlay involved with acquiring the new machine or the new building, etc., but must also take account of
the additional current assets that are usually required with any expansion of activity. Increased production leads to hold
additional stocks of raw materials and work in progress. Increased sales usually means that the level of debtors will increase. A
general increase in the firm.s scale of operations tends to imply a need for greater levels of working capital. A question then
arises what is an optimum amount of working capital for a firm? We can say that a firm should neither have too high an
amount of working capital nor should the same be too low. It is the job of the finance manager to estimate the requirements of
working capital
carefully and determine the optimum level of investment in working capital.
Optimum Working Capital:
If a company.s current assets do not exceed its current liabilities, then it may run into trouble with creditors
that want their money quickly. The working capital ratio, which measures this ability to pay back can be calculated as current
assets divided by current liabilities.
Current ratio (current assets/current liabilities) has traditionally been considered the best indicator of the
working capital situation. It is understood that a current ratio of 2 (two) for a manufacturing firm implies that the firm has an
optimum amount of working capital. This is supplemented by Acid Test Ratio (Quick assets/Current liabilities) which should
be at least 1 (one). Thus it is considered that there is a comfortable liquidity position if liquid current assets are equal to current
liabilities. Bankers, financial institutions, financial analysts, investors and other people interested in financial statements have,
for years, considered the current ratio at, .two. and the acid test ratio at, .one. as indicators of a good working capital situation.
As a thumb rule, this may be quite adequate. However, it should be remembered that optimum working capital can be
determined only with reference to the particular circumstances of a specific situation. Thus, in a company where the
inventories are easily saleable and the sundry debtors are as good as liquid cash, the current ratio may be lower than 2 and yet
firm may be sound. An optimum working capital ratio is dependent upon the business situation as such and the nature and
composition of various current assets. A company having short conversion cycle (from cash to cash) my have a lower current
ratio.
In nutshell, a firm needs to maintain a sound working capital position. It should have adequate working capital to run its
business operations. Both excessive as well as inadequate working capital positions are dangerous. Excessive working capital
means holding costs and idle funds which earn no profits for the firm. Paucity of working capital not only impairs the firm.s
profitability but also results in production interruptions, inefficiencies and sales disruptions. The management should therefore
maintain the right amount of working capital continuously.
MANAGEMENT OF WORKING CAPITAL
Working capital management is the functional area of finance that covers all the current accounts of its firm.
It is concerned with management of the level of individual current assets and the current liabilities or in other words the
management of total working capital. Managing Working Capital is a matter of balance. A firm must have sufficient cash on
hand to meet its immediate needs while ensuring that idle cash is invested to the organizations best possible advantage. To
avoid the difficulties, it is necessary to have clear and accurate reports on each of the components of working capital and an
awareness of the potential impact of likely influences. Sound financial and statistical techniques, supported by judgement
should be used to predict the quantum of working capital required at different times. Adequate provisions of working capital
mitigates risk. Working capital management entails short-term decisions generally, relating to its next one year period which
are .reversible.. Management will use a combination of policies and techniques for the management of working capital. These

CA- IPCC- Financial Management`

require managing the current assets . generally cash and cash equivalents, inventories and debtors. There are also a variety of
short term financing options which are considered. The various steps in the management of working capital involve:
Cash management . Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash
holding costs.
Inventory management . Identify the level of inventory which allows for uninterrupted production but reduces the
investment in raw materials and hence increases cash flow;The techniques like Just In Time (JIT) and Economic order quantity
(EOQ) are used for this.
Debtors management . Identify the appropriate credit policy, i.e., credit terms which will attract customers, such that any
impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice
versa). The tools like Discounts and allowances are used for this.
Short term financing . Inventory is ideally financed by credit granted by the supplier; dependent on the cash conversion
cycle, it may however, be necessary to utilize a bank loan (or overdraft), or to .convert debtors to cash. through .factoring. in
order to finance working capital requirements.
There are, however, certain constraints in the management of working capital such as:
(i) Non-realisation of the importance of working capital.
(ii) Continuous inflation in the economy.
(iii) The existence of seller.s market or monopoly conditions; and
(iv) High profitability.
Determinants of Working Capital: The following factors will generally influence the working capital requirements of the
firm:
(i) Nature of Business.
(ii) Market and demand conditions.
(iii) Technology and manufacturing Policies.
(iv) Credit Policy of the firm.
(v) Availability of credit from suppliers.
(vi) Operating efficiency.
(vii) Price Level Changes.
ISSUES IN THE WORKING CAPITAL MANAGEMENT
Working capital management entails the control and monitoring of all components of working capital i.e. cash, marketable
securities, debtors (receivables) and stocks (inventories) and creditors (payables). The finance manager has to determine the
levels and composition of current assets. He has to ensure a right mix of different current assets and that current
liabilities are paid in time. There are many aspects of working capital management which makes it important function of
financial management.
Time: Working capital management requires much of the finance manager.s time.
Investment: Working capital represents a large portion of the total investment in assets.
Credibility: Working capital management has great significance for all firms but it is very critical for small firms.
Growth: The need for working capital is directly related to the firm.s growth. It is advisable that the finance manager should
take precautionary measures for effective and efficient management of working capital. He has to pay particular attention to
the levels of current assets and their financing. To decide the levels and financing of current assets, the risk return trade off
must be taken into account.
Liquidity versus Profitability:
Risk return trade off A firm may follow a conservative, aggressive or moderate policy as discussed above. However, these
policies involve risk, return trade off. A conservative policy means lower return and risk. While an aggressive policy produces
higher return and risk.
The two important aims of the working capital management are profitability and solvency. A liquid firm has less risk of
insolvency that is, it will hardly experience a cash shortage or a stock out situation. However, there is a cost associated with
maintaining a sound liquidity position. However, to have higher profitability the firm may have to sacrifice solvency and
maintain a relatively low level of current assets. This will improve firm.s profitability as fewer funds will be tied up in idle
current assets, but its solvency would be threatened and exposed to greater risk of cash shortage and stock outs. The following
illustration explains the risk-return trade off of various working capital management policies, viz., conservative, aggressive
and moderate etc.
OPERATING OR WORKING CAPITAL CYCLE
A useful tool for managing working capital is the operating cycle. The operating cycle analyzes the accounts
receivable, inventory and accounts payable cycles in terms of number of days. In other words, accounts receivable are
analyzed by the average number of days it takes to collect an account. Inventory is analyzed by the average number of days it
takes to turn over the sale of a product (from the point it comes in the store to the point it is converted to cash or an account
receivable). Accounts payable are analyzed by the average number of days it takes to pay a supplier invoice. Most businesses
cannot finance the operating cycle (accounts receivable days + inventory days) with accounts payable financing alone.
Consequently, working capital financing is needed. This shortfall is typically covered by the net profits generated internally or
by externally borrowed funds or by a combination of the two. Most businesses need short-term working capital at some point

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10

in their operations. For instance, retailers must find working capital to fund seasonal inventory build-up. But even a business
that is not seasonal occasionally experiences peak months when orders are unusually high. This creates a need for working
capital to fund the resulting inventory and accounts receivable build-up.
Some small businesses have enough cash reserves to fund seasonal working capital needs. However, this is
very rare for a new business. If your new venture experiences a need for short-term working capital during its first few years of
operation, you will have several potential sources of funding. The important thing is to plan ahead. If you get caught off guard,
you might miss out on the one big order. Cash flows in a cycle into, around and out of a business. It is the business.s life blood
and every manager.s primary task is to help keep it flowing and to use the cashflow to generate profits. If a business is
operating profitably, then it should, in theory, generate cash surpluses.
If it doesn.t generate surplus, the business will eventually run out of cash. The faster a business expands, the
more cash it will need for working capital and investment. The cheapest and best sources of cash exist as working capital right
within business. Good management of working capital will generate cash which will help improve profits and reduce risks.
Bear in mind that the cost of providing credit to customers and holding stocks can represent a substantial proportion of a firm.s
total profits. There are two elements in the business cycle that absorb cash . Inventory (stocks and workin- progress) and
Receivables (debtors owing you money). The main sources of cash are Payables (your creditors) and Equity and Loans.
Working Capital Cycle
Each component of working capital (namely inventory, receivables and payables) has two dimensions
..TIME ...and MONEY, when it comes to managing working capital then time is money. If you can get money to move faster
around the cycle (e.g. collect monies due from debtors more quickly) or reduce the amount of money tied up (e.g. reduce
inventory levels relative to sales), the business will generate more cash or it will need to borrow less money to fund working
capital. As a consequence, you could reduce the cost of bank interest or you will have additional free money available to
support additional sales growth or investment. Similarly, if you can negotiate improved terms with suppliers e.g. get longer
credit or an increased credit limit, you are effectively creating free finance to help fund future sales. Working capital cycle
indicates the length of time between a company.s paying for materials, entering into stock and receiving the cash from sales of
finished goods. It can be determined by adding the number of days required for each stage in the cycle. For example, a
company holds raw materials on an average for 60 days, it gets credit from the supplier for 15 days, production process needs
15 days, finished goods are held for 30 days and 30 days credit is extended to debtors. The total of all these, 120 days, i.e., 60 .
15 + 15 + 30 + 30 days is the total working capital cycle. The determination of working capital cycle helps in the forecast,
control and management of working capital. It indicates the total time lag and the relative significance of its constituent parts.
The duration of working capital cycle may vary depending on the nature of the business.
Effect of Double Shift Working on Working Capital requirements:
Increase in the number of hours of production has an effect on the working capital requirements. The
greatest economy in introducing double shift is the greater use of fixed assets-little or marginal funds may be required for
additional assets.
It is obvious that in double shift working, an increase in stocks will be required as the production rises.
However, it is quite possible that the increase may not be proportionate to the rise in production since the minimum level of
stocks may not be very much higher. Thus, it is quite likely that the level of stocks may not be required to be doubled as the
production goes up two-fold. The amount of materials in process will not change due to double shift working since work
started in the first shift will be completed in the second; hence, capital tied up in materials in process will be the same as with
single shift working. As such the cost of work-in-process, will not change unless the second shift.s workers are paid at a higher
rate. Fixed overheads will remain fixed whereas variable overheads will increase in proportion to the increased production.
Semi-variable overheads will increase according to the variable element in them.

CA- IPCC- Financial Management`

11

Important Questions

12

Que:- MNO Ltd. has furnished the following cost data relating to the year ending of 31 st March, 2008.
Rs. (in lakhs)
Sales
450
Material Consumed
150
Direct wages
30
Factory overheads (100% variable)
60
Office and Administrative overheads (100% variable)
60
Selling overheads
50
The company wants to make a forecast of working capital needed for the next year and anticipates that:

Sales will go up 100%,

Selling expenses will be Rs. 150 lakhs,

Stock holdings for the next year will be-Raw material for two and half months, Work-in-progress for one month, Finished goods
for half month and Book debts for one and half months,

Lags in payment will be of 3 months for creditors, 1 month for wages and half month for Factory, Office and Administrative and
Selling overheads.
You are required to:
(i) Prepare statement showing working capital requirements for next year, and
(ii) Calculate maximum permissible bank finance as per Tandon Committee guidelines assuming that core current assets of the firm
are estimated to be Rs. 30 lakhs.
Que:- A company is considering its working capital investment and financial policies for the next year. Estimated fixed assets and current
liabilities for the next year are Rs. 2.60 crores and Rs. 2.34 crores respectively. Estimated Sales and EBIT depend on current assets
investment, particularly inventories and book-debts. The financial controller of the company is examining the following alternative Working
Capital Policies:
(Rs. in Crores)
Working Capital Policy
Investment in Current Assets
Estimated Sales
EBIT
Conservative
4.50
12.30
1.23
Moderate
3.90
11.50
1.15
Aggressive
2.60
10.00
1.0
After evaluating the working capital policy, the Financial Controller has advised the adoption of the moderate working capital
policy. The company is now examing the use of long-term and short-term borrowings for financing its assets. The company will use Rs. 2.50
crores of the equity funds. The corporate tax rate is 35%. The Company is considering the following debt alternatives.
(Rs. in Crores)
Financing Policy
Short-term Debt
Long-term Debt
Conservative
0.54
1.12
Moderate
1.00
0.66
Aggressive
1.50
0.16
Interest Rate-Average
12%
16%
You are required to calculate the following:
(1) Working Capital Investment for each policy:
(a) Net Working Capital Position
(b) Rate of Return on Total Assets
(c) Current Ratio
(2) Financing for each policy:
(a) Net Working Capital position,
(b) Rate of return on Shareholders equity.
(c) Current Ratio.
Que:- An engineering company is considering its working capital investment for the year end 2003-04. The estimated fixed assets and
current liabilities for the next year are Rs. 6.63 crore and Rs. 5.967 crore respectively. The sales and earnings before interest and taxes
(EBIT) depend on investment in its current assets- particularly inventory and receivables. The company is examining the following
alternative working capital policies:
(Rs. in crore)
Working capital policy
Investment in C. Assets
Estimated sales
EBIT
Conservative
11.475
31.365
3.1365
Moderate
9.945
29.325
2.9325
Aggressive
6.630
25.500
2.5500
You are required to calculate the following for each policy:
(i) Rate of return on total assets.
(ii) Net working capital position.
(iii) Current assets to fixed assets ratio.
(iv) Discuss the risk-return trade off of each working capital policy.

CA- IPCC- Financial Management`

Practical Questions:-

13

Q. 1. The selling price per unit of a product is computed as follows:


Cost per Unit
Raw Material
Rs. 50
Direct Labour
20
Factory overheads (including depreciation of Rs. 10)
20
Admn. Overheads (including depreciation of Rs. 5)
10
Selling Overheads (including depreciation of Rs. 5)
10
Total
110
Profit per unit
20
Selling price per unit
130
Average raw material in stock for one month . Average material in work in progress in for half month .
Credit allowed by suppliers is one month and credit allowed to debtors is one month. Average time lag in payment of
wages is 10 days. Average time lag in payment of overheads is 30 days. 25% of the sales are on cash basis. Cash
balance is approximately maintained at Rs. 1,00,000. The finished goods lie in the warehouse for one month.
You are required to prepare a statement of working capital requirement to finance a level of activity of
54,000 units of output.
Q. 2. A company is presently operating at 60% capacity, producing 36,000 units per annum,. It is now decided to operate at
90% capacity. The following information is available:
(1)
Existing cost price structure per unit is as follows:
Raw Material
Rs. 4
Wages
Rs. 2
Variable Overheads
Rs. 2
Fixed overheads
Re. 1
Profit
Re. 1
Rs.10
(2)
It is expected that the cost of raw material, wages, expenses and selling price per unit will remain unchanged
in 1997.
(3)
Raw material remain in store for 2 months and in production for 1 month.
(4)
Finished goods remain in godown for 2 months.
(5)
Credit allowed to debtors is 2 months and credit allowed by creditors is 3 months.
(6)
Lag in wages and overheads payment is one month.
Required:
(a)
Prepare Profit Statement at 90% capacity level.
(b)
Calculate the working capital requirement at 90% capacity level.
Q. 3. Ess Ltd. sells goods at a gross profit of 25% considering depreciation as part of the cost of production. Its annual figures
are as follows:
Rs.
Sales at two months credit
18,00,000
Materials consumed (suppliers extend two months credit)
4,50,000
Wages paid (monthly in arrear)
3,60,000
Manufacturing expenses outstanding at the end of the year
40,000
(cash expenses are paid one month in arrear)
Total Administrative Expenses, paid as above
1,20,000
Sales promotion expenses paid quarterly in advance
60,000
The company keeps one months stock each of raw materials and finished goods, and believes in keeping Rs.
1,00,000 in cash. Assuming a 15% safety margin ascertain the requirements of working capital requirement of the
company on cash costs basis. Ignore work-in-progress.
Q. 4. BS Ltd. has been operating its manufacturing facilities till 31:03:1999 on single shift-working with the following cost
structure:
Per Unit
Rs,
Cost of Materials
6.00
Wages (40% fixed)
5.00
Overheads (80% fixed)
5.00
Profit
2.00
Selling Price
18.00
Sales during 1998-1999 Rs. 4,32,000. As at 31;03:1999 the company held:
Rs.

CA- IPCC- Financial Management`

Stock of raw materials (at cost)


36,000
Work-in-progress (valued at prime cost)
22,000
Finished goods (valued at total cost)
72,000
Sundry debtors
1,08,000
In view of increased market demand, it is proposed to double production by working an extra shift. It is
expected that a 10% discount will be available from suppliers of raw materials in view of increased volume of business.
Selling price will remain the same. The credit period allowed to customers will remain unaltered. Credit availed of from
suppliers will continue to remain at the present level i.e. 2 months. Lag in payment of wages and expenses will continue
to remain half a month.
You are required to assess the additional working capital requirement, if the policy to increase output is implemented.
Q. 5. The following are the extracts from Balance Sheet of a company as on 31.12.1999.
Fixed Assets:
Land & Building
Rs. 5,00,000
Plant & Machinery
3,00,000
Working Capital:
Current Assets:
Stock
8,00,000
Debtors
3,00,000
Cash
2,00,000
13,00,000
Current Liabilities:
Creditors
3,40,000
Provision for tax
80,000
Bank Overdraft
1,40,000
Outstanding
Liabilities
1,60,000 7,20,000

Rs. 8,00,000

Total

5,80,000
13,80,000

Additional Information:(1) Sales will increase by 25% next. Year


(2) Maximum Bank Overdraft Rs. 1,60,000
(3) No increase in tax liability for next year.
(4) Period of credit allowed to customers and stock turnover will remain unchanged.
(5) Period of credit allowed by creditors will also remain same.
(6) Outstanding liabilities will remain at the same relative position.
(7) There will be no increase in cash balance.
You are required to computes the additional and total working capital required by the company for the next year.
Q. 6. At the beginning of the year, a company wants to know the working capital that will be required to meet the programme
of activity they have planned for the year. The following information is available
(1) Paid up Share Capital Rs. 2,00,000.
(2) 5% Debentures Rs. 50,000
(3) Fixed Assets Rs. 1,25,000 (at the beginning of year).
(4) Production during the last year was 60,000 units. It is to be maintained during the current year.
(5) Raw Material, Direct Wages and Overheads are 60% ,10% and 20% of selling price.
(6) Each unit is expected to be in production process for one month.
(7) Finished units will stay in warehouse for three months.
(8) Creditors allow credit of two months.
(9) Credit allowed to debtors is 3 months.
(10) Raw Material remains in store for 2 months.
(11) Selling price per unit = Rs. 5.
Prepare:
(i) Working Capital requirement forecast.
(ii) An estimated Profit and Loss Account and Balance Sheet as at the end of the year.
Q.7. A company provided the following data:
Raw materials
Direct labour
Overhead
Total
Profit
Selling price
The following additional information is available:

Cost Per units (Rs.)


52.00
19,50
39.00
110.50
19.50
130.00

CA- IPCC- Financial Management`

14

1. Average raw materials in stock:


one month;
2. Average raw materials in process:
half-a-moth;
3. Average finished goods in stock:
one month;
4. Credit allowed by suppliers:
one month;
5. Credit allowed to debtors:
two months;
6. Time lag in payment of wages:
one and a half weeks;
7. Overheads;
one month;
One-fourth of sales are on cash basis. Cash balance is expected to be Rs. 1.20.000.
You are required to prepare a statement showing the working capital needed to finance a level of activity of 70,000
units of annual output. The production is carried throughout the year on even basis and wages and overheads accrue
similarly. (Calculation be made on the basis on 30 days a months and 52 weeks a year.)
Q.8

Determine the working capital requirement from the following particulars:


Annual budget figures for:
(Rs. Lakhs)
Raw materials
360
Supplies and components
120
Manpower
240
Factory expenses
60
Administration
90
Sales
1190
You are given thee following additional information:
(1) Stock- levels planned:
Raw materials
30 days
Supplies and components 90 days
(2) 50% of the sales is for cash; for the remaining, 20 days credit is normal.
(3) Finished goods are held in stock for a period of seven days before they are released for sale.
(4) Goods remain in process for 5 days.
(5) The company enjoys 30 days credit facilities on 20% of the purchase.
(6) Cash/bank balance had been planned to be kept at the rate of half months budgeted expenses.

Q.9. Prepare an estimate of net working capital requirement for the WCM Ltd. Adding 10% for contingencies from the
information given below.
Estimate cost per unit of production Rs. 170, includes raw materials rs.80, direct labour Rs. 30 and overheads
(exclusive of depreciation) Rs. 60. Selling price is Rs.200 per unit. Level of activity per annum 1,04,000 units. Raw
material in stock: average 4 weeks: work-in-progress (assume 50% completion stage) : average 2 weeks; 4 weeks;
credit allowed to debtors: average 8 weeks; lag in payment of wages: average 1.5 weeks, and cash at bank is expected
to be Rs. 25,000. You may assume that production is carried on evenly throughout the year (52 weeks) and wages and
overhead accrue similarly. All dales are on credit basis only. You may state wages and overheads accrue similarly.
All sales are on credit basis only. You may state your assumptions, if any.
Q. 10. On 1st January, the Managing director of A Ltd. wishes to know the amount of working capital that will be required during the year.
From the following information, prepare the working capital requirement forecast:
Production during the previous year was 60,000 units. It is planned that this level of activity would be maintained during the present
year. The expected ratios of the cost to selling prices are Raw Material 60%. Direct Wages 10% and Overheads 20%, Raw Material is
expected to be in store for average of 2 months before issue to production. Each unit is expected to be in process for one month, the
raw material being fed into the pipeline immediately and labour and overheads cost accruing evenly during the month. Finished
goods will stays in the warehouse awaiting dispatch to customers for approximately 3 months credit allowed by creditors is 2 months
from the date of delivery of raw material. Credit allowed to debtors is 3 months from the date of dispatch. The selling price is Rs. 5
per unit. There is regular production and sales cycle. Wages and overheads are paid after one month. The company normally keep
cash in hand to the extent of Rs. 20,000.
Q. 11. A company newly commencing business in 1999 has the under-mentioned Projected Profit & Loss Account;
Rs.
Rs.
Sales
21,00,000
Less: Cost of goods sold
15,30,000
Gross Profit
5,70,000
Add: Administration Expenses
1,40,000
Add: Selling Expenses
1,30,000
2,70,000
Profit before Tax
3,00,000
Less: Provision for taxation
1,00,000
Profit after Tax
2,00,000
The cost of goods sold has been arrived at as under:
Materials used
8,40,000
Wages & Manufacturing Expenses
6,25,000
Depreciation
2,35,000

CA- IPCC- Financial Management`

15

Less: Stock of finished goods (10% of goods produced not yet sold

17,00,000
1,70,000
15,30,000

The figures given above relates only to finished goods and not to work in progress. Goods equal to 15% of years
production (in terms of physical units) will be in process on the average requiring full materials but only 40% of the other expenses.
The company believes in keeping materials equal to two months consumption in stock.
All expenses will be paid one month in arrear; suppliers of material will extend 1 months credit, sales will be 20% for
cash and the rest at two months credit, 70% of the income tax will be paid in advance in quarterly installments. The company wishes
to keep Rs 80,000 in cash . Prepare an estimate of the requirements of working capital.
Que. 12- Varuna & Co. have applied for working Capital limits from M/s Full of Funds Bank Ltd. who have agreed to sanction the same by
retaining the margins as under: Raw Materials 20%; WIP 30%; Finished Goods 25%; Debtors 10%
From the following projections for the forthcoming year, you are required to work out the following:

Working Capital required by the firm (Cash Cost Approach) and

Working Capital limits likely to be sanctioned by the Bankers


Annual Sales at one month credit
Rs. 14,40,000
Cost of production
Rs. 12,00,000
Raw Material Purchases (at 15 days credit)
Rs. 7,05,000
Monthly Cash Expenditure
Rs. 25,000
Anticipated Raw Material Stocks:
Opening
Rs. 1,40,000
Closing
Rs. 1,25,000
Inventory Norms are: Raw Materials 2 months, WIP 15 days; Finished Goods -1 month.
The firm has received an advance of Rs. 15,000 from customers on Sales Orders.
Q. 13. From the following data, calculate the maximum permissible bank finance under the three methods suggested by the Tandon
Committee:Current Assets
Rs. in lacs Current Liabilities
Rs. in lacs
Raw Material
180 Creditors
120
Work in progress
50 Other current liabilities
30
Finished goods
100 Bank borrowing
250
Receivables
150
Other current assets
20
Total
500
Total
400
The total core Current Assets (CCA) are Rs. 200 lacs.
Q.14. Following is the Balance Sheet of PBX Ltd. Calculate the amount of maximum permissible Bank Finance by all three methods for
working capital as per Tandon Committee Norms. You are required to assume the level of core current assets to be Rs. 60 lakhs.
You are also required to calculate the current ratios as recommended by the Committee, assuming that the bank has granted MPBF.
Balance Sheet of PBX Ltd
As at 31st March, 1998
Liabilities
Amount
Assets
Amount
Equity shares of Rs. 10 each
Fixed Assets
1,000
Retained earnings
400 Current assets:
11% Debentures
400 Raw materials
200
Public deposits
600 Work in progress
300
Trade creditors
200 Finished goods
150
Bills payable
160 Debtors
200
200 Cash at Bank
110
1,960
1,960
Que. 15- You are the management accountant of GANESHA Ltd. The following information is made available to you.
(a) Budgeted Production-600,000 units.
(b) Details of Stock Holding: Raw Materials -2 months; WIP -0.5 month; Finished goods -1 month
(c) Credit granted to customers -2 months; Credit availed from suppliers -1 month
(d) Minimum Cash Balance required at all times Rs. 25000
(e) Cost Structure of the Product is as under:
Cost Per Unit
Rs.
Raw Materials
10.00
Direct Labour
2.50
Overheads (of which depreciation- 0.25 paise)
7.50
Total Costs
20.00
Profit Margin
5.00
Selling Price
25.00
From the above you are required to forecast the working capital requirement of the Company using (a) Total Approach (b) Cash Cost
Approach

CA- IPCC- Financial Management`

16

Chapter : Cash Management


Tight money, escalating interest rates and economic volatility have called for a specialized skills called
Treasury Management. Until recently, no major efforts were made to manage cash. In the wake of the competitive business
environment resulting from the liberalization of the economy, there is a pressure to manage cash. The demand for funds for
expansions coupled with high interest rates, foreign exchange volatility and the growing volume of financial transactions have
necessitated efficient management of money. Treasury management is defined as .the corporate handling of all financial
matters, the generation of external and internal funds for business, the management of currencies and cash flows and the
complex, strategies, policies and procedures of corporate finance.. The treasury management mainly deals with working
capital management and financial risk management. The former constitutes cash management and decides the asset liability
mix. Financial risk management includes forex and interest rate management. The key goal of treasury management is
planning, organizing and controlling cash assets to satisfy the financial objectives of the organization. The goal may be to
maximize the return on the available cash, or minimize interest cost or mobilise as much cash as possible for corporate
ventures. Dealing in forex, money and commodity markets involves complex risks of fluctuating exchange rates, interest rates
and prices which can affect the profitability of the organization.
Treasury managers try to minimize lapses by adopting risk transfer and hedging techniques that suit the
internal policies of the organisation. Options, futures and swaps are a few of the major derivative instruments, the Treasury
Managers use for hedging their risk.
FUNCTIONS OF TREASURY DEPARTMENT
1. Cash Management: The efficient collection and payment of cash both inside the organisation and to third parties is the
function of the treasury department. The involvement of the department with the details of receivables and payables will be a
matter of policy. There may be complete centralization within a group treasury or the treasury may simply advise subsidiaries
and divisions on policy matter viz., collection/payment periods, discounts, etc. Any position between these two extremes
would be possible. Treasury will normally manage surplus funds in an investment portfolio. Investment policy will consider
future needs
for liquid funds and acceptable levels of risk as determined by company policy.
2. Currency Management: The treasury department manages the foreign currency risk exposure of the company. In a large
multinational company (MNC) the first step will usually be to set off intra-group indebtedness. The use of matching receipts
and payments in the same currency will save transaction costs. Treasury might advise on the currency to be used when
invoicing overseas sales. The treasury will manage any net exchange exposures in accordance with company policy. If risks
are to be minimized then forward contracts can be used either to buy or sell currency forward.
3. Funding Management: Treasury department is responsible for planning and sourcing the company.s short, medium and
long-term cash needs. Treasury department will also participate in the decision on capital structure and forecast future interest
and foreign currency rates.
4. Banking: It is important that a company maintains a good relationship with its bankers. Treasury department carry out
negotiations with bankers and act as the initial point of contact with them. Short-term finance can come in the form of bank
loans or through the sale of commercial paper in the money market.
5. Corporate Finance: Treasury department is involved with both acquisition and divestment activities within the group. In
addition it will often have responsibility for investor relations. The latter activity has assumed increased importance in markets
where share-price performance is regarded as crucial and may affect the company.s ability to undertake acquisition activity or,
if the price falls drastically, render it vulnerable to a hostile bid.
MANAGEMENT OF CASH
Management of cash is an important function of the finance manager. The Finance Manager has to provide
adequate cash to each of the units. For the survival of the business it is absolutely essential that there should be adequate cash.
It is the duty of finance manger to have liquidity at all parts of the organization while managing cash. On the other hand, he
has also to ensure that there are no funds blocked in idle cash. Idle cash resources entail a great deal of cost in terms of interest
charges and in terms of opportunities costs. Hence, the question of costs of idle cash must also be kept in mind by the finance
manager. A cash management scheme therefore, is a delicate balance between the twin objectives of liquidity and costs.
The Need for Cash:
The following are three basic considerations in determining the amount of cash or liquidity as have been outlined by Lord
Keynes:
Transaction need: Cash facilitates the meeting of the day-to-day expenses and other debt payments. Normally, inflows of
cash from operations should be sufficient for this purpose. But sometimes this inflow may be temporarily blocked. In such
cases, it is only the reserve cash balance that can enable the firm to make its payments in time.
Speculative needs: Cash may be held in order to take advantage of profitable opportunities that may present themselves and
which may be lost for want of ready cash/settlement.
Precautionary needs: Cash may be held to act as for providing safety against unexpected events. Safety as is explained by
the saying that a man has only three friends an old wife, an old dog and money at bank.

CA- IPCC- Financial Management`

17

Facets of Cash Management: Cash management is concerned with the managing of (i) Cash flows into and
out of the firm; (ii) Cash flows within the firm; and (iii) Cash balances held by the firm at a point of time by financing deficit
or investing surplus cash. It is generally represented by a cash management cycle. Sales generates cash which has to be
disbursed out.
In recent years, a number of innovations have been made in cash management techniques. An obvious aim
of the firm these days is to mange its cash affairs in such a way as to maintain a minimum balance of cash and to invest the
surplus immediately in profitable investment opportunities.
In order to synchronise the cash receipt and payments. A firm need to develop appropriate strategies for cash management viz:
(i) Cash Planning: The pattern of cash inflows and outflows should be properly predicted in advance. Cash budget is a tool to
achieve this objective.
(ii) Managing the cash flows: The cash inflows should be accelerated, while as far as possible, the outflows should be
decelerated.
(iii) Optimum cash level: In deciding about the appropriate level of cash balances, the cost of idle cash and danger of
shortage should be taken into consideration.
(iv) Investing surplus cash: The surplus cash should be properly invested to earn profits. The firm should decide about the
division of such cash balance between various alternative short term investment opportunities such as, bank deposits,
marketable securities, inter-corporate lending. The ideal cash management system will depend upon various factors viz.,
product, organization structure, competition, culture and options available. The task is really complex. The exact nature of a
cash management system would depend upon the organizational structure of an enterprise. In a highly centralized organization
the system would be such that the central or head office controls the inflows and outflows of cash on a routine and daily basis.
In a decentralized form of organisation, where the divisions have complete responsibility of conducting their affairs, it may not
be possible and advisable for the central office to exercise a detailed control over cash inflows and outflows.
Cash Planning:
Cash Planning is a technique to plan and control the use of cash. This protects the financial conditions of the
firm by developing a projected cash statement from a forecast of expected cash inflows and outflows for a given period. This
may be done periodically either on daily, weekly or monthly basis. The period and frequency of cash planning generally
depends upon the size of the firm and philosophy of management. As firms grows and business operations become complex,
cash planning becomes inevitable for continuing success.
The very first step in this direction is to estimate the requirement of cash. For this purpose cash flow statements and cash
budget are required to be prepared. The technique of preparing cash flow and funds flow statements have been discussed in
this book. The preparation of cash budget has however, been demonstrated here.
Cash Budget:
Cash Budget is the most significant device to plan for and control cash receipts and payments. This
represents cash requirements of business during the budget period.
One of the significant advantage of cash budget is to determine the net cash inflow or outflow so that the firm is enabled to
arrange finances. However, the firm.s decision for appropriate sources of financing should depend upon factors such as cost
and risk. Cash Budget helps a firm to manage its cash position. It also helps to utilise funds in better ways. On the basis of cash
budget, the firm can decide to invest surplus cash in marketable securities and earn profits. The cash budget is prepared on the
basis of receipts and payments method and offers following benefits:
(i) It provides a complete picture of all items of expected cash flows.
(ii) It is a sound tool of managing daily cash operations.
This method, however, suffers from the following limitations:
(i) Its reliability is reduced because of the uncertainty of cash forecasts. For example, collections may be
delayed, or unanticipated demands may cause large disbursements.
(ii) It fails to highlight the significant movements in the Working Capital items.
In order to maintain an optimum cash balance, what is required is (i) a complete and accurate forecast of net cash flows over
the planning horizon and (ii) perfect synchronization of cash receipts and disbursements. Thus, implementation of an efficient
cash management system starts with the preparation of a plan of firm.s operations for a period in future. This plan will help in
preparation of a statement of receipts and disbursements expected at different point of time of that period. It will enable the
management to pin point the time of excessive cash or shortage of cash. This will also help to find out whether there is any
expected surplus cash still unutilized or shortage of cash which is yet to be arranged for. In order to take care of all these
considerations, the firm should prepare a cash budget.
Managing Cash Collection and Disbursements:
The finance manager must control the levels of cash balance at various points in the organization. This task
assumes special importance on account of the fact that there is generally a tendency amongst divisional managers to keep cash
balance in excess of their needs. Hence, the finance manager must devise a system whereby each division of an organization
retains enough cash to meet its day-to-day requirements without having surplus balance on hand. For this, methods have to be
employed to:
(a) Speed up the mailing time of payments from customers;

CA- IPCC- Financial Management`

18

(b) Reduce the time during which payments received by the firm remain uncollected and speed up the movement of funds to
disbursement banks.
Having prepared the cash budget, the finance manager should ensure that there does not exists a significant
deviation between projected cash flows and actual cash flows. To achieve this cash management efficiency will have to be
improved through a proper control of cash collection and disbursement. The twin objectives in managing the cash flows should
be to accelerate cash collections as much as possible and to decelerate or delay cash disbursements.
Accelerating Cash Collections:
A firm can conserve cash and reduce its requirements for cash balances if it can speed up its cash collections
by issuing invoices quickly and taking other necessary steps for cash collection. It can be accelerated by reducing the time lag
between a customer pays bill and the cheque is collected and funds become available for the firm.s use. A firm can
decentralized collection system known as concentration banking and lock box system to speed up cash collection and reduce
float time.
(i) Concentration Banking: In concentration banking the company establishes a number of strategic collection centres in
different regions instead of a single collection centre at the head office. This system reduces the period between the time a
customer mails in his remittances and the time when they become spendable funds with the company. Payments received by
the different collection centers are deposited with their respective local banks which in turn transfer all surplus funds to the
concentration bank of head office. The concentration bank with which the company has its major bank account is generally
located a the headquarters. Concentration banking is one important and popular way of reducing the size of the float.
(ii) Lock Box System: Another means to accelerate the flow of funds is a lock box system. While concentration banking,
remittances are received by a collection centre and deposited in the bank after processing. The purpose of lock box system is to
eliminate the time between the receipt of remittances by the company and deposited in the bank. A lock box arrangement
usually is on regional basis which a company chooses according to its billing patterns. Under this arrangement, the company
rents the local post-office box and authorizes its bank at each of the locations to pick up remittances in the boxes. Customers
are billed with instructions to mail their remittances to the lock boxes. The bank picks up the mail several times a day and
deposits the cheques in the company.s account. The cheques may be microfilmed for record purposes and cleared for
collection. The company receives a deposit slip and lists all payments together with any other material in the envelope. This
procedure frees the company from handling and depositing the cheques. The main advantage of lock box system is that
cheques are deposited with the banks sooner and become collected funds sooner than if they were processed by the company
prior to deposit. In other words lag between the time cheques are received by the company and the time they are actually
deposited in the bank is eliminated. The main drawback of lock box system is the cost of its operation. The bank provides a
number of services in addition to usual clearing of cheques and requires compensation for them. Since the cost is almost
directly proportional to the number of cheques deposited. Lock box arrangements are usually not profitable if the average
remittance is small. The appropriate rule for deciding whether or not to use a lock box system or for that matter, concentration
banking, is simply to compare the added cost of the most efficient system with the marginal income that can be generated from
the released funds. If costs are less than income, the system is profitable, if the system is not profitable, it is not worth
undertaking.
(iii) Playing the float: Besides accelerating collections, an effective control over payments can also cause faster turnover of
cash. This is possible only by making payments on the due date, making excessive use of draft (bill of exchange) instead of
cheques. Availability of cash can be maximized by playing the float. In this, a firm estimates accurately the time when the
cheques issued will be presented for encashment and thus utilizes the float period to its advantage by issuing more cheques but
having in the bank account only so much cash balance as will be sufficient to honour those cheques which are actually
expected to be
presented on a particular date.
Different Kinds of Float with reference to Management of Cash:
The term float is used to refer to the periods that affect cash as it moves through the different stages of the collection process.
Four kinds of float with reference to management of cash are:
Billing float: An invoice is the formal document that a seller prepares and sends to the purchaser as the payment request for
goods sold or services provided. The time between the sale and the mailing of the invoice is the billing float.
Mail float: This is the time when a cheque is being processed by post office, messenger service or other means of delivery.
Cheque processing float: This is the time required for the seller to sort, record and deposit the cheque after it has been
received by the company.
Banking processing float: This is the time from the deposit of the cheque to the crediting of funds in the sellers account.
Delaying Payments: A firm can increase its net float by speeding up collections. It can also increase the net float by delayed
disbursement of funds from the bank by increasing the mail time. A company may make payment to its outstation suppliers by
a cheque and send it through mail. The delay in transit and collection of the cheque, will be used to increase
the float.
CASH MANAGEMENT MODELS

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In recent years several types of mathematical models have been developed which helps to determine the
optimum cash balance to be carried by a business organization. The purpose of all these models is to ensure that cash does not
remain idle unnecessarily and at the same time the firm is not confronted with a situation of cash shortage. All these models
can be put in two categories-inventory type models and stochastic models. Inventory type models have been constructed to aid
the finance manager to determine optimum cash balance of his firm. William J. Baumol.s economic order quantity model
applies equally to cash management problems under conditions of certainty or where the cash flows are predictable. However,
in a situation where the EOQ Model is not applicable, stochastic model of cash management helps in determining the optimum
level of cash balance. It happens when the demand for cash is stochastic and not known in advance.
William J. Baumol.s Economic Order Quantity Model, (1952): According to this model, optimum cash level is that level of
cash where the carrying costs and transactions costs are the minimum. The carrying costs refers to the cost of holding cash,
namely, the interest foregone on marketable securities. The transaction costs refers to the cost involved in getting the
marketable securities converted into cash. This happens when the firm falls short of cash and has to sell the securities resulting
in clerical, brokerage, registration and other costs.
The optimum cash balance according to this model will be that point where these two costs are minimum. The formula for
determining optimum cash balance is:
C = Optimum cash balance
U = Annual (or monthly) cash disbursement
P = Fixed cost per transaction.
S = Opportunity cost of one rupee p.a. (or p.m.)
Total Cost
Holding Cost
Cost
(Rs.)

Transaction Cost

Miller-Orr Cash Management Model (1966): According to this model the net cash flow is completely stochastic. When
changes in cash balance occur randomly the application of control theory serves a useful purpose. The Miller-Orr model is one
of such control limit models. This model is designed to determine the time and size of transfers between an investment account
and cash account. In this model control limits are set for cash balances. These limits may consist of h as upper limit, z as the
return point; and zero as the lower limit. When the cash balance reaches the upper limit, the transfer of cash equal to h . z is
invested in marketable securities account. When it touches the lower limit, a transfer from marketable securities account to
cash account is made. During the period when cash balance stays between (h, z) and (z, 0) i.e. high and low limits no
transactions between cash and marketable securities account is made. The high and low limits of cash balance a re set up on
the basis of fixed cost associated with the securities transactions, the opportunity cost of holding cash and the degree of likely
fluctuations in cash balances. These limits satisfy the demands for cash at the lowest possible total costs.

MANAGEMENT OF MARKETABLE SECURITIES


Management of marketable securities is an integral part of investment of cash as this may serve both the
purposes of liquidity and cash, provided choice of investment is made correctly. As the working capital needs are fluctuating,
it is possible to park excess funds in some short term securities, which can be liquidated when need for cash is felt. The
selection of securities

CA- IPCC- Financial Management`

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should be guided by three principles.


Safety: Return and risks go hand in hand. As the objective in this investment is ensuring liquidity, minimum risk is the
criterion of selection.
Maturity: Matching of maturity and forecasted cash needs is essential. Prices of long term securities fluctuate more with
changes in interest rates and are therefore, more risky.
Marketability: It refers to the convenience, speed and cost at which a security can be converted into cash. If the security can
be sold quickly without loss of time and price it is highly liquid or marketable.
The choice of marketable securities is mainly limited to Government treasury bills, Deposits with banks and Intercorporate
deposits. Units of Unit Trust of India and commercial papers of corporates are other attractive means of parking surplus funds
for companies along with deposits with sister concerns or associate companies. Besides this Money Market Mutual Funds
(MMMFs) have also emerged as one of the avenues of short-term investment. They focus on short-term marketable securities
such as Treasury bills, commercial papers certificate of deposits or call money market. There is a lock in period of 30 days
after which the investment may be converted into cash. They offer attractive yields, and are popular with institutional investors
and some big companies

Practical Questions:Que. 1: - Tarus Ltd. has an estimated cash payments of Rs. 8,00,000 for a one month period and the payments are expected to steady over
the period. The fixed cost per transaction is Rs. 250 and the interest rate on marketable securities is 12% p.a.
Calculate the optimal transaction size.
Que. 2: - The annual cash requirement of A Ltd. is Rs. 10 lakhs. The company has marketable securities in lot sizes of Rs. 50,000, Rs.
1,00,000, Rs. 2,00,000, Rs. 2,50,000 and Rs. 5,00,000. Cost of conversion of marketable securities per lot is Rs. 1,000. The
company can earn 5% annual yield on its securities.
You are required to prepare a table indicating which lot size will have to be sold by the company. Also show that the economic lot
size can be obtained by the Baumol Model.
Que. 3: - ABC Ltd. has estimated that use of Rs. 24 lakhs of cash during the next budgeted year. If intends to hold cash in a commercial
bank which pay interest @ 10% p.a. For each withdrawal, the Company incur expenditure of Rs. 150. What is the optimal size for
each withdrawal?

Chapter : Debtors Management


INTRODUCTION A firm needs to offer its goods and services on credit to customers as a Business
strategy to boost the sales. This represents a considerable investment of funds so the management of this asset can have
significant effect on the profit performance of the company. The basic objective of management of sundry debtors is to
optimise the return on investment on this assets known as receivables. Large amounts are tied up in sundry debtors, there are
chances of bad debts and there will be cost of collection of debts. On the contrary, if the investment in sundry debtors is low,
the sales may be restricted, since the competitors may offer more liberal terms. Therefore, management of sundry debtors is an
important issue and requires proper policies and their implementation.
Moreover, since cash flows from a sale cannot be invested until the accounts receivable are collected their control
warrants added importance, efficient collection will lead to both profitability and liquidity of the firm.
ASPECTS OF MANAGEMENT OF DEBTORS
There are basically three aspects of management of sundry debtors.
1. Credit policy: The credit policy is to be determined. It involves a trade off between the profits on additional sales that arise
due to credit being extended on the one hand and the cost of carrying those debtors and bad debt losses on the other. This seeks
to decide credit period, cash discount and other relevant matters. The credit period is generally stated in terms of net days. For
example if the firm.s credit terms are .net 50.. It is expected that
customers will repay credit obligations not later than 50 days. Further, the cash discount policy of the firm specifies:
(a) The rate of cash discount.
(b) The cash discount period; and
(c) The net credit period.
For example, the credit terms may be expressed as .3/15 net 60.. This means that a 3% discount will be granted if the customer
pays within 15 days; if he does not avail the offer he must make payment within 60 days.
2. Credit Analysis: This require the finance manager to determine as to how risky it is to advance credit to a particular party.
3. Control of receivable: This requires finance manager to follow up debtors and decide about a suitable credit collection
policy. It involves both laying down of credit policies and execution of such policies.
There is always cost of maintaining receivables which comprises of following costs:
(i) The company requires additional funds as resources are blocked in receivables which involves a cost in the form of interest
(loan funds) or opportunity cost (own funds)

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(ii) Administrative costs which include record keeping, investigation of credit worthiness etc.
(iii) Collection costs.
(iv) Defaulting costs.
FACTORS DETERMINING CREDIT POLICY
The credit policy is an important factor determining both the quantity and the quality of accounts receivables. Various factors
determine the size of the investment a company makes in accounts receivables. They are, for instance:
(i) The effect of credit on the volume of sales;
(ii) Credit terms;
(iii) Cash discount;
(iv) Policies and practices of the firm for selecting credit customers.
(v) Paying practices and habits of the customers
(vi) The firm.s policy and practice of collection.
(vii) The degree of operating efficiency in the billing, record keeping and adjustment function,
other costs such as interest, collection costs and bad debts etc., would also have an impact on the size of the investment in
receivables. The rising trend in these costs would depress the size of investment in receivables.
The firm may follow a lenient or a stringent credit policy. The firm which follows a lenient credit policy sells on credit to
customers on very liberal terms and standards. On the contrary a firm following a stringent credit policy sells on credit on a
highly selective basis only to those customers who have proper credit worthiness and who are financially sound.
Any increase in accounts receivables that is, additional extension of trade credit not only results in higher sales but also
requires additional financing to support the increased investment in accounts receivables. The costs of credit investigations and
collection efforts and the chances of bad debts are also increased.
Use of Financial tools/techniques: The finance manager while managing accounts receivables uses a number of financial
tools and techniques. Some of them have been described hereby as follows:
(i) Credit analysis: While determining the credit terms, the firm has to evaluate individual customers in respect of their credit
worthiness and the possibility of bad debts. For this purpose, the firm has to ascertain credit rating of prospective customers.
Credit rating: An important task for the finance manager is to rate the various debtors who seek credit facility. This involves
decisions regarding individual parties so as to ascertain how much credit can be extended and for how long. In foreign
countries specialized agencies are engaged in the task of providing rating information regarding
individual parties. Dun and Broadstreet is one such source. The finance manager has to look into the credit-worthiness of
a party and sanction credit limit only after he is convinced that the party is sound. This would involve an analysis of the
financial status of the party, its reputation and previous record of meeting commitments. The credit manager here has to
employ a number of sources to obtain credit information.
The following are the important sources:
Trade references; Bank references; Credit bureau reports; Past experience; Published financial statements; and Salesman.s
interview and reports. Once the credit-worthiness of a client is ascertained, the next question is to set a limit of the credit. In all
such enquiries, the credit manager must be discreet and should always have the interest of high sales in view.
(ii) Decision tree analysis of granting credit: The decision whether to grant credit or not is a decision involving costs and
benefits. When a customer pays, the seller makes profit but when he fails to pay the amount of cost going into the product is
also gone. If the relative chances of recovering the dues can be decided it can form a
probability distribution of payment or non-payment. If the chances of recovery are 9 out of 10 then probability of recovery is
0.9 and that of default is 0.1.
(iii) Control of receivables: Another aspect of management of debtors is the control of receivables. Merely setting of
standards and framing a credit policy is not sufficient; it is, equally important to control receivables.
(iv) Collection policy: Efficient and timely collection of debtors ensure that the bad debt losses are reduced to the minimum
and the average collection period is shorter. If a firm spends more resources on collection of debts, it is likely to have smaller
bad debts. Thus, a firm must work out the optimum amount that it should spend on collection of debtors. This involves a trade
off between the level of expenditure on the one hand and decrease in bad
debt losses and investment in debtors on the other. The collection cell of a firm has to work in a manner that it does not create
too much resentment amongst the customers. On the other hand, it has to keep the amount of the
outstandings in check. Hence, it has to work in a very smoothen manner and diplomatically. It is important that clear-cut
procedures regarding credit collection are set up. Such procedures must answer questions like the following:
(a) How long should a debtor balance be allowed to exist before collection process is started.
(b) What should be the procedure of follow up with defaulting customer? How reminders are to be sent and how should each
successive reminder be drafted?
(c) Should there be a collection machinery whereby personal calls by company.s representatives are made?
(d) What should be the procedure for dealing with doubtful accounts? Is legal action to be instituted? How should account be
handled?
Ageing Schedule: When receivables are analysed according to their age, the process is known as preparing the ageing
schedules of receivables. The computation of average age of receivables is a quick and effective method of comparing the
liquidity of receivables with the liquidity of receivables in the past and also comparing liquidity of one

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firm with the liquidity of the other competitive firm. It also helps the firm to predict collection pattern of receivables in future.
This comparison can be made periodically. The purpose of classifying receivables by age groups is to have a closer control
over the quality of individual accounts. It requires going back to the receivables ledger where the
dates of each customer.s purchases and payments are available. The ageing schedule, by indicating a tendency for old accounts
to accumulate, provides a useful supplement to average collection period of receivables/sales analysis. Because an analysis of
receivables in terms of associated dates of sales enables the firm to recognise the recent
increases, and slumps in sales. To ascertain the condition of receivables for control purposes, it may be considered desirable to
compare the current ageing schedule with an earlier ageing schedule in the same firm and also to compare this information
with the experience of other firms.
Notes on :-Credit Rating:
Credit-rating essentially reflects the probability of timely repayment of principal and interest by a
borrower company. It indicates the risk involved in a debt instrument as well its qualities. Higher the credit rating,
greater is the probability that the borrower will make timely payment of principal and interest and vice -versa.
It has assumed an important place in the modern and developed financial markets. It is a boon to the companies as well
as investors. It facilitates the company in raising funds in the capital market and helps the investor to select their risk return trade off. By indicating creditworthiness of a borrower, it helps the investor in arriving at a correct and rational
decision about making investments.
Credit rating system plays a vital role in investor protection. Fair and good credit ratings motivate the
public to invest their savings. As a fee based financial advisory service, credit rating is obviously extremely useful to the
investors, the corporates (borrowers) and banks and financial institutions. To the investors, it is an indicator expressing
the underlying credit quality of a (debt) issue programme. The investor is fully informed about the company as any
effect of changes in business/economic conditions on the company is evaluated and published regularly by the rating
agencies. The corporate borrowers can raise funds at a cheaper rate with good rating. It minimizes the role of the name
recognition and less known companies can also approach the marke t on the basis of their rating. The fund ratings are
useful to the banks and other financial institutions while deciding lending and investment strategies.
Notes on :-Impact of Inflation on Working Capital: The impact of inflation on working capital is direct. For the same
quantity of sales, the value of sundry debtors, closing stock etc. increases as a result of inflation. The valuation of
closing stock progressively on higher amounts would result in the company not being able to maintain its operating
capability unless it finds extra funds to maintain the same stock level. The higher valuation results in acute shortage
of funds as it triggers profit related cash outflows in respect of income tax, dividends and bonus. Unless proper
planning is done, the business is likely to face a condition known as technical insolvency.
Notes on:-Factoring: Factoring is a new financial service that is presently being developed in India. Factoring involves
provision of specialised services relating to credit investigation, sales ledger management, purchase and collection
of debts, credit protection as well as provision of finance against receivables and risk bearing. In factoring,
accounts receivables are generally sold to a financial institution (a subsidiary of commerc ial bank-called Factor),
who charges commission and bears the credit risks associated with the accounts receivables purchased by it.
Its operation is very simple. Clients enter into an agreement with the factor working out a factoring arrangement
according to his requirements. The factor then takes the responsibility of monitoring, follow -up, collection and risktaking and provision of advance. The factor generally fixes up a limit customer -wise for the client (seller).
Factoring offers the following advantages which makes it quite attractive to many firms.
(1) The firm can convert accounts receivables into cash without bothering about repayment.
(2) Factoring ensures a definite pattern of cash in flows.
(3) Continuous factoring virtually eliminates the need for the credit department. That is why receivables financing
through factoring is gaining popularly as useful source of financing short -term funds requirements of business
enterprises because of the inherent advantage of flexibility it affords to t he borrowing firm. The seller firm
may continue to finance its receivables on a more or less automatic basis. If sales expand or contract it can
vary the financing proportionally.
(4) Unlike an unsecured loan, compensating balances are not required in this case. Another advantage consists of
relieving the borrowing firm of substantially credit and collection costs and to a degree from a considerable
part of cash management.
However, factoring as a means of financing is comparatively costly source of financ ing since its cost of
financing is higher than the normal lending rates.
Notes on :-Effect on Inflation on Inventory Management: The main objective of inventory management is to
determine and maintain the optimum level of investment in inventories. For inv entory management a moderate

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inflation rate say 3% can be ignored but if inflation rate is higher it becomes important to take into consideration
the effect of inflation on inventory management. The effect of inflation on goods which the firm stock is rela tively
constant can be dealt easily, one simply deducts the expected annual rate of inflation from the carrying cost
percentage and uses this modified version in the EOQ model to compute the optimum stock. The reason for making
this deduction is that inflation causes the value of the inventory to raise, thus offsetting somewhat the effects of
depreciation and other carrying cost factors. Since carrying cost will now be smaller, the calculated EOQ and hence
the average inventory will increase. However, if rate of inflation is higher the interest rates will also be higher, and
this will cause carrying cost to increase and thus lower the EOQ and average inventories.
Thus, there is no evidence as to whether inflation raises or lowers the optimal level of invent ories of firms in the
aggregate. It should still be thoroughly considered, however, for it will raise the individual firms optimal holdings
if the rate of inflation for its own inventories is above average and is greater than the effects of inflation on i nterest
rates and vice-versa.

Practical Questions:Que. 1- A Company has prepared the following projections for a year:
Sales
21,000 units
Selling price per unit
Rs. 40
Variable costs per unit
Rs. 25
Total cost per unit
Rs. 35
Credit period allowed
One month
The company proposes to increase the credit period allowed to its customers from one month to two months. It is
envisaged that the change in the policy as above will increase the sales by 8%. The company desires a return of 25% on its
investment.
You are required to examine and advise whether the proposed credit policy should be implemented or not.
Que. 2- A company sells 40,000 units of its products per year @ Rs. 35/ unit. The average cost/unit is Rs. 31 out of which variable cost per
unit is Rs. 28. The average Collection period is 60 days. Bad debts losses are 3% on sales and the collection charges amount to Rs.
15,000.
The company is considering the proposal to follow stricter collection policy which would bring down the losses on account of
Bad Debts to 1% of sales and average collection period to 45 days. It would, however, reduce the sales volume by 1000 units and
increase collect expenses to Rs. 25,000. The company requires a Rate of Return of 20%.
Would you recommend the adoption of the new credit policy? (Assume 360 days in a year for the purpose of your calculation.)
Que. 3- The following are the details regarding the operation of firm during a period of 12 months: Sales Rs. 12,00,000, Selling price per
unit Rs. 10, Variable cost price per unit Rs. 7, Total cost per unit Rs. 9, Credit period allowed to customers One month.
The firm is considering a proposal for a more liberal extension of credit by increasing the average collection period from one
month to two months. This relaxation is expected to increase the sales by 25%.
You are required to advise the firm regarding adopting of the new credit policy, presuming that the firms required return on
investment is 25%.
Que. 4- ABC Ltd. is examining the question of relaxing its credit policy. It sells at present 20,000 units at a price of Rs. 100 per unit, the
variable cost per unit Rs. 88 and average cost per unit at the current sales volume is Rs. 92. All the sales are on credit, the average
collection being 36 days. A relaxed credit policy is expected to increase sales by 10% and the average age of receivables to 60 days.
Assuming 15% return, should the firm relax its credit policy?
Que. 5- ABC Ltd. is considering the following credit policy alternatives:
Particulars
Existing Policy
Option I
Option II
(a) Credit period
(days)
30
41
60
(b) Sales
(Rs. Lakhs)
10.00
9.60
12.000
(c) Bad debt
(% of sales)
5
3.33
6
(d) Cost of credit administration (Rs. Lakhs)
0.20
0.12
0.25
(e) Average effective collection period (days)
45
51
72
The average effective collection period differs from the credit period as all debtors do not strictly adhere to the condition
stipulated. The company achieves a contribution of 40% on sales and the firm requires a 20% p.a. return on investment. You are
required to suggest which period is more suitable to the company. Do you have any suggestions to make to the management in the
context of your finding?
Que. 6- Surya Industries Ltd. is marketing all its products through a network of dealers. All sales are on credit and the dealers are given one
month time to settle bills. The company is thinking of changing the credit period with a view to increase its overall profits. The
marketing department has prepared the following estimates for different periods of credit:
Present Policy
Plan I
Plan II
Plan III
Credit period
(in months)
1
1.5
2
3
Sales
(Rs. Lakhs)
120
130
150
180
Fixed costs
(Rs. Lakhs)
30
30
35
40
Bad debts
(% of sales)
0.5
0.8
1
2

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The company has a contribution sales ratio of 40% further it requires a pre-tax return on investment at 20%. Evaluate Balance
each of the above proposals and recommend the best credit period for the company.
Que. 7- Household Appliances Ltd. deals with consumer durable, having an annual turnover of Rs. 80 lakhs, 75% of which area credit sales
effected through a large number of dealers while the balance sales are made through show rooms on reach b Normal credit allowed is
30 days. The company proposes to expend its business substantially and there is good demand as well. However, the mark manager
finds that the dealers have difficulty in holding more stocks due to financial problems. He therefore, pro a change in the credit policy
as follows:
Proposal
Credit period
Anticipated credit sales
(In Lakhs of rupees)
Plan I
60 days
70
Plan II
90 days
75
The products yield an average contribution of 25% on sales. Fixed costs amount to Rs. 5 lakhs per annum. The company expects a
pre tax return of 20% on capital employed.
The finance manager after a review of the proposal has recommended increasing the provision for bad debts from current 1% to
1 % for Plan I and to 2% for Plan II.
Evaluate the merits of the new proposals and recommend the best policy
Que. 8- In order to increase sales from the normal level of Rs. 2.40 lakhs per annum, the marketing manager submits a proposal for
liberalizing credit policy as under:
Normal sales
Rs. 2.4 lakhs
Normal credit period
30 days
Proposed increase in credit
Relevant increase over
Period beyond normal
Normal sales
15 days
Rs. 12,000
30 days
Rs. 18,000
45 days
Rs. 21,000
60 days
Rs. 24,000
The P.V. ratios of the company is 33.33%. The company expects a pre tax return of 20 percent On investment Evaluate the
above four alternatives and advise the management (assume 360 days a year).
Que. 9- ABC firm is considering to make certain relaxation in its credit policy. The ABC management has evaluated two new policies. From
the following details advise the ABC management which policy has to be adopted:
(i) Annual credit sales at present
Rs. 87.5 lakhs
(ii) Proposed credit sales:
Under alternative I
Under alternative II
Rs. 105 lakhs
Rs. 118 lakhs
(i) Accounts receivable turnover ratio and bad debts losses:
EXISTING
I
II
7
5.25 times
4.2 times
Rs. 2.63 lakhs
Rs. 5.25 lakhs
Rs. 7.88 lakhs
(ii) The ABC is required to give a return over 30% on the investment in new accounts receivable.
(iii) Its PV ratio is 30%.
Que. 10- A firm is considering offering 30 days credit to its customers. The firm like to charge them an annualized rate of 24%. The firm
wants to structure the credit in terms of a cash discount for immediate payment. How much would the discount rate have to be?
Que. 11- Garments Ltd. manufactures readymade garments and sells them on credit basis through a network of dealers. Its present sale is Rs.
60 lakh per annum with 20 days credit period. The company is contemplating an increase in the credit period with a view to
increasing sales. Present variable costs are 70% of sales and the total fixed costs Rs. 8 lakh per annum. The company expects pre tax
return on investment @ 25%. Some other details are given as under:
Proposed Credit
Average Collection
Expected Annual
Policy
Period (days)
Sales (Rs. Lakh)
I
30
65
II
40
70
III
50
74
IV
60
75
Required: Which credit policy should the company adopt? Present your answer in a labour form. Assume 360 day a year.
Calculations should be made upto two digits decimal.
Que. 12- Super Sports Co. dealing in sports goods, have an annual sale of Rs. 50,00,000 and are currently extending 30 days credit to the
dealers. It is felt that sales can pick up considerably if the dealers are willing to carry increased stock, but the dealers have difficulty
in financing their inventory. Super Sports Co. is, therefore considering a shift in credit policy. The following information is available:
The average collection period now is 30 days.
Costs: Variable cost of 80% of sales.
Fixed cost Rs. 6 lace per annum
Required pre tax return an investment = 20%

CA- IPCC- Financial Management`

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Credit Policy

Average collection period

A
45 days
B
60 days
C
75 days
D
90 days
Determine which policy should be adopted by the company on the basis of

Annual sales
(Rs. In lacs)
56
60
62
63
(i) Total Profit, and (ii) Incremental Profit.

Que. 13- XYZ Ltd. makes all sales on a credit basis. Once a year it evaluates the creditworthiness of all its customers. The evaluation
procedure ranks customers from 1 to 5, with 1 indicating the best customers, Results of the ranking are as follows:
Customer Percentage of
Average Credit
Annual Sales Lost
Category Bad Debts
Collection Period Decision
Due to Credit
(Days)
Strictness
1.
None
7
Unlimited Credit None
2.
2.0
15
Unlimited Credit None
3.
4.0
20
Limited Credit
Rs. 4,00,000
4.
10.0
50
Limited Credit
Rs. 1,90,000
5.
19.0
90
Limited Credit
Rs. 2,40,000
The PV Ratio is 20%. The cost of capital invested in receivables is 18%. What would be the effect on the profitability of
extending unlimited credit to each of the categories 3, 4, and 5?
Que. 14- Easy Limited specialists in the manufacture of computer component . The component is currently sold for Rs. 1,000 and its
variable cost is Rs. 800. For the year ended 31.12.96 the company sold on an average 400 components per month.
At present the company grants one months credit to its customers. The company is thinking of extending the same to two
months on account of which the following is expected:
Increase in Sales
25%
Increase in Stock
Rs. 2,00,000
Increase in Creditors
Rs. 1,00,000
You are required: To advise the company on whether or not to extend the credit terms if:
(a) all customers avail the extended credit period of two months and
(b) existing customers do not avail the credit terms but only the new customers avail the same. Assume in this case the entire
increase in sales is attributable to the new customers.
The company expects a minimum return of 40% on the investment.
Que. 15- A firm has a current sales of Rs. 2,56,48,750. The firm has unutilized capacity. In order to boost its sales, it is considering the
relation in its credit policy. The proposed terms of credit will be 60 days credit against the present policy of 45 days. As a result, the
bad debts will increase from 1.5% to 2% of sales. The firms sales are expected to increase by 10%. The variable operating costs are
72% of the sales. The firms corporate tax rate is 35%, and it requires an after tax return of 15% on its investment. Should the firm
change its credit period?
Que. 16- Future Kidd Corporation presently gives credit terms of net 30 days. It has Rs. 60 million in credit sales and its average
collection period is 45 days. To stimulate sales, the company may give credit term of net 60 days. If it does instigate these terms,
sales are expected to increase by 15%. After the change the average collection period is expected to be 75 days with no difference in
payment habits between old and new customers. Variable cost is Re. 0.80 for every Re. 1.00 of sales; and the companys before tax
required rate of return on investment in receivables is 20%.
Should the company extend its credit period? (Assume a 360 day year).
Que. 17- The present credit terms of P Company are 1/10 net 30. Its annual sales are Rs. 80 lakhs, its average collection period is 20 days.
Its variable costs and average total costs to sales are 0.85 and 0.95 respectively and its cost of capital is 10%. The proportion of sales
on which customers currently take discount is 0.5. P Company is considering relaxing its discount terms to 2/10 net 30. Such
relaxation is expected to increase sales by Rs. 5 lakhs, reduce the average collection period to 14 days and increase the proportion of
discount sales to 0.80. What will be the effect of relaxing the discount policy on companys profit? Take year as 360 days.
Que. 18- The credit manager of XYZ Ltd. is reappraising the companys credit policy. The company sells its products on terms of net 30.
Cost of goods sold is 85% of sales and fixed costs are further 5% of sales. XYZ classifies its customers on a scale of 1 to 4.
During the past five years, the experience was as under:
Classification
Default as
Average Collection
A percentage of sales
period (in days)
1
0
45
2
2
42
3
10
40
4
20
80
The average rate of interest is 15%. What conclusions do you draw about the Companys Credit Policy? What other factors
should be taken into account before changing the present policy? Discuss.
Que. 19- A company offers standard credit terms of 60 days net. Its cost of short term borrowings is 16% per annum. Determine whether a
2.5% discount should be offered for payment within 7 days to customers who would normally pay after (i) 60 days, (ii) 80 days, and
(iii) 105 days.
Que. 20- A Company is considering using a factor, the following information is relevant:

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26

(a) The current average collection period for the companys debts is 80 days and % of debt-default. The factor has agreed to pay
over money due. After 60 days, and it will suffer loss of any bad debts.
(b) The annual charge for the factoring is 2% of turnover payable annually in arrears. Administration cost saving will total Rs.
1,00,000. per annum.
(c) Annual sales, all on credit, are Rs. 1,00,00,000. Variable costs total 80% of sales price. The companys cost of borrowings is
15% per annum. Assume year consisting of 365 days. Should the company enter into a factoring agreement?
Que. 21- Under an advance factoring arrangement Bharat Factors Ltd. (BFL) has advanced a sum of Rs. 14 lakh against the receivables
purchased from ABC Ltd. The Factoring agreement provides for an advance payment of 80% (maintaining factor reserve of 20% to
provide for disputes and deduction relating to the bills assigned) of the value of factored receivables and for guaranteed payment after
three months from the date of purchasing the receivables. The advance carries a rate of interest of 20% per annum compounded
quarterly and the factoring commission is 1.5% of the value of factored receivables. Both the interest and commission are collected
up front.
(i)
Compute the amount of advance payable to ABC Ltd.
(ii)
Calculate per annum the effective cost of funds made available to ABC Ltd.
(iii)
Calculate the effective cost of funds made available to ABC Ltd. assuming that the interest is collected in arrear and
commission is collected in advance.
Que. 22- ABC Ltd. currently has a centralized billing system. It takes around 4 days for customers mailed payments to reach the central
billing location. Subsequently, it takes another 1.5 days for processing these payments, only after which deposits are made. ABC
Limited has a daily average collection of Rs. 5,00,000. The company plans to initiate a lock box system in which customers mailed
payments would reach the receipt location 2.5 days earlier. Further the process time would be reduced by another 1 day, since each
lock box bank would collect mailed deposits twice daily.
You are required to;
(i)
Determine the reduction in cash balance that can be achieved through the use of a lock box system.
(ii)
Determine the opportunity cost of the present system, assuming a 5% return on short term investments.
(iii)
If the annual cost of the lock box system is Rs. 80,000, should the system be initiated?
Que. 23- JK Ltd. has received an order from Green Ltd. which insists that the Rs. 50,000 of machinery ordered by supplied on 60 days
credit. The variable costs of production which would be incurred by JK Ltd. in meeting the order amount to Rs. 40,000. Greens
credit worthwhileness is in doubt and the following estimates have been made.
Probability of Green Ltd. paying in full in 60 days
0.6
Probability of Green Ltd. completely defaulting
0.4
However, if the order is accepted by JK Ltd. and if Green Ltd. does not default, then there is felt to be a probality of about 0.7 that a
further eight identical orders will be placed by Green Ltd. in exactly 1 years time, and further orders in later years may also be
forthcoming. Experience has shown that once a firm meets the credit terms on a initial order, the probability of default in the next
year reduces to 0.1. Any work carried out on Greens Ltd. order would take place in otherwise idle time and would not encroach
upon JK Ltd. other activities. Should Green Ltd. defaults, the legal and other costs of debt collection would equal any money
obtained. JK Ltd. finances all trade credit with readily available overdrafts at a cost of 12% per annum. An appropriate discount rate
for long term decisions is 15% per annum. Evaluate the proposal if (i) only one order is expected from Green Ltd. and (ii) if further
orders are also expected from it (year may be taken consisting of 360 days).
Que. 24- The sale of goods to the customer to the value of Rs. 2,000 on 90 days credit terms with an average bad debt rate of 2% and 2% on
administration cost of outstanding balance. Calculate the cost of credit assuming cost of capital is 18% P.A. and discount on cash
sales is 6%.
Que. 25- Jupiter Ltd. is selling its products on credit basis and its customers are associated with 5% credit risk i.e. there is a change of 5
customers out of 100 customers will turn bad. Its annual turnover is expected at Rs. 5,00,000 if credit extended and if no credit is
given the sales would be at 60% there on. Suggest the profitability of extending credit and cash sale assuming cost of capital is 18%
P.A. and variable cost of 75% of sales, credit period is 60 days cost of Administration is 2% of sales.
Que. 26- Star Ltd. are considering the liberation of existing credit terms of there large customers. Relevant data:
Credit Period (Days)
Quantity of Sales
A
B
C
0
1,000
1,000
---30
1,000
1,500
---60
1,000
2,000
1,000
90
1,000
2,500
1,500
Selling price Rs. 9,000 per unit V.C. is 80 per cent of selling price. Cost of carrying debtors is 20 per cent p.a. Determine the
credit period allowed to each customer. Assume 360 days in a year.
Que. 27- A Bank is analyzing the receivables of Jackson Company in order to identify acceptable collateral for a short term loan. The
companys credit policy is 2/10 net 30. The bank lends 80 per cent on accounts where customers are not currently overdue and where
the average payment period does not exceed 10 days past the net period. A schedule of Jacksons receivables has been prepared. How
much will the bank lend on a pledge of receivables, if the bank uses a 10 per cent allowance for cash discount and returns?
Account
Amount
Days Outstanding
Average Payment
Rs.
In days
Period historically
74
25,000
15
20
91
9,000
45
60

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107
108
114
116
123

11,500
2,300
18,000
29,000
14,000
1,08,800

22
9
50
16
27

24
10
45
10
48

Que. 28- Star Ltd. is manufacturers of various electronic gadgets. The annual turnover for the year 1992 was Rs. 730 lakhs. The company
has a wide network of sales outlets all over the country. The turnover is spread evenly for each of 50 weeks of the working year. All
sales are for credit and sales within the week are also spread evenly over each of the five working days.
All invoicing of credit sales is carried out at the head office in Bombay. Sales documentation is sent by post, daily from each location
to the head office. Delays in preparing and dispatching invoices have come to the notice of management. An analysis of the delay in
invoicing being the interval between the date of sale and the date of dispatch of the invoice indicated the following pattern:
No. of days of delay in invoicing
3
4
5
6
% of weeks sales
20
10
40
30
A further analysis indicated that the debtors take on an average 36 days of credit before paying. The period is measured from the day
of dispatch of the invoice rather then the date of sale. It is proposed to hire an agency for undertaking the invoicing work at various
location. The agency has assured that the maximum delay would be reduced to three days under the following pattern.
No. of days of delay in invoicing
0
1
3
% of weeks sales
40
40
20
The agency has also offered additionally to monitor the collections which will reduce the credit period to 30 days. Star Ltd. expects
to save Rs. 4,000 per month in postage costs. All working funds are borrowed from a local bank at simple interest rate of 20 per cent
p.a. The agency has quoted a fee of Rs. 2,00,000 p.a. for the invoicing work and Rs. 2,50,000 p.a. for monitoring collections and is
willing to offer a discount of Rs. 50,000 providing both the works are given. You are required to advise Star Ltd. about the
acceptance of agencys proposal working should form part of the answer.
Que. 29- As a part of the strategy to increase sales and profits, the sales manager of a company proposes to sell goods to a group of new
customers with 10% risk of non payment. This group would require one and a half months credit and is likely to increase sales by
Rs. 1,00,000 p.a. production and selling expenses amount to 80% of sales and the income tax rate is 50%. The companys minimum
required rate of return (after tax) is 25%. Should the sales managers proposal be accepted?
Que. 30- A Firm is considering pushing up its sales by extending credit facilities to the following categories of customers.
(a) Customers with a 10% risk of non payment, and
(b) Customers with a 30% risk of non payment
The incremental sales expected in case of category (a) are Rs. 40,000 while in case of category (b) they are Rs. 50,000. The cost of
production and selling costs are 60% of sales while the collection costs amount to 5% of sales in case of category (a) and 10% of
sales in case of category (b). You are required to advice the firm about extending credit facilities to each of the above categories of
customers.
Que. 31- A trader whose current sales are in the region of Rs. 6 lakhs per annum and an average collection period of 30 days wants to purse
a more liberal policy to improve sales. A study made by a management reveals the following information:Credit Policy
Average
Annual
Bad Debts as a
Collection Period
Sales
Percentage of Sales
A
40 days
Rs. 6,30,000
1.5%
B
50 days
Rs. 6,48,000
2%
C
60 days
Rs. 6,75,000
3%
D
75 days
Rs. 6,90,000
4%
The P/V Ratio is 33.33%. The current bad debt loss is 1%. Required return on investment is 20%. Assume a 360 days. Which
of the above policies would you recommend for adoption?
Que. 32- A trader is considering to make certain relaxation in his credit policy. He has evaluated four new policies. From the following
details advise him which policy has to be adopted:
(i) Annual credit sales at present
Rs. 6,00,000
(ii) Proposed credit sales:
Under credit policy A
Rs. 6,30,000
Under credit policy B
Rs. 6,48,000
Under credit policy C
Rs. 6,75,000
Under credit policy D
Rs. 6,90,000
(iv)
Accounts receivable turnover ratio and bad debts losses:
Accounts receivable
Bad debts losses
Turnover ratio
EXISTING
12 times
Rs. 6,000
Under credit policy A
9 times
Rs. 9,450
Under credit policy B
7.2 times
Rs. 12,960
Under credit policy C
6 times
Rs. 20,250
Under credit policy D
4.8 times
Rs. 27,600
Required return on investment in new accounts receivable is 20%. The P/V Ratio is 33.33%.
Que. 33- Pollock Co. Ltd. , which is operating for the last 5 years, has approached Sundershan Industries for grant of credit limit on account
of goods bought from the latter, annexing Balance Sheet and Income Statement for the last 2 years as below:

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Share capital Equity


(Rs. 10)
Share Premium
Retained Earnings
Total Equity
First Mortgage
Second Mortgage
Bonds
Long term Liab.
Account payable
Notes Payable
Secured Liab.

Pollock Co. Pvt. Ltd. Balance Sheet (Rs. 000)st


Current Last
Year
Year
Plant & Equipment (less Depr.)
600
600
Land
400
400
Total Fixed Trusts
900
700
Inventories
1,900 1,700
Accounts Receivables
200
300
Marketable Securities
-200
Cash
300
300
Total Current Assets
500
800
300
60
600
220
100
70
1,000
350

Current Last
Year
Year
1,500
1,400
750
750
2,250
2,150
580
300
350
200
120
120
100
80
1,150
700

Total Current
Liabilities

3,400
2,850
3,400
2,850
Pollock Co. Pvt. Ltd. Income Statement (Rs. 000)
Current Year
Last Year
Sales
5,980
5,780
Income from Investments
20
6,000
20
5,800
Opening inventory
300
400
Total Mfg. Costs
4,200
3,200
Ending Inventory
(580)
3,920
(300)
3,300
2,080
2,500
General and Admin. Expenses
950
750
Operating income
1,130
1,750
Interest exp.
60
62
Earnings before Taxes
1,070
1,688
Income Tax
480
674
Net income after Taxes
590
1,014
Dividend declared and paid
250
Sudershan Industries has established the following broad guidelines for granting credit limits to its customers:
(i)
Limit credit limit to 10% of net worth and 20% of the net working capital.
(ii)
Not to give credit in excess of Rs. 1,00,000 to any single customer.
You are required to detail the steps required for establishing credit limits to Pollock Co. Pvt. Ltd. In this case, what you
consider to be reasonable credit limit?

Chapter : Leverages
Q ue stio n : Di s cu s s t he co nc ept o f l ev era g e a n d it s ty pe s ?
An sw er : T he ter m l e v er a ge g e ner a ll y, r e fers to a r ela tio n s h ip b e t we en 2 i n terr ela te d v ari ab le s. I n
f i na nc ia l a n al ys i s, i t r ep r e se nt s t he i n f l ue nc e o f o ne fi na n ci al v ari a b le o v er so me o t he r r ela ted
f i na nc ia l v ari ab le . T he s e f i na nc ia l var iab l es m a y b e co st s, o utp u t, sa le s re ve n u e, E BIT (E ar ni n g s
Be fo r e I nt ere st a nd T a x) , EP S ( E ar ni n g s P er S h a re), e tc.
Ty pe s o f lev e ra g e s : Co m mo n l y u sed le ver a ge s are o f t he fo llo wi n g t yp e :
1 ) O pera t ing Lev era g e : I t is d e fi n ed as t h e " fir m's ab i li t y to us e fi x ed o p erat i n g co s t s to m ag n i fy
ef f ec ts o f c ha n ge s i n sa le s o n it s E BI T " . W h e n t her e i s a n i ncr ea se o r d ecr ea se i n sa le s le ve l t h e
EBI T al so c ha n ge s. T h e ef f ec t o f c h a n ge s i n sal es o n t h e le ve l E B IT is me a s ured b y o p e rati n g
le ver a ge.
Op era ti n g le v era ge = % C ha n g e i n E BI T / % C ha n ge i n sa le s
= [ I n cr ea se i n E BI T /E BIT ] / [ In crea se i n sa le s/ sa le s]
Sig nif ica nc e o f o pe ra t ing lev era g e : A n al ys i s o f o p era ti n g le ve ra ge o f a fir m is u se ful t o t he
f i na nc ia l ma na ger . I t tel ls t h e i mp ac t o f ch a n ge s i n sa le s o n o p erat i n g i nco me . A fir m ha v i n g h ig h er
D.O. L. ( De gre e o f Op er ati n g Le ve r a ge) ca n e xp erie n ce a ma g n i fi ed e ff ect o n E BIT fo r e v e n a s ma ll
ch a n ge i n sa le s le ve l. Hi g her D. O. L. c a n d ra ma ti ca ll y i ncr ea se o p er ati n g p ro fi t s. B ut , i n c ase o f
d ecl i ne i n s ale s l e vel , EBI T ma y b e wi p ed o ut and a lo ss ma y b e o p e rated . A s o p era ti n g l e v era ge,
d ep e nd s o n fi xed co s ts , if t h e y ar e h i g h, t he fir m's o p era ti n g ri s k a n d lev era ge wo uld b e h i g h. I f

CA- IPCC- Financial Management`

29

o p er at i n g l e vera g e i s h i g h, it a uto ma t ica ll y mea n s t h at t he b rea k - e ve n p o in t wo uld al so b e rea c hed at


a hi g h le v el o f s al es. A lso , i n ca se o f hi g h o p e rat i n g le v era g e, t h e ma r gi n o f sa fet y wo uld b e lo w.
Th u s, i t i s p re fe r r ed t o o p er a te s u f f ic ie nt l y ab o v e t he b r ea k -e v e n p o i nt to a vo id t he d a n ger o f
f l uct u at io ns i n sa le s a nd p r o f it s.
2 ) Fi na n cia l Lev e ra g e :
I t is d e fi ned as t h e ab i li t y o f a f ir m to u s e fi xe d fi na n cia l c har ge s to m ag n i fy t he e ffe ct s o f c h an g es
in E BIT /Op era ti n g p r o f it s, o n t he fir m 's ea r ni n g s p er s hare. T he fi n a nc ia l l e vera g e o c c ur s whe n a
f ir m's cap it al str u ct ur e co n ta i ns o b li g at io n o f fix ed c har g e s e. g. i n ter e st o n d eb e nt ur es , d i vid e nd o n
p r e fere n ce s har e s, e tc. alo n g wi t h o wn er 's eq u it y to e n ha nc e e ar ni n g s o f eq u it y s h are ho ld er s . T he
f i xed fi na nc ia l c h ar ge s d o no t v ar y wit h t h e o p erat i n g p ro fit s o r E BIT. T he y are fi xed a nd are to b e
r ep aid irre sp ect i ve o f l ev el o f o p er a ti n g p ro fit s o r E BI T . T he o rd i nar y s har e ho ld e rs o f a fir m are
en ti tl ed to re sid u al i nco me i. e. e ar ni n g s a ft er fi xed fi na n ci al c har ge s. T h u s, t he e ffec t o f c ha n g es i n
o p er at i n g p ro fit o r E BI T o n t he le ve l o f EP S is me a s ured b y fi na n cia l le ver a ge.
Fi n a nci al le ve ra ge = % ch a n g e i n EP S / % c ha n g e i n E BIT
or
= ( I nc r ea se i n EP S /EP S) /{I n cr eas e i n E BIT /E BIT}
Th e fi na n cia l l e ver a g e i s fa vo ur ab le wh e n t h e fir m ear n s mo re o n t he i n ve s t me n t/a s se ts fi na n c ed b y
so urc es ha v i n g fi x ed c har g e s. I t i s o b vio u s t h at s h a re ho ld er s gai n a si t ua tio n wh e re t h e co mp a n y
ear n s a hi g h ra te o f r et u r n a nd p a ys a lo wer ra te o f ret ur n to t he s up p l ie r o f lo n g ter m fu nd s, i n s uc h
cas e s it i s ca lled 'tr ad i n g o n eq u it y'. T he fi na nc ial le ver a ge a t t h e le v el s o f E BIT is cal led d e gr ee o f
f i na nc ia l l e vera g e a nd i s cal c ula ted a s r a tio o f E BIT to p ro fit b e fo re ta x.
De gre e o f fi na nc ia l l e ve r ag e = E BI T/P r o f it b e fo re ta x
S hare ho ld er s ga i n i n a s it ua tio n wh er e a co mp a n y ha s a hi g h ra te o f re tu r n a nd p a ys a lo we r rate o f
in ter es t to t he s up p l ier s o f lo n g ter m f u nd s. Th e d i ffe re nc e acc r ue s to t he s har e ho ld ers . Ho we v er,
wh ere r at e o f re t ur n o n i n ve st me n t f al ls b elo w t he ra te o f i n tere s t, t h e s h are ho ld er s s u ffer, a s t h eir
ear ni n g s fal l mo re s h ar p l y t ha n t he fa ll i n t h e re tu r n o n i n v e st me n t.
Fi n a nci a l le v era ge help s t he f i na nc e ma n a ger i n d es i g ni n g t he ap p ro p r iat e c ap i tal s tr uc t ure. O ne o f
th e o b j ec ti ve o f p l a n ni n g a n ap p r o p r i ate c ap it al s tr uct u re is to ma xi mi s e r et ur n o n eq uit y
s har e ho ld er s ' fu nd s o r ma x i mi s e EP S. Fi n a nci a l l e vera g e i s d o ub le ed g ed s wo rd i.e. i t i ncre as e s EP S
o n o ne ha nd , a nd fi n a n cia l r i s k o n t he o t her. A hi g h fi na n cia l l e ver a ge mea n s h i g h fi x ed co st s a nd
hi g h fi na nc ia l ri s k i.e. as t he d eb t co mp o ne n t in c ap i tal str u ct ur e i ncr eas e s, t he fi n a nci al ri s k also
in cr e as es i. e. ri s k o f i n so l v e nc y i ncr e as es . T he fi na nc e ma n a ger t h u s, is r eq uir ed to trad e o f f i.e. to
b r i n g a b a la nc e b e t we e n r is k a nd r e t ur n fo r d e te r mi ni n g t he ap p ro p ria te a mo u n t o f d eb t i n t he c a p ita l
str u ct ur e o f a fir m. T h u s, a n al ys i s o f fi n a nc ia l l e vera g e i s a n i mp o rt an t to o l i n t h e ha nd s o f t he
f i na nc e ma na g er wh o a r e e n ga g ed i n f i na nc i n g t he c ap i ta l s tr uc t ure o f b u si n e ss fir ms , k eep in g i n
vi e w t he o b j e ct i ve s o f t he ir f ir m.
3 ) Co mb in ed lev era g e :
Op era ti n g l e vera g e exp lai n s o p er a ti n g r i s k a n d fi na n ci al le v era ge e x p lai n s t h e fi n a nc ial r is k o f a
f ir m. Ho we ver, a fir m h as to lo o k i n to o ve ral l ris k o r to t al ri s k o f t he fir m i.e. o p er at i n g ri s k as al so
f i na nc ia l r is k . He nce , t h e co mb i ned le v er a ge i s t he re s ul t o f a co mb i na ti o n o f o p er at i n g a nd fi na nc ia l
le ver a ge. T h e co mb i ned le ver a ge me a s ur e s t h e e ffe ct o f a % c h a n ge i n sa le s o n % c h a n ge i n EP S.
Co mb i ned Le vera g e = O p er at i n g l e ver a g e * Fi n a nc ia l l e vera g e
= (% c ha n g e i n E BI T/ % c h a n ge i n s ale s) * ( % c ha n ge i n EP S/ % c h a n ge i n E BIT)
= % c ha n g e i n EP S/ % c ha n ge i n sa le s
Th e ra tio o f co n tr ib u ti o n to e ar ni n g s b e fo re t ax, i s g i ve n b y a co m b in ed e ffec t o f fi na n ci al a nd
o p er at i n g le ve ra ge. A h ig h o p e r at i n g a nd h i g h fi na nc ia l le ver a ge i s v e r y ri s k y, e ve n a s ma ll fall i n
sa le s wo uld a ffec t tr e m end o u s f a ll i n EP S . A c o mp a n y mu s t t h us , mai n tai n a p ro p er b a la nc e b e t we e n
th e se 2 l e vera g e. A h i g h o p er at i n g a nd lo w fi na nc ia l le v era ge i nd i cate s t hat t he ma n a ge me n t i s
car e fu l a s h i g her a mo u nt o f r is k i n vo l v ed i n hi g h o p era ti n g le v era ge is b al a nced b y lo w fi n an c ia l
le ver a ge. B ut , a mo r e p r ef er ab le si t uat io n i s to ha v e a lo w o p era ti n g a n d a h i g h fi na n ci al l e ver ag e. A
lo w o p er at i n g le v er a ge au to ma ti cal l y i mp li e s t h at t h e co mp a n y r eac h es it s b rea k - e ve n p o i nt a t a lo w
le ve l o f sal es , t h u s, r is k is d i mi n i s hed . A hi g h l y ca ut io us a nd co n ser v at i ve ma n a ge r wo u ld keep b o t h
it s o p er at i n g a nd f i na n c ial le v er a ge at ver y lo w le ve l s. T h e ap p ro a c h m a y, mea n t h at t he co mp an y i s
lo s i n g p ro fitab le o p p o r t u ni ti e s.
Th e st ud y o f l e ver a g e s is e ss e nt ia l to d e fi n e the r is k u nd e rta k e n b y t he s har e ho ld e rs. E a rn i n gs
av ai lab l e to s hare ho ld er s fl u ct ua te o n ac co u nt o f 2 ri s k s, vi z. o p era ti n g ris k i.e. var iab il it y o f EBIT

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30

ma y ari se d ue to v ar i ab ili t y o f s al es o r /a nd e xp en se s. I n a g i ve n e n v iro n me n t, o p er at i n g ri s k c an no t


b e a vo id ed . T h e va r iab il it y o f EP S o r r e t ur n o n eq u it y d ep e nd s o n t he u se o f fi n a nc ial le v era g e and i s
ter med a s fi na nc ial r i s k. A f ir m fi n a nced to ta ll y b y eq ui t y fi na n ce h as no fi na n ci al ri s k, he nc e it
ca n no t b e a vo id ed b y e l i mi na ti n g u se o f b o rro wed fu nd s. T h us , a co mp an y ha s t o co n sid e r it s li ke l y
p r o f itab il it y p o s it io n s e t b e fo r e d e cid i n g up o n t he cap i ta l mi x o f t he co mp a n y, a s i t h a s far re a ch i n g
i mp l ica tio n s o n t he f i na nc ia l p o si tio n o f t he co mp a n y.
Q ue st io n : W ha t is t h e ef f ect o f lev era g e o n ca pita l t ur no v er a n d w o r ki ng ca p ita l ra tio ?
An sw er : A n i ncr e a se i n sal es i mp r o ve s t h e net p ro fi t ra tio , r ai si n g t he Re t ur n o n I n v es t me n t ( R. O.I)
to a hi g he r le v el. T h i s ho we ver , i s no t p o s sib l e i n al l si t uat io n s, a r is e i n cap it al t ur no ver i s to b e
s up p o rt ed b y ad eq ua te cap i tal b a se. T h u s, a s c ap it al t ur no ve r ra tio i n crea se s, wo r k i n g c ap i ta l ra tio
d eter io ra te s, t h u s, ma n a ge me n t c a n no t i ncre as e it s cap it al t ur no v er ra ti o b e yo nd a cert ai n li mi t . Th e
ma i n re a so ns fo r a fa ll i n r a tio s s ho wi n g t h e wo r ki n g cap i ta l p o s it io n d ue to i ncre as e i n t u rno ve r
r atio s i s t h at a s t he ac t iv it y i ncr e as e s wi t ho ut a co rre sp o nd i n g ri se i n wo r ki n g cap it al, t h e wo rk i n g
cap i tal p o s it io n b eco me s t i g ht. As t he sa le s i nc rea se s, b o t h c ur re nt as s et s a nd c urr e nt l iab il it ie s al so
in cr e as es b u t no t i n p r o p o r tio n t o c ur r e n t rat i o . If c urr e nt ra tio a nd acid t e st ra tio ar e hi g h , it i s
ap p are n t t ha t t he c ap i ta l t ur no ver r a tio c a n b e in cre as ed wi t ho ut a n y p ro b le m. Ho we v er, i t ma y b e
ver y ri s k y to i n cr ea se ca p ita l t u r no ver r at io wh e n, t he wo r ki n g cap it al p o si tio n i s no t s at is fac to r y.

Practical Questions:Que. 1: - Calculate the operating leverage, financial leverage and combined leverage from the following date under Situations I and II and
financial plans A and B:
Installed Capacity
4,000 units
Actual Production and Sales
75% of the Capacity
Selling Price
Rs. 30 Per Unit
Variable Cost
Rs. 15 per unit
Fixed Cost:
Under Situation
Rs. 15,000
Under Situation
Rs. 20,000
Capital Structure
(Rs.)
Financial Plan
A
B
Equity
10,000
15,000
Debt (Rate of Interest at 20%)
10,000
5,000
20,000
20,000
Que. 2: - The following figures relate to two Companies:
Particulars
P. Ltd.
Q. Ltd.
Sales
500
1,000
Variable Costs
200
300
Contribution
300
700
Fixed Cost
150
400
150
300
Interest
50
100
Profit before Tax (PBT)
100
200
You are required to calculate:
(1) Operating, Financial and Combined Leverages of the two Companies, and
(2) Comment on the relative position of the Companies in respect of the risk.
Que. 3: - Calculate EPS (earning per share) of Solid Ltd. and Sound Ltd. assuming (a) 20% before tax rate of return on assets (b) 10%
before tax rate of return on assets based on the following data:
Particulars
Assets
Debt
(12% Debenture & 7 Loan)
Equity

Solid Ltd.
100
---

Sound Ltd.
100
50

100
50
(Share of Rs. 10 each)
(Share of Rs. 10 each)
Assume a 50% Income tax in both cases. Give your comments on the financial leverage.
Que. 4: - XYZ Ltd. has an average selling price of Rs. 10 per unit. Its variable unit costs are Rs. 7, and fixed costs amount to Rs. 1,70,000. It
finances all its assets by equity funds. It pays 35% tax on its income. ABC Ltd. is identical of XYZ Ltd. except in the pattern of
financing. The latter finances it assets 50% by debt, the interest on which amounts to Rs. 20,000
Determine the degree of operating, financial and combined leverage at Rs. 7,00,000 sales for both the firms, and
interpret the results.

CA- IPCC- Financial Management`

31

Que. 5: - Saraju Ltd. produces electronic components with price per unit of Rs. 100. Fixed cost amount to Rs. 2,00,000.
5,000 units are produced and sold each year. Annual profits amount to Rs. 50,000. The companys all equity financed assets are
Rs. 5,00,000.
The company proposes to change its production process, adding Rs. 4,00,000 to investment and Rs. 50,000 to fixed operational
costs. The consequences of such a proposal are:
(i)
Reduction in variable cost per unit by Rs. 10
(ii)
Increase in output by 2,000 units
(iii)
Reduction in selling price per unit to Rs. 95
Assuming an average cost of capital 10%, examine the above proposal and advise whether or not the company should make the
change. Also measure the degree of operating leverage and break even point.
Que. 6: - The balance sheet of Alpha Numeric Company is given below:
Liabilities
Rs. Assets
Rs.
Equity capital (Rs. 10 per share)
90,000 Net fixed assets
2,25,000
10% Long term Debt.
1,20,000 Current assets
75,000
Retained earnings
30,000
Current liabilities
60,000
3,00,000
3,00,000
The companys total assets turnover ratio is 3, its fixed operating cost is Rs. 1,50,000 and its variable operating cost ratio is 50%.
The income tax rate is 50%.
You are required to:
(1) Calculate the different type of leverages for the company.
(2) Determine the likely level of EBIT if EPS is:
(a) Re. 1 (b) Rs. 2 (c) Re. 0
Que. 7: - A firm has sales of Rs. 75,00,000 variable cost of Rs. 42,00,000 and fixed cost of Rs. 6,00,000. It has a debt of Rs. 45,00,000 at
9% and equity of Rs. 55,00,000.
(i) What are the operating, financial and combined leverages of the firm?
(ii) What is the firms ROI?
(iii) Does it have favourable, financial and combined leverages of the firm?
(iv)
If the firm belong to an industry whose asset turnover is 3, does it have a high or low asset leverage?
(v)
If the sales drop to Rs. 50,00,000, what will be the new EBIT?
(vi)
At what level of sales the EBT of the firm will be equal to zero?
Que. 8: - The following summarizes the percentage changes in operating income, percentage
pharmaceutical firms.
Firm
Change in
Change in
Revenue
operating income
PQR Ltd.
27%
25%
RST Ltd.
25%
32%
TUV Ltd.
23%
36%
WXY Ltd.
21%
40%

changes in revenues, and betas for four


Beta
1.00
1.15
1.30
1.40

Required:
(i)
Calculate the degree of operating leverage for each of these firms. Comment also.
(ii)
Use the operating leverage to explain why these firms have different beta.
Que. 9: - The capital structures of the progressive Corporation consists of an ordinary share capital of Rs. 10,00,000 (Shares of Rs. 100 per
value) and Rs. 10,00,000 of 10% debentures. Sales increased by 20% from 1,00,000 units to 1,20,000 units, the selling price is Rs.
10 per unit; variable cost amount to Rs. 6 per unit and fixed expenses amount to Rs. 2,00,000. The income tax rate is assumed to
be Rs. 50%. You are Required to calculate the following:
(i)
the percentage increase in earning per share;
(ii)
the degree of financial leverage at 1,00,000 units to 1,20,000 units.
(iii)
The degree of operating leverage at 1,00,000 units and 1,20,000 units.
Comment on the behavior of operating and financial leverages in relation to increase in production from 1,00,000 units to
1,20,000 units.
Que. 10: -ABC Ltd.s capital structure on 31 -3-2001 includes 5,00,000 Equity shares of Rs. 10 each, 10,000 debentures of Rs. 150 each
tarrying 15% rate of interest and term loan of Rs. 20,00,000 repayable in 7 year period with 18% rate of interest. XYZ Ltd.s
Balance sheet shows the following capital structure: 2,00,000 Equity shares of Rs. 10 each
General Reserve of Rs. 5,00,000
Share premium A/c Rs. 3,00,000
32,000 Preference shares of Rs. 100 each (12%)
25,000 Non convertible debentures of Rs. 100 each (fully secoured) (14%)
From the above date you are required to calculate the leverage of both the firms and compare with each other.

Que. 11- The following data are available for the ABC Ltd. and XYZ Ltd.:
ABC Ltd.

CA- IPCC- Financial Management`

XYZ Ltd.

32

Sales volume
10,000 units
10,000 units
Selling price per unit of output
Rs. 200
Rs. 200
Variable cost per unit of output
Rs. 120
Rs. 150
Fixed operating cost per unit of output
Rs. 60
Rs. 30
Equity
Rs. 3,00,000
Rs. 6,00,000
Preference shares
Rs. 1,00,000

Debt
Rs. 6,00,000
Rs. 4,00,000
Interest rate on debt
16.25%
15%
Dividend rate on Preference share
13%

Tax rate
60%
60%
Required:(i)
Calculate the ROE, DOL, DFL, DTL, operating break even point, financial break even point and overall
break even point for each company.
(ii)
As a financial analyst which of the two companies would you describe as more risky? Give reasons
Que. 12 EXE Limited is considering three financing plans. The key information is as follows:(a) Total investment to be raised Rs. 2,00,000.
(b) Plans of Financing Proportion
Plans
Equity
Debt
Preference Shares
A
100%

B
50%
50%

C
50%

50%
(c) Cost of debt
8%
Cost of preference shares
8%
(d) Tax rate 50%.
(e) Equity shares of the face value of Rs. 10 each will be issued at a premium of Rs. 10 per share.
(f) Expected PBIT is Rs. 80,000.
Determine for each Plan
(i)
Earnings per share (EPS) and
(ii)
The financial break even point,
(iii)
Indicate if any of the plans dominate and compute the PBIT range among the plans for indifference.
Que. 13- Bharat Carpet Company is contemplating an expansion of their business, Current income statement of the company
is given below:
Rs.
Sales
8,00,000
Less: Variable expenses
3,60,000
(45% of sales)
Fixed expenses
3,20,000
EBIT
1,20,000
Interest (@ 6%)
24,000
EBT
96,000
Tax (@ 50%)
48,000
EAT
48,000
Shares of common stock
(40,000 shares)
EPS
Rs. 1.20
Bharat Carpet Company is currently financed with 50 per cent equity (common stock par value of Rs. 10). In
order to expand the business the company would need Rs. 4,00,000. The management has three following financing
plans in hand:
1. Sell Rs. 4 lakhs of debt at 9 per cent.
2. Sell Rs. 4 lakhs of common stock at Rs. 20 per share.
3. Sell Rs. 2 lakhs of debt @ 8 per cent and Rs. 2 lakhs of common stock @ Rs. 25/- per share.
Variable costs are expected to stay at 45 per cent of sales while fixed costs will increase to Rs. 4,20,000. The
management is not sure how much this expansion will add to sales but they estimate sales will rise to Rs. 9,60,000.The
Management is interested in a though analysis of the expansion plans and methods of financing.
Required:
(i)
Compile the break even point before and after expansion:
(ii)
Compute the degree of operating leverage before and after expansion;
(iii)
Calculate the degree of financial leverage before expansion and for all the three methods of financing
after expansions.

CA- IPCC- Financial Management`

33

34

Chapter : Cost of Capital & Capital Structure


Q ue st io n : E xp la i n t he co nc ept o f ca pit a l str u ctur e ?
An sw er : A fi n a nce ma na g er fo r p r o c ur e me n t o f fu nd s, i s req ui red to sel ect s uc h a fi na nc e mi x o r
cap i tal s tr uc t ure t ha t m ax i mi s es s h ar e ho ld er s we a lt h. Fo r d es i g ni n g o p ti mu m cap ita l str u ct ur e h e i s
r eq u ired to se lec t s uc h a mi x o f so ur ce s o f fi n an ce, so t hat t h e o v eral l co s t o f cap it al i s mi n i mu m.
Cap it al s tr uc t ure r e f er s to t he mi x o f so ur ce s fr o m wh e re lo n g t er m fu n d s req uir ed b y a b u si ne s s ma y
b e r ai s ed i. e. wh at s ho u ld b e t he p r o p o r tio n o f eq u it y s h are cap i ta l, p r e fer e nce s h are cap ita l, i n ter na l
so urc es, d eb e n t ur e s a nd o t her so ur ce s o f fu n d s in to ta l a mo u n t o f cap it al wh ic h a n u nd ert a ki n g ma y
r ai se fo r e stab li s h i n g i t s b u si n e ss. I n p l a n ni n g t h e cap ita l str u ct ur e, fo llo wi n g mu s t b e r e ferr ed to :
1 ) The re i s no d e fi n it e mo d e l t h at c a n b e s u g g es ted / u sed as a n id ea l fo r all b u si n es s u nd er ta k in g s.
Th i s i s d u e to var yi n g cir c u ms t a nce s o f var io u s b us i ne s s u nd ert a ki n g s. Cap i ta l s tr uc t ure d ep e nd s
p r i ma r il y o n a n u mb er o f fac to r s li ke , na t ure o f i nd u str y, ge s tat io n p er io d , c ert ai n t y wi t h wh ic h t he
p r o f it s wi l l ac cr ue a f ter th e u nd er ta ki n g co m me n ces co m mer cia l p ro d uc ti o n a nd t h e l i kel y q u a nt u m o f
r et ur n o n i n ve st me n t. I t i s t h u s, i mp o r ta n t to u nd e rs ta nd t ha t d i ffer en t t yp e s o f cap it al s tr uc t ure
wo u ld b e req u ired fo r d i f fe r e nt t yp e s o f u nd ert a ki n g s.
2 ) Go v er n me n t p o li c y i s a maj o r f acto r i n p la n ni n g cap i ta l s tr uct u re. Fo r i n st a nce, a c h a n ge in t he
le nd i n g p o l ic y o f f i na nc ia l i ns ti t ut io n s ma y me a n a co mp le te c ha n ge i n t h e fi na nc ia l p a tter n .
Si mi l arl y, r u le s a nd r e g ul at io n s fo r cap ita l mar ke t fo r mu l at ed b y SE BI affect t he c ap i tal st r uc tu re
d eci sio n s. T he fi na nc e ma n a ger s o f b u si n e ss c o nc er n s are r eq uir ed to p la n c ap i tal s tr uc t ure wi t h i n
th e se co n s tra i nt s.
O pt i mu m ca pi ta l st ru c t ure : T he cap i ta l str u ct ure i s sa id to b e o p t i mu m, wh e n t he co mp a n y h as
se lec ted s u c h a co mb i n atio n o f eq ui t y a nd d eb t, so t ha t t he co mp a n y 's we al t h is ma x i mu m. A t t h i s,
cap i tal st r uct ur e, t h e co st o f c ap i tal is mi n i mu m a nd ma r ket p r i ce p er s hare is ma x i mu m. B u t , it i s
d i f fic u lt to mea s ur e a fa ll i n t h e mar ke t v al ue o f an eq ui t y s h are o n acco u nt o f i n crea s e i n ri s k d ue to
hi g h d eb t co n te n t i n t h e cap i ta l s tr uc t ur e. I n r eal it y, ho we ver , i n ste ad o f o p t i mu m, a n ap p ro p riat e
cap i tal s tr uc t u re i s mo r e r eal i st ic. Fe at ur es o f a n ap p ro p ria te cap ita l str u ct ure are as b elo w :
1 ) Pro fita bi lity : T he mo st p r o f itab le cap it al str u ct ur e is o ne t h at te n d s to mi n i mi se fi n a nc i n g co st
and ma xi mi se o f ear n i n g s p er eq ui t y s har e.
2 ) Fl e xi bi lity : T h e c ap i t al s s tr uct u r e s ho u l d b e s uc h t h at t he co mp a n y i s ab l e to ra i se fu nd s
wh e ne v er need ed .
3 ) Co n se rv a tio n : D eb t co n te n t i n c ap i tal s tr uc tu re s ho uld no t e xce ed th e l i mi t wh i c h t he co m p an y
ca n b ea r.
4 ) So lv en cy : Cap it al s t r uc t ur e s ho u ld b e s u c h t ha t t h e b u si n es s d o es no t r u n t h e ri s k o f i n so l v e nc y.
5 ) Co nt ro l : Cap it al str uc t ur e s ho uld b e d e vi s e d in s uc h a ma n ne r t ha t it i n vo l ve s mi n i mu m r i s k o f
lo s s o f co ntro l o ver t he co mp a n y.
Q ue st io n : E xp la i n t he ma j o r co n s id era t io n s i n t he pla n ni ng o f ca p it a l s tr uct ure ?
An sw er : T he 3 maj o r c o n sid er at io n s e vid e n t i n cap it al s tr uc t ure p la n n i n g are ri s k, co st a nd co nt ro l,
th e y as s is t t he ma na g e m en t i n d e ter mi n i n g t h e p ro p o rtio n o f fu nd s to b e rai sed fro m v ario u s so u rce s.
Th e fi n a nce ma na g er a tt e mp t s to d e si g n t h e cap ita l str u ct ur e i n a ma n n er, t h at h i s ri s k a nd co s t are
lea st a nd t her e i s lea s t d il ut io n o f co nt r o l fro m t he e xi st i n g ma n a ge me nt . T h ere are al so s ub si d iar y
fa cto r s a s, ma r ke tab i li t y o f t h e is s u e, ma n e u ve rab il it y a nd fle x ib i li t y o f cap ita l s tr uc t ure a n d ti mi n g
o f r ai s i n g fu nd s. S tr uc t u r i n g c ap i tal , is a s hr e wd fi na n cia l ma na g e me n t d eci sio n a nd i s so me t h i n g t ha t
ma k e s o r ma rs t he f o r t u ne s o f t he co mp a n y. T he facto r s i n vo l v ed i n i t ar e a s fo l lo ws :
1 ) Ri s k : R is k s ar e o f 2 ki n d s v iz. fi na n ci al a nd b u si n es s r i s k. Fi na n ci al ris k i s o f 2 k i nd s a s b e l o w :

CA- IPCC- Financial Management`

i) Ri s k o f ca s h i n so lv e ncy : A s a b us i ne s s rai s es mo re d eb t, i t s ri s k o f cas h i n so l ve nc y i n cre as es, a s


:
a) th e h i g her p ro p o r tio n o f d eb t i n cap it al str uc tu re i ncr ea se s t he co m m it me n t s o f t h e co mp a n y wi t h
r eg ard to fi xed c har ge s. i.e. a co mp a n y s ta n d s co m mi tt ed to p a y a hi g h er a mo u nt o f i n tere st
ir r e sp ec ti v e o f t he f act wh et h er o r no t i t ha s ca s h. a nd
b ) t he p o s sib il it y t ha t t h e s up p li er o f f u nd s ma y wi t h d ra w fu n d s at a n y p o in t o f ti me.
Th u s, lo n g ter m cr ed ito r s ma y ha ve to b e p a id b ac k i n i n st al l me n ts , e v en i f s u ffic ie nt ca s h to d o so
d o es no t e x i st. S uc h r i s k is ab se n t i n ca se o f eq u it y s har es .
ii) Ri s k o f v a ria t io n i n t he e x pe ct e d ea r ni ng s a v a ila ble to eq u ity s h a re - ho l der s : I n c as e a fir m
ha s a h i g her d eb t co n te nt i n cap it al str u ct ur e, t he r i s k o f v ari at io ns i n exp ect ed ear n i n g s a va il ab le to
eq u it y s hare ho ld er s wo uld b e hi g h er ; d ue to t rad i n g o n eq u it y. T h er e is a lo wer p ro b ab il it y t ha t
eq u it y s h are ho ld er s ge t a st ab le d i v id e nd i f, t he d eb t co n te nt i s h i g h i n c ap i ta l str u ct ure a s t he
f i na nc ia l le ver a ge wo r k s b o t h wa ys i.e . it e n h an ce s s har e ho ld ers ' r et ur n s b y a hi g h ma g n it u d e o r
r ed u ce s it d ep e nd i n g o n wh e t her t he r e t ur n o n i n ve s t me n t i s hi g he r o r l o wer t ha n t he i n ter es t r ate. I n
o th er wo rd s, t h er e i s r e lat i ve d i sp er sio n o f e xp ected ear n i n g s a v ai lab l e to eq u it y s h are ho ld er s, t ha t
wo u ld b e grea ter i f cap i t al str u ct ur e o f a f ir m h a s a h i g her d eb t co nt e nt.
T he fi na nc ia l r is k i n vo l v ed i n vari o us so urc es o f fu nd s ma y b e u nd er sto o d wi t h t h e h elp o f
d eb e nt ur es. A co mp a n y ha s to p a y i nt er e st c h ar ge s o n d eb e n t ure s e ve n in ca se o f ab se nc e o f p ro fit s.
Ev e n t he p ri n cip a l s u m ha s to b e r ep aid u nd er t he st ip ul ated a gr ee me n t. The d eb e n t ure ho ld er s ha v e a
ch ar ge a g ai n st t he co mp an y 's as s et s a nd t h u s, t h e y ca n e n fo r ce a sa le o f as se ts i n ca se o f co mp an y 's
fa il ur e to me e t i ts co ntr act ua l o b l i ga tio n s. Deb e nt u re s al so i ncr ea se t h e ris k o f v ari at io n i n e xp ected
ear ni n g s a v ai lab l e to eq ui t y s har e ho ld er s t h ro u g h l e vera g e e ffe ct i.e. i f ret ur n o n i n v es t me n t re ma i n s
hi g h er t h a n i n ter es t r a te , s har e ho ld er s g et a hi g h re t ur n a nd v ic e ver sa. As co mp ar ed to d eb e nt ure s,
p r e fere n ce s hare s e n ta il a sl i g ht l y lo wer r i s k fo r t he co mp a n y, a s t h e p a yme n t o f d i vid e nd s o n s uc h
s har es i s co n ti n ge n t u p o n t he e ar ni n g o f p r o f it s b y t he co mp a n y. Ev e n i n ca se o f c u m ul at i ve
p r e fere n ce s har es , d i v id end s ar e to b e p aid o n l y i n t h e ye ar i n wh i c h co mp a n y e ar n s p ro fi t s. Ev e n,
th eir r ep a y me n t i s ma d e o n l y i f t h e y are r ed ee mab le a nd a ft er a st ip ula ted p er io d . Ho we v er,
p r e fere n ce s har es i ncr ea se t he v ar ia tio n s i n e xp ected ear n i n g s a va il ab l e to eq u it y s har e ho ld ers . Fro m
th e co mp a n y's v ie w p o i nt , eq u it y s h ar e s ar e l e as t ri s k y, a s a co mp a n y d o es no t r ep a y eq ui t y s har e
cap i tal e xcep t o n i ts l iq u id a tio n a nd ma y no t d ec lare d i vid e nd s fo r ye ars . T h us , a s s ee n her e,
f i na nc ia l ri s k e n co mp a s se s t h e vo l ati li t y o f e a rn i n gs a va ilab le to eq u it y s har e ho ld er s as al s o , t he
p r o b ab il it y
of
cas h
in so l ve nc y.
2 ) Co s t o f ca pita l : Co st is a n i mp o r ta n t co n sid e ratio n i n c ap i tal s tr uc t u re d ec is io n s a nd it is o b vio u s
th at a b u si n es s s ho u ld b e at lea s t c ap ab l e o f ea rn i n g e no u g h r e ve n ue t o meet i ts co st o f cap it al a nd
al so fi na n ce i t s gr o wt h . Th u s, a lo n g wi t h r is k , t he fi na nc e ma na g er ha s to co ns id er t he co st o f c ap it al
fa cto r fo r d e ter mi n a tio n o f t he cap ita l str u ct ur e .
3 ) Co nt ro l : A lo n g wi t h co s t a nd r i s k fac to r s, t h e co n tro l asp ec t i s al so an i mp o rt a nt fa cto r fo r cap i tal
str u ct ur e p la n n i n g. W h en a co mp a n y is s ue s e q ui t y s hare s, it a u to ma tic al l y d il u te s t h e co nt ro ll i n g
in ter es t o f p re se n t o wn er s. I n t he s a me ma n n e r, p re fere n ce s hare ho ld e rs ca n ha v e vo t i n g ri g h ts a nd
th er eb y a ffe ct t he co mp o si tio n o f Bo ar d o f d ire cto r s, i f d i v id e nd s a re no t p a id o n s uc h s har e s fo r 2
co n se c ut i ve ye ar s. F i na nc ia l i n st it u tio n s no r ma l l y s tip u la te t h at t he y s h all h a ve o ne o r mo re d ir ecto r s
o n t he b o ard . T h u s, wh e n ma n a ge me nt a gr e es to rai se lo a n s fro m fi na n ci al i ns ti t ut io n s, b y i mp l i cat io n
it a gr ee s to fo re go a p ar t o f i ts co ntr o l o ve r th e co mp a n y. It i s t h u s, o b vio u s t h at d e ci sio n s
co n cer n i n g cap it al s tr uc tu r e ar e t a ke n a ft er keep in g t he co n t ro l facto r i n v ie w.
4 ) Tra d ing o n e q uit y : A co mp a n y ma y r a is e fu nd s b y i s s ue o f s har es o r b y b o rro wi n g s, carr yi n g a
f i xed ra te o f i nt er e st t ha t i s p a yab le ir r e sp ec ti ve o f t h e fac t wh e t h er o r no t t here i s a p ro fit.
P r ef ere nc e s h are ho ld er s ar e a l so e n ti tl ed to a fi xed rat e o f d i vid e nd , b u t d i v id e nd p a y me n t i s s ub j ec t
to t he co mp a n y 's p r o fi ta b ili t y. I n ca se o f ROI t he to t al cap ita l e mp lo ye d i.e. s h are ho ld er s ' fu nd s p l u s
lo n g ter m b o rro wi n g s, i s mo r e t h a n t he r ate o f in tere s t o n b o rro wed fu nd s o r rat e o f d i vid e n d o n
p r e fere n ce s h are s, t he c o mp a n y is said to t rad e o n eq ui t y. It i s t he fi n a nc e ma na ger 's ma i n o b j ect i ve
to se e t ha t t h e ret u r n a n d o ver al l we al t h o f t he co mp a n y b o t h ar e ma x i mi s ed , a nd i t i s to b e k ep t i n
vi e w wh i le d ec id i n g o n t he so ur c es o f fi n a n ce . T h us , t h e e ffect o f e ac h p ro p o sed me t ho d o f n e w
f i na nc e o n EP S is to b e car e f ul l y a n al ys ed . T hi s, t h u s, h elp s i n d e ci d in g wh e t he r fu nd s s ho uld b e
r ai sed b y i nt er na l eq u it y o r b y b o r r o wi n g s .
5 ) Co r po ra t e ta xa t io n : U nd er t h e I n co me ta x la ws , d i vid e nd o n s h are s i s no t d ed uc tib le wh i le
in ter es t p a id o n b o r r o we d cap i tal is al lo wed as d ed u ct io n. Co s t o f ra is i n g fi n a nce t hro u g h b o rro wi n g s
is d ed u ct ib le i n t he ye ar i n wh ic h it i s i nc ur red . If i t i s i nc urr ed d ur i n g t he p re -co m me nc e me n t

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p er io d , i t is to b e cap i ta li sed . Co st o f s har e i ss u e is a llo wed a s d ed u ct io n. O wi n g to s uc h p ro vi s io n s,


co r p o rat e ta xa tio n , p l a y s a n i mp o r t a nt r o l e i n d eter mi n a tio n o f t he c ho i ce b e t we e n d i ffere n t so urc e s
o f f i na nc i n g.
6 ) G o v ern me nt Po l ic ie s : Go ve r n me n t p o lic ie s i s a maj o r fa ct o r i n d e te r mi ni n g cap it al str uc t ur e. Fo r
in s ta nc e, a c ha n g e i n t h e le nd i n g p o lic ie s o f fi na n cia l i ns ti t ut io n s wo u ld mea n a co mp le te c ha n ge i n
th e fi na nc ia l p att er n fo llo wed b y co mp a nie s. Al so , r ul es a nd re g ul at io n s fra med b y SE BI
co n s id erab l y a ffec t t h e ca p i ta l i s s ue p o li c y o f v ario u s co mp a ni es . M o ne tar y a nd fi s cal p o l i cie s o f
go ver n me nt al so a f fec t t he cap ita l str u ct ur e d e ci sio n s.
7 ) L eg a l re q uir e me nt s : Th e f i na nc e ma n a ger h as to k eep i n vie w t he l eg al req ui re me n t s a t t he ti me
o f d ecid i n g a s r e gar d s t he cap ita l str u ct ur e o f t he co mp a n y.
8 ) M a rketa b il ity : To o b tai n a b al a nced cap i ta l str u ct ur e, i t i s nec e ss a r y to co n sid er t he co mp an y 's
ab il it y to ma r ke t co r p o r ate se c ur i ti es .
9)
of
at
of

M a neuv e ra b il it y : M an e u ver ab il it y i s r eq uir e d to ha v e a s ma n y al ter n ati v es a s p o s sib le at t he ti me


e xp a nd i n g o r co n tr ac t in g t h e r eq uir e me n t o f fu nd s. I t e nab le s u se o f p ro p er t yp e o f fu nd s a v ai lab l e
a g i ve n t i me a nd al so en ha n ce s t he b ar ga i ni n g p o wer wh e n d ea li n g wi t h t he p ro sp ect i ve s u p p lier s
f u nd s.

1 0 ) Fl e xi bi lity : I t r e f er s to t he cap aci t y o f t h e b u si n es s a nd it s ma na g e m en t to ad j u st to e xp e cted a nd


u ne xp ect ed c ha n g e s i n cir c u ms t a nc es . I n o t he r wo rd s , t he ma na g e me n t wo u ld li k e to h a ve a cap i tal
str u ct ur e p ro vid i n g ma x i mu m fr e ed o m to c ha n g e s a t a ll ti me s.
1 1 ) T i mi ng : C lo sel y r e lat ed to f le xib il it y i s t he t i mi n g fo r i s s ue o f sec u rit ie s. P ro p er ti mi n g o f a
sec u rit y i s s ue o f te n b r i n g s s ub s ta n tia l sa v i n gs d ue to t h e d yn a mi c n at ure o f t he cap i ta l m ark et.
I n tel li g e nt ma n a ge me n t tr ie s to a n tic ip a te t he c l i mat e i n cap ita l ma r ke t wi t h a vi e w to mi n i mi s e co st
o f r ai si n g fu nd s a nd t he d il ut io n r es u lt i n g fro m a n is s u e o f ne w o rd i nar y s har es.
1 2 ) Siz e o f the co mp a n y : S mal l co mp a n ie s re l y hea v il y o n o wn e r 's fu n d s wh i le l ar ge co mp a ni e s are
u s ua ll y co ns id er ed , to b e le s s r is k y b y i n v es to r s an d t h u s, t he y ca n is s ue d i ffer e nt t yp e s o f se c ur iti e s.
1 3 ) Pur po se o f fi na nc i ng : T he p ur p o se o f fi na nc i n g al so , to so me e x te nt a ffec t s t he cap i ta l s tr uc t ure
o f t he co mp a n y. I n ca s e f u nd s ar e r eq u ired fo r p ro d uct i ve p urp o s es li k e ma n u fac t uri n g, e t c. t h e
co mp a n y ma y ra is e f u nd s t h r o u g h lo n g ter m so u rce s. O n t he o t he r ha nd , i f t h e fu nd s ar e req u ire d fo r
no n -p ro d u ct i ve p ur p o se s, l i ke wel f ar e fa ci li ti e s to e mp lo ye es s uc h as sc ho o l s, ho sp ita l s, et c . t he
co mp a n y ma y re l y o nl y o n i nte r nal r e so ur ce s.
1 4 ) Per io d o f Fi na n ce : Th e p er io d fo r wh i c h f in a nce i s r eq uir ed a l so affec ts t h e d e ter mi n a tio n o f
cap i tal s tr uc t ure. I n ca s e f u nd s ar e r eq u ir ed fo r lo n g ter m req ui re me n t s sa y 8 to 1 0 year s, it wo uld b e
ap p r o p ria te to r ai se b o r r o wed f u nd s. Ho we ver, i f t h e f u nd s ar e re q uire d mo re o r le s s p e r ma ne nt l y, it
wo u ld b e ap p ro p r ia te t o r ai se b o r r o we d fu nd s . Ho we v er, i f t he fu nd s ar e req u ired mo re o r le s s
p er ma ne n tl y, i t wo u ld b e ap p r o p r i at e to r ai se t h e m b y i s s ue o f eq ui t y s h are s.
1 5 ) Na tur e o f ent er pri se : T he na t ur e o f e n ter p ris e to a g rea t e xte n t affec ts t he co mp a n y 's c ap it al
str u ct ur e. B u s i ne ss e n te r p r is e s ha v i n g s tab il it y in ear n i n g s o r enj o yi n g mo no p o l y a s re gard s the ir
p r o d uc t s ma y go fo r b o r r o wi n g s o r p r e fere n ce s h are s, a s t he y h a ve ad eq ua te p ro fi t s to p a y
in t er es t/ fi xed c har g es. O n t he co ntr ar y, co mp a ni e s no t h a vi n g a s s ured i nco me s ho u ld p re ferab l y rel y
o n i nte r nal re so ur ce s to a lar g e e x te n t.
1 6 ) Re q uir e me n t o f i nv e st o r s : Di f f er e n t t y p es o f s ec ur it ie s ar e i s s ued to d i ffere n t c la s se s o f
in v e sto r s a cco rd i n g to t he ir r eq u ir e me nt .
1 7 ) Pro v i s io n fo r f ut u re : W hi le p la n n i n g cap ita l str u ct ure t he p ro vi s io n fo r fu t ure req u ire m en t o f
cap i tal i s a l so req u ir ed t o b e co n sid er ed .
Q ue stio n : G iv e i n det a il t he v a rio u s ca pita l str uct ur e t heo r ie s ?
An sw er : A fir m 's o b j e cti v e s ho uld b e d i rec te d to ward s t he ma x i mi sa tio n o f t he fir m 's va l ue ; t he
cap i tal s tr uc t ure o r l e v er a ge d e ci sio n ar e to e xa mi n ed fro m t he v ie w p o in t o f t h eir i mp ac t o n t h e
va l ue o f t he fir m. I f t he va l ue o f t he f ir m ca n b e a ffe cted b y cap i ta l str u ct u re o r fi na nc i n g d eci s i o n, a
f ir m wo uld li ke to h a ve a cap it al s tr uc t ure t h at ma x i mi se s t h e mar ke t va l ue o f t he fir m. T her e are

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b r o ad l y 4 ap p ro a c he s i n t he r e gar d , wh ic h a na l y se s r ela tio n s h ip b e t we e n le v era ge, co st o f cap i ta l a nd


th e va l ue o f t he fir m i n d i f fer e n t wa ys , u nd er t h e fo l lo wi n g a s s u mp t io n s :
1) Th ere a re o n l y 2 so ur ce s o f f u n d s v iz. d eb t a nd e q ui t y.
2) Th e to t al a s set s o f t h e f i r m ar e g i ve n a nd t h e d e gre e o f le ver a ge ca n b e alt ered b y s el li n g d eb t
to rep urc h a se s har es o r se ll i n g s h ar e s to re tir e d eb t .
3) Th ere a re no r eta i ned ea r n i n gs i mp l yi n g t ha t e n t ire p ro fit s a re d is trib u te d a mo n g s hare ho ld er s.
4) Th e o p era ti n g p r o fi t o f f ir m i s g i ve n a nd e xp e ct e d to gro w.
5) Th e b u si ne s s r is k i s a s s u med to b e co n st a nt a nd is no t a ffec ted b y t he fi na n ci n g mi x d e ci s io n.
6) Th e re a re no co r p o r a te o r p er so n al ta x es .
7) Th e i n v es to r s ha ve t he s a me s ub j ect i ve p ro b ab i li t y d i str ib ut io n o f e xp ec t ed ear n i n gs .
Th e ap p ro a c he s ar e a s b elo w :
1 ) Net I nco me Ap pro a ch ( N I A p pro a c h) : T h e ap p ro ac h i s s u g g es ted b y D ur a nd . Ac co rd i n g t o it, a
f ir m c a n i ncr ea se it s va l ue o r lo wer t he o ver al l co s t o f cap it al b y i ncr ea si n g t he p ro p o r tio n o f d eb t i n
th e c ap i tal str uc t ur e. I n o t her wo r d s, i f t h e d egr ee o f fi n a nci al le v era ge i ncr ea se s, t he we ig h ted
av er a ge co st o f cap it al wo u ld d ecl i ne wi t h e v er y i ncre a s e i n t he d eb t co nt e nt i n to ta l fu nd s e mp lo yed ,
wh i le t he va l ue o f t he fi r m wi ll i nc r ea se. Re ver s e wo u ld hap p e n i n a co n ver s e s it u at io n. I t i s b as ed o n
th e fo llo wi n g as s u mp tio n s :
i) T her e ar e no co r p o r at e ta x es .
ii) T h e co s t o f d eb t i s le s s t h a n co st o f eq u it y o r eq uit y cap it al is at io n ra t e.
iii) T he u se o f d eb t co nt e nt d o e s no t c ha n ge t he ri s k p er cep tio n o f i n ve s to rs a s a r e s ult o f b o th t he
K d ( D eb t cap ita li sa tio n r ate) a nd K e ( eq u it y cap it ali sa tio n rat e) re mai n s c o n st a nt.
T he va l ue o f t he f ir m o n t he b a s is o f Net I n co me Ap p ro ac h m a y b e as cer tai n ed a s fo ll o ws :
V = S + D
W her e,
V = Va l ue o f t he f ir m
S = Mar k et v al ue o f eq u it y
D = Mar ke t va l ue o f d eb t
O vera ll co s t o f cap ita l = EBI T/ Val u e o f t he fir m

2 ) Net O p era ti ng I nco me A p pro a ch ( NO I) :


T hi s ap p r o a c h i s a l so s u g ge st ed b y D ura nd , a cco rd i n g to i t, t he mar k et v al u e o f t he fir m is
no t a ffect ed b y t he ca p ita l str u ct ur e c h a n ge s . T he mar ke t va l ue o f t he fir m i s a s cert ai n e d b y
cap i tal i si n g t he ne t o p er at i n g i nco me a t t he o ver al l co s t o f cap it al, wh ic h i s co n sta n t. T he ma r ket
va l ue o f t he fir m i s d e te r mi ned as :
V = E BI T/ O vera ll co st o f cap i ta l
W her e, V = Mar ke t va l u e o f t h e fir m
S = V - D
W her e, S = Va l ue o f eq u it y
D = Mar ke t va l ue o f d eb t
V = Mar ke t va l ue o f fir m
Co st o f eq ui t y = E BI T /( V - D )
W her e, V = Mar ke t va l u e o f t h e fir m
EBI T = E ar ni n g s b e fo r e in ter es t a nd ta x
D = Mar ke t va l ue o f d eb t
I t is b a sed o n th e fo llo wi n g as s u mp tio n s :
i) T he o v era ll co s t o f ca p ita l r e mai n s co ns ta n t f o r al l d e gre e o f d eb t eq u it y mi x .
ii) T h e mar k et c ap i ta li s es va l ue o f t he f ir m a s a wh o le . T h u s, t h e sp li t b et we e n d eb t a nd eq ui t y i s no t
i mp o rt a nt.
iii ) T he us e o f le s s co st l y d eb t f u nd s i ncre as es t he r i s k o f s har e ho l d ers. T hi s ca u se s t he e q ui t y
cap ia li s at io n rate to i n cr ea se. T h u s, t h e ad va n ta ge o f d eb t i s set o ff ex act l y b y i ncre a se i n eq u it y
cap i tal i sa tio n r ate .
iv ) T her e ar e no co r p o r a te t a xe s.

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v) T he co s t o f d eb t i s co n st a nt.
U nd er, NOI a p p r o ac h s i nc e o v era ll c o st o f c ap i ta l i s co n st a nt , t h u s, t h ere is no o p ti ma l
cap i tal str uc t ure r a t her ev er y c ap i tal str uc t ure i s a s go o d a s a n y o t h er and so e ver y cap it al s tr uc t ure
is o p ti mal .
3 ) Tra dit io na l A pp ro a ch : T he t r ad i tio n al ap p r o ac h, al so ca ll ed a n i nt e r med ia te ap p ro ac h a s it ta ke s
a mid wa y b et we e n NI a p p r o ac h, t h at t h e val u e o f t h e fir m ca n b e i n cr eas ed b y i ncr ea si n g fi n an cia l
le ver a ge a nd NOI ap p r o ac h, t h at t he va l ue o f t he fi r m i s co n s ta nt i rresp ect i ve o f t he d e gr ee o f
f i na nc ia l le v era ge . Ac c o r d i n g to t h i s ap p ro a c h th e fir m s ho u l d s tri v e to reac h t he o p ti ma l c ap it al
str u ct ur e a nd it s to tal va lu at io n t hr o u g h a j ud ici o u s u s e o f d eb t a nd eq ui t y i n cap i ta l s tr uc t ure. At t he
o p ti ma l cap ita l s tr uc t ur e, th e o v er a ll co st o f c ap it al wi l l b e mi ni mu m and t he val u e o f t h e fir m is
ma x i mu m. It fur t her s ta te s, t h at t he v al ue o f t h e fir m i ncr ea se s wi t h fi na n cia l le ver a ge up to a cert ai n
p o i nt. B e yo nd t h i s, t h e in cr e as e i n f i na n ci al le v era ge wi ll i ncr ea se co s t o f eq ui t y, t he o ver al l c o st o f
cap i tal ma y s ti ll r ed u ce. Ho we ve r , i f fi n a nci al l ev era ge i n cre as e s b e yo n d an ac cep tab l e li mi t, t h e ris k
o f d eb t i n ve sto r ma y a l so i ncr ea se, co n seq u e nt l y co s t o f d eb t al so s ta rts i n crea s i n g. T he i nc r eas i n g
co s t o f eq ui t y o wi n g to in cr e as ed fi na n ci al ri s k and i ncre as i n g co st o f d eb t ma ke s t he o vera ll c o st o f
cap i tal to i ncr ea se. T h u s, a s p er t he tr ad it io nal ap p ro ac h t h e co s t o f ca p ita l i s a fu nct io n o f fi n an cia l
le ver a ge a nd t he va l ue o f f ir m c a n b e a f fec ted b y t he j ud ic io u s mi x o f d eb t a nd eq ui t y i n c ap it al
str u ct ur e. T he i ncr e a se o f f i na nc ia l le v er a ge up to a p o i n t fa vo ur ab l y a ffe ct t he va l ue o f t he fi r m. At
th i s p o i n t, t he cap i ta l st r uc t ur e i s o p t i ma l & t he o v eral l co s t o f c ap i ta l wi l l b e t he le a st.
4 ) M o dig lia ni a n d M il ler Ap pro a ch ( M M App ro a ch) : Ac co rd i n g to t h is ap p ro ac h , t h e to tal c o st o f
cap i tal o f p art ic u lar f ir m is i nd ep e nd e nt o f it s me t ho d a nd le ve l o f fi n an ci n g. Mo d i g lia n i a nd Mil ler
ar g u ed t ha t t h e we i g ht e d av er a ge co s t o f cap it al o f a fir m i s co mp let el y i nd ep e nd e n t o f it s cap i tal
str u ct ur e. I n o t h er wo r d s, a c h a n ge i n t he d eb t eq u it y mi x d o e s no t a ffect t he co st o f cap ita l. Th e y
ar g u ed , i n s up p o r t o f t he ir ap p r o a c h, t ha t as p er t he trad it io na l ap p r o ac h, co st o f cap i ta l i s t he
we i g h ted a vera g e o f co s t o f d eb t a nd co s t o f eq ui t y, etc . T he co s t o f e q ui t y, i s d et er mi n ed fro m t he
le ve l o f s har e ho ld e r 's e xp e cta tio n s. T ha t i s i f, s har e ho ld er s e xp ec t a p arti c ul ar ra te o f ret u r n, sa y 1 5
% fro m a p ar ti c ul ar co mp a n y, t he y d o no t ta ke in to acco u n t t he d eb t e q ui t y rat io a nd t he y e xp ect 1 5
% a s t he y fi nd t h at it co ver s t he p ar t ic ul ar r is k wh ic h t hi s co mp a n y e nt ail s. S u p p o se, t he d eb t c o nt e nt
in t he cap it al str u ct ur e o f t h e co mp a n y i n cre as es, t h i s mea n s, t h at i n th e e ye s o f s h are ho ld er s, t h e
r is k o f t he co mp a n y i n cr ea se s, s i nce d eb t is a mo re ri s k y mo d e o f fi na n ce. T h u s, t he s h are h o ld er s
wo u ld no w, e xp e ct a h i g her r at e o f r e t ur n fro m th e s hare s o f t he co mp an y. T h u s, ea c h c ha n g e in t he
d eb t eq u it y mi x is a uto ma ti ca ll y se t -o f f b y a c ha n g e i n t he e xp ec ta tio n s o f t he s har e ho ld e rs fro m t h e
eq u it y s h are cap it al. T hi s is b ec a u se, a c ha n ge i n t he d eb t - eq ui t y r at io c ha n g es t h e r is k e le me n t o f t h e
co mp a n y, wh i c h i n t ur n ch a n ge s t he e xp ec tat io n s o f t he s h are ho ld er s fro m t he p ar tic u lar s h are s o f t he
co mp a n y. Mo d i gli a ni a nd M ill er , t h u s, ar g ue th at fi n a nc ial l e ver a ge ha s no t hi n g to d o wi t h t he
o ver al l co st o f cap i ta l a nd t h e o ver a ll co s t o f c a p ita l i s eq u al to t he cap ita li sa tio n r at e o f p u re e q ui t y
str ea m o f i t s c la ss o f r i s k. T h u s, fi n a nci al le v e rag e ha s no i mp act o n s har e ma r ket p ri ce s no r o n t he
co s t o f c ap i tal . T he y ma ke t he f o l lo wi n g p ro p o si tio n s :
i) T he to ta l ma r ket v al u e o f a fir m a nd i t s co st o f c ap i ta l are i nd ep e nd e nt o f i ts cap i ta l str uc t ur e. T he
to ta l ma r ke t va l ue o f t h e fir m i s gi ve n b y c ap i t ali s i n g t h e e xp ec ted s tr ea m o f o p era ti n g ear n i n g s a t a
d is co u nt r ate co n sid er ed ap p r o p r ia te f o r i t s ri s k cla s s.
ii) T h e co st o f eq u it y ( K e) i s eq u al to t h e cap it al is at io n ra te o f p ur e eq u i t y s tre a m p l u s a p re mi u m fo r
f i na nc ia l ri s k. T he f i na nc ia l r i s k i ncr ea se s wi t h mo r e d eb t co n te n t i n t he cap i ta l str u ct ure . As a
r es u lt, Ke i ncr ea se s i n a ma n ner to o f f se t e xa ct l y t he u se o f le s s e xp e n si ve so ur ce s o f fu nd s.
iii ) Th e c ut o ff r at e fo r in ve s t me n t p ur p o se s i s co mp l ete l y i nd ep e nd e nt o f t he wa y i n wh i c h the
in v e st me n t is fi n a nced .
As s u mp t io n s :
i) - T he cap ita l mar k et s ar e a s s u med to b e p er fect. T hi s me a ns t ha t i n v es to rs are fr ee to b u y a nd se ll
sec u rit ie s.
- T he y a re wel l -i n f o r me d ab o ut t he r is k - r et u r n o n a ll t yp e o f sec ur it ie s.
- T here are no tr a ns act i o n co s t s.
- T he y b e h a ve r at io na ll y.
- T he y c a n b o rro w wi t h o ut r e str ic tio n s o n t he s a me t er ms a s t he fir ms d o .
ii) T h e fir ms c a n b e c la ss i fi ed i n to 'ho mo g e n o u s ri s k c la s s '. T h e y b elo n g to t hi s c la s s, i f th eir
exp ect ed e ar ni n g s ha v e i d en ti cal r i s k c h ar a cter i s tic s.

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iii ) Al l i n ve s to rs h a ve th e s a me e xp ect at io ns fro m a fir ms ' E BIT t h at is nec es s ar y to e va l ua t e t he


va l ue o f a fi r m.
iv ) T he d i vid e nd p a y me nt r a tio is 1 0 0 %. i .e. t h ere ar e no re ta i ned ear ni n g s.
v) T here are no co r p o r a t e ta x es , b ut, t h is a ss u mp tio n ha s b ee n r e mo ved .
Mo d i g li a ni a nd Mi ll er a gr ee t ha t wh i le co mp a n ie s i n d i ffere n t ind u s tri es fac e d i ffe r e nt ri s ks
r es u lt i n g i n t he ir ear n i n g s b ei n g c ap i ta li sed a t d i ffere n t ra te s, i t i s no t p o ss ib l e fo r t he se co m p an ie s
to a ffec t t heir ma r ket v al ue s, a nd t h u s, t he ir o ver al l cap i ta li sa tio n ra t e b y u se o f le v era ge. T ha t i s,
fo r a co mp a n y i n a p ar ti c ul ar r i s k c l as s, t h e to tal mar k et v al ue mu s t b e sa me irre sp e c ti ve o f
p r o p o rtio n o f d eb t i n co mp a n y 's cap it al str u ct ur e. T he s up p o rt fo r t hi s h yp o t he si s l ie s i n t he p re se nc e
o f arb itr a ge i n t he c ap i tal ma r ke t. T he y co n te n d th at arb itr a ge wil l s u b st it u te p er so na l l e ver a ge fo r
co r p o rat e l e vera g e.
Fo r i n s ta nc e : T h er e ar e 2 co mp a ni e s X a nd Y i n t he sa me ri s k c la s s. C o mp a n y X is fi na n ced b y o n l y
eq u it y a nd no d eb t, wh i le Co mp a n y Y i s fi na n c ed b y a co mb i n at io n o f d eb t a nd eq u it y. T h e ma r ket
p r ice o f s har es o f Co m p an y Y wo u ld b e hi g h e r t ha n t h at o f Co mp a n y X, mar ke t p ar ti cip a n t s wo u ld
ta ke ad va nt a ge o f d i f f er en ce b y se ll i n g eq u it y s har e s o f Co mp a n y Y, b o rro wi n g mo ne y to eq ua t e t he ir
p er so n al le ver a ge to t h e d e gr ee o f co r p o r ate l ev era ge i n Co mp a n y Y and u s e t he m fo r i n v e st in g i n
Co mp a n y X. T he sa le o f s har e s o f Co mp a n y Y r ed u ce s i ts p r ice u n ti l t h e mar ke t v al u e o f t he co mp a n y
Y, fi n a nced b y d eb t a nd eq u it y, eq ua l s t h at o f C o mp a n y X, fi na n ced b y o nl y eq ui t y.
Crit ic is m : T he se p r o p o si tio n s h a ve b ee n cri ti c is ed b y n u me ro u s a u t ho rit ie s. Mo s tl y cr it ici s m is a s
r eg ard s, p er fe ct mar k et and ar b itr a ge a ss u mp t io n . MM h yp o t h e si s ar g ue t hat t hro u g h p erso n ne l
ar b itr a ge i n ve sto r s wo ul d q ui c kl y el i mi n ate a n y in eq ua li tie s b e t we e n t he va l ue o f le ver a ged fir m s a nd
th at o f u nle v era ged f ir ms i n t he sa me r is k c la ss . T he b as ic a r g u m en t her e, i s t hat i nd i v id u al
ar b itr a ge ur s, t hro u g h t h e u se o f p er so na l le ver a ge c a n al ter co rp o r ate l ev era ge , wh i c h is no t a val id
ar g u me nt i n t h e p r act ic al wo r ld , a s i t is e x tre me l y d o ub t fu l t hat p er s o na l i n ve sto r s wo u ld s u b st it u te
p er so n al le ve ra ge fo r co r p o r ate le v er a g e, a s t he y d o no t h a ve t he s a me ris k c har ac teri s tic s. T he M M
ap p r o ac h as s u me s a va ila b ili t y o f f r ee a nd up to d ate i n fo r ma tio n , t h i s a ls o is no t no r mal l y va lid .
To co nc l ud e, o ne ma y s a y t ha t co n tro v ers y b et we e n t he trad it i o na li s ts a nd t he s up p o rt ers o f
MM ap p ro ac h ca n no t b e r e so l ved d ue to lac k o f e mp ir ica l re s earc h. Trad itio n al i st s a r g ue t ha t t h e co s t
o f c ap i tal o f a fir m ca n b e lo wer ed a nd t he ma r ket v al ue o f s har es in crea sed b y u se o f fi na n cia l
le ver a ge. B u t, a ft er a cer tai n sta g e, as t h e co mp a n y b eco me s hi g hl y ge ared i.e . d eb t co n te n t
in cr e as es , i t b eco me s to o r is k y f o r i n v e sto r s a n d le nd er s. T h us , b e yo nd a p o i n t, t h e o ver al l co st o f
cap i tal b e gi n s to r is e, t h is p o i nt i nd ica te s t h e o p ti ma l c ap i ta l s tr uc t ure. Mo d i gl ia n i a nd Mi ll er a rg ue s,
th at i n t he ab s e nce o f co r p o r ate i nco me t a xe s, o v eral l co st o f c ap i tal b e gi n s to ri se.
Q ue stio n : W ha t ki n d o f rela t io ns h ip e xi st s b etw een ta xa tio n a nd ca pita l str uct ur e ?
An sw er : T he l e ver a ge ir r el e va nc e t heo r y o f M M is va lid o n l y i n p er fe ct mar ke t co nd i tio n s, b ut , i n
fa ce o f i mp er fec tio n s c har ac ter i s i n g t he r e al wo rld cap i ta l mar ke t s, t h e cap i ta l s tr uct u re o f a fir m
ma y a ffec t it s val u at io n . P r ese nc e o f t a xe s i s a maj o r i mp er fec tio n i n t he re al wo r l d . W he n ta x es are
ap p li cab l e to co r p o r a te inco me, d eb t f i na nc i n g i s ad va n ta geo u s. T h i s i s b eca u se d i v id e nd s and
r eta i ned ear n i n gs ar e no t d ed uc tib le f o r t a x p ur p o se s, i nt ere st o n d eb t i s a d ed uc tib le e xp e n se fo r ta x
p ur p o se s. As a re s ul t, t he to t al a v ai lab l e i nco me fo r b o t h sto c k - h o ld e rs a nd d eb t - ho ld er s i s g reat er
wh e n d eb t cap ita l i s u s ed . I f t he d eb t e mp lo y ed b y a le ve ra ged fir m is p er ma ne n t i n na t ur e, t he
p r es e nt v al ue o f t h e t a x s hi eld a sso cia ted wi t h i nt ere st p a y me n t c a n b e o b t ai ned b y ap p l yi n g t he
fo r mu l a fo r p erp e t ui t y.
P r ese n t va l ue o f ta x s h ie ld ( T D) = ( T * k d * D) / k d
W her e, T = Co rp o r a te ta x r ate
D = Mar ke t va l ue o f d eb t
k d = I nt ere st rat e o n d eb t
T he p re se nt v al ue o f i nter e st ta x s h i eld s i s i nd ep e nd e n t o f th e co s t o f d eb t, it b ei n g a
d ed u ct ib le e xp e n se . I t i s si mp l y t he co r p o r a te ta x r ate t i me s t h e a mo u n t o f p er ma ne n t d eb t.
Va l ue o f a n u nlev era g e d f i r m :
V u = [E BIT ( 1 - t ) ] / K 0
Va l ue o f lev era g e d f ir m :

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V l = V u + Deb t (t)
Gr ea ter t he l e ver a ge, gr e ater wo u ld b e th e v al ue o f t he fir m, o th er t hi n g s b e i n g eq ual . Thi s
i mp l ie s t h at t he o p t i ma l s tr at e g y o f a fi r m s ho ul d b e to ma x i mi se t he d e gre e o f le ve ra ge i n it s c ap it al
str u ct ur e.
Q ue st io n : En u mera t e t he met ho ds t o ca lc ula t e the co st o f ca p ita l f ro m v a r io u s so urc e s ?
An sw er : T he co st o f cap it al i s a s i g ni fica nt fa cto r i n d e s i g ni n g the c ap i tal str u ct ur e o f a n
u nd er ta k i n g, a s b a s ic r e aso n o f r u n n i n g o f a b u si n es s u nd e rta k i n g i s to ear n re t ur n at le as t eq ua l to
th e co st o f cap it al. Co m me r ci al u nd er ta k i n g ha s no re le v a nce i f, it d o e s no t e xp e ct to ear n it s c o st o f
cap i tal . Th u s co st o f cap i tal co n s ti t ute s a n i mp o r ta n t facto r i n var i o u s b u s i ne ss d e ci sio n s. Fo r
ex a mp l e, i n a n al ys i n g f in a nc ial i mp li ca tio n s o f cap i ta l str u ct ur e p ro p o sa ls , co st o f cap i ta l ma y b e
ta ke n a s t h e d i sco u nt i n g r ate. Ob v io u sl y, i f a p a rtic u lar p ro j ec t gi ve s a n in ter na l ra te o f re t ur n h ig h er
th a n i ts co s t o f cap i ta l , it s ho u ld b e a n a ttr a cti v e o p p o rt u ni t y. Fo l l o wi n g ar e t he co st o f cap i tal
acq uir ed fro m v ar io u s s o ur c e s :
1 ) Co st o f de bt : T h e e x p lic it co s t o f d eb t i s t h e in ter es t ra te a s p er co n trac t ad j u s ted fo r ta x a n d th e
co s t o f ra i si n g d eb t.
- Co st o f irr ed ee ma b le de be nt u re s :
Co st o f d eb e n t u r es no t r ed ee ma b le d uri n g t he li fe t i me o f t he c o mp a n y,
K d = (I/ NP ) * (I - T)
W her e, K d = Co s t o f d eb t a f ter ta x
I = A n n u al i nt ere st r at e
NP = N et p ro ceed s o f d e b en t ur e s
T = Ta x ra te
Ho we ver , d eb t ha s a n i mp l ici t co st a l s o , t hat a ri se s d ue to t he fa ct t h at i f t he d eb t co nt e nt
r is es ab o ve t he o p ti ma l le ve l, i n v e sto r s wo u ld st art co ns id er i n g t h e c o mp a n y to b e to o r i s k y and ,
th u s, t he ir e xp e ct at io ns fr o m eq ui t y s h ar e s wi l l ris e. T h is r i se, i n t he co st o f eq ui t y s h are s i s a c tu al l y
th e i mp l ici t co s t o f d eb t .
Co s t o f r ed ee ma b le de be nt u re s :
I f t he d eb e nt ur es a r e r ed ee mab le a ft er t he e xp ir y o f a fi xed p erio d t h e co st o f d eb e nt u re s
wo u ld b e :
K d = I(1 - t) + [( R V - N P ) ] /N
[( R V + NP ) /2 ]
W her e, I = A n n u al i nt er es t p a y me n t
NP = N et p ro ceed s o f d e b en t ur e s
RV = Red e mp t io n va l ue o f d eb e nt ur e s
t = ta x r ate
N = Li fe o f d eb e n t ur e s
2 ) Co st o f pref ere nc e s ha re s :
I n ca se o f p r e fer e nce s h ar e s, t he d i vi d end rat e ca n b e t a ke n a s i t s co st, a s i t i s t hi s a mo u n t
th at t he co mp a n y i n te nd s to p a y a ga i ns t t he p re fere nce s h are s. A s, i n c a se o f d eb t, t he i ss u e e xp en se s
o r d i sco u nt /p re mi u m o n is s ue /r ed e mp t io n i s al so to b e ta ke n i n to ac co u n t.
Co s t o f i rre de e ma b le pref ere nc e sha re s : Co s t o f ir red e e mab le p re fer en ce s har es = P D /P O
W her e, P D = A n n u al p r e fer e nce d i v id e nd
P O = N et p ro ceed s o f a n is s u e o f p r e f er e n ce s har es
Co s t o f red ee ma b le p r ef ere nc e s ha re s : I f t he p re fere n ce s h are s are re d ee mab le a ft er t he e xp ir y o f a
f i xed p er io d , t he co s t o f p r e fer e n ce s har es wo u l d b e.
K p = P D + [( RV - NP ) ] / N
[( R V + NP ) /2 ]
W her e, P D = A n n u al p r e fer e nce d i v id e nd
NP = N et p ro ceed s o f d e b en t ur e s
RV = Red e mp t io n va l ue o f d eb e nt ur e s
N = Li fe o f d eb e n t ur e s

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Ho we v er , s in ce d i vid e nd o f p r e fer en ce s hare s i s no t al lo we d a s d ed uc tio n fro m in co me


fo r i n co me ta x p ur p o se s, t her e is no q ue st io n o f ta x ad va n ta ge i n t h e cas e o f co st o f p re fe ren ce
s har es. It wo uld , t h u s, b e s ee n t hat b o t h i n c a se o f d eb t a nd p re fere n ce s hare s, co st o f cap it al i s
calc u la ted b y r e fer e n ce to t he o b li g at io ns i nc urr ed a nd p ro ce ed s rec ei ve d . Th e ne t p ro ce ed s rec ei ve d
mu s t b e ta ke n i nto ac co u nt i n wo r ki n g co st o f c ap it al.
3 ) Co st o f o r d ina ry o r eq uit y s ha r es :
Ca lc ul at io n o f th e co s t o f o r d i nar y s har e s i n vo l v es a co mp l ex p ro c ed ure, b e ca u se u nl i ke
d eb t a nd p re fere nc e s h ar e s t her e i s no f i xed rate o f i n ter es t o r d i v i d end a g ai n s t o rd i nar y s har e s.
He nce , to a s si g n a cer tai n co s t to eq ui t y s h a re cap ita l i s no t a q ue st io n o f mer e ca lc u lat i o n, it
r eq u ire s a n u nd er s ta nd i n g o f ma n y f ac to r s b a si cal l y co nc er ni n g t he b e ha v io ur o f i n v es to r s a n d th eir
exp ect at io n s. A s, t h er e can b e d i f fer e nt i nter p reta tio n s o f i n ve s to r 's b eha v io ur, t h ere ar e ma n y
ap p r o ac he s r e gard i n g ca lc ul at io n o f co s t o f eq u i t y s h are s. T he 4 ma i n ap p ro ac he s ar e :
i) D/ P ra tio ( Div i de nd /Pr ice) a p pro a c h : T hi s e mp ha s is e s t ha t d i v id end e xp ec ted b y a n i n ve s to r
fr o m a p art ic u lar s har e d ete r mi n es i ts co st. A n i n ve sto r wh o i n ve s ts i n t he o rd i nar y s h are s o f a
p ar ti c ul ar co mp a n y, d o e s so i n t he e xp ec tat io n o f a c ert ai n re t ur n. I n o th er wo rd s, wh e n a n i n v es to r
b u ys o rd i nar y s h ar e s o f a cer ta i n r is k , he e xp e ct s a c e rta i n r et ur n, T he e xp e cted ra te o f re t ur n is t he
co s t o f o rd i nar y s har e cap it al. U nd er t h i s a p p ro ac h, t h u s, t h e co st o f o rd i n ar y s ha re cap ita l i s
calc u la ted o n t he b a si s o f t he p r es e nt v al u e o f t h e e xp ec ted fu t ure s tre a m o f d i vid e nd s.
Fo r e xa mp le, th e mar k et p r i ce o f t h e eq u it y s ha re s ( fac e v al ue R s. 1 0 ) o f a p ar ti cu la r
co mp a n y i s R s. 1 5 . I f i t ha s b ee n p a yi n g a d i vid end o f 2 0 % a nd i s e xp e cted to ma i nt ai n t he sa m e, i ts
co s t o f eq u it y s har es a t fa ce va l ue i s 0 .2 * 1 0 /1 5 = 1 3 .3 %, s i nce it i s t h e ma x i mu m ra te o f d i v i d end ,
at wh i c h t h e i n ve sto r wi ll b u y s h ar e a t t he p re s e nt v al ue . Ho we v er, it c a n a lso b e ar g ued t h at t h e co s t
o f eq u it y c ap i tal is 2 0 % fo r t he co mp a n y, a s i t i s o n t hi s e xp e cta tio n th at t he mar k et p ri ce o f s hare s
is ma i nta i ned at R s. 1 5 . Co st o f eq u it y s h are s o f a co mp a n y i s t ha t ra te o f d i vid e nd t h at ma i nta i n s t he
p r es e nt mar ke t p r ic e o f s har es. A s t h e o b j ecti v e o f fi n a nci al ma na g e me n t is to ma xi mi s e t he we a l th o f
s har e ho ld er s, i t i s r at io na l to a ss u me t ha t t he c o mp a n y mu s t ma i nt ai n t he p re se n t mar ke t v al u e o f it s
s har e b y p a yi n g 2 0 % d iv id e nd , wh i c h t he n is it s co st o f eq u it y c ap it al. T h u s, t he re la ti o n s hip
b et we e n d i vid e nd s a nd ma r ket p r ic e s ho ws t h e exp ect at io n o f t h e i n v es to rs a nd t h ereb y co s t o f eq u it y
cap i tal .
T h is ap p r o ac h co -r el ate s t he b a si c facto r s o f re t ur n a nd i n ve s t me n t fro m vi e w p o in t o f
in v e sto r. Ho we ver , i t i s to o s i mp le a s it p r e - s up p o se s t hat a n i n v e sto r lo o k s fo r ward o n l y to d i v i d end s
as a re t ur n o n h is i n ve s t me nt . T he e xp ec ted s tr ea m o f d i vid e nd s i s o f i mp o r ta nc e to a n i n v e sto r b u t,
he lo o ks fo r ward to c a p ita l ap p r e cia tio n a l so in t he va l ue o f s h are s. It ma y le ad u s to i g no r e t he
gr o wt h i n c ap i ta l v al ue o f t h e s h ar e. U nd er, t h is ap p ro ac h, a co mp a n y whi c h d ec lare s a h i g her a mo u n t
o f d i v id e nd o u t o f a g iv e n q u a nt u m o f ear ni n g s wi ll b e p la ced at a p re mi u m a s co mp a red to a
co mp a n y wh ic h ear n s t he s a me a mo u nt o f p ro fit s b ut ut ili s es a maj o r p art o f t he sa me i n fi n an ci n g
it s e xp a n sio n p ro gr a m me s. T h u s, D /P ap p ro a ch ma y no t b e ad eq uat e to d eal wi t h t h e p ro b le m o f
d eter mi n i n g t he co st o f o r d i nar y s har e cap it al.
ii) E/ P ( Ea r ni ng s /P ric e ) ra t io a p pro a c h : T he ad vo cat e s o f t hi s ap p ro a ch co -re lat es t he e ar ni n g s o f
th e co mp a n y wi t h t he m ar k et p r ic e o f i ts s h are s. As p er i t, t he co st o f o r d in ar y s hare cap ita l wo u l d b e
b ased o n t he e xp ec ted r ate o f e ar ni n g s o f a co mp a n y. T he a r g u me n t i s th at eac h i n ve sto r e xp ect s a
cer t ai n a mo u n t o f ear n i n g s, wh e t her d is tr ib u ted o r no t fro m t h e co mp a n y i n wh o s e s har e s h e i n ve s ts ,
th u s, a n i n v es to r e xp ec t s t h at t he co mp a n y i n whi c h h e is go i n g to s ub s crib e fo r s h are s ho uld h av e a t
lea st 2 0 % o f e ar ni n g, t he co s t o f o r d i nar y s h ar e cap i tal c a n b e co ns tr u ed o n t h is b a s is . S up p o se, a
co mp a n y i s e xp e cted to ear n 3 0 % t h e i n ve s to r wi l l b e p rep ared to p a y R s 1 5 0 (3 0 /2 0 * 1 0 0 ) fo r eac h
o f R s. 1 0 0 s ha re. T h i s a p p r o ac h i s s i mi lar to t h e d i vid e nd p r ice ap p ro a ch, o nl y it se e k s to n u ll i fy t h e
ef f ec t o f c ha n g es i n d i v i d end p o l ic y. T h is ap p ro ac h a l so d o es no t see m t o b e a co mp le te a n s we r to t h e
p r o b le m o f d e ter mi n i n g th e co st o f o r d i nar y s h are a s i t i g no re s t he fa c to r o f cap ita l ap p r eci at i o n o r
d ep r ec iat io n i n t h e mar k et va l ue o f s h ar e s.
iii ) D/P + g ro w t h a p p ro a ch : T he d i v id e nd /p rice + gro wt h ap p ro a c h e mp ha s is e s wh at a n i n ve s to r
act ua ll y e xp ec t s to r e ce iv e fr o m hi s i n ve st me n t in a p art ic u lar co mp a n y 's o rd i nar y s hare i n t er ms o f
d iv id e nd p l u s t h e r a te o f gr o wt h i n d i vid e nd /e ar ni n g s. T hi s gro wt h r at e in d i v id e nd ( g) i s t a ke n to b e
go o d to t h e co mp o u nd g r o wt h r ate i n ear n i n gs p er s h are.
K e = [D 1 /P 0 ] + g
W her e,
K e = Co s t o f cap i ta l
D 1 = Di v id e nd fo r t h e p e r io d 1
P 0 = P ric e fo r t he p er io d 0
g = Gro wt h rat e

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D /P + g ap p r o ac h se e ms to a n s wer t he p ro b le m o f e xp ec ta ti o n s o f i n ve sto r sa ti s fa c to ri l y,
ho we ver, i t p o se s o ne p r o b le m t ha t i s ho w to q ua nt i fy e xp ec ta tio n o f i n v es to r re la ti n g to d i vid e n d a n d
gr o wt h i n d i v id e nd .
iv ) Re a li s ed y ie ld a p pr o a ch : I t i s s u g ge s ted t ha t ma n y a ut ho r s t ha t t h e yie ld ac t ua ll y r ea li sed fo r a
p er io d o f t i me b y i n v es t o r s i n a p a r t ic ul ar co mp an y ma y b e us ed a s a n i nd i ca to r o f co st o f cap it al. I n
o th er wo rd s , t h is ap p r o ac h t a ke s i n to co n s id er atio n t he b as ic fac to r o f t he D/P + g ap p ro a c h b u t,
in s tead o f us i n g t he e xp ected val u es o f t h e d i v i d end s a nd cap it al ap p re cia tio n, p as t yi eld s are u sed to
d eno te t h e co s t o f cap i t al. T hi s ap p r o a c h i s b as ed up o n t he a s s u mp tio n th at t h e p a s t b e ha v io ur wo u ld
b e r ep e ated i n fu t ur e a n d t h us , t h e y ma y b e u se d to me as ur e t h e co s t o f o rd i nar y c ap i ta l.
Wh ic h a p pro a c h t o u se ? I n c as e o f co mp a n ie s wi t h st ab le i n co me a nd s tab l e d i v id e nd p o l ici e s t he
D/P ap p ro ac h ma y b e a go o d wa y o f me as ur in g t he c o st o f o rd i na r y s h are c ap i tal. I n c a se o f
co mp a ni es wh o s e ear ni n g s accr u e i n c ycl es , i t wo uld b e b et ter i f t h e E/P ap p ro ac h i s u sed , b ut
r ep r e se nt at i ve fi g ur e s s ho u ld b e ta ke n i nto ac co u n t to i nc l ud e co mp l ete c ycl e. I n ca se o f g ro wt h
co mp a ni es , wh ere e xp e c tat io n s o f g r o wt h ar e m o re i mp o rta n t, co st o f o rd i nar y s h are cap i ta l m a y b e
d eter mi n ed a s t he b a s is o f t he D /P + g ap p ro a c h . In t he c as e o f co mp a n ie s e nj o yi n g a st ead y gr o wt h
r ate a nd a st ead y r at e o f d i vid e nd , t he r ea li sed v al ue ap p ro a c h ma y b e us efu l. T h e b a sic fac to r b e hi n d
d eter mi n a tio n o f co st o f o r d in ar y s har e cap ita l is to me a s ure e xp e cta ti o n o f i n ve sto r s fro m o r d in ar y
s har es o f t hat p ar t ic ul a r co mp a n y. T h u s, t h e wh o le q u es tio n o f d e te r mi ni n g t he co st o f o r d in ar y
s har es h i n ge s up o n t he f acto r s wh ic h go i n to t h e exp ec tat io n s o f a p art ic ul ar gro up o f i n ve s to rs i n t he
co mp a n y o f a p ar tic u lar r is k cl as s.
4 ) Co st o f r es erv e s : T he p r o fi ts r et ai n ed b y a co mp a n y a nd us ed i n t he e xp a n sio n o f b u si ne s s a lso
en ta il co st . Ma n y p eo p l e te nd to fee l t ha t re ser ve s h a ve no co st . Ho we ver , it i s no t e as y to re ali sed
th at b y d ep r i vi n g t he s har e ho ld er s o f a p art o f t h e ear n i n g s, a co st is a u to ma ti cal l y i n c urr ed o n
r es er ve s. T hi s ma y b e t er med a s t he o p p o rt u n it y co st o f ret ai n ed ear ni n g s. S up p o se , t he se ear ni n g s
ar e no t re ta i ned a nd ar e p a ss ed o n to s ha r e ho ld ers, s up p o s e fur t her t ha t s h are ho ld er s i n v e st t he sa me
in ne w o rd i nar y s har es . Thi s e xp e cta tio n o f t h e in v es to r s fro m n e w o rd i nar y s h are s s ho u ld b e th e
o p p o rt u ni t y co s t o f r ese r ve s. I n o t h er wo r d s, i f ear n i n g s were p aid o u t as d i v id e nd s and
si mu l t a neo u sl y a n o f f er fo r r i g ht s ha r e s wa s m ad e s har e ho ld er s wo u ld h a ve s ub scr ib ed to t he ri g ht
s har e o n t he e xp e cta tio n o f a cer ta i n r et u r n. T hi s re t ur n ma y b e ta ke n as t he i nd i cato r o f t he co s t o f
r es er ve s. P eo p l e d o no t calc u la te t he co st o f ca p ita l o f re tai n ed ear n i n g s a s ab o ve . T he y t a ke c o st o f
r eta i ned e ar ni n g s as t h e s a me a s t ha t o f eq u i t y s h are s. Ho we v er, i f t he co s t o f eq u it y s ha res i s
d eter mi n ed o n t h e b a si s o f r ea li sed va l ue ap p ro ac h o r D/P + g ap p ro ac h, t he q ue st io n o f w o r ki n g o u t
a sep ar at e co s t o f r es er v es i s no t r e le va n t s i nce co s t o f re s er ve s i s a uto ma ti ca ll y i n cl ud ed i n t h e co s t
o f eq ui t y s hare cap ita l.
5 ) Co st o f de pr ec ia t io n f un d s : Dep r ec iat io n fu nd s, ca n no t b e co n st rued a s no t ha v i n g a n y co s t.
Lo g ica ll y sp ea k i n g, t h e y s ho u ld b e tr e ated o n t h e s a me fo o t i n g a s r es er v es wh e n it co me s to t he i r u se ,
tho u g h wh i l e ca lc u lat i n g t he co s t o f c ap i ta l t h e se fu nd s ma y no t b e co n sid ered .
Q ue st io n : En u mera t e t he pro ce du re o f ca lc u la ting th e w eig hte d a v e ra g e co st o f ca p ita l ?
An sw er : T he co mp o s it e o r o ver all co s t o f cap ita l o f a fir m i s t h e we i g ht ed a ver a ge o f t he co st s o f
var io u s so urce s o f f u nd s. W e i g ht s ar e ta k e n to b e p ro p o rt io n o f ea c h so urc e o f fu nd s i n t h e cap i tal
str u ct ur e. W h il e, ma ki n g fi n a nci al d ec i sio n s t h i s o v era ll o r we i g ht ed co st i s us ed . Eac h i n ve st m en t i s
f i na nc ed fro m a p o o l o f f u nd s wh i c h r ep re se n ts t h e v ario u s so u rce s fro m wh i c h fu nd s h a ve b een
r ai sed . A n y d e ci sio n o f in v e st me n t t h u s, ha s to b e mad e wi t h re fe re nc e to t he o vera ll co s t o f c a p ita l
and no t wi t h r e fer e nce to co st o f a sp eci fic so urc e o f fu nd u sed i n t ha t i n v es t me n t d e ci sio n s. T h e
we i g h ted a vera g e co st o f cap i ta l ( W A C C) i s c al cu la ted b y :
1 ) C alc u la ti n g co s t o f sp eci f ic so ur c es o f f u nd s, e.g . co st o f d eb t, e tc.
2 ) M ul tip l yi n g t he co s t o f eac h so ur ce b y it s p r o p o rtio n i n c ap i tal s tr uc tu re.
3 ) Ad d i n g t he we i g ht ed co mp o n e nt co st s to get t he fir m 's W A C C. T h us, W AC C i s ,
Th e wei g h t s to b e u sed ca n b e eit h er b o o k va l ue we i g ht s o r mar ke t va l u e wei g h ts . Bo o k val u e wei g ht s
ar e e a sier to ca lc u lat e an d ca n b e ap p l ied co n si s te nt l y. Mar k et v al u e we i g ht s are s up p o sed to b e
s up er io r to b o o k v al u e we i g h t s a s co mp o ne n t c o st s are o p p o rt u n it y co st s a nd ma r ket va l ue s r efle ct
eco no mi c va l ue s. Ho we v er , t h es e we i g h ts fl uc t ua te freq u e nt l y a nd fl uc t u atio n s are wid e i n n at ur e.
Q ue st io n : W ha t do y o u mea n by ma rg i na l co st o f ca p ita l ?
An sw er : T h e mar g i na l co s t o f cap ita l ma y b e d efi ned a s t he co s t o f rai si n g a n ad d i tio n al r u p ee o f
cap i tal . S i nce t he c ap i ta l i s r ai s ed i n s ub s ta n ti al a mo u n t i n p r act ic e mar gi n al c o s t i s re ferred to as t h e

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co s t i n c urred i n r ai s i n g ne w f u nd s. Mar g i na l co s t o f cap i ta l i s d eri v ed , wh e n we cal c ul ate t h e a ver a ge


co s t o f cap it al u si n g t h e mar gi n al wei g h t s. T h e mar gi n al wei g h t s rep r ese n t t h e p ro p o rt io n o f fu nd s
th e fi r m i n te nd s to e mp lo y. T h u s, t h e p r o b l e m o f c ho o s i n g b e t we e n t h e b o o k v al u e we i g ht s a nd t he
ma r ket va l ue we i g ht s d o es no t ar i se i n t h e c as e o f mar g i nal co st o f cap i tal co mp u ta tio n. To cal c ul at e
th e mar g i na l co st o f c ap it al, t he i nte nd ed fi n an ci n g p ro p o r tio n s ho u ld b e ap p lied as we i g h ts to
ma r gi na l co mp o ne n t co s ts. T h e mar gi n al co s t o f cap it al s ho uld , t h us, b e calc u lat ed i n t h e co mp o si te
se n se. W he n a fir m r ai s es f u n d s i n p r o p o r t io nal ma n ner a nd t he co mp o ne n t 's co s t r e ma i n u nc h an g ed ,
th er e wil l b e no d i f f er e nc e b et wee n a v er a g e co s t o f c ap it al o f to ta l fu nd s a nd t he ma r gi n al c o st o f
cap i tal . T he co mp o ne n t 's co st ma y r e ma i n u nc h an g ed , up to a c ert ai n le ve l o f fu nd s ra i sed a nd t he n
st ar t i ncr ea si n g wi t h a m o u n t o f f u nd s r ai sed , e. g. T he co s t o f d eb t re m ai n s 7 % a fter t a x t il l R s. 1 0
la k h s a nd b e t we e n R s. 1 0 - 1 5 la k h s, t h e co st m a y b e 8 % a nd so o n. S i mi la rl y, i f t h e fir m h a s to us e
th e e x ter n al eq ui t y wh e n t he r et ai n ed p r o fi t s a re no t s u ffic ie n t, t he c o st o f eq u it y wi l l b e h ig h er
b eca u se o f flo t at io n co s ts. W he n t h e co mp o ne n t s co s t s tar ts r is i n g, t he av era ge co s t o f cap it al wo u ld
r is e a nd ma r gi n al co s t o f cap i ta l wo u ld ho we ver , ri se a t a fa st er ra te.
Q ue stio n : W ha t is t h e ef f ect o f a f ina nc ing d eci sio n o n EP S ?
An sw er : O ne o f t he p r i me o b j ect i ve o f a fi na n c e ma na g er i s to ma xi mi s e b o t h t h e re t ur n o n o rd in ar y
s har es a nd t he to t al we alt h o f t he co mp a n y. T hi s o b j ec ti v e ha s to b e kep t i n v ie w wh i le , ta ki n g a
d eci sio n o n a ne w so ur c e o f f i na nc e. T h u s, t h e effec t o f eac h p ro p o sed me t ho d o f ne w fi na nc e o n t he
EP S is to b e ca r e f u l l y a na l ys ed . EP S d e no te s wh a t ha s b ee n ear n e d b y t h e co mp a n y d ur in g a
p ar ti c ul ar a cco u nt i n g p e r io d , o n ea c h o f it s o rd i nar y s h are s. T hi s ca n b e wo r k ed o u t b y d i vid i n g n et
p r o f it a ft er i n ter es t, ta x es a nd p r e f er e nc e d i v id e nd s b y t he n u mb er o f eq ui t y s h ar es . I f a co mp a n y h as
a n u mb er o f a lter n at i ve s fo r n e w f i na n ci n g, i t ca n co mp u te t he i mp act o f t he var io us al ter n at i ve s o n
ear ni n g s p er s har e. I t i s o b v io us t ha t, EP S wo uld b e t h e h i g he st i n ca se o f fi na n ci n g t ha t ha s t he lea st
co s t to t he co mp a n y.
1 ) E x pl ic it co st o f new ca p it a l : I t i s a me t ho d th at ca n co mp ar e t h e a lt ern at i ve s a v ai lab le fo r r ai si n g
cap i tal c a n b e t hr o u g h t he c al c ula tio n o f t h e e x p lic it co s t o f ne w cap it a l. E xp l ici t co st o f ne w c ap it al
is t he rat e o f ret ur n at wh ic h t h e n e w fu nd s mu s t b e e mp lo ye d so t ha t t he e x i st i n g EP S i s no t
af f ec ted . I n o t her wo r d s, t he r a te o f r et ur n o f ne w fu nd s mu s t ear n to mai n ta i n EP S at t h e ex is ti n g
le ve ls . It i s o b vio u s t ha t, i f EP S wer e Rs . 2 e a rlier , t h e ra te o f ret ur n req u ired to b e ear n ed b y t he
so urc e o f ne w cap it al t o mai n ta i n it at t h e o ld le v el i s to b e fo u nd . Lo n g ter m d eb t wo uld a g ai n b e
p r e ferred a s e v e n i f a lo wer r ate o f r e t ur n i s ear ned o n t he fu nd s so rais ed , t h e o ld EP S will b e
ma i nt ai n ed .
2 ) Ra ng e o f ea r n ing s cha rt / In d if f er en ce po i nt : A no t her met ho d o f co n sid er i n g t he i mp a ct o f
var io u s fi na nc i n g a lt er n ati v es o n EP S is to p re p are t he EB IT c h art o r th e r a n ge o f ear n i n g s c har t. It
s ho ws t he li k el y EP S a t var io us p r o b ab l e E BI T le v el s. T h u s, u nd er o ne p art ic u lar al ter na ti v e, EP S
ma y b e R s. 1 at a g i ve n EBI T le ve l. Ho we ver , t h e EP S ma y red uc e i f a n o th er al ter n at i ve o f fi na nc i n g
is c ho s e n e v e n t ho u g h t he E BI T u nd er t he al ter na ti v e ma y b e d ra wn . W her e ver t hi s li ne i nt er se ct s, i t
is k no wn a s b re a k - e ve n p o i nt. T h i s p o i n t i s a u se fu l g uid e i n fo r mu l a t in g t he cap i ta l str uc t ure . Th i s
is k no wn a s EP S eq u i v ale nc y p o i nt o r i nd i ffe ren ce p o i n t a s, it s ho ws t ha t, b e t we e n t h e 2 gi v e n
alt er na ti ve s o f fi n a nci n g i.e. r e gar d le s s o f le ve rag e i n fi n a nci al p la n s, EP S wo u ld b e t he s a me at t h e
gi v e n E BIT le ve l. T he e q ui v al e nc y o r i nd i ffer e n ce p o i n t ca n a l so b e c al cu la ted a l geb ra ic al l y a s b elo w
:
[ X - B] /S 1 = X/ S 2
W her e,
X = I nd i ffer e nce p o i nt ( EBI T )
S 1 = N u mb e r o f eq u it y s har e s o ut st a nd i n g
S 2 = N u mb e r o f eq u it y s har e s o ut st a nd i n g wh e n o nl y eq ui t y c ap i ta l i s u s ed .
B = I nte re st o n d eb t cap ita l i n r up ee s.
3 ) EP S Vo la ti lit y : EP S Vo lat il it y r e f er s to t he ma g n i t ud e o r e xt e nt o f fl u ct ua tio n s i n EP S o f a
co mp a n y i n var io u s ye a r s a s co mp ar ed to t h e me a n o r a ver a ge EP S. I n o t her wo rd s, EP S vo l ati li t y
s ho ws wh e t her a co mp a n y e nj o ys a s tab l e i n co me o r no t . It i s o b vio u s th at h i g her t he EP S Vo l ati li t y,
gr e at er wo u ld b e t he r i s k a tta c hed to t h e co m p an y. A maj o r ca u se o f EP S Vo la ti li t y wo u ld b e t he
f l uct u at io ns i n t he sa le s vo l u me a nd t he o p era ti n g le ver a ge. I t i s o b v io u s t ha t t h e net p ro fi t s o f a
co mp a n y wo uld gr e at l y fl uc t ua te wi t h s ma l l fl uc t ua tio n s i n t he s al es fi g ure s sp e cia ll y i f t he fi xed
co s t co nt e nt i s ver y h i g h. T h u s, EP S wi l l fl uc t u ate i n s uc h a s it u at io n. Th i s e ffec t ma y b e h ei g ht e ned
b y t he fi na nc ia l l e ver a g e.

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43

Neumericals : Cost of Capital


Important Questions
Que:- From the following information, Calculate the financial leverage:
(a) Existing Capital Structure: Equity Shares Rs. 60,000, 12% Debentures Rs. 40,000
(b) Rate of Return on Risk Free Investment = 10%
(c) Rate of Return on Market Portfolio = 30%
(d) Beta Coefficient = 0.5
(e) Tax Rate = 40%
Que:- Mr. Agent is planning to purchase the shares of X Ltd. Which had paid a dividend of Rs. 2 per share at last year. Dividends are
growing at a rate of 10%. What price would Mr. Agent be willing to pay for X Ltd.s shares if he expects a rate of return of 20%?
Que:- Tulsian Ltd. Is foresseing a growth rate of 10% p.a. for next two years. The growth rate is likely to increase to 12% for the next two
years. After that the growth rate is expected to continue atr 8% p.a. The company paid a dividend of Rs. 5 per share last year. Investors
required rater of return is 10%.
Required: At what price would you as investor be ready to buy the shares of this company now (t = 0)?
Que:- The following is the capital structure of a Company:
Source of Capital

Book Value
Market Value
Rs.
Rs.
Equity Shares @ Rs. 100 each
80,00,000
1,60,00,000
9 percent Cumulative Preference Shares @ Rs. 100 each
20,00,000
24,00,000
11 percent Debentures
60,00,000
66,00,000
Retained Earnings
40,00,000
-2,00,00,000
2,50,00,000
The current market price of the companys equity share is Rs. 200. For the last year the company had paid equity dividend at 25
per cent and its dividend is likely to grow 5 per cent every year. The corporate tax rate is 30 per cent and shareholders personal income tax
rate is 20 per cent.
You are required to calculate:
(i)
Cost of capital for each source of capital.
(ii)
Weighted average cost of capital on the basis of book value weights.
Weighted average cost of capital on the basis of market value weights
Que:- The capital structure of the Y Ltd. consists of 40% equity. The after tax cost of the Equity, Preference Shares and Debt are 20%, 15%
and 7.20% respectively. Calculate the proportion of the Preference Shares and Debt in the capital structure of the company if weighted
average cost of capital is 15.44%

Practical Questions:Que. 1- D Ltd. is issuing debentures carrying 12% coupon on nominal value Rs. 100. The issue price is Rs. 105. The cost of issue is Re. 1
per debenture. The debentures are redeemable at Rs. 125 after 10 years. Tax rate is 40%. Debenture cost of debt.
Que. 2- (a) A company issues Rs. 10,00,000 16% debentures of Rs. 100 each. The company is in 35% tax bracket. You are required to
calculate the cost of debt after tax. If debentures are issued at (i) Par, (ii) 10% discount and (iii) 10% premium
(b) If brokerage is paid at 2% what will be cost of debentures if issue is at par.
Que. 3- Vishnu steels Ltd. has issued 30,000 irredeemable 14% debentures of Rs. 150 each. The cost of floatation of debentures is 5% of the
total issued amount. The companys taxation rate is 40%. Calculate the cost of debt.
Que. 4- C Ltd. debentures carry 2% coupon on nominal value Rs. 100. The current price of the debentures is Rs. 108. The debentures are
redeemable at Rs. 132 after 8 years. Tax rate is 40%. Determine cost of debt.
Que. 5- Surya Industries Ltd. has raised funds through issue of 10,000 debentures of Rs. 150 each at a discount of Rs. 10 per debenture with
10 years maturity. The coupon rate is 16%. The flotation cost is Rs. 5 per debenture. The debentures are redeemable with a 10%
premium. The corporate taxation rate if 40%. Calculate the cost of debenture.
Que. 6- V Ltd. issues preference shares of face value Rs. 100 each carrying 14% dividend and realizes Rs. 92 per share. The shares are
repayable after 20 years at par.

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Que. 7- Searock Ltd. has issued 14% convertible debentures of Rs. 100 each at par. Each debenture will be convertible into 8 equity shares
of Rs. 10 each at a premium of Rs. 5 per share,. The conversion will take place at the end of 4 years the corporate tax rate is assumed
to be 40%. Assume that tax savings occur in the same year that the interest payments ar5ise. The flotation cost is 5% of the issue
amount. Calculate the cost of convertible debentures.
Que. 8- The current price of an equity share of Rs. 10 is Rs. 20. The next expected dividend per share is 20%. The dividends are expected to
grow at a rate of 5%. Calculate the cost of equity based on dividend growth model.
Que. 9- M Ltd. has issued 14% debentures and the inflation rate was 5%. The real cost of the loan can be calculated by using the following
formula.
Que. 10- A companys share is quoted in market at Rs 40 currently. A company pays a dividend of Rs. 2 per share and investors expect a
growth rate of 10% per year, compute:
(a) The companys cost of equity capital.
(b) If anticipated growth rate is 11% p.a. calculate the indicated market price per share
(c) If the companys cost of capital is 16% and anticipated growth rate is 10% p.a. . Calculate the market price if dividend of Rs. 2
per share is to be maintained.
Que. 11- Calculate the cost of capital in the following cases:
(i) X Ltd. issues 12% debentures of face value Rs. 100 each and realizes Rs. 95 per debenture. The debentures are redeemable after 10
years at premium of 10%.
(ii) Y Ltd. issues preferences shares of face value Rs. 100 each carrying 14% dividend and he realizes Rs. 92 per share. The shares
are repayable after 12 years at par.
Note: Both companies are paying Income tax at 50%.
Que. 12- X Ltd. has disbursed a dividend of Rs. 30 on each Equity share of Rs. 10. The current market price of share is Rs. 80. Calculate the
cost of equity as per dividend yield method.
Que. 13- A Ltd. plans to use long-term sources of funds in following proportions.
Equity Funds
40%
Preference Capital
10%
Debt Funds
50%
Based on Discussion with its merchant bankers and lenders, the company estimates the cost of its sources of finance for various
levels of uses as follows:

Sources

Range of New finance


Rs. lacs
Less than 20
20 or more
Less than 4
4 or moir
Less than 30
30 or more

Equity Funds
Preference Capital
Debt Funds

Cost
20%
22%
10%
12%
15%
16%

Prepare a schedule of marginal cost of capital.


Que. 14- Market price per share (MPS) and Earning per share (EPS) of 5 companies in same industry are given below. The cost of equity for
the industry can be taken as 20%. Identify the company having maximum potential for growth.
Company
MPS
EPS
Rs.
Rs.
A Ltd.
75.00
12.00
B Ltd.
63.00
9.45
C Ltd.
65.00
7.80
D Ltd.
70.00
11.90
E Ltd.
80.00
10.40
Que. 15- Dividends and year end prices of A Ltd. shares for 5 years are given below. You are required to compute cost of equity by
Realised Yield Approach.
Dividend
Price
Year
Per Share
Per share
2000-01
2.50
40.00
2001-02
3.20
42.00
2002-03
3.63
44.25
2003-04
5.33
46.00
2004-05
6.00
46.90
Que. 16- Sun Ltd. has its shares of Rs. 10 each quoted on the stock exchange, the current price per share is Rs. 24. The gross dividends per
share over the last four years have been Rs. 1.20, Rs. 1.32, Rs. 1.45 and Rs. 1.60. Calculate the cost of equity shares.
Que. 17- Capital of company consists of Rs. 10 lakh in equity funds and Rs. 15 lakh in 10% debt. The rate of return required by holders of
equity is 20%. Compute weighted average cost of capital (WACC) using proportion of debt and equity funds.

CA- IPCC- Financial Management`

45

Que. 18- Long-term capital of a company consists of the following. Rs. 000
Equity share capital (Rs. 10)
300
General Reserve
100
12% Debentures (Rs. 100)
100
Equity holders expect 20% return on their investments. The market price of ordinary shares and debentures are Rs. 16 and Rs. 120
respectively. Tax rate is 40%. Compute weighted average cost of capital.
Que. 19- Mr. A is contempolating purchase of 1,000 equity shares of a company. His expectation of return is 10% before tax by way of
dividend with an annual growth of 5%. The companys last dividend was Rs. 2 per share. Even as he is contemplating, Mr. A
suddenly finds, due to a budge3t announcement dividends have been exempted from tax in the hands of the recipients. However, the
imposition of dividend distribution tax on the company is likely to lead to a fall in dividend of Re. 0.20 per share. As marginal tax
rate is 30%. Calculate what should be Mr. As estimates of the price per share before and after the budget announcement?
Que. 20: - Modern Ltd.s share beta factor is 1.40. The risk free rate of interest on government securities is 9%. The expected rate of return
on company equity is 16%. Calculate cost of equity capital based on capital asset pricing model.
Que. 21: - Modern Ltd.s share beta factor is 1.40. the risk free rate of interest on government securities is 9%. The expected rate of return
on company equity shares is 16%. Calculate cost of equity capital based on capital asset pricing model.
Que. 23: - Calculate the return on investment from the following date/information:
Risk free return
10%
Market Return
12.5%
Beta
1.5
Que. 24: - The Beta coefficient of Computech Ltd. is 1.2. The company has been maintaining 5% rate of growth in dividends and earnings.
Current year expected dividend is Rs. 2.40 per share. Return on Government securities is 10%. Return on market portfolio is 14%.
The current market price of one share of Computech Ltd. is Rs. 28. The earnings per share is Rs. 3.90. Calculate the cost of equity
capital basing on:
(i) Dividend yield method
(ii) Dividend growth model
(iii) Capital asset pricing model.
Que. 25: - You are analyzing the beta for ABC Computers Ltd. and have divided the Company into four broad business groups, with market
values and betas for each group.
Business group
Market value of equity
Unleveraged beta
Main frames
Rs. 100 billion
1.10
Personal Computers
Rs. 100 billion
1.50
Software
Rs. 50 billion
2.00
Printers
Rs. 150 billion
1.00
ABC Computers Ltd. had Rs. 50 billion in debt outstanding. Required:
(i)
Estimate the beta for ABC Computers Ltd. as a Company.
(ii)
If the treasury bond rate is 7.5%, estimate the cost of equity for ABC Computers Ltd. Estimate the cost of equity for each
division. Which cost of equity would you use to value the printer division? The average market risk premium is 8.5%.

Que. 26: - As an investment manager you are given the following information:
Investment in Equity
Initial price
Dividends
Year ended market
Beta risk
Shares of
price
factor
A Cement Ltd.
Rs. 25
Rs. 2
Rs. 50
0.80
Steel Ltd.
35
2
60
0.70
Liquor Ltd.
45
2
135
0.50
B Government of India Bonds
1,000
140
1,005
0.99
Risk free return, 14 percent
You arte required to calculate (i) expected rate of return of market portfolio, and (ii) expected return in each security, using capital
asset pricing model.
Que. 27: - A company wishes to raise Rs. 100 lakh by either 14% institutional term loan or issue of 13% non convertible debentures. The
term loan option would not involve any incidental cost but the debentures have to be issued at 2.5% discount and the flotation cost
is estimated at Rs. 1,00,000. Advise the company. Assume tax rate 50%.
Que. 28: - The following is the capital structure of a company as on 31 Dec. 1998.
Equity Share Capital (Rs. 100)
10% Preference Capital (Rs. 100)
12% Debentures

Rs. Lakh
10
4
6
20
The market price of the companys share is Rs. 110 and it is expected that a dividend of Rs. 10 per share would be declared for the
year 1999. The dividend growth rate is 6%:
(a) If the company is in the 50% tax bracket, compute the weighted average cost of capital.

CA- IPCC- Financial Management`

46

(b) Assuming that in order to finance an expansion plan, the company intends to borrow a fund of Rs. 10 lakh bearing 14% rate
of interest, what will be the companys revised weighted average cost of capital? This financial decision is expected to
Increase dividend from Rs. 10 to Rs. 12 per share. However, the market price of equity share is expected to decline from Rs.
110 to Rs. 105 per share.
Que. 29: - Amaranth Cements Ltd. has the following capital structure:
(Rs. Lakh)
Particulars
Market Value
Book Value
Cost %
Equity Share Capital
80
120
18
Preference Share Capital
30
20
15
Fully secured Debentures
40
40
14
Calculate the Companys weighted average cost of capital. Cost of individual sources of capital is net of tax.
Que. 30: - The capital structure of Bombay Ltd. as on 31 -3 -2001 is as:
(Rs. Crores)
Equity Capital: 100 lakhs equity shares of Rs. 10 each
10
Reserves
2
14% Debenture of Rs., 100 each
3
For the year ended 31 -3 -2002 the company is likely to paid equity dividend at 20%. As the company is a market leader with good
future, dividend is likely to grow by 5% every year. The equity shares are now treated at Rs. 80 per share in the stock exchange.
Income tax rate applicable to the company is 50%. Required:
(a) The current weighted cost of capital.
(b) The company has plans to raise a further Rs. 5 crores by way of long term loan at 16% interest. When this takes place the
market value of the equity shares is expected to fall to Rs. 50 per share. What will be the new weighted average cost of capital
of the company?
Que. 31: - M/s. Albert & Co. has the following capital structure as on 31 3- 2001:
10% Debentures
3,00,000
9% Preference Shares
2,00,000
Equity 5,000 shares of Rs. 100 each.
5,00,000
Total
10,00,000
The equity shares of the company are quoted at Rs. 102 and the company is expected to declare a dividend of Rs. 9 per share for
2001. Growth rate is 5%.
(i) Assuming the tax rate applicable to the company at 50%. Calculate the weighted average cost of capital. State your assumptions, if
any.
(ii) Assuming in the exercise, that the company can raise additional term loan at 12% for Rs. 5,00,000 to finance an expansion,
calculate the revised weighted cost of capital. The companys assessment is that it will be in a position to increase the dividend
from Rs. 9 per share to Rs. 10 per share, but the business risk associated with new financing way bring down the market price from
Rs. 102 to Rs. 96 per share.
Que. 32: - You are required to determine the weighted average cost of capital (ko) of the K.C. Ltd. using: (i) book value weights; and (ii)
market value weights. The following information is available for your perusal.
The K.C. Ltd.s present book value capital structure is:
Rs.
Debentures (Rs. 100 per debenture)
8,00,000
Preference shares (Rs. 100 per share)
2,00,000
Equity shares ( Rs. 10 per share)
10,00,000
20,00,000
All these securities are traded in the capital markets. Recent prices are debentures @ Rs. 110, preference shares @ Rs. 120 and
equity shares @ Rs. 22. Anticipated external financing opportunities are: (i) Rs. 100 per debentures redeemable at par 20 year maturity, 8% coupon rate, 4% flotation costs, sale price Rs. 100.
(ii) Rs. 100 per Preference share redeemable at par; 15 year maturity. 10% dividend rate, 5% flotation costs, sale price Rs. 100.
(iii) Equity shares: Rs. 2 per share flotation costs, sale price Rs. 22.
(iv) In addition, the dividend expected on the equity share at the end of the year Rs. 2 per share; the anticipated growth rate in
dividends is 5% and the company has the practice of paying all its earning in the form of dividends. The corporate tax rate is 50%.
Que. 33: - The capital structure of Swan & Co. comprising of 12% debentures, 9% preference shares and equity shares of Rs. 100 each is in
the proportion of 3: 2: 5.
The company is contemplating to introduce further capital to meet the expansion needs by seeking 14% term loan from financial
institutions. As a result of this proposal, the proportions of debentures, preference shares and equity would get reduced by 1/10,
1/15, and 1/6 respectively.
In the light of above proposal, calculate the impact on weighted average cost of capital assuming 50% tax rate, expected dividend
of Rs. 9 per share at the end of the year current market price of equity shares of Rs. 110 and growth rate of dividends 5%. No
change in dividend, dividend growth rate and market price of share is expected after availing the proposed term loan.
Que. 34: - P Ltd. presently pays a dividend of Re. 1.00 per share and has a share price of Rs. 20.00.
(i)
If this dividend were expected to grow at a rate of 12% per annum forever, what is the firms expected or required return
on equity using a dividend discount model approach?
(ii)
Instead of this situation in part (i), suppose that the dividends were expected to grow at a rate of 20% per annum for 5
years and 10% per year thereafter. Now what is the firms expected, or required, return on equity?
Que. 35: -(a) Three companies A, B & C are in the same type of business and hence have similar operating risks. However, the capital
structure of each of them is different and the following are the details:
A
B
C

CA- IPCC- Financial Management`

47

Equity Share Capital


Rs. 4,00,000
2,50,000
5,00,000
(Face value Rs. 10 per share)
Market value per share
Rs. 15
20
12
Dividend per share
Rs. 2.70
4
2.88
Debentures
Rs Nil
1,00,000
2,50,000
(Face value per debenture Rs. 100)
Market value per debenture
. ----125
80
Interest rate
----10%
8%
Assume that the current levels of dividends are generally expected to continue indefinitely and the income tax rate at
50%. You are required to compute the weighted average cost of capital of each company.
(b) ZED Limited is presently financed entirely by equity shares. The current market value is Rs. 6,00,000. A dividend
Rs. 1,20,000 has just been paid. This level of dividends is expected to be paid indefinitely. The company is thinking of investing in
a new project involving a outlay of Rs. 5,00,000 now and is expected to generate net cash receipts of Rs. 1,05,000 per annum
indefinitely. The project would be financed by issuing Rs. 5,00,000 debentures at the market interest rate of 18%. Ignoring tax
consideration:
a. Calculate the value of equity shares and the gain made by the shareholders if the cost of equity rises to 21.6%.
b. Prove that weighted average cost of capital is not affected by gearing.
Que. 36: - John inherited the following securities on his uncles death:
Nos.
Annual
Maturity
Types of Security
Coupon %
Years
% Yield
Bond A (Rs. 1,000)
10
9
3
12
Bond B (Rs. 1,000)
10
10
5
12
Preference shares C (Rs. 100)
100
11
--13
Preference shares D (Rs. 100)
100
12
--13
The yield to preference shares is higher than coupon rate because they are likely to be recalled at a premium. Compute the current
value of Johns portfolio of investments.

CA- IPCC- Financial Management`

48

49

Chapter : EBIT-EBT Analysis


Important Questions
Que 1 :- X Ltd. Provides you the following information:
1. Funds required
: Rs. 10,00,000
2. Financial Plans
:
Financial Plan I
: 50% Equity Shares of Rs. 10 each, Current Market Price Rs. 20, 50%,
10% Debentures of Rs. 100 each.
Financial Plan II
: 40% Equity Shares of Rs. 10 each, Premium in Market 100%, 40%,
10% Debentures of Rs. 100 each, 20%, 15% Preference Shares of Rs. 100 each.
3. Tax Rate
: 40%
4. Annual Transfer to
: 20% of the Face Value of Debentures.
Debenture Redemption Reserve
Required: Calculate the Indifference Point under uncommitted EPS Approach.
Que 2:- Prepare the Income Statement and Balance-Sheet from the following data:
Price Earning ratio
3 times
Market Price per equity share
Rs. 18
No. of Equity shares of Rs. 10 each
10,000
No. of 12% Pref. Shares of Rs. 100 each
1,000
Degree of Financial Leverage
2-1
Degree of Operating Leverage
2-1
Income-Tax rate
40%
Variable Cost as % of Sales Revenue
60%
Rate of Interest on debt
10%

Practical Questions:Que. 1: - A firm requires total capital funds of Rs. 25 lacs and has two options; All equity; and half equity and half 15% debt. The equity
shares can be currently issued at Rs. 100 per share. The expected EBIT of the company is Rs. 2,50,000 with tax rate at 40%. Find
out the EPS under both the financial mix.
Que. 2: - The balance sheet of Delta Corporation shows a capital structure as follows:
Rs.
Current liabilities
0
Bonds (6% interest)
1,00,000
Common stock
9,00,000
Total Claims
Rs. 1,000,000
Its rate of return before interest and taxes on its assets of Rs. 1 million is 20%. The value of each share (whether market or book
value) is Rs. 30. The firm is in the 50% tax bracket. Calculate its earnings per share.
Que. 3: - Paramount Produces Ltd. wants to raise Rs. 100 lakhs for a diversification project. Current estimate of earnings before interest and
taxes (EBIT) from the new projects is Rs. 22 lakhs per annum. Cost of debt will be 15% for amounts up to and including Rs. 40
lakhs, 16% for additional amounts up to and including Rs. 50 lakhs and 18% for additional amounts above Rs. 50 lakhs. The
equity (face value Rs. 10) of the company have a current market value of Rs. 40. This is expected to fall to Rs. 32 if debts
exceeding Rs. 50 lakhs are raised.
The following options are under consideration of the company.
Option
Equity
I
50%
II
60%
III
40%

Debt
50%
40%
60%

Determine the earning per share (E.P.S.) for each option and state which option the company should exercise. Tax rate applicable
to the company is 50%.
Que. 4: - A Ltd. has agreed to buy the net assets of B Ltd. for Rs. 18,00,000. In order to finance the purchase the directing of A Ltd. are
considering the following proposals:
(i) To issue Rs. 18,00,000 5% 20 years sinking fund debentures.
(ii) To issue Rs. 18,00,000 5 % cumulative preference shares.
(iii) To issue 60,000 equity shares at a premium of Rs. 10

CA- IPCC- Financial Management`

Summarised balance sheets as on 31st December, 1990 and profits and loss accounts for the year ended for each company are as
follows:

Balance sheet as on 31st December, 1990


Liabilities
Equity shares issued:
25,000 shares fully paid
50,000 shares fully paid
Profit and loss account
Balance and general reserve
5% debentures
Current liabilities

Assets
Fixed assets
Current assets

A Ltd.
(Rs.)

B Ltd.
(Rs.)

5,00,000
-------

----2,00,000

19,00,000
10,00,000
16,00,000
50,00,000

2,00,000
---4,00,000
8,00,000

A Ltd.
(Rs.)
20,00,000
30,00,000
50,00,000

B Ltd.
(Rs.)
4,00,000
4,00,000
8,00,000

Profit and loss accounts for the year ended 31 st December, 1990
Sales
Profit before the items given below
Depreciation
Interest to debentures
Income tax
Net Profit
Dividends
Balance transferred to P & L appropriation a/c

A Ltd.
(Rs.)
28,00,000
15,10,000
2,60,000
50,000
6,00,000
9,16,000
6,00,000
1,25,000
4,75,000

B Ltd.
(Rs.)
60,00,000
2,80,000
50,000
-1,15,000
1,65,000
1,15,000
50,000
65,000

You are required to:


(a) calculate the consolidated net profit per equity share outstanding which would result under each of the above three proposals
assuming the profits before debenture interest and income tax of the combined operation will remain constant;
(b) calculate the additional net annual cash outlay during the next year under each of the above three proposals assuming the rate
of dividend on equity shares will be same as in 1990; and
(c) discuss the advantages and disadvantages of each of the above three proposals.
Que. 5: - A Companys capital structure consists of the following:
Equity Shares of Rs. 100 each
Retained earnings
9% Preference shares
7% Debentures shares
Total

Rs. (in lakhs)


20
10
12
8
50

The companys earnings before interest and tax (EBIT) is at the rate of 12% on its capital employed which is likely to remain
unchanged after expansion. The expansion involves additional finances of Rs. 25 lakhs for which following alternatives are
available to it:
(i)
Issue of 20,000 equity shares at a premium of Rs. 25 per share.
(ii)
Issue of 10% preference shares.
(iii)
Issue of 8% debentures.
It is estimated that P/E ratio in the case of equity shares. Preference shares and debentures financing would be 21.4, 17 and 15.7
respectively. Which of these alternatives of financing would you recommend and why? The income tax rate is 50%.
Que. 6: - A company needs Rs. 12,00,000 for the installation of a new factory which would yield an annual EBIT of Rs. 2,00,000. The
company has the objective of maximizing the earnings per share. It is considering the possibility of issuing equity shares plus
raising a debt of Rs. 2,00,000, Rs. 6,00,000 or Rs. 10,00,000. The current market price per share is Rs. 40 which is expected to
drop to Rs. 25 per share if the market borrowings were to exceed Rs. 7,50,000. Cost of borrowings are indicated as under:
Upto Rs. 2,50,000
------ 10% p.a.
Between Rs. 2,50,001 and Rs. 6,25,000
------- 14% p.a.
Between Rs. 6,25,001 and Rs. 10,00,000
------- 16% p.a.
Assuming the tax rate to be 50%, Work out the EPS.
Que. 7: - A company earns a profit of Rs. 3,00,000 p.a. after meeting its interest liability of Rs. 1,20,000 on 12% debentures. The tax rate is
50%. The number of Equity shares of Rs. 10 each are 80,000 and the retained earnings amount to Rs. 12,00,000. The company
proposes to take up an expansion scheme for which a sum of Rs. 4,00,000 is required. It is anticipated that after expansion, the

CA- IPCC- Financial Management`

50

company will be able to achieve the same return on investment as at present. The funds required for expansion can be raised either
through debt at the rate of 12% or by issuing Equity shares at par.
Required:
(i)
Compute the Earning per share (EPS), if:
the additional funds were raised as debt
the additional funds were raised by issue of equity shares
(ii)
Advise the company as to which source of finance is preferable.
Que. 8: - The following figures of Krish Ltd. are presented to you:
Earnings before interest and tax
Less: Debentures interest @ 8%
Long term loan interest @ 11%

(Rs.)
23,00,000
80,000
2,20,000

3,00,000
20,00,000
10,00,000
10,00,000

Less: Income Tax


Earnings after tax
No. of equity shares of Rs. 10 each
5,00,000
E.P.S.
Rs. 2
Market price of share
Rs. 20
P/E Ratio
10
The company has undistributed reserves and surplus of Rs. 20 lakhs. It is in need of Rs. 30 lakhs to payoff debentures
and modernize its plants. It seeks your advice on the following alternative modes of raising finance.
Alternative 1 Raising entire amount as term loan from banks @ 12%
Alternative 2 Raising part of the funds by issue of 1,00,000 shares of Rs. 20 each
and the rest by term loan at 12%.
The company expects to improve its rate of return by 2% as a result of modernization, but P/E ratio is likely to go, down
to 8 if the entire amount is raised as term loan.
(i)
Advice the company on the financial plan to be selected.
(ii)
If it is assumed that there will be no change in the P/E ratio if either of the two alternatives are adopted, would
your advice still hold good?

Que. 9: - Bhaskar Manufactures Ltd. has equity share capital of Rs. 5,00,000 (face value Rs. 100). To meet the expenditure of an expansion
programme, the company wishes to raise Rs. 3,00,000 and is having following four alternative sources to raise the funds:
Plan A: To have full money from the equity shares.
Plan B: To have Rs. 1 lakh from equity and Rs. 2 lakhs from borrowing from the financial institutions @ 10% per annum.
Plan C: Full money from borrowing @ 10% per annum
Plan D: Rs. 1 lakh in equity and Rs. 2 lakhs from preference shares @ 8% per annum dividend.
The company is having present earnings of Rs. 1,50,000. The corporate tax is 50%. Suggest a suitable plan of the above
four plans to raise the required funds.
Que. 10: -American Express Ltd. is setting up a project with a capital outlay of Rs. 60,00,000. It has the following two alternatives in
financing the project cost.
Alternatives
:
100% Equity finance
Alternative
:
Debt Equity ratio 2: 1
The rate of interest payable on the debt is 18% p.a. the corporate rate of tax is 40%. Calculate the indifference point between two
alternative methods of financing.
Que. 11: -PCB Corporation has plans for expansion which calls for 50% increase in assets. The alternatives before the corporation are issued
of equity shares or debt at 14%. Its balance sheet and profit and loss accounts are as given below:

Balance sheet as at 31st December, 1989


Liabilities
12% debentures
Ordinary shares
10 lakh shares of
Rs. 10 each
General reserve

Rs. in lakhs
Assets
25
Total assets

Rs. in lakhs
200

100
75
200

----200

Profit and Loss Account for the year ending 31st March, 2001
Sales
Total cost excluding interest
EBIT
Interest on Debentures
EBT
Taxes
EAT

Earnings per share =

Rs. 36,00,000

(Rs. in lakhs)
750
675
75
3
72
36
36

= Rs. 3.60

CA- IPCC- Financial Management`

51

10,00,000

52

PIE ratio = 5 times


Market price = Rs. 18
If the Corporation finances the expansion with debt, the incremental financing charges will be at 14% and P/E ratio is expected to
be at 4 times. If the expansion is through equity, the P/E ratio will remain at 5 times. The company expects that its new issues will
be subscribed to at a premium of 25%. The company expects that its new will be subscribed to at a premium of 25%. With the
above information determine the following:
(i)
IF EBIT is 10% of sales, calculate EPS at sales levels of Rs. 4 crores, Rs. 8 crores and Rs. 10 crores.
(ii)
After expansion determine at what level of EBIT, EPS would remain the same, whether new funds are raised
by equity or debt.
(iii)
Using P/E ratios, calculate the market value per share at each sales level for both debt and equity financing.
Que. 12: - ABC Corporation plans to expand assets by 50%; to finance the expansion, it is choosing between a straight 12% debt issue and
equity shares. Its balance sheet and profit and loss account are shown below:

ABC CORPORATION
Balance Sheet as on 31st December, 1996
Liabilities
11% Debentures
Equity share capital
(10,00,000 shares of Rs.
10 each)
Retained earnings

Rs.
40,00,000

Assets
Total assets

Rs.
2,00,00,000

1,00,00,000
60,00,000
2,00,00,000

2,00,00,000

ABC CORPORATION
Profit & Loss Account for the year ended 31 st December, 1996
Rs.
6,00,00,000
5,40,00,000
60,00,000
4,40,000
55,60,000
27,80,000
27,80,000

Sales
Total costs (excluding interest)
Net income before interest and taxes (EBIT)
Interest on debentures @ 11%
Income before taxes
Taxes @ 50%
Profit after tax
Earnings per share Rs. 27,80,000/10,00,000
Price/earnings ratio
Market price (7.5 x Rs. 2.78)

2.78
7.5 times
Rs. 20.85

If ABC Corporation finance Rs. 1 crore expansion with debt, the rate of the incremental debt will be 12% and the price/earnings
ratio of the equity shares will be 5 times. If the expansion is financed by equity, the new shares can be sold at Rs. 12 per share and
the price/earnings ratio will remain at 7.5 times.
(d) Assuming that net income before interest and taxes (EBIT) is 10% of sales, calculate earnings per share at sales level of Rs. 4
crores and Rs. 10 crores when financing is with (i) equity shares and (ii) debt.
(e) At what level of earnings before interest and taxes (EBIT), after the new capital is acquired, would earnings per share (EPS)
be the same when new funds are raised by issuing equity shares of raising debt?
(f) Using the P/E ratio, calculate the market value per share for each sales level for the debt and the equity financing.
Que. 13: - ABC Co. has a total capital of Rs. 2,50,000, and it normally earns Rs. 50,000 (before interest and taxes). The financial manager of
the firm wants to take a decision regarding the capital structure. After a study of the capital market, he gathers the following data:
Amount of Debt
Interest Rate
Equity Capitalization Rate
Rs.
%
(at given level of debt) %
0
--10.00
50,000
8.0
10.50
1,00,000
8.0
11.00
1,50,000
9.0
11.60
2,00,000
9.5
12.30
You are required (i) to determine the weighted average cost of capital and optimum capital structure by traditional approach, (ii)
Determine equity capitalization rate if Modigliani Miller approach is followed.

CA- IPCC- Financial Management`

53
Financial Management

Capital Structure
Practical Questions:Que. 1-

The following is the B/S as at 31st March, 1998 of S. Co. Ltd. :


Share Capital:
10,000 equity shares of Rs. 100 each fully paid up
25,000 11% Cum. Preference shares of Rs. 10 each
Fully paid up
Reserve & surplus
Secured Loans
Unsecured loans
Trade creditors
Outstanding expenses

Rs.
10,00,000

Rs.

2,50,000

12,50,000
25,00,000
20,00,000
12,00,000
18,00,000
7,50,000
95,00,000

Represented by Fixed assets


55,00,000
Current assets
37,00,000
Advances and deposits
3,00,000
95,00,000
The Co. plans to manufacture a new product in line with its current production, the capital cost of which is estimated to be Rs. 25
lakhs. The company desires to finance the new project to the extent of Rs. 16 lakhs by issue of equity shares at a premium of Rs. 100
per share and the balance to be raised from internal sources. Additional informations made available to you are.
(a) Rate of dividends declared in the past five years i.e. year ended 31st March, 1998. 31st March, 1997, 31st March, 1996, 31st
March, 1995 and 31st March, 1994 were 24%, 24%, 20%, 20% and 18% respectively.
(b) Normal earning capacity (net of tax) of the business is 10%
(c) Turnover in the last three years was Rs. 80 lakhs (31st March, 1998), Rs. 60 lakhs (31st March, 1997) and Rs. 50 lakhs (31st
March, 1996).
(d) Anticipated additional sales from the new project Rs. 30 lakhs annually.
(e) Net profit before tax from the existing business which was 10% in the last three years is expected to increase to 12% on
account of new product sales.
(f) Income tax rate es 35%
(g) The trend of market price of the equity share of the company quoted on the Stock Exchange was:
Year
High
Low
1997-98
Rs. 300
Rs. 190
1996-97
Rs. 250
Rs. 180
1995-96
Rs. 240
Rs. 180
You are required to examine whether the companys proposal is justified. Do you have any suggestions to offer in this regard ?
All workings must form part of your answer.
Que. 2-

The following figures are made available to you:


Net profits for the year
Less: Interest on secured debentures at 15% p.a.
(debentures were issued 3 months after the commencement of the year)

Rs.
18,00,000

1,12,500
16,87,500
Less: Income tax at 35% and dividend distribution tax
8,43,750
Profit after tax
8,43,750
Number of equity shares (Rs. 10 each)
1,00,000
Market quotation of equity share
Rs. 109.70
The company has accumulated revenue reserves of Rs. 12 lakhs. The company is examining a project calling for an
investment obligation of Rs. 10 lakhs: this investment is expected to earn the same rate of return as funds already employed.
You are informed that a debt equity ratio (Debt dividend by debt plus equity) higher than 60% will cause the price earning
ratio to come down by 25% and the interest rate on additional borrowals will cost company 300 basic points more than on their
current borrowal on secured debentures. You are required to advise the company on the probable price of the equity share, if
debentures. You are required to advise the company on the probable price of the equity share, if
(a) the additional investment were to be raised by way of loans; or
(b) the additional investment were to be raised by way of equity.
Que. 3-

AB Ltd. provides you with following figures:


Profit
Less: Interest on Debentures @ 12%
Income tax @ 50%

Rs.
3,00,000
60,000
2,40,000
1,20,000
1,20,000

CA- IPCC- Financial Management`

Number of Equity Shares (Rs. 10 each)


40,000
E.P.S (Earning per share)
3
Ruling price in market
30
P/E ratio (Price/EPS)
10
The company has undistributed reserves of Rs. 6,00,000. The company needs Rs., 2,00,000 for expansion. This amount
will earn at the same rate as funds already employed. You are informed that a debt equity ratio (Debt/Debt + Equity) higher than 35%
will push the P/E ratio down to 8 and raise the interest rate on additional amount borrowed to 14%.
You are required to ascertain the probable price of the share: (i) if the additional funds are raised as debt: and (ii) if the
amount is raised by issuing equity shares.
Que. 4- A companys capital structure consists of the following:
Equity Shares of Rs. 100 each
Rs. 20,00,000
Retained earnings
Rs. 10,00,000
9% Preference shares
Rs. 12,00,000
7% Debentures
Rs 8,00,000
Total
Rs. 50,00,000
Its capital employed which is likely to remain unchanged after expansion. The expansion involves additional finances of
Rs. 25 lakhs for which following alternatives are available to it:
(i) Issue of 20,000 equity shares at a premium of Rs. 25 per share.
(ii) Issue of 10% preference shares.
(ii) Issue of 8% debentures.
It is estimated that P/E ratio in the case of equity shares, preference shares and debentures financing would be 21.4, 17 and
15.7 respectively. Which of these alternatives of financing would you recommend and why? The income-tax rate is 50%.
Que. 5- The Halda Manufacturing Company Ltd. has to make a choice between debt issue and equity issue for financing its expansion
programme. The existing position of the company is given below:Rs.
Debt 5%
40,000
Equity share capital (Rs. 10 per share)
1,00,000
Reserves and surplus
60,000
Total capital
2,00,000
Sales
6,00,000
Less: Total cost
5,38,000
Income before interest and taxes
62,000
Less: Interest
2,000
Income before taxes
60,000
Less: Income tax @ 50%
30,000
Income after taxes
30,000
The expansion programme would require Rs. 1,00,000. If this is financed through debt, the rate of new debt will be 7 per
cent and the price earning ratio will be 6 times. If the expansion programme is financed through equity, new shares can be sold to net
Rs. 25 per share and the price earning ratio will be 7 times. The expansion will generate additional sales of Rs. 3,00,000, with a
return of 10 per cent on sales before interest and taxes.
If the company is to produce a policy of maximizing the market value of its shares, which form of financing should it
choose? Assume 50% company tax rate.
Que. 6- Diamond Tools Ltd. has developed a financial plan for the next three years based on following estimates:
(Rs. Lakhs)
Year 1
Year 2
Year 3
Sales
600
720
900
Fixed assets
480
570
660
The following assumptions have been made for the purpose of planning:
Gross profit
30%
Return on sales (net of taxes)
10%
Dividend pay-out ratio
50%
Ratios based on year end figures:
Cash and debtors to sales
4 times
Inventory (cost of goods sold)
3 times
Required current ratio
2:1
Required ratio of long-term debt to equity
1:2
At the beginning of Year 1 the firm expects to have equity of Rs. 360 lakhs and long term debt of Rs. 180 lakhs.
Determine how much additional equity capital the firm will have to raise each year based on above ratios and assumptions.
Assume that the company is not seeking separate finance from bank for additional working capital needs.
Que. 7: - A company has to raise Rs. 2,00,000 to finance an expansion program. It has two options; either to borrow or the issue sufficient
number of ordinary shares at current market price of Rs. 30 per share. Based on date for previous accounting year given below and
additional data provided you are required to evaluate the options.
Data for previous accounting year
Rs. lakh
Profit
3.00
Less: 12% Interest on debt
0.60
2.40
Less: 50% Tax
1.20

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54

1.20
Companys present share capital consists of 40,000 ordinary shares of Rs. 10 each. It has undistributed reserves of Rs. 6,00,000.
It is known that debt equity ratio higher than 40% will pull down P/E ratio to 8 and pre tax cost of additional borrowings will be
14%.
Que. 8: - A company requires Rs. 25,00,000 for a new plant, which is expected to yield earnings before interest and taxes Rs. 5,00,000. The
company seeks your advice on three financing alternatives under consideration. The companys objective is to maximize earnings
per share.
The following particulars regarding the alternatives are available:
Alternative A:
Raise Rs. 2,50,000 by debt and the rest by issue of fresh equity
Alternative B:
Raise Rs. 10,00,000 by debt and the rest by issue of fresh equity
Alternative C:
Raise Rs. 15,00,000 by debt ad the rest by issue of fresh equity
Funds can be borrowed at 10% p.a. upto Rs. 2,50,000, at 15% p.a. beyond Rs. 2,50,000 upto Rs. 10,00,000 and at 20% p.a. beyond
Rs. 10,00,000. The companys shares are currently selling at Rs. 150 but are expected to decline to Rs. 125 in case borrowed fund
exceeds Rs. 10,00,000. The tax rate is 50%.
Que. 9: - XYZ Co. has a capital structure of 30% debt and 70% of equity. The company is considering various investment proposals costing
less than Rs. 30 lakhs
The company does not want to disturb its present capital structure. The cost of raising the debt and equity are as follows:
Project Cost
Cost of Debt
Cost of Equity
Upto Rs. 5 lakhs
9%
13%
Above Rs. 5 lakhs and upto Rs. 20 lakhs
10%
14%
Above Rs. 20 lakhs and upto Rs. 40 lakhs
11%
15%
Above Rs. 40 lakhs and upto Rs. 1 crore
12%
15.5%
Assuming the tax rate is 50%, compute the cost of capital of two projects ABC & XYZ whose fund requirements are Rs. 5 lakhs &
21 lakhs respectively and if a project is expected to yield after tax return of 11%, determine under what conditions it would be
acceptable.
Que. 10: - For varying levels of debt equity mix, the estimates of the cost of debt and equity capital (after tax) are given below:
Debt as % of total
Cost of debt
Cost of equity
Capital employed
0
7.0
15.0
10
7.0
15.0
20
7.0
16.0
30
8.0
17.0
40
9.0
18.0
50
10.0
21.0
60
11.0
24.0
You are required to decide on the optimal debt equity mix for the company by calculating the composite cost of capital.
Que. 11: - XYZ Ltd. intends to set up a project with capital cost of Rs. 50,00,000. It is considering the three alternative proposals of
financing.
Alternative 1
= 100% Equity financing
Alternative 2
= Debt Equity 1: 1
Alternative 3
= Debt Equity 3: 1
The estimated annual net inflow is @ 24% i.e. Rs. 12,00,000 on the project. The rate of interest on debt is 15%. Calculate the
weighted average cost of capital for three different alternatives and analyze the capital structure decision.
Que. 12: - ABC Ltd. with EBIT of Rs. 3,00,000 is evaluating a number of possible capitals below which of the capital structure will you
recommend, and why?
Capital structure
Debt (Rs.)
Kd %
Ke %
I
3,00,000
10.0
12.0
II
4,00,000
10.0
12.5
III
5,00,000
11.0
13.5
IV
6,00,000
12.0
15.0
V
7,00,000
14.0
18.0
Que. 13: - X Ltd. and Y Ltd. are identical expect that the former uses debt while the later does no. Thus levered firm has issued 10%
Debentures of Rs. 9,00,000. Both the firms earn EBIT of 20% on total assets of Rs. 15,00,000. Assuming tax rate of 50% and
capitalization rate of 15% for an all equity firm.
(i)
Compute the value of the two firms using NI approach.
(ii)
Compute the value of the two firms NOI approach.
(iii)
Calculate the overall cost of capital, Ko, for both the firms using NOI approach.
Que. 14: -From the following selected data, determine the value of the firms, P and Q belonging homogeneous risk class under (a) the net
income (NI) approach, and (b) The net operating income approach.
Firm P
Firm Q
Rs.
Rs.

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55

EBIT
2,75,000
2,25,000
Interest at 15%
75,000
Equity capitalization rate, Ke
20%
Corporate tax rate
50%
Which of the two firms has an optimal capital structure under the (i) NI approach, and (ii) NOI approach?

56

Que. 15: - Summer Ltd. and Winter Ltd. are identical in all respects including risk factors expect for debt/equity mix. Summer Ltd. having
issued 12% debentures of Rs. 30 lakhs, while Winter Ltd. issued only equity capital. Both the companies earn 24% before interest
and taxes on their total assets of Rs. 50 lakhs. Assuming the corporate effective tax rate of 40% and capitalization rate of 18% for
an all equity company. Compute the value of Summer Ltd. and Winter Ltd. using (i) Net Income approach and (ii) Net operating
income approach.
Que. 16: -Cost of equity of an unlevered business is 20%. The cost of debt funds is 10%. Assume different degree of leverage and that net
operating Income approach holds. Hence, compute cost of levered equity (KLE) for each degree of leverage.
Que. 17: -The following data relate to two Companies X and Y
Company X
Company Y
Number of ordinary shares
90,000
1,50,000
Market price per share (Rs.)
1.20
1.00
6% Debentures (Rs.)
60,000
----Profit before interest (Rs.)
18,000
18,000
Explain how under Modigliani & Miller approach, an investor holding 10% of shares in Company X will be better off in switching
his holding to Company Y. Also show the way equilibrium is restored.
Que. 18: -A company expects to sell 20,000 units of product X at unit selling price Rs. 50. The variable cost of production per unit is Rs. 30.
The annual fixed cost is Rs. 1,50,000. Alternately, the company may sale 20,000 units of product Y at unit selling price Rs. 50. In
this case, the unit variable production cost and annual fixed cost are Rs. 25 and Rs. 2,50,000 respectively. Tax rate is 40%.
Both of the products require same initial investment Rs. 7,50,000. The following two capital structures are under consideration.
Sources of Funds
Plan 1
Plan 2
Rs. lakh
Rs. lakh
10% Preference Capital
1.50
2.00
Ordinary Share Capital (Rs. 100)
5.00
2.50
15% loan
1.00
3.00
Total Funds
7.50
7.50
Required:
(a) Operating break even points for products X and Y
(b) Financial break even points for products X and Y for both of the capital structures
(c) Overall break even point for products X and Y for both of the capital structure
(d) EBIT EPS indifference points for two proposed capital structures.
(e) Draw EBIT EPS indifference chart
(f) % Change in EBIT for 10% change in sales for products X and Y
(g) % Change in EPS for 10% change in sales for products X and Y for both of the capital structures
(h) Return on equity capital employed for products X and Y for both of the capital structures
(i) Return on long term capital employed for products X and Y for both of the capital structures
(j) Comment on risk and return of the products
Que. 19: - Tow companies, X and Y belong to the equivalent risk group. The two companies are identical in every respect that company Y is
levered, while X is unlevered. The outstanding amount of debt of the levered company is Rs. 6,00,000 in 10% debenture. The
other information for the two companies is as follows:

Net operating income (EBIT)


Interest
Earning to equity holders
Equity capitalization rate ke
Market value of equity
Market value of debt
Total value of firm, V,
Overall capitalization rate ke = EBIT/V
Debt equity ratio

X (Rs.)
1,50,000
--1,50,000
0.15
10,00,000
---10,00,000
15.0%
0

Y (Rs.)
1.50.000
60,000
90,000
0.20
4,50,000
6,00,000
10,50,000
14.3%
1.33%

An investor owns 5% equity shares of company Y. Show the process and the amount by which he could reduce his outlay through
use of the arbitrage process, is there any limit to the process?
Que. 20: - Firm A and B are similar except that A is unlevered, while B has Rs. 2,00,000 of 5 percent debenture outstanding. Assume that
the tax rate is 40 percent; NOI is Rs. 40,000 and the cost of equity is 10%. (i) Calculate the value of the firm, if the MM
assumptions are met. (ii) If the value of the firm B is Rs. 3,60,000 then do these values equilibrium values. It not, how will
equilibrium be set? Explain,

CA- IPCC- Financial Management`

Que. 21: - A firm has a bond outstanding Rs. 300 lakh. The bond has 12 years of life remaining until maturity, and has a 12.5% coupon and
is callable at Rs. 1,050 per bond; it had flotation costs of Rs. 4.2 lakh, which are being amortized at Rs. 30,000 annually. The
floatation costs for a new issue will be Rs. 9 lakh and the current interest rte will be 10%. The after tax cost of the debt is 6%.
Should the firm refund the outstanding debt?
Show detailed workings. Consider Corporate Income tax rate at 50%.
Que. 22: - X Ltd. and Y Ltd. are identical except for leverage. They earn same operating profit Rs. 4 lakh before tax. Y Ltd. has Rs. 8 lakh
in 10% debt while company X is entirely financed by equity. Assuming a tax rate of 40% and capitalization rate of 16% for an all
equity company, compute the value of business and overall cost of capital by
(i) Net Income Approach and
(ii) Net Operating Income Approach
Que. 23: - A Ltd. expects to earn Rs. 5 lakh annually before interests and taxes. The company is financed entirely by equity funds and cost
of unlevered equity is 15%. Tax rate is 40%. The company wishes to buy back Rs. 10 lakh of its equity and to replace the same by
10% debt. Determine income available to equity and debt holders of the business before and after buy back and hence explain
how the value of the company will change after buy back.

Chapter : Capital Budgeting


Q ue stio n : E x p la i n t he mea ni ng o f ca pit a l b u dg et ing ?
An sw er : T h e ter m cap ita l b ud g et i n g me a n s p l an n i n g fo r c ap i tal a s set s. C ap i tal b ud ge ti n g d e ci sio n
me a n s t he d ec is io n as to whe t her o r no t to i n ve s t i n lo n g -te r m p ro j ec t s s uc h a s s et ti n g up o f a fa cto r y
o r i n sta ll i n g a mac h i ner y o r cr e at i n g ad d it io nal cap ac it ie s to ma n u fac t ur e a p a rt wh i c h a t p re se n t ma y
b e p urc ha sed fro m o u ts id e a nd so o n. I t i nc l u d es t he fi na n cia l a n al y si s o f t he vario u s p ro p o sa ls
r eg ard i n g cap i ta l e xp e n d it ur e to e va l ua te t heir i mp ac t o n t h e fi na n ci al co nd it io n o f t h e co mp a n y fo r
th e p urp o se to c ho o se t he b es t o ut o f t he v ario u s a lter n at i ve s. T h e fi na nc e ma na g er ha s var io u s to o l s
and tec h n iq ue s b y me a n s o f wh i c h he a s si s ts t h e ma na g e me nt i n t a ki n g a p ro p er cap ita l b ud g eti n g
d eci sio n . C ap i ta l b ud get in g d ec is io n i s t h us , e va lu at io n o f e xp e n d it u re d eci sio n s t hat i n vo l v e c u rre nt
o ut la ys b ut are l i ke l y to p r o d uc e b e ne f it s o ver a p erio d o f t i me lo n g er t ha n o n e year. T h e b e ne fit t h a t
ar i se s fro m cap it al b ud ge ti n g d ec i sio n ma y b e ei t her i n t he fo r m o f i ncr ea sed re ve n u es o r r e d uc ed
co s ts . S uc h d ec i s io n r eq ui r e s e val u at io n o f t he p ro p o sed p ro j ec t to fo r e cas t li k el y o r e xp e cted r et ur n
fr o m t h e p ro j ect a nd d et er mi ne wh e t h er r et ur n fr o m t he p ro j ec t is ad eq ua te. A lso a s b u s i ne s s is a p art
o f so c ie t y, i t i s it s mo r al r e sp o n sib il it y to u nd erta k e o nl y t ho se p ro j ec ts t ha t ar e so ci al l y d e si rab le.
Cap it al b ud g et i n g d ec i si o n is a n i mp o r t a nt, cr uc i al a nd cri ti cal b us i ne s s d eci sio n d ue to :
1 ) S ub sta ntia l e x pe n dit ure :
cap i tal b ud g et i n g d ec is i o n i n vo l ve s t h e i n ve st m en t o f s ub s ta nt ia l a mo u nt o f fu nd s a nd i s t h us it i s
ne ce s sar y fo r a fir m t o ma k e s uc h d eci s io n after a t ho u g h t fu l co n sid erat io n, so a s to re s ul t i n
p r o f itab le u se o f sc ar ce r eso ur ce s. Ha s t y a nd i nc o rrect d e ci sio n s wo u ld no t o n l y r es u lt i n h u ge l o s se s
b ut wo u ld a lso ac co u nt f o r f ai l ur e o f t he f ir m.
2 ) lo ng ti me pe rio d :
cap i tal b ud g et i n g d ec i si o n ha s i t s e f f ect o v er a lo n g p erio d o f ti me , t h e y a ffec t t h e fut ur e b e n efit s
and al so t he fir m a nd i n f l ue nc e t h e r a te a nd d ir e ctio n o f gro wt h o f t he fi r m.
3 ) Ir rev e rs i bi lity :
mo st o f s uc h d e ci sio n s ar e ir r e v er sib le, o nc e ta ke n , t he fi r m ma y no t b ee n i n a p o si tio n to re v e rse i t s
i mp ac t. T hi s ma y b e d u e to t he r ea so n, t h at it i s d i ffic u lt to fi nd a b u yer fo r se co nd - ha nd c ap it al
ite ms .
4 ) Co mp le x de ci sio n :
cap i tal i n v es t me n t d e ci sio n i n vo l ve s a n a ss e s s me n t o f fut ur e e v e nt s, wh ic h i n fac t ar e d i ffi c ul t to
p r ed ic t, fur t her, it i s d i f fic u lt to e s ti ma t e i n q ua n ti ta ti ve ter ms al l b en e fi ts o r co st s r ela ti n g to a
p ar ti c ul ar i n v es t me n t d e ci sio n.
Q ue st io n: d is cu s s t he v a rio us t y p es o f ca pita l inv est me nt de c i sio n s?
An sw er : T her e ar e var i o u s wa ys to cl as s i fy cap ita l b ud ge ti n g d ec is io n s, ge n era ll y t he y are
cla s si fied as :
1 ) O n t he ba si s o f t h e f ir m' s e x i st e nce :

CA- IPCC- Financial Management`

57

cap it al b ud get in g d e ci sio n s ar e t a ke n b y b o t h n e wl y i nco rp o r ated a nd e xi s ti n g fir ms . Ne w


f ir ms ma y req u ir e to t ak e d ec is io n i n r esp ec t o f sel ec tio n o f p la nt t o b e i ns ta ll ed , wh i le e xi s ti n g
f ir ms ma y req u ire to t a k e d ec i sio n to mee t t he r eq u ire me n t s o f ne w e n vi ro n me n t o r to face c ha ll en g es
o f co mp e ti tio n. T he se d eci sio n s ma y b e cl as s i fi ed i nto :
i) R ep la c e me nt a nd mo der n isa t io n dec i sio ns : rep lac e me n t a nd mo d ern i sat io n d ec is io n s a i ms to
i mp ro ve o p era ti n g e f f ic i en c y a nd r ed u ce co st s. Us u al l y, p la n ts req u ire rep la ce me n t d u e to t he y b een
eco no mi cal l y d e ad i. e. n o mo r e eco no mic li fe l e ft o r o n t h e y b e co mi n g t ec h no lo g ica ll y o u td a ted . Th e
fo r me r d e ci s io n i s o f r e p lace me nt a nd la tt er o n e o f mo d er ni sa tio n , ho we v er, b o t h t h es e d e ci si o n s are
co s t red uc tio n d ec i sio n s .
ii) E x pa n sio n dec i sio n : e xi s ti n g s u cce s s ful fir ms ma y e x p eri e nce gro w t h i n d e ma nd o f t h e p ro d uc t
and ma y e xp er ie n ce s ho r ta ge o r d ela y i n d e li ve r y d ue to i n ad eq ua te p r o d uc tio n fac ili ti e s a nd th u s,
wo u ld co ns id er p r o p o s al s to ad d c ap ac it y to e xi s ti n g p ro d u ct li n es.
iii ) D iv e rs ifi ca tio n de c is io n s : t h es e d e ci sio n s req uir e e v al u at io n p ro p o sa ls to d i ve rs i fy i nto n e w
p r o d uc t li ne s, ne w mar k et s, e tc. to r ed uce ri s k o f fai l ure b y d ea li n g i n d i ffere n t p ro d u ct s o r o p e rati n g
in s e vera l ma r ke ts. e xp a n sio n a nd d i v er si f ica tio n d eci s io ns are re ve n ue exp a ns io n d e ci sio n s.
2 ) O n t he ba si s o f d eci s io n s it ua t io n :
i) M utua lly e x cl u siv e dec i sio n s : d ec i sio n s a re s aid to b e mu t u a ll y ex cl u si v e wh e n t wo o r mo r e
alt er na ti ve p ro p o s al s a r e s uc h t ha t a ccep ta nc e o f o n e wo u ld e x cl ud e t he accep ta nc e o f t he o t her.
ii) Ac ce pt - R eject d ec is io n s : t h e a ccep t -ej ec t d eci sio n s o cc ur s wh e n p ro p o sa ls ar e i nd ep e nd e nt a nd
d o no t co mp ete wi t h e ac h o t her . T he f ir m ma y a ccep t o r rej ec t a p ro p o s al o n t he b a s is o f a mi n i mu m
r et ur n o n t he r eq uir ed i n ve s t me n t. Al l t ho se p ro p o sa ls wh ic h h a ve a hi g h er ret ur n t h a n c er ta i n d e sir ed
r ate o f re t ur n ar e ac cep t ed a nd r e s t r ej ec ted .
iii ) Co nt ig e nt d ec is io ns :
co n ti g e nt d eci s io ns ar e d ep e nd ab l e p r o p o sa ls , i n ve s t me n t i n o n e req u ir es i n ve st me n t i n a no t her .
Q ue st io n: W ha t a r e t he v a rio us p ro j ect s ev a l u a tio n tec h ni qu es e x pl a i n t he m i n deta il ? '

An sw er : A t e ac h p o i nt o f t i me, b u s i ne s s ma n a ger , ha s to e v al ua te a n u mb e r o f p ro p o sa l s a s r eg ard s


var io u s p ro j ec ts wh er e he ca n i n ve st mo ne y. H e co mp ar e s a nd e val u at es p ro j e ct s a nd d ec id e s wh ic h
o ne to t a ke up a nd wh i c h to r ej ec t . Ap ar t fro m fi na nc ia l co n s id era tio n s , t he re are ma n y o t her facto r s
co n s id ered wh i le t a ki n g a cap i tal b ud g et i n g d e ci sio n. At t i me s a p ro j e ct ma y b e u nd e rta k e n o nl y to
es tab l i s h fo o t ho ld i n t h e mar ke t o r fo r b et ter wel far e o f t he so c ie t y a s a wh o l e o r o f t he b u si n es s o r
fo r i n crea s i n g t he sa fe t y a nd se c ur i t y o f wo r ker s, o r d ue to req u ire me n t s o f la w o r b e ca u se o f
e mo tio n al re aso n s fo r i n st a nce, ma n y i nd u str ia l se cto r p ro j ec ts ar e ta k en up a t ho me to wn s e ve n i f
b ett er lo cat io n s ar e a va ilab le. T he maj o r co n s i d erat io n i n ta k i n g a ca p ita l b ud ge ti n g d eci s io n is to
ev al ua te i t s ret ur n s a s co mp ar ed to i t s i n ve st m en t s. E val u at io n o f c ap i tal b ud ge ti n g p ro p o sa ls ha v e
t wo d i me n sio n s i. e. p r o f itab il it y a nd r i s k, wh i c h are d ire ct l y re lat ed . H i g her t he p ro fit ab il it y, h ig h er
wo u ld b e t he r i s k a nd v ice ve r s a. T h u s, t he fi na nc e ma na g er ha s to s tri k e a b a la nc e b e t we e n
p r o f itab il it y a nd r i s k. F o llo wi n g ar e so me o f t h e te c h niq ue s u s ed to e v al ua te fi na nc ia l a sp e ct s o f a
p r o j ect :
1 ) Pa y ba c k pe rio d :
it i s o ne o f t he si mp le s t me t ho d to calc u la te p er io d wi t h i n wh ic h e n ti re co st o f p ro j ect
wo u ld b e co mp le tel y r e co v er ed . I t i s t h e p er io d wi t hi n wh i c h to ta l c a s h i n flo ws fro m p ro j ec t wo uld
b e eq ua l to to t al ca s h o u t flo w o f p r o j ec t, c as h i n flo w me a n s p ro fit a ft er t ax b ut b e fo re d ep rec ia ti o n.
M erits :
a) t hi s me t ho d o f e v al u ati n g p r o p o sa ls fo r c ap i tal b ud ge ti n g is si mp le and e as y to u nd er sta nd , it h as
an ad va nt a ge o f ma k i n g clea r t ha t i t ha s no p ro fit o n a n y p ro j e ct u n ti l t he p a yb ac k p erio d is o v er i.e .
u nt il cap it al i n ve st ed is r eco ver ed . W he n f u n d s are l i mi ted , t h e y ma y b e mad e to d o mo r e b y se l ect i n g
p r o j ects ha vi n g s ho r ter p a yb ac k p er io d s. T h is m et ho d i s p a rti c ul arl y s ui tab l e i n t he c as e o f i nd u str ie s
wh ere ri s k o f t ec h no lo g ica l ser v ice s i s ver y h i g h. I n s uc h i nd u st r ie s, o nl y t ho se p ro j ec ts ha v in g a
s ho r t er p a yb a c k p er io d s ho u ld b e fi na n ced si n ce ch a n gi n g tec h no lo g y wo uld ma ke t he p ro j ect s to tal l y
o b so l ete , b e fo r e a ll co s t s ar e r e co ver ed .

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b ) i n c as e o f ro u ti ne p r o j ects al so u se o f p a yb a ck p erio d met h o d fa vo u rs p ro j ec ts t ha t ge n era te s c as h


in f lo ws i n ear li er year s, t h er eb y e li mi n a ti n g p ro j ects b r i n gi n g ca s h in flo ws i n la ter ye ar s t ha t
ge n era ll y are co n ce i ved to b e r i s k y a s t h i s t e nd s to i nc rea se wi t h fu t uri t y .
c) b y st re ss i n g ea r li er c as h i n f lo ws , liq u id i t y d i me n s io n i s a lso co ns id e red i n s el ect io n cr ite ria . Th is
is
i mp o rt a nt i n si t uat io n s o f liq u id i t y cr u n c h a nd h i g h co s t o f cap i ta l.
d ) p a yb ac k p er io d c a n b e co mp a r ed to b r e a k -e v en p o i n t, t he p o i nt at whi c h co s t s ar e fu ll y r ec o ver ed
b ut p ro fi t s are yet to co m me n ce.
e) t he ri s k as so c ia ted wi th a p r o j e ct ar i se s d u e t o u n cert ai n t y a s so c ia ted wi t h c as h i n flo ws . A s h o rter
p a yb ac k p e rio d me a n s t h at u nc er t ai n t y wi t h r e sp ect to p ro j ec t i s r eso l ve d fas ter.
Li mi ta tio n s : T ec h n iq u e o f p a yb a c k p er io d i s n o t a sc ie n t i fic o ne d ue t o t he fo llo wi n g rea so n s:
a) I t str es se s c ap i ta l r ec o ver y r at h er t ha n p ro fi t ab il it y. I t d o e s no t ta k e in to a cco u nt r et ur n s fro m t he
p r o j ect a fter it s p a yb ac k p e r io d . Fo r e x a mp l e : p ro j ect A ma y ha v e p a yb a c k p er io d o f 3 ye ar s and
p r o j ect B o f 8 year s, ac co r d i n g to t h i s me t ho d p ro j ect A wo u ld b e s ele cted , ho we v er, it i s p o s sib le
th at a fter 3 ye ar s p r o j ec t B e ar n s r et u r ns @ 2 0 % fo r a no t her 3 year s whi le p ro j ec t A sto p s yi e ld i n g
r et ur n s a ft er 2 year s. T h u s, p a yb a c k p er io d is no t a go o d me a s ure t o e val ua te wh e re t h e co mp ar i s o n i s
b et we e n 2 p ro j ect s, o n e in v o l vi n g lo n g ge st at io n p erio d a nd t h e o t her yi eld i n g q u ic k re s u lt s b ut fo r a
s ho r t p erio d .
b ) t h is me t ho d b e co me s a n i nad eq u ate me as u re o f e v al ua ti n g 2 p ro j e ct s wh ere t h e c a s h i n flo ws are
u ne v e n.
c) t h i s me t ho d d o e s no t g i ve a n y co n sid e rat io n to ti me v al ue o f mo ne y, ca s h flo ws o cc u rri n g at a ll
p o i nt s o f ti me are s i mp l y ad d ed . T h i s tr e at me n t is i n co n tra v e nt io n o f t h e b as ic p ri nc ip l e o f fi na nc ia l
an al ys i s t ha t s tip u lat es co mp o u n d i n g o r d i s co u n t i n g o f c as h flo ws a nd wh e n t h e y ar i se at d i ffere nt
p o i nt s o f ti me .
So me a cco u nt a nt s ca lc u lat e p a yb a ck p er io d a ft er d is co u nt i n g ca s h flo ws b y a p re d eter mi n ed r at e a nd t he p a yb ac k p e r io d so cal c u lat ed i s cal led " d i sco u n t ed p a yb ac k p er io d " .
2 ) Pa y ba c k rec i pro ca l :
it i s rec ip r o c a l o f t h e p a yb a c k p er io d . A maj o r d ra wb ac k o f t he p a yb ac k p erio d met h o d o f
cap i tal b ud g et i n g i s t h at i t d o e s no t i nd i ca te an y c ut o ff p erio d fo r t he p urp o se o f i n ve s t me nt
d eci sio n . I t is , ar g u ed t ha t r ec ip r o ca l o f p a yb ac k wo u ld b e a clo s e ap p r o xi mat io n o f t he i nt er na l ra te
o f r et u r n i f t h e li f e o f th e p r o j ec t i s a t lea s t t wi c e t he p a yb ac k p er io d a nd p ro j ec t g e nera te s eq ua l
a mo u n t o f fi nal ca s h i n f lo ws . I n p r a ct ice, p a yb a ck r ecip ro ca l i s a he lp ful to o l fo r q u ic k l y e st i ma ti n g
r ate o f ret u r n o f a p r o j e ct p r o vid ed i t s li f e i s at lea st t wi ce t h e p a yb ac k p erio d . Pa y ba c k re ci pr o ca l =
av er a ge a n n ua l c as h i n f l o ws /i n it ia l i n v es t me n t
3 ) A cco u nti ng o r a v era g e ra t e o f ret ur n met ho d (A RR ) :
Acco u n ti n g o r ave r a ge r a te o f r e t ur n me a n s a vera g e a n n ua l y ield o n t h e p ro j ect . U nd er t hi s
me t ho d p ro fit a ft er t a x a nd d ep r ec ia tio n as p erc e nt a ge o f to tal i n ve s t me n t i s co n s id ered .
Ra te o f ret ur n = ( to t al p r o f it * 1 0 0 ) /( ne t i n ve st me n t s i n t he p ro j ect * n u mb e r o f ye ar s o f p ro fit s)
T hi s ra te i s c o mp a r ed wi t h t h e rat e exp ect ed o n t he p ro j ec ts, had t he s a me fu nd s b een
in v e sted al ter na ti v el y in t ho se p r o j ec ts. So me ti me s, t h e ma na g e m en t co mp a re s t h is r ate wit h
mi n i mu m ra te k no wn a s cu t -o f f r ate .
M erits : I t i s a si mp le and p o p u lar me t ho d a s i t i s ea s y to u nd er st a nd and i nc l ud e s i nco me fro m t he
p r o j ect t hro u g ho u t it s li fe .
Li mi ta tio n s : It i s b a s ed up o n cr ud e a ver a ge p ro fit s o f t he fu t ure ye ars. I t i g no re s t he e ffe ct o f
f l uct u at io ns i n p r o fi t s fr o m ye ar to ye ar. A n d th u s i g no re s t i me va lu e o f mo ne y wh ic h i s ver y
i mp o rt a nt i n c ap i tal b ud ge ti n g d ec is io n s.
4 ) Net pr es en t v a l ue met ho d :
T he b e st me t ho d fo r e val u at io n o f i n ve s t me n t p ro p o sa l i s ne t p re se nt va l ue me t h o d o r
d is co u nted ca s h f lo w te ch n iq ue. T hi s me t ho d t ak es i n to ac co u nt t he ti me val u e o f mo n e y. T h e n et
p r es e nt v al u e o f i n ve s t me n t p r o p o s al ma y b e d efi ned a s s u m o f t he p r e se n t va l ue s o f a ll ca s h i n flo ws

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as r ed uced b y t he p r es en t va l ue s o f a ll ca s h o ut flo ws as so cia te d wi t h t he p ro p o sa l. Ea c h p ro j ect


in v o l ve s ce rta i n i n ve s t me n t s a nd co m mi t me n t o f ca s h a t cer ta i n p o i nt o f t i me. T h i s i s k no wn as ca s h
o ut f lo ws . Ca s h i n flo ws ca n b e ca lc u lat ed b y ad d in g d ep r eci at io n to p ro fit a ft er ta x ari si n g o ut o f t ha t
p ar ti c ul ar p ro j ec t .

Di sco un ti ng ca sh i nf lo w s : On ce ca s h i n flo ws and o ut flo ws ar e d eter mi n ed , ne x t s tep i s to


d is co u nt ea c h c as h i n f l o w a nd wo r k o ut i t s p re se n t va l ue. Fo r t he p urp o se, d i sco u n ti n g ra te s
mu s t b e k no wn . No r ma ll y, t he d i s co u nt i n g rat e eq ua l s t he o p p o rt u n it y co st o f cap i ta l as a
p ro j ect mu s t ear n at le as t t h at mu c h a s i s p ai d o u t o n t h e fu nd s lo c k ed i n t he p ro j ec t. T h e
co n cep t o f p r e se n t va l u e i s ea s y to u nd er s ta nd .To ca lc u lat e p re se n t va l ue o f v ario u s ca s h
in flo ws re fer e nce s h al l b e had to t he p re se n t va l ue tab le.

Di sco un ti ng ca sh o ut f l o w s : Th e ca s h o ut flo ws a l so req uir e s d i sco u nt i n g a s t he wh o l e o f


in v e st me n t i s no t mad e at t he i n it ia l st a ge i ts el f and wi l l b e sp re ad o ve r a p erio d o f t i me. T h is
ma y b e d u e to i n ter e s t - fr e e d e fer r ed cred it fa c ili ti e s fro m s up p lie rs o f p l a nt o r so me o t h er
rea so ns. A no t her c ha n g e i n ca s h flo ws to b e c o n sid ered i n t h e c ap i tal b ud g et i n g d ec i sio n i s
th e c ha n g e d ue to r eq uir e me nt o f wo r ki n g cap i ta l. Ap a rt fro m i n ve st me n t i n fi x ed a s set s, e ac h
p ro j ect i n vo l ve s co m mi t me nt o f f u nd s i n wo r k in g cap ita l. T h e co m mi t me nt o n t h is acco u n t
ma y ar is e a s so o n as t h e p la n t st art s p ro d u ct io n. T he wo r ki n g cap ita l co m mi t me n t e nd s a fter
th e fi x ed a ss et s o f t he p r o j ect are so ld o ut. Th u s, wh i le co n sid eri n g t h e to ta l o u t flo ws ,
wo r ki n g cap i ta l r eq u ir e me n t mu s t a lso b e co ns i d ered i n t h e year t h e p l a nt s tar t s p ro d uc tio n. A t
th e e nd o f t he p r o j ec t, t he wo r k i n g c ap i tal wi l l b e reco v ered a nd c a n b e tre ated a s c as h i n flo w
o f la st year .
Acce pta nc e r ul e : A p r o j ect ca n b e a ccep ted i f NP V i s p o s it i ve i.e. NP V > 0 a nd rej ec ted ; i f i t
is n e ga ti ve i.e . NP V < 0 . I f NP V = 0 , p ro j ec t ma y b e ac cep t ed a s it i mp l i es a p ro j ect g e ner ate s
cas h flo ws at t he r at e j u st eq ua l to t he o p p o r t u ni t y co st o f cap it al.

M erits :
1 ) NP V me t ho d ta ke s i nt o acco u n t t h e t i me v al u e o f mo ne y.
2 ) T he wh o le s trea m o f cas h flo ws i s co n s id ered .
3 ) NP V ca n b e se e n a s ad d it io n to t he we al t h o f s hare ho ld er s. T he cri ter io n o f NP V i s t h u s i n
co n fo r mi t y wi t h b a sic fi na n cia l o b j ec ti v es .
4 ) NP V us es d i sco u nt e d cas h f lo ws i .e. e xp r e s se s ca s h flo ws i n t er m s o f c urre n t r up e es. NP V 's o f
d i f fere n t p ro j ect s t her efo r e ca n b e co mp ar e d . It i mp l ie s t hat e ac h p ro j ect c a n b e ev al ua ted
ind ep e nd e n t o f o t her s o n it s o wn mer it s.
Li mi ta tio n s :
1 ) I t i n v o l ve s d i ffer e nt calc u la tio n s.
2 ) Th e ap p l ica tio n o f t hi s me t ho d ne ce ss it at es fo re ca st i n g ca s h flo ws and t he d i sco u n t rat e. Th u s
acc ura c y o f NP V d ep e n d s o n a cc ur a te es ti mat i o n o f t he se 2 fac to r s t ha t ma y b e q u ite d i ffic ul t i n
r eal it y.
3 ) T he ra n k i n g o f p r o j e c ts d ep e nd s o n t he d is co u nt ra te.
5 ) De si ra b il ity fa ct o r/ P ro f it a bi lit y I n de x :
I n ca se s o f, a n u mb e r o f c ap i tal e xp e n d it ure p ro p o s al s, eac h i n vo l vi n g d i ffer e nt a mo u nt s o f
cas h i n flo ws , t he me t h o d o f wo r k i n g o u t d e si rab il it y fa cto r o r p ro fit ab il it y i nd e x i s fo l lo we d . In
ge n era l t er ms , a p r o j e ct is acc ep t ab le i f it s p ro fi tab i li t y i nd e x va l ue i s g reat er t h a n 1 .
M erits :
1 ) T hi s me t ho d a l so u se s t h e co n cep t o f t i me v a lu e o f mo n e y.
2 ) I t i s a b e tt er p r o j ec t e va l ua tio n tec h n iq ue t ha n NP V.
Li mi ta tio n s o f P ro f it a bi lit y i nd e x :

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1 ) P ro fi tab il it y i nd e x fa il s a s a g uid e i n re so l v i n g 'cap i ta l rat io ni n g ' wher e p ro j ect s ar e i nd i vi sib le.


O nce a si n g le lar ge p r o j ect wi t h h i g h NP V i s se lec ted , p o s sib il it y o f a c cep t i n g se ver al s ma l l p r o j ects
th at to ge t her ma y ha v e hi g h er NP V, t he n a s i n g le p ro j ec t i s e xcl ud ed .
2 ) Sit u at io n s ma y ar i se wh er e a p r o j ect se lec t ed wi t h lo we r p ro fi tab i lit y i nd e x ma y ge n erat e cas h
f lo ws i n s u c h a ma n n er th at a no t he r p r o j ect ca n b e ta k e n up o ne o r t wo ye ar s la ter, t he to t al N P V i n
s uc h ca se b ei n g mo r e t h an t h e o n e wit h a p ro j ec t ha vi n g hi g he s t P ro fi ta b ili t y I nd e x.
T h e p ro f it ab il it y i nd e x ap p r o ac h t h u s, ca n no t b e u sed i nd i sc ri mi n at el y b u t all o t h er t y p e o f
alt er na ti ve s o f p r o j ect s wo u ld h a ve to b e wo r ke d o u t.
6 ) I nter na l Ra t e o f Ret ur n( IR R) :
I R R is t h at r ate o f r et ur n a t wh ic h th e s u m to ta l o f d i sco u nt ed ca s h i n flo ws eq u al s to
d is co u nted ca s h o ut f lo ws. T h e I RR o f a p ro j ec t is t he d is co u nt r ate t ha t ma ke s t he n et p r es e nt va l ue
o f t he p ro j ec t eq u al to z er o .
T he d i sco u nt r ate i.e . co st o f c ap i tal i s a s s u med to b e k no wn in t h e d e ter mi n a tio n o f NP V,
wh i le i n t h e I R R, t he N P V i s se t a t 0 ( zer o ) a nd d i sco u nt ra te sa ti s fyi n g t hi s co nd i tio n i s d eter mi n ed .
I R R c a n b e i nt erp r e ted i n 2 wa ys :
1 ) I R R r ep re se n t s t h e r a te o f r et ur n o n t he u nrec o ver ed i n v e st me n t b a la n ce i n t he p ro j ect.
2 ) I R R i s t h e ra te o f r et ur n ear ned o n t he i n ti al i n ve st me n t mad e i n t he p ro j ect.
It ma y no t b e p o ss ib l e fo r a ll f ir ms t o rei n ve st i n ter me d i ate cas h flo ws at a r ate o f ret ur n
eq u al to t he p ro j e ct 's I R R, h e nce t he fir s t i n terp reta tio n s ee ms to b e mo re rea li s tic . T h u s, I R R s ho u ld
b e vi e wed a s t he r a te o f r et u r n o n u nr eco ve red b al a nce o f p ro j ec t r at h er t h a n co mp o u nd ed r at e o f
r et ur n o n i ni ti al i n ve st m en t o ver t he l i fe o f t he p ro j ec t.
Acce pta nc e R ul e :
Th e u se o f IR R , as a c r iter io n to ac cep t c ap i t al i n ve st me nt d e ci sio n i n vo l ve s a co mp ari so n o f I R R
wi t h req u ired ra te o f r e tu r n cal led a s C u to ff ra te. T he p ro j ect s ho uld t he a ccep ted i f I R R is g reat er
th a n c ut o ff r at e.I f I R R is eq u al to c ut o f f r ate t he fir m i s i nd i ffe re nt . I f IR R le s s t h a n c uto ff r at e, t he
p r o j ect i s r ej ect ed .
M erits :
1 ) Th i s me t ho d ma k e s u se o f t he co ncep t o f ti me val u e o f mo n e y.
2 ) Al l t h e c as h flo ws i n th e p r o j ec t ar e co n sid er ed .
3 ) I R R i s e as ier to u se as i n sta n ta n eo us u nd er s ta nd i n g o f d e si rab i li t y i s d e ter mi n ed b y co mp ar in g i t
wi t h
th e co s t o f c ap i tal .
4 ) I R R tec h n iq ue h elp s i n a c hi e vi n g t he o b j ec ti v e o f mi n i mi s at io n o f s ha reho ld er s wea lt h .
De mer it s :
1 ) T he ca lc u lat io n p r o ce s s i s ted io u s i f t here ar e mo re t ha n o ne ca s h o u t flo w i nt er sp er sed b et we e n t he
cas h i n flo ws t he n t her e wo u ld b e mu l tip le I R R 's , t he i nt erp re tat io n o f whi c h i s d i ffic ul t.
2 ) Th e I R R ap p r o ac h cr ea te s a p e c ul iar s it u atio n i f we co mp are t he 2 p ro j ect s wi t h d i ffer e nt
in f lo w/o u t flo w p a tte r ns.
3 ) I t i s a ss u med t h at u n d er t hi s me t ho d a ll fu t u re ca s h i n flo ws o f a p ro p o sa l are re i n ve s ted a t a rate
eq u al to I R R wh ic h i s r i d ic ulo u s as s u mp tio n.
4 ) I n c as e o f mu t ua ll y e x cl u si v e p r o j ect s, i n ve s t me n t o p tio n s ha v e co ns id er ab l y d i ffere n t ca s h
o ut la ys . A p ro j ec t wi t h lar ge f u n d co m mi t me nt s b u t lo wer I R R co n trib u te mo r e i n ter ms o f ab s o lu te
NP V a nd i ncr ea se s t h e s har e ho ld er s ' we a lt h t he n d eci s io ns b a sed o n l y o n IR R ma y no t b e co r rec t .
Q ue st io n : W ha t is t h e sig ni f ica nc e o f c ut o f f r a te?

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An sw er : C ut o ff r ate i s th e mi n i mu m t h at t he m an a ge me n t wi s he s to h a ve fro m a n y p ro j ec t, u s u all y i t


is b a sed o n co st o f ca p ita l. T he t ec h ni ca l ca lc ul at io n o f co s t o f c a p ita l i n vo l v es a co mp l i cated
p r o ced ure, as a co ncer n p r o cu r e s f u nd s fr o m a n y so urce s i .e. e q u it y s har es, c ap i ta l g e nera ted fro m it s
o wn o p erat io n s a nd r et a in ed i n ge ner al r e ser v e s i.e. ret ai n ed ear ni n g s, d eb e nt ur es, p r e fere n ce s har e
cap i tal ,lo n g /s ho r t t er m lo a n s, et c. T h u s, t he fir m 's co s t o f cap it al c a n b e k no wn o nl y b y wo r ki n g o ut
we i g h ted a v er a ge o f t h e var io u s co s t s o f ra is i n g vario u s t yp es o f ca p ita l. A fir m s ho uld no t and
wo u ld no t i n v es t i n p r o j ect s yi eld i n g r e t ur n s a t a rat e b e lo w t he c ut o ff rate.
Q ue st io n : D ist i ng u i sh bet w ee n de si ra b il ity fa cto r, NPV a n d IR R met ho d o f ra n ki ng pro je ct s?
An sw er : I n ca se o f a n u nd er ta k i n g ha v i n g 2 o r mo r e co mp et i n g p ro j ect s a nd a l i mi ted a mo u nt o f
f u nd s at i t s d i sp o s al, t h e q ue s tio n o f r a n ki n g t h e p ro j ects ar i se s. Fo r e v er y p ro j ec t, d e sir ab il it y fa cto r
and NP V me t ho d wo uld gi v e t h e s a me s i g nal i.e . accep t o r r ej ect. B u t, i n c as e o f mu t u al l y e xc l u si v e
p r o j ects , NP V me t ho d i s p r e fer r ed d u e to t he fact t h at NP V i nd ic ate s eco no mi c co ntr ib ut io n o f t h e
p r o j ect i n ab so l u te ter m s. T h e p r o j ec t gi v i n g hi g her eco no mi c co ntr ib ut io n i s p r e ferred .
A s r e gar d s NP V v s.I R R me t ho d , o n e ha s to co n sid er t he b as i c p res u mp t io n u nd er e a ch. I n
cas e o f IR R, t he p r e s u m p tio n i s t h at i n ter me d i at e ca s h i n flo ws wi ll b e rei n ve st ed at t he ra te i. e. IR R,
wh i le t ha t u nd er NP V i s t ha t i n ter med ia te ca s h in flo ws ar e p re s u me d t o b e rei n ve st ed at t h e c ut o ff
r ate. It i s o b vio u s t ha t r ei n ve st me nt o f f u n d s a t c u t o ff ra te i s p o s sib l e t h a n a t t he i nt er na l r ate o f
r et ur n, wh i c h a t t i me s ma y b e ver y h i g h. He n c e t he NP V o b ta i ned a fte r d is co u nt i n g a t a fi xed cu t o ff
r ate are mo re re l i ab l e fo r r a n ki n g 2 o r mo r e p ro j ect s t ha n t he I R R.
Q ue st io n : W rit e a no t e o n ca p it a l ra t io n ing ?
An sw er : U s ua ll y, f ir ms d ecid e ma x i mu m a mo u nt t hat c a n b e i n ve sted in cap it al p ro j ect s, d u ri n g a
gi v e n p e rio d o f t i me, s a y a ye ar . T he f ir m, t he n at te mp t s to s el ect a co mb i nat io n o f i n ve s t me nt
p r o p o sa ls , t ha t wil l b e wi t hi n sp ec i f ic l i mi t s p ro v id i n g ma x i mu m p ro fitab il it y a nd ra n k t h e m i n
d esc e nd i n g o rd er a s p er th eir r a te o f r e t ur n, t hi s i s a cap it al rat io ni n g s i tu at io n. A fir m s ho u ld a ccep t
all i n v e st me n t p r o j ect s wi t h p o si ti v e NP V, wi t h an o b j ect i ve to ma x i mi se t h e wea lt h o f s h are ho ld er s.
Ho we v er, t her e ma y b e r eso ur ce co n s tr a i nt s d ue to wh i c h a fir m ma y ha ve to sel ec t fro m a mo n g st
var io u s p ro j ec t s. T h u s, t her e ma y ar i se a si t ua tio n o f c ap i tal ra tio n i n g wh er e, t her e ma y b e i n ter na l o r
ex ter n al co n str ai n ts o n p r o cur e me nt o f fu nd s need ed to i n ve s t i n a ll i n ve s t me n t p ro p o s al s wit h
p o si ti v e NP V 's . Cap i ta l r atio n i n g c a n b e e xp erie nc ed d ue to e xt er na l fac to rs , mai n l y i mp er fe ct io n s i n
cap i tal ma r ke ts at tr ib u t ab le to no n - a va ilab il it y o f mar k et i n fo r ma tio n, in v es to r a tt it ud e , a nd so o n.
I n ter na l cap i ta l r at io ni n g i s d u e to se l f -i mp o s ed restr ic tio n s i mp o sed b y ma na g e me n t as, no t to rai se
ad d it io na l d eb to r l a y d o wn a sp e ci f ied mi n i mu m rate o f ret ur n o n ea c h p ro j ect. T h er e are var io u s wa ys
o f r e so rt i n g to cap it al r atio n i n g. I t ma y p ut u p a ceil i n g wh e n i t h a s b ee n fi n a nci n g i n v e st me n t
p r o p o sa ls o n l y b y wa y o f r e tai n ed ear n i n gs i .e. p lo u g h i n g b ac k o f p ro fit s. C ap i ta l rat io ni n g ca n al s o
b e i n tro d uced b y fo l lo wi n g t he co ncep t o f 'R esp o n sib il it y Ac co u nt i n g ', wh e reb y ma n a ge me n t ma y
in tr o d uc e c ap i tal r a tio n in g b y a u t ho r i s i n g a p a rtic u lar d ep ar t me n t to i n ve s t up to a sp e ci fied li mi t,
b e yo nd wh i c h d ec i sio n s wo uld b e ta k e n b y t he hi g h er - up s. Se lec tio n o f a p ro j ect u nd er cap it a l
r ati o n i n g i n vo l ve s :
1 ) I d e nt i fi cat io n o f t he p r o j ects t ha t c a n b e acc e p ted b yu s i n g e va l uat io n tec h n iq ue a s d i sc u s sed .
2 ) Se lec tio n o f t h e co mb in at io n o f p r o j ec t s.
I n cap it al ra tio n i n g, i t wo u ld b e d e sir ab l e to a ccep t se v eral s ma ll i n v es t me n t p ro p o sa l s t ha n a fe w
lar ge o n es , fo r a f u ll er uti li s at io n o f t h e b ud ge ted a mo u nt. T hi s wo uld r es u lt i n a cce p ti n g
r ela ti v el yl e ss p ro f it ab le in v es t me n t p r o p o s al s i f ful l u ti li s at io n o f b ud g et i s a p ri ma r y co ns id er atio n.
I t ma y a l so mea n t ha t th e f ir m fo r go e s t he ne xt p ro fitab le i n v es t me n t fo llo wi n g a fter t he b ud ge t
cei li n g, e v e n i f i t i s es ti ma ted to yi e ld a rat e o f re t ur n hi g her t ha n t h e req u ired r ate. T h u s c ap it a l
r atio n i n g d o e s no t a l wa ys l ead to o p t i mu m r e s u lt s.
Q ue st io n : D is cu s s t he est i ma t io n o f f ut ure ca sh flo w s?
An sw er : I n o rd er to us e a n y tec h n iq ue o f fi na nc ia l e v al ua tio n , d a ta a s r e gard s c as h flo ws fr o m t he
p r o j ect i s ne ce s sar y, i m p l yi n g t hat co st s o f o p er atio n s a nd ret u r ns fro m th e p ro j ec t fo r a co ns id e rab le
p er io d i n fut u re s ho u ld b e es ti ma ted . F ut u r e, i s al wa ys u nc ert ai n a nd p r ed ic tio n s ca n b e ma d e a b o u t it
o nl y wi t h re fe re nc e to c er ta i n p r o b ab il it y l e vel s , b u t, s ti ll wo uld no t b e e xac t, t h u s, c as h flo ws area t
b es t o n l y a p ro b ab il it y . Fo l lo wi n g ar e t he va rio us st a ge s o r s tep s u sed i n d e velo p i n g re l ev a nt
in f o r ma tio n fo r ca s h f lo w a na l ys i s :

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1 ) E sti ma t io n o f co st s : To e st i ma te ca s h o u t flo ws , i n fo r mat io n as re ga r d s fo llo wi n g are need ed wh i c h


ma y b e o b tai n ed fr o m v end o r s o r co nt r ac to r s o r b y i nte r nal e st i ma te s :
i) Co s t o f n e w eq uip me n t;
ii) Co st o f re mo v al a nd d isp o sa l o f o ld eq u ip me nt le s s scr ap va l ue;
iii ) Co s t o f p r ep ar i n g t h e s it e a nd mo u n ti n g o f n e w eq u ip me n t; a nd
iv ) Co st o f a n ci llar y s er v ic es r eq u ir ed fo r ne w eq u ip me n t s uc h a s n e w co n ve yo r s o r ne w p o wer
s up p l ie s a nd so o n .
T he ve nd o r ma y ha ve r el ated d a ta o n c o st s o f si mi la r eq uip me nt o r t he co mp a n y ma y ha v e to
es ti ma te co s ts fro m i t s o wn e xp er i e nce . B u t, c o st o f a ne w p ro j ec t sp ecia ll y t he o ne i n vo l v i n g lo n g
ge s tat io n p er io d , mu s t b e es ti ma ted i n vie w o f t h e c ha n ge s i n p ric e le vel s i n t he e co no m y . Fo r
in s ta nc e h i g h ra te s o f i n f lat io n h as ca u sed ver y hi g h i n crea se s i n t he co st o f var io u s c ap i tal p ro j ects .
Th e i mp a ct o f p o s sib le i n f lat io n o n t h e val u e o f cap i tal go o d s mu s t t h u s, b e as se s sed a nd e st i ma t ed i n
wo r ki n g o u t es ti mat ed c as h o u t f lo w. Ma n y fir m s wo r k o u t a sp ec i fic i n d ex s ho wi n g c h a n ge s i n p ric e
le ve ls o f cap i ta l go o d s s uc h a s b ui ld i n g s, ma c h in er y, p la n t a nd ma c hi n er y, e tc. T he i nd e x i s u sed to
es ti ma te t he l i ke l y i ncr eas e i n co st s fo r fu t ur e ye ar s a nd a s p er i t, es ti ma ted ca s h o u t flo ws are
ad j u sted . A no t h er ad j u s t me nt r eq uir ed i n ca s h o ut flo ws e s ti ma te s i s t h e p o s sib i li t y o f d ela y i n t he
ex ec ut io n o f a p ro j ec t d ep e nd i n g o n a n u mb er o f fa cto r s, ma n y o f wh i c h are b e yo nd t he ma na ge me n t 's
co n tro l . I t is i mp er a ti v e t ha t a n e s ti ma te ma y b e mad e r e gard i n g t h e i n crea se i n p ro j ect co st d ue to
d ela y b e yo nd e xp ec ted ti me . T he i n cr ea s e wo u ld b e d ue to ma n y fac t o rs a s i n fla tio n, i ncre a se i n
o ver h ead e xp e nd i t ur e, et c.
2 ) E sti ma t io n o f a dd it i o na l w o r ki ng ca p ita l r eq ui re me nts : T he n e xt st ep i s to a sc ert ai n ad d i tio na l
wo r ki n g cap it al r eq u ir e d fo r f i na nc i n g i ncr ea s ed acti v it y o n ac co u nt o f ne w cap it al e xp e n d it ure
p r o j ect. P ro j ect p la n ner s o f te n d o no t ta ke i nto a cco u nt t he a mo u n t req u i red to fi n a nce t he i ncre a se i n
ad d it io na l wo r ki n g cap i tal t ha t ma y e x ceed a m o u n t o f cap i ta l e xp e nd i t ure req u ired . U n le ss a n d u n ti l
th i s facto r i s ta k e n i n to acco u n t, t he ca s h o u t fl o w wi l l r e ma i n i n co mp l ete. T he i nc rea se i n wo rk i n g
cap i tal req u ire me n t ar is es d ue to t he need fo r ma i nt ai n i n g h i g her s u nd r y d eb to r s, sto c k - i n - ha n d a n d
p r ep aid e xp e ns es , etc . Th e f i na nc e ma na g er s h o ul d ma ke a car e ful e s t i mat e o f t he req u ire me nt s o f
ad d it io na l wo r k i n g ca p ita l. As t h e ne w c ap ita l p ro j ec t co m me n c e s o p er at io n, c a s h o ut flo ws
r eq u ire me n t s ho u ld b e s ho wn i n ter ms o f ca s h o u t flo ws . A t t h e e xp ir y o f t he u se fu l li fe o f t h e p ro j ect,
th e wo r k i n g cap it al wo u ld b e r el ea sed a nd c a n b e t h us , tre ated as ca s h i n flo w. T h e i mp a ct o f i n flat io n
is al so to b e b ro u g h t i n t o acco u n t, wh i l e wo r k i n g o u t ca s h o u t flo ws o n a cco u nt o f wo r k i n g cap it a l. I n
an i n flat io nar y eco no m y, wo r ki n g cap ita l r eq u ire me n t s ma y r i se p ro gr es si v el y e ve n t ho u g h t h ere i s
in cr e as e i n ac ti v it y o f a ne w p r o j ect. T hi s i s b ec a us e t he va l ue o f sto c k , et c. ma y ri se d ue to
in f la tio n , h e nce , ad d i ti o na l wo r k i n g cap it al re q ui re me n t s o n t hi s a cco u nt s ho u ld b e s ho wn a s cas h
o ut f lo ws .
3 ) E sti ma t io n o f pro du ct io n a nd sa le s : P l a n n in g fo r a ne w p ro j ec t req u ire s a n e st i ma te o f t he
p r o d uc tio n t hat it wo u ld ge ner at e a nd t he sa le t h at i t wo uld e n ta il. Ca s h in flo ws ar e hi g h l y d ep e nd e n t
o n t he e st i ma tio n o f p r o d uc tio n a nd s ale s le v el s. T hi s d ep e nd e n ce i s d ue to p ec u li ar na t ure o f fi xed
co s t. Ca s h i n flo ws te nd to i n cr ea s e co n s id erab l y a ft er t he sa le s are ab o v e t h e b re a k -e ve n p o i n t. I f i n a
ye ar , s al es ar e b elo w t h e b r ea k -e v e n p o i nt, wh i ch is q u i te p o s sib le i n a lar ge cap it al i n te n si v e p ro j ect
in t he i ni ti al ye ar o f i t s co m mer c ia l p r o d uc tio n, th e co mp a n y ma y e v e n ha v e ca s h o u t flo ws i n t er ms
o f lo s s es. O n t he b a s is o f ad d it io na l p r o d uc tio n u ni t s t h at ca n b e so ld a n d p rice at wh i c h t h e y m a y b e
so ld , t h e gro s s r e v e n ue s fr o m a p r o j e ct ca n b e wo r k ed o ut . I n d o i n g so ho we v er, p o s sib il it y o f a
r ed u ct io n i n s al e p r i ce, in tr o d uc tio n o f c h eap er o r mo re e ffic ie n t p ro d uc t b y co mp et ito r s, rece s s i o n i n
th e ma r ket co nd i tio n s a n d s uc h o t her fac to r s ar e to b e co n s i d ered .
4 ) E sti ma t io n o f ca sh e x pe ns e s : I n t h is s tep , t he a mo u nt o f ca s h e xp e n se s to b e i nc u rred i n r u n n i n g
th e p ro j ec t a fter i t go e s i nto co m mer c ia l p ro d uc tio n ar e to b e e st i ma ted . It i s o b vio u s t ha t wh i c he v er
le ve l o f c ap ac it y u ti li s atio n is a tt ai ned b y t h e p ro j ect, fi x ed co s t s re mai n s t h e sa me. Ho we v er,
var iab le co s t s var y wi t h ch a n ge s i n t he le v el o f c ap aci t y u ti li sa tio n.
5 ) Wo r ki ng o ut ca s h i n f lo w s : T he d i f fer e n ce b et we e n gro ss r e ve n ue s and c as h e xp e n se s ha s to b e
ad j u sted fo r ta xa tio n b efo r e c a s h i n f lo ws ca n b e wo r k ed o u t. I n v ie w o f d ep rec iat io n a nd o th er
ta xab le e xp e n s es, etc . t he ta x l iab il it y o f t he c o mp a n y ma y b e wo r k ed o ut . T he ca s h i n flo w wo uld b e
r ev e n ue s l e ss ca s h e xp e n se s a nd l iab i li t y fo r ta x atio n.

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O ne p r o b l e m is o f tr ea t m e n t o f d i vid e nd s a nd i nt ere st. S o me a cco u n ta nt s s u g ge st t h at


in ter es t b ei n g a c a s h e xp e n se is to b e d ed u ct ed and d i v id e nd s to b e d ed uc ted fro m ca s h i n flo ws .
Ho we v er, t hi s see ms to b e i nco r r ec t. Bo t h d i v id end s a nd i n tere s t i n vo l v e a c as h o ut flo w, t he fac t
r e mai n s t hat t he se co n s t it ut e co st o f cap i ta l, he nc e, i f d i sco u nt i n g ra te, is it se l f b a sed o n t h e c o st o f
cap i tal , i n ter es t o n lo n g ter m f u n d s a nd d i v id e n d s to eq u it y o r p r e fere n ce s har e ho ld er s s ho u ld no t b e
d ed u cted wh i le wo r k i n g o ut ca s h i n f lo ws . T h e rate o f ret ur n yi eld ed b y a p ro j ect at a cer tai n r ate o f
r et ur n i s co mp ared wi t h co st o f cap i ta l fo r d e te r mi ni n g wh et h er a p ar ti cu lar p ro j e ct c a n b e ta ke n up
o r no t. I f t h e co st o f ca p ita l b eco me s p ar t o f ca s h o u t flo ws , t he co mp ar iso n b e co me s vi tia ted . Th u s,
cap i tal co s t li k e i nt er e st o n lo n g t er m fu nd s and d i v id e nd s s ho u ld no t b e d ed u cted fro m gro ss
r ev e n ue s i n o rd er to wo r k o ut ca s h i n f lo ws . Ca s h i n flo ws ca n al so b e wo r k ed o u t b ac k wa rd s, o n
ad d i n g i n tere s t o n lo n g ter m f u nd s a nd d ep re ci a tio n to ne t p ro fi t s a nd d ed u ct i n g li ab i li t y fo r ta xa tio n
fo r t he ye ar.
Q ue stio n : Wr ite a no t e o n so c ia l b en ef it a na l y si s?
An sw er : I t i s b e i n g i n c r ea si n gl y r eco g n is ed t h at co m me rc ial e va l uat io n o f i nd us tri al p ro j ec t s is no t
eno u g h to j u st i fy co m m it me n t o f f u nd s to a p r o j ect sp ec ia ll y, i f it b el o n g s to t h e p ub l ic s ecto r a nd
ir r e sp ec ti v e o f it s f i na n cia l v iab il it y, i t i s to b e i mp le me n ted i n t he lo n g te r m i nt ere st o f t he n atio n.
I n t h e co nt e xt o f t he n atio n al p o lic y o f ma k i n g h u ge p ub lic i n ve st me nt s i n vario u s sec to r s o f t h e
eco no m y, t h e n eed fo r a p r act ica l me t ho d o f m ak i n g so ci al co st b e n e fi t a nal ys i s h as a cq uir ed gre at
ur ge n c y. H u nd r ed s o f c r o r es o f r up e e s are co m mi t ted e v er y year to var io u s p ub li c p ro j ect s o f a ll
t yp e s - i nd us tr ial , co m me r ci al a nd t ho s e p ro v id i n g b a si c i n fra s tr uc t u re faci li ti es , etc . A na l y si s o f
s uc h p ro j ect s h as to b e d o ne wi t h r e fer e nce to so cia l co s ts a nd b e ne fit s a s t he y ca n no t b e e xp ec t ed to
yi eld a n ad eq uat e co m m er ci al r e t ur n o n t he fu n d s e mp lo ye d , at lea s t d u ri n g t he s ho rt r u n. So ci a l co s t
b en e fi t a n al ys i s i s i mp o r ta nt fo r p r i va te co rp o ratio n s ha vi n g a mo ra l re sp o n sib il it y to u nd erta k e
so c ial l y d es irab le p r o j ect s. I n a n al ys i n g var io u s al ter n at i ve s o f ca p ita l e xp e nd i t ure, a p ri vat e
co r p o rat io n s ho uld ke ep i n vie w t h e so ci al co n tr ib u tio n a sp ec t. It ca n t h u s b e se e n t ha t t h e p urp o se o f
so c ial co st b e ne f it a n al ys i s te c h niq ue i s no t to rep l ace t he e x is ti n g t e ch n iq ue s o f fi n a nc ial a na l ys i s
b ut to s up p l e me n t and str e n gt he n t he m. T he c o nc ep t o f so c ia l co s t b en e fi t a nal ys i s ha s p ro g res sed
b e yo nd t h e s ta ge o f i n t ell ect u al sp ec u la tio n. T he p l a n ni n g co m mi s s io n ha s alr ead y d ec id ed t ha t i n
f u t ure, t he fe as ib i li t y s t ud i e s fo r p ub l ic s ec to r p ro j ects wil l h a ve to i n cl ud e a n a na l ys i s o f t h e so cia l
r ate o f ret u r n. I n c as e o f p r i va te se cto r al so , a so ci al l y b e ne fic ia l p ro j ect ma y b e mo r e ea si l y
accep tab le to t he go ve r n me n t a nd t h us , t h is an al ys i s wo uld b e r ele va n t wh i l e g ra nt i n g va rio us
lic e ns es a nd ap p r o v al s, etc. Al so , i f t h e p ri va te se cto r i n cl ud e s so ci a l co s t b en e fi t a nal ys i s in i t s
p r o j ect e val u at io n tec h n iq u e s, it wi l l e n s ure t ha t it i s no t i g no r i n g it s o wn lo n g -te r m i nt ere st, as i n
th e lo n g r u n o nl y t ho se p r o j ects wi l l s ur vi ve t ha t are so cia ll y b e ne fic ial and acc ep t ab le to so c ie t y.
Nee d fo r So cia l Co st B enef it Ana ly si s ( SC B A) :
1 ) Mar k et p ri ce s u sed to mea s ur e co st s a nd b e ne fit s i n p ro j ec t a na l ys i s d o no t rep re se n t so c ia l v al ue s
d ue to ma r ke t i mp er fe cti o n s.
2 ) Mo ne tar y co st b e n e fi t an al ys i s fa il s to co n si d er th e e xte r nal it ie s o r ex ter n al e ffe ct s o f a p ro j ect.
Th e e xt er nal e ffec t s ca n b e p o si ti ve li k e d e ve lo p me n t o f i n fr as tr uc t ure o r ne g at i ve l i ke p o l l ut io n a nd
i mb al a nce i n e n vir o n me nt .
3 ) Ta xe s a nd s ub sid ie s a r e mo net ar y co s ts a nd g ai n s, b ut t he se are o n l y tra n s fer p a y me n ts fro m so c ial
vi e wp o i nt a nd t h u s ir r e l ev a nt.
4 ) SC B A i s e s se nt ia l fo r me as ur i n g t h e r e d i s trib ut io n e ffect o f b e n e fi t s o f a p ro j ec t a s b e ne fit s go i n g
to p o o rer se ct io n ar e mo r e i mp o r ta n t t h a n o ne go in g to se ct io ns wh i c h a r e eco no mi ca ll y b et ter o f f.
5 ) P ro j ects ma n u f ac t ur in g liq u e ur a nd c i gar e tte s ar e no t d is ti n g u i s hed fro m t ho se ge n er ati n g
elec tr ici t y o r p ro d uc i n g ne ce s si tie s o f li f e. T h u s, me ri t wa n t s ar e i mp o rta nt ap p ra is al cri ter io n fo r
S C BA.
It i s e s se nt ia l to u nd er s ta nd t hat ac t ual co s t o r re v e n ue s d o n o t e ss e nt ia ll y re fle ct c o st o r
b en e fi t to t he so c iet y. I t i s so , b ec a u se t he m ark et p ri ce o f go o d s a n d ser vi ce s are o ft e n g r o s sl y
d is to rt ed d ue to var io u s a r t i fic ia l r es tr i ct io n s a nd co n tro l s fro m a ut h o ri tie s. T h u s, a d i f fer e nt
yar d s tic k i s to b e ad o p t ed i n e va l uat i n g a p ar ti c ul ar p ro p o sal a nd it s co st b e n e fi t a na l ys i s are u s u a ll y
va l ued a t " o p p o r t u ni t y co s t" o r s had o w p ric es to j ud ge t he re al i mp ac t o f t he ir b urd e n a s co st s to
so c iet y. T h e so c ia l co s t va l ua tio n so met i me s co mp let el y c ha n g e s t he e st i mat e s o f wo r k i n g re s ul t s o f a
p r o j ect.

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64

Q ue st io n : I s t he re a ny rela t io ns h ip be t w e en r is k a nd ret ur n, if y e s, o f w ha t so rt?


An sw er :
Ri s k: Th e ter m r i s k wi th r e f er e n ce to i n ve st m en t d eci s io n is d e fi ned as t he v ari ab i li t y i n act ua l
r et ur n e ma n at i n g fr o m a p r o j ect in f ut u r e o v er i ts wo r k i n g li fe i n rel at i o n to t he e s ti ma ted re t u rn a s
fo r eca st ed at t he t i me o f i n it ia l cap ita l b ud ge ti n g d ec i sio n s. Ri s k i s d i ffe re nt ia ted wi t h u nc ert ai nt y
and i s d e fi ned a s a si t u atio n wh e r e t he fa ct s a n d fi g ur es ar e no t a vai la b le o r p ro b ab il it ie s ca n no t b e
as si g n ed .
Ret u rn : It c a n no t b e d en ied t h at r e t ur n i s t h e mo ti v at i n g fo rce a nd th e p ri nc ip a l re wa rd t o th e
in v e st me n t p ro ce ss . T he r et ur n ma y b e d e fi n ed i n ter ms o f :
1 ) r eal i sed re t ur n i .e. t h e r et ur n wh i c h wa s ear n ed o r co uld h a ve b e e n e arn ed , me a s uri n g t he re ali sed
r et ur n a llo ws a fir m to a s se ss h o w t he f u t ure e xp ected re t ur ns ma y b e.
2 ) exp ect ed re t ur n i.e . th e r e t ur n t ha t t h e fir m a n ti cip a te s to ear n o ver so me fu t ure p erio d . The
exp ect ed re t ur n is a p r e d ict ed r e t ur n a nd ma y o r ma y no t o cc ur.
Fo r, a f ir m t he r et ur n f r o m a n i n ve s t m en t is t he e xp ec ted ca s h i n flo ws . T he re t ur n ma y b e
me a s ured a s t he to t al g ai n o r lo s s to t he fir m o ver a gi v e n p e rio d o f ti me a nd ma y b e d e fi n e d a s
p er ce n ta ge o n t he i n iti al a mo u nt i n ve st ed .
Rela t io ns h ip bet w ee n r is k a n d r et u rn : T he ma in o b j ec ti v e o f fi na n ci al ma n a ge me n t i s to ma x i mi s e
we a lt h o f s har e ho ld er s ' as r e f le cted i n t he m ark et p r ice o f s har es , th at d ep e nd s o n ri s k -r et ur n
ch ar ac ter i st ic s o f t h e fi n an cia l d e ci sio n s ta ke n b y t he fir m. I t al so e mp h as ize s t hat r i s k a nd r et u rn a re
2 i mp o r ta nt d e ter mi n a nt s o f val u e o f a s har e. So , a fi na nc e ma n a ger a s a lso i n ve s to r, i n ge n era l ha s to
co n s id er t he r is k a nd r e tu r n o f e ac h a nd e ver y fi na nc ia l d ec i sio n. Acc e p ta nce o f a n y p ro p o sa l d o es
no t al ter t he b u s i ne ss r i s k o f f ir m a s p er ce i ved b y t he s up p l ier o f ca p i tal, b ut, d i ffer e nt i n ve st me n t
p r o j ects wo u ld h a ve d i f fe r e nt d e gr ee o f r is k . T h u s, t he i mp o r ta nc e o f ri s k d i me n s io n i n c ap it al
b ud ge ti n g c a n h ar d l y b e o ver - st r e ss ed . I n fac t, r is k a nd re t ur n are c lo sel y re lat ed , i n ve s t me n t p ro j ect
th at i s e xp ec ted to yie l d h i g h r et ur n ma y b e t o o ri s k y t ha t i t ca u se s a si g ni fic a nt i nc rea se i n t he
p er ce i ved ri s k o f t he f ir m. T hi s tr ad e o ff b et we e n ri s k a nd re t ur n wo u ld ha ve a b e ari n g o n t h e
in v e sto r ' p e rcep tio n o f t he f ir m b e fo r e a nd a fter accep ta nc e o f a sp ec i fi c p ro p o sal. T h e ret ur n fr o m a n
in v e st me n t d ur i n g a gi ve n p er io d is eq ual to th e c ha n g e i n va l ue o f in v es t me n t p l u s a n y i nco me
r ece i ved fro m i n ve s t me nt . I t i s t h us , i mp o rta n t t ha t a n y cap i ta l o r r e v en u e i n co me fro m i n v e s t me nt s
to i n ve sto r mu s t b e i n c lud ed , o t h er wi s e t he m eas u re o f ret u r n wi ll b e d e fic ie n t. T he re t ur n fro m
in v e st me n t ca n no t b e fo r eca st ed wi t h cer ta i nt y as t here i s r is k t ha t t he cas h i n flo ws fro m p ro j e ct ma y
no t b e a s e xp e cted . Gr e ater t he var iab il it y b e t wee n t he es ti mat ed a nd a ct ua l ret u r n, mo re r is k y i s t he
p r o j ect.

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65

Important Questions

66

Que:- Excel Ltd. manufactures a special chemical for sale at Rs. 30 per kg. The variable cost of manufacture is Rs. 15 per kg. Fixed cost
excluding depreciation is Rs. 2,50,000. Excel Ltd. is currently operating at 50% capacity. It can produce a maximum of 1,00,000 kgs at full
capacity.
The Production Manager suggests that if the existing machines are fully replaced the company can achieve maximum capacity in
the next five years gradually increasing the production by 10% per year.
The Finance Manager estimates that for each 10% increase in capacity, the additional increase in fixed cost will be Rs. 50,000. The
existing machines with a current book value of Rs. 10,00,000 can be disposed of for Rs. 5,00,000. The Vice-President (finance) is willing to
replace the existing machines provided the NPV on replacement is about Rs. 4,53,000 at 15% cost of capital after tax.
(i) You are required to compute the total value of machines necessary for replacement.
For your exercise you may assume the following:
(a) The company follows the block assets concept and all the assets are in the same block. Depreciation will be on straightline basis and the same basis is allowed for tax purposes.
(b) There will be no salvage value for the machines newly purchased. The entire cost of the assets will be depreciated over
five year period.
(c) Tax rate is at 40%.
(d) Cash inflows will arise at the end of the year.
(e) Replacement outflow will be at the beginning of the year (year 0).
0
1
2
3
4
5
Year
1
0.87
0.76
0.66
0.57
0.49
Discount factor at 15%
(ii) On the basis of data give above, the managing director feels that the replacement, if carried out, would at least yield post tax return
of 15% in the three years provided the capacity build up is 60%, 80% and 100% respectively. Do you agree?
Que:- A company is planning to set up a Project at a cost of Rs. 3 crores. It has to decide whether to locate the plant in Bombay or Janupur
(a backward district). Locating the plant in Janupur would mean a cash subsidy of Rs. 15 lakhs from the Central Government. In addition,
the taxable profits to the extent of 20% would be exempt for 10 years. The project envisages a borrowings of Rs. 2 crores in either case. The
cost of borrowing would be 12% for Bombay and 10% for Janupur. However, the revenue costs are likely to be higher in Janupur. The
borrowings have to be repaid in four equal annual instalments beginning from the end of the fourth year. With the help of following
information and by using Cost of Equity of 15%, advise as to where the project should be set up:
Profit (Loss) before Interest and Depreciation
Present Value Factors
(Rs. In Lacs)
(at 15%)
Year
Bombay
Janupur
1
(6.00)
(50.00)
0.87
2
34.00
(20.00)
0.76
3
54.00
10.00
0.66
4
75.00
20.00
0.57
5
110.00
50.00
0.50
6
140.00
100.00
0.43
7
150.00
150.00
0.38
8
250.00
200.00
0.33
9
350.00
225.00
0.28
10
450.00
350.00
0.25
Notes:
(i) Income-tax is payable @ 30% on profits.
(ii) Central subsidy receipt is not to affect depreciation and income-tax.
(iii) Useful Life of the Plant is estimated as 10 years.
Que:- PQR Limited has decided to go in for a new model of Mercedes Car. The cost of the vehicle is Rs. 40 lakhs the company has two
alternatives:
(i)
Taking the car on finance lease; or
(ii) Borrowing and purchasing the car.
LMN Limited is willing to provide the car on finance lease of PQR Limited for five years at annual rental of Rs. 8.75 lakhs, payable at the
end of the year. The vehicled is expected to have useful life of 5 years, an it will fetch a net salvage value of Rs. 10 lakhs at the end of yeare
five. The depreciation rate for tax purpose is 40% on written down value basis. The applicable tax rate for the company is 35% and
incremental borrowing rate of the co. is 13.8462%.
What is the net advantage of leasing for the PQR Limited? Ignore Tax on capital profits
The values of Present value interest factor at different rate of discount are as under:
Rate of Discount T1
T2
T3
T4
T5
0.8784
0.7715
0.6777
0.5953
0.5229
0.9174
0.7715
0.7722
0.7084
0.6499

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Practical Questions:-

67

Que. 1: - Dolly company has an investment opportunity costing Rs. 40,000 with the following expected cash inflow (i.e. after tax and before
depreciation)
Year
Inflows (Rs.)
PVF (10%)
1
7,000
0.909
2
7,000
0.826
3
7,000
0.731
4
7,000
0.653
5
7,000
0.621
6.
8,000
0.564
7.
10,000
0.513
8.
15,000
0.467
9.
10,000
0.424
10
4,000
0.386
Using 10% as the cost of capital (rate of discount) determine the (i) Net Present value; and (ii) Profitability Index.
Que. 2: - Consider the following investment opportunity: A machine is available for purchase at a cost of Rs. 80,000. We expect it to have a
life of five years and to have a scrap value of Rs. 10,000 at the end of the five year period. We have estimated that it will generate
additional profits over its life as follows:
Year
Amount (Rs.)
1
20,000
2
40,000
3
30,000
4
15,000
5
5,000
These estimates are of profits before depreciation. You are required to calculate the return on capital employed.
Que. 3: - L & T Ltd. has decides to purchase a machine to augment the companys installed capacitys to meet the growing demand for its
products. There are machine under consideration of the management. The relevant details including estimated yearly expenditure
and sales are given below: All sales are on cash. Corporate Income Tax rate is 40%.
Machine 1
Machine 2
Machine 3
Initial investment required
Rs. 3,00,000
Rs. 3,00,000
Rs. 3,00,000
Estimated annual sales
5,00,000
4,00,000
4,50,000
Cost of Production(estimated)
Direct Materials
40,000
50,000
48,000
Direct Labour
50,000
30,000
36,000
Factory Overheads
60,000
50,000
58,000
Administration costs
20,000
10,000
15,000
Selling and distribution costs
10,000
10,000
10,000
The economic life of Machine 1 is 2 years, while it is 3 years for the other two. The scrap values are Rs. 40,000, Rs. 25,000 and
Rs. 30,000 respectively. You are required to find out the most profitable investment based on Pay Back Method.
Que. 4: - D Company wants to replace the manual operation by new machine. There are two alternative models X and Y of the new
machine. Using Payback period, suggest the most profitable investment. Ignore taxation.
Machine X
Machine Y
Original Investment (Rs.)
9,000
18,000
Estimated life of the machine (Years)
4
5
Estimated saving in cost (Rs.)
500
800
Estimated saving in Wages (Rs.)
6,000
8,000
Additional cost of maintenance
800
1,000
Additional cost of supervision (Rs.)
1,200
1,800
Que. 5: - A company is contemplating to purchase a machine. Two machine A and B are available, each costing Rs. 5 lakhs. In comparing
the profitability of the machines, a discounting rate of 10% is to be used and machine is to be written off in five years by straight
line method of depreciation with nil residual value. Cash inflows after tax are expected as follows:
Year
1
2
3
4
5

Machine A
(Rs. in lakhs)
1.5
2.0
2.5
1.5
1.0

Machine B
(Rs. in lakhs)
0.5
1.5
2.0
3.0
2.0

Indicate which machine would be profitable using the following methods of ranking investment proposals:
(i)
Pay Back method;
(ii)
Net present value method;
(iii)
Profitability index method; and

CA- IPCC- Financial Management`

(iv)

Average rate of return method.

The discounting factors at 10% are:


Year
1
Discounting factor
0.909

68
2
0.826

3
0.751

4
0.683

5
0.621

Que. 6: - S Ltd. have decided to purchase a machine to augment the companys installed capacity to meet the growing demand for its
products. There are three machines under consideration of the management. The relevant details including estimated yearly
expenditure and sales are given below. All sales are on cash. Corporate Income Tax rate is 40%, interest on capital may be
assumed to be 10%.
Rs.
Particulars
Machine
1
2
3
Initial investment required
3,00,000
3,00,000
3,00,000
Estimated annual sales
5,00,000
4,00,000
4,50,000
Cost of production (estimated):
Direct materials
40,000
40,000
48,000
Direct labour
50,000
30,000
36,000
Factory overheads
60,000
50,000
58,000
Administration
20,000
10,000
15,000
Selling and distribution costs
10,000
10,000
10,000
The economic life of Machine 1 is 2 years, while it is 3 years for the other two. The scrap values Rs. 40,000, Rs. 25,000 and Rs.
30,000 respectively.
You are required to find out the most profitable investment based on Payback Method.
Que. 7: - A machine is purchased six years back for Rs. 1,50,000 has bee depreciated to a book value of Rs. 90,000. It originally had a
projected life of fifteen years and zero salvage. A new machine will cost Rs. 2,50,000 and result in a reduced operating cost of Rs.
30,000 per year for the next nine years. The older machine could be sold for Rs. 50,000. The machine also will be depreciated on a
straight line method on nine year life with salvage value of Rs. 25,000. The companys tax rate is 50% and cost of capital is
10%. Ignore tax on capital/loss gain. Determine whether the old machine should be replace.
Given Present value of Re. 1 at 10% on 9th year 0.424 and present value of an annuity of Re. 1 at 10% for 8 years = 5.335.
Que. 8: - Project A cost Rs. 2,00,000 and Project B costs Rs. 3,00,000 both have a ten year life. Uniform cash receipts expected are A Rs.
40,000 p.a. and B Rs. 80,000 p.a. salvage values expected area Rs. 1,40,000 declining at an annual rate of Rs. 20,000 and B Rs.
1,60,000 declining at an annual rate of Rs. 40,000. Calculate traditional and bailout payback period.
Que. 9: - Royal Industries is considering the replacement of one of its moulding machines. The existing machine is in good operating
condition, but is smaller than required if the firm is to expand its operations. The old machine is 5 years old, has a current salvage
value of Rs. 30,000 and a remaining depreciable life of 10 Years. The machine was originally purchased for Rs. 75,000 and is
being depreciated on a straight line basis over 10 years, with no salvage value. The management anticipates that with the expended
operations, there will be need for an additional net working capital of Rs. 30,000. The new machine will allow the firm to expand
current operations, and thereby increase revenues of Rs. 40,000, and variable operating costs from Rs. 2,00,000 to Rs. 2,10,000.
The companys tax rate is 50% and its cost of capital is 10%. Should the company replace its existing machine, given that capital
taxable at the same rate of tax?
Que. 10: - R Ltd. is implementing a project with an capital outlay of Rs. 7,600. Its cash inflows are as follows:
Years
Rs.
1
6,000
2
2,000
3
1,000
4
5,000
The expected rate of return on the capital invested is 12% p.a. Calculate the discounted payback period of the project.
Que. 11: - A Firm can invest Rs. 10,000 in a project with a life of three years.
The project cash inflow are as follows:
Year
Rs.
1
4,000
2
5,000
3
4,000
The cost of capital is 10% p.a. Should the investment be made?
Que. 12: - Machine A cost Rs. 1,00,000, payable immediately. Machine B costs Rs. 1,20,000, half payable immediately and half payable in
one years time. The cash receipts expected are as follows:
Year (at the end)
A
B
1
20,000
2
60,000
60,000
3
40,000
60,000
4
30,000
80,000
5
20,000
With 7% interest which machine should be selected as per NPV method. Also calculate profitability index.
Que. 13: - A Company has to select one of the following two projects: (Rs.)

CA- IPCC- Financial Management`

Project A
Cost
11,000
Cash in flows
Year 1
6,000
2
2,000
3
1,000
4
5,000
Using the Internal rate of return method suggest which project is preferable.

Project B
10,000
1,000
1,000
2,000
10,000

Que. 14: - The project cash flows from two mutually exclusive Projects A and B are as under:
Period
Project A
Project B
0 (outflow)
Rs. 22,000
Rs. 27,000
1 to 7 (inflow)
Rs. 6,000 each year
Rs. 7,000 each year
Project life
7 years
7 years
(i)
Advice on project selection with reference to internal rate of return.
(ii)
Will it make any difference in project selection, if the cash flow from project B is for 8 years instead of 7 years @ Rs.
7,000 each year?
Que. 15: - Following are the data on a capital project being evaluated by the management of X Ltd.:
Project M
Rs. 40,000
4 years
15%
1.064
?
?
?
?
0

Annual cost saving


Useful life
I.R.R.
Profitability Index (P.I.)
NPV
Cost of capital
Cost of project
Payback
Salvage value
Find the missing values considering the following table of discount factor only:
Discount factor
1 year
2 year
3 year
4 year

15%
0.869
0.756
0.658
0.572
0.855

14%
0.877
0.769
0.675
0.592
2.913

13%
0.885
.0783
0.693
0.613
2.974

12%
0.893
0.797
0.712
0.636
3.038

Que. 16: - P Ltd. has a machine having an additional life of 5 years, which costs Rs. 10,00,000 and has a book value of Rs. 4,00,000. A new
machine costing Rs. 20,00,000 is available. Though its capacity is the same as that of the old machine, it will mean a saving in
variable costs to the extent of Rs. 7,00,000 per annum. The life of the machine will be 5 years at the end of which it will have a
scrap value of Rs. 2,00,000. The rate of income tax is 46% and P Ltd.s policy is not to make an investment if the yield is less than
12% per annum. The old machine, if sold today, will realise Rs. 1,00,000 it will have no salvage value if sold at the end of 5th year.
Advise P Ltd. whether or not the old machine should be replaced. (Present value of Re. 1 receivable annually for 5 years at 12% =
3.605, present value of Re. 1 receivable at the end of 5 years at 12% per annum = 0.567). Capital gain is tax free.
Ignore income tax savings on depreciation as well as on loss due to sale of existing machine.
Que. 17: - Arjun Ltd. is considering the question of taking up new project, which requires an investment of Rs. 200 lakhs on machinery and
other assets. The project is expected to yield the following gross profits (before depreciation and tax) over the next five years:
Year
Gross profit (in lakhs of rupees)
1
80
2
80
3
90
4
90
5
75
The cost of raising the additional capital is 12% and the assets have to be depreciated at 20% on written down value basis. The
scrap value at the end of the five year period may be taken as zero. Income tax applicable to the company is 50%.
Calculate the Net Present Value of the project and advise the management whether the project has to be implemented. Also of the
project and advise the management whether the project has to be implemented. Also calculate the Internal Rate of Return of the
Project.
Que. 18: - ABC company is having difficulties with an automated grinding machine has 4 years of service life, its operating cost are fairly
sizable compared to its revenues. For the next four years, the revenues generated will be Rs. 5,20,000 annually but the annual cost
expenses will be Rs. 3,80,000. In addition, it must take depreciation of Rs. 80,000 per year until the machine reaches zero book
value. The machine could be sold today for net cash of Rs. 80,000 which is less than its current book value of Rs. 1,60,000. This is
not good since if the machine were held for 4 years it could probably be sold for Rs. 80,000 net cash. The firms alternative is to
invest in a new grinding machine costing Rs. 4,00,000, not counting the Rs. 80,000 needed to transport and install it.
The new machine would generate a revenue of Rs. 9,20,000 with cash expense of Rs. 5,80,000. It would be depreciated over a 4
year period to a book value of Rs. 1,60,000 at which time it could be sold for Rs. 1,40,000 net cash. Depreciation would be by the

CA- IPCC- Financial Management`

69

straight line method. The new machine would require tying up an additional Rs. 2,00,000 of inventory and receivable over the 4
year period. What is the differential after tax cash flow stream for this proposal?
Assume tax rate of 50% on Income and Capital gain. Also evaluate the proposal assuming discount rate of 10%.
Que. 19: - A Machine purchased 6 years back for Rs. 1,50,000 has been depreciated to a book value of Rs. 90,000. It originally had as
projected of 15 years (salvage nil). There is a proposal to replace this machine. A new machine will cost Rs. 2,50,000 and result in
reduction of operating cost by Rs. 30,000 p.a. for next 9 years.
The existing machine can now be scrapped away for Rs. 50,000. The new machine will also be depreciated over 9 years period as
per straight line method with salvage of Rs. 25,000. Find out whether the existing machine be replaced given that the tax rate
applicable is 50% and cost of capital 10% (profit or loss on sale of assets is to be ignored for tax purposes).
Que. 20: - New Style Ltd. is considering the replacement of one of its moulding machines. The existing machine is in good operating
condition, but is smaller than required if the firm is to expand its operations. The old machine is 5 years old, and has remaining
depreciable life of 10 years. The machine was originally purchased for Rs. 1,50,000 and is being depreciated at Rs. 10,000 per year
for tax purposes.
The new machine will cost Rs. 2,20,000 or Rs. 1,70,000 if exchanged with the existing machine. It will be depreciated
on a straight line basis for 10 years, with no salvage value. The management anticipates that, with the increased operations, there
will be need for an additional net working capital of Rs. 30,000. The new machine will allow the company to expand current
operations, thereby increasing annual revenue by Rs. 60,000 and variable operating costs from Rs. 2,00,000 to Rs. 2,20,000.
The companys tax rate is 35% and its cost of capital is 10%.
Should the company replace its existing machine? Assume that the loss on exchange of existing machine can be claimed
as short term capital loss in the current year itself.
Que. 21: - Supersonic Ltd. has decided to diversify its production and wants to invest its surplus funds on the most profitable project. It has
under consideration only two projects A and B. The cost of project A is Rs. 100 lakhs and that of B is Rs. 150 lakhs. Both
projects are expected to have a life of 8 years only and at the end of this period. A will have a salvage value of Rs. 41 lakhs and
B Rs. 14 lakhs. The running expenses of A of A will be Rs. 35 lakhs per year and that of B Rs. 20 lakhs per year. In either
case the company expects a rate of return of 10%. The companys tax rate is 50%. Depreciation is charged on straight line basis.
Which project should the company take up?
Present value of annuity of Re. 1 for eight years at 10% is 5.335 and present value of Re. 1 received at the end of the eight year is
0.647.
Que. 22: - A Company proposes to install a machine involving a Capital Cost of Rs. 3,60,000. The life of the machine is 5 years and its
salvage value at the end of the life is nil. The machine will produce the net operating income after depreciation of Rs. 68,000 per
annum. The companys tax rate is 45%.
The Net Present Value factors for 5 years as under:
Discounting Rate: 14
15
16
17
18
Cumulative factor: 3.43
3.35
3.27
3.20
3.13
You are required to calculate the internal rate of return of the proposal.
Que. 23: - Supreme Industries Ltd. is manufacturing a fast selling product under the brand name Supreme. The variable cost of the product
is Rs. 6 per unit and the total annual fixed cost is Rs. 1,20,000. Current demand is 40,000 units a selling price of Rs. 10 per unit.
As the market for the product is steadily expanding, the company has plans to partly mechanize operations by installing a semi
automatic machine (life 8 years) at a cost of Rs. 2 lakhs. This will reduce the variable cost to Rs. 4 per unit and the annual fixed
cost will be Rs. 1,80,000.
The company has also an alternative plan to completely mechanize operations by installing a fully automatic machine (life 8 years)
at a cost of Rs. 5 lakhs. The variable cost per unit in this case will be Rs. 2 only and the annual fixed cost will rise to Rs. 3,20,000.
Required:
(a) Current profit earned by the company and its break even sales.
(b) Minimum level of sales which will make it more profitable to switch over from manual Operations to semi automatic
machine
(c) Minimum level of sales for change over from manual operations directly to automatic machine, ignoring consideration of the
semi automatic machine.
1. Cost of capital of the company is 12%.
2. Present value of an annuity of Re. 1 at 12% for 8 years is 4.97.
Que. 24: - National Bottling Company is contemplating to replace one of its bottling machines was a new and more efficient machine. The
old machine has a cost of Rs. 10 lakhs and useful life of ten year. The machine was bought five years back. The company does not
expect to realise any return from scrapping the old machine at the end of ten years but if it is sold to another company in the
industry, national Bottling Company would receive Rs. 6 lakhs for it.
The new machine has a purchase price of Rs. 20 lakhs. It has an estimated salvage value of Rs. 2 lakhs and has useful life of five
years.
The new machine will have a greater capacity and annual sales are expected to increase from Rs. 10 lakhs to Rs. 12
lakhs. Operating efficiencies with the new machine will also produce savings of Rs. 2 lakhs a year. Depreciation is on a straight
line basis over a ten year life.
The cost of capital is 8% and a 50% tax rate is applicable. The present value interest factor for an annuity for five years,
at 8% is 3.993 and present value interest factor at the end of five years is 0.681. Should the company replace the old machine?
Que. 25: - P Ltd. has a machine having an additional life of 5 years which costs Rs. 10,00,000 and has a book value of Rs. 4,00,000. a new
machine costing Rs. 20,00,000 is available. Though its capacity is the same as that of the old machine, it will mean a saving in
variable costs to the extent of Rs. 7,00,000 per annum. The life of the machine will be 5 years at the end of which it will have a

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scrap value of Rs. 2,00,000. The rate of income tax is 46% and P Ltd. s policy is not to make an investment if the yield is less
than 12% per annum. The old machine, if sold today, will realise Rs. 1,00,000; it will have no salvage value if sold at the end of 5th
year. Advice P Ltd. whether or not the old machine should be replaced.
(Present value of Re. 1 receivable annually for 5 years at 12% = 3.605, present value of Re. 1 receivable at the ed of S years at
12% per annum = 0.657). Capital gain is tax free. Ignore income tax savings on depreciation as well as on loss due to sale of
existing machine.
Que. 26: - Beta Company Limited is considering replacement of its existing by a new machine, which is expected to cost Rs. 2,64,000. The
new machine will have a life of five years. And will yield annual cash revenues of Rs. 5,68,750 and incur annual cash expenses of
Rs. 2,95,750. The estimated salvage value of the new machine is Rs. 18,200. The existing machine has a book value of Rs. 91,000
and can be sold for Rs. 45,000 today.
The existing machine has a remaining useful life of five years. The cash revenues will be Rs. 4,55,000 and associated cash
expenses will be 3,18,500. The existing machine will have a salvage value of Rs. 4,550 at the end of five years. The Beta
Company is in 35% tax bracket, and write off depreciation at 25% on written down value method. The Beta Company has a target
debt to value ratio of 15%. The company in the past has raised debt at 11% and it can raise fresh debt at 10.5%.
Beta Company plans to follow dividend discount model to estimate the cost of equity capital. The company plans to pay a dividend
of Rs. 2 per share in the next year. The current market price of companys equity share is Rs. 20 per equity share. The dividend per
equity share of the company is expected to grow at 8% p.a.
Required:
(i) Compute the incremental cash flows of the replacement decision.
(ii) Compute the weighted average cost of capital of the company.
(iii) Find out the net present value of the replacement decision.
(iv) Estimate the discounted payback period of the replacement decision.
(v) Should the company replace the existing machine? Advice.
Que. 27: - ABC Company is considering the following six proposals:
Project
Cost
NPV
1
Rs. 1,000
Rs. 210
2
6,000
1,560
3
5,000
850
4
2,000
260
5
2,500
500
6
500
95
You are required to calculate the profitability index for each project and rank them. Which projects would you choose if the total
funds if the total funds are Rs. 8,000. Assume projects are undivisable.
Que. 28-S Ltd. has Rs.10,00,000 allocated for capital budgeting purpose. The following proposals and associated profitability indexes have
been determined :
Project
Outflow
PI
1
Rs.3,00,000
1.22
2
1,50,000
0.95
3
3,50,000
1.20
4
4,50,000
1.18
5
2,00,000
1.20
6
4,00,000
1.05
Which of the above investment should be undertaken ? Assume that project are indivisible and there is no alternative use of the
money allocated for capital budgeting.
Que. 29: - Navyug Enterprises is considering the introduction of a new product. Generally the companys products have a life of about five
year, after which they are usually dropped from the range of products the company sells. The new product envisages the purchase
of new machinery costing Rs. 4,00,000 including freight and installation charges. The useful life of the equipment is five year,
with an estimated salvage value of Rs. 1,57,000 at the end of that time. The machine will be depreciated for tax purposes by
reducing balance method at a rate of 15% of the book value.
The new product will be produced in a factory which is already owned by the company. The company built the factory
some years ago at Rs. 1,50,000. The book value on the written down value basis is zero. Today, the factory has a resale value of
Rs. 3,50,000 which should remain fairly stable over the next five years. The factory is currently being rented to another company
under a lease agreement, which has five years to run, and which provides for annual rental of Rs. 5,000. Under the lease agreement
if the lessor wishes to cancel the lease, he can do so by paying the lessee compensation equal to one years rental payment. This
amount is not deductible for income tax purpose. Additions to current assets will required Rs. 22,500 at he commencement of the
proposal which, it is assumed, is fully recoverable at the end of year 5. The company will have to spend Rs. 50,000 in year 1
towards market research.
The net cash inflow from operation before depreciation and income tax are:
Year
Rs.
1
2,00,000
2
2,50,000
3
3,25,000
4
3,00,000
5
1,50,000

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71

It may be assumed that all cash flows are received or paid at the end of the each year and that income taxes are paid in the year in
which the inflows occur. The companys tax rate may be assumed to be 50% for both revenue and capital gains/losses and the
companys required return after tax is 10%. Evaluate the proposal.
Que. 30: - A chemical company is presently paying on outside firm Re. 1 per gallon to dispose off the waste resulting from its
manufacturing operations. At normal operating capacity, the waste is about 50,000 gallons per year.
After spending Rs. 60,000 on research, the company discovered that the waste could be sold for Rs. 10 per gallon if it was
processed further. Additional processing would, however, require an investment of Rs. 6,00,000 in new equipment, which would
have an estimated life of 10 years with no salvage value. Depreciation would be calculated by straight line method.
Expect for the costs incurred in advertising Rs. 20,000 per year, no change in the present selling and administrative
expenses is expected, if the new product is sold. The details of additional processing costs are as follows;
Variable: Rs. 5 per gallon of waste put into process.
Fixed: (excluding depreciation): Rs. 30,000 per year.
In costing the new product, general administrative overheads will be allocated at the rate of Rs. 2 per gallon. There will be no
losses in processing, and it is assumed that the total waste processed in a given year will be sold in that very year. Estimates
indicate that 40,000 gallons of the product could be sold each year.
The management when confronted with the choice disposing off the waste or processing it further and selling it, seeks your advice.
Which alternative would you recommended? Assuming that the firms cost of capital is 15% and it pays on an average 35% tax on
its income.
Que. 31: - A company wish to acquire an asset costing Rs. 1,00,000. The company has an offer from a bank to lend @ 18%. The principal
amount is repayable in 5 years end installments. A leasing Company has also submitted a proposal to the Company to acquire the
asset on lease at yearly rentals of Rs. 280 per Rs. 1,000 of the assets value for 5 years payable at year end. The rate of depreciation
of the asset allowable for tax purposes is 20% on W.D.V. with no extra shift allowance. The salvage value of the asset at the end of
5 years period is estimated to be Rs. 1,000. Whether the Company should accept the proposal of Bank or leasing company, if the
effective tax rate of company is 50% A required rate of return of the company is 18%?
Que. 32: - PQR Limited has decided to go in for a new model of Mercedes Car. The cost of the vehicle is Rs. 40 lakhs the company has two
alternatives:
(i) Taking the car on finance lease; or (ii) borrowing and purchasing the car
LMN Limited is willing to provide the car on finance lease of PQR Limited for five years at annual rental of Rs. 8.75 lakhs,
payable at the end of the year. The vehicle is expected to have useful life of 5 years, an it will fetch a net salvage value of Rs. 10
lakhs at the end of year five. The depreciation rate for tax purpose is 40% on written down basis. The applicable tax rate for the
company is 35% and incremental borrowing rate of the co. is 13.8462%.
What is the net advantage of leasing for the PQR Limited? Ignore Tax on capital profits
The values of present value interest factor at different rates of discount are as under:
Rate of Discount
t1
t2
t3
t4
t5
0.138462
0.8784
0.7715
0.6777
0.5953
0.5229
0.09
0.9174
0.7715
0.7722
0.7084
0.6499
Que. 33: - The management of Ram Ltd. is considering an investment project costing Rs. 1,50,000 and it will have a scrap value of Rs.
10,000 at the end of its 5 years life. Transportation charges and installation charges are expected to be Rs. 5,000 and Rs. 25,000
respectively. If the project is accepted, a spare port inventory of Rs. 10,000 must also be maintained. It is estimated that the spare
parts will have an estimated scrap value of 60% of their initial cost after 5 years. Annual revenue from the project is expected to be
Rs. 1,70,000; and annual labour, material and maintenance expenses are estimated to be Rs. 15,000 and Rs. 5,000 respectively.
The depreciation and taxes for five years will be:
Year
1
2
3
4
5

Depreciation (Rs.)
72,000
43,200
32,400
21,600
800

Tax (Rs.)
11,200
22,720
27,040
31,360
39,680

(a) Calculate the cost of the project and Scrap value of the following after 5 years. (Note: Ignore tax effect on loss in spare ports)
(b) Evaluate the project at 12% rate of interest.
Que 34- A company is reviewing an investment personal in a project involving a capital outlay of Rs. 90,00,000 in plant and machinery .The
project would have at life of 5 year at the end of which the plant and machinery could fetch a resale value of Rs.30,00,000. Father the project
would also need a working capital of Rs. 12,50,000 which would be built during the year I and to be released from the project at the end of
year 5. The project is expected to yield the following cash profit:
Year
Cash profit (Rs.)
1.
2.
3.
4.
5.

35,00,000
30,00,000
25,00,000
20,00,000
20,00,000

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72

A25% deprecation for plant and machinery is available on WDV basis as Income-tax exemption. Assume that the corporate Tax is paid one
year in arrear o the periods to which it relates and the first year deprecation allowance, would be clamed against the profit of year 1. The
assistant Manager Accountant has calculated NPV of the project using the companys
corporate target of 20% per-Tax rate of return and has ignored the taxation effect in the cash flows.
As the newly recruited Management Accountant, you realize that the projects cash flower should incorporate the effects of tax. The
corporate tax is expected to be 35% during the life of the project and thus the companys rate of return post-Tax is 13% (65%of 20%).
Your Assistant is surprised of note the difference between discounting the per-tax cash flows at a per-tax DCF rate and post-tax cash flows at
a post-tax rate.
Required:
a. Calculate he NPV of the project as the Assistant Management Accountant would calculated it
b. Re calculate the NPV of the project taking tax into consideration;
c. Comment on the desirability of the project vis--vis your finding in (b).

Que 35-Swastik Ltd. manufacturers of special purpose machine tools, have two division which are periodically assistant b visiting teams of
calculation. The Management is worried about the steady increase of expense in this regard over the year. Analysis of last years expenses
reveals the:
Rs.
Consultants Remuneration
2,50,000
Travel and conveyances
1,50,000
Boarding charges
2,00,000
Special Allowances
50,000
Accommodation Expenses
6,00,000

The management estimates accommodation expenses to increase by Rs.2,00,000 annually.


As part of a cast reduction drive, Swastik Ltd. are proposing to construct a consultancy centre to take care of the accommodation
requirements of the consultant. This centre will additionally save the company Rs.50,000 in boarding charges and Rs.2.00.000 in the cost of
Executive training programmes hitherto conducted out side the companys premises every year
The following details are available regarding the construction and maintenance of the new center:
(a) Land: at cost of Rs.8,00,000 already owned by the company, will be used.
(b) Construction cost Rs.15,00,000 including special furnishings.
(c) Cost of annual maintenance:Rs.1,50,000.
(d) Construction cost will be written off over 5 years being the useful life.
Assuming that the writ-off of construction cost as aforesaid will be accepted for purpose, that the rate of tax will be 50% and that the desired
rate of return is 15%; you are requested to analyses the feasibility of the proposal and make recommendations.
Que 36-A company is considering which of two mutually exclusive project it should undertake. The finance director think that the project
with the higher NPV should be chosen whereas the Managing Director think that the one with the higher IRR should be undertake especially
as both project have the same initial outlay and length of life.The company anticipates a cost of capital of 10%and the net after-tax cash
flows of the project are as follows:
Year
0
1
2
3
4
5
Cash Flows
Project X
(200)
35
80
90
75
20
Project Y
(200)
218
10
10
4
3
Required:
(a) Calculate the NPV and IRR of each project.
(b) State, with reasons, which project you would recommend.
(c) Explain the inconsistency in the ranking of the two project.
Que 37-SCL Limited, highly profitable company, is engaged he manufacture of power intensive product. As part of its diversification plans
the company propose to put up Windmill to generate electricity. The details of the scheme are as follows:
(1) Cost of the windmill:
Rs. 300 lakhs
(2) Cost of land
Rs. 15 lakhs
(3) Subside from state Government to be received
At the end of first year of installation
Rs. 15 lakhs
(4) Cost of electricity will be Rs.2.25 per unit year 1. this will increase by Rs. 0.25 per unit
every year till year 7. After that it will increase by Rs. 0.50 per unit.
(5) Maintenance cost will be Rs. 4 lakhs in year I and the same will increase by Rs.2 lakhs
every year.
(6) Estimated life 10 years.
(7) Cost of capital 15%.
(8) Residual value of windmill will be nil. However land value will go up to Rs. 60 lakhs, at the end of year 10.
(9) Deprecation will be 100% of the cost windmill in year I and the same will be allowed for tax purpose.
(10) As Windmills are expected to work based on wind velocity, the efficiency is expected to be an average 30%. Gross electricity
generated at this level will be 25 lakhs unite per annum. 4%of this electricity generated will be committed free to this sate Electricity
Board as per the agreement.
(11 )Tax rate 50%.
From the above information you are requested to:

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73

(a) Calculate the net present value.[Ignore tax on capital profit.]


(b) List down two non-financial factor that should be considered before taking a decision .
For your exercise use the following discount factors:
Year
1
2
3
4
5
6
7
8
Discount Factors
0.87
0.76
0.66
0.57
0.50
0.43
0.38
0.33

74
9
0.28

10
0.25

Que 38-Nine Gems Ltd. has just installed Machine R at accost ofRs.2,00,000.The machine has a five year life with no residual value. The
annual volume of production is estimated at1,50,000 units, which can be sold at Rs. 6 per unit, Annual operating costs are estimated at rs.
20,00 000 (excluding deprecation )at this output level. Fixed costs are estimated at Rs.3 per unit for the same level of production.
Nine Gems Lid has just came across another model called Machine S capable of giving the same output at an annual operating coat of Rs.
1,80,000 (exclusive of deprecation .) There will be no charge in fixed costs. Capital cost of this machine is Rs.2,50,000 and the estimated life
is for five years with nil residual value.
The company has an offer for sale of machine R at Rs. 1,00,000. But the cost of dismantling and removal will amount to Rs.30,000 As the
company has not yet commenced operation, it wants to sell machine R and purchase Machine S.
Nine gems Ltd. will be zero-tax company for seven years in view of several incentives and allowances available.
The cost of capital may be assumed at 14%.
(1) Advise whether the company should opt for the replacement.
(2) Will there be any change in your view, if Machine R has not been installed but the company is in the process of selecting one or the
other machine ?
(3) Support your view with necessary workings.
Que 39-Elite Builders, leading construction company have been approached by a Foreign Embassy to build for them a block of six flats to
be used as guest houses. A per the terms of contract the foreign Embassy would provide Elite Builders the plans and the land costing Rs.25
lakhs. Elite Builders would build the flats at their own cost and lease them out the Foreign Embassy for 15 years at the end of which the flats
will be transferred to the foreign Embassy for a nominal value of Rs. 8 lakhs. Elite Builders estimate the cost of construction as follows:
Area per flat
1,000 sq.ft
Construction cost
Rs.400 sq.ft.
Registration and other costs
2.5% of cost construction
Elite Builders will also incur Rs. 4 lakhs each in year 14 and 15 towards repairs.
Elite Builders proposes to charge the lease rentals as follows :
Years
1 to 5
6 to 10
11 to 15

Rentals
Norma
120% of normal
150%of normal

Elite builders present tax rate averages at 50%. The full cost of construction will be written off over 15 years and will be allowed for tax
purpose. You are required :
To calculate the normal per flat.
For your exercise assume :
(a) Minimum desired return of 10%
(b) Rentals & repairs will arise on the last day of the year.
(c) Construction registration and other cost will be incurred at time O.
Note :Cumulative discount factors may be used.
Que 40-ABC Limited is considering to acquire an additional sophisticated computer to augment is time share Computer sevices to its
clients. It has two options:
Either, (a) to purchase the Computer at a cost of Rs.44,00,000
Or,
(b) to take the Computer on lease for 3 year from leasing company at an annual lease
Rental of Rs. 10 lacs plus 10%of the gross time share service revenue. The
Agreement also requires an additional payment of Rs.12 lacs at the end of the third
Year end and the Computer reverts back to lessor after period of contract.
The company estimates that the computer will be worth Rs.20 lacs at the end of the third year.
The gross revenue to be earned
are as follows:Year
Rs. in lakhs
1
45
2
50
3
55
Annual operating cost (excluding depreciation/lease rental) are estimated at Rs.18 lacs with an additional cost of Rs.2 lacs for start up and
training at the beginning of the first year . These costs are to be borne by purchase of the computer and the repayment are to be made as per
the following schedule:Year end
Repayment of principal Rs.
Interest year Rs.
Total Rs.
1
10,00,000
7,04,000
17,04,000
2
17,00,000
5,44,000
22,44,000
3
17,00,000
2,72,000
19,72,000
For the purpose of this computation assume that the company uses the straight line method deprecation on asses and pay 50% tax on its
income.
You are requested to analyes and recommend to the company which of the to option is better. (PV factor @8% for year 1 (0.929), year 2
(0.857),year 3(0.794)and @16% for year 1(0.862), year 2 (0.743)and year 3(0.641)]

CA- IPCC- Financial Management`

Que. 41- Santosh & Co. is considering setting up a new unit. The following data has been compiled by the company for the purpose of
determining the acceptability of the proposal for setting up the new unit.
(i) Land
(a) To be paid at the time of purchase (t =0)
Rs. 2 lakhs
(b) 1st , 2nd & 3rd installments at the end of next 3 following years. Rs. 1 lakh each installment
(ii) Factory buildings (Total Rs. 20 lakhs)
(a) Initial payment on signing of contract
Rs. 2 lakhs
(b) At the end of year 2
Rs. 10 lakhs
(c) Balance at the end of year 3
Rs. 8 lakhs
(iii) Plant, Machinery & Equipment:
To be paid at the beginning of
- year 4
Rs. 15 lakhs
- year 5
Rs. 5 lakhs
(iv) Extra margin for working capital (at the end of year 5) Rs. 4 lakhs
(v) Operations will begin in the 6th year and will continue for 10 years upto year 15. Assume revenue and costs at the end of each
year.
(vi) Building, Plant, Machinery and equipment will be depreciated on straight line method over the 10 years starting from year 6,
as under:
Building @ 5% Plant, machinery and equipment @ 10%
(vii) Buildings are expected to be sold Rs. 6 lakhs and land for Rs. 8 lakhs at the end.
(viii) Plant, Machinery & Equipment will have a salvage value of Rs. 2 lakhs.
(ix) Cost of Capital is 12%.
(x) Other operating data:
Annual Sales Rs. 30 lakhs.
Variable costs of operation Rs. 12 lakhs
Fixed costs (excluding depreciation) Rs. 8 lakhs: and Tax rate 50%.
Assuming Profit or loss on sale of assets at end has no tax effect.
Advise whether the company should accept the project or reject it on the basis of NPV of the project.
Que. 42- Sagar industries, is planning to introduce a new product with a projected life of 8 years. The project, to be set up in a backward
region, qualifies for a one time (as it5s starting) tax free subsidy from the government of Rs. 20 lakhs equipment cost will be
Rs. 140 lakhs and additional equipment costing Rs. 10 lakhs will be needed at the beginning of the third year. At the end of 8
years the original equipment will have no resale value, but the supplementary equipment can be sold for Rs. 1 lakh. A working
capital of Rs. 15 lakhs will be needed. The sales volume over the eight year period have been forecasted as follows:
Year
Units
0
80,000
1
1,20,000
3-5
3,00,000
6-8
2,00,000
A sale price of Rs. 100 per unit is expected and variable expenses will amount to 40% of sales revenue. Fixed cash operating costs
will amount to Rs. 16 lakhs per year. In addition, an extensive advertising will be implemented, requiring annual outlays as
follows:
Year
(Rs. in lakhs)
1
30
2
15
3-5
10
6-8
4
The company is subject to 50% tax and considers 12% to be an appropriate after tax cost of capital for this project. The company
follows the straight line method of depreciation.
Should the project be accepted? Assume that the company has enough income form its existing products.

You Should Know


1. ADVANTAGES AND DISADVANTAGES OF IRR AND NPV
A number of surveys have shown that, in practice, the IRR method is more popular than the NPV approach. The
reason may be that the IRR is straightforward, but it uses cash flows and recognizes the time value of money, like
the NPV. In other words, while the IRR method is easy and understandable, it does not have the drawbacks of
the ARR and the payback period, both of which ignore the time value of money.
The main problem with the IRR method is that it often gives unrealistic rates of return. Suppose the cutoff
rate is 11% and the IRR is calculated as 40%. Does this mean that the management should immediately accept
the project because its IRR is 40%. The answer is no! An IRR of 40% assumes that a firm has the opportunity to
reinvest future cash flows at 40%. If past experience and the economy indicate that 40% is an unrealistic rate for
future reinvestments, an IRR of 40% is suspect. Simply speaking, an IRR of 40% is too good to be true! So

CA- IPCC- Financial Management`

75

unless the calculated IRR is a reasonable rate for reinvestment of future cash flows, it should not be used as a
yardstick to accept or reject a project.
Another problem with the IRR method is that it may give different rates of return. Suppose there are two
discount rates (two IRRs) that make the present value equal to the initial investment. In this case, which rate
should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases
where there are different IRRs. The purpose is to let you know that the IRR method, despite its popularity in the
business world, entails more problems than a practitioner may think.

2. WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT PROJECTS


When comparing two projects, the use of the NPV and the IRR methods may give different results. A project
selected according to the NPV may be rejected if the IRR method is used.
Suppose there are two alternative projects, X and Y. The initial investment in each project is $2,500. Project
X will provide annual cash flows of $500 for the next 10 years. Project Y has annual cash flows of $100, $200,
$300, $400, $500, $600, $700, $800, $900, and $1,000 in the same period. Using the trial and error method
explained before, you find that the IRR of Project X is 17% and the IRR of Project Y is around 13%. If you use
the IRR, Project X should be preferred because its IRR is 4% more than the IRR of Project Y. But what happens
to your decision if the NPV method is used? The answer is that the decision will change depending on the
discount rate you use. For instance, at a 5% discount rate, Project Y has a higher NPV than X does. But at a
discount rate of 8%, Project X is preferred because of a higher NPV.

The purpose of this numerical example is to illustrate an important distinction: The use of the IRR
always leads to the selection of the same project, whereas project selection using the NPV method
depends on the discount rate chosen.

CA- IPCC- Financial Management`

76

77

Chapter : Fund Flow Statements


Another important tool in the hands of finance managers for ascertaining the changes in financial position of
a firm between two accounting periods is known as funds flow statement. Funds flow statement analyses the reasons for
change in financial position between two balance sheets. It shows the inflow and outflow of funds i.e., sources and application
of funds during a particular period. Fund Flow Statement summarises for a particular period the resources made available to
finance the activities of an enterprise and the uses to which such resources have been put. A fund flow statement may serve as
a supplementary financial information to the users. Fund. means working capital. Working capital is viewed as the difference
between current assets and current liabilities.
Importance of Funds Flow Statement
The balance sheet and profit and loss account failed to provide the information which is provided by funds flow statement i.e.,
changes in financial position of an enterprise. This statement indicates the changes which have taken place between the two
accounting dates. This statement by giving details of sources and uses of funds during a given period is of great help to the
users of financial information. It is also a very useful tool in the hands of management for judging the financial and operating
performance of the company. It also indicates the working capital position which helps the management in taking policy
decisions regarding dividend etc. The projected funds flow statement can also be prepared and thus budgetary control and
capital expenditure control can be exercised in the organisation.
Funds Flow Statement vs. Cash Flow Statement
Both funds flow and cash flow statements are used in analysis of past transactions of a business firm. The
differences between these two statements are given below:
(a) Funds flow statement is based on the accrual accounting system. In case of preparation of cash flow statements all
transactions effecting the cash or cash equivalents only is taken into consideration.
(b) Funds flow statement analyses the sources and application of funds of long-term nature and the net increase or decrease in
long-term funds will be reflected on the working capital of the firm. The cash flow statement will only consider the increase or
decrease in current assets and current liabilities in calculating the cash flow of funds from
operations.
(c) Funds Flow analysis is more useful for long range financial planning. Cash flow analysis is more useful for identifying and
correcting the current liquidity problems of the firm.
(d) Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow
statement starts with the opening balance of cash and reach to the closing balance of cash by proceeding through sources and
uses.

Chapter : Cash Flow Statements


Practical Questions:Que. 1 From the following particulars, calculate Cash Flows from Operating Activities by Indirect Method.
Dr.
Profit & Loss Account of X Ltd.
Cr.
For the year ended 31st March, 20X2
Particulars
Rs
Particulars
Rs
To Depreciation
1,40,000 By Operating Profit before
To Discount on Issue of Debentures w/o
Depreciation
To Interest on Long-term Borrowings
By Profit on Sale on Investments
To Loss on Sale of Machine
1,000 By Dividend on Shares
To Patents w/o
28,000 By Interest on Investments
To Provision for Tax
30,000 By Rent from a plot of Land
To Transfer to Reserve
1,50,000 By Insurance Proceeds from
To Interim Divided
1,00,000
earthquake disaster settlement
To Proposed Divided
90,000 By Refund of Tax
To Premium payable on redemption
72,000
of Red. Pre. Share
To Net Profit
10,000

CA- IPCC- Financial Management`

9,18,000
20,000
10,000
6,000
30,000
1,00,000
3,000

4,36,000
10,87,000
Additional information:
Particulars

10,87,000
31.3.20X1
Rs
1,00,000
10,000
5,000
50,000
16,000
10,000
10,000
10,000
10,000

Stock
Trade Debtors
Trade Creditors
Provision for Tax
Prepaid Manufacturing Overheads
Outstanding Office & Adm. Expenses
Prepaid Selling & Distribution Expenses
Outstanding Trading Commission Payable
Accrued Trading Commission Receivable
Solution
Cash Flows from Opening Activities (Under Indirect Method)
Particulars
A. Net Profit as per Profit & Loss A/c
Add: Proposed dividend for the current year
Add: Interim dividend paid during the year
Add: Transfer to reserve
Add: Provision for Tax made during the Current Year
Less: Refund of Tax
Less: Extraordinary item (i.e., Insurance proceeds from Earthquake
disaster settlement)
B. Net profit before taxation, and extraordinary item
C. Add: Items to be added:
Depreciation
Interest on Long term borrowings
Discount on Issue of Debenture w/o
Patents written off
Loss on sale of Machinery
Premium payable on redemption of Preference shares
D. Less: Items to be deducted:
Interest Income
Dividend Income
Rental Income
Profit on sale of investments
E. Operation Profit before working capital charges [B + C D]
F. Add: Decrease in Current Assets & Increase in Current Liabilities:
Decrease in Prepaid Mfg. Overheads
Increase in Creditors for goods
Increase in Outstanding Trading Commission
Increase in Outstanding Office & Adm. Expenses
G. Less: Increase in Current Assets & Decrease in Current Liabilities:
Increase in Stock
Increase in Debtors
Increase in Prepaid Selling & Distribution Expenses
Increase in Accrued Commission
H. Cash generated from operations [E + F G]
I. Less: Income taxes paid (Net of Refund)
J. Cash flow before extraordinary item [H I]
K. Extraordinary items
L. Net Cash from Operating Activities
Que. 2 From the following Balance Sheets of X Ltd., prepare Cash Flow Statement:
Liabilities
31.3.20X1 31.3.30X2 Assets
Rs.
Rs
Equity Share Capital
3,00,000
4,00,000 Goodwill
15% Redeemable Pref.
Land & Building
Share Capital
1,50,000
1,00,000 Plant &Machinery
General Reserve
40,000
70,000 Debtors

CA- IPCC- Financial Management`

31.3.20X2
Rs
1,50,000
6,00,000
1,50,000
82,000
10,000
15,000
14,000
15,000
30,000

Rs.
4,36,000
72,000
90,000
1,00,000
1,50,000
3,000
1,00,000
7,45,000
1,40,000
28,000
1,000
30,000
30,000
10,000
10,000
6,000
30,000
20,000

6,000
1,45,000
5,000
5,000
50,000
5,90,000
4,000
20,000

31.3.20X1
Rs
1,15,000
2,00,000
80,000
1,60,000

2,39,000

66,000
9,18,000

1,161,000

6,64,000
4,15,000
1,15,000
3,00,000
1,00,000
4,00,000

31.3.20X2
Rs
90,000
1,70,000
2,00,000
2,00,000

78

Profit & Loss A/c


Creditors
Bills Payable
Provision for Taxation
Proposed Dividend

30,000
55,000
20,000
40,000
42,000
6,77,000

48,000
83,000
16,000
50,000
50,000
8,17,000

Stock
Bills Receivable
Cash in Hand
Cash at Bank

77,000
20,000
15,000
10,000

1,09,000
30,000
10,000
8,000

6,77,000
8,17,000
Additional Information:
(a) Depreciation of Rs 10,000 and Rs 20,000 has been charged on plant and land and buildings respectively.
(b) An interim dividend of Rs 20,000 has been paid, and
(c) Income-tax Rs 35,000 has been paid.
Solution
Cash Flow Statement
For the year ended 31st March, 20X2
Particulars
Rs. Rs.
I. Cash Flows from Operating Activities:
A. Closing Balance as per Profit & Loss A/c
48,000
Less: Opening balance as per Profit & Loss A/c
(30,000)
Add: Proposed dividend during the year (on equity & Preference
50,000
shares)
20,000
Add: Interim dividend paid during the year
30,000
Add: Transfer to reserve
45,000
Add: Provision fo Tax
1,63,000
B. Net Profit before taxation, and extraordinary item
C. Add: Items to be added
Depreciation
30,000
Goodwill w/o
25,000
55,000
D. Operating Profit before working capital charges [B + C]
2,18,000
E. Add: Decrease in Current Assets & Increase in Current Liabilities:
Increase in Creditors for goods
28,000
F. Less: Increase in Current Assets & Decrease in Current Liabilities:
Increase in Stock
32,000
Increase in Debtors (Gross)
40,000
Increase in Bills Receivable
10,000
Decrease in Bills Payable
4,000
(86,000)
G. Cash generated from operations [D + E F]
1,60,000
H. Less: Income taxes paid (Net of Refund)
(35,000)
I. Net Cash from Operating Activities
1,25,000
II. Cash Flows from Investing Activities:
Purchases of Plant
(1,30,000)
Proceeds from sale of Building
10,000
Net Cash used in investing activities
(1,20,000)
III. Cash Flows from Financing Activities:
Proceeds from issuance of share capital
1,00,000
Redemption of Preference shares
(50,000)
Interim Dividend Paid
(20,000)
Final Dividend paid (on equity & preference shares)
(42,000)
Net Cash used in financing activities
(12,000)
(7,000)
IV. Net Decrease in Cash and Cash Equivalents [I + II + III]
V. Cash and Cash Equivalents at Beginning of Period
Cash in hand
15,000
Cash at Bank
10,000
25,000
VI. Cash and Cash Equivalents at end of Period [IV + V]
Cash in hand
10,000
Cash at bank
8,000
18,000
Working Notes:
Dr.
(i) Plant Account
Cr.
Particulars
Rs
Particulars
Rs
To Balance b/d
80,000 By Depreciation A/c
10,000
To Bank A/c (Purchases)
1,30,000 By Balance c/d
2,00,000
(Balancing figure)
2,10,000
2,10,000
Dr.
(ii) Land & Building Account
Cr.
Particulars
Rs
Particulars
Rs

CA- IPCC- Financial Management`

79

To Balance b/d

2,00,000

By Depreciation A/c
By Bank A/c (Sale)
(Balancing figure)
By Balance c/d

2,00,000

20,000
10,000
1,70,000
2,00,000

Que. 3 From the following particulars, prepare Cash Flow Statement.


Liabilities
20X2
20X1
Assets
20X2
20X1
Rs.
Rs
Rs
Rs
Equity Share Capital
80,000
55,000 Fixed Assets
80,000
82,000
12% Pre. Share Capital
20,000
25,000 Less: Accumulated
General Reserve
4,000
4,000
Depreciation
30,000
22,000
Profit & Loss A/c
2,400
2,000
50,000
60,000
15% Debentures
14,000
12,000 Debtors
48,000
40,000
Creditors
22,000
24,000 Stock
70,000
60,000
Provision for Taxation
8,400
6,000 Prepaid Expenses
1,000
600
Proposed Dividend
11,600
10,000 Cash
7,000
2,400
Bank Overdraft
13,600
25,000
1,76,000
1,63,000
1,76,000
1,63,000
Additional Information: (a) Provision for Tax made Rs 9,400, (b) Fixed Assets sold for Rs 10,000, their cost Rs 20,000 and
accumulated depreciation till date of sale of them Rs 6,000 (c) An Interim Dividend paid during the year Rs 9,000.
Que. 4 From the following particulars, prepare the Cash Flows Statement:
Liabilities
20X2
20X1
Assets
20X2
20X1
Rs.
Rs
Rs
Rs
Share Capital
5,00,000
5,00,000 Lands & Building
1,20,000
80,000
Reserve
80,000
1,50,000 Plant & Machinery
6,00,000
5,00,000
10% Loans
3,00,000
1,00,000 Stock
75,000
1,00,000
10% Public Deposits
30,000
50,000 Debtors
1,60,000
1,50,000
Creditors
1,50,000
1,40,000 Cash
1,15,000
1,20,000
Outstanding Expenses
6,000
7,000
Provision for Doubtful
Debts
4,000
3,000
10,70,000
9,50,000
10,70,000
9,50,000
During the year, Rs 50,000 depreciation has been provided on Plant & Machinery and a machine costing Rs 15,000
(Depreciation provided thereon Rs 10,000) was sold at 60% profit on book value.
Que. 5 From the following Balance Sheets of X Ltd. prepare a Cash flow Statement.
Liabilities
20X1
20X2
Assets
20X1
20X2
Rs.
Rs
Rs
Rs
Equity Share Capital
30,000 35,000
Goodwill
10,000
8,000
General Reserve
10,000 15,000
Machinery
41,000
54,000
Profit & Loss A/c
6,000 7,000
10% Investments
3,000
8,000
10% Debentures
15,000 25,000
Stock
4,000
5,500
Sundry Creditors
7,500 11,000
Debtors
8,000
19,000
Bills Payable
1,000 1,500
Cash and Bank Balance
12,000
13,000
Provision for Depreciation
Discount on Debentures
On Machinery
9,000 13,000
500
78,500 1,07,000
78,500
1,07,000
Additional Information: Investments costing Rs 3,000 were sold Rs 2,800 during the year 20X2. A new machine was
purchased for Rs 13,000.
Que. 6 XYZ Ltd. companys Comparative Balance Sheet for 2009 and the Companys Income Statement for the year follows:
XYZ Ltd.
Comparative Balance Sheet December 31, 2009 and 2008
(Rs. Crores)
Particulars
2009
2008
Sources of Funds:
Share holders Funds:
Share capital
140
140
Retained earnings
110
250
92
232
Loan Funds:
Bonus payable
135
40
385
272

CA- IPCC- Financial Management`

80

Application of Funds:
Fixed Assets:
Plant and equipment
Less: Accumulated depreciation
Investments
Current Assets:
Inventory
Accounts receivable
Prepaid expenses
Cash

81
430
(218)

Less: Current Liabilities and Provisions


Accounts payable
Accrued Liabilities
Deferred income-tax provision

309
(194)

212
60

205
180
17
26
428

160
270
20
10
460

230
70
15
315

310
60
8
378

113
385

115
75

82
272

XYZ Ltd.
Income Statement for the year ended December 31, 2009

(Rs.Crores)
Particulars
Sales
1,000
Less: Cost of goods sold
530
Gross margin
470
Less: Operating expenses
352
Net operating income
118
Non- operating items:
Loss on sale of equipment
(4)
Income before taxes
114
Less: Income- taxes
48
Net income
66
Additional Information:
(i)
Dividends of Rs 48 crores were paid in 2009.
(ii)
The loss on sale of equipment of Rs 4 crore reflects a transaction in which equipment with an original cost of Rs
12 crores and accumulated depreciation Rs 5 crore were sold for Rs 3 crore in cash.
Required: Using the indirect method, determine the net cash provided by operating activities for 2009 and construct a
statement of cash flows.
Que. 7 The following is the Income statement of XYZ Company for the year 2009
(Rs.)
1,62,700
6,000
1,68,700

Sales
Add: Equity in ABC Companys earning

Expenses:
Cost of goods sold
Salaries
Depreciation
Insurance
Research and development
Patent amortization
Interest
Bad debts
Income tax:
Current
Deferred
Total expenses
Net income
Additional information are;
(i)
70% gross revenue from sales were on credit.
(ii)
Merchandise purchases amounting to Rs 92,000 were on credit.
(iii)
Salaries payable totaled Rs 1,600 at the end of year.
(iv)
Amortisation of premium on bonds payable was Rs 1,350.

89,300
34,400
7,450
500
1,250
900
10,650
2,050
6,600
1,550

CA- IPCC- Financial Management`

8,150
1,54,650
14,050

(v)
No dividends were received from the other company.
(vi)
XYZ Company declared cash dividend of Rs 4,000.
(vii)
Charges in Current assets and Current liabilities were as follows:
Cash
Marketable securities
Accounts receivable
Allowance for bad debt
Inventory
Prepaid insurance
Accounts payable (for merchandise)
Salaries payable
Dividends payable
Prepare a statement showing the amount of cashflow from operations.

82
Increase (Decrease)(Rs.)
500
1,600
(7,150)
(1,900)
2,700
700
5,650
(2,050)
(3,000)

Que. 8 From the following summary Cash account of X Ltd. prepare Cashflow statement for the year ended 31st March, 2009
in accordance with AS-3 (Revised) using the direct method. The company does not have any cash equivalents.
Summary Cash Account for the year ended 31.3.2009
(Rs. 000)
Balance on 1-4-2005
50 Payment of suppliers
2,000
Issue of equity Shares
300 Purchase of fixed assets
200
Receipts from customers
2,800 Overhead expenses
200
Sale of fixed assets
100 Wages and salaries
100
Taxation
250
Dividend
50
Repayment of bank loan
300
Balance on 31.3.2006
150
3,250
3,250
Que. 9 Ms. Jyothi of Star Oils Limited has collected the following information for the preparation of Cashflow statement for
the year 2009:
Net Profit
25,000
Dividend (including dividend tax) paid
8,535
Provision for Income-tax
5,000
Income-tax paid during the year
4,248
Loss on sale of assets (net)
40
Book value of the assets sold
185
Depreciation charged to Profit and Loss A/c
20,000
Amortisation of capital grant
6
Profit on sale of investments
100
Carrying amount of investment sold
27,765
Interest income on investments
2,506
Interest expenses
10,000
Interest paid during the year
56,075
Increase in working capital (excluding cash and bank balances)
14,560
Purchases of fixed assets
3,850
Investment in Joint venture
34,740
Expenditure on construction work-in-progress
2
Proceeds from calls-in-arrear
12
Receipt of grant for capital projects
25,980
Proceeds from long-term borrowings
20,575
Proceeds from short-tem borrowings
20,575
Opening cash and bank balance
5,003
Closing cash and bank balance
6,988
Required- Prepare the Cashflow statement for the year 2009 in accordance with AS -3, Cashflow Statements issued by the
Institute of Chartered Accountants of India. (Make necessary assumptions).
Que. 10 From the information contained in Income Statement and Balance Sheet of A Ltd., prepare cash flow statement:
Income Statement for the year ended March 31, 2009
(Rs)
Net Sales
(a)
2,52,00,000
Less:
Cash cost of sales
1,98,00,000
Depreciation
6,00,000
Salaries and wages
24,00,000
Operating expenses
8,00,000

CA- IPCC- Financial Management`

Provision for taxation


Net operating profit
Non-recurring income (profit on sale of equipment)

(b)
(a) (b)

Retained earnings and profit brought forward


Dividends declared and paid during the year
Profit and Loss account balance as on March 31, 2009
Balance Sheet as on

March 31
2009

Assets
Fixed Assets:
Land
Buildings and equipment
Current Assets:
Cash
Debtors
Stock
Advances
Liabilities and Equity
Share capital
Surplus in Profit and Loss account
Sundry creditors
Outstanding expenses
Income-tax payable
Accumulated depreciation on Buildings and equipment

8,80,000
2,44,80,000
7,20,000
1,20,000
8,40,000
15,18,000
23,58,000
7,20,000
16,38,000
(Rs)
March 31
2008

4,80,000
36,00,000
6,00,000
16,80,000
26,40,000
78,000
90,78,000

9,60,000
57,60,000
7,20,000
18,60,000
9,60,000
90,000
1,03,50,000

36,00,000
15,18,000
24,00,000
2,40,000
1,20,000
12,00,000
90,78,000

44,40,000
16,38,000
23,40,000
4,80,000
1,32,000
13,20,000
1,03,50,000

The original cost of equipment sold during the year 2008-09 was Rs 7,20,000.
Que. 11 The Balance Sheet of JK Limited as on 31st March, 2008 and 31st March, 2009 are given below;
Balance Sheet as on
(Rs 000)
Liabilities
31-03-08
31-03-09
Assets
31-09-08
31-03-09
Share Capital
1,440
1,920 Fixed Assets
3,840
4,560
Capital reserve
-48 Less: Depreciation
1,104
1,392
General reserve
816
960
2,736
3,168
Profit and Loss Account
288
360 Investment
480
384
9% Debentures
960
672 Cash
210
312
Current liabilities
576
624 Other Current assets
Proposed dividend
144
174 (including stock)
1,134
1,272
Provision for tax
432
408 Preliminary expenses
96
48
Unpaid dividend
-18
4,656
5,184
4,656
5,184
Additional Information:
(i)
During the year 2008-09, fixed assets with a book value of Rs 2,40,000 (accumulated depreciation Rs 84,000)
was sold for Rs 1,20,000.
(ii)
Provided Rs 4,20,000 as depreciation.
(iii)
Some investments are sold at a profit of Rs 48,000 and profit was credited to capital reserve.
(iv)
It decided that stocks be valued at cost, whereas previously the practice was to value stock at cost less 10 per
cent. The stock was Rs 2,59,200 as on 31-03-08. The stock as on 31-03-09 was correctly valued at Rs 3,60,000.
(v)
It decided to write off Fixed assets costing Rs 60,000 on which depreciation amounting to Rs 48,000 has been
provided.
(vi)
Debentures are redeemed at Rs 105.
Required; Prepare a Cash flow statement.
Que. 12 The Balance Sheet of X Ltd. as on 31st March, 2009 is as follows:
Liabilities
(Rs 000) Assets
Equity share capital
6,000 Fixed assets (at cost) 16,250
8% Preference share capital
3,250 Less: Dep. Written off 5,200
Reserve and surplus
1,400 Stock
10% Debentures
1,950 Sundry debtors

CA- IPCC- Financial Management`

(Rs 000)
11,050
1,950
2,600

83

Sundry creditors

3,250
15,850

Cash

250
15,850

The following additional information is available:


(i)
The stock turnover ratio based on cost of goods sold would be 6 times.
(ii)
The cost of fixed assets to sales ratio would be 1.4.
(iii)
Fixed assets costing Rs 30,00,000 to be installed on 1 st April 2009, payment would be made on March, 31 2010.
(iv)
In March, 2010, a dividend of 7 per cent on equity capital would be paid.
(v)
Rs 5,50,000, 11% Debentures would be issued on 1 st April, 2009.
(vi)
Rs 30,00,000, Equity shares would be issued on 31 st March, 2010.
(vii)
Creditors would be 25% of materials consumed.
(viii)
Debtors would be 10% of sales.
(ix)
The cost of goods sold would be 90% of sales including material 40% and depreciation 5% of sales.
(x)
The profit is subject to debenture interest and taxation @ 30%.
Required:
(i)
Prepare the projected balance sheet as on 31st March, 2010.
(ii)
Prepare projected cash flow statement in accordance with AS-3.
Que. 13 X Ltd. has the following balances as on 1st April 2009:
Fixed assets
Less; Depreciation

(Rs)
11,40,000
3,99,000

7,41,000
Stocks and Debtors
4,75,000
Bank balance
66,500
Creditors
1,14,000
Bills payable
76,000
Capital (shares of Rs 100 each)
5,70,000
The company made the following estimates for financial year 2009-10:
(i)
The company will pay a free of tax dividend of 10% the rate of tax being 25%.
(ii)
The company will acquire fixed assets costing Rs 1,90,000 after selling one machine for Rs 38,000 costing Rs
95,000 and on which depreciation provided amounted to Rs 66,500.
(iii)
Stocks and Debtors, Creditors and Bills Payables at the end of financial year are expected to be Rs 5,60,500, Rs
1,48,200 and Rs 98,800 respectively.
(iv)
The profit would be Rs 1,04,500 after depreciation of Rs 1,14,000.
Prepare the projected cash flow statement and ascertain the bank balance of X Ltd. at the end of financial year 2009-10.
Que. 14 Balance sheets of a company as on 31st March, 2007 and 2008 were as follows:
Liabilities
31-03-07
31-03-08
Assets
(Rs)
(Rs)
Equity share capital
10,00,000
10,00,000 Goodwill
8% Preference share capital
Land and Buildings
General reserve
2,00,000
3,00,000 Plant and Machinery
Securities premium
1,20,000
1,45,000 Investment (Non-trading)
Profit and loss A/c
-25,000 Stock
11% Debentures
2,10,000
3,00,000 Debtors
Creditors
5,00,000
3,00,000 Cash and bank
Provision for taz
1,85,000
2,15,000 Prepaid expenses
Proposed dividend
80,000
1,05,000 Premium on redemption
1,36,000
1,44,000 Of Debentures
24,31,000

25,34,000

31-09-07
(Rs)
1,00,000
7,00,000
6,00,000

31-03-08
(Rs)
80,000
6,50,000
6,60,000

2,40,000
4,00,000
2,88,000
88,000
15,000

2,20,000
3,85,000
4,15,000
93,000
11,000

-24,31,000

25,34,000
Additional information:
(1) Investments were sold during the year at a profit of Rs 15,000.
(2) During the year an old machine costing Rs 80,000 was sold for Rs 36,000. Its written down value was Rs
45,000.
(3) Depreciation charged on plant and machinery @ 20 percent on the opening balance.
(4) There was no purchase or sale of land and buildings.
(5) Provision for tax made during the year was Rs 96,000.
(6) Preference shares were issued for consideration of cash during the year.
You are required to prepare:
(i)
Cash flow statement as per AS-3.
(ii)
Schedule of Changes in working capital.
Solution
Working Notes

CA- IPCC- Financial Management`

84

To Bank (paid)
To Balance c/d

To Balance b/d
To Profit and loss A/c (profit on sale)

To Balance b/d
To Bank A/c (purchase)

Provision for Tax A/c


Rs
71,000 By Balance b/d
1,05,000 By Profit and loss A/c
1,76,000
Investment A/c
Rs
2,40,000 By Bank A/c
15,000 By Balance c/d
2,55,000
Plant and Machinery A/c
Rs
6,00,000 By Bank (sale)
2,25,000 By Profit and loss A/c (loss of sale)
By Depreciation
By Balance c/d

Rs.
80,000
96,000
1,76,000
Rs
35,000
2,20,000
2,55,000
Rs
36,000
9,000

1,20,000
6,60,000
8,25,000
8,25,000
Note- Since the date of redemption of debentures is not mentioned in the question, it is assumed that the debentures are
redeemed at the beginning of the year.
Cash Flow Statement for the year ending 31st March, 2008
(A) Cash flow from Opening Activities
Profit and Loss A/c as on 31-3-2008
Less: Profit and Loss as on 31-3-2007
Add: Transfer to General reserve
Provision for tax
Proposed dividend
Profit before tax
Adjustment for Depreciation:
Land and Buildings
Plant and machinery
Profit on sale of investments
Loss on sale of plant and machinery
Goodwill written off
Interest expenses
Operating profit before working capital changes
Adjustment for working capital changes:
Decrease in Prepaid expenses
Decrease in Stock
Increase in Debtors
Increase in Creditors
Cash generated from operations
Income tax paid
Net Cash Inflow from Operating Activities

(Rs)
3,00,000
2,10,000
90,000
25,000
96,000
1,44,000

50,000
1,20,000

(B) Cash flow from Investing Activities


Sale of investment
Sale of Plant and machinery
Purchases of Plant and machinery
Net Cash Outflow from Investing Activities
(C) Cash Flow from Financing Activities
Issue of Preference shares
Premium received on issue of securities
Redemption of Debentures at premium
Dividend paid
Interest paid to Debenture holders
Net Cash Outflow from Financing Activities
Net increase in Cash and Cash Equivalents during the year
Cash and Cash Equivalents at the beginning of the year

1,70,000
(15,000)
9,000
20,000
33,000
5,72,000

(a)

4,000
15,000
(1,27,000)
30,000
4,94,000
(71,000)
4,23,000

(b)

35,000
36,000
(2,25,000)
(1,54,000)

(c)

1,00,000
25,000
(2,20,000)
(1,36,000)
(33,000)
(2,64,000)

(a) + (b) + (c)

CA- IPCC- Financial Management`

2,65,000
3,55,000

5,000
88,000

85

Cash and Cash Equivalents at the end of the year


Schedule of Charges in Working Capital
Particulars
2007
Current Assets:
Stock
Debtors
Prepaid expenses
Cash and bank
Current Liabilities:
Creditors
Working Capital
Increase in Working capital

93,000
(Rs)
Charge in working capital
Increase
Decrease

31st March
2008

4,00,000
2,88,000
15,000
88,000
7,91,000

3,85,000
4,15,000
11,000
93,000
9,04,000

-1,27,000
-5,000

15,000
-4,000
--

1,85,000
1,85,000
6,06,000
83,000
6,89,000

2,15,000
2,15,000
6,89,000
-6,89,000

--

30,000

-1,32,000

83,000
1,32,000

Que. 15- From the following Balance Sheet and information prepare a Cash Flow Statement
31.3.2003
31.3.2002
Liabilities
Equity Share Capital
6,00,000
5,00,000
10% Redeemable Preference Capital
----2,00,000
General Reserve
1,00,000
2,50,000
Profit and Loss A/c
70,000
50,000
Capital Reserve
1,00,000
----Capital Redemption Reserve
1,00,000
----9% Debentures
2,00,000
----Sundry Creditors
95,000
80,000
Outstanding Expenses
30,000
20,000
Provision for Taxation
95,000
60,000
Proposed Dividend
90,000
60,000
Bills Payable
20,000
30,000
15,00,000
12,50,000
Assets
Land & Building
1,50,000
2,00,000
Plant & Machinery
7,65,000
5,00,000
Investments
50,000
80,000
Inventories
95,000
90,000
Bills Receivable
65,000
70,000
Sundry Debtors
1,75,000
1,30,000
Preliminary Expenses
10,000
25,000
Voluntary Separation Payments
1,25,000
65,000
Cash & Bank
65,000
90,000
15,00,000
12,50,000
Other information:
1. A piece of land has been sold out for Rs. 1,50,000 (Cost Rs. 1,20,000) and the balance land was revalued. Capital reserve
consisted of profit on sale and profit on revaluation.
2. on 1.4.2002 a plant was sold for Rs. 90,000 (original cost Rs. 70,000 and W.D.V. Rs. 50,000) and Debenture worth Rs. 1
lakh was issued at par as part consideration for plant of Rs. 4.5 lakhs acquired.
3. Part of investments (Cost Rs. 50,000) was sold for Rs. 70,000. 50% of the convertible debentures were converted during the
year at par.
4. Pre acquisition dividend received Rs. 5,000 was adjusted against cost of investment.
5. Directors have proposed 15% dividend for the current year.
6. Voluntary Separation Cost of Rs. 50,000 was adjusted against General Reserve.
7. Income tax liability for the current year was estimated at Rs. 1,35,000.
8. Depreciation @ 15% has been written off from Plant Account but no depreciation has been charged on Land and Building.
Que. 16:- The Balance Sheet of New Light Ltd. for the years ended 31 st March, 2001 and 2002 are as follows:
Liabilities
31-03-01
31-03-02
Assets
31-03-01
31-03-02
Equity share
Capital
10% Pre. Share
Capital
Capital Reserve
General Reserve
P & L A/c
9% Debentures

12,00,000
4,00,000
----6,80,000
2,40,000
4,00,000

16,00,000

Fixed Assets
Less: Dep.

32,00,000
9,20,000
22,80,000
4,00,000
10,000

2,80,000 Investment
40,000 Cash
8,00,000 Other current
3,00,000
assets
11,10,000
2,80,000 Preliminary exp.
80,000

38,00,000
11,60,000
26,40,000
3,20,000
10,000
13,10,000
40,000

CA- IPCC- Financial Management`

86

Current liab.
Proposed dividend
Provision for Tax
Unpaid dividend

4,80,000
5,20,000
1,20,000
1,44,000
3,60,000
3,40,000
---16,000
38,80,000
43,20,000
38,80,000
43,20,000
Additional information:
(i)
The company sold one fixed asset for Rs. 1,00,000, the cost of which was Rs. 2,00,000 and the depreciation provided en it
was Rs. 80,000.
(ii)
The company also decided to write off another fixed asset costing Rs. 56,000 on which depreciation amounting to Rs. 40,000
has been provided.
(iii) Depreciation on fixed assets provided Rs. 3,60,000.
(iv)
Company sold some investment at s profit of Rs,. 40,000, which was credited to capital reserve.
(v)
Debentures and preference share capital redeemed at 5% premium.
(vi)
Company decided to value stock at cost, whereas previously the practice was to value stock at cost less, 10%. The stock
according to books on 31.3.2001 was Rs. 2,16,000. The stock on 31.3.2002 was correctly valued at Rs. 3,00,000.
Prepare cash Flow Statement as per revised Accounting Standard 3 by indirect method.

Que. 17- The Summarized Balance Sheet of LAL & LAL Ltd. for the years ended 31.3.2001and 31.3.2002 are given below:
Liabilities
31.3.01
31.3.02 Assets
31.3.01
31.3.02
Rs.
Rs.
Rs.
Rs.
Share Capital
500
500 Land & Buildings
180
200
General reserve
200
220 Plant & machinery
210
276
P/L account
40
32 Other fixed assets
30
45
Bank loan (long term)
-100 Investments
50
50
Creditors
158
172 Stock
200
190
Provision for taxation
45
30 Debtors
170
195
Cash at bank
103
98
943
1054
943
1054
Prepare a statement of Cash Flow, given the following additional information relating to the year ended 31.3.2002.
(a) Dividend amounting to Rs. 30,000 was paid during the year.
(b) Provision for taxation made Rs. 12,000.
(c) Machinery Worth Rs. 15,000 (book value) was sold at a loss of Rs. 3,000.
(d) Investment costing Rs. 10,000 was sold for Rs. 12,000.
(e) Depreciation provided on assets:
Land and buildings
Rs. 5,000
Plant and Machinery
Rs. 20,000
Que. 18- Summarised balance Sheets of Ganga Ltd. for years ending 31.3.2001 and 31.3.2002 are reproduced below:
Liabilities
31.3.2001
31.3.2002 Assets
31.3.2001
31.3.2002
Rs.
Rs.
Rs.
Rs.
Equity Capital
60,00,000
60,00,000 Land & Buildings,
14,20,000
17,50,000
General Reserve
30,90,000
34,10,000 (less depreciation)
Profit and Loss A/c
1,50,000
1,80,000 Plant & Machinery
31,00,000
37,50,000
16% Debentures
-15,00,000 (less depreciation)
Sundry Creditors
3,10,000
3,70,000 Furniture and fixture
(less depreciation)
Investments
Debtors
8,40,000
9,80,000
Stock
50,000
60,000
Cash and bank
30,00,000
36,00,000
3,40,000
4,20,000
8,00,000
9,00,000
95,50,000
1,14,60,000
95,50,000
1,14,60,000
Additional information for the year ending 31.3.2002
(a) Dividend of Rs. 1,80,000 for the year ended 31.3.2001 was paid during 2002.
(b) Investment costing Rs. 10,000 was sold for Rs. 12,000.
(c) Depreciation on assets for the year ending 31.3.2002 was charged to profit and loss account as follows.
Land and buildings
Rs. 42,000
Plant and Machinery
Rs. 1,84,000
(d) sales of fixed assets
Machinery: Sale value Rs. 1,00,000 (W.D.V. Rs.2,20,000)
Furniture: Sale value Rs. 30,000 (W.D.V. Rs. 20,000)
Your are required to prepare the cash flow statement for the year ending 31.3.2002 together with the relevant ledger accounts.
Que. 19- The comparative balance sheet of XYZ Company are given below:
Liabilities
1995
1996 Assets
Share Capital
500
500
Fixed assets (net)
Reserve and surplus 425
500
Inventories
Long term debt
300
330
Debtors
Short term debt bank
Cash
Borrowings
200
225
other current assets

1995
850
340
360
30
20

CA- IPCC- Financial Management`

1996
1,000
350
330
35
15

87

Trade creditors
Provisions

100
95
75
80
1,600
1,730
The income statement of XYZ Company for the year 1996 is given below:
Net Sales
Cost of goods sold
Stocks
Wages and salaries
210
Other manufacturing expenses
140
Gross profit
Operating expenses
Depreciation
110
Selling, administration & general
230
Operating profit
Non operating surplus
Profit before interest and tax
Interest
Profit before tax
Tax
Profit after tax
Dividends
Retained earnings
Prepare a Cash Flow Statement.

1,600
(Rs. In lakhs)
2,040

1,73

1,010
(1,360)
680

(340)
340
(25)
365
(70)
295
(130)
165
90
75

Que. 20- Prepare cash flow statement of R Ltd. for 31.12.2004 (Make necessary assumptions)
Net Profit
Dividend (including dividend tax) paid
Provision for income tax
Income tax paid during the year
Loss on sale of assets (net)
Book value of the assets sold
Depreciation charged to P&L A/c
Amortization of Capital grant
Profit on sale of investments
Carrying amount of investment sold
Interest income on investment
Interest expenses
Interest paid during the year
Increase in working capital (excluding cash & bank balance)
Purchase of fixed assets
Investment in joint venture
Expenditure on construction WIP
Proceeds from calls in arrear
Receipt of grant for capital projects
Proceeds from long term borrowings
Proceeds from short term borrowings
Opening cash and Bank balance
Closing cash and Bank balance

(Rs. In Lakhs)
25,000
8,535
5,000
4,248
40
185
20,000
6
100
27,765
2,506
10,000
10520
56,075
14,560
3,850
34,740
2
12
25,980
20,575
5,003
6,988

Que. 21- The following are the changes in the account balances taken from the Balance Sheets of PQ Ltd. as at the beginning and end of the
year:
Changes in Rupees
In debit or [credit]
Eq. sh. Capital 30,000 shares of Rs. 10 each issued and fully paid
0
Capital reserve
[49,200]
8% debentures
[50,000]
Debenture discount
1,000
Freehold property at cost/revaluation
43,000
Plant and machinery at cost
60,000
Depreciation on plant and machinery
[14,400]
Debtors
50,000
Stock and Work in-progress
38,500
Creditors
[11,800]
Net profit for the year
[76,500]
Dividend paid in respect of earlier year
30,000
Provision for doubtful debts
[3,300]
Trade investments at cost
47,000
Bank
[64,300]
You are informed that:

CA- IPCC- Financial Management`

88

(a) Capital reserve as at the end of the year represented realized profits on sale of one freehold property together with surplus
arising on the revaluation of balance of freehold properties.
(b) During the year plant costing Rs. 18,000 against which deprecation provision of Rs. 13,500 was lying, was sold for Rs. 7,000.
(c) During the middle of the year Rs. 50,000 debentures were issued for cash at a discount of Rs. 1,000.
(d) The net profit for the year was after crediting the profit on sale of plant and charging debenture interest. You are required to
prepare a statement which will explain, why bank borrowing has increased by Rs. 64,300 during the year end.
Que. 22- From the following summarized Balance Sheets of a Company , as at 31 st March, you are required to prepare Cash Flow
statement. All working should from part of your answer.
Liabilities
1995 Rs.
1996 Rs. Assets
1995 Rs.
1996 Rs.
Equity Share Capital
75,000
1,20,000 Fixed Assets
2,40,070
2,53,730
10% Redeemable
Less: Depreciation
(90,020)
(98,480)
Pref. Share Capital
1,00,000
80,000
Profit and Loss Account
1,00,350
1,02,700
Reserve for Replacement of
1,50,050
1,55,250
Machinery
15,000
10,000 Bank
11,750
32,000
Long Term Loans
40,000 Investment

61,000
76,000
Bank Overdraft
22,000
Stock
98,000
1,04,000
Trade Creditors
84,450
75,550 Trade Debtors
88,000
85,000
Proposed Dividend
12,000
24,000

1.
2.
3.
4.
5.
6.
7.
8.

4,08,800
4,52,250
4,08,800
4,52,250
During the year, additional equity capital was issued to the extent of Rs. 25,000 by way of bonus shares fully paid up.
Final dividend on preference shares and an interim dividend of Rs. 4,000 on equity shares were paid on 31 st March, 1996.
Proposed dividends for the year ended 31st March, 1995 were paid in October, 1995.
Movement in Reserve for replacement of machinery account represents transfer to Profit and Loss Account.
During the year, one item of plant was up valued by Rs. 3,000 and credit for this was taken in the Profit and Loss Account.
Rs. 1,700 being expenditure of fixed assets for the year ended 31 st March, 1995 wrongly debited to Sundry Debtors then, was
corrected in the next year.
Fixed Assets costing Rs. 6,000 (accumulated depreciation Rs. 4,800) were sold for Rs. 250. Loss arising therefrom was written off.
Preference shares redeemed in year (June, 1995) were out of a fresh issue of equity shares, Premium paid on redemption was 10%.

Que. 23- The Balance Sheet of Zee Ltd. as on 31st March, 1989 was as follows:
Equity Share Capital
Land & Buildings
(fully paid shares of Rs. 10 each)
5,00,000 Plant and Machinery
11% Redeemable Preference Share Capital
Patents
(fully paid shares of Rs. 100 each)
Trade Investments
Capital Redemption Reserve A/c
2,00,000 Investments in Government
General Reserve
1,00,000 Securities as current assets
10% Debentures
2,50,000 Stock in trade
Creditors for goods
2,50,000 Trade Debtors
Provision for Income tax
1,70,000 Cash
Proposed Equity Dividend
1,80,000 Preliminary Expenses
70,000

2,00,000
6,80,000
1,00,000
2,50,000
70,000
1,20,000
1,60,000
1,30,000
10,000

17,20,000
17,20,000
Trade company has prepared the following Summarised projected Profit and Loss Account for the year ending on 31 st March,
1990.
Rs.
Rs.
To Opening Stock
1,20,000 By Sales
24,00,000
To Purchases
15,00,000 By Closing Stock
1,80,000
To Wages
2,60,000 By Income from Investments
31,300
To Salaries and Other Expenses
2,62,500 By profit on sale of machinery
To Interest on Debentures
25,000 By savings in provision for income tax
6,000
To Provision for Depreciation
1,10,500 for 19888-89
To Preliminary Expenses written off
5,000
15,000
To Provision for Income Tax
1,67,150
To Preference Dividend Paid
22,000
To Proposed Equity Dividend
75,000
To Balance of Profit
85,150
26,32,300
26,32,300
You are given the under mentioned further information:(i)
Provision for depreciation as on 31.3.1989 was Rs. 2,30,000 against Plant and Machinery and Rs. 20,000 against Land and
Buildings. Of the amount provided against depreciation in 1989-90, Rs. 10,000 will be for Land and Buildings.
(ii)
At the ends of March, 1990 the Redeemable Preference Shares are to be redeemed.

CA- IPCC- Financial Management`

89

(iii)

New Machinery costing Rs. 1,50,000 will be installed towards the end of March, 1990. The machine, which will be disposed
of , cost Rs. 40,000 against which Rs. 30,000 has been provided as depreciation till 31.3.1989 the sale will take place in the
beginning of April, 1989.
(iv)
The 10% Debentures are to be redeemed at the end of March, 1990. Debenture holders for half of the amount are expected
to agree to take new 14% Debentures while the remaining debenture holders are expected to agree to get their debentures
converted into equity shares at par.
(v)
The company allows one months credit to its customers and receives one and a half months credit from its suppliers. On
31.3.1990, outstanding wages will be Rs. 45,000.
Prepare the Balance sheet of the company as it likely to be at 31 st March, 1990. Also prepare a statement showing sources and
application of funds during the year. Assume that to the necessary extent, government securities will be sold at book value and no bank
overdraft will be raised. Payment of tax should be shown separately.
Que.24- The Balance Sheet of North Mills Ltd. as at 31st March, 1988 was as follows:
Liabilities
Equity share capital
General Reserve
Profit and loss account
Trade creditors
Provision for tax

Rs.
10,00,000
1,50,000
2,50,000
1,62,850
1,95,000

Assets
Plant and Machinery (cost)
Less: depreciation
Furniture: fittings and fixtures (cost)
Less: dep.
Long term investments
Stock
Debtors
Less: provision for bad debts
Cash at Bank
Advance Payment of income tax

Rs.
6,00,000
2,21,050
1,00,000
27,100

3,78,950
72,900
2,00,000
4,50,000

80,000
4,000

76,000
3,80,000
2,00,000
17,57,850
17,57,850
On 1st April, 1988 the company took over a business for Rs. 5,00,000. The purchase consideration was satisfied by
allotment to vendor 27,000 equity shares of Rs. 10 each at par and a cash payment of Rs. 2,30,000 which was raised by sale of all the
long term investments. The assets and liabilities taken over and their agreed values were as follows:Plant and Machinery
3,00,000
Furniture, fittings and fixtures
40,000
Stock
1,05,000
Trade Debtors
45,000
Trade Creditors
15,000
In July, 1988, the company paid a dividend @ 20% per annum for the year ended 31st March, 1988.
In Dec. 1988 the Income tax officer settled the income tax liability for the accounting year, ended 31 st March, 19888 for
Rs. 2,00,000.
In Feb. 1989 the company made a public issue of 1,00,000 equity shares of Rs. 10 each at par, the whole amount being
payable along with applications. The issue was got underwritten for the maximum commission allowed by law. The purpose of the
issue was to finance a new plant which was acquired for Rs. 9,00,000 in last week of march, 1989.
The balance sheet of North Mills Ltd. as at 31st March, 1989 stood as follows:Liabilities
Rs. Assets
Rs.
Equity share capital
22,70,000 Goodwill
25,000
(of the above shares, 27,000 shares of Rs.,
Plant and machinery (cost)
10 each have been allotted as fully paid up
18,00,000
pursuant to a contract without payment
Less: dep.
(3,21,893)
14,78,107
being received in cash)
Furniture, fittings and fittings
General reserve
(cost)
1,40,000
Profit and loss a/c
2,00,000 Less: dep.
(38,390)
1,01,610
Trade creditors
3,00,000 Stock
5,05,283
Provision for income tax
1,43,100 Debtors
98,000
3,10,000 Less: provision
for bad debts
4,900
93,100
Cash at Bank
6,70,000
Advance payment of income tax
3,00,000
Underwriting commission
50,000
32,23,100
32,23,100
You are required to prepare Cash flow Statement
Que. 25- The Balance sheet of Pragati Ltd. for the year ended 31 st March 2001 & 2002 were summarized thus:
Liability
31.3.01
31.3.02 Assets
31.3.01
Equity share capital
5,00,000
9,00,000 Goodwill
10,000
Pref. share capital
2,00,000
1,00,000 Land & Building
4,50,000
Capital Reserve
---24,000 Plant and machinery
1,70,000
General reserve
50,000
70,000 Car
----Profit & Loss
20,000
30,000 Investments
40,000
Hire vendor
---28,000 Stock
60,000
10% debenture
----2,00,000 Debtors
75,000
Creditors
95,000
85,000 Cash
45,000
Provision for Tax
30,000
45,000 Advances tax
35,000

CA- IPCC- Financial Management`

31.3.02
14,000
6,90,000
1,60,000
40,000
20,000
1,00,000
1,45,000
2,61,000
50,000

90

Unclaimed dividend

1.
2.
3.
4.
5.
6.
7.
8.

9.
10.
11.
12.
13.

-----

7,000

Underwriting
Commission

10,000

9,000

8,95,000
14,89,000
8,95,000
Tax for year ended 31st March was assessed to be 50,000.
A car of 50,000 was purchased on Hire Purchase and Rs. 25,000 was paid to Hire Vendor during the year.
The debentures were issued @ 10% premium which was taken to Capital Reserve on 1 st April, 2001.
Accumulated Depreciation on Land and Building was 1,50,000 and 2,10,000 respectively.
Accumulated Depreciation on Plant and Machinery was 1,30,000 and 1,40,000 respectively.
investment was sold @ 20% premium, the profit of which was taken to capital reserve.
bonus shares of 1 for every 5 held was issued in the beginning the year.
land and building worth
1,50,000
Plant and machinery worth
50,000
Stock worth
20,000
Debtors worth
70,000
Creditors worth
30,000
were purchased by issue of shares of Rs. 2,50,000 shares @ 10% premium
Dividend paid during the year = Rs. 43,000
The preference shares were redeemed @ 25% premium.
Plant and Machinery costing Rs,. 50,000 (WDV 22,000) was disposed off.
Bad debts written off Rs. 5,000
Dividend received was Rs. 17,000 of which Rs. 7,000 was post acquisition.
Prepare Cash flow Statement.

14,89,000

Chapter : Ratio Ananlysis


Ratio Analysis: It is concerned with the calculation of relationships, which after proper identification & interpretation
may provide information about the operations and state of affairs of a business enterprise. The analysis is used to
provide indicators of past performance in terms of critical success factors of a business. This assistance in
decision-making reduces reliance on guesswork and intuition and establishes a basis for sound judgments.

Types of Ratios
Liquidity
Measurement

Profitability
Indicators

Financial
Leverage/Gearing

Operating Performance

Investment
Valuation

Current Ratio

Profit Margin
Analysis

Equity Ratio

Fixed Assets Turnover

Price/Earnings
Ratio

Quick Ratio

Return on Assets

Debt Ratio

Sales/ Revenue

Price/Earnings to
Growth ratio

Return on Equity

Debt-Equity Ratio

Average Collection Period Dividend Yield

Return on Capital
Employed

Capitalization Ratio

Inventory Turnover

Interest Coverage Ratio

Total assets Turnover

Dividend Payout
Ratio

Liquidity Measurement Ratios


Liquidity refers to the ability of a firm to meet its short-term financial obligations when and as they fall due. The main concern
of liquidity ratio is to measure the ability of the firms to meet their short-term maturing obligations. The greater the coverage
of liquid assets to short-term liabilities the better as it is a clear signal that a company can pay its debts that are coming due in
the near future and still fund its ongoing operations. On the other hand, a company with a low coverage rate should raise a red
flag for investors as it may be a sign that the company will have difficulty meeting running its operations, as well as meeting
its obligations.
Ratio

Formula

Meaning

Analysis

CA- IPCC- Financial Management`

91

The number of times that the


short term assets can cover the
short term debts. In other
words, it indicates an ability to
Current assets includes cash,
marketable securities, accounts meet the short term obligations
as & when they fall due
receivable and inventories.
Current liabilities includes
accounts payable, short term
notes payable, short-term
loans, current maturities of
long term debt, accrued income
taxes and other accrued
expenses

Higher the ratio, the better it is,


however but too high ratio
reflects an in-efficient use of
resources & too low ratio leads
to insolvency. The ideal ratio is
considered to be 2:1.,

Indicates the ability to meet


short term payments using the
most liquid assets. This ratio is
more conservative than the
current ratio because it
excludes inventory and other
current assets, which are more
difficult to turn into cash

The ideal ratio is 1:1. Another


beneficial use is to compare the
quick ratio with the current
ratio. If the current ratio is
significantly higher, it is a clear
indication that the company's
current assets are dependent on
inventory.

Current Ratio

Current Assets/Current
Liabilities

Quick Ratio or
Acid Test Ratio

(Cash+Cash
Equivalents+Short Term
Investments+Accounts
Receivables) / Current
Liabilities

Profitability Indicators Ratios


Profitability is the ability of a business to earn profit over a period of time.The profitability ratios show the combined effects of
liquidity, asset management (activity) and debt management (gearing) on operating results. The overall measure of success of
a business is the profitability which results from the effective use of its resources.
Ratio

Formula

Meaning

Analysis

Gross Profit
Margin

(Gross Profit/Net Sales)*100

A company's cost of goods


sold represents the expense
related to labor, raw materials
and manufacturing overhead
involved in its production
process. This expense is
deducted from the company's
net sales/revenue, which
results in a company's gross
profit. The gross profit margin
is used to analyze how
efficiently a company is using
its raw materials, labor and
manufacturing-related fixed
assets to generate profits.

Higher the ratio, the higher is


the profit earned on sales

Operating Profit
Margin

(Operating Profit/Net
Sales)*100

By subtracting selling, general Lower the ratio, lower the


and administrative expenses
expense related to the sales
from a company's gross profit
number, we get operating
income. Management has
much more control over
operating expenses than its
cost of sales outlays. It
Measures the relative impact of
operating expenses

Net Profit Margin

(Net Profit/Net Sales)*100

This ratio measures the


ultimate profitability

Higher the ratio, the more


profitable are the sales.

Return on Assets

Net Income / Average Total

This ratio illustrates how well

Higher the return, the more

CA- IPCC- Financial Management`

92

Assets
( Earnings Before Interest &
Tax = Net Income)
Return on Equity

Net Income / Average


Shareholders Equity*100

Return on Capital
Employed

Net Income / Capital


Employed

management is employing the efficient management is in


company's total assets to make utilizing its asset base
a profit.
It measures how much the
shareholders earned for their
investment in the company

This ratio complements


the return on equity ratio by
adding a company's debt
Capital Employed = Avg. Debt liabilities, or funded debt, to
Liabilities + Avg. Shareholders equity to reflect a company's
total "capital employed". This
Equity
measure narrows the focus to
gain a better understanding of a
company's ability to generate
returns from its available
capital base.

Higher percentage indicates the


management is in utilizing its
equity base and the better
return is to investors.

It is a more comprehensive
profitability indicator because
it gauges management's ability
to generate earnings from a
company's total pool of capital.

Financial Leverage/Gearing Ratios


These ratios indicate the degree to which the activities of a firm are supported by creditors funds as opposed to owners as the
relationship of owners equity to borrowed funds is an important indicator of financial strength. The debt requires fixed
interest payments and repayment of the loan and legal action can be taken if any amounts due are not paid at the appointed
time. A relatively high proportion of funds contributed by the owners indicates a cushion (surplus) which shields creditors
against possible losses from default in payment.
Financial leverage will be to the advantage of the ordinary shareholders as long as the rate of earnings on capital employed is
greater than the rate payable on borrowed funds.

Ratio

Formula

Meaning

Analysis

Equity Ratio

(Ordinary Shareholders
Interest / Total assets)*100

This ratio measures the


strength of the financial
structure of the company

A high equity ratio reflects a


strong financial structure of the
company. A relatively low
equity ratio reflects a more
speculative situation because
of the effect of high leverage
and the greater possibility of
financial difficulty arising
from excessive debt burden.

Debt Ratio

Total Debt / Total Assets

This compares a company's


total debt to its total assets,
which is used to gain a general
idea as to the amount of
leverage being used by a
company. This is the measure
of financial strength that
reflects the proportion of
capital which has been funded
by debt, including preference
shares.

With higher debt ratio (low


equity ratio), a very small
cushion has developed thus not
giving creditors the security
they require. The company
would therefore find it
relatively difficult to raise
additional financial support
from external sources if it
wished to take that route. The
higher the debt ratio the more
difficult it becomes for the
firm to raise debt.

CA- IPCC- Financial Management`

93

Debt Equity
Ratio

Total Liabilities / Total


Equity

. This ratio measures how


much suppliers, lenders,
creditors and obligors have
committed to the company
versus what the shareholders
have committed.
This ratio indicates the extent
to which debt is covered by
shareholders funds.

A lower ratio is always safer,


however too low ratio reflects
an in-efficient use of equity.
Too high ratio reflects either
there is a debt to a great extent
or the equity base is too small

Capitalization
Ratio

Long Term Debt / (Long


Term Debt + Shareholders
Equity)

This ratio measures the debt


component of a company's
capital structure, or
capitalization (i.e., the sum of
long-term debt liabilities and
shareholders' equity) to
support a company's
operations and growth.

A low level of debt and a


healthy proportion of equity in
a company's capital structure is
an indication of financial
fitness.
A company too highly
leveraged (too much debt) may
find its freedom of action
restricted by its creditors
and/or have its profitability
hurt by high interest costs.
This ratio is one of the more
meaningful debt ratios because
it focuses on the relationship of
debt liabilities as a component
of a company's total capital
base, which is the capital
raised by shareholders and
lenders.

Interest Coverage
Ratio

EBIT / Interest on Long


Term Debt

This ratio measures the


number of times a company
can meet its interest expense

The lower the ratio, the more


the company is burdened by
debt expense. When a
company's interest coverage
ratio is only 1.5 or lower, its
ability to meet interest
expenses may be questionable.

Operating Performance Ratios:


These ratios look at how well a company turns its assets into revenue as well as how efficiently a company converts its sales
into cash, i.e how efficiently & effectively a company is using its resources to generate sales and increase shareholder value.
The better these ratios, the better it is for shareholders.

Ratios

Formula

Meaning

Analysis

Fixed Assets
Turnover

Sales / Net Fixed Assets

This ratio is a rough measure


of the productivity of a
company's fixed assets with
respect to generating sales

High fixed assets turnovers are


preferred since they indicate a
better efficiency in fixed
assets utilization.

Average Collection
Period

( Accounts
Receivable/Annual Credit
Sales )*365 days

The average collection period


measures the quality of
debtors since it indicates the
speed of their collection.

The shorter the average


collection period, the better
the quality of debtors, as a
short collection period implies

CA- IPCC- Financial Management`

94

the prompt payment by


debtors. An excessively long
collection period implies a
very liberal and inefficient
credit and collection
performance. The delay in
collection of cash impairs the
firms liquidity. On the other
hand, too low a collection
period is not necessarily
favorable, rather it may
indicate a very restrictive
credit and collection policy
which may curtail sales and
hence adversely affect profit.
Inventory Turnover Sales / Average Inventory

It measures the stock in


relation to turnover in order to
determine how often the stock
turns over in the business.
It indicates the efficiency of
the firm in selling its product.

Total Assets
Turnover

This ratio indicates the


Higher the firms total asset
efficiency with which the firm turnover, the more efficiently
uses all its assets to generate
its assets have been utilised.
sales.

Sales / Total Assets

High ratio indicates that there


is a little chance of the firm
holding damaged or obsolete
stock.

Investment Valuation Ratios:


These ratios can be used by investors to estimate the attractiveness of a potential or existing investment and get an idea of its
valuation.
Ratio

Formula

Meaning

Analysis

Price Earning Ratio Market Price per Share /


( P/E Ratio )
Earnings Per Share

This ratio measures how many A stock with high P/E ratio
times a stock is trading (its
suggests that investors are
price) per each rupee of EPS
expecting higher earnings
growth in the future compared
to the overall market, as
investors are paying more for
today's earnings in
anticipation of future earnings
growth. Hence, stocks with
this characteristic are
considered to be growth
stocks. Conversely, a stock
with a low P/E ratio suggests
that investors have more
modest expectations for its
future growth compared to the
market as a whole.

Price Earnings to
Growth Ratio

The price/earnings to growth


ratio, commonly referred to as
the PEG ratio, is obviously
closely related to the P/E ratio.
The PEG ratio is a refinement
of the P/E ratio and factors in
a stock's estimated earnings

( P/E Ratio ) / Earnings Per


Share

The general consensus is that


if the PEG ratio indicates a
value of 1, this means that the
market is correctly valuing
(the current P/E ratio) a stock
in accordance with the stock's
current estimated earnings per

CA- IPCC- Financial Management`

95

growth into its current


valuation. By comparing a
stock's P/E ratio with its
projected, or
estimated, earnings per share
(EPS) growth, investors are
given insight into the degree
of overpricing or under pricing
of a stock's current valuation,
as indicated by the traditional
P/E ratio.

Dividend Yield
Ratio

( Annual Dividend per Share This ratio allows investors to


compare the latest dividend
/ Market Price per
they received with the current
market value of the share as an
Share ) *100
indictor of the return they are
earning on their shares

Dividend Payout
Ratio

(Dividend per Share /


Earnings per Share ) * 100

share growth. If the PEG ratio


is less than 1, this means that
EPS growth is potentially able
to surpass the market's current
valuation. In other words, the
stock's price is being
undervalued. On the other
hand, stocks with high PEG
ratios can indicate just the
opposite - that the stock is
currently overvalued.

This enables an investor to


compare ratios for different
companies and industries.
Higher the ratio, the higher is
the return to the investor

This ratio identifies the


percentage of earnings (net
income) per common share
allocated to paying
cash dividends to
shareholders. The dividend
payout ratio is an indicator of
how well earnings support the
dividend payment.

Practical Questions:Que. 1- Following is the Trading and Profit and Loss Account of Adarsh Trading House for the year ended 31 st March, 1989:-

To Stock on 1.4.1988
To Purchase
To Freight
To Gross Profit c/d

Trading and Profit and Loss Account


Rs.
75,000
By Sales
3,10,000
By Stocks on 31.3.1989
15,000
2,00,000

To Administrative Expenses
To Selling and Distribution Exp
To Financial Expanses
To Other Non operating Exp.
To Net Profit

6,00,000
85,000
40,000
6,000
3,000
71,000

By Gross Profit b/d


By Interest on Investments

2,05,000
You are required to calculate:(i)
Gross profit Ratio
(ii)
Net Operating Profit Ratio
(iii)
Operating Ratio
(iv)
Administrative Expenses Ratio
(v)
Selling and Distribution Expenses Ratio.
Que. 2- Calculate Debt Equity Ratio from the balance sheet f Prestige Ltd. as at 31st March, 1989:
Liabilities
Rs
Assets
80,000 Equity Share of Rs. 10 each
Land and Buildings
Fully paid up
8,00,000
Plant and Machinery
4,000 11% Redeemable Preference
Furniture and Fittings
Shares of Rs. 100 each, fully
Stock
Paid up
4,00,000
Trade debtors

CA- IPCC- Financial Management`

Rs.
5,00,000
1,00,000

6,00,000
2,00,000
5,000

2,05,000

Rs
6,20,000
12,00,000
1,80,000
5,30,000
4,70,000

96

Share Premium Account


General Reserve
Profit and Loss A/c
10,000 12.5% Convertible Debentures
Of Rs. 100 each, fully paid up
Bills Payable
Trade Creditors
Outstanding Expenses
Provision for tax

80,000
5,80,000
1,40,000

Cash in hand
Cash at Bank
Bills Receivable

65,000
3,00,000
1,35,000

10,00,000
80,000
1,40,000
60,000
2,20,000

__
35,00,000
35,00,000
Que. 3- You are required to calculate Return on Investment from the following details of Rahu Ltd. for the year ending 31 st March, 1989:
Rs.
Net Profit after tax
6,50,000
Rate of Income tax
50%
12.5% Convertible Debentures of Rs. 100 each, fully paid up
8,00,000
Fixed Assets, at cost
24,60,000
Depreciation up to date
4,60,000
Current Assets
15,00,000
Current Liabilities
7,00,000
Que. 4- M/s Jupiter Ltd. intends to supply goods on credit to M/s Pluto Ltd. and M/s Mars Ltd. The relevant details for the year ending 31st
March, 1989 are is follows:M/s Pluto Ltd.
M/s Mars Ltd.
Rs.
Rs.
Trade Creditors
3,00,000
1,60,000
Total Purchases
9,30,000
6,60,000
Cash Purchases
30,000
20,000
Advise with reasons as to which company he should prefer to deal with.
Que. 5- Compute the amount of capital employed from the balance sheet of Mars Ltd. as at 31 st March, 1989:Liabilities
Rs
Assets
Rs
Equity Share Capital
7,00,000
Land and Buildings
5,00,000
12% Pre. Share Capital
2,60,000
Plant and Machinery
6,00,000
General Reserve
3,20,000
Furniture and Fittings
1,00,000
Profit and Loss A/c
1,60,000
Investments (Non trading)
1,00,000
11% Debentures
2,00,000
Stock
4,00,000
Bills Payable
1,92,000
Sundry Debtors
3,00,000
Sundry Creditors
3,60,000
Cash in hand
80,000
Income Tax Payable
1,60,000
Cash at Bank
2,00,000
Outstanding Expenses
48,000
Bills Receivable
90,000
Prepaid expenses
10,000
Preliminary Expenses
20,000
_________
24,00,000
24,00,000
Que. 6- The balance sheet of Star Ltd. as at 31st March, 1989 is given below:Liabilities
Rs
Assets
Equity share Capital
6,00,000
Plant and Machinery
Reserves
1,80,000
Furniture
Creditors
1,20,000
Stock
Debtors
Cash at Bank

Rs
4,50,000
50,000
1,80,000
1,20,000
1,00,000

9,00,000
9,00,000
The other details are as follows:
(i)
Total sales during the year have been Rs. 10,00,000 out of which cash sales amounted to Rs. 2,00,000.
(ii)
The Gross Profit has been earned @ 20%.
(iii)
Amounts as on 1.4.88:
Rs.
Debtors
80,000
Stock
1,40,000
Creditors
30,000
(iv)
Cash paid to creditors during the year, Rs. 2,10,000.
You are required to calculate the following ratios:
(i)
Debtors Turnover Ratio;
(ii)
Creditors Turnover Ratio;
(iii)
Stock Turnover Ratio.
Que. 7- (a) Calculate Debt Collection Period of Confident Ltd. for the year ending 31 st March, 1989:
Rs.
Sales During the year
3,65,000

CA- IPCC- Financial Management`

97

Debtors as on 31.3.1989
42,500
Bills Receivable as on 31.3.1989
7,500
(b) Compute Debtors Turnover Ratio and Average Collection Period of Prosperous Ltd. for the year ending 31 st March, 1989:
Rs.
Net Credit Sales
8,00,000
Opening Trade Debtors
1,80,000
Closing Trade Debtors
1,40,000
The sixty days credit is common to the industry to which the company belong. State whether the debts are being collected
efficiently or not.
Que. 8- Calculate the following ratios from the financial statements given below for AB Ltd.:
(a) Current Ratio;
(b) Acid Test Ratio;
(c) Stock Turnover Ratio;
(d) Debt Equity Ratio;
(e) Interest Coverage Ratio;
Income Statement of AB Ltd. for the year ending 31 st March, 1989:
Rs.
Sales
Cost of Goods Sold:
Stock, April 1, 1988
40,000
Add: Purchases
2,45,000
Direct Expenses
25,000
3,10,000
Less: Stock, March 31, 1989
60,000
Gross Profit
Operating Expenses
1,10,000
Interest Expenses
20,000
Net Profit before Tax
Provision for Income Tax
Net Profit

Assets
Fixed Assets (cost)
Less: Accumulated Depreciation
Stock
Debtors
Cash at Bank
Bills Receivable
Prepaid Expenses
Total Assets
Liabilities
Equity share capital
Reserves and Surplus
10% Debentures
Creditors
Bills Payable
Total Liabilities

Rs.
5,00,000

2,50,000
2,50,000
1,30,000
1,20,000
60,000
60,000

Balance Sheet of AB Ltd. as at 31st March, 1989:


Rs
Rs
5,40,000
1,40,000
4,00,000
60,000
2,30,000
1,55,000
43,000
12,000
9,00,000
1,50,000
3,00,000
2,00,000
1,80,000
70,000
9,00,000

Que. 9- The following data have been abstracted from the annual accounts of a company:
Rs. (in lakhs)
Share Capital:
20,00,000 Equity Shares of Rs. 10 each
General Reserve
Investment Allowance Reserve
15% Long term Loan
Profit before Tax
Provision for Tax
Proposed Dividend

200
150
50
300
140
84
10

Calculate, from the above, the following ratios:


(i)
Return on Capital Employed
(ii)
Return on Net Worth
Que. 10- Mr. T Munim is made an offer by the promoters of S Enterprises Ltd. to invest in the project of the company by purchasing a
substantial portion of the share capital. He is promised good return by way of dividends and capital appreciation.
Mr. Munim desires you to compute the following ratios for financial analysis. Working should form part of your answer.
(i)
Return on Investment Ratio
(ii)
Net Profit Ratio
(iii)
Stock Turnover Ratio

CA- IPCC- Financial Management`

98

(iv)
(v)

Current Ratio
Debt Equity Ratio

99

The figures given to him are as under:


Sales..
Raw Materials Consumed.
Consumables.
Direct Labour
Other Direct Expenses..
Administrative Expenses..
Selling Expenses..
Interest.
Fixed Assets.
Income tax...
Depreciation
Share Capital
Reserves and Surplus
Secured Term Loans
Unsecured Term Loans
Trade Creditors
Investments
Inventories
Receivables
Cash in hand and at Bank
Provisions
Other Current Liabilities

(Rs. 000)
16,000
7,800
800
750
480
1,200
260
1,440
14,000
50
700
5,000
1,500
12,000
1,500
3,350
400
6,000
3,700
100
650
200

Que. 11- Some years ago, the sales manager of a company persuaded the management to increase the stocks of finished goods (to improve
delivery period) and to sell more on credit (terms being 6 weeks). The following figures are given to you:

Year

Sales

Finished Goods Debtors at


Gross Profit
Stock
end
Rs.
Rs.
Rs.
Rs.
1985-86
5,00,000
50,000
40,000
60,000
1986-87
5,50,000
54,000
45,000
65,000
1987-88
7,00,000
90,000
90,000
75,000
1988-89
7,50,000
1,00,000
1,00,000
80,000
Assuming the stock levels and debtors to be true for the whole year, comment upon the wisdom of the decision taken.
The company financed working capital by borrowing from banks. What remedial action do you suggest?
Que. 12- You are given the following figures:
Current Ratio
2.5
Liquidity Ratio
1.5
Net Working Capital
Rs. 3,00,000
Stock Turnover Ratio
6
Ratio of Gross Profit to Sale
20%
Ratio of Turnover to Fixed Assets (net)
2
Average Debt Collection Period
2 months
Fixed Assets to Net Worth
0.80
Reserves and Surplus to Capital
.5
Draw up the Balance Sheet of the concern to which the figures relate.
Que. 13- The assets of ABC Ltd. consist of fixed assets and current assets while its current liabilities comprise bank credit and trade credit in
the ratio of 2:1. Form the following figures relating to the company for the year 1988-98, prepare its balance sheet showing the
details of working:
Share Capital
Rs. 1,99,500
Working Capital i.e. Current Assets Current Liabilities
Rs. 45,000
Gross Margin
20%
Inventory Turnover
6
Average Collection Period
2 months
Current Ratio
1.5
Quick Ratio
0.9
Reserves and Surplus to Cash
3
Que. 14- You are advised by the Management of ABC Ltd. to project a Trading and Profit and Loss Account and the Balance Sheet on the
basis of the following estimated figures and ratios, for the next financial year ending March 31, 1990:
Ratio of Gross Profit..
25%
Stock Turnover Ratio
.5 times

CA- IPCC- Financial Management`

Average Debt Collection Period


Creditors Velocity
Current Ratio..
Proprietary Ratio (Fixed Assets to Capital Employed)..
Capital Gearing Ratio (Preference Shares & Debentures to Equity).
Net Profit to issued capital (Equity)
General Reserve and P/L to Issued Capital (Equity)
Preference Share Capital to Debentures. .
Cost of Sales consists of 50% for Materials
Gross Profit, Rs. 12,50,000.
Working notes should be clearly shown.

3 times
3 times
2
80%
.30%
10%
25%
2

Que. 15- From the following information, prepare the projected Trading and Profit and Loss Account for the next financial year
ending March 31, 1989 and the projected Balance Sheet as on the date:
Gross Profit Ratio
25%
Net Profit to Equity Capital..
10%
Stock Turnover ratio.
5 times
Average Debt Collection Period...
2 times
Creditors Velocity
3 times
Current Ratio
2
Proprietary Ratio
(Fixed Assets to Capital Employed). ...
80%
Capital Gearing Ratio
(Preference Shares and Debentures to Equity).
30%
General Reserve and Profit and Loss to Issued Equity Capital
25%
Preference Share Capital to Debentures...
2
Cost of Sales consist of 40% for Materials and balance for Wages and Overheads. Gross Profit is Rs. 6,00,000. Working
notes should be clearly shown.
Question 16:From the following particulars prepare the Balance Sheet of X ltd:Working Capital
Rs 300000
Current Ratio
1.6
Current Asset / Fixed Asset
1 : 1.25
Fixed Asset to turnover
1 : 1.5
Gross Profit
20%
Debt Equity ratio
1 : 1.6
Debtors Velocity ratio
2.4 months
Creditors Velocity ratio
3 months
Stock Velocity ratio
2 months
Total Liabilities / Current Liabilities
2

Question 17Current Ratio


Working Capital
Capital Block to Current Asset
Fixed Asset to Turnover
Sales Cash / Credit
Creditors Velocity ratio
Stock Velocity Ratio
Debtors Velocity ratio
Capital Block:Net Profit 10% of turnover
Reserve 2.5% of turnover
Debenture / Share Capital
Gross Profit ratio

2
Rs 400000
3:2
1:3
1:2
2 months
2 months
3 months

1:2
25% (to sales)

Question 18Prepare Profit & Loss account & Balance sheet with the following information:Current asset to Stock
3:2
Acid test ratio
1
EPS (Per share @10/)
10
Average Collection Period
30 days
Fixed Asset turnover ratio
1.2
Working Capital
Rs 10 lacs
Variable Cost
60%
Taxation
Nil
Current Ratio
3
Financial Leverage
2.2
Book Value per Share
Rs 40

CA- IPCC- Financial Management`

100

Stock Turnover Ratio


Total Liabilities to Net Worth
Net Profit to Sales
Long Term Loan Interest

5
2.75
10%
12%

Chapter : Sources of Finances


Q ue st io n : Li st do w n t he f i na nc ia l nee d s a n d th e so urc e s a v a ila b l e w ith a b u si ne s s en ti ty to
sa t i sfy s uc h nee d s ?
An sw er : O ne o f t he m o st i mp o r ta n t co ns id er a tio n fo r a n e n trep r e ne ur -co mp a n y i n i mp le me n t in g a
ne w p ro j ec t o r u nd er ta ki n g e xp a n s io n, d i v er si fica tio n, mo d er n is at io n a nd re hab il it at io n sc h e me i s
asc ert ai n i n g t he co st o f p r o j ect a nd t he me a n s o f fi na nc e. T he re ar e s e v eral so urc e s o f fi n a nce / fu nd s
av ai lab l e to a n y co mp a n y. A n e f f ec ti ve ap p ra is a l mec h a ni s m o f v ario u s so urc es o f fu nd s a va ilab le to
a co mp a n y mu s t b e i n s t it ut ed i n t he co mp a n y t o ac hie v e i t s ma i n o b j ecti v es . S u c h a me c ha n is m is
r eq u ired to e val u at e r i s k, t e n ur e a nd co s t o f e ac h a nd e ver y so urce o f fu nd . T h is se lec tio n o f f u nd
so urc e is d ep e nd e n t o n th e fi na n ci al s tr a te g y p ur s ued b y t he co mp a n y, the le ver a ge p la n n ed b y t he
co mp a n y, t he fi na n ci al co nd i tio n s p r e val e nt i n t he eco no m y & t he ris k p ro fi le o f b o t h i. e. t h e
co mp a n y a nd t he i nd u s t r y i n wh i c h t h e co mp a n y o p era te s. Ea c h a nd e v er y so urc e o f fu nd ha s so me
ad v a nta g e s a nd d is ad va n ta ge s.
I) F ina nc ia l n ee ds o f a bu s in es s a re g ro u pe d a s fo llo w s :
1 ) Lo ng te r m fi na nc ia l nee ds : S uc h ne ed s ge n eral l y r e fer to t ho se req ui re me n t s o f fu nd s wh i c h are
fo r a p er io d e xce ed i n g 5 - 1 0 ye ar s. A ll i n v es t me n t s i n p la n t a nd mac h in er y, l a nd , b u ild i n g s, e tc. are
co n s id ered a s lo n g te r m f i na nc ia l ne ed s . F u nd s req uir ed to fi na n ce p er ma n e nt o r hard co re wo rk i n g
cap i tal s ho u ld a l so b e p r o cur ed fr o m lo n g ter m s o urc e s.
2 ) M ediu m t er m f ina nc ia l n ee ds : S uc h r eq u ire me n t s re fer to t ho se fu nd s wh i c h are req uir ed fo r a
p er io d e x ceed i n g o ne ye ar b ut no t e x ceed i n g 5 y ear s. F u nd s req ui red fo r d e ferred re ve n u e e xp e n d it ure
( i.e b e n e fi t o f e xp e n se e xp i r e s a f ter a p er io d o f 3 to 5 year s), are cla s s i fied a s me d i u m ter m f i na nc ia l
ne ed s . So me ti me s lo n g t er m r eq u ir e me n t s, fo r whi c h lo n g ter m fu n d s c a n no t b e arr a n ged i m med iat el y
ma y b e me t fro m med i u m ter m so ur ce s a nd t h u s t h e d e ma n d o f med iu m t er m fi n a nc ial nee d s ar e
ge n era ted , as a nd wh e n t he d e sir ed lo n g - ter m fu n d s ar e a va il ab l e med i u m ter m lo a n ma y b e p aid o ff.
3 ) Sho rt te r m f ina nc ia l ne ed s : S uc h t yp e o f fi na nc ia l n eed s ar i se fo r fi na nc i n g c urr e nt a s se ts as,
sto c k, d eb to rs, ca s h, e tc. I n ve s t me nt i n t h es e as se t s i s k no wn a s me et i n g o f wo r k i n g ca p ita l
r eq u i re me n t s o f t he co nc er n. Fir ms r eq u ire wo rk i n g cap it al to e mp lo y fi xed a s se ts g ai n fu ll y . Th e
r eq u ire me n t o f wo r k i n g cap it al d ep e nd s o n a n u mb e r o f fa cto r s t ha t ma y d i ffer fro m i nd u s tr y to
ind u s tr y a nd fro m co mp an y to co mp a n y i n t he sa me i nd u s tr y. T h e ma i n c hara ct eri st ic o f s ho rt ter m
f i na nc ia l need s is t ha t t he y ar i se fo r a s ho r t p e rio d o f t i me no t e x ceed in g t he acco u n ti n g p eri o d i.e .
o ne year.
T he b as ic p r i nc ip l e fo r cat e go r i s i n g th e fi na nc ia l need s i nto s ho r t t er m, me d i u m te r m a nd
lo n g te r m i s t hat t he y a r e met fr o m t he co rr e sp o nd i n g viz . s ho rt ter m, med i u m ter m a nd lo n g ter m
so urc es r esp ect i ve l y. A c co r d i n gl y t he so urc e o f fi na nc i n g i s d ec id ed wi t h re fere nc e to t he p er io d fo r
wh ic h fu nd s are r eq uir e d . Ba si ca ll y, t h er e ar e 2 so u rce s o f rai s i n g fu n d s fo r a n y b u s i ne s s e nte r p ris e
vi z. o wn e r s cap i ta l a nd b o r r o wed cap it al. T he o wn er s cap ita l i s u sed fo r me et i n g lo n g t er m fi n an cia l
ne ed s a nd i t p r i mar il y c o me s fr o m s h ar e cap it al a nd r et ai ned ea r ni n g s. Bo rro wed cap ita l fo r a ll o t her
t yp e s o f req u ire me n t ca n b e r ai sed fr o m d i ffer en t so ur ce s as d eb e nt ur es, p ub l ic d ep o si t s, fi n an cia l
in s ti t ut io ns , co m me r c ial b a n ks, et c.
I I) So ur ce s o f f i na n ce o f a b u si ne s s a re :
1 ) Lo ng te r m :
i) S h are cap i ta l o r Eq u it y s har e cap it al
ii) P re fere nc e s har e s
iii ) Ret ai n ed ea r ni n g s

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iv ) D eb e nt u re s/ Bo nd s o f d i f fer e nt t yp e s
v) Lo a n s fro m fi na n cia l in s ti t ut io ns
vi ) Lo a n s fro m S ta te Fi n an cia l Co r p o r at io n
vi i) Lo a n s fro m co m mer cia l b a n k s
vi ii ) V e nt ure cap it al f u n d in g
ix ) A s se t sec ur it i sat io n
x) I n ter n at io nal fi na n ci n g li ke E ur o - is s ue s, Fo r ei g n c urre nc y lo a n s.
2 ) M ediu m t er m :
i) P re fer e nce s h ar e s
ii) Deb e n t ure s /Bo nd s
iii ) P ub li c d ep o si t s / f i xe d d ep o s it s fo r a d ura tio n o f 3 year s
iv ) Co m mer ci al b a n ks
v) Fi n a nc ial i n st it u tio n s
vi ) S ta te fi na nc ia l co r p o r atio n s
vi i) Lea se fi n a n ci n g /H ir e -p u r c ha se f i na n ci n g
vi ii ) E xt er na l co m me r c i al b o r r o wi n g s
ix ) E uro - is s u es
x) Fo re i g n c urr e nc y b o nd s.
3 ) S ho rt - t er m :
i) Trad e cr ed i t
ii) Co m me rc ia l b a n k s
iii ) F i xed d ep o s it s fo r a p er io d o f 1 year o r le s s
iv ) Ad v a nce s r ece i ved fr o m c us to mer s
v) Var io us s ho r t - ter m p r o vi s io n s
I II) Fi na ncia l so urc es o f a b u si ne s s ca n a l so b e cla s sif ie d a s fo llo w s o n us ing d iffe re nt ba s i s :
1 ) Acco rd i ng to per io d :
i) Lo n g ter m so ur ce s
ii) Med i u m t er m so ur c es
iii ) S ho r t ter m so ur ce s
2 ) Acco rd i ng to o w n er s hi p :
i) O wn er s c ap i ta l o r eq u it y c ap i ta l, r e ta i ned e ar n in g s, et c.
ii) Bo rro wed cap i ta l s uc h a s, d eb e n t ur e s, p ub li c d ep o s it s, lo a n s, e tc.
3 ) Acco rd i ng to so u rce o f g en era t i o n :
i) I nt er na l so u rce s e . g. r eta i ned e ar ni n g s a nd d e p reci at io n fu nd s, e tc.
ii) E x ter n al so ur ce s e. g. d eb e nt ur es , lo a ns , e tc.
Ho we v er , fo r co n ve n ie nc e, t he d i ffe ren t so ur ce s o f fu nd s c an a lso b e c la s si fied i n to t he
fo llo wi n g :
a) S ec uri t y fi na nc i n g - f in a nc i n g t hr o u g h s h are s and d eb e n t ure s
b ) I n ter n al fi na nc i n g - f i na n ci n g t hr o u g h r e ta i ne d ear ni n g , d ep re ci at io n
c) Lo a n s fi na nc i n g - t hi s i ncl ud e s b o t h s ho r t t er m a nd lo n g ter m lo a ns
d ) I n ter n at io nal fi na n ci n g
e) O t her so urc es .
Q ue st io n : W rit e a no t e o n lo ng t er m so urc e s o f fi na n ce.
An sw er : T her e ar e d i f fer e nt so ur ce s o f fu nd s av ai lab le to me et lo n g ter m fi na n cia l ne ed s o f t he
b u si n es s. T he s e so ur c es ma y b e b r o ad l y cl as s i fie d in to s har e cap i ta l (b o t h eq ui t y a nd p re fer e nce) and
d eb t (i n cl ud i n g d eb e n t ur e s, lo n g t er m b o rro wi n g s o r o t h er d eb t i n str u me nt s). I n I nd ia, ma n y
co mp a ni es ha v e r ai sed l o n g te r m f i na n ce b y o fferi n g vario u s i n s tr u me n t s to p ub l ic li k e d eep d i s co u n t
b o nd s, ful l y co n ve r t ib le d eb e nt ur e s, etc . T he se ne w i n str u me nt s ha v e ch arac ter i st ic s o f b o t h eq u it y
and d eb t a nd it is d i f fi cu lt to ca te go r is e t h e m in to eq u it y a nd d eb t. D i ffere n t so urce s o f lo n g ter m
f i na nc e are :
1 ) O w ner s ' ca pit a l o r e qu it y ca p it a l :
A p ub l ic li mi t ed co mp a n y ma y rai se f u nd s fro m p ro mo ter s o r fro m t he i n v e st i n g p ub lic b y
wa y o f o wn er s c ap i tal o r eq ui t y cap it al b y i ss u i n g o rd i nar y eq ui t y s h ar es. Ord i n ar y s har e ho ld e rs ar e

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o wn er s o f t h e co mp a n y and t he y u nd er ta ke ri s k s o f b u si n es s. T he y e l ect t he d irec to r s to ru n the


co mp a n y a nd ha ve t h e o p ti mu m co nt r o l o v er t he ma na ge me nt o f t he co m p an y. Si nc e eq u it y s h are s c a n
b e p aid o ff o n l y i n t he ev e nt i n liq u id a tio n, t h i s so urc e ha s t he le as t r i s k i n vo l ved , a nd mo re d ue to
th e fac t t ha t t he eq u it y s har e ho ld er s c a n b e p ai d d iv id e nd s o n l y wh e n t her e are d i s trib u tab le p r o fit s.
Ho we v er, t he co st o f o r d i nar y s h ar e s is u s u all y t h e hi g h e st. T hi s is d ue to t he fac t t ha t s u c h
s har e ho ld er s e xp e ct a hi g her r a te o f r e t ur n o n t he ir i n ve s t me n ts co mp a red to o t her s up p l ier s o f lo n g
ter m fu nd s. T he d i v id e nd p a yab le o n s har e s i s an ap p ro p r ia tio n o f p r o fit s a nd no t a c h ar ge ag ai n st
p r o f it s, mea n i n g t hat i t h a s to b e p aid o nl y o ut o f p ro fi ts a fter ta x. Ord i n ar y s har e cap i ta l al so
p r o v id e s a s ec ur it y to o th er s up p li er s o f fu nd s. T h u s, a co mp a n y h a v in g s ub st a nt ial o rd i nar y s hare
cap i tal ma y fi nd i t ea si e r to r ai se f u nd s, i n vie w o f t he fa ct t h at t h e s h a re cap i ta l p ro v id e s a s ec ur it y
to o t he r s up p l ier s o f f u nd s. T h e Co mp a n ie s Act , 1 9 5 6 a nd SE BI G uid el i ne s fo r d i sclo s ur e a nd
in v e sto r s ' p ro tec tio n s a nd t h e c lar i f ic at io ns t he reto l a ys d o wn a n u mb e r o f p ro v is io n s re ga rd i n g t h e
is s ue a nd ma n a ge me n t o f eq ui t y s har e cap it a l.
Adv a nta g e s o f ra i s ing f un d s by i s s ue o f eq ui ty s ha re s a re :
i) I t i s a p er ma n e nt so ur ce o f f i na nc e.
ii) T h e i s s ue o f ne w eq u it y s har es i ncr ea se s t he co mp a n y's fle xi b il it y.
iii ) T he co mp a n y ca n m ak e f ur t h er is s ue o f s har e cap ita l b y ma k i n g a r i g ht i s s ue.
iv ) T her e i s no ma nd a to r y p a y me n ts to s har e ho l d ers o f eq ui t y s har es .

2 ) Pref ere nc e s ha r e ca pit a l :


T h e se ar e sp ec i al ki nd o f s har e s, t he h o ld er s o f wh ic h e nj o y p rio ri t y i n b o t h, r ep a y me nt o f
cap i tal a t t he ti me o f wind i n g up o f t he co mp a n y a nd p a y me n t o f fi xe d d i vid e nd . Lo n g -t er m fu nd s
fr o m p re fere nc e s ha r e s can b e r a is ed t hr o u g h a p ub li c i ss u e o f s har es. S u c h s ha re s are no r mal l y
cu mu l a ti v e, i. e. t h e d i v id e nd p a yab le i n a ye ar o f lo s s ge t s carr ied o v er to t h e ne xt ti ll , t her e are
ad eq uat e p ro fi ts to p a y cu mu l at i ve d i v id e nd s. Rat e o f d i v id e nd o n p refere n ce s h are s i s no r ma ll y
hi g h er t ha n t he ra te o f i nt er e st o n d eb e nt u re s, l o an s, e tc. Mo st o f p re fe ren ce s h are s no w a d a ys carr y
a st ip ul at io n o f p er io d and t he f u nd s ha v e to b e rep a id a t t he e nd o f a stip u la ted p er io d . P re fere nce
s har e cap it al i s a h yb r i d fo r m o f f i na n ci n g t ha t p ar ta ke s so me c h arac t eri st ic s o f eq ui t y c ap i ta l a nd
so me a ttr ib ut es o f d eb t cap it al. I t is si mi l ar to eq u it y b e ca u se p re fere nce d i v id e nd , li ke e q ui t y
d iv id e nd i s no t a ta x d e d uc tib le p a y me n t. It re s e mb le s d eb t c ap it al a s t he ra te o f p r e fere n ce d i vid e nd
is f i xed . W he n p r e f er e n ce d i vid e nd i s s k ip p ed , it i s p a yab le i n fu t ure d ue to t he c u mu l a ti ve fe at ure
as so c iat ed wi t h mo st o f p r e fer e nce s h ar e s. C u mu l at i ve Co n v er t ib l e P refere n ce S har es ( C CP s ) ma y
al so b e o ffered , u nd er wh ic h t he s har e s wo u ld carr y a c u mu l at i ve d i v id e nd o f sp ec i fied l i mi t fo r a
p er io d o f sa y 3 ye ar s , af ter wh i c h t he s har es are co n v erted i n to eq u i t y s h are s. T he se s har es are
attr ac ti ve fo r p ro j ec t s w i t h a lo n g ge st at io n p erio d . Fo r no r ma l p re fer e nce s har e s, t he ma xi mu m
p er mi s sib le rat e o f d i v id end i s 1 4 %. P r e fer e nce s har e cap i tal ma y b e red ee med at a p red ecid ed fut u re
d ate o r at a n ear li er s t ag e i nt er ali a o u t o f t h e co mp a n y's p ro fi ts. T hi s e nab le s t he p ro mo t ers to
wi t h d ra w t hei r cap i ta l f r o m t h e co mp a n y wh ic h is no w se l f - s u ffi ci e nt, a nd t h e wi t hd ra wn cap ita l ma y
b e r e i n ve sted i n o t h er p r o f itab le ve nt u r e s. Irr e d ee mab le p r e fer e nce s h are s ca n n o t b e is s ued b y a n y
co mp a n y. P re fer e nce s h ar e s g ai ned i mp o r t a nce after t h e F i na nc e B il l 1 9 9 7 as d i vid e nd s b eca m e ta x
ex e mp t ed i n t he h a nd s o f t he i nd i vid u al i n v es to r and are ta x ab l e i n t he h and s o f t he co mp a n y a s ta x i s
i mp o s ed o n d i st rib ut ab l e p r o f it s a t a f la t r at e. T he B ud g et, fo r 2 0 0 0 - 0 1 ha s d o ub led t h e d i v id e n d ta x
fr o m 1 0 % to 2 0 % b e s i d es a s ur c h ar ge o f 1 0 % . T he b ud g et fo r 2 0 0 1 - 2 0 0 2 h as red uc ed t he d i vid e nd
ta x fro m 2 0 to 1 0 %. Ma n y co mp a n ie s fo llo wed t h i s ro u te d ur i n g 1 9 9 7 e sp ec ial l y t hro u g h p ri vat e
p lace me nt o r p re f er e nc e s har es a s t h e c ap it al ma rke t s w e re no t vib ra nt.
T he a dv a nta g e s o f t a ki ng t he pre f er en ce sha r e ca pita l a re a s fo l lo w s :
1 ) No d i l ut io n i n EP S o n e n lar g ed cap it al b as e : I f eq u it y i s i s s ued it r ed u ce s EP S , t h u s a ffec ti n g t he
ma r ket p erc ep t io n ab o u t t he co mp a n y.
2 ) T here i s l e vera g i n g a d va n ta ge a s i t b e ar s a fi xed c har g e.
3 ) T here i s no r is k o f t a keo v er .
4 ) T here i s no d il ut io n o f ma n a ger ia l co n tr o l .
5 ) P refere n ce c ap i tal ca n b e r ed e e med a ft er a sp eci fied p erio d .

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104
3 ) Reta i ne d Ea rn ing s : Lo n g ter m f u nd s ma y a lso b e p ro vid ed b y ac c u mu l at io n o f co mp a n y's p ro fit s
and o n p lo u g h i n g t he m b ack i nto b u si n es s. S uc h fu nd s b e lo n g to t h e o rd i nar y s hare ho ld er s and
in cr e as es t he co mp a n y 's ne t wo r t h. A p ub lic li mi ted co mp a n y mu s t p l o u g h b a c k a r ea so nab le a mo u n t
o f p ro fi t e ver y ye ar , k e ep i n g i n vie w t he le ga l req u ire me n t s i n t hi s re gard , a nd it s o wn e xp a n sio n
p la n s. S uc h fu nd s e n ta il al mo st no r i s k a nd t he p res e nt o wn er 's co ntro l is mai n ta i ned as t her e is no
d il ut io n o f co ntro l.
4 ) De be nt ure s o r bo nd s : Lo a n s c a n b e r a is ed fro m p ub l ic o n i s s ue o f d eb e nt ur es o r b o nd s b y p ub lic
li mi ted co mp a ni es. D eb en t ur e s ar e no r ma ll y i s s ued i n d i ffere n t d e no mi na tio n s ra n gi n g fro m R s . 1 0 0
to 1 0 0 0 a nd ca rr y d i f f er en t r a te s o f i n ter es t. O n is s ue o f d eb e n t ure s, a co mp a n y ca n rai se lo n g ter m
lo a n s fro m p ub lic . U s ua ll y, d eb e nt u r e s ar e i s s u ed o n t he b a si s o f a d e b en t ure tr u st d eed wh ic h li st s
ter ms a n d co nd it io ns o n wh i c h d eb e nt ur es a re flo ated . T h e y ar e n o r mal l y sec ur ed a g ai n s t t h e
co mp a n y's a s se t s. A s co mp a r ed wi t h p r e f ere nc e s har es , d eb e n t ure s p ro vid e a mo re co n v e ni e nt mo d e
o f lo n g t er m fu nd s. Co s t o f cap it al r ai sed t hro u g h d eb e nt ur es i s lo w a s th e i n ter es t c a n b e c h ar ged a s
an e xp e ns e b e fo r e ta x. Fr o m t he i n ve sto r s ' v ie w p o i nt, d eb e nt ur es o ffer a mo r e at trac ti v e p r o sp ec t
th a n p re fer e nce s har es a s i nt er e st o n d eb e nt ure s is p a ya b le wh et h er o r no t t he co mp a n y ma k e s p r o fit s.
Deb e n t ure s are t h us , i n s tr u me n ts fo r r ai si n g lo n g t er m d eb t cap i ta l. S ec ured d eb e nt ur e s are p ro t ected
b y a c har g e o n t he co mp a n y 's as se t s. W hi le t he sec ur ed d eb e n t ure s o f a we l l -e st ab l is h ed c o mp a n y
ma y b e a ttr act i ve to i n ve s to r s , se c ur ed d eb e n t ure s o f a n e w co mp a n y d o no t no r ma l l y e vo ke sa me
in ter es t i n t h e i n v es ti n g p ub lic.
Adv a nta g e s :
1 ) Th e co s t o f d eb e n t ur e s i s mu c h lo we r t ha n t he co st o f p r e fere n ce o r eq ui t y cap it al a s t he i n ter e st is
ta x -d ed u ct ib le . A l so , in v e sto r s co ns id er d eb en t ure i n v es t me n t sa fer t h a n eq u it y o r p r e fer red
in v e st me n t a nd t h u s, ma y r eq uir e a lo we r r e t ur n o n d eb e nt ur e i n v es t me n t .
2 ) Deb e n t ure fi na n ci n g d o es no t r e s u lt i n d i l ut i o n o f co ntro l.
3 ) I n a p er io d o f r i si n g p r ice s, d eb e n t ur e i s s ue is ad va n ta geo u s. T he fi xed mo ne tar y o ut go d ec rea se s
in r ea l ter ms a s t he p r ic e le v el i ncr ea se s.
Di sa dv a nta g es o f d eb en t ure f i na nci ng a re a s b elo w :
1 ) Deb e n t ure i nt er e st a n d cap i ta l r ep a y me n t are o b li ga to r y p a y me n t s.
2 ) T he p r o tec ti v e co ve n an t s a s so ci at ed wi t h a d eb e nt ur e i s s ue ma y b e r es tric ti v e.
3 ) Deb e n t ure s fi na n ci n g en h a nce s t he f i na n cia l r is k a sso cia ted wi t h t he fir m.
T he se d a ys ma n y co mp a n ie s ar e i s s u i n g co n ver tib le d eb e n t ure s o r b o nd s wi t h a n u mb er o f
sc he me s/ i nce n ti v es li ke war r a n ts /o p t io n s, et c. Th es e b o nd s o r d eb e nt ure s ar e e xc ha n g eab le at t he
o r d i nar y s h are ho ld e r 's o p tio n u nd er sp eci fied ter ms a nd co nd i tio n s. T h u s, fo r t he fir s t fe w ye ar s
th e se s ec ur it ie s r e ma i n as d eb e n t ur e s a nd l ate r th e y ca n b e co n ver ted in to eq ui t y s ha re s at a p re d eter mi n ed co n v er sio n p r ice. T h e i s s ue o f co n ver tib le d eb e nt ur es h as d is ti nc t ad va n ta g es fro m t h e
vi e w p o i nt o f t h e i s s ui n g c o mp a n y.
- s uc h a s i ss u e e nab le s th e ma na g e me n t to rai s e eq u it y c ap i tal i nd ir ect l y wi t ho ut d i l ut i n g t he eq u it y
ho l d i n g, u n ti l t h e c ap i ta l r a is ed star t s e ar ni n g a n a d d ed re t ur n to s up p o r t ad d i tio n al s h are s.
- s uc h s ec ur iti e s ca n b e is s ued e ve n wh e n t he eq ui t y ma r ke t i s no t ver y go o d .
- co n ver tib le b o nd s ar e no r ma ll y u n s ec ur ed a n d , t h u s, t he ir i ss u a nce ma y o rd i nari l y no t i mp air t he
b o r r o wi n g cap a ci t y.
T h es e d eb e nt ur es /b o nd s ar e i ss u ed s ub j ect to t h e SE BI g uid el i n es no ti fied fro m t i me to ti me .
P ub l ic i ss u e o f d eb e n t ur es a nd p r i vat e p lac e me n t to mu t u al fu n d s, req u i re t h at t he i s s ue b e ra te d b y a
cr ed i t ra ti n g a ge n c y as C RI SI L ( Cr ed it R at i n g a nd I n fo r ma t io n Ser v i ces o f I nd ia Ltd . ). T h e cred it
r ati n g i s g i ve n a fter e v al ua ti n g f ac to r s a s t rac k r eco rd o f t he co mp a n y, p r o fi tab i li t y, d eb t se rv ice
cap ac it y, cred it wo r t hi n es s a nd t he p er c ei ved ri s k o f le nd i n g.
5 ) Lo a n s fro m f i na nci a l in st it u t io ns : I n I nd i a sp ec ia li sed i n s ti t ut io n s p ro vid e lo n g - ter m fi n an cia l
as si s ta nc e to i nd u str ie s. So me o f t he m are , Ind u st ria l Fi na n ce C o rp o ratio n s, Li fe I n s u ran ce

CA- IPCC- Financial Management`

Co r p o ra tio n o f I nd i a, Natio n al S mal l I nd u str ie s Co rp o rat io n Li mi ted , Ind u s tria l C red it a nd


I n ve s t me n t Co rp o r a tio n , I nd us tr i al De v elo p m en t Ba n k o f I nd ia a n d I nd us tri al Reco n st r uc tio n
Co r p o ra tio n o f I nd ia. Be fo r e sa n ct io ni n g o f a ter m lo a n, a co mp a n y h a s to sa ti s fy t he co n cer ned
f i na nc ia l i n st it u t io n r e gar d i n g t h e te c h nic al, co m merc ia l, eco no mi c, fi na n cia l a nd ma n a ger ia l
vi ab i li t y o f t he p r o j ec t fo r wh ic h t he lo a n i s re q ui red . S uc h lo a ns are av ai lab l e at d i ffer e nt ra te s o f
in ter es t u nd er d i f fer e nt sc h e me s o f f i na nc ial i n st it u tio n s a nd a re to b e rep a id as p er a s tip ul at ed
r ep a y me n t s c hed u le. T he lo a n s i n ma n y c as e s st ip ula te a n u mb er o f co nd it io n s a s re g ar d s t h e
ma n a ge me n t a nd cer ta i n o t he r f i na nc ia l p o li c ie s o f t h e co mp a n y. T er m lo a n s rep re se n t se cur ed
b o r r o wi n g s a nd ar e a n i mp o r t a nt so u r ce o f fu n d s fo r ne w p ro j ect s. T h e y ge n eral l y, car r y a r a te o f
in ter es t i ncl u s i ve o f i n te r es t t a x, d ep e nd i n g o n t he cred it rat i n g o f t he b o rro wer, t he p erc ei ved r is k o f
le nd i n g a nd co s t o f f u n d s a nd ge ne r al l y r ep a ya b le o v er a p er io d o f 6 to 1 0 ye ar s i n a n n u al, se mi an n u al o r q uar ter l y i n sta ll me n t s. Ter m lo a n s are al so p ro v id ed b y b a n k s, Sta te Fi n a nci al /D e velo p me n t
in s ti t ut io ns a nd a ll I nd i a ter m le nd i n g fi n a nc ial i ns ti t ut io n s. Ba n k s a nd St ate F i na nc ia l Co rp o r atio n s
p r o v id e ter m lo a n s to p r o j ects i n t he s ma ll s cal e s ect o r wh i le , fo r med i u m a nd l ar ge i nd us tri es ter m
lo a n s ar e p ro v id ed b y S tat e d e v elo p me n t al i n st i tu tio n s alo n e o r i n co n s o rti u m wi t h b a n k s a nd Sta te
f i na nc ia l co rp o ra tio n s. Fo r l ar ge sca le p r o j e ct s Al l I nd ia fi na n ci al i ns t it ut io n s p ro vid e b ul k o f ter m
f i na nc e s i n gl y o r i n co n so r t i u m wi t h o t h er s u ch i ns ti t ut io n s, S tat e le ve l i n st it u tio n s a nd /o r b an k s .
A fte r i nd ep e nd e nce , t he in st it u tio n al se t up i n Ind i a fo r t he p ro v is io n o f med i u m a nd lo n g t er m cred it
fo r i nd u s tr y ha s b ee n b r o ad e ned . T h e as s i sta nc e s a nct io ned a nd d is b ur sed b y t h es e sp eci a li sed
in s ti t ut io ns ha s i ncr e a s ed i mp r es s i ve l y o ver t he year s. A n u mb er o f sp e ci al is ed i n s ti t ut io n s ar e
es tab l i s hed o ve r t h e co u nt r y.
6 ) Lo a ns fro m co mme r cia l ba n ks : T h e p ri ma r y ro le o f t h e co m me rc ia l b a n k s i s to cat er to t he s ho rt
ter m req ui re me n t o f i n d u str y. Ho we v er , o f l a te, b a n k s ha v e st art ed ta k i n g a n i nter e st i n ter m
f i na nc i n g o f i nd u str ie s i n se v er a l wa ys , t ho u g h t he fo r ma l ter m le n d i n g i s, s ti ll, s mal l a nd co n fi n ed to
maj o r b a n ks . Te r ms l e n d in g s b y b a n k i s a co nt r o ver s ial i s s ue t he se d a y s. I t is ar g ued t h at ter m lo a n s
d o no t s at is fy t h e ca no n o f l iq uid it y t ha t i s a maj o r co n sid erat io n i n al l b an k o p er at io ns . Acco rd i n g to
tr ad i tio n al v al ue s, b a n k s s ho uld p r o v id e lo a n s o n l y fo r s ho rt p erio d s and o p era tio n s re s u lt i n g i n
au to ma ti c liq u id a tio n o f s uc h cr ed i ts o v er s ho r t p erio d s. O n t he o t h er ha nd , it i s co nt e nd ed t h at t h e
tr ad i tio n al co n cep t ne e d s mo d i f ica tio n . Th e p ro ceed s o f ter m lo a n a re u sed fo r wh a t ar e b ro ad l y
k no wn as fi xed a s se t s o r exp a ns io n i n p la nt c ap aci t y. T h eir rep a y me nt i s u s u al l y s c hed ul ed o ver a
lo n g p er io d o f t i me. T he l iq uid it y o f s uc h lo an s i s sa id to d ep e n d o n t he a nt ic ip at ed i nco me o f
b o r r o wer s.
W o r ki n g cap i t al l o a n is mo r e p er ma n en t a nd lo n g ter m a s c o mp a red to a ter m lo a n . T he
r ea so n b e i n g t hat a ter m lo a n i s a l wa ys r ep a yab l e o n a fi x ed d a te a nd u l ti ma te l y, t he acco u n t wi ll b e
to ta ll y ad j us ted . Ho we v er , i n c as e o f wo r k i n g cap i tal fi n a nce , t ho u g h p a yab le o n d e ma nd , i n act ua l
p r act ice it i s no t ic ed t h at t h e a cco u nt i s ne ve r ad j u st ed a s s uc h a nd i f at a ll t he p a y me n t i s as ked
b ac k, i t is wi t h a cl ear p ur p o se a nd i n te n tio n o f r e fi n a nce b ei n g p ro v id ed a t t h e b e g i n ni n g o f n e x t
ye ar o r hal f ye ar . T hi s te c h niq u e o f p r o vid i n g lo n g ter m fi na n ce i s k no wn a s, " ro l led o v er fo r
p er io d s e xc eed i n g mo r e t ha n o ne ye ar " . I n ste a d o f i nd ul g i n g i n ter m fi na nc i n g b y t h e ro l led o ve r
me t ho d , b a n k s ca n a nd s ho uld e x te nd cr ed i t te r m a fter a p ro p e r ap p ra is al o f ap p l ic at io ns fo r ter m
lo a n s. T h e d e gree o f liq uid it y i n t h e p r o v i sio n fo r re g ul ar a mo rt i sa tio n o f ter m lo a n s is mo r e t h an i n
so me o f t he se so ca ll ed d e ma nd lo a n s wh i c h ar e re ne wed fro m ye ar to y ear. Ac t ual l y, te r m fi na nc i n g,
d is cip li ne s b o t h t h e b a n ker a nd b o r r o wer a s l o n g te r m p la n n i n g i s req u ired to e n s ur e t hat cas h
in f lo ws wo u ld b e ad eq u ate to mee t t he i n st r u m en t s o f rep a y me n t s a nd al lo w a n ac ti ve t ur no v er o f
b an k lo a n s. T he ad o p t io n o f t h e fo r ma l ter m lo an le nd i n g b y co m me rci al b a n k s wi l l no t ha mp e r t he
cr it eri a o f liq u id it y, a nd wi ll i ntr o d u ce f le x ib i li t y i n t h e o p er at io ns o f t h e b a n ki n g s ys t e m.
T h e rea l l i mi ta t io n to t he sco p e o f b a n k a ct i vi tie s i s t ha t a ll b an k s a re no t we ll eq uip p ed to
ap p r ai se s uc h lo a n p r o p o sa ls . Ter m lo a n p ro p o s al s i n vo l ve a n ele me n t o f r is k b eca u se o f c ha n ge s i n
co nd it io n s a ffec ti n g t he b o r r o we r . T h e b a n k ma ki n g s uc h a lo a n, t h u s, ha s to as s es s t he s it u at i o n to
ma k e a p ro p er ap p r ai s al. T he d e ci sio n i n s u ch c as e s d ep e nd s o n var io u s fac to r s a ffec ti n g t h e
co n cer ned i nd u str y 's co n d itio n s a nd b o r r o wer 's ear ni n g p o te n ti al.
7 ) B ri dg e f ina nc e : I t r e fer s to lo a n s t a ke n b y a co mp a n y fro m co m me r cia l b a n k s fo r a s ho rt p erio d ,
p end i n g d i sb ur se me n t o f lo a n s sa nc tio n ed b y fi na n ci al i n st it u tio n s. No r mal l y, it t a ke s ti me fo r
f i na nc ia l i n s ti t ut io ns to d i sb ur se lo a n s to co m p an ie s. Ho we ver, lo a ns o n ce ap p ro ved b y t h e ter m
le nd i n g i n st i t u tio n s p e n d in g t h e si g n i n g o f re g ul ar ter m lo a n a gr ee me nt , t hat ma y b e d ela ye d d u e to
no n -co mp l ia nc e o f co nd itio n s st ip ul ated b y t he in s ti t ut io ns wh i le sa nc tio ni n g t he lo a n. T he b rid ge
lo a n s ar e rep aid /ad j u s te d o u t o f ter m lo a ns a s a nd wh e n d i sb ur sed b y t h e co nc er ned i n st it u tio n s. T he y
ar e sec ur ed b y h yp o t h e cat i n g mo vab le a s se ts , p erso n al g uar a nt ee s a n d d e ma nd p ro mi s so r y n o te s.
Ge ner al l y, t h e i n ter es t r ate o n t he m i s h i g her t h an o n te r m lo a ns .

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Q ue st io n : W ha t do y o u mea n by Ve nt ur e Ca pita l F ina nc i ng ?


An sw er : Ve nt u r e cap i tal f i na nc i n g r e f er s to fi na nc i n g o f ne w h i g h r is k y v e nt ure p ro mo t ed b y
q ua li fied e ntrep re ne ur s lac k i n g e xp er ie n ce a nd fu nd s to g i ve s hap e to th eir id e as . U nd er it ve nt u re
cap i tal i st ma ke i n v es t m en t to p ur c h a se eq ui t y o r d eb t s ec ur it i e s fro m i ne xp erie n ced e ntr ep re ne ur s
u nd er ta k i n g hi g h l y r i s k y ve n t ur e s wi t h a p o t e nt i al o f s ucc es s. T he ve n t u re cap ita l i nd u s tr y i n I n d ia i s
j us t a d e cad e o ld . T he ve n t ur e cap it al is t fi na n ce ve n t ure s t ha t a re i n na tio n al p rio r it y are as s uc h a s
en er g y co n ser va tio n, q u ali t y up g r ad a tio n, e tc. T he Go ver n me n t o f I nd ia in No ve mb er 1 9 8 8 is s ue d th e
f ir s t set o f g u id e li ne s f o r ve n t ur e c ap i ta l co mp an ie s, fu nd s a nd mad e t he m el i gib le fo r c ap i tal ga i n
co n ce s sio n s. I n 1 9 9 5 , c er ta i n n e w c la u se s a nd a me nd me n t s wer e mad e in t h e g uid e li n es t ha t req u ire
th e ve n t ure cap ita li s ts to me et t he r eq uir e me nt s o f d i ffere n t sta t uto r y b o d ie s a nd t h is ma ke s it
d i f fic u lt fo r t he m to o p e r ate a s t h e y d o no t ha ve mu c h fl e xib il it y i n st r u ct uri n g i n ve s t me n ts . I n 1 9 9 9 ,
th e e xi s ti n g g uid e li n e s we r e r e la xed fo r i n crea si n g t h e at trac ti v e ne s s o f t h e ve n t ure sc he me s and to
ind u ce hi g h net wo r t h i n ve s to r s to co m mi t t he ir fu nd s to 's u nri se ' sec to r s, p art ic u larl y t h e
in f o r ma tio n tec h n o lo g y se cto r . I ni tia ll y t he co nt rib u tio n to t h e fu nd s a vai lab le fo r ve n t u re cap i tal
in v e st me n t i n t h e co u nt r y wa s fr o m t he A ll I nd ia d e velo p me nt fi na nc ia l i n st it u tio n s, Sta te
d ev elo p me n t fi na n ci al i n st it u tio n s, co m me rci al b a n k s a nd co mp a nie s i n p ri va te s ec to r. Lat el y ma n y
o f f s ho re fu n d s h a ve b ee n star ted i n t h e co u nt r y a nd ma x i mu m c o nt rib u tio n is fro m fo rei g n
in s ti t ut io na l i n ve sto r s. A fe w ve nt u r e cap it a l co mp a n ie s o p era te a s b o t h i n v es t me n t a nd fu nd
ma n a ge me n t co mp a n ie s, o t her se t up f u nd s a nd fu n ct io n a s a s se t ma n a ge me n t co mp a n y. It i s ho p ed
th at c ha n ge s i n t he g ui d eli n es f o r i mp le me n ta t io n o f ve nt u re c ap i tal s ch e me s i n t he co u ntr y wo u ld
en co ura ge mo re f u nd s t o b e se t up to g i ve t he req u ired mo me n t u m fo r ve n t ure cap it al i n ve s t m en t i n
I nd ia. So me co m mo n me tho d s o f ve n t ur e c ap i ta l fi na nc i n g ar e :
1 ) Eq uity f ina nc ing : T he ve n t ur e cap it al u nd er ta ki n g s us u al l y r eq uir e fu nd s fo r a lo n g er p er io d b ut,
ma y n o t b e ab le to p r o vid e r e t ur n s to i n ve s to r s d ur i n g t h e i n it ial s ta g es. T h us , t h e ve n t ure c ap it al
f i na nc e i s g e nera ll y p r o vi d ed b y wa y o f eq u i t y s har e cap ita l. T he e q ui t y co n trib u t io n o f v en t ure
cap i tal fir m d o es no t e x ceed 4 9 % o f t h e to ta l eq u it y cap i ta l o f ve n t ur e cap ita l u nd er ta k i n gs s o t hat
th e e ffec ti ve co nt r o l a n d o wn er s hip r e ma i n s wi t h t he e n trep r e ne ur.
2 ) Co nd itio na l lo a n : I t i s r ep a ya b le i n t h e fo r m o f a ro ya lt y a fter t h e ve n t ure i s ab le to g e n erat e
sa le s. No i n ter es t i s p a id o n s uc h lo a n s. I n I n d ia ve n t ure cap it al fi na nc er s c ha r ge ro ya l t y ra n gi n g
b et we e n 2 a nd 1 5 % , a ct ua l r at e d ep e nd s o n o th er fac to r s o f t he ve n t ure as ge s ta tio n p er io d , cas h
f lo w p at ter n s, r is k i ne s s an d o t he r fac to r s o f t he e nt erp ri se . So me ve nt u re c ap i ta l fi n a ncer s gi v e a
cho ice to t he e n ter p r is e o f p a yi n g a h i g h rat e o f i n ter es t, wh i c h ca n b e wel l b elo w 2 0 %, i n s t ead o f
r o ya lt y o n sal es o nce it b eco me s co m mer c ia ll y s o u nd s.
3 ) I nco me no t e : I t i s a h yb r id sec ur it y co m b in i n g fea t ure s o f b o t h co n ve nt io na l a nd co nd itio n al
lo a n. T h e e nt rep r e n e ur ha s to p a y i n ter es t a nd r o ya lt y o n sa le s b u t, a t s ub st a nt ial l y lo w ra te s. I DB I 's
Ve nt ur e Cap it al F u nd ( VC F) p r o vid e s f u nd i n g eq u al to 8 0 - 8 7 .5 % o f th e p ro j ec t co s t fo r co m me rci al
ap p li cat io n o f i nd i g e no u s t ec h no lo g y.
4 ) Pa rti ci pa ti ng de be n t ure s : S uc h se c uri t y c arrie s c h ar ge s i n 3 p h a se s - i n t he st art up p h ase no
in ter es t i s c ha r ged , ne x t sta g e - a lo w r at e o f i n tere st i s c har ged up to a p arti c ular le ve l o f o p er atio n
and a ft er t h at, a h i g h r a t e o f i n ter e s t i s r eq uir ed to b e p a id .
Q ue stio n : Wr ite a no t e o n De bt Sec ur it isa t io n ?
An sw er : Deb t s ec ur iti s atio n i s a me t ho d o f re c yc li n g o f fu nd s. I t i s es p ecia ll y b e ne fici al to fi na n cia l
in ter med i ari es to s up p o r t t he l e nd i n g vo l u me s . As se ts ge n era ti n g ste a d y ca s h flo ws are p ac k ag ed
to g et h er a nd a g ai n st t h is as se t p o o l mar ke t se cur it ie s c a n b e i s s ued . Th e b a sic d eb t se c uri ti sa tio n
p r o ce ss ca n b e c la ss i fi e d i n t h e fo l lo wi n g 3 fu n ctio n s :
1 ) Th e O rig i na t io n f u nct i o n : A b o r r o wer s ee ks a lo a n fro m a fi n an ce co mp a n y, b a n k, h o u si n g
co mp a n y o r a le a se fr o m a l ea si n g co mp a n y. T he cred it wo rt h i ne s s o f t he b o rro we r i s e v al u ate d and a
co n tra ct is e nt ered i nto wi t h r ep a y me n t s c hed ul e s tr uc t ured o v er t h e l i fe o f t h e lo a n.
2 ) Th e Po o li ng f u nc t io n : Si mi l ar lo a n s o r rec ei vab le s are cl ub b ed to ge t her to cr eat e a n u nd e rl yi n g
p o o l o f a ss et s. T hi s p o o l i s tr a ns f er r ed i n fa vo u r o f a SP V ( Sp e cia l P ur p o se Ve h ic le), wh i c h ac ts a s a
tr us tee fo r t h e i n v e sto r . O nce t he as s et s ar e tr a n s fer r ed , t he y ar e he ld i n t he o r i gi n ato r s ' p o rt fo li o .
3 ) Th e Se cu rit isa t io n f un ct io n : I t i s t he SP V 's j o b no w to str u ct ure a nd i s s ue t he se c uri tie s o n t he
b as is o f t he as se t p o o l . Th e s ec ur it ie s carr y a co up o n a nd a n e xp ec ted ma t ur it y wh ic h ca n b e as se t

CA- IPCC- Financial Management`

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b ased o r mo r t ga ge b a s ed . T he se ar e ge ner al l y so ld to i n ve s to rs t hr o u g h me rc ha n t b a n ker s . T he


in v e sto r s i nt ere st ed i n t hi s t yp e o f se c ur i ti es ar e ge ner al l y i ns ti t ut io na l i n ve sto rs l i ke mu t ua l fu nd s,
in s ur a nce co mp a ni es , et c. Th e o r i g i nato r u s ua ll y keep s t h e sp r ead a va i lab l e i.e . d i ffer e nce b e t we e n
yi eld fro m s ec ured a s se ts a nd i nt er e st p a id to in v e sto r s. T he p ro ce s s o f s ec uri ti s at io n i s ge n eral l y
wi t h o ut r eco ur se i.e. t h e i n ve s to r b ea r s t he cre d it r is k o r r is k o f d e fa ul t a nd t he i s s uer i s u n d er a n
o b li ga tio n to p a y to i n v es to r s o nl y i f t he ca s h flo ws a re r ece i ved b y hi m fro m t he co l la tera l. T he ri s k
r u n b y t he i n v es to r ca n b e f ur t her r ed uc ed t hro u g h cred it e n h a nce me n t faci li tie s a s i n s ura n ce, le tter s
o f cred it a nd g uar a n te es . I n a si mp le p a s s t hro u g h s tr uc t ure, t h e i n ve sto r o wn s a p ro p o rt io nat e s har e
o f t he a ss et p o o l a nd c a s h f lo ws wh e n ge ner ate d are p a ss ed o n d ire ct l y to t he i n ve sto r . T h is i s d o n e
b y i ss u i n g p as s t hr o u g h cer t i fi cat e s. I n mo rt g a ge o r a s se t b a c ked b o nd s, th e i n ve sto r ha s a lie n o n t he
u nd er l yi n g a s se t p o o l. Th e SP V ac c u mu l ate s p a yme n t s fro m b o rro we r s fro m ti me to ti me a n d ma ke
p a yme n t s to i n v es to r s a t r e g ular p r ed et er mi n ed in ter va l s. T he SP V c a n in ve s t t he fu nd s rece i v ed in
s ho r t ter m i n st r u me n ts a nd i mp r o ve yi e ld wh e n t her e i s a t i me la g b et we en rec eip t a nd p a y me n t.
Be nef it s to t he O rig i na t o r :
1 ) Th e a s set s are s hi f te d o f f t he b ala n ce s hee t, t h us, gi v i n g t he o ri g i n ato r re co ur se to o ff b a l an ce
s hee t fu nd i n g.
2 ) I t co n v ert s il liq u id a s se ts to liq u id p o r t fo lio .
3 ) It fa ci li ta te s b et ter b ala nce s he et ma n a g e me nt a s a s set s ar e t ran s ferred o ff b al a nce sh ee t
fa ci li ta ti n g sa ti s fa ct io n o f cap i ta l ad eq uac y no r ms .
4 ) T he o r i gi na to r 's cr ed i t r a ti n g e n ha nc es.
Fo r t he i n ve sto r, sec u r iti s at io n o p e n s up ne w i n ve st me nt a ve n u e s. T ho u g h t he i n ve s to r b e a r s t he
cr ed i t ri s k. T he sec ur it i es a r e t ied up to d e fi ni t e as s et s. A s co mp ared t o fa cto r i n g o r b i ll d i sco u nt i n g
wh ic h l ar ge l y so l v e t he p r o b le ms o f s ho r t ter m tr ad e fi na n ci n g. S ec ur it is at io n he lp s to co n ver t a
str ea m o f c as h rec ei vab l es i nto a so ur ce o f lo n g ter m fi na n ce. Fo r a d e v elo p ed s ec uri ti s at io n ma rke t,
hi g h q u al it y a s se ts wi t h lo w d e fa u lt r ate are es se n tia l wi t h st a nd ard i sed lo a n d o c u me n ta tio n and
st ab le i n ter es t r ate str u ct ur e a nd s u f f ic ie nt d a ta o n a s set p er fo r ma n c e, d e v elo p ed seco nd ar y d eb t
ma r ke t s are es s e nt ial fo r t hi s. I n I nd i a n co n te x t d eb t se c uri ti sa tio n ha s b eg a n to ta k e o ff. T he i d eal
ca nd id a te s fo r t hi s ar e hi r e p ur c ha se a nd l ea si n g co mp a n ie s, a s set fi n an ce a nd rea l es ta te fi na n ce
co mp a ni es . I CI CI , H DF C, Ci tib a n k, Ba n k o f A me ric a, e tc. ha v e o r ar e p la n n i n g to ra i se f u n d s b y
sec u rit i sa tio n.
Q ue st io n : E xp la i n br ie f ly t he t e r m Lea se F i na nci ng ?
An sw er : Lea si n g i s a ge n er a l co n tr a ct b et wee n t he o wn e r a nd u ser o f t he a s set o ver a sp ec i fied
p er io d o f ti me . T h e a s se t i s p ur c h a sed i ni tia ll y b y t he le sso r (l ea si n g c o mp a n y) a nd t here a ft er lea sed
to t he u s er (l es se e co m p an y) t ha t p a ys a sp e ci fied re n t a t p er io d i cal i nt er va ls . T h u s, l ea si n g is a n
alt er na ti ve to t he p ur c h ase o f a n a s se t o ut o f o wn o r b o rro wed fu nd s. Mo reo ver, l ea se fi na n ci n g ca n
b e arra n ged mu c h fa st er as co mp ar ed to ter m lo a n s fro m fi n a nci al in st it u tio n s. I n rece n t year s,
lea si n g ha s b e co me a p o p u lar so u r ce o f fi n a nci n g i n I nd ia. F ro m t he le s see 's v ie w p o i nt, l ea si n g ha s
th e at trac tio n o f el i mi na ti n g i m me d i ate c as h o u t fl o w a nd t he le as e re nt al s ca n b e d ed u ct ed fo r
co mp u ti n g t he to t al i nc o me u n d er t h e I nco me t ax act . A s a g ai n st t hi s, b u yi n g ha s t he ad va n ta g es o f
d ep r ec iat io n all o wa n ce in cl u s i ve o f ad d i tio n al d ep rec iat io n a nd i n ter e st o n b o rro wed cap i ta l b ei n g
ta x d ed u ct ib le . T h u s, a n ev al u at io n o f t he 2 al te rna ti v es i s to b e ma d e i n o rd er to ta k e a d ec is io n.

Q ue st io n : E xp la i n t he v a rio us so ur ce s o f s ho r t ter m fi na nc e ?
An sw er : Fo llo wi n g ar e th e var io u s so ur ce s o f s ho r t t er m fi na nc e :

1 ) T ra d e cr ed it : I t r ep r es e nt s cr ed i t gr a n ted b y s up p l ier s o f go o d s , e t c. a s a n i nc id e n t o f sa le . T he
u s ua l d ur at io n o f s uc h cr ed i t i s 1 5 to 9 0 d a ys. It ge n erat e s a uto ma ti ca ll y, i n t h e co ur se o f b u si n es s
and i s co m mo n to a l mo s t a ll b u s i ne ss o p era tio n s. I t c a n b e i n t he fo r m o f a n 'o p e n a cco u n t ' o r 'b i ll s
p a yab le '. Trad e cr ed i t i s p r e fer r ed as a so u rce o f fi n a nce a s it i s wi t ho ut a n y e xp li cit co s t and till a
b u si n es s i s a go i n g co n c er n , i t ke ep s o n r o tat i n g . It al so , e n ha nc es a uto ma ti ca ll y wi t h t he i ncre ase i n
th e vo l u me o f b u s i ne s s.

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108
2 ) A dv a n ce s fro m c ust o mer s : M a n u fac t urer s
co s tl y go o d s i n vo l vi n g co n s id er ab le le n g t h o f
ad v a nce mo ne y fr o m t he ir c u sto me r s a t t he
co n tra ct s o r s up p l yi n g t he g o o d s. T hi s i s a co s t

and co nt rac to r s e n g a ged i n p ro d u ci n g o r co n str uc ti n g


ma n u fac t uri n g o r co n s tr uc tio n t i me u s u al l y, d e ma nd
ti me o f ac cep ti n g t h e i r o rd ers fo r e xec u ti n g the ir
fre e so urc e o f fi na nce a nd r eal l y u se fu l.

3 ) Ba n k a dv a nce s : B a n k s r e cei v e d ep o si t s fr o m p ub lic fo r d i ffere n t p erio d s at v ar yi n g r at es o f


in ter es t t her e are f u nd s in ve s ted a nd le n t i n s u ch a ma n n er t ha t wh e n req u ired , t he y ma y b e c all ed
b ac k. Le nd i n g r e s u lt s i n gr o s s r e ve n ue s o ut o f wh i c h co s ts , s uc h as i n tere s t o n d e p o si t s,
ad mi ni s tra ti ve co st s, e t c. ar e me t a nd a re aso nab le p ro fit i s mad e . A b an k 's le nd i n g p o l ic y is no t
me r el y p ro fit mo t i va ted b ut ha s to keep i n mi n d th e so c io -e co no mi c d e ve lo p me nt o f t he co u n tr y. As a
p r ud e n t p o lic y, b a n k s n o r mal l y sp r ead o u t t heir fu nd s as u nd er :
i) Ab o u t 9 - 1 0 % i n c a s h.
ii) Ab o ut 3 2 % i n ap p r o ved go ver n me n t a nd s e m i - go ver n me n t se c u ri tie s.
iii ) Ab o u t 5 8 % i n ad va nc es to t he ir cr ed i ts.
Ba n k s ad va nc es a r e i n t h e fo r m o f lo a n, o v erd ra ft, ca s h cred it a nd b ill s
p ur c h a sed /d i sco u nt ed , e tc. B a n ks d o no t sa n c tio n ad va nc es o n lo n g ter m b a si s b e yo nd a s ma ll
p r o p o rtio n o f t he i r d e m and a nd t i me liab il it ie s. Ad va n ce s are gra n ted a ga i n st t a n gib le s ec uri ti e s s uc h
as go o d s, s hare s, go ver n me n t p r o mi s so r y no te s , b il l s, etc . I n r are ca se s, cle a n ad v a nce s ma y a lso b e
allo wed .
a ) Lo a n s : I n a lo a n acc o u n t, t he e nt ir e ad va nc e i s d isb ur s ed a t o ne t i m e i n ca s h o r b y tra n s fer to t h e
cur r e nt a cco u n t o f t he b o r r o wer . I t i s a si n g le a d va n ce, e x cep t b y wa y o f i n ter es t a nd o t h er c h arg e s,
no fu rt he r ad j u st me n t s ar e mad e i n t h is a cc o u n t. Lo a n a cco u n ts a re no t r u n ni n g ac co u nt s li ke
o ver d ra ft a nd ca s h cr ed i t acco u n t s, r ep a y me n t u nd er t he lo a n a cco u n t, ma y b e ful l a mo u n t s o r b y wa y
o f sc hed u le o f r ep a y me nt s a gr eed up o n a s i n cas e o f ter ms lo a n s. T he se c uri tie s ma y b e s har e s,
go ver n me nt s ec ur it ie s, l i fe i ns ur a nce p o l ici es a n d fi xed d ep o s it rec eip ts and so o n.
b) O v er dra ft s : U nd er th i s f aci li t y, c us to me rs are a llo wed to wi t hd ra w i n e xc e ss o f cred i t b ala nc e
st a nd i n g i n t he ir c ur r e n t d ep o si t a cco u nt. A fi x e d li mi t i s t h us, gr a nt ed to t he b o rro wer wi t hi n wh ic h
th e b o rro we r is a llo we d to o ver d r a w hi s acc o u nt . Op e n i n g o f a n o ve rd ra ft ac co u nt req u ire s th at a
cur r e nt acco u n t is f o r ma ll y o p e ned . A lt ho u g h o ve rd ra fts are r ep a y ab le o n d e ma nd , t he y u s ua ll y
co n ti n u e fo r lo n g p er io d s b y a n n ual r e ne wa l s o f l i mi t s. T hi s i s a co n ve n ie n t arra n g e me n t fo r th e
b o r r o wer, a s h e i s i n a p o si tio n to a va il t he s an ct io ned l i mi t a s p e r hi s r eq uir e me n ts. I nter e st is
ch ar ged o n d ai l y b a la n c es, c heq ue b o o k s ar e p r o vi d ed , t he se acco u n t s b ei n g o p er at i ve as ca s h cred i t
and c ur re nt a cco u n ts . Sec ur it y, as i n ca se o f lo a n acco u n t s, ma y b e s hare s, d eb e nt ur es and
go ver n me nt s ec ur it ie s, l i fe i ns u r a nc e p o l ic ie s a nd fi xed d ep o si t re ce ip t s a re a l so a ccep ted i n s p ecia l
cas e s.
c) Clea n o v er dra f t s : R eq u es t fo r s u c h f aci li t y is e n ter tai n ed o n l y fro m fi n a nci al l y so u nd p ar ti e s t ha t
ar e rep ut ed fo r t he ir i n t egr it y. B a n k i s to re l y o n p er so na l s ec ur it y o f th e b o rro we rs , t h u s, i t ha s to
ex er c is e a go o d d ea l o f r es tr a i nt i n e n ter ta i ni n g s uc h p ro p o s al s, as t he y h a ve no b ac k i n g o f a n y
ta n gib le se c uri t y. I n c a s e p ar t ie s ar e a lr ead y e nj o yi n g s ec ured ad va nc e faci li tie s, t hi s ma y b e a p o i nt
in f a vo ur a nd ma y b e t a ke n i nto a cco u nt wh i le s cree n i n g s uc h p ro p o sa l s . Th e t ur no ver i n t he a c co u n t,
sa ti s fa cto r y d e ali n g s fo r co n sid er ab le p er io d a n d rep u tat io n i n t h e mar k et are a l so co ns id er ed b y t h e
b an k . A s a s a fe g u ar d , b a n k s t a ke g u ar a n tee s fro m o t her p er so ns wh o are cred i t wo rt h y b e fo re gr an ti n g
th i s fac il it y. A cl ea n ad va n ce i s ge ner al l y gra nt ed fo r a s ho rt p erio d a n d mu st no t b e co nt i n ue d fo r
lo n g .
d) Ca s h cr ed it s : Ca s h cr ed i t i s a n ar r a n ge me nt u nd er wh i c h, a c u s to me r is al lo we d a n ad v a nce up t o
cer t ai n l i mi t a ga i ns t cr e d it gr a n ted b y b a n k. U n d er it, a c u s to mer ne ed no t b o rro w, t h e e nt ire a mo u n t
o f ad v a nce at o n e t i me. He c a n o nl y d r a w to t he e xt e nt o f h i s req ui re me n t s a nd d ep o s it h i s s urp l us
f u nd s i n h i s acco u n t. I nt er e st is no t c ha r ged o n t he ful l a mo u nt o f ad v a nce b ut , o n t he a mo u n t
act ua ll y a vai led b y hi m. Us ua ll y, cr ed i t l i mi t s a re sa n ct io ned a ga i n st t h e sec u ri t y o f go o d s b y wa y o f
p led ge o r h yp o t he cat io n, t ho u g h t h e y ar e rep a yab le o n d e ma nd , b a n k s u s ual l y d o no t rec al l t he m,
u nl e ss t h e y ar e co mp el led to d o so b y ad ver s e fac to r s. H yp o t h eca tio n i s a n eq ui tab le c har g e o n
mo vab le go o d s fo r a n a mo u n t o f d eb t wh e re n eit h er p o ss es s io n no r o wn er s hip i s p a s sed o n t o t he
cr ed i to r. Fo r p led ge, t h e b o r r o we r d e li ve rs t he g o o d s to t h e cr ed i to r as se c uri t y fo r r ep a y me nt o f

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d eb t. S i nc e t he b a n k er , as cr ed i to r , i s i n p o s se s sio n o f t h e go o d s, he i s ful l y s ec ured a nd i n c ase o f


e mer ge n c y h e ma y f al l b ac k o n t h e go o d s fo r r eal is at io n o f h is ad v a nc e u nd er p ro p e r no tic e t o the
b o r r o wer.
e) Adv a nc es a g a i n st g o o ds : Ad v a nce s a ga i ns t go o d s o cc up y a n i mp o r t an t p la ce i n to t al b a n k c red it ,
go o d s a s se c uri t y ha v e c er ta i n d i s ti nc t ad v a nt a ge s :
- t he y p ro v id e a r e li ab le so ur c e o f r ep a y me n t
- ad va nc es a ga i ns t go o d s ar e sa fe a nd l iq uid
Ge n era ll y, go o d s ar e c h ar ged to t he b a n k b y wa y o f p led g e o r h yp o t h eca tio n . T h e ter m
'go o d s ' i nc l ud e s al l fo r ms o f mo vab le s t ha t are o ffered to t he b a n k a s s ec ur it y. T h e y m a y b e
agr ic u lt ur al co m mo d i ti e s, i nd us tr i al r a w ma ter ial s, p art l y fi ni s h ed go o d s a nd so o n. R BI is s ue s
d ir ec ti v es fro m t i me to ti me i mp o s i n g r es tri ct io n s o n ad va nc es a g ai n st ce rta i n co m mo d it ie s. It is
o b li ga to r y o n b a n k s to f o llo w t he s e d ir ect i ve s i n let ter a nd sp ir it, t he y ma y so met i me s, al so st i p ul at e
ch a n ge s i n mar g i n.
f ) B il l s pu rc ha s ed / di sc o unt ed : T he se ad va nc es are al lo we d a g ai n st t he s ec ur it y o f b i ll s t ha t ma y b e
clea n o r d o c u me n tar y. Bi ll s ar e so me ti me s , p urc h a sed fro m ap p ro ve d cu sto me r, i n wh o se fa vo u r
li mi t s ar e sa nc tio n ed . B efo r e gr a n ti n g a li mi t, t he b a n ker sa ti s fie s h i ms el f a s to t h e cr ed i t wo r t h in e ss
o f t he d ra wer. Al t ho u g h t h e t er m 'b il ls p ur c ha sed ' g i ve s t h e i mp r e ss i o n t h at t he b a n k b eco m es t he
o wn er o r p urc ha s er o f s uc h b i ll s, i n r eal it y, t h e b an k ho ld s t he b il l s a s s ec uri t y o n l y, fo r t he ad v an ce.
I n ad d it io n to t he r i g ht s aga i n st t h e p ar t ie s li ab l e o n t h e b il ls , t he b a n k s can a l so e xerc i se a p l e d ge e 's
r i g ht s o ver t he go o d s co ver ed b y t he d o c u me nt s. Us u a nce b i ll s ma t ur i n g at a fut ur e d a te o r s i g h t are
d is co u nted b y t h e b a n k s fo r ap p r o ved p ar ti es . W he n a b il l i s d i sco u nt ed , t he b o rro we r i s p ai d th e
p r es e nt wo r t h. T he b a n k er s, ho we ver , co l lec t t he ful l a mo u n ts o n ma t uri t y, t h e d i ffe re nc e b et wee n t h e
2 i.e. t he a mo u nt o f t h e b ill a nd t he d i sco u n ted a mo u n t rep r es e nt s ear n i n g s o f b a n ker s fo r t he p erio d ;
it is ter med a s 'd i sco u n t '. So met i me s, o v erd ra ft o r ca s h cr ed i t l i mi t s are allo wed a ga i ns t t h e sec ur it y
o f b il l s. A s u it ab l e mar gi n i s u s ua ll y mai n ta i ne d . Her e t h e b i ll i s no t a p ri mar y s ec ur it y b u t, o nl y a
co ll ate ral o n e. I n s u c h c ase , t he b a n k er d o e s no t b eco me a p a r t y to t he b ill , b u t mer el y co ll ect s it a s
an a ge n t fo r it s c u sto me r . W he n a b a n ker p urc h ase s o r d i sco u n t s a b il l, h e ad v a nce s a gai n s t t h e b i ll,
he t h us , h a s to b e ver y ca ut io us a nd gr a nt s uc h fa ci li tie s o nl y to cred it wo rt h y c u s to mer s, ha v i n g a n
es tab l i s he d st ead y r ela ti o n s hip wi t h t he b a n k . Cr ed it rep o rt s are al so co mp lied o n t h e d ra wee s.
g ) Adv a nce a g a in st do c u me n t s o f t it le t o g o o d s : A d o c u me n t b e co me s o f d o c u me n t o f t it le to go o d s
wh e n i ts p o s se s sio n i s r eco g ni sed b y l a w o r b u si ne s s c u sto m as p o s se ss io n o f t he go o d s. The se
d o cu me n t s i nc l ud e a b ill o f lad i n g, d o c k wa r eho u se keep er 's cert i fi cate , ra il wa y rec eip t, e tc. A
p er so n i n p o s se s sio n o f a d o cu me nt to go o d s c an b y e nd o r s e me n t o r d eli v er y o r b o t h o f d o c u me n t,
en ab le s a no t her p er so n to t a ke d el i ver y o f t he go o d s i n h is r i g ht. A n a d va n ce a ga i ns t p led ge o f s u c h
d o cu me n t s i s eq ui v al e nt to a n ad va nc e a ga i n st t he p led g e o f go o d s t he m se l ve s.
h) A dv a nce a g a i n st su pp ly o f bi ll s : Ad va n ce s a g ai n st b il l s fo r s up p l y o f go o d s to go ver n me nt o r
se mi - g o ver n me n t d ep ar t me n t s a ga i ns t fir m o rd e rs a fter ac cep ta nc e o f te nd er fal l u nd er t h is cat e go r y.
Ot her t yp e o f b i ll s u n d er t h is ca te go r y are b ill s fro m co n trac to r s fo r wo r k e x ec u ted wh o ll y o r
p ar ti al l y u nd er fi r m co n tr ac ts e nte r ed i n to wi t h th e here i n me n tio n ed go ver n m e nt a ge nc ie s. T he s e are
clea n b i ll s, wi t ho ut b ei n g acco mp a ni ed b y a n y d o cu me n t o f t it le o f go o d s. B u t, t he y e v id e n ce s u p p l y
o f go o d s d ire ct l y to G o ver n me nt al a g e nc ie s. Th e y ma y, so me ti me s , b e acco mp a nied b y i ns p ect io n
no t e s fro m rep r es e nta ti v es o f go ver n me nt a ge n c ie s fo r i n sp ec ti n g t h e g o o d s b e fo re d e sp at c h. I f b il l s
ar e wi t ho u t i n sp e ct io n r ep o r t, b a n k s li ke to e x a mi ne t he m wi t h t he ac cep ted te nd er o r co nt ra ct fo r
ver i fyi n g t hat t h e go o d s sup p li ed u nd er t he b i ll s s tri ctl y co n fo r m to t h e ter ms a nd co nd i tio n s in t he
accep ta nc e t e nd er . T he se s up p l y b i ll s r ep re se nt d eb t i n fa vo ur o f s u p p lier s /co nt rac to r s, fo r go o d s
s up p l ied to go ver n me n t b o d ie s o r wo r k e xec u t ed u nd er co n trac t fro m th e Go ver n me n t b o d i es . T hi s
d eb t i s as s i g ned to t he b an k b y e nd o r se me nt o f s up p l y b il l s a nd ex ec ut i n g irre vo c ab l e p o we r o f
atto r n e y i n fa vo ur o f b an k s fo r r e ce i vi n g th e a mo u nt o f s up p l y b ill s fro m t he Go ve rn me n t
d ep art me n t s. T he p o we r o f at to r ne y h as go t t o b e re g is ter ed wi t h t h e d ep ar t me n t co nc er ned . T he
b an k s a lso ta ke sep a r at e let te r fr o m t h e s up p lier s/ co ntra cto r s i n s tr uc ti n g th e Go ver n me n t b o d y t o p a y
th e a mo u nt o f b i ll s d ir ect to t he b a n k. S up p l y b il l s d o no t e nj o y t he le g al s ta t us o f ne go tiab le
in s tr u me n t s a s t he y ar e no t b il l s o f e xc ha n g e. T he s ec ur it y a va ilab le to a b a n ker i s b y wa y o f
as si g n me nt o f d eb t s r ep r es e nted b y t he s up p l y b ill s.
i) Ter m lo a ns by ba n ks : I t i s a n i n st al me n t cred i t r ep a yab le o v er a p erio d o f t i me i n
mo n t hl y/ q uar terl y/ h a l f - ye ar l y o r year l y i n st al m en t s. B a n ks gra n t te r m l o an s fo r s ma l l p ro j ect s fa ll i n g
u nd er t he p r io ri t y sec to r , s ma ll sc al e s ec to r a nd b ig u n it s. B a n ks h a ve n o w b ee n p er mi tt ed to sa nc tio n
ter m lo a n fo r p ro j ect s a s we ll wi t ho ut as so c ia ti o n o f fi n a nc ial i n st it u ti o n s. T he b a n ks gr a nt lo an s fo r

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p er io d s no r ma l l y r a n gi n g fr o m 3 to 7 year s a nd at t i me s e ve n mo re. T h ese lo a n s are gr a nted o n t he


sec u rit y o f fi x ed a s se ts .
j ) Fina nc ing o f e x po rt s by ba n ks : Ad va n ce s b y co m merc ia l b a n ks fo r exp o r t fi na nc i n g are in t he
fo r m o f :
a ) Pre - sh i p me nt f i na n ce i. e. b ef o re s hi p me n t o f g o o d s : T hi s u s ua l l y, ta k e s t he fo r m o f p ac ki n g
cr ed i t fac il it y, wh i c h i s a n ad va n ce e x te nd ed b y b a n k s to a n e xp o rt e r fo r t h e p urp o se o f b u yi n g ,
ma n u fac t uri n g, p r o c es s i n g, p ac k i n g, s h ip p i n g g o o d s to o ver s ea s b u yer s. A n y e xp o rt er, h a vi n g at h a nd
a fir m e xp o r t o rd er p la c ed wi t h h i m b y h i s fo r e ig n b u yer o r a n irre vo ca b le let ter o f cr ed i t o p e n ed i n
hi s fa vo ur , ca n ap p r o a c h a b a n k fo r a va il i n g p ac ki n g cr ed i t. A n ad v an ce so ta ke n req u ire s to b e
liq uid at ed wi t h i n 1 8 0 d a ys fr o m t he d ate o f it s co m me nc e me n t b y ne g o tia tio n o f e xp o rt p ro ce ed s i n
an ap p ro v ed ma n ner . T h u s, p ac k i n g cr ed i t i s es se n tia ll y a s ho rt te r m a d va n ce. U s ua ll y, b a n k s in s i st
o n t h eir c u s to mer s to lo d ge wi t h t he m ir r e vo cab le le tt er s o f cred it o p e n ed i n fa vo ur o f t h e c u st o me rs
b y o ver se a s b u ye r s. T h e le tter o f cr ed it a nd fir m s al e co ntr act s no t o nl y se r ve a s e v id e nc e o f a
d ef i ni te arra n g e me n t fo r r ea li sa tio n o f t he e xp o rt p ro c eed s b u t al so i n d ica te t he a mo u n t o f fi na n ce
r eq u ired b y t he e xp o r ter . P ack i n g c r ed i t i n ca se o f c u s to mer s o f lo n g s t and i n g, ma y al so b e gr a nt ed
ag ai n st fir m co ntr act s e nt er ed i nto b y t he m wi t h o ve rs ea s b u yer s. Fo ll o wi n g a re t h e t yp es o f p ac ki n g
cr ed i t a v ai lab l e :
i) Cl ea n pa c ki ng cre d i t : Thi s i s a n ad va n ce av ai lab l e to a n e xp o r ter o nl y o n p ro d uct io n o f a fir m
exp o r t o rd er o r a le tte r o f cr ed i t wi t ho u t e xe rci si n g a n y c har ge o r co n tro l o ver ra w ma ter ial o r
f i ni s hed go o d s. Ea c h p r o p o sa l i s we i g ht ed a cco rd i n g to p ar tic u lar req u ire me n t s o f trad e a nd c red it
wo r t h i ne ss o f t h e e xp o r ter . A s ui tab le ma r gi n ha s to b e ma i nta i ned . Al so , E xp o r t Cr ed i t G u ara nt ee
Co r p o ra tio n (E. C. G. C.) co v er s ho uld b e o b t ai ne d b y t he b a n k.
ii) P a c ki ng c re dit a g a i ns t hy po t he ca t io n o f g o o ds : E xp o r t fi na nc e i s mad e a v ai lab l e o n c e rtai n
ter ms a nd co nd i tio n s wh er e t h e e xp o r ter ha s p l e d ge ab le i n tere s t a nd t he go o d s ar e h yp o t heca ted to t h e
b an k a s sec u ri t y wi t h s t ip u la ted mar g i n. A t t h e ti me o f u ti li si n g t he ad v an ce, t h e e xp o rt er i s req ui red
to s ub mi t, a lo n g wi t h t h e fir m e xp o r t o r d er o r le tter o f cr ed i t, re la ti ve s t o ck s ta te me n t s a nd t her ea ft er
co n ti n u e s ub mi tt i n g t h e m e ver y fo r t ni g h t a nd /o r wh e ne v er t h ere i s a n y mo ve me nt i n s to c k s.
iii ) Pa c ki ng cre di t a g a i ns t p le dg e o f g o o d s : E xp o r t fi n a nce i s mad e a va il ab le o n ce rta i n t er m s a nd
co nd it io n s wh e re t he e xp o r tab l e f i ni s hed go o d s a re p led ged to t h e b an k s wi t h ap p ro ved cl eari n g
ag e nt s wh o wo u ld s hip th e sa me fr o m ti me to t i me a s req uir ed b y t he exp o r ter. P o s se s sio n o f go o d s
so p l ed ged li es wi t h t he b an k a nd ar e kep t u nd er it s lo c k a nd k e y.
iv ) E. C.G . C. g ua ra nt e e : A n y lo a n g i ve n to a n exp o r ter fo r t he ma n u fa ct ure, p ro c es s i n g, p ur c h as i n g
o r p ac ki n g o f go o d s me an t fo r e xp o r t a gai n s t a fir m o rd e r q ua li fie s fo r p ac ki n g. C red i t g uar a n tee i s
is s ued b y t h e E xp o r t Cr ed it G uar a nt ee Co r p o ra t io n (E. C. G. C.).
v ) Fo rw a rd e x cha ng e c o nt ra c t : A no t her req u i re me nt o f p ac k i n g cred i t fac il it y is t ha t i f t he e xp o r t
b ill is to b e d ra wn i n a fo r ei g n c ur r e n c y, t he e x p o rter s ho u ld e nt er i nto a fo r wa rd ex c ha n ge co nt rac t
wi t h t he b a n k, t her eb y a vo i d i n g r i s k i n vo l ved i n a p o s s ib l e c ha n g e i n t h e e xc ha n g e ra te.
Do c u me nt s re qu ire d :
- I n ca se o f p ar t ner s hip f ir ms , b a n k s u s ua ll y req ui re t he fo llo wi n g d o c u me n t s :

J o in t a nd se v er a l d e ma nd p r o no te s i g ned o n b e h al f o f t he fir m as al so b y p ar t ner s


ind i vid u al l y;

Let ter o f co nt i n ui t y, si g ned o n b e ha l f o f t he fir m a nd p ar t ner s i nd i v id u all y;

Let ter o f p led ge to s ec ur e d e ma n d c as h cr ed i t ag ai n st sto c k , i n ca s e o f p led g e o r a gre e me n t


of
h yp o t hec at io n to s ec ur e d e ma nd c a s h cred it , i n cas e o f h yp o t hec at io n.

Let ter o f a ut ho r it y to o p er at e t h e ac co u nt ;

Dec lar at io n o f P ar t ner s hip , i n ca se o f so le trad ers, so le p ro p r ie to r s hip d ecla rat io n;

A gree me nt to u ti li se t h e mo nie s d r a wn i n ter ms o f co ntr act ;

Let ter o f h yp o t he ca tio n fo r b il l s.


- Fo l lo wi n g d o c u me nt s a r e r eq ui r ed b y b a n ks , i n cas e o f li mi t ed co mp a ni es :

De ma n d p r o - no t e;

Let ter o f co nt i n ui t y;

A gree me nt o f h yp o t h ec atio n o f l et ter o f p led g e, si g n ed o n b e h al f o f t h e co mp a n y;

Ge ner al g u ar a n tee o f t h e d ir e cto r s ' re so l u tio n ;

A gree me nt to u ti li se t h e mo nie s d r a wn i n ter ms o f co ntr act s ho u ld b e ar th e co mp a n y's se al;

CA- IPCC- Financial Management`

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Let ter o f h yp o t he ca tio n fo r b il l s
b) Po st s hi p me nt f i na n ce : I t t a ke s t h e b e lo w me n tio n ed fo r ms :
i) P ur cha se /D i sco unt i ng o f do cu me nt a ry e x po rt b il ls : F i na nce i s p ro v id ed to e xp o r ter s b y
p ur c h a si n g e xp o r t b il ls d r a wn p a yab l e at si g ht o r b y d i sco u n ti n g u s ua nc e e xp o rt b i ll s co ver i n g
co n f ir med s ale s a nd b a ck ed b y d o c u me n t s i n cl u si v e o f d o c u me n t s o f tit le to go o d s s uc h a s b ill o f
lad i n g, p o s t p ar ce l r e cei p ts o r a ir co n si g n me nt n o te s. Do c u me n t s to b e o b tai n ed ar e :
Let ter o f h yp o t he cat io n co v er i n g t he go o d s ; a nd
Ge ner al g u ar a nt ee o f d ir ecto r s o r p art n er s o f t h e fir m, as t he ca se ma y b e.
E. C.G . C. G ua ra nt ee : P o st -s h ip me n t f i na n ce , gi ve n to a n e xp o r ter b y b an k t hro u g h p ur ch as e,
ne go ti at io n o r d i s co u nt o f a n e xp o r t b i ll a ga i ns t a n o rd er, q ua li fie s fo r p o st - s h ip me n t e xp o r t c red it
g uar a nt ee. I t i s ne ce ss ar y, t ha t e x p o r ter s o b ta i n a s h ip me n t o r co n trac t s ris k p o l ic y o f E. C. G. C. Ba n k s
in s i st o n t he e xp o r t er s to ta ke a co ntr a ct s s h ip me nt s (co mp re he n s i ve ris k s) p o l ic y co v eri n g b o th
p o lit ic al a nd co m me r ci a l r is k s. T he Co r p o ra tio n , o n acc ep ta n ce o f t he p o lic y, wo uld fi x cred it l i mi ts
fo r i nd i vid ua l e xp o r t er s a nd t he Co r p o r at io n 's l iab i li t y wi ll b e li mi ted to t h e e xte n t o f t h e li m it s o
f i xed fo r t he e xp o r t er co nc er ned ir r e sp e ct i ve o f t he p o li c y a mo u n t.
ii) A dv a n ce a g a in st e x po rt b il ls s ent f o r co l l ectio n : F i na nc e is p ro v id ed b y b a n k s to e xp o r t ers b y
wa y o f ad va nce a g ai n s t exp o r t b il ls fo r ward ed thro u g h t h e m fo r co l le ctio n, ta ki n g i nto ac co u nt t he
p ar t y's cred it wo r t h i ne s s , na t ur e o f go o d s e xp o rted , u s ua nce , s ta nd i n g o f d ra we e, e tc. ap p ro p riat e
ma r gi n is kep t . Do c u me nt s to b e o b ta i ned :
De ma nd p ro mi s so r y no t e;
Let ter o f co nt i n ui t y;
Let ter o f h yp o t he cat io n co v er i n g b il l s;
Ge ner al g u ara nt ee o f d ir ecto r s o r p ar t n er s o f t h e fir m, as t he ca se ma y b e.
iii ) Adv a nc e a g a in st d ut y dra w ba c ks , ca sh su b si dy , etc . : To fi na nc e ex p o rt lo s se s s u st ai ned b y
exp o r ter s, b a n k ad v a nce aga i n st d ut y d r a w - b a c k , cas h s ub s id y, e tc. re ce iv ab l e b y t h e m a ga i n st e xp o r t
p er fo r ma nc e. S uc h ad va nc es ar e o f c lea n n at ur e, he n ce, n ece s sar y p rec a ut io n is to b e e xer ci sed .
Co n dit io ns : Ba n k p r o v i d in g fi n a nce i n t hi s ma n ner s ho u ld see t ha t t he r ela ti ve e xp o r t b i ll s a re e it her
ne go ti ated o r fo r war d e d fo r co l lec tio n t hro u g h it so t h at, i t i s i n a p o si tio n to ver i fy t h e e xp o rter 's
cla i ms fo r d ut y d r a w - b a ck s, ca s h s ub s id y, e tc. A n ad va n ce so a va il ed b y a n e xp o rt er i s req u ire d to b e
liq uid at ed wi t h i n 1 8 0 d a ys fr o m t he d at e o f s hip me n t o f r el at i ve go o d s.
Do c u me nt s to b e o b t a i ne d a r e :
De ma nd p r o mi s so r y no t e;
Let ter o f co nt i n ui t y;
Ge ner al g u ar a nt ee o f d ir ecto r s o r p art n er s o f t h e fir m, as t he ca se ma y b e.
U nd ert a ki n g fr o m t he b o r r o wer s t h at t he y wi l l d ep o s it t he c h eq ue s/p a y m en t s rec ei ved fro m t h e
ap p ro p ria te a ut ho r it ie s i m med iat el y wi t h t h e b an k a nd wi l l no t ut il is e s uc h a mo u nt s i n a n y
o th er wa y.
c) O t her fa ci lit ie s e xt e nd ed t o e x po rt er s :
i) O n b e h al f o f ap p r o ve d e xp o r t er s, b a n ks e st ab li s h le tter s o f cred it o n t he ir o v er sea s o r up -co u nt r y
s up p l ier s.
ii) G uar a nte es fo r wai v er o f e x ci se d u t y, etc . d ue p er fo r ma n ce o f co nt rac ts , b o nd i n l ie u o f ca s h
sec u rit y d ep o si t, g uar a n tee s fo r ad va nc e p a y me n ts, et c. ar e a l so i s s ued b y b a n ks to ap p ro ved c li e nt s.
iii ) To ap p ro ved c li e nt s u nd er ta k i n g e xp o r t s o n d eferred p a y me n t t er ms , b a n ks al so p ro v id e fi na nc e.
iv ) Ba n k s a lso e nd ea vo ur to sec ur e fo r t h eir e xp o r ter -c u s to mer s st at u s rep o r t s o f t h eir b u ye r s a nd
tr ad e
in f o r ma tio n o n v ar io u s c o mmo d it ie s t hr o u g h t h ei r co rre sp o nd e n ts .
v) Eco no mi c i n te ll i ge nc e o n var io us co u ntr ie s is al so p ro v id ed b y b a n ks to t he ir e xp o rte r c lie n t s.
5 ) I nter co r po ra t e d ep o sit s : T he co mp a ni es c an b o rro w fu nd s fo r a s ho r t p er io d s a y 6 m o n t h s fro m
o th er co mp a n ie s h a vi n g sur p l u s liq u id i t y. T he rate o f i nt ere st o n i t v a rie s d ep e nd i n g o n t he a mo u n t
in v o l ved a nd t i me p er io d .

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6 ) Cert ifi ca te o f d e po s i t ( CD) : I t i s a d o c u me n t o f ti tl e s i mi lar to a t i me d ep o s it r ece ip t is s u e d b y a


b an k e x cep t, t ha t t he r e i s no p r e scr ib ed i n tere s t rate o n s uc h fu nd s. It s ma i n ad va n ta g e i s t ha t b an k er
is no t req u ired to e nca s h t he d ep o si t b e fo r e ma t ur it y p erio d a nd t h e i n v es to r is a s s ured o f liq u i d it y a s
he ca n se ll i t i n t he se co nd ar y mar ke t.
7 ) Pu b lic de po s it s : T h e y ar e i mp o r t a nt so ur ce o f s ho r t a nd me d i u m t er m fi n a nce s p art ic u lar l y d ue to
cr ed i t sq ue eze b y t he R BI . A co mp a n y c a n a cce p t s uc h d ep o si ts s ub j ect to t he stip u la tio n s o f t h e R BI
fr o m t i me to ti me ma x i mu m up to 3 5 % o f i ts p aid up c ap i tal a nd re s erv e s , fro m t he p ub l ic and t h e
s har e ho ld er s. T h es e ma y b e ac cep ted fo r a p erio d o f 6 mo n t h s to 3 year s. P ub l ic d ep o si t s are
u n sec u red lo a n s, a nd no t me a nt to b e u sed fo r a cq u i si tio n o f fi x ed as se t s, s i nce, t h e y ar e to b e r ep aid
wi t h i n a p er io d o f 3 ye a r s. T h e se ar e ma i nl y u s e d to fi n a nce wo r k i n g ca p ita l req u ire me n t s.

Q ue st io n : En u mera t e a nd e x pla in t he o t h er s o urc es o f fi na nc ing ?


An sw er : T he o t her so ur ces o f fi n a nc i n g are a s d is c us sed b elo w :
1 ) See d ca p ita l a s s is t a nce : T he s eed cap ita l a s si s ta nc e sc he me is d e si g n ed b y I D B I fo r
p r o f es s io nal l y o r te c h ni cal l y q ua li f ied e ntr ep re ne ur s a nd /o r p er so ns p o s se ss i n g r ele v a nt e xp er i en ce,
s ki ll s a nd e ntrep r e ne ur i al tr a it s. A ll t he p ro j ect s el i gib le fo r fi n a nc ial as si s ta nc e fro m ID BI , d irec tl y
o r ind irec tl y t hro u g h r e f in a nce a r e el i gib le u nd e r th e sc h e me. T he p ro j e ct co st s ho u ld no t e xc ee d Rs .
2 cr o re s a nd t he ma x i m u m a ss i sta n ce u nd er t h e p ro j ect wi l l b e re s tri cted to 5 0 % o f t he re q ui red
p r o mo ter 's co nt rib ut io n o r R s. 1 5 l a k h s, wh ic h e ver i s lo we r. Se ed c ap i t al a s si s ta nc e is i n tere s t fre e,
b ut c arri es a ser vi ce c h ar g e o f 1 % p er a n n u m fo r t h e firs t 5 ye ars a nd at in crea s i n g rate t h ere after.
Ho we v er, ID BI wi l l ha v e t h e o p tio n to c har g e i nt ere st a t s uc h ra te a s d eter mi n ed b y it o n t he l o an i f
th e fi n a nc ial p o s it io n a nd p r o f itab il it y o f t he co mp a n y so p er mi t s d ur in g t he c urre nc y o f t he lo a n.
Th e rep a y me n t s c hed u l e is f i xed d ep e nd i n g o n t h e rep a yi n g cap a cit y o f t he u n it wi t h a n in it ia l
mo r ato r i u m up t o 5 ye a r s. Fo r p r o j ec t s wi t h c o st e xce ed i n g R s. 2 0 0 la k h s, se ed cap it a l m a y b e
o b tai n ed fro m t he Ri s k Cap it al a nd Te c h no lo g y Co rp o r at io n Ltd . ( R CT C). Fo r s ma l l p ro j ec ts c o st i n g
up t o Rs . 5 l a k hs , a s si st a nc e u nd er t he Na tio n al Eq u it y F u nd o f t he SI D BI ma y b e a vai led .
2 ) I nter na l
ca s h
a c crua l s
:
Ex i st i n g
p ro fi t
ma k i n g
c o mp a n i e s
u nd er ta k i n g
an
exp a ns io n/d i ver s i fic at io n p r o gr a m me ma y b e p e r mit ted to i n v es t a p art o f t he ir ac c u mu l ated re s erv e s
o r cas h p ro fi ts fo r cr e at io n o f cap ita l a s se ts . I n s uc h c as e s, t he co mp a n y's p a s t p er fo r ma n ce p e r mit s
cap i tal e xp e nd i t ur e fr o m wi t hi n t h e co mp a n y b y wa y o f d i si n v es t me n t o f wo r ki n g /i n ve s ted fu n d s. I n
o th er wo rd s, t h e s ur p l u s g e ner ated fr o m o p er at io n s, a fter me et i n g al l t he co n tra ct ua l, s ta t uto r y a nd
wo r ki n g r eq uir e me n t o f f u nd s, is a va il ab le fo r fur t her c ap i ta l e xp e nd it u re.
3 ) Un se cu re d lo a ns : T he y ar e p r o vid ed b y p r o mo ter s to mee t t he p r o mo ter s ' co n trib u tio n n o r m.
Th es e lo a n s ar e s ub o r d in at e to i n st it u tio n al lo an s a nd i n ter es t ca n b e p aid o n l y a fter p a y me nt o f
in s ti t ut io na l d ue s. T h es e lo a n s c a n no t b e rep ai d wi t ho ut t he p r io r ap p r o va l o f fi na nc ia l i n s ti t u tio n s.
U ns ec ured lo a n s ar e co n sid er ed a s p ar t o f t h e eq ui t y fo r t he p u rp o s e o f c alc u lat i n g d eb t eq u it y ra tio .
4 ) Defe rre d pa y me nt g ua ra nt ee : Ma n y a ti me s up p lie rs o f ma c h i ner y p ro v id e a d e ferr e d cred i t
fa ci li t y u nd er wh i c h p a y me n t fo r t h e p ur c ha se o f ma c hi n er y ma y b e m ad e o v er a p er io d o f ti m e. T he
en tir e co st o f ma c h i ner y i s f i na nc ed a nd t h e co mp a n y i s no t req uir e d to co ntr ib ut e a n y a m o u n t
in it ia ll y to ward s acq u is i tio n o f ma c hi n er y. No r ma ll y, t he s up p li er o f m ac hi ne r y wo uld i n si s t t h at t he
b an k g uar a nte e b e f ur n is h ed b y t he b u yer . S u ch a fac il it y d o e s no t ha v e a mo r ato r i u m p eri o d fo r
r ep a y me n t. He nc e, i t is ad v i sab l e o nl y f o r a n e xi s ti n g p ro fi t ma k i n g co mp a n y.
5 ) Ca p ita l I nc ent iv e s : Ba c k wa r d ar e a d e ve lo p me n t i nce n ti ve s a vai lab l e o fte n d et er mi n e t he lo cat io n
o f a ne w i n d us tri al u n it . Th e y u s ua ll y co ns i st o f a l u mp s u m s ub s id y a nd e xe mp tio n fro m o r d e fe r me nt
o f sa le s ta x a nd o ctr o i d ut y. T he q ua nt u m o f i n c en ti v es i s d e ter mi n ed b y t he d e g ree o f b ac k war d ne s s
o f t he lo ca tio n. Sp e cia l cap i tal i nc e nt i ve i n t he fo r m o f a l u mp s u m s ub sid y i s a q ua n t u m sa nc t io n ed
b y t he i mp le me nt i n g a g en c y a s a p er ce n ta ge o f t he fi xed c ap i tal i n ve st me n t s ub j ec t, to a n o ver al l
cei li n g. T h i s a mo u n t fo r ms a p ar t o f t h e lo n g - ter m me a n s o f fi na n ce fo r t he p ro j ect . Ho we ve r, t he
vi ab i li t y o f t he p r o j ec t mu s t no t b e d ep e nd e nt o n t h e q ua n t u m a n d av ai lab il it y o f i nc e n ti ve s.
I n st it u tio n s, wh i le ap p r ai si n g t he p r o j ec t, a s se s s i t s viab il it y p er se, wit ho ut co n sid er i n g t h e i mp a ct
o f i nce n ti v es o n t he cas h f lo ws a nd t h e p r o j ect 's p ro fi tab il it y. S p ecia l c ap i tal i nc e nt i v es a re
sa nc tio n ed a nd r el ea sed to th e u n it s o nl y a fte r th e y ha v e co mp l ied wi t h t he req ui re me n t s o f t h e
r ele v a nt sc h e me. T he r eq u ir e me n t s ma y b e cla s si fied i nto i ni ti al effec ti ve s tep s, t hat i nc l ud e
fo r ma t io n o f t h e f ir m/ co mp a n y, acq u is it io n o f la nd i n t h e b a c k wa r d are a a nd re g i stra tio n fo r
ma n u fac t ure o f t he p r o d uc t s. T he fi na l e ffec ti ve s tep s i n cl ud e o b t ai n in g cl eara n ce s u nd er F EMA,

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cap i tal go o d s cle ar a nc e/ i mp o r t l ice n se , co n v er si o n o f Let ter o f In te n t to Ind us tri al Li ce n se, t ie up o f


th e mea n s o f fi n a nce, a ll c lear a nce s r eq u ired fo r th e se tt i n g up o f t he u ni t, a g gre g ate e xp e nd it ure
in c urred fo r t he p r o j ec t s ho uld e x ceed 2 5 % o f th e p ro j ect co s t a nd a tl eas t 1 0 %, i f t he fi x ed as se ts
s ho uld ha ve b e e n cr ea te d /acq u ir ed at si te. T he r elea s e o f sp ec ia l cap i ta l inc e nt i ve s b y t h e co nce rned
Sta te Go v er n me n t ge n er all y t a ke s 1 to 2 yea rs. P ro mo t er s t h us, fi nd i t co n v e nie n t to a vai l t he b rid ge
f i na nc e ag ai n s t t he cap ita l i nc e nt i ve s. P r o v is io n fo r t he sa me s ho uld b e mad e i n t he p re -o p e rati v e
exp e ns e s co n sid er ed i n t he p r o j ec t co st . A s t h e b rid ge fi n a nce ma y b e a v ail ab le to t h e e xt e nt o f 8 5 %,
th e b a la nc e i .e. 1 5 % ma y h a ve to b e b r o u g h t i n b y t he p ro mo ter s fro m t he ir o wn re so urc es .
6 ) Va rio u s s ho r t t er m p ro v i sio n s/a c cr ua l s a cco unt : Accr u al s a cco u nt s are a sp o n ta neo u s so ur ce o f
f i na nc i n g as t h e y ar e s el f - ge n er a ti n g. T he mo s t co m mo n accr u al ac co u nt s ar e wa ge s a nd ta x es. I n
b o t h ca se s, t he a mo u nt b eco me s d ue b ut is no t p a id i m me d i ate l y.
Q ue st io n : W rit e s ho r t no t e s o n :
1 ) Dee p Di sc o u nt Bo nd s
3 ) Ze ro i nt ere st f u lly c o nv ert i ble d eb ent ur es
5 ) Do u b le O pt io n Bo n d s
7 ) I nfla t io n Bo n d s

2 ) Sec ur ed Pre miu m No te s


4 ) Zero Co up o n Bo n d s
6 ) O ptio n Bo n ds
8 ) F lo a ti ng Ra te Bo nd s

An sw er :
1 ) Dee p Di sco u nt Bo nd s :
It i s a fo r m o f a zer o in ter es t b o nd , so ld at a d i sco u nt ed v al u e and o n mat u ri t y face va l ue i s
p aid to t he i n v es to r s. I n su c h b o nd s, t he r e i s no in ter es t p aid d uri n g lo c k in p erio d . ID BI wa s t he fir st
to is s u e a d eep d i sco u n t b o nd i n I nd ia i n J an u ar y, 1 9 9 2 . It had a fa ce va lu e o f R s. 1 l a k h a nd wa s so ld
fo r R s. 2 7 0 0 wi t h a ma tu r i t y p er io d o f 2 5 ye ar s. T h e i n v e sto r co uld h o ld t h e b o nd fo r 2 5 yea rs o r
see k red e mp tio n at t he e nd o f e ver y 5 year s wi t h mat ur it y v al u e a s b e lo w :
H o ld i ng p eri o d ( y ea r s)

10

15

20

25

M a t urity v a l ue ( R s.)

5700

12000

25000

50000

100000

1 6 .0 9

1 5 .9 9

1 5 .7 1

1 5 .5 4

An n ua l ra t e o f i nt e r est
1 6 .1 2
( %)

T he i n ve sto r c an se ll t he b o nd s i n st o ck ma r ke t a nd rea li se th e d i ffere nc e b et wee n fa ce


va l ue ( R s. 2 7 0 0 ) a nd t he mar ke t p r i ce a s cap ita l ga i n.
2 ) Se cu re d Pr e mi u m N o t es :
It i s i ss u ed alo n g wi t h a d eta c hab le wa rra nt a nd i s red ee ma b le aft er a no t i fi ed p erio d o f s a y
4 to 7 year s. T he co n v er sio n o f d et ac hab le warr an t i n to eq u it y s har e s will ha ve to b e d o ne wi t h in t he
ti me p er io d no t i fi ed b y t he co mp a n y.
3 ) Ze ro i nt ere st f u lly c o nv ert i ble d eb ent ur es :
T he s e ar e f u ll y co n ve r t ib le d eb e nt ure s wh ic h d o no t ca rr y a n y i nte re st. T h e y are
co mp u l so ri l y a nd a u to ma ti ca ll y co n ver ted a ft er a sp e ci fied p erio d o f ti me a nd ho ld ers t h er eo f are
en ti tl ed to ne w eq ui t y s har e s o f t he co mp a n y at p red eter mi ned p r ice . Fr o m t h e co mp a n y 's v ie w p o i nt ,
th i s ki nd o f i ns tr u me n t i s b e ne f ic ia l i n t h e se n se , t hat no i nt ere st i s to b e p aid o n it, i f t he s h are p rice
o f t he co mp a n y i n t he ma r ket i s ver y hi g h , th e n t h e i n ve s to r t e nd s to g et eq ui t y s h are s o f t he
co mp a n y a t a lo we r r a te.
4 ) Ze ro Co u po n Bo n d s :
A z ero co up o n b o nd d o e s no t carr y a n y i nt ere st, b ut it i s so ld b y t he i s s ui n g co mp a n y at a
d is co u nt. T h e d i ff er e nc e b et we e n t h e d i sco u n ted and ma t ur i n g o r fac e v al ue rep re se nt s t he i n ter es t to
b e ear n ed b y t h e i n v es to r o n t he m.
5 ) Do u b le O pt io n Bo n d s :
Do ub l e Op t io n Bo nd s ar e r ec e nt l y is s ued b y t he ID BI. T he face v al u e o f eac h b o nd is Rs .
5 0 0 0 , it carr ie s i nter es t at 1 5 % p er a n n u m co mp o u nd ed hal f year l y fr o m t he d ate o f a llo t me n t. T he
b o nd ha s a ma t ur it y p er io d o f 1 0 year s. E ac h h av i n g 2 p ar ts , i n t h e fo r m o f 2 sep arat e cer ti fi cate s,
o ne fo r t he p ri n cip a l o f R s. 5 0 0 0 a nd o t her fo r i nt ere st , i nc l ud i n g red e m p tio n p re mi u m o f Rs. 1 6 5 0 0 .
Bo t h t he se ce rt i fic at es a r e li st ed o n al l maj o r st o ck e x c ha n ge s. T h e i n ve sto r ha s t h e fac il it y o f s e ll i n g
eit h er o ne o r b o t h p ar t s an yt i me he li k e s.

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114
6 ) O pt io n bo n ds :
T he se ar e c u m ul at i ve a nd no n -c u mu la ti ve b o nd s wh e re i nte re st i s p a ya b l e o n ma t ur i t y o r
p er io d i ca ll y. R ed e mp tio n p r e mi u m i s a l so o ffer ed to a tt rac t i n v es to r s. Th es e we re r ece n tl y i ss ued b y
I D BI, I CI CI, et c.
7 ) I nfla t io n bo n d s :
T h e y are b o nd s in wh i c h i n ter e s t ra te is ad j u st ed fo r i n fla tio n . Th e i n v es to r, t h u s, g e ts a n
in ter es t fr ee fro m t h e e f fe ct s o f i n f lat io n. Fo r i n st a nce, i f i nt ere st rat e i s 1 2 % a nd i n f la tio n r at e i s 5
%, t he i n ve sto r wi ll ear n 1 7 %, mea n i n g t h at t h e i n ve s to r i s p ro tec ted a ga i n st i n fl at io n.
8 ) Flo a t ing Ra te Bo n d s :
A s t h e na me s u g ge s ts , F lo a ti n g Rat e B o nd s ar e o ne s, wh e re t h e ra te o f i nt ere st i s no t fi xed
and i s al lo wed t o flo at d ep e nd i n g up o n t h e ma r ke t co nd it io n s. T h i s is a n id ea l i n str u me n t t ha t ca n b e
r eso r ted to b y t he i s s uer to hed g e t he ms el ve s a g ai n st t h e vo la ti li t y i n i n tere st r at es. T h i s ha s b e co me
mo r e p o p u lar a s a mo ne y mar k et i n st r u me nt a nd ha s b ee n s u cce s s fu ll y i s s ued b y fi na nc ia l i n st it ut io n s
li ke ID BI, IC IC I, e tc.
Q ue stio n : G iv e a d et a ile d a c co u nt o f I nt er na tio na l F ina nc i ng ?
An sw er : T he e s se n ce o f fi n a nc ial ma n a ge me n t is to rai se & u ti li se th e fu nd s r ai sed e ffec ti ve l y.
Th ere are va rio u s a ve n u es fo r o r ga n is at io ns to rai se fu nd s eit h er t hro u g h i n ter na l o r e xt er nal so urc e s.
Ex ter na l so urc es i nc l ud e :
Co mme r ci a l ba n ks : Li ke d o me st ic lo a ns, c o mme rc ial b a n k s al l o ver t h e wo rld e x te nd
Fo re i g n C ur r e nc y ( F C) lo a n s, fo r i nter n at io n al o p er at io ns . T he se b an k s a l so p ro vid e to
o verd ra w o ver a nd ab o v e t he lo a n a mo u nt .
Dev e lo p me nt ba n ks : o f fe r lo n g a nd med i u m te r m lo a n s i ncl ud i n g F C l o an s. Ma n y a ge nc ie s a t
th e na tio n al le ve l o f fe r a n u mb er o f co nce s sio n s to fo rei g n co mp a n ie s to i n v es t wi t h i n t heir
co u n tr y a nd to f i na nc e e xp o r ts fr o m t heir co u ntr ie s e. g. E XIM Ba n k o f US A.
Di sco un ti ng o f t ra de b ill s : T h is i s us ed as a s ho r t ter m fi n a nci n g me t ho d wi d el y, i n Euro p e
and A si a n co u n tr ie s to f in a nce b o t h d o me s t ic a n d i nte r nat io na l b u si ne s s.
In ter na tio na l a g en ci es : A n u mb er o f i nte r nat i o na l a ge n cie s ha ve e me rged o ve r t he yea rs to
fi na nc e i n ter na tio n al t r ad e a nd b u s i ne ss . T he mo re no tab l e a mo n g t he m i nc l ud e s :
In ter na tio n al Fi n a nce Co r p o r a tio n ( IF C), In ter na tio n al Ba n k fo r Re co ns tr uc tio n &
De ve lo p me n t ( I B R D) , As ia n D e vel o p me nt Ba n k (A D B), I nt er na tio na l Mo n et ar y F u nd (IM F),
etc.
In t er na tio na l ca pit a l ma r ket s :
Mo d er n o r g a n is at io ns i nc l ud i n g MN C 's d ep e nd up o n s ize ab l e b o rro wi n g s i n R up ee s a s a lso
Fo r e i g n C urre n c y. I n o r d er to ca ter to t he n eed s o f s u c h o r ga n i sat io n , i nt er na tio na l cap i ta l m ark et s
ha v e sp r u n g a ll o ve r t he glo b e s uc h as i n Lo nd o n. I n I nt er na tio na l cap it al mar ke t, t h e a va ilab il i t y o f
F C i s as s ured u nd er t he 4 mai n s ys t e ms , a s :
Euro - c urre n c y mar k et
Exp o r t cr ed i t fa ci li tie s
Bo nd s i s s ue s
Fi n a nci al I n s ti t ut io ns
T he o ri g i n o f th e E u r o -c ur r e n c y ma r k et wa s wi t h t he d o ll ar d eno mi n a ted b a n k d ep o si t s &
lo a n s i n E uro p e p ar t ic ul ar l y, Lo nd o n. E uro -d o llar d ep o s it s ar e d o l l ar d e no mi n ated ti me d ep o s it s
av ai lab l e a t fo r ei g n b r a n ch es o f US b a n k s a nd at so me fo re i g n b a n k s. B a n k s b a sed i n E uro p e acc ep t &
ma k e d o l lar d e no mi n at ed d ep o s it s to t he cl ie nt s. T hi s fo r ms t he b a ckb o n e o f t h e E uro -c ur ren c y
ma r ket a ll o ver t he glo b e. I n t hi s mar ke t, fu nd s are ma d e a vai lab le a s lo an s t hro u g h s yn d ica ted Euro cr ed i t o f i ns tr u me n t s a s F RN 's, F R cer ti f ica te s o f d ep o s it s.
Be lo w me nt io n ed a re s o me o f t h e f i na nc ia l in str u me nts :
1 ) Eu ro Bo n d s : E ur o Bo nd s ar e d eb t i n str u me n t s d e no mi n at ed i n a cu rre nc y is s ued o u ts i d e t he
co u n tr y o f t ha t c ur r e nc y , fo r i n st a nce : a ye n no t e flo a ted i n Ger ma n y.
2 ) Fo re ig n Bo nd s : T h ese ar e d eb t i n str u me n t s d e no mi n ated i n a c urr en c y wh ic h i s fo re i g n t o t he
b o r r o wer a nd i s so ld i n t he co u ntr y o f t h at c urre nc y.

CA- IPCC- Financial Management`

3 ) Ful ly H e dg e d Bo nd s : I n fo r ei g n b o nd s, t h e ris k o f c urre nc y fl uc t u atio n s e x i st s. T h e y el i m in at e


th e r is k b y s el li n g i n fo r wa r d ma r ket s t he e nt ire str ea m o f p ri nc ip a l a nd i nt ere st p a y me n t s.
4 ) Flo a ti ng Ra te No t e s : Th e y ar e i ss u ed up to 7 ye ars mat ur it y. I nt ere st rate s ar e ad j u s ted to re flec t
th e p re v ai li n g e xc ha n g e r ate s. T he y p r o v id e c h ea p er mo ne y t ha n fo r ei g n lo a n s.
5 ) Eu ro Co mme rc ia l P a per s ( EC P) : ECP 's ar e s ho rt t er m mo ne y mar ke t i n str u me n t s, wi t h m at uri t y
o f le s s t h a n 1 ye ar a nd d es i g nat ed i n U S d o l lar s.
6 ) Fo re ig n C urr en cy O pt io n : A FC Op tio n is th e r i g ht to b u y o r se ll, sp o t o r fut ur e o r fo r wa rd , a
sp ec i fi ed fo re i g n c u r r e n c y. I t p r o vid e s a hed ge a ga i n st fi na nc ia l a nd eco no mi c r is k s.
7 ) Fo re ig n Cu rre ncy F ut u re s : FC F ut ur es ar e o b li g at io n s to b u y o r s ell a sp eci fied c urr e nc y in t h e
p r es e nt fo r s et tle me nt at a f ut u r e d a te.
8 ) E uro I s su es : I n t he I nd i a n co n te x t, E uro Is s u e d e no t es t ha t t he is s ue is li s ted o n a E uro p ea n Sto c k
Ex c ha n ge. Ho we ver , s u b scr ip t io n c a n co me fro m a n y p ar t o f t he wo rld e xcep t I nd i a. Fi n a nce c an b e
r ai sed b y Glo b al D ep o s i to r y Re ce ip t s ( G D R), F o rei g n C u rre nc y Co n ver tib l e Bo nd s (F C C B) a nd p ure
d eb t b o nd s. Ho we v er , G DR 's a nd F C C B 's ar e mo re p o p ular .
9 ) G lo ba l D epo s it o ry Rece i pt s : A d ep o s i to r y rec eip t i s b a si ca l l y a ne go tiab le cer t i fi cate ,
d eno mi n a ted i n U S Do ll ar s r ep r e se n ti n g a no n US co mp a n y 's p ub li cl y trad ed lo ca l c urr e nc y (I nd i a n
R up e e) eq ui t y s har es, . Th eo r et ic al l y, t ho u g h a d ep o s ito r y r ece ip t ca n al so s i g ni fy d eb t i n str u me n t,
p r act ica ll y it rare l y d o e s so . DR 's ar e cr e at ed wh e n t he lo ca l c urr e nc y s har es o f a n I nd ia n co mp a n y
ar e d el i vered to t he d ep o si to r y's lo c al c u s to d ia n b an k, a g ai n st wh ic h t he d ep o si to r y b a n k i s s ue s DR 's
in U S Do l lar s. T he se DR 's ma y b e fr eel y tr a d ed i n t he o v er sea s - m ark et s li k e a n y o t her d o llar
d eno mi n a ted se c ur i t y vi a ei t her a fo r e i g n sto c k ex c ha n ge o r t hro u g h a o ve r t h e co u nt er ma r k et o r
a mo n g a re str ic ted gr o u p a s Q ual i fi ed I n s tit u ti o na l B u ye rs (Q IB ). R u l e 1 4 4 A o f t h e Sec ur it i es a nd
Ex c ha n ge Co m mi s sio n ( SE C) o f U SA p er mi t s c o mp a n ie s fro m o ut s id e US A to o ffer t he ir G D R 's to
cer t ai n i ns ti t ut io na l b u y er s, k no wn as QI B s.
1 0 ) G DR w it h Wa rra nt : Th es e r ec eip ts are m o re at trac ti v e t ha n p la i n GD R 's i n v ie w o f ad d it io n al
va l ue o f at ta c hed war r a n ts.
1 1 ) A me ri ca n D epo s it o ry Rec ei pt s ( AD R' s) : Dep o si to r y R ece ip t s i s s ued b y a co mp a n y i n U SA i s
k no wn a s A D R 's. S uc h r eceip t s ha ve to b e i s s ue d i n ac co rd a nc e wi t h t h e p ro v i sio n s st ip ul ated b y t he
SE C, U SA t hat ar e s tr i n ge n t. I n a b id to b yp a s s s uc h str i n ge nt d is clo s ur e no r ms ma nd ated b y t h e SE C
fo r eq u it y s h are s, t h e I nd i a n co mp a n ie s h a ve, ho we ver, c ho se n t he i n d irec t ro u te to t ap t he va st
A mer ica n fi na n ci al m ar k et t hr o u g h p r i va te d eb t p la ce me n t o f GD R 's li s ted i n Lo nd o n a nd
Lu x e mb o ur g sto c k e xc h an g es .
I nd ia n co mp a ni es ha ve p r e fe r r ed t he G DR 's a nd A D R 's as t h e US mar k et e xp o se s t he m to a
hi g h er le v el o r re sp o n s i b ili t y t ha n a E ur o p e a n l is ti n g i n t h e ar ea s o f d i sc lo s ur e, co st s, li ab i li ti es a nd
ti mi n g . T he S E Cs r e g u l atio n s s et up to p r o t ec t th e ret ai l i n ve sto r b a s e are so me wh a t mo re s tri n ge n t
and o ne ro us, e ve n fo r c o mp a n ie s a lr ead y li st ed and he ld b y r eta il i n v es to rs i n t he ir ho me co u nt r y.
Mo s t o n ero u s asp ec t o f a US l is ti n g fo r co m p an ie s i s to p ro vid e fu ll, ha l f year l y a nd q u a rterl y
acco u nt s i n ac co r d a nc e wi t h o r at le as t r eco nc il ed wit h U S G AAP s. Ho we v er, I nd ia n co mp a n ie s are
s hed d i n g t he ir rel u ct a n ce to t ap t he U S ma r ke ts a s e v id e nc ed b y I n fo s ys Tec h no lo gi es Ltd . r ece nt
li st i n g i n N AS DA Q. Mo st o f I nd i a 's to p no tc h c o mp a n ie s i n t h e p h ar ma ce ut ica l, i n fo - tec h a nd o th er
s u nri se i nd u st rie s ar e p l an n i n g fo r a ys i n to t h e US mar ke t s. A no t he r p r o hi b it i ve a sp ec t o f t he AD R 's
vi s - - vi s G D R 's i s t he co s t i n vo l v ed o f p rep ar in g a nd fil li n g U S G A AP acco u nt s. Ad d it io na ll y, t h e
in it ia l SE C r e gi str at io n fe e s b a sed o n a p erce n t ag e o f is s u e siz e a n md 'B l ue S k y' re g is tra tio n co s ts ,
p er mi tt i n g t he sec ur it ie s to b e o f fer ed i n al l S tat es o f U S, wi ll ha ve to b e met. T h e U S mar ke t i s
wi d e l y r eco g n is ed a s t he mo st l it i gio u s mar k et i n t he wo r ld . Ac co r d in g l y, t h e b ro ad er t h e t ar ge t
in v e sto r b a se i n U S, hi g her i s t he p o t e nt ia l le g al l iab i li t y. A n i mp o rt a nt asp ec t o f GD R is t ha t t he y
ar e no n vo t i n g a nd h e n ce sp e ll s no d il u tio n o f eq ui t y. G D Rs ar e se tt l ed thro u g h CE DE L a nd Euro clea r I nt er na tio na l Bo o k En tr y S ys te ms .
O t he r ty pe s o f In t er na t io na l i s s ue s :
Fo reig n E uro Bo nd s : I n d o me s ti c cap it al m ark et s o f var io u s co u n t rie s t he Bo nd i ss u e s
referred to ab o ve ar e k no wn b y d i ffere n t n a m es as Y a n kee Bo nd s i n US , S wi s s Fra n ce s i n
S wi t zerl a nd , Sa mu r ai B o nd s i n To k yo a nd B u lld o g s i n U K.

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E uro Co nv e rt i b le Bo n d s : A co n ver tib le b o nd i s a d eb t i n s tr u me n t gi v i n g t h e ho ld er s o f t he


b o nd a n o p tio n to co n v er t t h e b o nd s i n to a p r e -d et er mi n ed n u mb er o f eq u it y s hare s o f t he
co mp a n y. Us u al l y, t h e p r ice o f eq ui t y s hare s a t t he ti me o f co n ver sio n wi ll h a ve a p r e mi u m
ele me n t. T he y car r y a f i xed r at e o f i nt ere st a nd i f t he i s s uer co mp a n y so d e sir es ma y al so
in cl ud e a Ca ll Op tio n, wh er e t h e i s s uer co mp a n y h a s t he o p tio n o f ca lli n g /b u yi n g t h e b o nd s
fo r red e mp t io n p r io r to th e ma t ur i t y d at e, o r a P ut Op t io n, wh i c h gi v es th e ho ld e r t he o p tio n
to p ut /s el l hi s b o nd s to t he i s s uer co mp a n y a t a p re - d et er mi n ed d a te a nd p rice.
E uro Bo nd s : P lai n E ur o Bo nd s ar e no t h i n g b u t d eb t i n str u me nt s. Th es e ar e no t v er y
attr ac ti ve fo r a n i n ve sto r wh o d e s ir e s to ha ve v a lu ab l e ad d it io ns to h is i n ve s t me n ts.
E uro Co nv er t i bl e Ze ro Bo n d s : Th es e are str uc t ured a s a co n ver tib l e b o nd . No i n ter es t i s
p a yab le o n t he b o nd s. B ut co n ver s io n o f b o nd s ta ke p la ce o n ma t uri t y at a p re - d et er mi n ed
p rice. Us u al l y, t h er e i s a 5 yea r s ma t ur it y p er io d a nd t he y a re tr eat e d as a d e ferred eq u it y
is s ue .
E uro Bo n d s w it h Eq uit y Wa rra nt s : T he se c ar r y a co up o n ra te d et er m in ed b y ma r ket ra te s.
Th e warr a nt s ar e d e ta ch ab le . P ur e b o nd s are trad ed at a d is co u nt. Fi xed I nco me F u nd s
Ma na ge me nt ma y li k e to i n ve st f o r t h e p urp o se s o f r e g ula r i n co me.

Important Note for Students


Concentrate equally on theoretical portion of Cost & FM. Near
about 35% to 40% of the questions asked in examination
relates to theory. So, it gives you an assurance to get positive
result in odd situations also.

CA- IPCC- Financial Management`

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