Mahesh-RSREC

Financial Management
Unit - I Introduction: Financial Management is that managerial activity which is concerned with the planning and controlling of the firms financial resources. Financial management is a process of identification, accumulation, analysis, preparation, interpretation and communication of financial information to plan, evaluate and control a business firm. Financial management is a specialized function of general management which is related to the procurement of finance and its effective usage for the achievement of the goals of an organization. It was branch of economics till 1890, and as separate discipline it is of recent origin still, the theoretical concepts are drawn from economics. Definition: Finance can be defined as the art and science of managing money. Finance is concerned with the process, institutions, markets and instruments involved in the transfer of money among individuals, business and government. Financial Management is the process of decision making and controlling business operations. Western Bringham Nature and scope of Financial Management: Financial Management as an academic discipline has undergone fundamental changes with regard to its scope and coverage. In the earlier years, it was treated synonymously with the raising of funds. In the later years, its broader scope, included in addition to the procurement of funds, efficient use of resources. Firms create manufacturing capacities for production of goods; they sell their goods or services to earn profit. They raise funds to acquire manufacturing and other facilities. The three most important activities of a business firm are: - Production - Marketing - Finance A firm secures whatever sources it needs and employs it in activities which generate returns on invested capital. Real and financial assets: A firm requires real assets to carry on its business. Tangible real assets are physical assets that include plant, machinery, office, factory, furniture, and building. Intangible real assets are technical know how, technological collaboration, patents and copyrights. Financial assets include shares, bonds and debentures. Equity and borrowed Funds: There are two types of funds that a firm can raise: Equity funds and borrowed funds. A firm sells shares to acquire equity funds. Share holders invest their money in the shares of a company in the expectation of a return on their invested capital. The return of share holders consists of dividend. Another important source of securing capital is creditors or lenders. Loans are generally furnished for a specified period at a fixed rate of interest. For lenders, the return on loans comes in the form of interest paid by the firm. Financial management is broadly concerned with the acquisition and use of funds by a business firm. The important tasks of financial management are, 1. Financial analysis, planning and control a) Analysis of financial condition b) Profit planning c) Financial forecasting d) Financial control 2. Investing a) Management of current assets
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b) Capital budgeting c) Managing of mergers, reorganizations and divestments 3. Financing a) Identification of sources of finance and determination of financing mix b) Cultivating sources of funds and raising funds. c) Allocation of profits Evolution of Financial Management: The need for formation of large scale business enterprises and consolidation movements in the early stages of the 20th century gave rise to the emergence of financial management as a distinct field of study. It was branch of economics till 1890, and as separate discipline it is of recent origin still, the theoretical concepts are drawn from economics. During the initial stages of the evolution of financial management, more focus was placed on the study of sources and different forms of financing business enterprises. Business enterprises faced difficulties in raising finance from banks and other financial institutions in 1930s due to economic recession. Hence, the areas such as sound financial structure and liquidity position of the firm were emphasized. New methods of planning and control were concerned. The ways and means for assessing the credit worthiness of the firms were developed. The consequences of World War II facilitated the business enterprises to adopt sound financial structure and reorganization. In the early 50s emphasis was laid upon liquidity and day to day operations of the firm rather than on profitability and institutional finance. Therefore the extent of financial management was broadened to include the process of decision making within the firm. The modern phase began in the mid 1950s, and the concept of financial management became more analytical and qualitative, with the application of economic theories and quantitative methods of finance analysis. 1960s witnessed phenomenal advances in the theory of portfolio analysis. CAPM (capital asset pricing model) was developed in 1970s, which suggested that investment in diversified portfolio of securities can neutralize the risks faced in financial investments. In 1980s taxation policies in personal and corporate finance played a vital role. During this period the option pricing theory was also developed. Globalization of markets led to the emergence of Financial Engineering which involves formation of optimal solutions to problems confronted in corporate finance Financing Functions: The functions of raising funds investing them in assets and distributing returns earned from assets to shareholders are respectively known as financing decision, investment decision and dividend decision. A firm attempts to balance cash inflows and outflows while performing these functions. This is called liquidity decision. - Long term asset mix or Investment decision - Capital mix or Financing decision - Profit allocation or Divided decision - Short term asset mix or Liquidity decision A firm performs finance functions simultaneously and continuously in the normal course of the business. Finance functions call for skillful planning, control and execution of a firms activity. Investment decision: A firm investment decision involves capital expenditures. They are referred as capital budgeting decisions. A capital budgeting decision involves the decision of allocation of capital and also the evaluating of the prospective profitability of new investment. Future benefits of investments are difficult to measure and cannot be predicted with certainty. Risk in investment arises because of the uncertain returns.
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Hence, investment proposals are to be evaluated in terms of both expected return and risk. Capital budgeting also involves replacement decisions. Financing decision: Financing decision is the second important function in finance department. It is to decide, where from and how to acquire funds to meet the firms investment needs. The central issue here is to determine the appropriate proportion of equity and debt. The mix of debt and equity is known as the firms capital structure. The firms capital structure is considered optimum when the market value of shares is maximized. Dividend decision: Dividend decision is the third major financial decision. The finance manager has to decide in what proportion the firm has to distribute the dividends. The proportion of profits distributed as dividends is called the dividend payout ration and retained portion of the profits is known as the retention ratio. The optimum dividend policy is one that maximizes the market value of the firms shares. Liquidity decision: Investment in current assets affects the firms profitability and liquidity. Current assets management that affects a firms liquidity is yet another important finance function. Current assets should be managed efficiently for safeguarding the firm against the risk of illiquidity. Lack of liquidity in extreme situations can lead to the firms insolvency. A high rate of investment in current assets would provide liquidity but it would lose profitability. As, the current assets would not earn anything thus, profitability liquidity tradeoff must be maintained. Finance functions are said to influence production, marketing and other functions of the firm. Hence, finance functions may affect the size, growth, profitability and risk of the firm and ultimately value of the firm. Role of a Financial Manager: A financial manager is a person who is responsible, in a significant way, to carry out the finance functions. It should be noted that, the financial manager occupies a key position. Finance managers functions not confined to preparing, maintaining records and raising funds when needed. He is now responsible for shaping fortunes of the enterprise, and is involved in the most vital decision of the allocation of capital. He needs to have broader outlook and must ensure the funds of the enterprise are utilized in the most efficient manner. The main functions of financial manager are, Funds raising: During the major events, such as promotion, reorganization, expansion or diversification in the firm that the financial manager was called upon to raise funds. Funds allocation: A number of economic and environmental factors, such as the increasing pace of industrialization, technological innovations, intense competition, increasing intervention of government on account of management inefficiency and failure, have necessitated efficient and effective utilization of financial resources. The development of a number of management skills and decision-making techniques facilitated the implementation of a system of optimum allocation of firms resources. As a result, the emphasis shifted from raising of funds to efficient and effective use of funds. Profit planning: The functions of the financial manager may be broadened to include profit planning function. Profit planning refers to the operating decisions in the area of pricing costs, volume of output and the firms selection of product lines. Profit planning is a prerequisite for optimizing investment and financing decisions. Understanding capital markets: Capital markets bring investors and firms together. Hence, the financial manager has to deal with capital markets. He should understand the operations of 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 financing decisions.
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Relation between finance and other management functions: Finance is the life blood of an organization. It is a common thread, which binds all the organizational functions. There is an inseparable relationship between finance and other functions. All most all business activities, directly or indirectly, involve the acquisition and use of funds. For ex: recruitment and promotion of employees in production is clearly a responsibility of production department, but it requires payment of wages and salaries and other benefits, and thus, involves finance. Sales promotion activity come with in the purview of marketing, but advertising and other sales promotion activities require investment of cash and therefore, affect financial resources. We do not find an answer to the question where do the production and marketing functions end and finance function begin? The finance function of raising and using money will have a significant effect on other functions. Manufacturing - Finance: 1. Manufacturing function needs a large investment. Productive use of resources ensures a cost advantage for the firm. 2. Optimum investment in inventories improves profit margin. 3. Many parameters of the production cost having effect on production cost are possible to control through internal management thus improving profits. 4. Important production decisions like make or buy can be taken only after financial implications have been considered. Marketing Finance: 1. Many aspects of marketing management have financial implications eg: hold inventories to provide uninterrupted service to customers, extension of credit facility 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 firms are moving to leaner and flat organizations. Investments in human resource development are also bound to increase. 2. Providing remuneration and other incentives. 3. Restructuring of remuneration structure, voluntary retirement scheme, sweat equity, etc., has become major financial decisions in the area of human resource management. Strategic planning Finance: Finance function is an important tool in the hands of management for strategic planning and control on two counts: 1. The decision variables when converted into monetary terms are easier to grasp. 2. Finance function has strong inter-links with other functions. Controlling other functions is possible through finance function. The changing role of financial management in India: Modern financial management has come a long way form the traditional corporate finance. The finance 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 finance manager have no limits. At the
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same time, one must understand the risk in the decisions. Financial management is passing through an era of experimentation, as a large part of the finance activities carried out today were not heard of a few years ago. 1. Interest rates have been deregulated. Further, interest rates are fluctuating, and minimum cost of capital necessitates anticipating interest rate movements. 2. The rupee has become freely convertible in current account of international market. 3. Optimum debt equity mix is possible. Firms have to take advantage of the financial leverage to increase the shareholders wealth. However, financial leverage entails financial risk. Hence a correct trade off between risk and improved rate of return to share holders is a challenging task. 4. With free pricing of issues, the optimum price of new issue is a challenging task, as overpricing results in under subscription and loss of investor confidence, whereas under pricing leads to unwarranted increase in a number of shares and also reduction of earnings per share. 5. Maintaining share prices is crucial. In the liberalized scenario, the capital markets are important avenue of funds for business. 6. The dividend and bonus policies framed have a direct bearing on the share prices. 7. Ensuring management control is vital, especially in the light of foreign participation in equity, making the firm an easy takeover target. Financial strategies to prevent this are vital to the present management. Approaches to Finance Function: The different approaches associated with finance function can be broadly categorized into two types. They are as follows, 1. The Traditional Approach 2. The Modern Approach 1. The Traditional Approach: The term financial management used in this modern era was known as corporate finance under traditional approach. This approach to financial management was popular in the initial stages of its evolution as a separate branch of academic study. Under this approach the role of financial manager was limited to raising and administering of funds needed by corporate enterprises to meet their financial needs. It broadly covers the following three aspects. 1. Arrangement of funds from financial institutions. 2. Arrangement of funds through instruments, viz. shares, bonds, etc. 3. The legal and accounting relationships between a firm and its sources of funds. The scope of traditional approach to financial management was mainly concerned with raising of funds externally. The finance manager had a limited role to perform. He was expected to keep accurate financial records, prepare reports on the enterprise status, performance and manage funds in such a way that the firm could meet its maturing obligations. The traditional approach evolved during 1920s and 1930s and dominated academic thinking during the 1950s and through early 1940. It has now been discarded as it suffers from serious limitations. Limitations of Traditional Approach: 1. Outsider Looking Approach: This approach is concentrated only on raising and administering of funds from the view point of suppliers of funds i.e., bankers, financial institutions. It completely ignored the view point of those who had to take internal financing decisions. 2. Ignored working capital problems: This approach emphasized on events like mergers, consolidation and reorganizations of enterprises, the result of which is that the day to day financial problems of business undertakings were ignored. This approach focused on long term financing of the business enterprises. The problems relating to short term funds of working capital were ignored.
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3. No emphasis on allocation of funds: The approach was confined to issues involving procurement of funds. It did not emphasize on allocation of funds, which is a matter of concern today. 2. The Modern Approach: The narrow scope of traditional approach led to the emergence of modern approach in the mid 1950s. The modern approach ahs a broader aspect of financial management which provides conceptual and analytical framework for financial decision making, by including both areas of finance, raising of funds as well as their effective utilization. The new approach is an analytical way of viewing the financial problems of firms. Features of Modern Approach: 1. The approach emphasizes not only on sources of raising funds but also their effective and optimum utilization. 2. The cost of raising finance and the return on their investment are compared. The investment should yield more returns than the cost of raising finance. 3. Financial management according to this approach covers the areas of financial planning and control, raising of corporate finance, effective utilization of funds, etc. 4. The techniques of models, linear programming, simulations, queuing and financial engineering are used to solve problems of financial management. Thus, the modern approach widens the scope of financial management considering the major management decisions such as financing decision, investment decision and dividend policy decision. Goals of financial management: 1. Maintenance of liquid assets: In order to meet the day to day operation, every firm should maintain necessary liquid assets. 2. Maximization of Profitability: The immediate objective of any business is to earn profits and to maximize the profit as much as possible. Without profit objective no businessman starts business at all. 3. Ensuring fair return to share holders 4. Building up reserves for growth and expansion. 5. Ensuring maximum operational efficiency by efficient and effective utilization of funds. 6. Ensuring financial discipline in the organization. Profit Maximization: Maximization of profits is generally regarded as the main objective of a business enterprise. Each company collects its finances by way of issue of shares to the public. Investors invest in shares with the hope of getting maximum profits from the company in the form of dividend. Price system is the most important organ of a market economy indicating what goods and services society wants. Goods and services in great demand command higher prices. This result in higher profit for firms more of such goods and services are produced. Higher profit opportunities attract other firms to produce such goods and services. Ultimately, with intensifying competition, an equilibrium price is reached at which demand and supply match. In the case of goods and services, which are not required by society, their prices and profits will fall. In the economic theory, the behavior of a firm is analyzed in terms of profit maximization. Profit maximization implies that a firm either produces maximum output for a given amount of input or uses minimum input for producing a given output. The underlying logic of profit maximization is efficiency. It is assumed that profit maximization causes the efficient allocation of resources under the competitive market conditions and profit is considered as the most appropriate measure of a firms performance.
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On the other hand, higher profits are the barometer of its efficiency on all fronts, i.e., production, sales and management. A few replace the goals of maximization of profits to fair profits. Fair profits mean the general rate of profit earned by similar organizations in a particular area. The main objective of financial management is to safeguard the economic interest of 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 for their contribution. But this is possible only when the company earns higher profits or sufficient profits to discharge its obligations to them. Therefore the goal of maximization of profits is said to be best criterion of the decision making. Arguments in favour of profit maximization: 1. Profit is the test of economic efficiency: It is a measuring rod by which the economic performance of the company can be judged. 2. Efficient allocation of fund: Profit leads to efficient allocation of resources as resources tend to be directed to uses which in terms of profitability are the most desirable. 3. Social welfare: It ensures maximum social welfare i.e., maximum dividend to shareholders, timely payments to creditors, more and more wages and other benefits to employees, better quality at cheaper rate to consumers, more employment society and maximization of capital to the entrepreneur. 4. Internal resources for expansion: It will consume a lot of time to raise equity funds in a primary market. Retained profits can be used for expansion and modernization. 5. Reduction in risk and uncertainty: Once after availing huge profits the company develops risk bearing capacity. The gross present value of a course of action is found by discounting and low capitalizing is benefits at a rate which reflects their timing and uncertainty. A financial action which has positive net present value creates wealth and therefore is desirable. The negative present value should be rejected. 6. More competitive: More and more profits enhance the competitive spirit thus, under such conditions firms having more and more profits are considered to be more dependable and can survive in any environment. 7. Desire for controls: More and more profits are desirable and imperative for the management t make optimum use of available financial resources for continued survival. Objections to Profit Maximization: 1. It is argued that profit maximization assumes perfect completion, and in the face of imperfect modern markets, it cannot be a legitimate objective of the firm. 2. It is also argued that profit maximization, as a business objective, developed in the early 19 th century for single entrepreneurship. Only aim of single owner was to enhance his individual wealth. But the modern business environment is characterized by limited liability and a difference between management and ownership. Share holders and lenders today finance the firm but it is controlled and directed by professional management. In the new business environment, profit maximization is regarded as unrealistic, difficult, inappropriate and immoral. 3. It is also feared that profit maximization behavior in a market economy may tend to produce goods and services that are wasteful and unnecessary from the societys point of view. 4. Firms producing same goods and services differ substantially in terms of technology, costs and capital. In view of such conditions, it is difficult to have a truly competitive price system, and thus, it is doubtful if the profit maximizing behavior will lead to the optimum social welfare. 5. Profit cannot be ascertained will in advance to express the probability of return as future is uncertain. It is not possible to maximize something that is unknown. Moreover the term profit is vague and not clearly expressed. 6. The executive or the decision maker may not have enough confidence in the estimates of future returns so that he does not attempt further to maximize. It is argued that a firms goal cannot be, to maximize profits but to attain a certain level or certain share of the market or certain level of sales. 7. The criterion of profit maximization ignores the time value factor it considers the total benefits or profits into account while considering a project whereas the length of time in earning that profits is not considered at all.
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Wealth Maximization: Wealth maximization (shareholders wealth maximization) means maximizing the net present value of a course of action to shareholders. Net present value or wealth of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has a positive NPV creates wealth for shareholders and, therefore, is desirable. A financial action resulting in negative NPV should be rejected since it would destroy shareholders wealth. The objective of shareholder wealth maximization takes care of the timing and risk of the expected benefits. These problems are handled by selecting an appropriate rate for discounting the expected flow of future benefits. It is important to emphasize that benefits are measured in terms of cash flows. In investment decisions, it is the flow of cash that is important, not the accounting profits. The objective of shareholders wealth maximization is an appropriate and operationally feasible criterion to choose among the alternative financial actions. It provides unambiguous measure of what financial manager should seek to maximize in making investment and financing decisions on behalf of shareholders. Wealth maximizing objectives is consistent with the objective of maximizing the business economic welfare i.e., their wealth. The wealth of owner is reflected by the market value of companys shares. Thus, it implies that the fundamental principle of the company is to maximize the market value of 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 of its shares on the basis of the day to day fluctuation in the market price. Features of Wealth maximization: 1. Protection of interest of shareholders: Shareholders interest is protected by increased market value of their holdings in the firm. 2. Security to financial lenders: It provides security to short term and long term financial lenders, who supply funds to the business enterprise. Short term lenders are interested in the firms liquidity position, whereas long term lenders enjoy priority over shareholder at the time of return of funds besides getting fixed rate of interest. 3. Protection of interest of employees: Employees contribution is a primary consideration in raising the wealth of an enterprise. Their productivity and efficiency ultimately leads to fulfilling companys objective of wealth maximization. 4. Survival of Management: Management is a representative body of shareholders. When shareholders interest is protected, they may not wish to change the management and hence it can survive for a longer period of time. 5. Interest of society: When all the available productive resources are put to optimum and efficient use, economic interest of the society is served. Profit Maximization Vs. Wealth Maximization: Profit Maximization 1. Profit cannot be ascertained well in advance to express the probability of return. The term profit has no clear meaning. 2. The executive or the decision maker may not have enough confidence in the estimates of future returns so he does not attempt to maximize further. 3. The risk variations and related capitalization rate is not considered in the concept of profit maximization. 4. The goal of profit maximization is considered to be
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Wealth Maximization 1. There is no vagueness in wealth maximization goal. It represents the value of benefits minus the cost of investment. 2. It is argued that a firms goal cannot be, to maximize profits but to attain a certain level or share of the market or certain level of sales. 3. In wealth maximization, it is considered that there should be balance between expected return and risk. 4. The goal of wealth maximization is considered to be

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a narrow outlook. a broad outlook. 5. It ignores the interests of the community. 5. Its objective is to enhance the shareholders wealth. 6. The criterion of profit maximization ignores the 6. Wealth maximization concept fully considers the time value factor for the profits of a project. time value factor of cash inflows. Agency Relationship and Cost In large companies, there is a difference between management and ownership. The decision taking authority in a company lies in the hands of managers. Shareholders as owners of 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 of 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 form of high salaries at the cost of shareholders. Such satisfying behaviour of mangers will frustrate the objective of shareholders wealth maximization. It is in the interests of managers that the firm survives over the long run. Managers also wish to enjoy independence and freedom from outside interference, control and monitoring. Thus their actions are very likely to be directed towards the goals of survival and self sufficiency. Managers in practice may perceive their role as reconciling conflicting objectives of stakeholders. Shareholders continuously monitor modern companies that would help them to restrict managers freedom to act in their own self interest at the cost of shareholders. Emplo9yees, creditors, customers and government also keep an eye on managers activities. Thus the possibility of managers pursuing exclusively their own personal goals is reduced. Managers can survive only when they are successful and they are successful when they manage the company better than someone else. Every group connected with the company will, however, evaluate management success from the pint of view of the fulfillment of its own objective. The survival of management will be threatened if the objective of any of these groups remains unfulfilled. The wealth maximization objective may be generally in harmony with the interests of the various groups such as owners, employees, creditors and society and thus, it may be consistent with the management objective of survival. Still, there are many situations where a conflict may occur between the shareholders and managers goals. The conflict between the interests of shareholders and managers is referred as agency problem and it results in agency costs. Agency costs include the less than optimum share value for shareholders and costs incurred by them to monitor the actions of mangers and control their behavior. The optimal solution to shareholders management conflicts is to monitor the managerial actions to some extent and the managerial compensation should be based upon the performance. Specific 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. Different companys follows different compensation policies such as apart form specified annual salary, a senior executive can be provided with cash or bonus shares at the end of financial year. 2. Intervention of shareholders in decision making: Shareholders, being the owners of the company enjoy voting rights and right to attend the annual general meetings of the company. Today majority ownership lies with corporate investors like insurance companies, mutual funds. They can suggest to the management on ways to operate the business. 3. Threat of firing: If the shareholders are not satisfies with the managements performance, they can exercise voting rights and replace the management at the annual general meeting. 4. Hostile takeover: Hostile takeovers are likely to occur when firms shares are undervalued because of the poor performance of the management. In such takeovers, the management of subsidiary company is replaced by the management of the holding company.
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Risk Return Trade-off Financial decisions incur different degree of risk. Your decision to invest your money in government bonds has less risk as interest rate is known and the risk of default is very less. On the other hand, you would incur more risk if you decide to invest your money in shares, as return is not certain. However, you can expect a lower return from government bond and higher from shares. Risk and expected return move in one behind another. The greater the risk, the greater the expected return. Financial decisions of a firm are guided by the risk-return trade-off. These decisions are interrelated and jointly affect the market value of its shares by influencing return and risk of the firm. The relationship between return and risk can be simply expressed as: Return = Risk free rate + Risk Premium

Expected Return Risk Premium

Risk-free Return Risk Risk free rate: Risk free rate is a rate obtainable from a default risk free government security. An investor assuming risk from his investment requires a risk premium above the risk free rate. Risk free rate is a compensation for time and risk premium for risk. Higher the risk of 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 of a firms share. Such balance is called risk return trade off and every financial decision involves this trade off.
Financial Management

Maximization of share value

Financial Decisions

Investment Decisions

Liquidity Management

Financing Decisions

Dividend Decisions

Return

Trade-off
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The financial manager in order to maximize shareholders wealth should strive to maximize returns in relation to the given risk. He should seek courses of actions that avoid unnecessary risks. To ensure maximum return, funds flowing in and out of the firm should be constantly monitored to assure that they are safeguarded and properly utilized. The financial reporting system must be designed to provide timely and accurate picture of the firms activities. Unit II Introduction: An efficient allocation of capital is the most important finance function in the modern times. It involves decisions to commit the firms funds to the long term assets. Capital budgeting or investment decisions are of considerable importance to the firm since they tend to determine its value by influencing its growth, profitability and risk. Capital Budgeting: The investment decisions of a firm are generally known as the capital budgeting or capital expenditure decisions. A capital budgeting decision may be defined as the firms decision to invest its current funds most efficiently in the long term assets in anticipation of an expected flow of benefits over a series of years. The long term assets are those that affect the firms operations beyond the one year period. The firms investment decisions would generally include expansion, acquisition, modernization and replacement of the long term assets. Capital budgeting may also be defined as The decision making process by which a firm evaluates the purchase of major fixed assets. The term 'Capital Budgeting' is used interchangeably with capital expenditure management, capital expenditure decision, long term investment decision, management of fixed assets, etc. It may be defined as planning, evaluation and selection of capital expenditure proposals. Capital budgeting involves a current outlay or serves as outlays of cash resources in return for an anticipated flow of future benefits. Lynch - "Cash budgeting consists in planning, development of available capital for the purchase of maximizing the long term profitability in the concern. Opportunity cost of capital: The investments should be evaluated on the basis of a criterion, which is compatible with the objective of the shareholders wealth maximization. An investment will add to the shareholders wealth if it yields benefits in excess of the minimum benefits as per the opportunity cost of capital. In other words, the system of capital budgeting is employed to evaluate expenditure decisions which involve current outlays, but likely to produce benefits over a period of time longer than one year. These benefits may be either in the form of increased revenue or reduction in costs. Capital expenditure management therefore includes addition, disposition, modification and replacement of fixed assets. The basic features of capital budgeting are: 1. Potentially large anticipated benefits; 2. A relatively high degree of risk and 3. A relatively long time period between initial outlay and anticipated returns. Fixed assets are frequently termed as earning assets of the firm in the sense that they usually generate large return. Future sales growth is correlated with expansion of capital expenditure. It is a specialized process requiring highly sophisticated techniques and intricate forecasting for future years. Closely scrutinized capital expenditure selections result in increased sales, profits, dividends and ultimately share price value of the firm.

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Importance Capital budgeting is of paramount importance in financial decision making. Special care should be taken in making these decisions on account of the following reasons: 1. Such decisions affect the profitability of the firm. They also have bearing on the competitive position of the enterprise. This is mainly because of the fact that they relate to fixed assets. The fixed assets represent in a sense, the true earning assets of the firm. They enable the firm to generate finished goods that can ultimately be sold for a profit. However, current assets are not generally earning assets. They provide a buffer that allows the firm to make sales and extend credit. Capital budgeting decisions determine the future destiny of 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 of large sized firms. A few wrong decisions and a firm can be forced into bankruptcy. Capital budgeting is of utmost importance to avoid over-investment and underinvestment in fixed assets. 2. A capital expenditure decision has its effect over a long time span and inevitably affects the company's future cost structure. To illustrate, if a particular plan has been purchased by a company to start a new product, the company commits itself to a sizable amount of fixed assets in terms of supervisors, salary, insurance, rent of buildings and so on. If the investment in future turns out to be unsuccessful or yields less profit than anticipated, the firm will have to bear the burden of fixed costs unless it writes off the investment completely. In short, a firm's future costs, break-even point, sales and profits will all be determined by the firm's selection of assets i.e., capital budgeting. Long term investment decisions are more difficult to take because: Decision extends to a series of years and beyond the current accounting period; Uncertainties of future and Higher degree of risk 3. Capital investment decision once made is not easily reversible without much financial loss to the firm. It is because there may be no market for second hand plant and equipment and their conversion to other uses may not be financially feasible. 4. Capital investment involves cost and the majority of the firms have scarce capital resource. This underlines the need for thoughtful, wise and correct investment decisions as an incorrect decision would not only result in losses but also prevent the firm from earning profits from other investments which could not be undertaken for want of funds. 5. Over / under capacity: To improve timing and quality of asset acquisition, the capital expenditure decision must be carefully drawn. If the firm has invested too much in assets, it will incur unnecessary heavy expenditure. If it has not spent enough on fixed assets, two serious problems may arise (i) The firms equipment may not be sufficiently modern to enable it to produce competitively. (ii) If it has inadequate capacity it may lose a portion of its share of market to its rival firm. 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 of national importance because it determines employment, economic activities and economic growth. CAPITAL BUDGET DECISION Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals. Basically the firm may be confronted with three types of capital budgeting decisions. 1. Accept / Reject decision: This is the fundamental decision in capital budgeting. If the project is accepted, the firm invests in it. If the proposal is rejected the firm does not invest. In general all those proposals which yield a
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rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected. By applying this criterion, all independent projects are accepted. Independent projects are projects that do not compete with one another in such a way that acceptance of one preclude the possibility of acceptance of another. Under the acceptance decision, all the independent projects that satisfy the minimum investment criteria are implemented. 2. Mutually exclusive project decision: Mutually exclusive projects are projects which compete with other projects in such a way that the acceptance of one will exclude the acceptance of other projects. The alternatives are mutually exclusive and only one may be chosen. It may be noted that the mutually exclusive project decisions are not independent of accept / reject decision. Mutually exclusive investment decisions acquire significance when more than one proposal is acceptable under the accept / reject decision. Then some techniques have to be used to determine the best one. The acceptance of 'best' alternative automatically eliminates the other alternatives. 3. Capital rationing decision: In a situation where the firm has unlimited funds, 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 of the business firm's of real world. They have fixed capital budget. A large number of investment proposals compete in these limited funds. The firm allocates funds to projects in a manner that it maximizes long run returns. Thus capital rationing refers to the situation where the firm has more acceptable investments requiring a greater amount of finance than is available with the firm. It is concerned with the selection of a group of investment proposals acceptable under the accept / reject decision. Ranking of the investment project is employed. In capital rationing, projects can be ranked on the basis of some predetermined criterion such as the rate of return .The project with highest return is ranked first and the acceptable projects are ranked thereafter. Importance of Investment Decisions / Capital Budgeting Decisions: 1. They influence the firms growth in the long run 2. They affect the risk of the firm 3. They involve commitment of large amount of funds 4. They are irreversible, or reversible at substantial loss 5. They are among the most difficult decisions to make Growth: The effects of investment decisions extend into the future and have to be endured for a longer period than the consequences of the current operating expenditure. Unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. Risk: A long term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky. Funding: Investment decisions generally involve large amount of funds which make it necessary for the firm to plan its investment programmes very carefully and make an advance arrangement for procuring finances internally or externally. Irreversibility: Most investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped. Investment decisions once made cannot be reversed or may be reversed but at a substantial loss. Complexity: Another important characteristic feature of capital investment decision is that it is the most difficult decision to make. Such decisions are an assessment of future events which are difficult to predict. It is really a complex problem to correctly estimate the future cash flow of an investment.

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KINDS OF CAPITAL BUDGETING PROPOSALS: 1. Replacement / modification of fixed assets: e.g. worn out, obsolete are replaced at appropriate time. 2. Expansion: involves an addition of capacity to existing production facilities. 3. Modernization of investment expenditure: They make it easier for a firm 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 of time. Strategic investments are defensive, offensive and mixed motive decision. The vertical integration of a firm is an example of defensive investment in which a continuous source of raw materials is assumed. Horizontal combinations are offensive investments for they ensure a firm's internal and external growth respectively. Mixed motive investments are outlays on research and development programmes. 5. Diversification of business: Means operating in several markets or firm one market into another market. It may even amount to changing product lines. 6. Research and development: Where the technology is rapidly changing, research and development area is a continuous activity in any firm. Usually large sums of money are invested in research and development activities which lead to capital budgeting decisions. 1. Expansion of existing business 2. Expansion of new business 3. Replacement and modernization 4. Expansion and Diversification: Generally expanding the firms capacity to produce more output will accommodate high operational efficiency. Related expansion / diversification: A company may add capacity to its existing product lines to expand existing operations. Unrelated diversification: A firm may expand its activities in a new business. Expansion of a new business requires investment in new products and a new kind of production activity within the firm. Revenue expansion investments: Sometimes a company acquires existing firms to expand its business. In either case, the firm makes investment in the expectation of additional revenue. Replacement and Modernization: The main objective of modernization and replacement is to improve operating efficiency and reduce costs. Cost savings will reflect in the increased profits, but the firms revenue may remain unchanged. Assets become outdated and obsolete with technological changes. The firm must decide to repalcee those assets with new assets that operate more economically. If a certain company changes form semi automatic equipment to fully automatic drying equipment, it is an example of 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. If one investment is undertaken, others will have to be excluded. A company may, for 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 different purposes and do not compete with each other. Depending on their profitability and availability of funds, the company can undertake both investments. For example, Mahindra & Mahindra can manufacture two wheelers as well as four wheelers. Contingent Investments: Contingent investments are dependent projects the choice of one investment necessitates undertaking one or more other investments.
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For example, if a company decides to build a factory in a remote, backward area, it may have to invest in houses, roads, hospitals, schools etc. for employees to attract the work force. Investment Decision Process The allocation of investible funds to different long term assets is known as capital budgeting decisions. Capital budgeting is a complex process which may be divided into five broad phases. 1. Project generation 2. Project evaluation 3. Project selection 4. Project implementation 5. Controlling and review 1. Project generation: The planning phase of a firms capital budgeting process is concerned with the circulation of its broad investment strategy and the generation and preliminary screening project proposals. The investments strategy of the firm delineates the broad areas or types of investments the firm plans to undertake. This provides the framework which shapes and guides the identification of individual project opportunities. 2. Project evaluation: If the preliminary screening suggests that the project is prima facie worth while, a detailed analysis of the marketing technical, financial, economic and ecological aspects is undertaken. The questions and issues raised in such a detailed analysis are described in the following section. The focus of this phase of capital budgeting is on gathering, preparing and summarizing relevant information about various project proposals which are being considered for inclusion in the capital budget. Based on the information developed in this analysis, the stream of costs and benefits associated with the project can be defined. 3. Project selection: Selection follows an often overlaps, analysis. It addresses the questions. Is the project worth while? A wide range of appraisal criteria have been suggested to judge to worth while of a project. 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 of return. The key discounting criteria are the net present value, the internal rate of return and profitability index. To apply the various appraisal criteria suitable cut off values have to be specified. These are essentially a function for the fix of financing and the level of project risk while the former can be defined with relative case; the latter truly tests the liability of the project evaluation. 4. Project implementation: The implementation phase for an industrial project which involves setting up of manufacturing facilities consists of several stages. Stage Project and engineering design Negotiation and contracting Concerned with Site probing and prospecting, preparation of blue prints and plant designs, plant engineering selection of specific machines and equipment. Negotiating and drawing up of legal contracts with respect to project financing, acquisition of technology, supply of machinery and know how and marketing arrangements. Site preparation, construction of buildings and civil work, erection and installation of machinery and equipment. Training of engineers, technicians and workers. Start up of the plant.

Construction Training Plant commissioning

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5. Project Review: Once the project is commissioned the review phase has to be set in motion. Performance review should be done periodically to compare actual performance with projected performance. A feedback device, it is useful in several ways, 1. It throws light on how realistic were the assumptions underlying the project. 2. It provides a documented long of experience that is highly valuable in future decision making. 3. It suggests corrective action to be taken in the light of the actual performance. Steps involved in Feasibility study The available capital must be used in a manner which is consistent with the over all socio economic objectives. This becomes more difficult when there are several competing projects, each giving a rate of return higher than the minimum cut off rate. Project appraisal may be defined as a detailed evaluation of the project to determine the technical feasibility, economic feasibility, financial feasibility and managerial competence. Project feasibility study or appraisal consists of the following: 1. Technical feasibility 2. Economic feasibility 3. Financial feasibility 4. Managerial competence 5. Market feasibility 1. Technical feasibility: A project must be technically feasible. This can be judged by a detailed assessment of the following factors. 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 of good reputation. b. Plant and equipment: The supplier of plant equipment needed for the projects are of experience and reputation. Plant layout is in accordance with the production flow programme. 2. Economic and social feasibility: Economic feasibility analysis is also referred to as a social cost benefit analysis which is concerned with judging a project from the larger social point of view but not in monetary terms. In such an evaluation, the focus is on the social costs and benefits of a project which may often be different from the monetary costs and benefits to the firm. a. The extent to which, the project is expected to contribute to national development. b. The project can bring about the development in that area. c. The project 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 project will be financially viable in the sense of being able to meet the burden of servicing debt and whether the proposed project will satisfy the return expectations of those who provide capital. While appraising a project financially, the following aspects should be kept in mind. a. Cost of project: The estimates of the project should cover all items expenditure and should be realistic. b. Sources of finance: Sources of finance contemplated by the promoters should be adequate and necessary finance should be available during installation. Factors to be considered while evaluating project on financial criteria: 1. Investment outlay or cost of project 2. Means of financing 3. Projected profitability 4. Break even point
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5. Cash flows of the project 6. Level of risk 4. Managerial competence: The technical competence, administrative ability, integrity and resourcefulness of borrowing concerns top managerial personnel determines to a great extent the willingness of a financial institutional to accept a term loan proposal. The loan application from firms having competent and honest management finds favourable considerations. It can therefore be stated that the appraisal of the managerial competence is of primary importance in the overall appraisal of a project. 5. Market feasibility: Market appraisal is concerned with two questions. 1. What would be the aggregate demand of the proposed product/service in future? 2. What would be the market share of the project under appraisal? In order to answer these questions a market analyst requires a wide variety of information and suitable forecasting methods. The information required includes, a. Past and present consumption trends, consumer behavior and preferences. b. Past and present supply position c. Production constraints d. Imports and exports e. Structure of competition f. Cost structure and marketing policies Capital Budgeting Techniques: The most important techniques used in capital budgeting are, Traditional Methods: 1. Pay back Period Method 2. Accounting Rate of Return or Average Rate of Return Method Discounted Cash Flow Methods: 3. Net Present Value Method 4. Internal Rate of Return Method 1. Pay back Period Method: Pay back period method is the simplest method of evaluating investment proposals. Payback period represents the number of years required to recover the original investment. The payback period is also called payoff or payout. This period is calculated by dividing the cost of the project by the annual earnings after tax but before depreciation. Under this method project with shortest pay back period will be given the highest rank and taken as best investment. It is a traditional method of capital budgeting. It is the simplest and most widely employed quantitative method for appraising capital expenditure decisions. This method answers the question - how many years will it take for cash benefits to pay the original cost of an investment normally disregarding salvage value. Cash benefits here represent cash flow after tax (CFAT) technique to pay back the original outlay required in an investment proposal. There are two ways of calculating the payback period. The first method can be applied when the cash flow stream is in the nature of annuity for each year of project's life, for cash flow adjusted techniques are uniform. In such a situation the initial cost of investment is divided by the constant annual cash flow. The second method
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is used when a project's cash flows are not equal, but vary from year to year. In such a situation payback is calculated by the process of accumulating cash flows till the time when cumulative cash flows are equal to original investment outlay. Accept / Reject criterion: The payback period can be used as a decision criterion to accept or reject an investment proposal. One application of this technique is to compare the actual payback period with a predetermined payback i.e., the payback set up by the management. If the actual payback period is less than the predetermined payback, the project will be accepted. If not, it will be rejected. Alternatively the payback can be used as a rationing method. When mutually exclusive projects are under one consideration, they may be ranked according to the length of payback period. Thus the project having the shortest payback may be assigned rank one followed in the order so that the project with longest payback might be ranked last. The term mutually exclusive refers to the proposals out of which only one can be accepted. Obviously project with shorter payback period will be selected. Original cost of the project _______________________ Annual cash inflow

Payback period =

Advantages: 1. Simple to understand and easy to calculate. 2. It reduces the chance of loss. As the project with a short payback period is preferred. 3. A firm which has shortage of funds finds this method very useful. 4. This method costs less as it requires only very little effort for its computation. Disadvantages: 1. This method does not take into consideration the cash inflows beyond the pay back period. 2. It does not consider the time value of money. 3. It gives over emphasis to liquidity. 4. The first major shortcoming of payback method is that it ignores all cash inflows after the payback period. This could be very misleading in capital budgeting valuation. 5. Another deficiency of payback method is that it does not measure correctly even the cash flows expected to be received within the payback period as it does not differentiate between projects in terms of timing or magnitude of cash flows. It considers only the recovery period as a whole. This happens because it does not discount the future cash inflows but rather treats a rupee received from second or third year as valuable as a rupee received from first year. In other words, to the extent that payback method fails to consider the pattern of cash inflows, it ignores the time value of money. 6. Another failure of the payback method is that it does not take into consideration the entire life of the project during which cash flows are generated. As a result the project with large inflows in the later part of their lives may be rejected in favor of less profitable projects which happen to generate a larger proportion of their cash inflows in the earlier part of their lives. 7. It does not reflect all the relevant dimensions of profitability. 2. Accounting Rate of Return or Average Rate of Return Method: This method is based on accounting profit, takes into account the earnings expected from the investment over the entire lifetime of the asset. The various projects are ranked in the order of the rate of returns. The project with the higher rate of return is accepted. Return on investment method overcomes the deficiencies of payback period method in the sense that it considers the earnings of a project over its entire life.
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1. The return on investment is estimated i.e., earnings or profits estimated from an investment proposal during its economic life, after providing for depreciation and taxes. It means net profit from estimation is as per the accounting principles. 2. The rate of return is compared with cut off rate as determined by the management. Cut off rate is the minimum rate of return on investment. It should be generated from a profit which is generally the firm's cost of capital. Cost of capital 15% - cut off rate of return = 15%. The comparison helps management to rank the various projects and select the most profitable one. If return on investment proposal is less than the cut off rate, it is rejected and accepted if it is equal or more than the cut off rate. In case of mutually exclusive alternative projects, the projects with higher rate of return are selected. Average annual earnings _______________________ X 100 Average investment

ARR =

Advantages: 1. It is easy to understand and calculate. 2. It can be compared with the cut off point of return and hence the decision to accept or reject is made easier. 3. It considers all the cash inflows during the life of the project, not like payback method. 4. It is a reliable measure because it considers net earnings. 5. The most favorable attribute of this method is its simplicity and it is easy to understand. 6. It is based on the accounting concepts of profit which are easily calculated for financial data. 7. The total benefits associated with projects are taken into account while calculating the IRR. Payback method for instance does not use the entire stream of income. This approval gives due weightage for the profitability of project. 8. Profits determined under this method after deducting depreciation and tax are as per the accounting principles which give a better basis of commission. Disadvantages: 1. The concept of time value of money is ignored. 2. The average concept is not reliable, particularly in the times of high fluctuation in the returns. 3. The average concept dilutes the profitability of the project. 4. The method of computation of ARR is not standardized. 5. It uses accounting profits and not cash flows in appraising the projects. Accounting profits are based on arbitrary assumptions and choices and also include non-cash items. It is, therefore, inappropriate to rely on them for measuring the acceptability of the investment projects. 6. It does not take into account the time value of money. The timing of cash inflows and outflows is a major decision valuable in financial decision making. Accordingly benefits in the earlier years and later years cannot be valued at par. To that extent, the ARR method treats these benefits at par and fails to take into account the difference in the time value of money. 7. It does not differentiate between the sizes of investment regarding each project. Competing investment proposals may have the same ARR but may require different average investments. 8. This method does not take into consideration any benefits which can accrue to the firm from the sale or abandonment of equipment which is replaced by the new investment. The new investment from the point of view of correct financial decision should be measured in terms of incremental cash outflow due to new investment (i.e., new investment minus sale proceeds of existing equipment plus / minus tax adjustment). But the ARR method doesn't make any adjustment in this regard to determine the level of average investment. Investment in fixed assets is determined at their acquisition costs. 9. This method cannot be applied to a situation where investment in a project is to be made in parts.
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Discounted Cash Flow / Time Adjusted Techniques Discounted Cash Flow: Discounted cash flows are the future cash inflows reduced to their present value based on a discounting factor. The process of reducing the future cash inflows to their present value based on a discounting factor or cutoff return is called discounting. 3. Net Present Value Method: The net present value method considers the time value of money. The cash flows of different years are valued differently and made comparable in terms of present values. The net cash inflows of various periods are discounted using required rate of return which is predetermined. Taking into conside3ration the scrap value, if the present value of as cash inflows exceeds the initial cost of the project, the project is accepted otherwise rejected. If there are two projects giving net present value, the project with the higher net present value is selected. The cash inflow in different years are discounted (reduced) to their present value by applying the appropriate discount factor or rate and the gross or total present value of cash flows of different years are ascertained. The total present value of cash inflows are compared with present value of cash outflows (cost of project) and the net present value or the excess present value of the project and the difference between total present value of cash inflow and present value of cash outflow is ascertained and on this basis, the various investments proposals are ranked. NPV = Present value of cash inflows Investment Merits: 1. The most significant advantage is that it explicitly recognizes the time value of money, e.g., total cash flows pertaining to two machines are equal but the net present value are different because of differences of pattern of cash streams. The need for recognizing the total value of money is thus satisfied. 2. It also fulfills the second attribute of a sound method of appraisal. In that it considers the total benefits arising out of proposal over its life time. 3. It is particularly useful for selection of mutually exclusive projects. 4. This method of asset selection is instrumental for achieving the objective of financial management, which is the maximization of the shareholder's wealth. In brief the present value method is a theoretically correct technique in the selection of investment proposals. Demerits: 1. It is difficult to calculate as well as to understand and use, in comparison with payback method or average return method. 2. The second and more serious problem associated with present value method is that it involves calculations of the required rate of return to discount the cash flows. The discount rate is the most important element used in the calculation of the present value because different discount rates will give different present values. The relative desirability of a proposal will change with the change of discount rate. The importance of the discount rate is thus obvious. But the calculation of required rate of return pursuits serious problem. The cost of capital is generally the basis of the firm's discount rate. The calculation of cost of capital is very complicated. In fact there is a difference of opinion even regarding the exact method of calculating it. 3. Another shortcoming is that it is an absolute measure. This method will accept the project which has higher present value. But it is likely that this project may also involve a larger initial outlay. Thus, in case of projects involving different outlays, the present value may not give dependable results.
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4. The present value method may also give satisfactory results in case of two projects having different effective lives. The project with a shorter economic life is preferable, other things being equal. It may be that, a project which has a higher present value may also have a larger economic life, so that the funds will remain invested for longer period while the alternative proposal may have shorter life but smaller present value. In such situations the present value method may not reflect the true worth of alternative proposals. This method is suitable for evaluating projects whose capital outlays or costs differ significantly. 4. Internal Rate of Return Method: The internal rate of return for an investment proposal is that discount rate which equates the present value of cash inflows with the present value of cash outflows of an investment. When compared the internal rate of return with a required rate of return, if the internal rate of return is more than required rate of return then, the project is accepted else rejected. Incase of more than one project; the project with highest IRR is selected. The technique is also known as yield on investment, marginal efficiency value of capital, marginal productivity of capital, rate of return, time adjusted rate of return and so on. Like net present value, internal rate of return method also considers the time value of money for discounting the cash streams. The basis of the discount factor however, is difficult in both cases. In the net present value method, the discount rate is the required rate of return and being a predetermined rate, usually cost of capital and its determinants are external to the proposal under consideration. The internal rate of return on the other hand is based on facts which are internal to the proposal. In other words, while arriving at the required rate of return for finding out the present value of cash flows, inflows and outflows are not considered. But the IRR depends entirely on the initial outlay and cash proceeds of project which is being evaluated for acceptance or rejection. It is therefore appropriately referred to as internal rate of return. The IRR is usually, the rate of return that a project earns. It is defined as the discount rate which equates the aggregate present value of net cash inflows (CFAT) with the aggregate present value of cash outflows of a project. In other words it is that rate which gives the net present value zero. IRR is the rate at which the total of discounted cash inflows equals the total of discounted cash outflows (the initial cost of investment). It is used where the cost of investment and its annual cash inflows are known but the rate of return or discounted rate is not known and is required to be calculated.

P1 - Q IRR = L + ___________ x D P1 - P2 L = Lower discount rate; P1= Present value of earnings at lower rate; P2= Present value of earnings at higher rate; Q= Actual investment; D= Difference in rate of return. Advantages: 1. Is a theoretically correct technique to evaluate capital expenditure decision? It possesses the advantages which are offered by the NPV criterion such as; it considers the time value of money and takes into account the total cash inflows and outflows. 2. In addition, the IRR is easier to understand. Business executives and non-technical people understand the concept of IRR much more readily than they understand the concept of NPV. For instance, Business X will understand the investment proposal in a better way if it is said that the total IRR of Machine B is 21% and cost of capital is 10% instead of saying that NPV of Machine B is Rs. 15,396. 3. It itself provides a rate of return which is indicative of profitability of proposal. The cost of capital enters the calculation later on. 4. It is consistent with overall objective of maximizing shareholders wealth. According to IRR, the acceptance / rejection of a project is based on a comparison of IRR with required rate of return. The required rate of return is
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the minimum rate which investors expect on their investment. In other words, if the actual IRR of an investment proposal is equal to the rate expected by the investors, the share prices will remain unchanged. Since, with IRR, only such projects are accepted which have IRR of the required rate; therefore, the share prices will tend to rise. This will naturally lead of maximization of shareholders wealth. The IRR suffers from serious limitations: 1. It involves tedious calculations. It involves complicated computation problems. 2. It produces multiple rates which can be confusing. This situation arises in the case of non-conventional projects. 3. In evaluating mutually exclusive proposals, the project with highest IRR would be picked up in exclusion of all others. However, in practice it may not turn out to be the most profitable and consistent with the objective of the firm i.e., maximization of shareholders wealth. 4. Under IRR, it is assumed that all intermediate cash flows are reinvested at the IRR. It is rather ridiculous to think that the same firm has the ability to reinvest the cash flows at different rates. The reinvestment rate assumption under the IRR is therefore very unrealistic. Moreover it is not safe to assume always that intermediate cash flows from the project may be reinvested at all. A portion of cash inflows may be paid out as dividends, a portion may be tied up with current assets such as stock, cash, etc. Clearly, the firm will get a wrong picture of the project if it assumes that it invests the entire intermediate cash proceeds. Net Present Value Vs. Internal Rate of Return Net Present Value 1. NPV is expressed in terms of currency. 2. NPV calculates additional wealth. 3. NPV can deal with changing cash inflows. Internal Rate of Return 1. IRR is expressed in terms of percentage. 2. IRR does not calculate additional wealth. 3. IRR method cannot be used to evaluate where the cash flows are changing (i.e. initial outlay followed by cash flows and later outlay) 4. A manager can better understand the concept of returns stated in percentages and find it easy to summarize and compare to the required cost of capital. 5. IRR suggests smaller projects with shorter life and earlier cash inflows. 6. In IRR method what ever the discount rate we use, it gives the same result.

4. This is an easy method which can be understood even by a layman because the NPV is expressed in terms of money. 5. NPV suggests larger projects which generates more cash inflows. 6. In NPV using different discount rates will result in different recommendations.

Developing cash flows Capital expenditures typically involve current and near future costs that are expected to generate benefits in the future. While measuring the costs and benefits of a capital expenditure proposal, you must bear in mind the following guidelines: 1. Focus on cash flows: Costs and benefits must be measured in terms of cash flows. Costs are cash outflows and benefits are cash inflows. Cash flows matter because they represent the purchasing power. Since accounting figures are based on the accrual principle, they have to be adjusted to derive the cash flows. For example, depreciation and other non cash charges, which are deducted in computing profits from the accounting point of view, have to be added back as they do not entail cash outflows. Estimate cash inflows on a post-tax basis. Some firms look at pre-tax cash flows and, to compensate that, apply a discount rate greater than the cost of the capital. However, there is no reliable basis for making such adjustments. 2. Consider all incidental effects: In addition to its direct cash flows, a project may have incidental effects on the rest of the firm. It may enhance the profitability of some of the existing activities of the firm as it has a
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complementary relationship with them or it may detract from the profitability of some of 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 for new investment decisions. 4. Include opportunity cost: If a project requires the use of some resources already available with a firm, the opportunity cost of the resources should be charged to the project. The opportunity cost of a resource is the value of net cash flows that can be derived from it if it were put to its best alternative use. 5. Networking capital: Apart from investment in fixed assets like land, machinery, building and technical know how, a project also requires investment in current assets like cash receivables (debtors), and inventories. A portion of current assets is supported by non interest bearing current liabilities accounts payable (creditors) and provisions. The difference between current assets and non interest bearing current liabilities is the net working capital. It is financed by equity, preference and debt. Components of Cash Flow Stream: The cash flows stream of a project may be divided into three parts as follows: Initial Outlay: These represent the cash outflows associated with investment in various project components. Initial outlay = Outlay on fixed assets + Outlay on net working capital Operational Flow: These are cash inflows expected during the operational phase of the project. Operational flow = Profit + Depreciation Tax Terminal Flow: Cash flows expected from the disposal of assets when the project is terminated are referred to as terminal flows. Terminal flow = Post tax salvage value of fixed asset + Post tax salvage value of net working capital Approaches for Reconciliation The conflicts in project rankings may arise because of size disparity, time disparity and life disparity. Size Disparity A source of ranking conflict may be the disparity in the size of initial outlays. Such conflicts may arise mainly because NPV represents an absolute magnitude whereas the IRR is a relative measure. The resolution of conflict depends on the following circumstances of the firm. 1. If the firm has enough funds available to it at a given cost of capital, a project with bigger size is preferable as it contributes more to the NPV of the firm. 2. If the firm has limited availability of the funds and acceptance of big sized project means the rejection of some other projects, then the NPV of big project must be compared with the sum of NPV of other projects and alternative with higher NPV is to be accepted. Time Disparity Projects may differ with respect to the sequence of the pattern of cash inflows associated with that and such time disparities of cash inflows may lead to conflicts in ranking. This conflict can be resolved by defining the reinvestment rates that are applicable to cash flow and calculation modified versions of NPV and IRR. This method is known as terminal value method and it involves the following two steps.
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Life Disparity In some cases the mutually exclusive alternatives have varying times and it may lead to conflict in rankings. One approach to resolve this conflict is by comparing the alternatives on the basis of their Uniform Annual Earnings (UAE) and selects the alternative with highest UAE. The UAE of a project is equal to the project of NPV and CRF UAE = NPV X CRF Where capital recovery factor (CRF) is simply the inverse of the present value interest factor for annuity. The UAE method appears appealing because it expresses the gains from the project in an annualized form and hence renders easy comparison between projects with different expected lives.

Unit III In evaluating a capital budgeting proposal, the firm should recognize that the forecasted return may or may not be achieved. This is the element of risk in the decision making process. Risk Risk may be defined as the likelihood that the actual return from an investment will be less than the forecast return. Stated differently, it is the variability of return form an investment. Different types of risks / Sources of risks All projects face certain risks. Some of the main risks are elaborated below. 1. Project specific risk: Revenue as well as cash flows from the project could be lower than estimated due to inaccurate forecasts or poor management. 2. Risk from competition: Again, revenue and cash flows could be influenced by sudden, unexpected action by the competition. 3. Industry specific risk: Government legislation or the introduction of new technology could have its effect on the industry to which the project belongs. 4. Market risk: Once more, developments of an unexpected nature like a slow down in market growth or even bank interest increase will take in toll on the project. Other factors in market risk are changing needs of consumers, changes in demand and supply.
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5. International risk: Projects abroad could face political risks or lower currency exchange rates which would lower revenue and cash flows. Business Risk Business risk refers to the variability in the operating profit (EBIT) due to change in sales. In such a change that the firm will not have ability to compete successfully with the assets that it purchases. Any operational problems are classified as business risk. Financial Risk Financial risk refers to a risk on account of pattern of capital structure i.e., Debt-Equity mix. At this point the investment will not generate sufficient cash flows either to cover interest payments on money borrowed to finance it or principal repayments on the debt or to provide profits to the firm. Simply it is the variability of return from 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) 2. Uncertainty 3. Risk The risk situation is one in which the probabilities of particular event occurring are known while an uncertain situation is one where these probabilities are not known. In other words in case of risk chance of future loss can be foreseen because of past experience. Risk of an investment proposal can be judged from variability of its possible returns. Risk with reference to capital budgeting decision may be defined as the variability that is likely to occur in future between estimated and actual return. Greater the variability, the greater will be the risk and vice versa. Therefore, the risk situation is one in which the probabilities of the particular event occurring are known. While uncertainty is a situation where the probabilities of the particular event are not known, in such a case risk chances of future loses can be foreseen because of past experience. In case of uncertainty the future cannot be foreseen. Risk has been always involved in all the capital budgeting decisions. So, there is a need to consider risk at the time of evaluating various investment proposals. In order to control risk, there are several techniques which differ in their approach and methodology. These techniques are divided into two types. They are, a) Conventional techniques - Payback period method - Risk adjusted discount rate - Certainty equivalents - Sensitivity analysis - Beta coefficient b) Statistical techniques - Probability distribution approach - Decision tree approach Risk 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 for risk, the business man required a premium over and above an alternative, which was risk free. Accordingly, the more uncertain the returns in the future, the greater the risk and the greater the risk premium required based on this reasoning, it is proposed that the risk
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premium be incorporated into the capital budgeting analysis through the discount rate. That is, if the time preference for money is to be recognized by discounting estimated future cash flows, at some risk free rate, to their present value, then to allow for the riskiness, we add a risk premium rate to the risk free discount rate. The composite discount rate which consists of risk free rate and risk premium is called risk adjusted discount rate. It will allow both time preference and risk preference. NPV = NCFt ________ (1+K)t Where k is a risk adjusted discount rate. Risk adjusted discount rate = risk free rate + risk premium The risk adjusted discount rate accounts for risk by varying the discount rate depending on the degree of risk of investment projects. A higher rate will be used for riskier projects and a lower rate for less risky projects. According to risk adjusted discount rate method, if NPV is negative then the project is rejected. If the NPV is positive then the project is accepted. If the IRR is greater than the risk adjusted discount rate then the project is accepted or if the IRR is less than the risk adjusted discount rate then the project is rejected. Advantages 1. It is simple and easily understood. Disadvantages 1. There is no easy way of deriving a risk adjusted discount rate. CAPM provides a basis of calculating the risk adjusted discount rate. 2. It is based on the assumption that investors are risk averse.

2. It provides information for risk-averse businessman. 3. It incorporates an attitude of risk aversion towards uncertainty.

Certainty Equivalent: Certainty equivalent is common procedure for dealing with risk in capital budgeting which involves reducing the forecasts of cash flows to some conservative levels. For example, if an investor, according to his best estimate, expects a cash flow of Rs 60,000 next year, he will apply an intuitive correction factor and may work with Rs 40,000 to be on safe side. There is a certainty equivalent cash flow. In formal way, the certainty equivalent approach may be expressed as: tNCF NPV = (1+Kf)t Where, NCFt = the forecasts of net cash flow without risk adjustment t = the risk adjustment factor or the certainty equivalent coefficient kf = risk free rate assumed to be constant for all periods. The certainty equivalent coefficient, assumes a value between 0 and 1, and varies inversely with risk. A lower CE will be used if greater risk is perceived and a higher CE will be used if lower risk is anticipated. The decision maker subjectively establishes the coefficients. The certainty equivalent coefficient can be determined as a relation ship between the certain cash flows and the risky cash flows. Certain net cash flow CE =
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Risky net cash flow Sensitivity Analysis: Sensitivity analysis is a way of analyzing change in the projects NPV for a given change in one of the variables. It indicates how sensitive a project NPV is to changes in particular variables. The more sensitive the NPV, the more critical is the variable. It is also called What if analysis. It allows the investor to ask himself: What is the NPV if sales increases or decreases? What is the NPV if the variable cost or fixed cost increases or decreases? What is the NPV if the investment increases or decreases? The following three steps are involved in the use of sensitivity analysis: 1. Identification of all those variables, which have an influence on the projects NPV 2. Definition of the underlying relation ship between the variables. 3. Analysis of the impact of the change in each of the variables on the projects NPV. The decision maker, while performing sensitivity analysis, computes the projects NPV for each forecast under three assumptions: a. Pessimistic b. Expected c. Optimistic Beta Coefficient: CAPM explains the behavior of security prices and provides mechanism, whereby investors could assess the impact of proposed security investment on their overall portfolio risk and return. The risk falls into two groups, 1. Systematic risk 2. Unsystematic risk Systematic risk can be measured in relation to the risk of a diversified portfolio known as market portfolio. Unsystematic risk is a diversifiable risk which concerns the factors internal to the firm. Systematic risk affects all the firms. Non-diversifiable risk is assessed in terms of beta coefficient. Beta is a measure of volatility of a security return relating to the returns of a broad based portfolio. If beta coefficient = 1, risk of specified security = market portfolio risk. If beta coefficient = 0, no market related risk accrues to the investor. If beta coefficient = -1, relationship is opposite. With reference to the cost of capi9tal CAPM draws the relationship between the rate of return and nondiversifiable or relevant risk of the firm Ke =Rf + (Km Rf) Where, Ke = Cost of equity Rf = Risk free return = Beta coefficient Km = Market return Probability distribution approach: The conventional techniques used to analyze and integrate risk associated with a project, do not calculate or quantify the risk accurately. However, certain statistical techniques can be used to calculate the risk return elements of capital budget proposals. The most significant element in statistical techniques is probability. Concept of Probability Probability is defined as the chance of happening or non happening of a particular event. It is the probability of a particular event which can occur or cannot occur. If there is a possibility of an event occurring, then it is
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defined as one (1). If there is no such chance that a particular event will happen then it is termed as zero (0). Hence, the value of the probability always lies between 0 and 1. Probability Distribution When calculating cash flows for a proposal, a financial controller could end up with a series of different cash flows instead of one. These cash flows are also associated with the degree of probability that they would be identical to those calculated. The cash flows and their probabilities are called probability distribution.

Unit - 4 Overview of Capital Structure Solomon defines Financial Management is concerned with the efficient use of an important economic resource, namely capital funds; this definition clearly reveals that the prime objective of Financial Management is Procurement of funds and Effective use of these funds to achieve business objectives. A scientific analysis of these instruments and its mobilization has a considerable significance in the real life situation. An unplanned capital structure may yield good result in the short run but it is dangerous in the long run. Hence the study of capital structure is become more relevance. Capital structure planning keyed to the objective of profit maximization ensures the minimum cost of capital and the maximum rate of return to equity holders. The proper mix of debt and equity play major part in capital structure, capital structure analysis helps to identify how much that organization raise their fund in the form of equity and debt. A financial manager determines the proper capital structure for the firm. Meaning of Capital structure Capital Structure refers to the mix of sources from where the long term funds required in a business may be raised, i.e. what should be the proportions of the equity share capital, preference share capital, internal
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sources, debentures, and other sources of funds in the total amount of capital which an undertaking may raise for establishing its business. Features of Appropriate Capital Structure 1. Profitability: The most profitable capital structure is one which tends to minimize the cost of financing and maximize earnings per share. 2. Flexibility: The capital structure should such that company can raise funds whenever needed. 3. Conservation: The debt content in the capital structure should not exceed the limit which a company can bear. 4. Solvency: The capital structure should be such that the firm does not run the risk of becoming insolvent. 5. Control: The capital structure should be so devised that it involves minimum risk of loss of control. Factors Determining Capital Structure The capital structure decisions have to be planned in the initial stages of a company. It is a management decision aims at supplying the required amount of capital. The role of finance manager in deciding the amount of capital structure is significant he has to study and analyze the benefits and defects of issuing each type of securities. Factors influencing capital structure: 1. Financial leverage The use of fixed bearing securities, such as debt and preference capital along with owners equity in the capital structure is described as Financial leverage. This decision is most important from the point of view of financing decision. By having debt and equity in the capital mix, accompany will have an opportunity of deployment certain amount of debt with an intention enjoy the benefit of reduction in the percentage tax. The benefit so enjoyed will be passed on to the equity shareholders in the form of high percentage of dividend. 2. Risk Ordinarily, debt securities increase the risk, while equity securities reduce the risk. Risk can be measured to some extent by the use of ratio, measuring gearing and time interest earned. The risk attached to the use of leverage is called Financial risk. Financial risk is added with the use of debt because of increased variability in the shareholders earnings. A firm can avoid the risk by doesnt employ debt capital in the capital mix. 3. Growth and Stability In the initial stages, a firm can meet its financial requirement through long-term sources, particularly by raising equity shares when a company starts getting good response and cash inflow capacity is increased through sales, company can raise debt or preference capital for growth and expansion programmes of the company. The company which is having high sales revenue will opt for more amount of debt for their financial requirement. In contrast to this when company which having less sales revenue must reduce its burden towards debt. 4. Retaining control The attitude of the management towards retaining the control over the company will have direct impact on the capital structure. If the existing shareholder wants to continue the same holding on the company, they may not encourage the issue of additional equity shares. The issues of debenture and preference share will also influenced by the reputation that is enjoyed by the company. If the credit worthiness of a firm is good; it can raise the funds according to the desire of the existing shareholders. 5. Cost of capital The cost of capital refers to the expectation of suppliers to funds. The objective of knowing the cost of capital is to increase the return on investment, so that, a firm should earn sufficient profits to repay the
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interest and installment of principal to the lenders. The market value of equity share does not fall because of minimum rate of return. The cost of debenture is assessed by taking the assured percentage of interest. The fund borrowed from bank or financial institutions will have the cost of interest. The source of preference share capital will have cost of percentage of dividend. Debt is the cheaper source of fund when compared to other sources. Careful decision has to be made in selecting the size of debt, because, beyond a particular ratio debt increase the risk of the firm. Hence cost of capital influences the capital structure. 6. Cash flows Cash flow ability of a company will have direct impact on the capital structure. Cash flow generation capacity of a firm increases the flexibility of the capital structure. Cash flow permits the company to meet its short term obligations. A firm will have the obligation to pay dividend to equity share holders, interest to bankers and debenture holders. Sound cash flow facilitates the company to raise funds through debt. Insufficient availability of cash or cash inflow takes the company to a disastrous situation. 5.2 CAPITAL STRUCTURE THEORIES Capital Structure Theories: The objective of a firm should be directed towards the maximization of the value of the firm, the capital structure, or the leverage decision should be examined from the point of view of its impact on the value of firm, there are broadly three approaches or theories to study the capital structure they are as below: 1. 2. 3. Net Income Approach. Net Operating Income Approach. Modigliani and Miller Approach.

These approaches analyses the relationship between the leverage, cost of capital, and the value of firm in different ways, however the following assumptions are made to understand these relationship. 1. There are only two sources of Finance i.e. Debt and Equity. 2. The degree of leverage can be changed by selling debt to repurchase shares or selling shares to retire debentures. 3. There are no retained earnings; it implies that entire profit is distributed to shareholders. 4. The Operating profit of the firm is given and it is expected to grow. 5. The business risk is assumed to be constant and is not affected by the financing mix decisions. 6. There are no corporate or personal taxes. 7. The investors have same subjective probability distribution of expected earnings.

Net Income Approach This Approach has been suggested by Durand. According to this approach a firm can increase its value or lower the overall cost of capital by increasing the proportion of debt in the capital structure. In other words if the degree of financial leverage increases the weighted average cost of capital will decline with every increase in the debt content in total funds employed, while the value of the firm will increase. Reverse will happen in converse situation. Under this approach the value of a firm will be maximum at a point where weighted average cost of capital is minimum. o o The use of debt does not change the risk perception of investors. Debt capitalization rate is less than the equity capitalization rate.
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Corporate income taxes do not exist.

Net Operating Income Approach According to net operating approach, the overall capitalization rate and the cost of debt remain constant for all degrees of leverage. The cost of debt, equity and overall capitalization in response to change in market value of debt and equity. The critical premise of this approach is that the market capitalizes the firm as a whole at a discount rate which is independent of the firms debt-equity ratio is a consequence, the division between debt and equity is irrelevant. An increase in the use of debt funds which are apparently cheaper is offset by an increase in the equity capitalization rate. This approach follows certain assumptions The market capitalizes the value of the firm as a whole (split between debt and equity is not important) The market uses an overall capitalization rate depending on business risk Use of less costly debt funds increases the risk of shareholders Debt capitalization rate is a constant Corporate income taxes do not exist

Modigliani and Miller Position The Modigliani miller results indicate that the firm cannot change the value of a firm by repacking the firms securities. This approach argues that the firms overall cost of capital cannot be reduced as debt is substituted for equity, even though debt appears to be cheaper than equity. The reason for this is that as firm adds debt. As this risk rises, the cost of equity capital rises as a result. MM prove that the two effects exactly offset each other, so that the value of the firm and the firms overall cost of capital are invariant to leverage. The following are the assumptions followed by MM approach. The market capitalizes the value of the firm as a whole, which makes the split between debt and equity unimportant The market uses an overall capitalization rate to capitalize the NOI. This overall capitalization depends on the business risks. The use of less costly debt funds increases the risk of shareholder which causes the increase of overall capitalization rate. 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 different sources of finance can be classified into the following 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 different sources of funds available to meet the long term financial needs of the business. These sources may be broadly classified into share capital (both preference and equity share capital) and Debt.
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Preference share Long term funds from preference shares can be raised through a public issue of shares. Such shares are normally cumulative i.e. dividend payable in a year of loss gets carried over to the next year till there is adequate profit to pay cumulative dividends. Most of the preference shares these days carry a stipulation of period and the funds have to be repaid at the end of a stipulated period. Preference share capital is a hybrid form of financing which partakes some characteristics of equity capital and some attributes of debt capital. It is similar to equity because preference dividend is not a tax deductible payment. It resembles debt capital because the rate of preference dividend is fixed. Typically, when preference dividend is skipped it is payable in future because of the cumulative feature associated with most of the preference shares. Advantages There is no legal obligation to pay preference dividend. A company does not face bankruptcy or legal action if it skips dividend Preference capital is generally regarded as part of net worth. Hence, it enhances the creditworthiness of the firm Preference shares do not, under normal circumstances, carry voting right. Hence, there is no dilution of control No assets are pledged in favour of preference shareholders. Hence, the mortgage able assets of the firm are conserved Dis-advantages Compared to debt capital, it is very expensive source of financing because the dividend paid to preference shareholders is not, unlike debt interest, a tax-deductible expense Compared to equity shareholders, preference shareholders have a prior claim on the assets and earnings of the firm.

Equity capital Equity capital represents ownership capital, as equity shareholders collectively own the company. They enjoy the rewards and bear the risks of ownership. However, their liability, unlike the liability of the owner in a proprietary firm and the partners in a partnership concern, is limited to their capital contribution.

Advantages There is no compulsion to pay dividends. If the firm has insufficiency of cash it can skip equity dividends without suffering any legal consequences Equity capital has no maturity date and hence the firm has no obligation to redeem. Presently, dividends are tax-exempt in the hands of investors. The company paying equity dividend, however, is required to pay a dividend distribution tax. Dis-Advantages Sales of equity shares to outsiders dilutes the control of existing owners The cost of equity capital is high, usually the highest. The rate of return required by equity shareholders is generally higher than the rate of return required by other investors

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Equity dividends are paid out of profit after tax, whereas interest payments are tax-deductible expenses. This makes the relative cost of equity more. Partially offsetting this advantage is the fact that equity dividends are tax-exempt, whereas interest income is taxable, in the hands of investors Retained Earnings: Long term funds may be also provided by accumulating the profits of the company and by ploughing back the profit into the business. Such funds belong to the ordinary share holders and increase the net worth of the company. A public limited company must plough back a reasonable amount of profit every year keeping in view of legal requirements, these funds entail no risk and the control of the owners is not diluted. 5.4 LEVERAGE A firm can make use of different sources of financing whose costs are different. These sources may be, for the purpose of exposition, classification into those which carry a fixed rate of return and those on which the returns vary. The fixed returns of some sources of finance have implications for those who are entitled to a variable return. Thus, since these debts involves the payment of a stated rate of interest, the return to the ordinary share holders is affected by the magnitude of debt in the capital structure of the firm. The employment of an asset or source of funds for which the firm has to pay a fixed cost or fixed return may be termed as Leverage. Consequently, the earnings available to the shareholders as also affected. If the earnings less the variable cost exceed the fixed cost or earnings before interest and taxes exceeds the fixed return requirements, the leverage is called as Favourable Leverage. When they do not, the result is Unfavourable Leverage. There are two types of leverage-Operating and Financial. The leverage associated with investment activities is referred to as Operating leverage. The leverage associated which is associated with financing activities is known as Financial Leverage, while leverage associated with financial leverage for purpose of the financial decision of a firm, the discussion of operating leverage is to serve as a background to the understanding of financial leverage because the two are closely related. Operating leverage is determined by the relationship between the firms sales revenues and its earnings before interest and taxes (EBIT). The earnings before interest and taxes are also generally called as Operating profit. Financial leverage represents the relationship between the firms earnings before interest and taxes (Operating profit) and the earnings available for ordinary shareholders. The operating profits (EBIT) are, thus, used as the pivotal point in defining operating and financial leverages. In a way, Operating and Financial leverage represents two stages in the process of determining the earning available to the equity shareholders.

Operating leverage; Operating leverage results from the existence of fixed operating expenses in the firms income stream. The operating cost of a firm fall into three categories; (i) fixed cost which may be defined as those which do not vary with sales volumes; they are a function of time and are able; (ii) variable cost which vary directly with the sales volume; and (iii) semi-variable or semi-fixed costs are those which are partly fixed and partly variable. They are fixed over a certain range of sales volume and increase to higher levels for higher sales volumes components, the costs of the cost of a firm, in operational terms, can be divided into (a) fixed, and (b) variable. The operating leverage may be defined as the firms ability to use fixed operating costs to modify the effect of changes in sales on its earnings before interest and taxes. Operating leverage occurs any times a firm has fixed cost that must meet regardless of volume. We employ assets with fixed cost in the hope that volume will produce revenues more than sufficient to cover all fixed and variable cost. In the other words, with fixed costs, the percentage change in profits 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 following formula;
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Sales Variable cost Operating leverage = EBIT Degree of Operating Leverage - DOL; This is more precise measurement in terms of degree of operating leverage (DOL). The DOL measures in quantitative terms to extend or degree of operating leverage. The higher the degree of operating leverage, the more volatile the EBIT figure will be relative to a given change in sales, all other things remaining the same. The formula is as follows: Percentage change in EBIT DFL= Percentage change in SALES This ratio is useful as it helps the user in determining the effects that a given level of operating leverage has on the earnings potential of the firm. This ratio can also be used to help the firm determine the most appropriate level of operating leverage in order to maximize the company's EBIT. Financial leverage; Financial leverage relates to the financing activities of a firm. The sources from which funds can be raised by a firm, from the point of view of the cost/charges, can be categorised into (i) those which carry a fixed financial charges, and (ii) those which do not involve any fixed charges. The sources of funds in the first category consist of various types of long-term interest which is a contractual obligation for the firm. Although the dividend on preference shares is not a contractual obligation, it is a fixed charge and must be paid before anything is paid to the ordinary shareholders. The equity shareholders are entitled to remember of the operating profits of the firm after all the prior obligations are met. We assume in the subsequent discussions that all preference dividends are paid in order to ascertain the operating profits available for distribution to ordinary shareholders. Financial leverage results from the presence of fixed financial charges in the firms income stream. These fixed charges do not vary with the earning before interest and taxes (EBIT) or operating profit. They are to be paid regardless of the amount of EBIT available to pay them. After paying them, the operating profit (EBIT) belongs to ordinary share holders. Financial leverage is concerned with the effect of changes in EBIT on the earning available to equity shareholders. It is defined as the ability of the firm to use fixed financial charges to magnify the effect of changes in EBIT on the earnings per share. In the other words, financial leverage involves the use of funds to obtain at a fixed cost in the hope of increasing the returns to the shareholders. Favourable leverage occurs when earns more on the assets purchased with the funds, than the fixed cost of their use. Unfavourable or Negative leverage occurs when the firm does not earn as much as the fund cost. Thus, financial leverage is based on the assumption that the firm is to earn more on the assets that are required by the use of funds on which a fixed rate of interest/dividend is to be paid. Financial leverage is calculated by the following formula; EBIT Financial leverage = EBIT - Interest >1

Degree of Financial Leverage - DFL; Financial leverage can be more precisely expressed in terms of the degree of financial leverage (DFL). The DFL can be calculated by
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Percentage change in EPS DFL= Percentage change in EBIT Combined leverage; The operating leverage has it effects on the operating risk and is measured by the percentage change in EBIT due to the percentage change in sales. The financial leverage has its effects on financial risk and is measured by the percentage change in EPS due to percentage change in EBIT. Since both these leverages are closely concerned with ascertaining the ability to cover fixed financial charges (fixed-operating coat in the case of operating leverage and fixed-financial costs in case of financial leverage), if 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 following formula can also be used to calculate combined leverage. Sales Variable cost Combined Leverage = EBIT Interest >1

ABC ANALYSIS: ABC analysis refers to the annual consumption value of the items. One of the most widely recognized concepts of inventory management is referred to as ABC inventory control. The maintaining appropriate control according to the potential savings associated with a proper level of such control. The ABC approach is a means of categorizing inventoried items into three classes A, B, C according to the potential amount to be controlled. A items justify the use of price control techniques, where C items should be controlled by means of general control techniques.
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The primary criterion for classifying items into A and C categories is the annual rupees usage of each item. This is accomplished by multiplying the annual unit usage of 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 reflects the distribution of annual rupees usage. A typical distribution in a manufacturing operation shows that the top 15% of the line items, in terms of annual rupees usage, represent 80% of the total annual rupees usage. These items are normally classified as A items. The next 15% of the line items, in terms of the annual rupees usage, reflect an additional 15% of the annual rupees usages and are designed as B items. The C items represent the remaining 70% of the items in inventory and account for only 5% of the total rupees usage. In addition to annual rupees usage, several other factors need to be considered in developing criteria for classifying items into A, B and C categories. Advantages of ABC analysis: Closer and stricter control on those items which represent a major portion of total stock value. Investment in inventory can be regulated and funds can be utilized in the best possible manner. Saving in stock carrying costs. Helps in maintaining enough safety stock for C category of items. Scientific and selective control helps in the maintenance of high stock turnover rate. ECONOMIC ORDER QUANTITY (EOQ): The economic order quantity is that inventory level, which minimizes the total of ordering costs and carrying costs. It is the question, how much to order the quantity when inventory is replenished. If the firm is buying raw materials, the question is to purchase the quantity of each replenishment and if it has to plan for production run, it is how much production to schedule. It may be solved through EOQ. It involves two types of costs: 1. Carrying cost 2. Ordering cost EOQ for an item is arrived by the following formula; the following assumptions are made in the standard Wilson lot size formula to obtain EOQ: a. Demand is continuous at a constant rate. b. The process continues infinity. 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 for an item is arrived by the following formula,

EOQ =

2 * AC * CO CC

Where EOQ = Economic Order Quantity AC = Annual Consumption of an item CO = Ordering Cost CC = Carrying Cost

Merger:
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Merger is defined as combination of 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 of 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 defined as amalgamation. Merger is the fusion of two or more existing companies. All assets, liabilities and the stock of one company stand transferred to transferee company in consideration of payment in the form of: Equity shares in the transferee company, Debentures in the transferee company, Cash, or A mix of the above modes.

Acquisition: Acquisition in general sense is acquiring the ownership in the property. In the context of business combinations, an acquisition is the purchase by one company of a controlling interest in the share capital of another existing company.

Methods of Acquisition: An acquisition may be affected by (a) agreement with the persons holding majority interest in the company management like members of the board or major shareholders commanding majority of voting power; (b) purchase of shares in open market; (c) to make takeover offer to the general body of shareholders; (d) purchase of new shares by private treaty; (e) Acquisition of share capital through the following forms of considerations viz. means of cash, issuance of loan capital, or insurance of share capital. Takeover: A takeover is acquisition and both the terms are used interchangeably. Takeover differs from merger in approach to business combinations i.e. the process of takeover, transaction involved in takeover, determination of share exchange or cash price and the fulfillment of goals of combination all are different in takeovers than in mergers. For example, process of takeover is unilateral and the offeror company decides about the maximum price. Time taken in completion of transaction is less in takeover than in mergers, top management of the offeree company being more co-operative. De-merger or corporate splits or division: De-merger or split or divisions of a company are the synonymous terms signifying a movement in the company.
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What will it take to succeed? Funds are an obvious requirement for would-be buyers. Raising them may not be a problem for multinationals able to tap resources at home, but for local companies, finance is likely to be the single biggest obstacle to an acquisition. Financial institution in some Asian markets are banned from leading for takeovers, and debt markets are small and illiquid, deterring investors who fear that they might not be able to sell their holdings at a later date. The credit squeezes and the depressed state of many Asian equity markets have only made an already difficult situation worse. Funds apart, a successful 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. Assess 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 fraught with problems, and several deals have gone badly wrong because buyers failed to dig deeply enough. The attraction of knockdown price tag may tempt companies to skip crucial checks. Concealed high debt levels and deferred 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 half of the initial figure. Due diligence can be difficult because disclosure practices are poor and companies often lack the information buyer need. Moreover, most Asian conglomerates still do not present consolidated financial statements, leaving the possibilities that the sales and the profit figures might be bloated by transactions between affiliated companies. The financial records that are available are often unreliable, with different projections made by different departments within the same company, and different projections made for different audiences. Banks and investors, naturally, are likely to be shown optimistic forecasts. Purpose of Mergers and Acquisition: The purpose for an offeror company for acquiring another company shall be reflected in the corporate objectives. It has to decide the specific objectives to be achieved through acquisition. The basic purpose of merger or business combination is to achieve faster growth of the corporate business. Faster growth may be had through product improvement and competitive position. Other possible purposes for acquisition are short listed below: (1)Procurement of supplies: 1. To safeguard the source of supplies of raw materials or intermediary product; 2. To obtain economies of purchase in the form of discount, savings in transportation costs, overhead costs in buying department, etc.; 3. To share the benefits of suppliers economies by standardizing the materials. (2)Revamping production facilities: 1. To achieve economies of scale by amalgamating production facilities through more intensive utilization of plant and resources; 2. To standardize product specifications, improvement of quality of product, expanding 3. market and aiming at consumers satisfaction through strengthening after sale 4. services; 5. To obtain improved production technology and know-how from the offeree company 6. To reduce cost, improve quality and produce competitive products to retain and
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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 of the offeree; 3. To obtain new product for diversification or substitution of existing products and to enhance the product range; 4. Strengthening retain outlets and sale the goods to rationalize distribution; 5. To reduce advertising cost and improve public image of the offeree company; 6. Strategic control of patents and copyrights. (4) Financial strength: 1. To improve liquidity and have direct access to cash resource; 2. To dispose of surplus and outdated assets for cash out of combined enterprise; 3. To enhance gearing capacity, borrow on better strength and the greater assets backing; 4. To avail tax benefits; 5. To improve EPS (Earning per Share). (5) General gains: 1. To improve its own image and attract superior managerial talents to manage its affairs; 2. To offer better satisfaction to consumers or users of the product. (6) Own developmental plans: The purpose of acquisition is backed by the offeror companys own developmental plans. A company thinks in terms of 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 of taxation, accounting, valuation, etc. but might feel resource constraints with limitations of funds and lack of skill managerial personnels. It has to aim at suitable combination where it could have opportunities to supplement its funds by issuance of securities, secure additional financial facilities, eliminate competition and strengthen its market position. (7) Strategic purpose: The Acquirer Company view the merger to achieve strategic objectives through alternative type of combinations which may be horizontal, vertical, product expansion, market extensional or other specified unrelated objectives depending upon the corporate strategies. Thus, various types of combinations distinct with each other in nature are adopted to pursue this objective like vertical or horizontal combination. (8) Corporate friendliness: Although it is rare but it is true that business houses exhibit degrees of cooperative spirit despite competitiveness in providing rescues to each other from hostile takeovers and cultivate situations of collaborations sharing goodwill of each other to achieve performance heights through business combinations. The combining corporates aim at circular combinations by pursuing this objective. (9) Desired level of integration: Mergers and acquisition are pursued to obtain the desired level of integration between the two combining business houses. Such integration could be operational or financial. This gives birth to conglomerate combinations. The purpose and the requirements of the offeror company go a long way in selecting a suitable partner for merger or acquisition in business combinations. Types of Mergers: Merger or acquisition depends upon the purpose of the offeror company it wants to achieve. Based on the offerors objectives profile, combinations could be vertical, horizontal, circular and conglomeratic as precisely described below with reference to the purpose in view of the offeror company.
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(A) 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 of supply and forward integration towards market outlets. The acquiring company through merger of another unit attempts on reduction of inventories of raw material and finished goods, implements its production plans as per the objectives 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 for final production. The following main benefits accrue from the vertical combination to the acquirer company i.e. (1) it gains a strong position because of imperfect market of the intermediary products, scarcity of resources and purchased products; (2) has control over products specifications. (B) Horizontal combination: It is a merger of two competing firms which are at the same stage of industrial process. The acquiring firm belongs to the same industry as the target company. The mail purpose of such mergers is to obtain economies of scale in production by eliminating duplication of facilities 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 facilities to obtain economies by elimination of cost on duplication and promoting market enlargement. The acquiring company obtains benefits in the form of economies of resource sharing and diversification. (D) Conglomerate combination: It is amalgamation of two companies engaged in unrelated industries like DCM and Modi Industries. The basic purpose of such amalgamations remains utilization of financial resources and enlarges debt capacity through reorganizing their financial structure so as to service the shareholders by increased leveraging and EPS, lowering average cost of capital and thereby raising present worth of the outstanding shares. Merger enhances the overall stability of the acquirer company and creates balance in the companys total portfolio of diverse products and production processes. Advantages of Mergers and Takeovers: Mergers and takeovers are permanent form of combinations which vest in management complete control and provide centralized administration which are not available in combinations of holding company and its partly owned subsidiary. Shareholders in the selling company gain from the merger and takeovers as the premium offered to induce acceptance of the merger or takeover offers much more price than the book value of shares. Shareholders in the buying company gain in the long run with the growth of the company not only due to synergy but also due to boots trapping earnings. Motivations for mergers and acquisitions Mergers and acquisitions are caused with the support of shareholders, managers ad promoters of the combing companies. The factors, which motivate the shareholders and managers to lend support to these combinations and the resultant consequences they have to bear, are briefly noted below based on the research work by various scholars globally.
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(1) From the standpoint of shareholders Investment made by shareholders in the companies subject to merger should enhance in value. The sale of shares from one companys 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 from merger in different ways viz. from the gains and achievements of the company i.e. through (a) realization of monopoly profits; (b) economies of scales; (c) diversification of product line; (d) acquisition of human assets and other resources not available otherwise; (e) Better investment opportunity in combinations. One or more features would generally be available in each merger where shareholders may have attraction and favour merger. (2) From the standpoint of managers Managers are concerned with improving operations of the company, managing the affairs of the company effectively for all round gains and growth of the company which will provide them better deals in raising their status, perks and fringe benefits. Mergers where all these things are the guaranteed outcome get support from the managers. At the same time, where managers have fear of displacement at the hands of new management in amalgamated company and also resultant depreciation from the merger then support from them becomes difficult. (3) Promoters gains Mergers do offer to company promoters the advantage of increasing the size of their company and the financial 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 of mergers on general public could be viewed as aspect of benefits and costs to: (a) Consumer of the product or services; (b) Workers of the companies under combination; (c) General public affected 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 different approaches to business combinations. Mergers are pursued under the Companies Act, 1956 vide sections 391/394 thereof or may be envisaged under the provisions of Income-tax Act, 1961 or arranged through BIFR under the Sick Industrial Companies Act, 1985 whereas, takeovers fall solely under the regulatory framework of the SEBI Regulations, 1997. Minority shareholders rights SEBI regulations do not provide insight in the event of minority shareholders not agreeing to the takeover offer. However section 395 of the Companies Act, 1956 provides for the acquisition of shares of the shareholders. According to section 395 of the Companies Act, if the offerer has acquired at least 90% in value of those shares may give notice to the non-accepting shareholders of the intention of buying their shares. The 90% acceptance level shall not include the share held by the offerer or its associates. The procedure laid down in this section is briefly noted below. 1. In order to buy the shares of non-accepting shareholders the offerer must have reached the 90% acceptance level within 4 months of the date of the offer, and notice must have been served on those shareholders within 2 months of reaching the 90% level.
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2. The notice to the non-accepting shareholders must be in a prescribed manner. A copy of a notice and a statutory declaration by the offerer (or, if the offerer is a company, by a director) in the prescribed form confirming that the conditions for giving the notice have been satisfied must be sent to the target. 3. Once the notice has been given, the offerer is entitled and bound to acquire the outstanding shares on the terms of the offer. 4. If the terms of the offer give the shareholders a choice of consideration, the notice must give particulars of options available and inform the shareholders that he has six weeks from the date of the notice to indicate his choice of consideration in writing. 5. At the end of the six weeks from the date of the notice to the non-accepting shareholders the offerer must immediately send a copy of notice to the target and pay or transfer to the target the consideration for all the shares to which the notice relates. Stock transfer forms executed on behalf of the nonaccepting shareholders by a person appointed by the offerer must also be sent. Once the company has received stock transfer forms it must register the offerer as the holder of the shares. 6. The consideration money, which is received by the target, should be held on trust for the person entitled to shares in respect of which the sum was received. 7. Alternatively, if the offerer does not wish to buy the non-accepting shareholders shares, it must still within one month of company reaching the 90% acceptance level give such shareholders notice in the prescribed manner of the rights that are exercisable by them to require the offerer to acquire their shares. The notice must state that the offer is still open for acceptance and specify a date after which the right may not be exercised, which may not be less than 3 months from the end of the time within which the offer can be accepted. If the offerer fails to send such notice it (and its officers who are in default) are liable to a fine unless it or they took all reasonable steps to secure compliance. 8. If the shareholder exercises his rights to require the offerer to purchase his shares the offerer is entitled and bound to do so on the terms of the offer or on such other terms as may be agreed. If a choice of consideration was originally offered, the shareholder may indicate his choice when requiring the offerer to acquire his shares. The notice given to shareholder will specify the choice of consideration and which consideration should apply in default of an election. 9. On application made by an happy shareholder within six weeks from the date on which the original notice was given, the court may make an order preventing the offerer from acquiring the shares or an order specifying terms of acquisition differing from those of the offer or make an order setting out the terms on which the shares must be acquired. In certain circumstances, where the takeover offer has not been accepted by the required 90% in value of the share to which offer relates the court may, on application of the offerer, make an order authorizing it to give notice under the Companies Act, 1985, section 429. It will do this if it is satisfied that: a. The offerer has after reasonable enquiry been unable to trace one or more shareholders to whom the offer relates; b. The shares which the offerer has acquired or contracted to acquire by virtue of acceptance of the offerer, together with the shares held by untraceable shareholders, amount to not less than 90% in value of the shares subject to the offer; and c. The consideration offered is fair and reasonable.
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The court will not make such an order unless it considers that it is just and equitable to do so, having regarded in particular, to the number of shareholder who has been traced who did accept the offer. Alternative modes of acquisition The terms used in business combinations carry generally synonymous connotations and can be used interchangeably. All the different terms carry one single meaning of 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 of merger, amalgamation or reconstruction. Particularly the takeover Regulations for substantial acquisition of shares and takeovers known as SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 vide section 3 excludes any attempt of merger done by way of any one or more of the following modes: (a) By allotment in pursuant of an application made by the shareholders for right issue and under a public issue; (b) Preferential allotment made in pursuance of a resolution passed under section 81(1A) of the Companies Act, 1956; (c) Allotment to the underwriters pursuant to underwriters agreements; (d) Inter-se-transfer of shares amongst group, companies, relatives, Indian promoters and Foreign collaborators who are shareholders/promoters; (e) Acquisition of shares in the ordinary course of business, by registered stock brokers, public financial institutions and banks on own account or as pledges; (f) Acquisition of shares by way of transmission on succession or inheritance; (g) Acquisition of shares by government companies and statutory corporations; (h) Transfer of shares from state level financial institutions to co-promoters in pursuance to agreements between them; (i) Acquisition of shares in pursuance to rehabilitation schemes under Sick Industrial Companies (Special Provisions) Act, 1985 or schemes of arrangements, mergers, amalgamation, De-merger, etc. under the Companies Act, 1956 or any other law or regulation, Indian or Foreign; (j) Acquisition of shares of company whose shares are not listed on any stock exchange. However, this exemption in not available if the said acquisition results into control of a listed company; (k) Such other cases as may be exempted from the applicability of Chapter III of SEBI regulations by SEBI. The basic logic behind substantial disclosure of takeover of a company through acquisition of shares is that the common investors and shareholders should be made aware of the larger financial stake in the company of the person who is acquiring such companys shares. The main objective of these Regulations is to provide greater transparency in the acquisition of shares and the takeovers of companies through a system of disclosure of information. Escrow account To ensure that the acquirer shall pay the shareholders the agreed amount in redemption of 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 for performance of obligation. The Escrow amount shall be calculated as per the manner laid down in regulation 28(2). Accordingly: For offers which are subject to a minimum level of acceptance, and the acquirer does want to acquire a minimum of 20%, then 50% of the consideration payable under the public offer in cash shall be deposited in the Escrow account.
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Payment of consideration Consideration may be payable in cash or by exchange of securities. Where it is payable in cash the acquirer is required to pay the amount of consideration within 21 days from the date of closure of the offer. For this purpose he is required to open special account with the bankers to an issue (registered with SEBI) and deposit therein 90% of the amount lying in the Escrow Account, if any. He should make the entire amount due and payable to shareholders as consideration. He can transfer the funds from Escrow account for such payment. Where the consideration is payable in exchange of securities, the acquirer shall ensure that securities are actually issued and dispatched to shareholders in terms of regulation 29 of SEBI Takeover Regulations. (a) Consumers The economic gains realized from mergers are passed on to consumers in the form of lower prices and better quality of the product which directly raise their standard of living and quality of life. The balance of benefits in favour of consumers will depend upon the fact whether or not the mergers increase or decrease competitive economic and productive activity which directly affects the degree of welfare of the consumers through changes in price level, quality of products, after sales service, etc. (b) Workers community The merger or acquisition of a company by a conglomerate or other acquiring company may have the effect on both the sides of increasing the welfare in the form of purchasing power and other miseries of life. Two sides of the impact as discussed by the researchers and academicians are: firstly, mergers with cash payment to shareholders provide opportunities for them to invest this money in other companies which will generate further employment and growth to uplift of 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 suffer on lessening job opportunities, preventing the distribution of benefits resulting from diversification of production activity. (c) General public Mergers result into centralized concentration of power. Economic power is to be understood as the ability to control prices and industries output as monopolists. Such monopolists affect social and political environment to tilt everything in their favour to maintain their power ad expand their business empire. These advances result into economic exploitation. But in a free economy a monopolist does not stay for a longer period as other companies enter into the field to reap the benefits of higher prices set in by the monopolist. This enforces competition in the market as consumers are free to substitute the alternative products. Therefore, it is difficult to generalize that mergers affect the welfare of general public adversely or favorably. Every merger of two or more companies has to be viewed from different angles in the business practices which protects the interest of the shareholders in the merging company and also serves the national purpose to add to the welfare of the employees, consumers and does not create hindrance in administration of the Government polices. Reverse Merger: Generally, a company with the track record should have a less profit earning or loss making but viable company amalgamated with it to have benefits of economies of scale of production and marketing network, etc. As a consequence of this merger the profit earning company survives and the loss making company extinguishes its existence. But in many cases, the sick companys survival becomes more important for many strategic reasons and to conserve community interest. The law provides encouragement through tax relief for the companies that are profitable but get merged with the loss making companies. Infact this type of merger is not a normal or a routine merger. It is, therefore, called as a Reverse Merger.
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Procedure for Takeover and Acquisition: Public announcement: To make a public announcement an acquirer shall follow the following procedure: 1. Appointment 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 of offer on his behalf. 2. Use of media for announcement: Public announcement shall be made at least in one national English daily one Hindi daily and one regional language daily newspaper of that place where the shares of that company are listed and traded. 3. Timings of announcement: Public announcement should be made within four days of finalization of negotiations or entering into any agreement or memorandum of understanding to acquire the shares or the voting rights. 4. Contents of announcement: Public announcement of offer is mandatory as required under the SEBI Regulations. Therefore, it is required that it should be prepared showing therein the following information: (1) Paid up share capital of the target company, the number of fully paid up and partially paid up shares. (2) Total number and percentage of shares proposed to be acquired from public subject to minimum as specified in the sub-regulation (1) of Regulation 21 that is: a) The public offer of minimum 20% of voting capital of the company to the shareholders; b) The public offer by a raider shall not be less than 10% but more than 51% of shares of voting rights. Additional shares can be had @ 2% of voting rights in any year. (3) The minimum offer price for each fully paid up or partly paid up share; (4) Mode of payment of consideration; (5) The identity of the acquirer and in case the acquirer is a company, the identity of the promoters and, or the persons having control over such company and the group, if any, to which the company belong; (6) The existing holding, if any, of the acquirer in the shares of the target company, including holding of persons acting in concert with him; (7) Salient features of the agreement, if any, such as the date, the name of the seller, the price at which the shares are being acquired, the manner of payment of the consideration and the number and percentage of shares in respect of which the acquirer has entered into the agreement to acquirer the shares or the consideration, monetary or otherwise, for the acquisition of 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 for acquisition, if any, of shares of the target company made by him during the twelve month period prior to the date of the public announcement; (9) Objects and purpose of the acquisition of the shares and the future plans of the acquirer for the target company, including disclosers whether the acquirer proposes to dispose of or otherwise encumber any assets of the target company: Provided that where the future plans are set out, the public announcement shall also set out how the acquirers propose to implement such future plans; (10) The specified date as mentioned in regulation 19; (11) The date by which individual letters of offer would be posted to each of the shareholders;
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The date of opening and closure of the offer and the manner in which and the date by which the acceptance or rejection of the offer would be communicated to the share holders; (13) The date by which the payment of consideration would be made for the shares in respect of which the offer has been accepted; (14) Disclosure to the effect that firm arrangement for financial resources required to implement the offer is already in place, including the details regarding the sources of the funds whether domestic i.e. from banks, financial institutions, or otherwise or foreign i.e. from Nonresident Indians or otherwise; (15) Provision for acceptance of the offer by person who own the shares but are not the registered holders of such shares; (16) Statutory approvals required to obtained for the purpose of acquiring the shares under the Companies Act, 1956, the Monopolies and Restrictive Trade Practices Act, 1973, and/or any other applicable laws; (17) Approvals of banks or financial institutions required, if any; (18) Whether the offer is subject to a minimum level of acceptances from the shareholders; and (19) Such other information as is essential fort the shareholders to make an informed design in regard to the offer. 5. Offer Price The acquirer is required to ensure that all the relevant parameters are taken into consideration while determining the offer price and that justification for the same is disclosed in the letter of offer. 6. Disclosure The offer should disclose the detailed terms of the offer, identity of the offerer, details of the offerers existing holdings in the Offeree Company etc and information should be made available to all the shareholders. 7. Offer Document: The offer document should contain the offers financial information, its intention to continue the offeree companys business and to make major change and long term commercial justification for the offer. Legal Procedures: Permission of merger: Two or more companies can amalgamate only when amalgamation is permitted under their memorandum of association. Also, the acquiring company should have the permission in its object clause to carry on the business of the acquired company. In the absence of these provisions in the memorandum of association, it is necessary to seek the permission of shareholders, board of directors and the company law board before affecting the merger. Information to the stock exchange: The acquiring and the acquired companies should inform the stock exchanges where they are listed about the merger. Approval of board of director: The boards of the directors of the individual companies should approve the draft proposal for amalgamation and authorize the managements of companies to further pursue the proposal. Application in the high court: An application for approving the draft amalgamation proposal duly approved by the boards of directors of the individual companies should be made to the high court. The high court would convene a meeting of the shareholders and creditors to approve the amalgamation proposal. Shareholders and creditors meetings: The individual companies should hold separate meeting of their shareholders and creditors for approving the amalgamation scheme. Sanction by the high court: After the approval of shareholders and creditors on the petitions of the companies, the high court will pass order sanctioning the amalgamation scheme after it is satisfied that the scheme is fair and reasonable. Filing of court order: Certified true copies of court orders will be filed with the registrar of companies. Transfer of assets and liabilities: The assets and liabilities of the acquired company will be transferred to the acquiring company in accordance with the approved scheme, with effect from the specified date.
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Value Based Management and Corporate Governance Corporate Governance: Corporate governance is the set of processes, customs, policies, laws and institutions affecting 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 for which the corporation is governed. Definition: Corporate governance is a field in economics that investigates how to secure/motivate efficient management of corporations by the use of incentive mechanisms, such as contracts, organizational designs and legislation. This is often limited to the question of improving financial performance, for example, how the corporate owners can secure/motivate that the corporate managers will deliver a competitive rate of return History of corporate governance: In 19th century, state corporation law enhanced the rights of corporation boards to govern without unanimous consent of shareholders in exchange of statutory benefits like appraisal rights, in order to make coporate governance more efficient. Since that time, and because most large publicly traded corporations in america are incorporated under corporate administration friendly delaware law, and because americas wealth has been increasingly securitized into various corporte entities and institutions, the rights of individual owners and sharehoders have become increasingly derivative and dissipated. The concerns of share holders over administration, pay and stock losses periodically have led to more frequent calls for corporte governance reforms. In the 20th century immediately after wall street crash of 1929, legal scholars pondred on changing role of the modern corporation in society. American expansion after world war II through the emergence of multinational corporations saw the establishment of managerial class. Many large corporations have dominent control over business affairs without sufficient accoutability or monitoring by their board of directors. Current preoccupation of corporate governance can be pinpointed at two events: The East Asian crisis of 1997 saw the economies of Thailand, Indonesia, South Korea, Malaysia and The philippines severly affected by the exit of foreign capital after property assets collapsed. The lack of corporte governance mechanisms in those countires highlited the weakness of institutions in their economies. The second event was the american corporate crisis of which saw the collapse of two big corporations: Enron and World Com. Principles of corporate governance / OECD principles of corporate governance / Elements of corporate governance: Among the various attempts to evaluate best global standards, the principles evolved by organisation for Economic Cooperation and Development (OECD) released in 1999 have been accepted as an international benchmark. The OECD principles protect the interests of share holders as well as stake holders like employees, creditors, suppliers, customers and environment. 1. The rights of shareholders: Rights of shareholder mentioned in the OECD report cover the registration of right to ownership with the company, conveyance or transfer of shares, obtain relevant information from the company on a timely and regular basis, participate and vote in general share holders meetings, elect members of the board and share in the profits of the company. 2. The equitable treatment of shareholders: All shareholders should be treated equitably and the law should not make any distinction among different shareholders holding a given class or types of shares. Any changes in voting rights of common shareholders can be done with the consent of those shareholders. 3. The role stakeholders: The rights of stakeholders as established by law should be recognized ans active cooperation between corporations and stakeholders in creating wealth, jobs and sustainabiity of functionally sound enterpreses should be encouraged. While the share holders re the true oweners, the functioning of a
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company is affected by several other economic players in the society. There is a significant synergetic relationship between the company and its employees. 4. Disclosure and transperancy: Organisations should clarify and make publicly known the roles and responsibilities of board and management to provide shareholders with a level of accountability. They should also implement procedures to independenly verify and safeguard the integrity of the companys financial reporting. Disclosure of material matters concerning the organisation should be timely and balanced to ensure that all investors have access to clear, factual information. 5. Roles and responsibilities of board: The board needs a range of skills and understanding to be able to deal with various business issues and have the ability to review and challenge management performance. It nees to be of sufficient size and have appropriate level of commitment to fulfil its responsibilites and duties. 6. Integrity and ethical behaviour: Organisations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making. Internal corporate governance controls: Monitoring by board of directors Remuneration Disclosure External corporate governance controls: Government regulations Media pressure Takeovers Managerial labour market Telephone tapping Corporate governance models: Anglo american model: There are many different models of corporate governance around the world. These differ according to the variety of capitalism in which they are embeded. The liveral model that is common in anglo american countries tends to give priority to the interests of shareholders. The coordinated model that one finds in continental europe and japan also recognizes the interests of workers, managers, suppliers, customers and the community. The liveral model of corporate govenance encourages radical innovation and cost competition, whereas the coordinated model of corporte governance facilitates incremental innovation and quality competition. In the united states, a corporation is governed by a board of directors, which has the power to choose chief executive officer. The CEO has broad power to manage the corporation on a daily basis, but needs to get approval for certain major actions such as raising money, acquiring another company, and other expensive projects. Other duties of the board may include policy setting, decision making, monitiring managements performance or corporate control. The UK has pioneered a flexible model of regulation of corporate governance known as to comply or explain code of governance. This is a principle based code that lists a dozen of recommended practices, such as the seperation of CEO and chairman of the board, the introduction of a time limit for CEOs contracts, the introduction of a minimum number of non executive directors, independent directors, the formation and composition of remuneration, audit and nomination committees. Listed companies in the UK have to apply those principles, if they choose not to apply those principles they have to explain in their annual reports why they dicided not to do so. The monitoring of these explanations is left to shareholders themselves. Non-anglo american model: In East asian counties family owned companies dominate corporate assests. In countries such as Pakistan, Indonesia and the Philippines, the top 15 families controlled over 50% of publicly owned corportion through a system of family cross-holdings, thus dominating capital markets. Family
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companies also dominate the Latin model of 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 Confederation of the Indian Industry (CII) took the lead in framing a desirable code of Corporate Governance in April 1998. This was followed by the recommendations of Kumaramangalam Birla Committee in Corporate Governance appointed by the Securities and Exchange Board of India (SEBI) the recommendations were accepted by SEBI in December 1999 and are now enshrined in Clause 49 of the Listing Agreement of every Indian stock exchange. Corporate Governance can be defined as a systematic process by which companies are directed and controlled to enhance their wealth generating capacity. Since large corporate employs a vast quantum of 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 freedom to drive the enterprese forward without undue restraints. 2. This freedom of management should be exercised within a framework of effective accountability. CII Code of Desirable Corporate Governance: 1. As the key to good corporate governance lies with effective functioning of the board of directors, the full board should meet at intervals of two months and atleast 6 times a year. 2. The non executive directors should at least be 30% of the board. 3. No individual should be director on the boards for more than 10 companies at any given time. 4. Non executive directors must be active, have defined responsibiity and be conversant with profit and loss account, balance sheet, cash flow statement, financial ratios and have some knowledge of company law. 5. Non executive directors should be paid commission and offered stock option for their professional inputs besides their sitting fees. 6. Directors who have not been present for at least 50% of the board meetings should not be reappointed. 7. The board should be informed of the operating plans and budgets, long term plans, quarterly divisional results and internal audit reports. 8. Details of defaults, payments for intangibles and foreign exchange exposures should be reported to access to all financial information. 9. Incase, multiple credit ratings are obtained, all the ratings should be disclosed with comparisions explaining their significance. 10. Major Indian stock exchanges should gradually insist upon compliance certificate signed by CEO and CFO clearly stating that accounting policies and standards have been followed. 11. The government must allow for greater funding to the corporate sector against the security of shares and other papers. 12. Companies that default on fixed deposits should not be permitted to accept further deposits, make intercorporate loans or investments and declare dividens until the default is made good. Recommendations of Birla Committee: 1. Board of Directors: There should be a combination of executive and non executive directors. The board should consist of not less than 30% of non executive directors. 2. Audit Committee: a. The board should appoint a qualified and independent audit committee. The committee should have minimum three members all being non executive directors with majority being independent and at least one director having financial and accounting knowledge.
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b. The chairman of committee should be an independent director and should be present at the companies annual general meeting. c. The chairman should invite finance director, head of internal audit and representatives of external auditor for committee meetings. The company secretary should act as secretary of the committee. 3. Powers of the audit committee: The audit committee should look into the rasons for substantial default to depositors, creditors, debenture holders and shareholders. 4. Frequency of the meetings and quorum: The committee should meet at least thrice a year, once before finalization of annual accounts and once compulsority every 6 months. Quorum should be either two members or 1/3rd of audit committee, which ever is higher. 5. Remuneration of non executive directors: a. The board of directors should decide remuneration of non executive directors. b. All elements of the package inclusive of salary benefits, bonuses, stock options, etc. should be disclosed. 6. Committee membership of directos: Directors should not be members of more than ten committees and chairman of 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 framed to attend to shareholders grievances and board of directors should delegete power of checking share transfer to either officer or committee or to registrar and share transfer agent. List of items to be included in the report on Corporate Governance: 1. A brief statement on companies philosophy on code of governance. 2. Board of Directors: a. Composition and category of directors b. Attendance of each director at the Board of Directors meetings and the last Annual General Meeting c. Number of other Board of Directors or Board Committees in which he/she is a member. d. Number of Board of Directors meetings held, dates on which held. 3. Audit Committee: a. Brief description of terms of reference b. Composition, name of members and chairperson c. Meetings and attendance during the year. 4. Remuneration Committee: a. Brief description of terms of reference b. Composition, name of members and chairperson c. Attendance during the year d. Remuneration policy e. Details of remuneration to all the directors, as per format in main report. 5. Shareholders Committee: a. Name of non executive director heading the committee b. Name and designation of compliance officer c. Number of shareholders complaints received so far. d. Number not solved to the satisfaction of shareholders. e. Number of pending complaints. 6. General Body Meetings: a. Location and time, where last three AGMs held b. Whether any special resolution passed last year through postal ballot c. Person who conducted the postal ballot exercise d. Procedure of postal ballot
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7. Disclosures a. Disclosures on materially significan related party transactions that may have potential conflict with the interests of company at large. b. Disclosures of accounting treatment with explanation c. Details of 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 of communication: a. Half yearly report sent to each household of shareholder b. Quarterly results c. Newspapers wherein results normally published. d. Any website, where displayed e. Whether it also displays official news releases f. The presentations made to institutional investors or to the analysts 9. General shareholder information a. AGM: date, time, venue b. Financial calander c. Date of book closure d. Dividend payment date e. Listing on stock exchanges f. Stock code g. Market price data 10. Performance in comparision to broad based indices such as BSE Sensex, CRISIL, etc. a. Registrar and Transfer Agents b. Share transfer system c. Distribution of shareholding d. Dematerialization of shares and liquidity e. Plant locations f. Address for correspondence

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