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Unit - I
Introduction: Financial Management is that managerial activity which is concerned with the planning and
controlling oI the Iirm`s Iinancial resources. Financial management is a process oI identiIication, accumulation,
analysis, preparation, interpretation and communication oI Iinancial inIormation to plan, evaluate and control a
business Iirm. Financial management is a specialized Iunction oI general management which is related to the
procurement oI Iinance and its eIIective usage Ior the achievement oI the goals oI an organization. It was
branch oI economics till 1890, and as separate discipline it is oI recent origin still, the theoretical concepts are
drawn Irom economics.
Definition: Finance can be deIined as the art and science oI managing money. Finance is concerned with the
process, institutions, markets and instruments involved in the transIer oI money among individuals, business
Financial Management is the process oI decision making and controlling business operations.
Nature and scope of Financial Management:
Financial Management as an academic discipline has undergone Iundamental changes with regard to its scope
and coverage. In the earlier years, it was treated synonymously with the raising oI Iunds. In the later years, its
broader scope, included in addition to the procurement oI Iunds, eIIicient use oI resources.
Firms create manuIacturing capacities Ior production oI goods; they sell their goods or services to earn proIit.
They raise Iunds to acquire manuIacturing and other Iacilities. The three most important activities oI a business
A Iirm secures whatever sources it needs and employs it in activities which generate returns on invested capital.
#eal and financial assets: A Iirm requires real assets to carry on its business. Tangible real assets are physical
assets that include plant, machinery, oIIice, Iactory, Iurniture, and building. Intangible real assets are technical
know how, technological collaboration, patents and copyrights. Financial assets include shares, bonds and
Equity and borrowed Funds: There are two types oI Iunds that a Iirm can raise: Equity Iunds and borrowed
Iunds. A Iirm sells shares to acquire equity Iunds. Share holders invest their money in the shares oI a company
in the expectation oI a return on their invested capital. The return oI share holders consists oI dividend.
Another important source oI securing capital is creditors or lenders. Loans are generally Iurnished Ior a
speciIied period at a Iixed rate oI interest. For lenders, the return on loans comes in the Iorm oI interest paid by
Financial management is broadly concerned with the acquisition and use oI Iunds by a business Iirm. The
important tasks oI Iinancial management are,
1. Financial analysis, planning and control
a) Analysis oI Iinancial condition
b) !roIit planning
c) Financial Iorecasting
d) Financial control
a) Management oI current assets
b) Capital budgeting
c) Managing oI mergers, reorganizations and divestments
a) IdentiIication oI sources oI Iinance and determination oI Iinancing mix
b) Cultivating sources oI Iunds and raising Iunds.
c) Allocation oI proIits
Evolution of Financial Management:
The need Ior Iormation oI large scale business enterprises and consolidation movements in the early stages oI
century gave rise to the emergence oI Iinancial management` as a distinct Iield oI study. It was branch
oI economics till 1890, and as separate discipline it is oI recent origin still, the theoretical concepts are drawn
During the initial stages oI the evolution oI Iinancial management, more Iocus was placed on the study oI
sources and diIIerent Iorms oI Iinancing business enterprises. Business enterprises Iaced diIIiculties in raising
Iinance Irom banks and other Iinancial institutions in 1930`s due to economic recession. Hence, the areas such
as sound Iinancial structure and liquidity position oI the Iirm were emphasized. New methods oI planning and
control were concerned. The ways and means Ior assessing the credit worthiness oI the Iirms were developed.
The consequences oI World War II Iacilitated the business enterprises to adopt sound Iinancial structure and
reorganization. In the early 50`s emphasis was laid upon liquidity and day to day operations oI the Iirm rather
than on proIitability and institutional Iinance. ThereIore the extent oI Iinancial management was broadened to
include the process oI decision making within the Iirm.
The modern phase began in the mid 1950`s, and the concept oI Iinancial management became more analytical
and qualitative, with the application oI economic theories and quantitative methods oI Iinance analysis. 1960`s
witnessed phenomenal advances in the theory oI portIolio analysis`. CA!M (capital asset pricing model) was
developed in 1970`s, which suggested that investment in diversiIied portIolio oI securities can neutralize the
risks Iaced in Iinancial investments. In 1980`s taxation policies in personal and corporate Iinance played a vital
role. During this period the option pricing theory` was also developed. Globalization oI markets led to the
emergence oI Financial Engineering` which involves Iormation oI optimal solutions to problems conIronted in
The Iunctions oI raising Iunds investing them in assets and distributing returns earned Irom assets to
shareholders are respectively known as Iinancing decision, investment decision and dividend decision. A Iirm
attempts to balance cash inIlows and outIlows while perIorming these Iunctions. This is called liquidity
- Long term asset mix or Investment decision
- Capital mix or Financing decision
- !roIit allocation or Divided decision
- Short term asset mix or Liquidity decision
A Iirm perIorms Iinance Iunctions simultaneously and continuously in the normal course oI the business.
Finance Iunctions call Ior skillIul planning, control and execution oI a Iirm`s activity.
Investment decision: A Iirm investment decision involves capital expenditures. They are reIerred as capital
budgeting decisions. A capital budgeting decision involves the decision oI allocation oI capital and also the
evaluating oI the prospective proIitability oI new investment. Future beneIits oI investments are diIIicult to
measure and cannot be predicted with certainty. Risk in investment arises because oI the uncertain returns.
Hence, investment proposals are to be evaluated in terms oI both expected return and risk. Capital budgeting
also involves replacement decisions.
Financing decision: Financing decision is the second important Iunction in Iinance department. It is to decide,
where Irom and how to acquire Iunds to meet the Iirms investment needs. The central issue here is to determine
the appropriate proportion oI equity and debt. The mix oI debt and equity is known as the Iirm`s capital
structure. The Iirm`s capital structure is considered optimum when the market value oI shares is maximized.
Dividend decision: Dividend decision is the third maior Iinancial decision. The Iinance manager has to decide
in what proportion the Iirm has to distribute the dividends. The proportion oI proIits distributed as dividends is
called the dividend payout ration and retained portion oI the proIits is known as the retention ratio. The
optimum dividend policy is one that maximizes the market value oI the Iirm`s shares.
Liquidity decision: Investment in current assets aIIects the Iirm`s proIitability and liquidity. Current assets
management that aIIects a Iirm`s liquidity is yet another important Iinance Iunction. Current assets should be
managed eIIiciently Ior saIeguarding the Iirm against the risk oI illiquidity. Lack oI liquidity in extreme
situations can lead to the Iirm`s insolvency. A high rate oI investment in current assets would provide liquidity
but it would lose proIitability. As, the current assets would not earn anything thus, proIitability liquidity
tradeoII must be maintained.
Finance Iunctions are said to inIluence production, marketing and other Iunctions oI the Iirm. Hence, Iinance
Iunctions may aIIect the size, growth, proIitability and risk oI the Iirm and ultimately value oI the Iirm.
#ole of a Financial Manager:
A Iinancial manager is a person who is responsible, in a signiIicant way, to carry out the Iinance Iunctions. It
should be noted that, the Iinancial manager occupies a key position. Finance managers Iunctions not conIined to
preparing, maintaining records and raising Iunds when needed. He is now responsible Ior shaping Iortunes oI
the enterprise, and is involved in the most vital decision oI the allocation oI capital. He needs to have broader
outlook and must ensure the Iunds oI the enterprise are utilized in the most eIIicient manner.
The main Iunctions oI Iinancial manager are,
Funds raising: During the maior events, such as promotion, reorganization, expansion or diversiIication in the
Iirm that the Iinancial manager was called upon to raise Iunds.
Funds allocation: A number oI economic and environmental Iactors, such as the increasing pace oI
industrialization, technological innovations, intense competition, increasing intervention oI government on
account oI management ineIIiciency and Iailure, have necessitated eIIicient and eIIective utilization oI Iinancial
resources. The development oI a number oI management skills and decision-making techniques Iacilitated the
implementation oI a system oI optimum allocation oI Iirm`s resources. As a result, the emphasis shiIted Irom
raising oI Iunds to eIIicient and eIIective use oI Iunds.
!roIit planning: The Iunctions oI the Iinancial manager may be broadened to include proIit planning Iunction.
!roIit planning reIers to the operating decisions in the area oI pricing costs, volume oI output and the Iirm`s
selection oI product lines. !roIit planning is a prerequisite Ior optimizing investment and Iinancing decisions.
Understanding capital markets: Capital markets bring investors and Iirms together. Hence, the Iinancial
manager has to deal with capital markets. He should understand the operations oI capital markets and the way in
which it values the securities. He should also know how risk is measured and how to cope up with the risk in
investment and Iinancing decisions.
#elation between finance and other management functions:
Finance is the liIe blood oI an organization. It is a common thread, which binds all the organizational Iunctions.
There is an inseparable relationship between Iinance and other Iunctions. All most all business activities,
directly or indirectly, involve the acquisition and use oI Iunds. For ex: recruitment and promotion oI employees
in production is clearly a responsibility oI production department, but it requires payment oI wages and salaries
and other beneIits, and thus, involves Iinance. Sales promotion activity come with in the purview oI marketing,
but advertising and other sales promotion activities require investment oI cash and thereIore, aIIect Iinancial
We do not Iind an answer to the question where do the production and marketing Iunctions end and Iinance
Iunction begin? The Iinance Iunction oI raising and using money will have a signiIicant eIIect on other
Manufacturing - Finance:
1. ManuIacturing Iunction needs a large investment. !roductive use oI resources ensures a cost advantage Ior
2. Optimum investment in inventories improves proIit margin.
3. Many parameters oI the production cost having eIIect on production cost are possible to control through
internal management thus improving proIits.
4. Important production decisions like make or buy can be taken only aIter Iinancial implications have been
Marketing - Finance:
1. Many aspects oI marketing management have Iinancial implications eg: hold inventories to provide
uninterrupted service to customers, extension oI credit Iacility to customers in order to increase the sales.
2. Marketing strategies to increase sales have additional cost impact.
Personnel - Finance:
1. In the global competitive scenario, business Iirms are moving to leaner and Ilat organizations. Investments in
human resource development are also bound to increase.
2. !roviding remuneration and other incentives.
3. Restructuring oI remuneration structure, voluntary retirement scheme, sweat equity, etc., has become maior
Iinancial decisions in the area oI human resource management.
Strategic planning - Finance:
Finance Iunction is an important tool in the hands oI management Ior strategic planning and control on two
1. The decision variables when converted into monetary terms are easier to grasp.
2. Finance Iunction has strong inter-links with other Iunctions. Controlling other Iunctions is possible through
The changing role of financial management in India:
Modern Iinancial management has come a long way Iorm the traditional corporate Iinance. The Iinance
manager is working in a challenging environment, which changes continuously. As the economy is opening up
and global resources are being tapped, the opportunities available to Iinance manager have no limits. At the
same time, one must understand the risk in the decisions. Financial management is passing through an era oI
experimentation, as a large part oI the Iinance activities carried out today were not heard oI a Iew years ago.
1. Interest rates have been deregulated. Further, interest rates are Iluctuating, and minimum cost oI capital
necessitates anticipating interest rate movements.
2. The rupee has become Ireely convertible in current account oI international market.
3. Optimum debt equity mix is possible. Firms have to take advantage oI the Iinancial leverage to increase the
shareholders wealth. However, Iinancial leverage entails Iinancial risk. Hence a correct trade oII between risk
and improved rate oI return to share holders is a challenging task.
4. With Iree pricing oI issues, the optimum price oI new issue is a challenging task, as overpricing results in
under subscription and loss oI investor conIidence, whereas under pricing leads to unwarranted increase in a
number oI shares and also reduction oI earnings per share.
5. Maintaining share prices is crucial. In the liberalized scenario, the capital markets are important avenue oI
Iunds Ior business.
6. The dividend and bonus policies Iramed have a direct bearing on the share prices.
7. Ensuring management control is vital, especially in the light oI Ioreign participation in equity, making the
Iirm an easy takeover target. Financial strategies to prevent this are vital to the present management.
pproaches to Finance Function:
The diIIerent approaches associated with Iinance Iunction can be broadly categorized into two types. They are
1. The Traditional Approach
2. The Modern Approach
1. The Traditional pproach: The term Iinancial management` used in this modern era was known as
corporate Iinance` under traditional approach. This approach to Iinancial management was popular in the initial
stages oI its evolution as a separate branch oI academic study. Under this approach the role oI Iinancial manager
was limited to raising and administering oI Iunds needed by corporate enterprises to meet their Iinancial needs.
It broadly covers the Iollowing three aspects.
1. Arrangement oI Iunds Irom Iinancial institutions.
2. Arrangement oI Iunds through instruments, viz. shares, bonds, etc.
3. The legal and accounting relationships between a Iirm and its sources oI Iunds.
The scope oI traditional approach to Iinancial management was mainly concerned with raising oI Iunds
externally. The Iinance manager had a limited role to perIorm. He was expected to keep accurate Iinancial
records, prepare reports on the enterprise status, perIormance and manage Iunds in such a way that the Iirm
could meet its maturing obligations.
The traditional approach evolved during 1920`s and 1930`s and dominated academic thinking during the 1950`s
and through early 1940. It has now been discarded as it suIIers Irom serious limitations.
Limitations oI Traditional Approach:
1. Outsider Looking Approach: This approach is concentrated only on raising and administering oI Iunds Irom
the view point oI suppliers oI Iunds i.e., bankers, Iinancial institutions. It completely ignored the view point oI
those who had to take internal Iinancing decisions.
2. Ignored working capital problems: This approach emphasized on events like mergers, consolidation and
reorganizations oI enterprises, the result oI which is that the day to day Iinancial problems oI business
undertakings were ignored. This approach Iocused on long term Iinancing oI the business enterprises. The
problems relating to short term Iunds oI working capital were ignored.
3. No emphasis on allocation oI Iunds: The approach was conIined to issues involving procurement oI Iunds. It
did not emphasize on allocation oI Iunds, which is a matter oI concern today.
. The Modern pproach: The narrow scope oI traditional approach led to the emergence oI modern approach
in the mid 1950`s. The modern approach ahs a broader aspect oI Iinancial management which provides
conceptual and analytical Iramework Ior Iinancial decision making, by including both areas oI Iinance, raising
oI Iunds as well as their eIIective utilization. The new approach is an analytical way oI viewing the Iinancial
problems oI Iirms.
Features of Modern pproach:
1. The approach emphasizes not only on sources oI raising Iunds but also their eIIective and optimum
2. The cost oI raising Iinance and the return on their investment are compared. The investment should yield
more returns than the cost oI raising Iinance.
3. Financial management according to this approach covers the areas oI Iinancial planning and control, raising
oI corporate Iinance, eIIective utilization oI Iunds, etc.
4. The techniques oI models, linear programming, simulations, queuing and Iinancial engineering are used to
solve problems oI Iinancial management.
Thus, the modern approach widens the scope oI Iinancial management considering the maior management
decisions such as Iinancing decision, investment decision and dividend policy decision.
Goals of financial management:
1. Maintenance oI liquid assets: In order to meet the day to day operation, every Iirm should maintain necessary
2. Maximization oI !roIitability: The immediate obiective oI any business is to earn proIits and to maximize the
proIit as much as possible. Without proIit obiective no businessman starts business at all.
3. Ensuring Iair return to share holders
4. Building up reserves Ior growth and expansion.
5. Ensuring maximum operational eIIiciency by eIIicient and eIIective utilization oI Iunds.
6. Ensuring Iinancial discipline in the organization.
Maximization oI proIits is generally regarded as the main obiective oI a business enterprise. Each company
collects its Iinances by way oI issue oI shares to the public. Investors invest in shares with the hope oI getting
maximum proIits Irom the company in the Iorm oI dividend.
!rice system is the most important organ oI a market economy indicating what goods and services society
wants. Goods and services in great demand command higher prices. This result in higher proIit Ior Iirms more
oI such goods and services are produced. Higher proIit opportunities attract other Iirms to produce such goods
and services. Ultimately, with intensiIying competition, an equilibrium price is reached at which demand and
supply match. In the case oI goods and services, which are not required by society, their prices and proIits will
In the economic theory, the behavior oI a Iirm is analyzed in terms oI proIit maximization. !roIit maximization
implies that a Iirm either produces maximum output Ior a given amount oI input or uses minimum input Ior
producing a given output. The underlying logic oI proIit maximization is eIIiciency. It is assumed that proIit
maximization causes the eIIicient allocation oI resources under the competitive market conditions and proIit is
considered as the most appropriate measure oI a Iirm`s perIormance.
On the other hand, higher proIits are the barometer oI its eIIiciency on all Ironts, i.e., production, sales and
management. A Iew replace the goals oI maximization oI proIits to Iair proIits.
Fair proIits mean the general rate oI proIit earned by similar organizations in a particular area. The main
obiective oI Iinancial management is to saIeguard the economic interest oI the persons who are directly or
indirectly connected with the company i.e., shareholders, creditors and employees.
All such interested parties must get the maximum return Ior their contribution. But this is possible only when
the company earns higher proIits or suIIicient proIits to discharge its obligations to them. ThereIore the goal oI
maximization oI proIits is said to be best criterion oI the decision making.
rguments in favour of profit maximization:
1. !roIit is the test oI economic eIIiciency: It is a measuring rod by which the economic perIormance oI the
company can be iudged.
2. EIIicient allocation oI Iund: !roIit leads to eIIicient allocation oI resources as resources tend to be directed to
uses which in terms oI proIitability are the most desirable.
3. Social welIare: It ensures maximum social welIare i.e., maximum dividend to shareholders, timely payments
to creditors, more and more wages and other beneIits to employees, better quality at cheaper rate to consumers,
more employment society and maximization oI capital to the entrepreneur.
4. Internal resources Ior expansion: It will consume a lot oI time to raise equity Iunds in a primary market.
Retained proIits can be used Ior expansion and modernization.
5. Reduction in risk and uncertainty: Once aIter availing huge proIits the company develops risk bearing
capacity. The gross present value oI a course oI action is Iound by discounting and low capitalizing is beneIits
at a rate which reIlects their timing and uncertainty. A Iinancial action which has positive net present value
creates wealth and thereIore is desirable. The negative present value should be reiected.
6. More competitive: More and more proIits enhance the competitive spirit thus, under such conditions Iirms
having more and more proIits are considered to be more dependable and can survive in any environment.
7. Desire Ior controls: More and more proIits are desirable and imperative Ior the management t make optimum
use oI available Iinancial resources Ior continued survival.
Objections to Profit Maximization:
1. It is argued that proIit maximization assumes perIect completion, and in the Iace oI imperIect modern
markets, it cannot be a legitimate obiective oI the Iirm.
2. It is also argued that proIit maximization, as a business obiective, developed in the early 19
single entrepreneurship. Only aim oI single owner was to enhance his individual wealth. But the modern
business environment is characterized by limited liability and a diIIerence between management and ownership.
Share holders and lenders today Iinance the Iirm but it is controlled and directed by proIessional management.
In the new business environment, proIit maximization is regarded as unrealistic, diIIicult, inappropriate and
3. It is also Ieared that proIit maximization behavior in a market economy may tend to produce goods and
services that are wasteIul and unnecessary Irom the society`s point oI view.
4. Firms producing same goods and services diIIer substantially in terms oI technology, costs and capital. In
view oI such conditions, it is diIIicult to have a truly competitive price system, and thus, it is doubtIul iI the
proIit maximizing behavior will lead to the optimum social welIare.
5. !roIit cannot be ascertained will in advance to express the probability oI return as Iuture is uncertain. It is not
possible to maximize something that is unknown. Moreover the term proIit is vague and not clearly expressed.
6. The executive or the decision maker may not have enough conIidence in the estimates oI Iuture returns so
that he does not attempt Iurther to maximize. It is argued that a Iirm`s goal cannot be, to maximize proIits but to
attain a certain level or certain share oI the market or certain level oI sales.
7. The criterion oI proIit maximization ignores the time value Iactor it considers the total beneIits or proIits into
account while considering a proiect whereas the length oI time in earning that proIits is not considered at all.
Wealth maximization (shareholders wealth maximization) means maximizing the net present value oI a course
oI action to shareholders. Net present value or wealth oI a course oI action is the diIIerence between the present
value oI its beneIits and the present value oI its costs.
A Iinancial action that has a positive N!' creates wealth Ior shareholders and, thereIore, is desirable. A
Iinancial action resulting in negative N!' should be reiected since it would destroy shareholders wealth.
The obiective oI shareholder wealth maximization takes care oI the timing and risk oI the expected beneIits.
These problems are handled by selecting an appropriate rate Ior discounting the expected Ilow oI Iuture
beneIits. It is important to emphasize that beneIits are measured in terms oI cash Ilows. In investment decisions,
it is the Ilow oI cash that is important, not the accounting proIits.
The obiective oI shareholders wealth maximization is an appropriate and operationally Ieasible criterion to
choose among the alternative Iinancial actions. It provides unambiguous measure oI what Iinancial manager
should seek to maximize in making investment and Iinancing decisions on behalI oI shareholders.
Wealth maximizing obiectives is consistent with the obiective oI maximizing the business economic welIare
i.e., their wealth. The wealth oI owner is reIlected by the market value oI company`s shares.
Thus, it implies that the Iundamental principle oI the company is to maximize the market value oI the shares in
the long run. Long run means a considerably long period in order to work out a normalized market price, the
management can make decision to maximize the value oI its shares on the basis oI the day to day Iluctuation in
the market price.
Features of ealth maximization:
1. !rotection oI interest oI shareholders: Shareholders interest is protected by increased market value oI their
holdings in the Iirm.
2. Security to Iinancial lenders: It provides security to short term and long term Iinancial lenders, who supply
Iunds to the business enterprise. Short term lenders are interested in the Iirm`s liquidity position, whereas long
term lenders enioy priority over shareholder at the time oI return oI Iunds besides getting Iixed rate oI interest.
3. !rotection oI interest oI employees: Employees contribution is a primary consideration in raising the wealth
oI an enterprise. Their productivity and eIIiciency ultimately leads to IulIilling company`s obiective oI wealth
4. Survival oI Management: Management is a representative body oI shareholders. When shareholders interest
is protected, they may not wish to change the management and hence it can survive Ior a longer period oI time.
5. Interest oI society: When all the available productive resources are put to optimum and eIIicient use,
economic interest oI the society is served.
!roIit Maximization 's. Wealth Maximization:
!roIit Maximization Wealth Maximization
1. !roIit cannot be ascertained well in advance to
express the probability oI return. The term proIit has
no clear meaning.
1. There is no vagueness in wealth maximization goal.
It represents the value oI beneIits minus the cost oI
2. The executive or the decision maker may not have
enough conIidence in the estimates oI Iuture returns so
he does not attempt to maximize Iurther.
2. It is argued that a Iirm`s goal cannot be, to
maximize proIits but to attain a certain level or share
oI the market or certain level oI sales.
3. The risk variations and related capitalization rate is
not considered in the concept oI proIit maximization.
3. In wealth maximization, it is considered that there
should be balance between expected return and risk.
4. The goal oI proIit maximization is considered to be 4. The goal oI wealth maximization is considered to be
a narrow outlook. a broad outlook.
5. It ignores the interests oI the community. 5. Its obiective is to enhance the shareholders wealth.
6. The criterion oI proIit maximization ignores the
time value Iactor Ior the proIits oI a proiect.
6. Wealth maximization concept Iully considers the
time value Iactor oI cash inIlows.
gency #elationship and Cost
In large companies, there is a diIIerence between management and ownership. The decision taking authority in
a company lies in the hands oI managers. Shareholders as owners oI a company are the principals and managers
are their agents. Thus there is a principal agent relationship between them. In theory, managers should act in the
best interests oI shareholders i.e., their actions and decisions should lead to shareholders wealth maximization.
In practice, managers may not necessarily act in the best interest shareholders, and they may pursue their own
personal goals. Managers may maximize their own wealth in the Iorm oI high salaries at the cost oI
Such satisIying behaviour oI mangers will Irustrate the obiective oI shareholders wealth maximization. It is in
the interests oI managers that the Iirm survives over the long run. Managers also wish to enioy independence
and Ireedom Irom outside interIerence, control and monitoring. Thus their actions are very likely to be directed
towards the goals oI survival and selI suIIiciency. Managers in practice may perceive their role as reconciling
conIlicting obiectives oI stakeholders.
Shareholders continuously monitor modern companies that would help them to restrict manager`s Ireedom to
act in their own selI interest at the cost oI shareholders. Emplo9yees, creditors, customers and government also
keep an eye on manager`s activities. Thus the possibility oI managers pursuing exclusively their own personal
goals is reduced. Managers can survive only when they are successIul and they are successIul when they
manage the company better than someone else. Every group connected with the company will, however,
evaluate management success Irom the pint oI view oI the IulIillment oI its own obiective. The survival oI
management will be threatened iI the obiective oI any oI these groups remains unIulIilled.
The wealth maximization obiective may be generally in harmony with the interests oI the various groups such
as owners, employees, creditors and society and thus, it may be consistent with the management obiective oI
survival. Still, there are many situations where a conIlict may occur between the shareholders and managers
The conIlict between the interests oI shareholders and managers is reIerred as agency problem and it results in
agency costs. Agency costs include the less than optimum share value Ior shareholders and costs incurred by
them to monitor the actions oI mangers and control their behavior.
The optimal solution to shareholders management conIlicts is to monitor the managerial actions to some extent
and the managerial compensation should be based upon the perIormance. SpeciIic mechanisms, should be used
to motivate management to act in the shareholders interest are,
1. Management compensation plans: Managerial compensation should be designed in a way that it attracts and
retains desired management and managerial actions are close to shareholders interests. DiIIerent company`s
Iollows diIIerent compensation policies such as apart Iorm speciIied annual salary, a senior executive can be
provided with cash or bonus shares at the end oI Iinancial year.
2. Intervention oI shareholders in decision making: Shareholders, being the owners oI the company enioy voting
rights and right to attend the annual general meetings oI the company. Today maiority ownership lies with
corporate investors like insurance companies, mutual Iunds. They can suggest to the management on ways to
operate the business.
3. Threat oI Iiring: II the shareholders are not satisIies with the management`s perIormance, they can exercise
voting rights and replace the management at the annual general meeting.
4. Hostile takeover: Hostile takeovers are likely to occur when Iirm`s shares are undervalued because oI the
poor perIormance oI the management. In such takeovers, the management oI subsidiary company is replaced by
the management oI the holding company.
#isk - #eturn Trade-off
Financial decisions incur diIIerent degree oI risk. Your decision to invest your money in government bonds has
less risk as interest rate is known and the risk oI deIault is very less. On the other hand, you would incur more
risk iI you decide to invest your money in shares, as return is not certain. However, you can expect a lower
return Irom government bond and higher Irom shares. Risk and expected return move in one behind another.
The greater the risk, the greater the expected return.
Financial decisions oI a Iirm are guided by the risk-return trade-oII. These decisions are interrelated and iointly
aIIect the market value oI its shares by inIluencing return and risk oI the Iirm. The relationship between return
and risk can be simply expressed as:
Return ÷ Risk Iree rate ¹ Risk !remium
Risk Iree rate: Risk Iree rate is a rate obtainable Irom a deIault risk Iree government security. An investor
assuming risk Irom his investment requires a risk premium above the risk Iree rate. Risk Iree rate is a
compensation Ior time and risk premium Ior risk. Higher the risk oI an action, higher will be the risk premium
leading to higher required return on that action. A proper balance between return and risk should be maintained
to maximize the market value oI a Iirms share. Such balance is called risk return trade oII and every Iinancial
decision involves this trade oII.
MaxlmlzaLlon of share value
The Iinancial manager in order to maximize shareholders wealth should strive to maximize returns in relation to
the given risk. He should seek courses oI actions that avoid unnecessary risks. To ensure maximum return,
Iunds Ilowing in and out oI the Iirm should be constantly monitored to assure that they are saIeguarded and
properly utilized. The Iinancial reporting system must be designed to provide timely and accurate picture oI the
Unit - II
Introduction: An eIIicient allocation oI capital is the most important Iinance Iunction in the modern times. It
involves decisions to commit the Iirm`s Iunds to the long term assets. Capital budgeting or investment decisions
are oI considerable importance to the Iirm since they tend to determine its value by inIluencing its growth,
proIitability and risk.
Capital Budgeting: The investment decisions oI a Iirm are generally known as the capital budgeting or capital
expenditure decisions. A capital budgeting decision may be deIined as the Iirms decision to invest its current
Iunds most eIIiciently in the long term assets in anticipation oI an expected Ilow oI beneIits over a series oI
years. The long term assets are those that aIIect the Iirm`s operations beyond the one year period. The Iirm`s
investment decisions would generally include expansion, acquisition, modernization and replacement oI the
long term assets.
Capital budgeting may also be deIined as 'The decision making process by which a Iirm evaluates the purchase
oI maior Iixed assets.¨
The term 'Capital Budgeting' is used interchangeably with capital expenditure management, capital expenditure
decision, long term investment decision, management oI Iixed assets, etc. It may be deIined as 'planning,
evaluation and selection oI capital expenditure proposals¨. Capital budgeting involves a current outlay or serves
as outlays oI cash resources in return Ior an anticipated Ilow oI Iuture beneIits.
Lynch - "Cash budgeting consists in planning. development of available capital for the purchase of maximizing
the long term profitabilitv in the concern`.
Opportunity cost of capital: The investments should be evaluated on the basis oI a criterion, which is
compatible with the obiective oI the shareholders wealth maximization. An investment will add to the
shareholders wealth iI it yields beneIits in excess oI the minimum beneIits as per the opportunity cost oI capital.
In other words, the system oI capital budgeting is employed to evaluate expenditure decisions which involve
current outlays, but likely to produce beneIits over a period oI time longer than one year. These beneIits may be
either in the Iorm oI increased revenue or reduction in costs. Capital expenditure management thereIore
includes addition, disposition, modiIication and replacement oI Iixed assets. The basic Ieatures oI capital
1. !otentially large anticipated beneIits;
. A relatively high degree oI risk and
3. A relatively long time period between initial outlay and anticipated returns.
Fixed assets are Irequently termed as earning assets oI the Iirm in the sense that they usually generate large
return. Future sales growth is correlated with expansion oI capital expenditure. It is a specialized process
requiring highly sophisticated techniques and intricate Iorecasting Ior Iuture years. Closely scrutinized capital
expenditure selections result in increased sales, proIits, dividends and ultimately share price value oI the Iirm.
Capital budgeting is oI paramount importance in Iinancial decision making. Special care should be taken in
making these decisions on account oI the Iollowing reasons:
1. Such decisions aIIect the proIitability oI the Iirm. They also have bearing on the competitive position oI the
enterprise. This is mainly because oI the Iact that they relate to Iixed assets. The Iixed assets represent in a
sense, the true earning assets oI the Iirm. They enable the Iirm to generate Iinished goods that can ultimately be
sold Ior a proIit. However, current assets are not generally earning assets. They provide a buIIer that allows the
Iirm to make sales and extend credit. Capital budgeting decisions determine the Iuture destiny oI the company.
An opportune investment decision can yield spectacular returns. On the other hand an ill advised and incorrect
investment decision can endanger the very survival even oI large sized Iirms. A Iew wrong decisions and a Iirm
can be Iorced into bankruptcy. Capital budgeting is oI utmost importance to avoid over-investment and under-
investment in Iixed assets.
. A capital expenditure decision has its eIIect over a long time span and inevitably aIIects the company's Iuture
cost structure. To illustrate, iI a particular plan has been purchased by a company to start a new product, the
company commits itselI to a sizable amount oI Iixed assets in terms oI supervisors, salary, insurance, rent oI
buildings and so on. II the investment in Iuture turns out to be unsuccessIul or yields less proIit than anticipated,
the Iirm will have to bear the burden oI Iixed costs unless it writes oII the investment completely. In short, a
Iirm's Iuture costs, break-even point, sales and proIits will all be determined by the Iirm's selection oI assets i.e.,
Long term investment decisions are more difficult to take because:
O Decision extends to a series oI years and beyond the current accounting period;
O Uncertainties oI Iuture and
O Higher degree oI risk
3. Capital investment decision once made is not easily reversible without much Iinancial loss to the Iirm. It is
because there may be no market Ior second hand plant and equipment and their conversion to other uses may
not be Iinancially Ieasible.
4. Capital investment involves cost and the maiority oI the Iirms have scarce capital resource. This underlines
the need Ior thoughtIul, wise and correct investment decisions as an incorrect decision would not only result in
losses but also prevent the Iirm Irom earning proIits Irom other investments which could not be undertaken Ior
want oI Iunds.
5. Over / under capacity: To improve timing and quality oI asset acquisition, the capital expenditure decision
must be careIully drawn. II the Iirm has invested too much in assets, it will incur unnecessary heavy
expenditure. II it has not spent enough on Iixed assets, two serious problems may arise
(i) The Iirm`s equipment may not be suIIiciently modern to enable it to produce competitively.
(ii) II it has inadequate capacity it may lose a portion oI its share oI market to its rival Iirm. To regain lost
customers it would require heavy selling expenses, price reduction, product improvement, etc.
6. Investment decision though taken by individual concerns is one oI national importance because it determines
employment, economic activities and economic growth.
CPITL BUDGET DECISION
Capital budgeting reIers to the total process oI generating, evaluating, selecting and Iollowing up on capital
expenditure alternatives. The Iirm allocates or budgets Iinancial resources to new investment proposals.
Basically the Iirm may be conIronted with three types oI capital budgeting decisions.
1. ccept / #eject decision: This is the Iundamental decision in capital budgeting. II the proiect is accepted, the
Iirm invests in it. II the proposal is reiected the Iirm does not invest. In general all those proposals which yield a
rate oI return greater than a certain required rate oI return or cost oI capital are accepted and the rest are
reiected. By applying this criterion, all independent proiects are accepted. Independent proiects are proiects that
do not compete with one another in such a way that acceptance oI one preclude the possibility oI acceptance oI
another. Under the acceptance decision, all the independent proiects that satisIy the minimum investment
criteria are implemented.
. Mutually exclusive project decision: Mutually exclusive proiects are proiects which compete with other
proiects in such a way that the acceptance oI one will exclude the acceptance oI other proiects. The alternatives
are mutually exclusive and only one may be chosen. It may be noted that the mutually exclusive proiect
decisions are not independent oI accept / reiect decision. Mutually exclusive investment decisions acquire
signiIicance when more than one proposal is acceptable under the accept / reiect decision. Then some
techniques have to be used to determine the best one. The acceptance oI 'best' alternative automatically
eliminates the other alternatives.
3. Capital rationing decision: In a situation where the Iirm has unlimited Iunds, capital budgeting becomes a
very simple process. In that, independent investment proposals yielding a return greater than some
predetermined level are accepted. However, this is not the situation prevailing in most oI the business Iirm's oI
real world. They have Iixed capital budget. A large number oI investment proposals compete in these limited
Iunds. The Iirm allocates Iunds to proiects in a manner that it maximizes long run returns. Thus capital rationing
reIers to the situation where the Iirm has more acceptable investments requiring a greater amount oI Iinance
than is available with the Iirm. It is concerned with the selection oI a group oI investment proposals acceptable
under the accept / reiect decision. Ranking oI the investment proiect is employed. In capital rationing, proiects
can be ranked on the basis oI some predetermined criterion such as the rate oI return .The proiect with highest
return is ranked Iirst and the acceptable proiects are ranked thereaIter.
Importance of Investment Decisions / Capital Budgeting Decisions:
1. They inIluence the Iirm`s growth in the long run
2. They aIIect the risk oI the Iirm
3. They involve commitment oI large amount oI Iunds
4. They are irreversible, or reversible at substantial loss
5. They are among the most diIIicult decisions to make
Growth: The eIIects oI investment decisions extend into the Iuture and have to be endured Ior a longer period
than the consequences oI the current operating expenditure. Unwanted or unproIitable expansion oI assets will
result in heavy operating costs to the Iirm.
#isk: A long term commitment oI Iunds may also change the risk complexity oI the Iirm. II the adoption oI an
investment increases average gain but causes Irequent Iluctuations in its earnings, the Iirm will become more
Funding: Investment decisions generally involve large amount oI Iunds which make it necessary Ior the Iirm to
plan its investment programmes very careIully and make an advance arrangement Ior procuring Iinances
internally or externally.
Irreversibility: Most investment decisions are irreversible. It is diIIicult to Iind a market Ior such capital items
once they have been acquired. The Iirm will incur heavy losses iI such assets are scrapped. Investment decisions
once made cannot be reversed or may be reversed but at a substantial loss.
Complexity: Another important characteristic Ieature oI capital investment decision is that it is the most
diIIicult decision to make. Such decisions are an assessment oI Iuture events which are diIIicult to predict. It is
really a complex problem to correctly estimate the Iuture cash Ilow oI an investment.
INDS OF CPITL BUDGETING P#OPOSLS:
1. #eplacement / modification of fixed assets: e.g. worn out, obsolete are replaced at appropriate time.
. Expansion: involves an addition oI capacity to existing production Iacilities.
3. Modernization of investment expenditure: They make it easier Ior a Iirm to reduce cost and may coincide
with replacement decision.
4. Strategic investment proposal: These are capital budgeting decisions which do not assume that the return
will be immediate or measured over a long period oI time. Strategic investments are deIensive, oIIensive and
mixed motive decision. The vertical integration oI a Iirm is an example oI deIensive investment in which a
continuous source oI raw materials is assumed. Horizontal combinations are oIIensive investments Ior they
ensure a Iirm's internal and external growth respectively. Mixed motive investments are outlays on research and
5. Diversification of business: Means operating in several markets or Iirm one market into another market. It
may even amount to changing product lines.
6. #esearch and development: Where the technology is rapidly changing, research and development area is a
continuous activity in any Iirm. Usually large sums oI money are invested in research and development
activities which lead to capital budgeting decisions.
1. Expansion oI existing business
2. Expansion oI new business
3. Replacement and modernization
4. Expansion and DiversiIication: Generally expanding the Iirm`s capacity to produce more output will
accommodate high operational eIIiciency.
Related expansion / diversiIication: A company may add capacity to its existing product lines to expand existing
Unrelated diversiIication: A Iirm may expand its activities in a new business. Expansion oI a new business
requires investment in new products and a new kind oI production activity within the Iirm.
Revenue expansion investments: Sometimes a company acquires existing Iirms to expand its business. In either
case, the Iirm makes investment in the expectation oI additional revenue.
Replacement and Modernization: The main obiective oI modernization and replacement is to improve operating
eIIiciency and reduce costs. Cost savings will reIlect in the increased proIits, but the Iirms revenue may remain
unchanged. Assets become outdated and obsolete with technological changes. The Iirm must decide to repalcee
those assets with new assets that operate more economically.
II a certain company changes Iorm semi automatic equipment to Iully automatic drying equipment, it is an
example oI modernization and replacement. These are also called cost reduction investment.
Mutually exclusive investments: Mutually exclusive investments serve the same purpose and compete with each
other. II one investment is undertaken, others will have to be excluded. A company may, Ior example, either use
a labour intensive production method or capital intensive production method choosing capital intensive
production method will preclude labour intensive production method.
Independent investments: Independent investments serve diIIerent purposes and do not compete with each
other. Depending on their proIitability and availability oI Iunds, the company can undertake both investments.
For example, Mahindra & Mahindra can manuIacture two wheelers as well as Iour wheelers.
Contingent Investments: Contingent investments are dependent proiects the choice oI one investment
necessitates undertaking one or more other investments.
For example, iI a company decides to build a Iactory in a remote, backward area, it may have to invest in
houses, roads, hospitals, schools etc. Ior employees to attract the work Iorce.
Investment Decision Process
The allocation oI investible Iunds to diIIerent long term assets is known as capital budgeting decisions. Capital
budgeting is a complex process which may be divided into Iive broad phases.
1. !roiect generation
2. !roiect evaluation
3. !roiect selection
4. !roiect implementation
5. Controlling and review
1. Project generation: The planning phase oI a Iirm`s capital budgeting process is concerned with the
circulation oI its broad investment strategy and the generation and preliminary screening proiect proposals.
The investments strategy oI the Iirm delineates the broad areas or types oI investments the Iirm plans to
undertake. This provides the Iramework which shapes and guides the identiIication oI individual proiect
. Project evaluation: II the preliminary screening suggests that the proiect is prima Iacie worth while, a
detailed analysis oI the marketing technical, Iinancial, economic and ecological aspects is undertaken. The
questions and issues raised in such a detailed analysis are described in the Iollowing section.
The Iocus oI this phase oI capital budgeting is on gathering, preparing and summarizing relevant inIormation
about various proiect proposals which are being considered Ior inclusion in the capital budget. Based on the
inIormation developed in this analysis, the stream oI costs and beneIits associated with the proiect can be
3. Project selection: Selection Iollows an oIten overlaps, analysis. It addresses the questions. Is the proiect
worth while? A wide range oI appraisal criteria have been suggested to iudge to worth while oI a proiect. They
are divided into two broad categories: Non discounting criteria and Discounting criteria.
The principle in non discounting criteria is the pay back period and the accounting rate oI return.
The key discounting criteria are the net present value, the internal rate oI return and proIitability index.
To apply the various appraisal criteria suitable cut oII values have to be speciIied. These are essentially a
Iunction Ior the Iix oI Iinancing and the level oI proiect risk while the Iormer can be deIined with relative case;
the latter truly tests the liability oI the proiect evaluation.
4. Project implementation:
The implementation phase Ior an industrial proiect which involves setting up oI manuIacturing Iacilities
consists oI several stages.
Stage Concerned with
!roiect and engineering
Site probing and prospecting, preparation oI blue prints and plant designs, plant
engineering selection oI speciIic machines and equipment.
Negotiation and contracting Negotiating and drawing up oI legal contracts with respect to proiect Iinancing,
acquisition oI technology, supply oI machinery and know how and marketing
Construction Site preparation, construction oI buildings and civil work, erection and
installation oI machinery and equipment.
Training Training oI engineers, technicians and workers.
!lant commissioning Start up oI the plant.
5. Project #eview: Once the proiect is commissioned the review phase has to be set in motion. !erIormance
review should be done periodically to compare actual perIormance with proiected perIormance. A Ieedback
device, it is useIul in several ways,
1. It throws light on how realistic were the assumptions underlying the proiect.
2. It provides a documented long oI experience that is highly valuable in Iuture decision making.
3. It suggests corrective action to be taken in the light oI the actual perIormance.
Steps involved in Feasibility study
The available capital must be used in a manner which is consistent with the over all socio economic obiectives.
This becomes more diIIicult when there are several competing proiects, each giving a rate oI return higher than
the minimum cut oII rate.
!roiect appraisal may be deIined as a detailed evaluation oI the proiect to determine the technical Ieasibility,
economic Ieasibility, Iinancial Ieasibility and managerial competence.
!roiect Ieasibility study or appraisal consists oI the Iollowing:
1. Technical Ieasibility
2. Economic Ieasibility
3. Financial Ieasibility
4. Managerial competence
5. Market Ieasibility
1. Technical feasibility:
A proiect must be technically Ieasible. This can be iudged by a detailed assessment oI the Iollowing Iactors.
a. Technology used: The technology used has been tested and suits the local conditions. The technical study
helps us to know how is available and technical collaborators are persons oI good reputation.
b. !lant and equipment: The supplier oI plant equipment needed Ior the proiects are oI experience and
reputation. !lant layout is in accordance with the production Ilow programme.
. Economic and social feasibility:
Economic Ieasibility analysis is also reIerred to as a social cost beneIit analysis which is concerned with
iudging a proiect Irom the larger social point oI view but not in monetary terms. In such an evaluation, the Iocus
is on the social costs and beneIits oI a proiect which may oIten be diIIerent Irom the monetary costs and
beneIits to the Iirm.
a. The extent to which, the proiect is expected to contribute to national development.
b. The proiect can bring about the development in that area.
c. The proiect will crate more employment.
d. The atmospheric and other pollutants could be contained.
3. Financial Feasibility:
Financial appraisal is done to ascertain whether the proposed proiect will be Iinancially viable in the sense oI
being able to meet the burden oI servicing debt and whether the proposed proiect will satisIy the return
expectations oI those who provide capital. While appraising a proiect Iinancially, the Iollowing aspects should
be kept in mind.
a. Cost oI proiect: The estimates oI the proiect should cover all items expenditure and should be realistic.
b. Sources oI Iinance: Sources oI Iinance contemplated by the promoters should be adequate and necessary
Iinance should be available during installation. Factors to be considered while evaluating proiect on Iinancial
1. Investment outlay or cost oI proiect
2. Means oI Iinancing
3. !roiected proIitability
4. Break even point
5. Cash Ilows oI the proiect
6. Level oI risk
4. Managerial competence:
The technical competence, administrative ability, integrity and resourceIulness oI borrowing concerns top
managerial personnel determines to a great extent the willingness oI a Iinancial institutional to accept a term
The loan application Irom Iirms having competent and honest management Iinds Iavourable considerations. It
can thereIore be stated that the appraisal oI the managerial competence is oI primary importance in the overall
appraisal oI a proiect.
5. Market feasibility:
Market appraisal is concerned with two questions.
1. What would be the aggregate demand oI the proposed product/service in Iuture?
2. What would be the market share oI the proiect under appraisal?
In order to answer these questions a market analyst requires a wide variety oI inIormation and suitable
The inIormation required includes,
a. !ast and present consumption trends, consumer behavior and preIerences.
b. !ast and present supply position
c. !roduction constraints
d. Imports and exports
e. Structure oI competition
I. Cost structure and marketing policies
Capital Budgeting Techniques:
The most important techniques used in capital budgeting are,
1. !ay back !eriod Method
2. Accounting Rate oI Return or Average Rate oI Return Method
Discounted Cash Flow Methods:
3. Net !resent 'alue Method
4. Internal Rate oI Return Method
1. Pay back Period Method: !ay back period method is the simplest method oI evaluating investment
proposals. !ayback period represents the number oI years required to recover the original investment. The
payback period is also called payoII or payout. This period is calculated by dividing the cost oI the proiect by
the annual earnings aIter tax but beIore depreciation. Under this method proiect with shortest pay back period
will be given the highest rank and taken as best investment.
It is a traditional method oI capital budgeting. It is the simplest and most widely employed quantitative method
Ior appraising capital expenditure decisions. This method answers the question - how many years will it take Ior
cash beneIits to pay the original cost oI an investment normally disregarding salvage value. Cash beneIits here
represent cash Ilow aIter tax (CFAT) technique to pay back the original outlay required in an investment
There are two ways oI calculating the payback period. The Iirst method can be applied when the cash Ilow
stream is in the nature oI annuity Ior each year oI proiect's liIe, Ior cash Ilow adiusted techniques are uniIorm.
In such a situation the initial cost oI investment is divided by the constant annual cash Ilow. The second method
is used when a proiect's cash Ilows are not equal, but vary Irom year to year. In such a situation payback is
calculated by the process oI accumulating cash Ilows till the time when cumulative cash Ilows are equal to
original investment outlay.
ccept / #eject criterion:
The payback period can be used as a decision criterion to accept or reiect an investment proposal. One
application oI this technique is to compare the actual payback period with a predetermined payback i.e., the
payback set up by the management. II the actual payback period is less than the predetermined payback, the
proiect will be accepted. II not, it will be reiected. Alternatively the payback can be used as a rationing method.
When mutually exclusive proiects are under one consideration, they may be ranked according to the length oI
payback period. Thus the proiect having the shortest payback may be assigned rank one Iollowed in the order so
that the proiect with longest payback might be ranked last. The term mutually exclusive reIers to the proposals
out oI which only one can be accepted. Obviously proiect with shorter payback period will be selected.
Original cost oI the proiect
!ayback period ÷
Annual cash inIlow
1. Simple to understand and easy to calculate.
2. It reduces the chance oI loss. As the proiect with a short payback period is preIerred.
3. A Iirm which has shortage oI Iunds Iinds this method very useIul.
4. This method costs less as it requires only very little eIIort Ior its computation.
1. This method does not take into consideration the cash inIlows beyond the pay back period.
2. It does not consider the time value oI money.
3. It gives over emphasis to liquidity.
4. The Iirst maior shortcoming oI payback method is that it ignores all cash inIlows aIter the payback period.
This could be very misleading in capital budgeting valuation.
5. Another deIiciency oI payback method is that it does not measure correctly even the cash Ilows expected to
be received within the payback period as it does not diIIerentiate between proiects in terms oI timing or
magnitude oI cash Ilows. It considers only the recovery period as a whole. This happens because it does not
discount the Iuture cash inIlows but rather treats a rupee received Irom second or third year as valuable as a
rupee received Irom Iirst year. In other words, to the extent that payback method Iails to consider the pattern oI
cash inIlows, it ignores the time value oI money.
6. Another Iailure oI the payback method is that it does not take into consideration the entire liIe oI the proiect
during which cash Ilows are generated. As a result the proiect with large inIlows in the later part oI their lives
may be reiected in Iavor oI less proIitable proiects which happen to generate a larger proportion oI their cash
inIlows in the earlier part oI their lives.
7. It does not reIlect all the relevant dimensions oI proIitability.
. ccounting #ate of #eturn or verage #ate of #eturn Method:
This method is based on accounting proIit, takes into account the earnings expected Irom the investment over
the entire liIetime oI the asset. The various proiects are ranked in the order oI the rate oI returns. The proiect
with the higher rate oI return is accepted.
Return on investment method overcomes the deIiciencies oI payback period method in the sense that it
considers the earnings oI a proiect over its entire liIe.
1. The return on investment is estimated i.e., earnings or proIits estimated Irom an investment proposal during
its economic liIe, aIter providing Ior depreciation and taxes. It means net proIit Irom estimation is as per the
2. The rate oI return is compared with cut oII rate as determined by the management. Cut oII rate is the
minimum rate oI return on investment. It should be generated Irom a proIit which is generally the Iirm's cost oI
capital. Cost oI capital 15° - cut oII rate oI return ÷ 15°. The comparison helps management to rank the
various proiects and select the most proIitable one. II return on investment proposal is less than the cut oII rate,
it is reiected and accepted iI it is equal or more than the cut oII rate. In case oI mutually exclusive alternative
proiects, the proiects with higher rate oI return are selected.
Average annual earnings
ARR ÷ X 100
1. It is easy to understand and calculate.
2. It can be compared with the cut oII point oI return and hence the decision to accept or reiect is made easier.
3. It considers all the cash inIlows during the liIe oI the proiect, not like payback method.
4. It is a reliable measure because it considers net earnings.
5. The most Iavorable attribute oI this method is its simplicity and it is easy to understand.
6. It is based on the accounting concepts oI proIit which are easily calculated Ior Iinancial data.
7. The total beneIits associated with proiects are taken into account while calculating the IRR. !ayback method
Ior instance does not use the entire stream oI income. This approval gives due weightage Ior the proIitability oI
8. !roIits determined under this method aIter deducting depreciation and tax are as per the accounting principles
which give a better basis oI commission.
1. The concept oI time value oI money is ignored.
2. The average concept is not reliable, particularly in the times oI high Iluctuation in the returns.
3. The average concept dilutes the proIitability oI the proiect.
4. The method oI computation oI ARR is not standardized.
5. It uses accounting proIits and not cash Ilows in appraising the proiects. Accounting proIits are based on
arbitrary assumptions and choices and also include non-cash items. It is, thereIore, inappropriate to rely on them
Ior measuring the acceptability oI the investment proiects.
6. It does not take into account the time value oI money. The timing oI cash inIlows and outIlows is a maior
decision valuable in Iinancial decision making. Accordingly beneIits in the earlier years and later years cannot
be valued at par. To that extent, the ARR method treats these beneIits at par and Iails to take into account the
diIIerence in the time value oI money.
7. It does not diIIerentiate between the sizes oI investment regarding each proiect. Competing investment
proposals may have the same ARR but may require diIIerent average investments.
8. This method does not take into consideration any beneIits which can accrue to the Iirm Irom the sale or
abandonment oI equipment which is replaced by the new investment. The new investment Irom the point oI
view oI correct Iinancial decision should be measured in terms oI incremental cash outIlow due to new
investment (i.e., new investment minus sale proceeds oI existing equipment plus / minus tax adiustment). But
the ARR method doesn't make any adiustment in this regard to determine the level oI average investment.
Investment in Iixed assets is determined at their acquisition costs.
9. This method cannot be applied to a situation where investment in a proiect is to be made in parts.
Discounted Cash Flow / Time djusted Techniques
Discounted Cash Flow: Discounted cash Ilows are the Iuture cash inIlows reduced to their present value based
on a discounting Iactor. The process oI reducing the Iuture cash inIlows to their present value based on a
discounting Iactor or cutoII return is called discounting.
3. Net Present Value Method:
The net present value method considers the time value oI money. The cash Ilows oI diIIerent years are valued
diIIerently and made comparable in terms oI present values. The net cash inIlows oI various periods are
discounted using required rate oI return which is predetermined. Taking into conside3ration the scrap value, iI
the present value oI as cash inIlows exceeds the initial cost oI the proiect, the proiect is accepted otherwise
reiected. II there are two proiects giving net present value, the proiect with the higher net present value is
The cash inIlow in diIIerent years are discounted (reduced) to their present value by applying the appropriate
discount Iactor or rate and the gross or total present value oI cash Ilows oI diIIerent years are ascertained. The
total present value oI cash inIlows are compared with present value oI cash outIlows (cost oI proiect) and the
net present value or the excess present value oI the proiect and the diIIerence between total present value oI
cash inIlow and present value oI cash outIlow is ascertained and on this basis, the various investments proposals
NPV ÷ !resent value oI cash inIlows Investment
1. The most signiIicant advantage is that it explicitly recognizes the time value oI money, e.g., total cash Ilows
pertaining to two machines are equal but the net present value are diIIerent because oI diIIerences oI pattern oI
cash streams. The need Ior recognizing the total value oI money is thus satisIied.
2. It also IulIills the second attribute oI a sound method oI appraisal. In that it considers the total beneIits arising
out oI proposal over its liIe time.
3. It is particularly useIul Ior selection oI mutually exclusive proiects.
4. This method oI asset selection is instrumental Ior achieving the obiective oI Iinancial management, which is
the maximization oI the shareholder's wealth. In brieI the present value method is a theoretically correct
technique in the selection oI investment proposals.
1. It is diIIicult to calculate as well as to understand and use, in comparison with payback method or average
2. The second and more serious problem associated with present value method is that it involves calculations oI
the required rate oI return to discount the cash Ilows. The discount rate is the most important element used in
the calculation oI the present value because diIIerent discount rates will give diIIerent present values. The
relative desirability oI a proposal will change with the change oI discount rate. The importance oI the discount
rate is thus obvious. But the calculation oI required rate oI return pursuits serious problem. The cost oI capital is
generally the basis oI the Iirm's discount rate. The calculation oI cost oI capital is very complicated. In Iact there
is a diIIerence oI opinion even regarding the exact method oI calculating it.
3. Another shortcoming is that it is an absolute measure. This method will accept the proiect which has higher
present value. But it is likely that this proiect may also involve a larger initial outlay. Thus, in case oI proiects
involving diIIerent outlays, the present value may not give dependable results.
4. The present value method may also give satisIactory results in case oI two proiects having diIIerent eIIective
lives. The proiect with a shorter economic liIe is preIerable, other things being equal. It may be that, a proiect
which has a higher present value may also have a larger economic liIe, so that the Iunds will remain invested Ior
longer period while the alternative proposal may have shorter liIe but smaller present value. In such situations
the present value method may not reIlect the true worth oI alternative proposals. This method is suitable Ior
evaluating proiects whose capital outlays or costs diIIer signiIicantly.
4. Internal #ate of #eturn Method:
The internal rate oI return Ior an investment proposal is that discount rate which equates the present value oI
cash inIlows with the present value oI cash outIlows oI an investment. When compared the internal rate oI
return with a required rate oI return, iI the internal rate oI return is more than required rate oI return then, the
proiect is accepted else reiected. Incase oI more than one proiect; the proiect with highest IRR is selected.
The technique is also known as yield on investment, marginal eIIiciency value oI capital, marginal productivity
oI capital, rate oI return, time adiusted rate oI return and so on. Like net present value, internal rate oI return
method also considers the time value oI money Ior discounting the cash streams. The basis oI the discount
Iactor however, is diIIicult in both cases. In the net present value method, the discount rate is the required rate
oI return and being a predetermined rate, usually cost oI capital and its determinants are external to the proposal
under consideration. The internal rate oI return on the other hand is based on Iacts which are internal to the
proposal. In other words, while arriving at the required rate oI return Ior Iinding out the present value oI cash
Ilows, inIlows and outIlows are not considered. But the IRR depends entirely on the initial outlay and cash
proceeds oI proiect which is being evaluated Ior acceptance or reiection. It is thereIore appropriately reIerred to
as internal rate oI return. The IRR is usually, the rate oI return that a proiect earns. It is deIined as the discount
rate which equates the aggregate present value oI net cash inIlows (CFAT) with the aggregate present value oI
cash outIlows oI a proiect. In other words it is that rate which gives the net present value zero. IRR is the rate at
which the total oI discounted cash inIlows equals the total oI discounted cash outIlows (the initial cost oI
investment). It is used where the cost oI investment and its annual cash inIlows are known but the rate oI return
or discounted rate is not known and is required to be calculated.
!1 - Q
IRR ÷ L ¹ x D
!1 - !2
L ÷ Lower discount rate; !1÷ !resent value oI earnings at lower rate; !2÷ !resent value oI earnings at higher
rate; Q÷ Actual investment; D÷ DiIIerence in rate oI return.
1. Is a theoretically correct technique to evaluate capital expenditure decision? It possesses the advantages
which are oIIered by the N!' criterion such as; it considers the time value oI money and takes into account the
total cash inIlows and outIlows.
2. In addition, the IRR is easier to understand. Business executives and non-technical people understand the
concept oI IRR much more readily than they understand the concept oI N!'. For instance, Business X will
understand the investment proposal in a better way iI it is said that the total IRR oI Machine B is 21° and cost
oI capital is 10° instead oI saying that N!' oI Machine B is Rs. 15,396.
3. It itselI provides a rate oI return which is indicative oI proIitability oI proposal. The cost oI capital enters the
calculation later on.
4. It is consistent with overall obiective oI maximizing shareholders wealth. According to IRR, the acceptance /
reiection oI a proiect is based on a comparison oI IRR with required rate oI return. The required rate oI return is
the minimum rate which investors expect on their investment. In other words, iI the actual IRR oI an investment
proposal is equal to the rate expected by the investors, the share prices will remain unchanged. Since, with IRR,
only such proiects are accepted which have IRR oI the required rate; thereIore, the share prices will tend to rise.
This will naturally lead oI maximization oI shareholders wealth.
The I## suffers from serious limitations:
1. It involves tedious calculations. It involves complicated computation problems.
2. It produces multiple rates which can be conIusing. This situation arises in the case oI non-conventional
3. In evaluating mutually exclusive proposals, the proiect with highest IRR would be picked up in exclusion oI
all others. However, in practice it may not turn out to be the most proIitable and consistent with the obiective oI
the Iirm i.e., maximization oI shareholders wealth.
4. Under IRR, it is assumed that all intermediate cash Ilows are reinvested at the IRR. It is rather ridiculous to
think that the same Iirm has the ability to reinvest the cash Ilows at diIIerent rates. The reinvestment rate
assumption under the IRR is thereIore very unrealistic. Moreover it is not saIe to assume always that
intermediate cash Ilows Irom the proiect may be reinvested at all. A portion oI cash inIlows may be paid out as
dividends, a portion may be tied up with current assets such as stock, cash, etc. Clearly, the Iirm will get a
wrong picture oI the proiect iI it assumes that it invests the entire intermediate cash proceeds.
Net Present Value Vs. Internal #ate of #eturn
Net Present Value Internal #ate of #eturn
1. N!' is expressed in terms oI currency. 1. IRR is expressed in terms oI percentage.
2. N!' calculates additional wealth. 2. IRR does not calculate additional wealth.
3. N!' can deal with changing cash inIlows. 3. IRR method cannot be used to evaluate where the
cash Ilows are changing (i.e. initial outlay Iollowed by
cash Ilows and later outlay)
4. This is an easy method which can be understood
even by a layman because the N!' is expressed in
terms oI money.
4. A manager can better understand the concept oI
returns stated in percentages and Iind it easy to
summarize and compare to the required cost oI capital.
5. N!' suggests larger proiects which generates more
5. IRR suggests smaller proiects with shorter liIe and
earlier cash inIlows.
6. In N!' using diIIerent discount rates will result in
6. In IRR method what ever the discount rate we use,
it gives the same result.
Developing cash flows
Capital expenditures typically involve current and near Iuture costs that are expected to generate beneIits in the
Iuture. While measuring the costs and beneIits oI a capital expenditure proposal, you must bear in mind the
1. Focus on cash Ilows: Costs and beneIits must be measured in terms oI cash Ilows. Costs are cash outIlows
and beneIits are cash inIlows. Cash Ilows matter because they represent the purchasing power. Since accounting
Iigures are based on the accrual principle, they have to be adiusted to derive the cash Ilows. For example,
depreciation and other non cash charges, which are deducted in computing proIits Irom the accounting point oI
view, have to be added back as they do not entail cash outIlows.
Estimate cash inIlows on a post-tax basis. Some Iirms look at pre-tax cash Ilows and, to compensate that, apply
a discount rate greater than the cost oI the capital. However, there is no reliable basis Ior making such
2. Consider all incidental eIIects: In addition to its direct cash Ilows, a proiect may have incidental eIIects on
the rest oI the Iirm. It may enhance the proIitability oI some oI the existing activities oI the Iirm as it has a
complementary relationship with them or it may detract Irom the proIitability oI some oI the existing activities
as it has a competitive relationship with them all these must be taken into account.
3. Ignore sunk costs: Sunk costs represent past outlays that cannot be recovered and hence, are not relevant Ior
new investment decisions.
4. Include opportunity cost: II a proiect requires the use oI some resources already available with a Iirm, the
opportunity cost oI the resources should be charged to the proiect. The opportunity cost oI a resource is the
value oI net cash Ilows that can be derived Irom it iI it were put to its best alternative use.
5. Networking capital: Apart Irom investment in Iixed assets like land, machinery, building and technical know
how, a proiect also requires investment in current assets like cash receivables (debtors), and inventories. A
portion oI current assets is supported by non interest bearing current liabilities accounts payable (creditors) and
provisions. The diIIerence between current assets and non interest bearing current liabilities is the net working
capital. It is Iinanced by equity, preIerence and debt.
Components of Cash Flow Stream:
The cash Ilows stream oI a proiect may be divided into three parts as Iollows:
Initial Outlay: These represent the cash outIlows associated with investment in various proiect components.
Initial outlay ÷ Outlay on Iixed assets ¹ Outlay on net working capital
Operational Flow: These are cash inIlows expected during the operational phase oI the proiect.
Operational Ilow ÷ !roIit ¹ Depreciation Tax
Terminal Flow: Cash Ilows expected Irom the disposal oI assets when the proiect is terminated are reIerred to as
Terminal Ilow ÷ !ost tax salvage value oI Iixed asset ¹ !ost tax salvage value oI net working capital
pproaches for #econciliation
The conIlicts in proiect rankings may arise because oI size disparity, time disparity and liIe disparity.
A source oI ranking conIlict may be the disparity in the size oI initial outlays. Such conIlicts may arise mainly
because N!' represents an absolute magnitude whereas the IRR is a relative measure. The resolution oI
conIlict depends on the Iollowing circumstances oI the Iirm.
1. II the Iirm has enough Iunds available to it at a given cost oI capital, a proiect with bigger size is preIerable as
it contributes more to the N!' oI the Iirm.
2. II the Iirm has limited availability oI the Iunds and acceptance oI big sized proiect means the reiection oI
some other proiects, then the N!' oI big proiect must be compared with the sum oI N!' oI other proiects and
alternative with higher N!' is to be accepted.
!roiects may diIIer with respect to the sequence oI the pattern oI cash inIlows associated with that and such
time disparities oI cash inIlows may lead to conIlicts in ranking.
This conIlict can be resolved by deIining the reinvestment rates that are applicable to cash Ilow and calculation
modiIied versions oI N!' and IRR. This method is known as terminal value method and it involves the
Iollowing two steps.
In some cases the mutually exclusive alternatives have varying times and it may lead to conIlict in rankings.
One approach to resolve this conIlict is by comparing the alternatives on the basis oI their UniIorm Annual
Earnings (UAE) and selects the alternative with highest UAE.
The UAE oI a proiect is equal to the proiect oI N!' and CRF
UAE ÷ N!' X CRF
Where capital recovery Iactor (CRF) is simply the inverse oI the present value interest Iactor Ior annuity.
The UAE method appears appealing because it expresses the gains Irom the proiect in an annualized Iorm and
hence renders easy comparison between proiects with diIIerent expected lives.
In evaluating a capital budgeting proposal, the Iirm should recognize that the Iorecasted return may or may not
be achieved. This is the element oI risk in the decision making process.
Risk may be deIined as the likelihood that the actual return Irom an investment will be less than the Iorecast
return. Stated diIIerently, it is the variability oI return Iorm an investment.
Different types of risks / Sources of risks
All proiects Iace certain risks. Some oI the main risks are elaborated below.
1. Project specific risk: Revenue as well as cash Ilows Irom the proiect could be lower than estimated due to
inaccurate Iorecasts or poor management.
. #isk from competition: Again, revenue and cash Ilows could be inIluenced by sudden, unexpected action by
3. Industry specific risk: Government legislation or the introduction oI new technology could have its eIIect
on the industry to which the proiect belongs.
4. Market risk: Once more, developments oI an unexpected nature like a slow down in market growth or even
bank interest increase will take in toll on the proiect. Other Iactors in market risk are changing needs oI
consumers, changes in demand and supply.
5. International risk: !roiects abroad could Iace political risks or lower currency exchange rates which would
lower revenue and cash Ilows.
Business risk reIers to the variability in the operating proIit (EBIT) due to change in sales. In such a change that
the Iirm will not have ability to compete successIully with the assets that it purchases. Any operational
problems are classiIied as business risk.
Financial risk reIers to a risk on account oI pattern oI capital structure i.e., Debt-Equity mix. At this point the
investment will not generate suIIicient cash Ilows either to cover interest payments on money borrowed to
Iinance it or principal repayments on the debt or to provide proIits to the Iirm. Simply it is the variability oI
return Irom an investment.
Incorporation of risk into business decisions:
The decision situation as to risk may be broken down into three types,
1. Certainty (no risk)
The risk situation is one in which the probabilities oI particular event occurring are known while an uncertain
situation is one where these probabilities are not known. In other words in case oI risk chance oI Iuture loss can
be Ioreseen because oI past experience. Risk oI an investment proposal can be iudged Irom variability oI its
possible returns. Risk with reIerence to capital budgeting decision may be deIined as the variability that is likely
to occur in Iuture between estimated and actual return.
Greater the variability, the greater will be the risk and vice versa. ThereIore, the risk situation is one in which
the probabilities oI the particular event occurring are known.
While uncertainty is a situation where the probabilities oI the particular event are not known, in such a case risk
chances oI Iuture loses can be Ioreseen because oI past experience. In case oI uncertainty the Iuture cannot be
Risk has been always involved in all the capital budgeting decisions. So, there is a need to consider risk at the
time oI evaluating various investment proposals. In order to control risk, there are several techniques which
diIIer in their approach and methodology. These techniques are divided into two types. They are,
a) Conventional techniques
- !ayback period method
- Risk adiusted discount rate
- Certainty equivalents
- Sensitivity analysis
- Beta coeIIicient
b) Statistical techniques
- !robability distribution approach
- Decision tree approach
#isk adjusted discount rate: When an investor plans to invest in a particular business, he thinks about the
returns. In the same way, it is necessary to think about the risk.
For a long time, economic theorists have assumed that, to allow Ior risk, the business man required a premium
over and above an alternative, which was risk Iree. Accordingly, the more uncertain the returns in the Iuture, the
greater the risk and the greater the risk premium required based on this reasoning, it is proposed that the risk
premium be incorporated into the capital budgeting analysis through the discount rate. That is, iI the time
preIerence Ior money is to be recognized by discounting estimated Iuture cash Ilows, at some risk Iree rate, to
their present value, then to allow Ior the riskiness, we add a risk premium rate to the risk Iree discount rate.
The composite discount rate which consists oI risk Iree rate and risk premium is called risk adiusted discount
rate. It will allow both time preIerence and risk preIerence.
N!' ÷ NCF
Where k is a risk adiusted discount rate.
Risk adiusted discount rate ÷ risk Iree rate ¹ risk premium
The risk adiusted discount rate accounts Ior risk by varying the discount rate depending on the degree oI risk oI
investment proiects. A higher rate will be used Ior riskier proiects and a lower rate Ior less risky proiects.
According to risk adiusted discount rate method, iI N!' is negative then the proiect is reiected. II the N!' is
positive then the proiect is accepted.
II the IRR is greater than the risk adiusted discount rate then the proiect is accepted or iI the IRR is less than the
risk adiusted discount rate then the proiect is reiected.
1. It is simple and easily understood. 1. There is no easy way oI deriving a risk adiusted
discount rate. CA!M provides a basis oI calculating
the risk adiusted discount rate.
2. It provides inIormation Ior risk-averse businessman. 2. It is based on the assumption that investors are risk
3. It incorporates an attitude oI risk aversion towards
Certainty equivalent is common procedure Ior dealing with risk in capital budgeting which involves reducing
the Iorecasts oI cash Ilows to some conservative levels.
For example, iI an investor, according to his best estimate`, expects a cash Ilow oI Rs 60,000 next year, he will
apply an intuitive correction Iactor and may work with Rs 40,000 to be on saIe side. There is a certainty
equivalent cash Ilow.
In Iormal way, the certainty equivalent approach may be expressed as:
÷ the Iorecasts oI net cash Ilow without risk adiustment
÷ the risk adiustment Iactor or the certainty equivalent coeIIicient
÷ risk Iree rate assumed to be constant Ior all periods.
The certainty equivalent coeIIicient, assumes a value between 0 and 1, and varies inversely with risk. A lower
CE will be used iI greater risk is perceived and a higher CE will be used iI lower risk is anticipated. The
decision maker subiectively establishes the coeIIicients.
The certainty equivalent coeIIicient can be determined as a relation ship between the certain cash Ilows and the
risky cash Ilows.
Certain net cash Ilow
Risky net cash Ilow
Sensitivity analysis is a way oI analyzing change in the proiects N!' Ior a given change in one oI the variables.
It indicates how sensitive a proiect N!' is to changes in particular variables. The more sensitive the N!', the
more critical is the variable. It is also called 'What iI¨ analysis. It allows the investor to ask himselI: What is the
N!' iI sales increases or decreases? What is the N!' iI the variable cost or Iixed cost increases or decreases?
What is the N!' iI the investment increases or decreases? The Iollowing three steps are involved in the use oI
1. IdentiIication oI all those variables, which have an inIluence on the proiects N!'
2. DeIinition oI the underlying relation ship between the variables.
3. Analysis oI the impact oI the change in each oI the variables on the proiects N!'.
The decision maker, while perIorming sensitivity analysis, computes the proiects N!' Ior each Iorecast under
CA!M explains the behavior oI security prices and provides mechanism, whereby investors could assess the
impact oI proposed security investment on their overall portIolio risk and return.
The risk Ialls into two groups,
1. Systematic risk
2. Unsystematic risk
Systematic risk can be measured in relation to the risk oI a diversiIied portIolio known as market portIolio.
Unsystematic risk is a diversiIiable risk which concerns the Iactors internal to the Iirm. Systematic risk aIIects
all the Iirms.
Non-diversiIiable risk is assessed in terms oI beta coeIIicient. Beta is a measure oI volatility oI a security return
relating to the returns oI a broad based portIolio.
II beta coeIIicient ÷ 1, risk oI speciIied security ÷ market portIolio risk.
II beta coeIIicient ÷ 0, no market related risk accrues to the investor.
II beta coeIIicient ÷ -1, relationship is opposite.
With reIerence to the cost oI capi9tal CA!M draws the relationship between the rate oI return and non-
diversiIiable or relevant risk oI the Iirm
÷ Cost oI equity
÷ Risk Iree return
þ ÷ Beta coeIIicient
÷ Market return
Probability distribution approach:
The conventional techniques used to analyze and integrate risk associated with a proiect, do not calculate or
quantiIy the risk accurately. However, certain statistical techniques can be used to calculate the risk return
elements oI capital budget proposals. The most signiIicant element in statistical techniques is probability.
Concept of Probability
!robability is deIined as the chance oI happening or non happening oI a particular event. It is the probability oI
a particular event which can occur or cannot occur. II there is a possibility oI an event occurring, then it is
deIined as one (1). II there is no such chance that a particular event will happen then it is termed as zero (0).
Hence, the value oI the probability always lies between 0 and 1.
When calculating cash Ilows Ior a proposal, a Iinancial controller could end up with a series oI diIIerent cash
Ilows instead oI one. These cash Ilows are also associated with the degree oI probability that they would be
identical to those calculated. The cash Ilows and their probabilities are called probability distribution.
Unit - 4
Overview of Capital Structure
Solomon deIines 'Financial Management is concerned with the eIIicient use oI an important economic
resource, namely capital Iunds¨; this deIinition clearly reveals that the prime obiective oI Financial
Management is !rocurement oI Iunds and EIIective use oI these Iunds to achieve business obiectives.
A scientiIic analysis oI these instruments and its mobilization has a considerable signiIicance in the real
liIe situation. An unplanned capital structure may yield good result in the short run but it is dangerous in the
long run. Hence the study oI capital structure is become more relevance.
Capital structure planning keyed to the obiective oI proIit maximization ensures the minimum cost oI
capital and the maximum rate oI return to equity holders. The proper mix oI debt and equity play maior part in
capital structure, capital structure analysis helps to identiIy how much that organization raise their Iund in the
Iorm oI equity and debt. A Iinancial manager determines the proper capital structure Ior the Iirm.
Meaning of Capital structure
Capital Structure reIers to the mix oI sources Irom where the long term Iunds required in a business may
be raised, i.e. what should be the proportions oI the equity share capital, preIerence share capital, internal
sources, debentures, and other sources oI Iunds in the total amount oI capital which an undertaking may raise
Ior establishing its business.
Features of ppropriate Capital Structure
1. !roIitability: The most proIitable capital structure is one which tends to minimize the cost oI Iinancing
and maximize earnings per share.
2. Flexibility: The capital structure should such that company can raise Iunds whenever needed.
3. Conservation: The debt content in the capital structure should not exceed the limit which a company can
4. Solvency: The capital structure should be such that the Iirm does not run the risk oI becoming insolvent.
5. Control: The capital structure should be so devised that it involves minimum risk oI loss oI control.
Factors Determining Capital Structure
The capital structure decisions have to be planned in the initial stages oI a company. It is a management
decision aims at supplying the required amount oI capital. The role oI Iinance manager in deciding the amount
oI capital structure is signiIicant he has to study and analyze the beneIits and deIects oI issuing each type oI
Factors influencing capital structure:
1. Financial leverage
The use oI Iixed bearing securities, such as debt and preIerence capital along with owner`s equity
in the capital structure is described as Financial leverage`. This decision is most important Irom the point oI
view oI Iinancing decision. By having debt and equity in the capital mix, accompany will have an opportunity
oI deployment certain amount oI debt with an intention enioy the beneIit oI reduction in the percentage tax. The
beneIit so enioyed will be passed on to the equity shareholders in the Iorm oI high percentage oI dividend.
Ordinarily, debt securities increase the risk, while equity securities reduce the risk. Risk can be
measured to some extent by the use oI ratio, measuring gearing and time interest earned. The risk attached to
the use oI leverage is called Financial risk`. Financial risk is added with the use oI debt because oI increased
variability in the shareholders earnings. A Iirm can avoid the risk by doesn`t employ debt capital in the capital
3. Growth and Stability
In the initial stages, a Iirm can meet its Iinancial requirement through long-term sources,
particularly by raising equity shares when a company starts getting good response and cash inIlow capacity is
increased through sales, company can raise debt or preIerence capital Ior growth and expansion programmes oI
the company. The company which is having high sales revenue will opt Ior more amount oI debt Ior their
Iinancial requirement. In contrast to this when company which having less sales revenue must reduce its burden
4. #etaining control
The attitude oI the management towards retaining the control over the company will have direct
impact on the capital structure. II the existing shareholder wants to continue the same holding on the company,
they may not encourage the issue oI additional equity shares. The issues oI debenture and preIerence share will
also inIluenced by the reputation that is enioyed by the company. II the credit worthiness oI a Iirm is good; it
can raise the Iunds according to the desire oI the existing shareholders.
5. Cost of capital
The cost oI capital reIers to the expectation oI suppliers to Iunds. The obiective oI knowing the
cost oI capital is to increase the return on investment, so that, a Iirm should earn suIIicient proIits to repay the
interest and installment oI principal to the lenders. The market value oI equity share does not Iall because oI
minimum rate oI return. The cost oI debenture is assessed by taking the assured percentage oI interest. The Iund
borrowed Irom bank or Iinancial institutions will have the cost oI interest. The source oI preIerence share
capital will have cost oI percentage oI dividend. Debt is the cheaper source oI Iund when compared to other
sources. CareIul decision has to be made in selecting the size oI debt, because, beyond a particular ratio debt
increase the risk oI the Iirm. Hence cost oI capital inIluences the capital structure.
6. Cash flows
Cash Ilow ability oI a company will have direct impact on the capital structure. Cash Ilow
generation capacity oI a Iirm increases the Ilexibility oI the capital structure. Cash Ilow permits the company to
meet its short term obligations. A Iirm will have the obligation to pay dividend to equity share holders, interest
to bankers and debenture holders. Sound cash Ilow Iacilitates the company to raise Iunds through debt.
InsuIIicient availability oI cash or cash inIlow takes the company to a disastrous situation.
5. CPITL ST#UCTU#E THEO#IES
Capital Structure Theories:
The obiective oI a Iirm should be directed towards the maximization oI the value oI the Iirm, the capital
structure, or the leverage decision should be examined Irom the point oI view oI its impact on the value oI Iirm,
there are broadly three approaches or theories to study the capital structure they are as below:
1. Net Income Approach.
2. Net Operating Income Approach.
3. Modigliani and Miller Approach.
These approaches analyses the relationship between the leverage, cost oI capital, and the value oI Iirm in
diIIerent ways, however the Iollowing assumptions are made to understand these relationship.
1. There are only two sources oI Finance i.e. Debt and Equity.
2. The degree oI leverage can be changed by selling debt to repurchase shares or selling shares to retire
3. There are no retained earnings; it implies that entire proIit is distributed to shareholders.
4. The Operating proIit oI the Iirm is given and it is expected to grow.
5. The business risk is assumed to be constant and is not aIIected by the Iinancing mix decisions.
6. There are no corporate or personal taxes.
7. The investors have same subiective probability distribution oI expected earnings.
Net Income pproach
This Approach has been suggested by Durand. According to this approach a Iirm can increase its value
or lower the overall cost oI capital by increasing the proportion oI debt in the capital structure. In other words iI
the degree oI Iinancial leverage increases the weighted average cost oI capital will decline with every increase
in the debt content in total Iunds employed, while the value oI the Iirm will increase. Reverse will happen in
converse situation. Under this approach the value oI a Iirm will be maximum at a point where weighted average
cost oI capital is minimum.
4 The use oI debt does not change the risk perception oI investors.
4 Debt capitalization rate is less than the equity capitalization rate.
4 Corporate income taxes do not exist.
Net Operating Income pproach
According to net operating approach, the overall capitalization rate and the cost oI debt remain constant
Ior all degrees oI leverage. The cost oI debt, equity and overall capitalization in response to change in market
value oI debt and equity. The critical premise oI this approach is that the market capitalizes the Iirm as a whole
at a discount rate which is independent oI the Iirm`s debt-equity ratio is a consequence, the division between
debt and equity is irrelevant. An increase in the use oI debt Iunds which are apparently cheaper is oIIset by an
increase in the equity capitalization rate. This approach Iollows certain assumptions
The market capitalizes the value oI the Iirm as a whole (split between debt and equity is not important)
The market uses an overall capitalization rate depending on business risk
Use oI less costly debt Iunds increases the risk oI shareholders
Debt capitalization rate is a constant
Corporate income taxes do not exist
Modigliani and Miller Position
The Modigliani miller results indicate that the Iirm cannot change the value oI a Iirm by repacking the
Iirm`s securities. This approach argues that the Iirm`s overall cost oI capital cannot be reduced as debt is
substituted Ior equity, even though debt appears to be cheaper than equity. The reason Ior this is that as Iirm
adds debt. As this risk rises, the cost oI equity capital rises as a result. MM prove that the two eIIects exactly
oIIset each other, so that the value oI the Iirm and the Iirm`s overall cost oI capital are invariant to leverage. The
Iollowing are the assumptions Iollowed by MM approach.
The market capitalizes the value oI the Iirm as a whole, which makes the split between debt and equity
The market uses an overall capitalization rate to capitalize the NOI. This overall capitalization depends
on the business risks.
The use oI less costly debt Iunds increases the risk oI shareholder which causes the increase oI overall
The debt capitalization rate is constant.
The corporate Income-tax does not exist.
5.3 Sources of Long term Fund
Different sources of Finance:
The diIIerent sources oI Iinance can be classiIied into the Iollowing categories;
Security Financing : Financing through Shares and Debentures
Internal Financing : Financing through retained earnings.
Loans Financing : Includes both short and long term loans.
Long Term Sources of Finance:
There are diIIerent sources oI Iunds available to meet the long term Iinancial needs oI the business. These
sources may be broadly classiIied into share capital (both preIerence and equity share capital) and Debt.
Long term Iunds Irom preIerence shares can be raised through a public issue oI shares. Such
shares are normally cumulative i.e. dividend payable in a year oI loss gets carried over to the next year till there
is adequate proIit to pay cumulative dividends. Most oI the preIerence shares these days carry a stipulation oI
period and the Iunds have to be repaid at the end oI a stipulated period.
!reIerence share capital is a hybrid Iorm oI Iinancing which partakes some characteristics oI equity capital
and some attributes oI debt capital. It is similar to equity because preIerence dividend is not a tax deductible
payment. It resembles debt capital because the rate oI preIerence dividend is Iixed. Typically, when preIerence
dividend is skipped it is payable in Iuture because oI the cumulative Ieature associated with most oI the
There is no legal obligation to pay preIerence dividend. A company does not Iace bankruptcy or legal
action iI it skips dividend
!reIerence capital is generally regarded as part oI net worth. Hence, it enhances the creditworthiness oI
!reIerence shares do not, under normal circumstances, carry voting right. Hence, there is no dilution oI
No assets are pledged in Iavour oI preIerence shareholders. Hence, the mortgage able assets oI the Iirm
Compared to debt capital, it is very expensive source oI Iinancing because the dividend paid to
preIerence shareholders is not, unlike debt interest, a tax-deductible expense
Compared to equity shareholders, preIerence shareholders have a prior claim on the assets and earnings
oI the Iirm.
Equity capital represents ownership capital, as equity shareholders collectively own the company. They
enioy the rewards and bear the risks oI ownership. However, their liability, unlike the liability oI the owner in a
proprietary Iirm and the partners in a partnership concern, is limited to their capital contribution.
There is no compulsion to pay dividends. II the Iirm has insuIIiciency oI cash it can skip equity
dividends without suIIering any legal consequences
Equity capital has no maturity date and hence the Iirm has no obligation to redeem.
!resently, dividends are tax-exempt in the hands oI investors.
The company paying equity dividend, however, is required to pay a dividend distribution tax.
Sales oI equity shares to outsiders dilutes the control oI existing owners
The cost oI equity capital is high, usually the highest. The rate oI return required by equity shareholders
is generally higher than the rate oI return required by other investors
Equity dividends are paid out oI proIit aIter tax, whereas interest payments are tax-deductible expenses.
This makes the relative cost oI equity more. !artially oIIsetting this advantage is the Iact that equity dividends
are tax-exempt, whereas interest income is taxable, in the hands oI investors
Long term Iunds may be also provided by accumulating the proIits oI the company and by ploughing back
the proIit into the business. Such Iunds belong to the ordinary share holders and increase the net worth oI the
company. A public limited company must plough back a reasonable amount oI proIit every year keeping in
view oI legal requirements, these Iunds entail no risk and the control oI the owners is not diluted.
A Iirm can make use oI diIIerent sources oI Iinancing whose costs are diIIerent. These
sources may be, Ior the purpose oI exposition, classiIication into those which carry a Iixed rate oI return and
those on which the returns vary. The Iixed returns oI some sources oI Iinance have implications Ior those who
are entitled to a variable return. Thus, since these debts involves the payment oI a stated rate oI interest, the
return to the ordinary share holders is aIIected by the magnitude oI debt in the capital structure oI the Iirm.
The employment oI an asset or source oI Iunds Ior which the Iirm has to pay a Iixed cost or
Iixed return may be termed as Leverage.
Consequently, the earnings available to the shareholders as also aIIected. II the earnings less the variable cost
exceed the Iixed cost or earnings beIore interest and taxes exceeds the Iixed return requirements, the leverage is
called as Favourable Leverage. When they do not, the result is UnIavourable Leverage.
There are two types oI leverage-Operating` and Financial`. The leverage associated with
investment activities is reIerred to as Operating leverage. The leverage associated which is associated with
Iinancing activities is known as Financial Leverage, while leverage associated with Iinancial leverage Ior
purpose oI the Iinancial decision oI a Iirm, the discussion oI operating leverage is to serve as a background to
the understanding oI Iinancial leverage because the two are closely related.
Operating leverage is determined by the relationship between the Iirm`s sales revenues and its earnings
beIore interest and taxes (EBIT). The earnings beIore interest and taxes are also generally called as Operating
proIit. Financial leverage represents the relationship between the Iirm`s earnings beIore interest and taxes
(Operating proIit) and the earnings available Ior ordinary shareholders. The operating proIits (EBIT) are, thus,
used as the pivotal point in deIining operating and Iinancial leverages. In a way, Operating and Financial
leverage represents two stages in the process oI determining the earning available to the equity shareholders.
Operating leverage results Irom the existence oI Iixed operating expenses in the Iirm`s income stream.
The operating cost oI a Iirm Iall into three categories; (i) Iixed cost which may be deIined as those which do not
vary with sales volumes; they are a Iunction oI time and are able; (ii) variable cost which vary directly with the
sales volume; and (iii) semi-variable or semi-Iixed costs are those which are partly Iixed and partly variable.
They are Iixed over a certain range oI sales volume and increase to higher levels Ior higher sales volumes
components, the costs oI the cost oI a Iirm, in operational terms, can be divided into (a) Iixed, and (b) variable.
The operating leverage may be deIined as the Iirm`s ability to use Iixed operating costs to modiIy the
eIIect oI changes in sales on its earnings beIore interest and taxes. Operating leverage occurs any times a Iirm
has Iixed cost that must meet regardless oI volume. We employ assets with Iixed cost in the hope that volume
will produce revenues more than suIIicient to cover all Iixed and variable cost. In the other words, with Iixed
costs, the percentage change in proIits accompanying a change in the volume is greater than the percentage
change in the volume. This occurrence is known as operating leverage. Operating leverage is calculated by
using the Iollowing Iormula;
Sales - Variable cost
Operating leverage ÷
Degree of Operating Leverage - DOL; This is more precise measurement in terms oI degree oI operating
leverage (DOL). The DOL measures in quantitative terms to extend or degree oI operating leverage. The higher
the degree oI operating leverage, the more volatile the EBIT Iigure will be relative to a given change in sales, all
other things remaining the same. The Iormula is as Iollows:
Percentage change in EBIT
DFL÷ > 1
Percentage change in SLES
This ratio is useIul as it helps the user in determining the eIIects that a given level oI operating leverage has on
the earnings potential oI the Iirm. This ratio can also be used to help the Iirm determine the most appropriate
level oI operating leverage in order to maximize the company's EBIT.
Financial leverage relates to the Iinancing activities oI a Iirm. The sources Irom which Iunds can be
raised by a Iirm, Irom the point oI view oI the cost/charges, can be categorised into (i) those which carry a Iixed
Iinancial charges, and (ii) those which do not involve any Iixed charges. The sources oI Iunds in the Iirst
category consist oI various types oI long-term interest which is a contractual obligation Ior the Iirm. Although
the dividend on preIerence shares is not a contractual obligation, it is a Iixed charge and must be paid beIore
anything is paid to the ordinary shareholders. The equity shareholders are entitled to remember oI the operating
proIits oI the Iirm aIter all the prior obligations are met. We assume in the subsequent discussions that all
preIerence dividends are paid in order to ascertain the operating proIits available Ior distribution to ordinary
Financial leverage results Irom the presence oI Iixed Iinancial charges in the Iirm`s income
stream. These Iixed charges do not vary with the earning beIore interest and taxes (EBIT) or operating proIit.
They are to be paid regardless oI the amount oI EBIT available to pay them. AIter paying them, the operating
proIit (EBIT) belongs to ordinary share holders. Financial leverage is concerned with the eIIect oI changes in
EBIT on the earning available to equity shareholders. It is deIined as the ability oI the Iirm to use Iixed Iinancial
charges to magniIy the eIIect oI changes in EBIT on the earnings per share. In the other words, Iinancial
leverage involves the use oI Iunds to obtain at a Iixed cost in the hope oI increasing the returns to the
Favourable leverage occurs when earns more on the assets purchased with the Iunds, than the
Iixed cost oI their use. UnIavourable or Negative leverage occurs when the Iirm does not earn as much as the
Iund cost. Thus, Iinancial leverage is based on the assumption that the Iirm is to earn more on the assets that are
required by the use oI Iunds on which a Iixed rate oI interest/dividend is to be paid. Financial leverage is
calculated by the Iollowing Iormula;
Financial leverage ÷
EBIT - Interest
Degree of Financial Leverage - DFL; Financial leverage can be more precisely expressed in terms oI the
degree oI Iinancial leverage (DFL). The DFL can be calculated by
Percentage change in EPS
DFL÷ > 1
Percentage change in EBIT
The operating leverage has it eIIects on the operating risk and is measured by the percentage
change in EBIT due to the percentage change in sales. The Iinancial leverage has its eIIects on Iinancial risk and
is measured by the percentage change in E!S due to percentage change in EBIT.
Since both these leverages are closely concerned with ascertaining the ability to cover Iixed
Iinancial charges (Iixed-operating coat in the case oI operating leverage and Iixed-Iinancial costs in case oI
Iinancial leverage), iI they are combined, the result is total leverage and the risk associated with Combined
Leverage is known as total risk. Combined leverage can be calculated by multiplying both Operating leverage
and Financial leverage. The Iollowing Iormula can also be used to calculate combined leverage.
Sales - Variable cost
Combined Leverage ÷
EBIT - Interest
'ABC analvsis refers to the annual consumption value of the items.`
One oI the most widely recognized concepts oI inventory management is reIerred to as ABC inventory
control. The maintaining appropriate control according to the potential savings associated with a proper level oI
such control. The ABC approach is a means oI categorizing inventoried items into three classes 'A¨, 'B¨, 'C¨
according to the potential amount to be controlled. 'A¨ items iustiIy the use oI price control techniques, where
'C¨ items should be controlled by means oI general control techniques.
The primary criterion Ior classiIying items into 'A¨ and 'C¨ categories is the annual rupees usage oI each item.
This is accomplished by multiplying the annual unit usage oI each inventories item by its unit cost and then
listing all items in descending order according to annual rupees usage. This listing should also include 'C¨
column to show the cumulative annual rupees usage by line item. Such a listing reIlects the distribution oI
annual rupees usage. A typical distribution in a manuIacturing operation shows that the top 15° oI the line
items, in terms oI annual rupees usage, represent 80° oI the total annual rupees usage. These items are
normally classiIied as 'A¨ items. The next 15° oI the line items, in terms oI the annual rupees usage, reIlect an
additional 15° oI the annual rupees usages and are designed as 'B¨ items. The 'C¨ items represent the
remaining 70° oI the items in inventory and account Ior only 5° oI the total rupees usage.
In addition to annual rupees usage, several other Iactors need to be considered in developing criteria Ior
classiIying items into 'A¨, 'B¨ and 'C¨ categories.
Advantages of ABC analvsis:
Closer and stricter control on those items which represent a maior portion oI total stock value.
Investment in inventory can be regulated and Iunds can be utilized in the best possible manner.
Saving in stock carrying costs.
Helps in maintaining enough saIety stock Ior 'C¨ category oI items.
ScientiIic and selective control helps in the maintenance oI high stock turnover rate.
ECONOMIC O#DE# QUNTITY (EOQ):
The economic order quantity is that inventory level, which minimizes the total oI ordering costs and carrying
It is the question, how much to order the quantity when inventory is replenished. II the Iirm is buying raw
materials, the question is to purchase the quantity oI each replenishment and iI it has to plan Ior production run,
it is how much production to schedule. It may be solved through EOQ.
It involves two types oI costs:
1. Carrying cost
. Ordering cost
EOQ Ior an item is arrived by the Iollowing Iormula; the Iollowing assumptions are made in the
standard Wilson lot size Iormula to obtain EOQ:
a. Demand is continuous at a constant rate.
b. The process continues inIinity.
c. No constraints are imposed on quantities ordered, storage capacity, budget etc.
d. Replenishment is instantaneous.
e. All costs are time invariant.
f. No shortages are allowed.
g. Quantity discounts are not available.
EOQ Ior an item is arrived by the Iollowing Iormula,
EOQ ÷ 2 * AC * CO
EOQ ÷ Economic Order Quantity
AC ÷ Annual Consumption oI an item
CO ÷ Ordering Cost
CC ÷ Carrying Cost
Merger is deIined as combination oI two or more companies into a single company where one survives
and the others lose their corporate existence. The survivor acquires all the assets as well as liabilities oI the
merged company or companies. Generally, the surviving company is the buyer, which retains its identity, and
the extinguished company is the seller.
Merger is also deIined as amalgamation. Merger is the Iusion oI two or more existing companies. All
assets, liabilities and the stock oI one company stand transIerred to transIeree company in consideration oI
payment in the Iorm oI:
O Equity shares in the transIeree company,
O Debentures in the transIeree company,
O Cash, or
O A mix oI the above modes.
Acquisition in general sense is acquiring the ownership in the property. In the context oI business
combinations, an acquisition is the purchase by one company oI a controlling interest in the share capital oI
another existing company.
Methods oI Acquisition:
An acquisition may be aIIected by
(a) agreement with the persons holding maiority interest in the company management like members oI the
board or maior shareholders commanding maiority oI voting power;
(b)purchase oI shares in open market;
(c) to make takeover oIIer to the general body oI shareholders;
(d)purchase oI new shares by private treaty;
(e) Acquisition oI share capital through the Iollowing Iorms oI considerations viz. means oI cash, issuance
oI loan capital, or insurance oI share capital.
A takeover` is acquisition and both the terms are used interchangeably.
Takeover diIIers Irom merger in approach to business combinations i.e. the process oI takeover,
transaction involved in takeover, determination oI share exchange or cash price and the IulIillment oI goals oI
combination all are diIIerent in takeovers than in mergers. For example, process oI takeover is unilateral and the
oIIeror company decides about the maximum price. Time taken in completion oI transaction is less in takeover
than in mergers, top management oI the oIIeree company being more co-operative.
De-merger or corporate splits or division:
De-merger or split or divisions oI a company are the synonymous terms signiIying a movement in the
at will it take to succeed?
Funds are an obvious requirement Ior would-be buyers. Raising them may not be a problem Ior
multinationals able to tap resources at home, but Ior local companies, Iinance is likely to be the single biggest
obstacle to an acquisition. Financial institution in some Asian markets are banned Irom leading Ior takeovers,
and debt markets are small and illiquid, deterring investors who Iear that they might not be able to sell their
holdings at a later date. The credit squeezes and the depressed state oI many Asian equity markets have only
made an already diIIicult situation worse. Funds apart, a successIul Mergers & Acquisition growth strategy
must be supported by three capabilities: deep local networks, the abilities to manage uncertainty, and the skill to
distinguish worthwhile targets. Companies that rush in without them are likely to be stumble.
ssess target quality:
To say that a company should be worth the price a buyer pays is to state the obvious. But assessing
companies in Asia can be Iraught with problems, and several deals have gone badly wrong because buyers
Iailed to dig deeply enough. The attraction oI knockdown price tag may tempt companies to skip crucial checks.
Concealed high debt levels and deIerred contingent liabilities have resulted in large deals destroying value. But
in other cases, where buyers have undertaken detailed due diligence, they have been able to negotiate prices as
low as halI oI the initial Iigure.
Due diligence can be diIIicult because disclosure practices are poor and companies oIten lack the
inIormation buyer need. Moreover, most Asian conglomerates still do not present consolidated Iinancial
statements, leaving the possibilities that the sales and the proIit Iigures might be bloated by transactions
between aIIiliated companies. The Iinancial records that are available are oIten unreliable, with diIIerent
proiections made by diIIerent departments within the same company, and diIIerent proiections made Ior
diIIerent audiences. Banks and investors, naturally, are likely to be shown optimistic Iorecasts.
Purpose of Mergers and cquisition:
The purpose Ior an oIIeror company Ior acquiring another company shall be reIlected in the corporate
obiectives. It has to decide the speciIic obiectives to be achieved through acquisition. The basic purpose oI
merger or business combination is to achieve Iaster growth oI the corporate business. Faster growth may be had
through product improvement and competitive position.
Other possible purposes Ior acquisition are short listed below: -
(1)Procurement of supplies:
1. To saIeguard the source oI supplies oI raw materials or intermediary product;
2. To obtain economies oI purchase in the Iorm oI discount, savings in transportation costs, overhead costs
in buying department, etc.;
3. To share the beneIits oI suppliers economies by standardizing the materials.
()#evamping production facilities:
1. To achieve economies oI scale by amalgamating production Iacilities through more intensive utilization
oI plant and resources;
2. To standardize product speciIications, improvement oI quality oI product, expanding
3. market and aiming at consumers satisIaction through strengthening aIter sale
5. To obtain improved production technology and know-how Irom the oIIeree company
6. To reduce cost, improve quality and produce competitive products to retain and
7. To improve market share.
(3) Market expansion and strategy:
1. To eliminate competition and protect existing market;
2. To obtain a new market outlets in possession oI the oIIeree;
3. To obtain new product Ior diversiIication or substitution oI existing products and to enhance the product
4. Strengthening retain outlets and sale the goods to rationalize distribution;
5. To reduce advertising cost and improve public image oI the oIIeree company;
6. Strategic control oI patents and copyrights.
(4) Financial strength:
1. To improve liquidity and have direct access to cash resource;
2. To dispose oI surplus and outdated assets Ior cash out oI combined enterprise;
3. To enhance gearing capacity, borrow on better strength and the greater assets backing;
4. To avail tax beneIits;
5. To improve E!S (Earning per Share).
(5) General gains:
1. To improve its own image and attract superior managerial talents to manage its aIIairs;
2. To oIIer better satisIaction to consumers or users oI the product.
(6) Own developmental plans:
The purpose oI acquisition is backed by the oIIeror company`s own developmental plans.
A company thinks in terms oI acquiring the other company only when it has arrived at its own
development plan to expand its operation having examined its own internal strength where it might not
have any problem oI taxation, accounting, valuation, etc. but might Ieel resource constraints with
limitations oI Iunds and lack oI skill managerial personnel`s. It has to aim at suitable combination where
it could have opportunities to supplement its Iunds by issuance oI securities, secure additional Iinancial
Iacilities, eliminate competition and strengthen its market position.
(7) Strategic purpose:
The Acquirer Company view the merger to achieve strategic obiectives through alternative type oI
combinations which may be horizontal, vertical, product expansion, market extensional or other
speciIied unrelated obiectives depending upon the corporate strategies. Thus, various types oI
combinations distinct with each other in nature are adopted to pursue this obiective like vertical or
(8) Corporate friendliness:
Although it is rare but it is true that business houses exhibit degrees oI cooperative spirit despite
competitiveness in providing rescues to each other Irom hostile takeovers and cultivate situations oI
collaborations sharing goodwill oI each other to achieve perIormance heights through business
combinations. The combining corporates aim at circular combinations by pursuing this obiective.
(9) Desired level of integration:
Mergers and acquisition are pursued to obtain the desired level oI integration between the two combining
business houses. Such integration could be operational or Iinancial. This gives birth to conglomerate
combinations. The purpose and the requirements oI the oIIeror company go a long way in selecting a suitable
partner Ior merger or acquisition in business combinations.
Types of Mergers:
Merger or acquisition depends upon the purpose oI the oIIeror company it wants to achieve. Based on
the oIIerors` obiectives proIile, combinations could be vertical, horizontal, circular and conglomeratic as
precisely described below with reIerence to the purpose in view oI the oIIeror company.
() Vertical combination:
A company would like to takeover another company or seek its merger with that company to expand
espousing backward integration to assimilate the resources oI supply and Iorward integration towards
market outlets. The acquiring company through merger oI another unit attempts on reduction oI inventories
oI raw material and Iinished goods, implements its production plans as per the obiectives and economizes
on working capital investments. In other words, in vertical combinations, the merging undertaking would be
either a supplier or a buyer using its product as intermediary material Ior Iinal production.
The Iollowing main beneIits accrue Irom the vertical combination to the acquirer company i.e.
(1)it gains a strong position because oI imperIect market oI the intermediary products, scarcity oI resources
and purchased products;
(2)has control over products speciIications.
(B) Horizontal combination:
It is a merger oI two competing Iirms which are at the same stage oI industrial process. The acquiring Iirm
belongs to the same industry as the target company. The mail purpose oI such mergers is to obtain
economies oI scale in production by eliminating duplication oI Iacilities and the operations and broadening
the product line, reduction in investment in working capital, elimination in competition concentration in
product, reduction in advertising costs, increase in market segments and exercise better control on market.
(C) Circular combination:
Companies producing distinct products seek amalgamation to share common distribution and research
Iacilities to obtain economies by elimination oI cost on duplication and promoting market enlargement. The
acquiring company obtains beneIits in the Iorm oI economies oI resource sharing and diversiIication.
(D) Conglomerate combination:
It is amalgamation oI two companies engaged in unrelated industries like DCM and Modi Industries. The basic
purpose oI such amalgamations remains utilization oI Iinancial resources and enlarges debt capacity through re-
organizing their Iinancial structure so as to service the shareholders by increased leveraging and E!S, lowering
average cost oI capital and thereby raising present worth oI the outstanding shares. Merger enhances the overall
stability oI the acquirer company and creates balance in the company`s total portIolio oI diverse products and
dvantages of Mergers and Takeovers:
Mergers and takeovers are permanent Iorm oI combinations which vest in management complete control and
provide centralized administration which are not available in combinations oI holding company and its partly
owned subsidiary. Shareholders in the selling company gain Irom the merger and takeovers as the premium
oIIered to induce acceptance oI the merger or takeover oIIers much more price than the book value oI shares.
Shareholders in the buying company gain in the long run with the growth oI the company not only due to
synergy but also due to 'boots trapping earnings¨.
otivations for mergers and acquisitions
Mergers and acquisitions are caused with the support oI shareholders, manager`s ad promoters oI the
combing companies. The Iactors, which motivate the shareholders and managers to lend support to these
combinations and the resultant consequences they have to bear, are brieIly noted below based on the research
work by various scholars globally.
(1) From the standpoint of shareholders
Investment made by shareholders in the companies subiect to merger should enhance in value. The sale
oI shares Irom one company`s shareholders to another and holding investment in shares should give rise to
greater values i.e. the opportunity gains in alternative investments. Shareholders may gain Irom merger in
diIIerent ways viz. Irom the gains and achievements oI the company i.e. through
(a) realization oI monopoly proIits;
(b) economies oI scales;
(c) diversiIication oI product line;
(d) acquisition oI human assets and other resources not available otherwise;
(e) Better investment opportunity in combinations.
One or more Ieatures would generally be available in each merger where shareholders may have
attraction and Iavour merger.
()From the standpoint of managers
Managers are concerned with improving operations oI the company, managing the aIIairs oI the
company eIIectively Ior all round gains and growth oI the company which will provide them better deals in
raising their status, perks and Iringe beneIits. Mergers where all these things are the guaranteed outcome get
support Irom the managers. At the same time, where managers have Iear oI displacement at the hands oI new
management in amalgamated company and also resultant depreciation Irom the merger then support Irom them
(3) Promoter`s gains
Mergers do oIIer to company promoters the advantage oI increasing the size oI their company and the Iinancial
structure and strength. They can convert a closely held and private limited company into a public company
without contributing much wealth and without losing control.
(4) Benefits to general public
Impact oI mergers on general public could be viewed as aspect oI beneIits and costs to:
(a) Consumer oI the product or services;
(b) Workers oI the companies under combination;
(c) General public aIIected in general having not been user or consumer or the worker in the companies
under merger plan.
Consideration for Merger and Takeover:
Mergers and takeovers are two diIIerent approaches to business combinations. Mergers are pursued under the
Companies Act, 1956 vide sections 391/394 thereoI or may be envisaged under the provisions oI Income-tax
Act, 1961 or arranged through BIFR under the Sick Industrial Companies Act, 1985 whereas, takeovers Iall
solely under the regulatory Iramework oI the SEBI Regulations, 1997.
inoritv sareolders rigts
SEBI regulations do not provide insight in the event oI minority shareholders not agreeing to the
takeover oIIer. However section 395 oI the Companies Act, 1956 provides Ior the acquisition oI shares oI the
shareholders. According to section 395 oI the Companies Act, iI the oIIerer has acquired at least 90° in value
oI those shares may give notice to the non-accepting shareholders oI the intention oI buying their shares. The
90° acceptance level shall not include the share held by the oIIerer or it`s associates. The procedure laid down
in this section is brieIly noted below.
1. In order to buy the shares oI non-accepting shareholders the oIIerer must have reached the 90°
acceptance level within 4 months oI the date oI the oIIer, and notice must have been served on those
shareholders within 2 months oI reaching the 90° level.
2. The notice to the non-accepting shareholders must be in a prescribed manner. A copy oI a notice and a
statutory declaration by the oIIerer (or, iI the oIIerer is a company, by a director) in the prescribed Iorm
conIirming that the conditions Ior giving the notice have been satisIied must be sent to the target.
3. Once the notice has been given, the oIIerer is entitled and bound to acquire the outstanding shares on the
terms oI the oIIer.
4. II the terms oI the oIIer give the shareholders a choice oI consideration, the notice must give particulars
oI options available and inIorm the shareholders that he has six weeks Irom the date oI the notice to
indicate his choice oI consideration in writing.
5. At the end oI the six weeks Irom the date oI the notice to the non-accepting shareholders the oIIerer
must immediately send a copy oI notice to the target and pay or transIer to the target the consideration
Ior all the shares to which the notice relates. Stock transIer Iorms executed on behalI oI the non-
accepting shareholders by a person appointed by the oIIerer must also be sent. Once the company has
received stock transIer Iorms it must register the oIIerer as the holder oI the shares.
6. The consideration money, which is received by the target, should be held on trust Ior the person entitled
to shares in respect oI which the sum was received.
7. Alternatively, iI the oIIerer does not wish to buy the non-accepting shareholder`s shares, it must still
within one month oI company reaching the 90° acceptance level give such shareholders notice in the
prescribed manner oI the rights that are exercisable by them to require the oIIerer to acquire their shares.
The notice must state that the oIIer is still open Ior acceptance and speciIy a date aIter which the right
may not be exercised, which may not be less than 3 months Irom the end oI the time within which the
oIIer can be accepted. II the oIIerer Iails to send such notice it (and it`s oIIicers who are in deIault) are
liable to a Iine unless it or they took all reasonable steps to secure compliance.
8. II the shareholder exercises his rights to require the oIIerer to purchase his shares the oIIerer is entitled
and bound to do so on the terms oI the oIIer or on such other terms as may be agreed. II a choice oI
consideration was originally oIIered, the shareholder may indicate his choice when requiring the oIIerer
to acquire his shares. The notice given to shareholder will speciIy the choice oI consideration and which
consideration should apply in deIault oI an election.
9. On application made by an happy shareholder within six weeks Irom the date on which the original
notice was given, the court may make an order preventing the oIIerer Irom acquiring the shares or an
order speciIying terms oI acquisition diIIering Irom those oI the oIIer or make an order setting out the
terms on which the shares must be acquired.
In certain circumstances, where the takeover oIIer has not been accepted by the required 90° in value oI
the share to which oIIer relates the court may, on application oI the oIIerer, make an order authorizing it to give
notice under the Companies Act, 1985, section 429. It will do this iI it is satisIied that:
a. The oIIerer has aIter reasonable enquiry been unable to trace one or more shareholders to whom the
b. The shares which the oIIerer has acquired or contracted to acquire by virtue oI acceptance oI the oIIerer,
together with the shares held by untraceable shareholders, amount to not less than 90° in value oI the
shares subiect to the oIIer; and
c. The consideration oIIered is Iair and reasonable.
The court will not make such an order unless it considers that it is iust and equitable to do so, having
regarded in particular, to the number oI shareholder who has been traced who did accept the oIIer.
Alternative modes of acquisition
The terms used in business combinations carry generally synonymous connotations and can be used
interchangeably. All the diIIerent terms carry one single meaning oI 'merger¨ but each term cannot be given
equal treatment in the discussion because law has created a dividing line between take-over` and acquisitions
by way oI merger, amalgamation or reconstruction. !articularly the takeover Regulations Ior substantial
acquisition oI shares and takeovers known as SEBI (Substantial Acquisition oI Shares and Takeovers)
Regulations, 1997 vide section 3 excludes any attempt oI merger done by way oI any one or more oI the
(a) By allotment in pursuant oI an application made by the shareholders Ior right issue and under a public
(b) !reIerential allotment made in pursuance oI a resolution passed under section 81(1A) oI the Companies
(c) Allotment to the underwriters pursuant to underwriters agreements;
(d) Inter-se-transIer oI shares amongst group, companies, relatives, Indian promoters and Foreign
collaborators who are shareholders/promoters;
(e) Acquisition oI shares in the ordinary course oI business, by registered stock brokers, public Iinancial
institutions and banks on own account or as pledges;
(I) Acquisition oI shares by way oI transmission on succession or inheritance;
(g) Acquisition oI shares by government companies and statutory corporations;
(h) TransIer oI shares Irom state level Iinancial institutions to co-promoters in pursuance to agreements
(i) Acquisition oI shares in pursuance to rehabilitation schemes under Sick Industrial Companies (Special
!rovisions) Act, 1985 or schemes oI arrangements, mergers, amalgamation, De-merger, etc. under the
Companies Act, 1956 or any other law or regulation, Indian or Foreign;
(i) Acquisition oI shares oI company whose shares are not listed on any stock exchange. However, this
exemption in not available iI the said acquisition results into control oI a listed company;
(k) Such other cases as may be exempted Irom the applicability oI Chapter III oI SEBI regulations by SEBI.
The basic logic behind substantial disclosure oI takeover oI a company through acquisition oI shares is
that the common investors and shareholders should be made aware oI the larger Iinancial stake in the company
oI the person who is acquiring such company`s shares. The main obiective oI these Regulations is to provide
greater transparency in the acquisition oI shares and the takeovers oI companies through a system oI disclosure
To ensure that the acquirer shall pay the shareholders the agreed amount in redemption oI his promise to
acquire their shares, it is a mandatory requirement to open escrow account and deposit therein the required
amount, which will serve as security Ior perIormance oI obligation.
The Escrow amount shall be calculated as per the manner laid down in regulation 28(2). Accordingly:
For oIIers which are subiect to a minimum level oI acceptance, and the acquirer does want to acquire a
minimum oI 20°, then 50° oI the consideration payable under the public oIIer in cash shall be deposited in the
!avment of consideration
Consideration may be payable in cash or by exchange oI securities. Where it is payable in cash the
acquirer is required to pay the amount oI consideration within 21 days Irom the date oI closure oI the oIIer. For
this purpose he is required to open special account with the bankers to an issue (registered with SEBI) and
deposit therein 90° oI the amount lying in the Escrow Account, iI any. He should make the entire amount due
and payable to shareholders as consideration. He can transIer the Iunds Irom Escrow account Ior such payment.
Where the consideration is payable in exchange oI securities, the acquirer shall ensure that securities are
actually issued and dispatched to shareholders in terms oI regulation 29 oI SEBI Takeover Regulations.
The economic gains realized Irom mergers are passed on to consumers in the Iorm oI lower
prices and better quality oI the product which directly raise their standard oI living and quality oI
liIe. The balance oI beneIits in Iavour oI consumers will depend upon the Iact whether or not the
mergers increase or decrease competitive economic and productive activity which directly
aIIects the degree oI welIare oI the consumers through changes in price level, quality oI
products, aIter sales service, etc.
(b) orkers community
The merger or acquisition oI a company by a conglomerate or other acquiring company may
have the eIIect on both the sides oI increasing the welIare in the Iorm oI purchasing power and
other miseries oI liIe. Two sides oI the impact as discussed by the researchers and academicians
are: firstly. mergers with cash payment to shareholders provide opportunities Ior them to invest
this money in other companies which will generate Iurther employment and growth to upliIt oI
the economy in general. Secondly. any restrictions placed on such mergers will decrease the
growth and investment activity with corresponding decrease in employment. Both workers and
communities will suIIer on lessening iob opportunities, preventing the distribution oI beneIits
resulting Irom diversiIication oI production activity.
(c) General public
Mergers result into centralized concentration oI power. Economic power is to be understood as
the ability to control prices and industries output as monopolists. Such monopolists aIIect social
and political environment to tilt everything in their Iavour to maintain their power ad expand
their business empire. These advances result into economic exploitation. But in a Iree economy a
monopolist does not stay Ior a longer period as other companies enter into the Iield to reap the
beneIits oI higher prices set in by the monopolist. This enIorces competition in the market as
consumers are Iree to substitute the alternative products. ThereIore, it is diIIicult to generalize
that mergers aIIect the welIare oI general public adversely or Iavorably. Every merger oI two or
more companies has to be viewed Irom diIIerent angles in the business practices which protects
the interest oI the shareholders in the merging company and also serves the national purpose to
add to the welIare oI the employees, consumers and does not create hindrance in administration
oI the Government polices.
Generally, a company with the track record should have a less proIit earning or loss making but viable
company amalgamated with it to have beneIits oI economies oI scale oI production and marketing network, etc.
As a consequence oI this merger the proIit earning company survives and the loss making company
extinguishes its existence. But in many cases, the sick company`s survival becomes more important Ior many
strategic reasons and to conserve community interest. The law provides encouragement through tax relieI Ior
the companies that are proIitable but get merged with the loss making companies. InIact this type oI merger is
not a normal or a routine merger. It is, thereIore, called as a #everse Merger.
Procedure for Takeover and cquisition:
To make a public announcement an acquirer shall Iollow the Iollowing procedure:
1. ppointment of merchant banker:
The acquirer shall appoint a merchant banker registered as category I with SEBI to advise him on the
acquisition and to make a public announcement oI oIIer on his behalI.
. Use of media for announcement:
!ublic announcement shall be made at least in one national English daily one Hindi daily and one
regional language daily newspaper oI that place where the shares oI that company are listed and traded.
3. Timings of announcement:
!ublic announcement should be made within Iour days oI Iinalization oI negotiations or entering into
any agreement or memorandum oI understanding to acquire the shares or the voting rights.
4. Contents of announcement:
!ublic announcement oI oIIer is mandatory as required under the SEBI Regulations. ThereIore, it is
required that it should be prepared showing therein the Iollowing inIormation:
(1) !aid up share capital oI the target company, the number oI Iully paid up and partially paid
(2) Total number and percentage oI shares proposed to be acquired Irom public subiect to
minimum as speciIied in the sub-regulation (1) oI Regulation 21 that is:
a) The public oIIer oI minimum 20° oI voting capital oI the company to the shareholders;
b) The public oIIer by a raider shall not be less than 10° but more than 51° oI shares oI
voting rights. Additional shares can be had ( 2° oI voting rights in any year.
(3) The minimum oIIer price Ior each Iully paid up or partly paid up share;
(4) Mode oI payment oI consideration;
(5) The identity oI the acquirer and in case the acquirer is a company, the identity oI the
promoters and, or the persons having control over such company and the group, iI any, to
which the company belong;
(6) The existing holding, iI any, oI the acquirer in the shares oI the target company, including
holding oI persons acting in concert with him;
(7) Salient Ieatures oI the agreement, iI any, such as the date, the name oI the seller, the price at
which the shares are being acquired, the manner oI payment oI the consideration and the
number and percentage oI shares in respect oI which the acquirer has entered into the
agreement to acquirer the shares or the consideration, monetary or otherwise, Ior the
acquisition oI control over the target company, as the case may be;
(8) The highest and the average paid by the acquirer or persons acting in concert with him Ior
acquisition, iI any, oI shares oI the target company made by him during the twelve month
period prior to the date oI the public announcement;
(9) Obiects and purpose oI the acquisition oI the shares and the Iuture plans oI the acquirer Ior
the target company, including disclosers whether the acquirer proposes to dispose oI or
otherwise encumber any assets oI the target company:
!rovided that where the Iuture plans are set out, the public announcement shall also set
out how the acquirers propose to implement such Iuture plans;
(10) The speciIied date` as mentioned in regulation 19;
(11) The date by which individual letters oI oIIer would be posted to each oI the shareholders;
(12) The date oI opening and closure oI the oIIer and the manner in which and the date by which
the acceptance or reiection oI the oIIer would be communicated to the share holders;
(13) The date by which the payment oI consideration would be made Ior the shares in respect oI
which the oIIer has been accepted;
(14) Disclosure to the eIIect that Iirm arrangement Ior Iinancial resources required to implement
the oIIer is already in place, including the details regarding the sources oI the Iunds whether
domestic i.e. Irom banks, Iinancial institutions, or otherwise or Ioreign i.e. Irom Non-
resident Indians or otherwise;
(15) !rovision Ior acceptance oI the oIIer by person who own the shares but are not the registered
holders oI such shares;
(16) Statutory approvals required to obtained Ior the purpose oI acquiring the shares under the
Companies Act, 1956, the Monopolies and Restrictive Trade !ractices Act, 1973, and/or any
other applicable laws;
(17) Approvals oI banks or Iinancial institutions required, iI any;
(18) Whether the oIIer is subiect to a minimum level oI acceptances Irom the shareholders; and
(19) Such other inIormation as is essential Iort the shareholders to make an inIormed design in
regard to the oIIer.
5. Offer Price
The acquirer is required to ensure that all the relevant parameters are taken into consideration
while determining the oIIer price and that iustiIication Ior the same is disclosed in the letter oI oIIer.
The oIIer should disclose the detailed terms oI the oIIer, identity oI the oIIerer, details oI the
oIIerer`s existing holdings in the OIIeree Company etc and inIormation should be made available to all the
7. OIIer Document:
The oIIer document should contain the oIIers Iinancial inIormation, its intention to continue the
oIIeree company`s business and to make maior change and long term commercial iustiIication Ior the oIIer.
Permission of merger: Two or more companies can amalgamate only when amalgamation is permitted under
their memorandum oI association. Also, the acquiring company should have the permission in its obiect clause
to carry on the business oI the acquired company. In the absence oI these provisions in the memorandum oI
association, it is necessary to seek the permission oI shareholders, board oI directors and the company law
board beIore aIIecting the merger.
Information to the stock exchange: The acquiring and the acquired companies should inIorm the stock
exchanges where they are listed about the merger.
pproval of board of director: The boards oI the directors oI the individual companies should approve the
draIt proposal Ior amalgamation and authorize the managements oI companies to Iurther pursue the proposal.
pplication in the high court: An application Ior approving the draIt amalgamation proposal duly approved
by the boards oI directors oI the individual companies should be made to the high court. The high court would
convene a meeting oI the shareholders and creditors to approve the amalgamation proposal.
Shareholders and creditors meetings: The individual companies should hold separate meeting oI their
shareholders and creditors Ior approving the amalgamation scheme.
Sanction by the high court: AIter the approval oI shareholders and creditors on the petitions oI the companies,
the high court will pass order sanctioning the amalgamation scheme aIter it is satisIied that the scheme is Iair
Filing of court order: CertiIied true copies oI court orders will be Iiled with the registrar oI companies.
Transfer of assets and liabilities: The assets and liabilities oI the acquired company will be transIerred to the
acquiring company in accordance with the approved scheme, with eIIect Irom the speciIied date.
Value Based Management and Corporate Governance
Corporate Governance: Corporate governance is the set oI processes, customs, policies, laws and institutions
aIIecting the way in which a corporation is directed, administered or controlled. Corporte governance also
includes the relationships among the many players involved and the goals Ior which the corporation is
Definition: Corporate governance is a Iield in economics that investigates how to secure/motivate eIIicient
management oI corporations by the use oI incentive mechanisms, such as contracts, organizational designs and
legislation. This is oIten limited to the question oI improving Iinancial perIormance, Ior example, how the
corporate owners can secure/motivate that the corporate managers will deliver a competitive rate oI return
History of corporate governance:
century, state corporation law enhanced the rights oI corporation boards to govern without unanimous
consent oI shareholders in exchange oI statutory beneIits like appraisal rights, in order to make coporate
governance more eIIicient. Since that time, and because most large publicly traded corporations in america are
incorporated under corporate administration Iriendly delaware law, and because americas wealth has been
increasingly securitized into various corporte entities and institutions, the rights oI individual owners and
sharehoders have become increasingly derivative and dissipated. The concerns oI share holders over
administration, pay and stock losses periodically have led to more Irequent calls Ior corporte governance
In the 20
century immediately aIter wall street crash oI 1929, legal scholars pondred on changing role oI the
modern corporation in society.
American expansion aIter world war II through the emergence oI multinational corporations saw the
establishment oI managerial class. Many large corporations have dominent control over business aIIairs without
suIIicient accoutability or monitoring by their board oI directors.
Current preoccupation oI corporate governance can be pinpointed at two events: The East Asian crisis oI 1997
saw the economies oI Thailand, Indonesia, South Korea, Malaysia and The philippines severly aIIected by the
exit oI Ioreign capital aIter property assets collapsed. The lack oI corporte governance mechanisms in those
countires highlited the weakness oI institutions in their economies. The second event was the american
corporate crisis oI which saw the collapse oI two big corporations: Enron and World Com.
!rinciples oI corporate governance / OECD principles oI corporate governance / Elements oI corporate
Among the various attempts to evaluate best global standards, the principles evolved by organisation Ior
Economic Cooperation and Development (OECD) released in 1999 have been accepted as an international
benchmark. The OECD principles protect the interests oI share holders as well as stake holders like employees,
creditors, suppliers, customers and environment.
1. The rights of shareholders: Rights oI shareholder mentioned in the OECD report cover the registration oI
right to ownership with the company, conveyance or transIer oI shares, obtain relevant inIormation Irom the
company on a timely and regular basis, participate and vote in general share holders meetings, elect members oI
the board and share in the proIits oI the company.
. The equitable treatment of shareholders: All shareholders should be treated equitably and the law should
not make any distinction among diIIerent shareholders holding a given class or types oI shares. Any changes in
voting rights oI common shareholders can be done with the consent oI those shareholders.
3. The role stakeholders: The rights oI stakeholders as established by law should be recognized ans active
cooperation between corporations and stakeholders in creating wealth, iobs and sustainabiity oI Iunctionally
sound enterpreses should be encouraged. While the share holders re the true oweners, the Iunctioning oI a
company is aIIected by several other economic players in the society. There is a signiIicant synergetic
relationship between the company and its employees.
4. Disclosure and transperancy: Organisations should clariIy and make publicly known the roles and
responsibilities oI board and management to provide shareholders with a level oI accountability. They should
also implement procedures to independenly veriIy and saIeguard the integrity oI the companys Iinancial
reporting. Disclosure oI material matters concerning the organisation should be timely and balanced to ensure
that all investors have access to clear, Iactual inIormation.
5. #oles and responsibilities of board: The board needs a range oI skills and understanding to be able to deal
with various business issues and have the ability to review and challenge management perIormance. It nees to
be oI suIIicient size and have appropriate level oI commitment to IulIil its responsibilites and duties.
6. Integrity and ethical behaviour: Organisations should develop a code oI conduct Ior their directors and
executives that promotes ethical and responsible decision making.
Internal corporate governance controls:
Monitoring by board oI directors
External corporate governance controls:
Managerial labour market
Corporate governance models:
nglo american model: There are many diIIerent models oI corporate governance around the world. These
diIIer according to the variety oI capitalism in which they are embeded. The liveral model that is common in
anglo american countries tends to give priority to the interests oI shareholders. The coordinated model that one
Iinds in continental europe and iapan also recognizes the interests oI workers, managers, suppliers, customers
and the community. The liveral model oI corporate govenance encourages radical innovation and cost
competition, whereas the coordinated model oI corporte governance Iacilitates incremental innovation and
In the united states, a corporation is governed by a board oI directors, which has the power to choose chieI
executive oIIicer. The CEO has broad power to manage the corporation on a daily basis, but needs to get
approval Ior certain maior actions such as raising money, acquiring another company, and other expensive
proiects. Other duties oI the board may include policy setting, decision making, monitiring managements
perIormance or corporate control.
The UK has pioneered a Ilexible model oI regulation oI corporate governance known as 'to comply or explain¨
code oI governance. This is a principle based code that lists a dozen oI recommended practices, such as the
seperation oI CEO and chairman oI the board, the introduction oI a time limit Ior CEO`s contracts, the
introduction oI a minimum number oI non executive directors, independent directors, the Iormation and
composition oI remuneration, audit and nomination committees. Listed companies in the UK have to apply
those principles, iI they choose not to apply those principles they have to explain in their annual reports why
they dicided not to do so. The monitoring oI these explanations is leIt to shareholders themselves.
Non-anglo american model: In East asian counties Iamily owned companies dominate corporate assests. In
countries such as !akistan, Indonesia and the !hilippines, the top 15 Iamilies controlled over 50° oI publicly
owned corportion through a system oI Iamily cross-holdings, thus dominating capital markets. Family
companies also dominate the Latin model oI corporate governance that is companies in Mexico, Italy, Spain,
France, Brazil, Argentina and tother countries in south america.
Corporate Governance in India:
In India, the ConIederation oI the Indian Industry (CII) took the lead in Iraming a desirable code oI Corporate
Governance in April 1998. This was Iollowed by the recommendations oI Kumaramangalam Birla Committee
in Corporate Governance appointed by the Securities and Exchange Board oI India (SEBI) the
recommendations were accepted by SEBI in December 1999 and are now enshrined in Clause 49 oI the Listing
Agreement oI every Indian stock exchange.
Corporate Governance can be deIined as a systematic process by which companies are directed and controlled
to enhance their wealth generating capacity. Since large corporate employs a vast quantum oI societal resources,
the governance process should ensure that these resources are utilized in a manner that meets stakeholders
aspirations and societal expectations. Thus, corporate governance structure, system and process are based on
two core principles:
1. Management must have excutive Ireedom to drive the enterprese Iorward without undue restraints.
2. This Ireedom oI management should be exercised within a Iramework oI eIIective accountability.
CII Code of Desirable Corporate Governance:
1. As the key to good corporate governance lies with eIIective Iunctioning oI the board oI directors, the Iull
board should meet at intervals oI two months and atleast 6 times a year.
2. The non executive directors should at least be 30° oI the board.
3. No individual should be director on the boards Ior more than 10 companies at any given time.
4. Non executive directors must be active, have deIined responsibiity and be conversant with proIit and loss
account, balance sheet, cash Ilow statement, Iinancial ratios and have some knowledge oI company law.
5. Non executive directors should be paid commission and oIIered stock option Ior their proIessional inputs
besides their sitting Iees.
6. Directors who have not been present Ior at least 50° oI the board meetings should not be reappointed.
7. The board should be inIormed oI the operating plans and budgets, long term plans, quarterly divisional results
and internal audit reports.
8. Details oI deIaults, payments Ior intangibles and Ioreign exchange exposures should be reported to access to
all Iinancial inIormation.
9. Incase, multiple credit ratings are obtained, all the ratings should be disclosed with comparisions explaining
10. Maior Indian stock exchanges should gradually insist upon compliance certiIicate signed by CEO and CFO
clearly stating that accounting policies and standards have been Iollowed.
11. The government must allow Ior greater Iunding to the corporate sector against the security oI shares and
12. Companies that deIault on Iixed deposits should not be permitted to accept Iurther deposits, make
intercorporate loans or investments and declare dividens until the deIault is made good.
#ecommendations of Birla Committee:
1. Board oI Directors: There should be a combination oI executive and non executive directors. The board
should consist oI not less than 30° oI non executive directors.
2. Audit Committee:
a. The board should appoint a qualiIied and independent audit committee. The committee should have
minimum three members all being non executive directors with maiority being independent and at least
one director having Iinancial and accounting knowledge.
b. The chairman oI committee should be an independent director and should be present at the companies
annual general meeting.
c. The chairman should invite Iinance director, head oI internal audit and representatives oI external
auditor Ior committee meetings. The company secretary should act as secretary oI the committee.
3. !owers oI the audit committee: The audit committee should look into the rasons Ior substantial deIault to
depositors, creditors, debenture holders and shareholders.
4. Frequency oI the meetings and quorum: The committee should meet at least thrice a year, once beIore
Iinalization oI annual accounts and once compulsority every 6 months. Quorum should be either two members
oI audit committee, which ever is higher.
5. Remuneration oI non executive directors:
a. The board oI directors should decide remuneration oI non executive directors.
b. All elements oI the package inclusive oI salary beneIits, bonuses, stock options, etc. should be
6. Committee membership oI directos: Directors should not be members oI more than ten committees and
chairman oI not more than 5 committees. Directors need to disclose about their membership with other
committees, to the company.
7. Shareholders committee: This committee would be Iramed to attend to shareholders grievances and board oI
directors should delegete power oI checking share transIer to either oIIicer or committee or to registrar and
share transIer agent.
List oI items to be included in the report on Corporate Governance:
1. A brieI statement on companies philosophy on code oI governance.
2. Board oI Directors:
a. Composition and category oI directors
b. Attendance oI each director at the Board oI Directors meetings and the last Annual General Meeting
c. Number oI other Board oI Directors or Board Committees in which he/she is a member.
d. Number oI Board oI Directors meetings held, dates on which held.
3. Audit Committee:
a. BrieI description oI terms oI reIerence
b. Composition, name oI members and chairperson
c. Meetings and attendance during the year.
4. Remuneration Committee:
a. BrieI description oI terms oI reIerence
b. Composition, name oI members and chairperson
c. Attendance during the year
d. Remuneration policy
e. Details oI remuneration to all the directors, as per Iormat in main report.
5. Shareholders Committee:
a. Name oI non executive director heading the committee
b. Name and designation oI compliance oIIicer
c. Number oI shareholders complaints received so Iar.
d. Number not solved to the satisIaction oI shareholders.
e. Number oI pending complaints.
6. General Body Meetings:
a. Location and time, where last three AGM`s held
b. Whether any special resolution passed last year through postal ballot
c. !erson who conducted the postal ballot exercise
d. !rocedure oI postal ballot
a. Disclosures on materially signiIican related party transactions that may have potential conIlict with
the interests oI company at large.
b. Disclosures oI accounting treatment with explanation
c. Details oI non compliance by the company, penalties imposed on company by stock exchange or
SEBI or any statutory authority on any matter relating to capital markets.
8. Means oI communication:
a. HalI yearly report sent to each household oI shareholder
b. Quarterly results
c. Newspapers wherein results normally published.
d. Any website, where displayed
e. Whether it also displays oIIicial news releases
I. The presentations made to institutional investors or to the analysts
9. General shareholder inIormation
a. AGM: date, time, venue
b. Financial calander
c. Date oI book closure
d. Dividend payment date
e. Listing on stock exchanges
I. Stock code
g. Market price data
10. !erIormance in comparision to broad based indices such as BSE Sensex, CRISIL, etc.
a. Registrar and TransIer Agents
b. Share transIer system
c. Distribution oI shareholding
d. Dematerialization oI shares and liquidity
e. !lant locations
I. Address Ior correspondence