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UNIT 1: INTRODUCTION TO CORPORATE FINANCE Contents 1.0 Aim and Objectives 1.1 Introduction 1.2 Meaning of Finance 1.

3 Classification of Finance 1.4 Growth and Evolution of Corporate Finance 1.5 Financial Markets Instruments Institutions 1.6 Sources of Corporate Finances 1.7 Summary 1.8 Answers to Check Your Progress 1.9 Model Examination Questions 1.10 References 1.0 AIMS AND OBJECTIVES This unit aims at presenting the meaning of finance, classification of finance, evolution of finance and sources of finance. After completing this unit, you will be able to: understand the term finance explain the importance of finance list out the various sources of finance distinguish between public finance and business finance. 1.1 INTRODUCTION In simple language finance is money. To start any business we need capital. Capital is the amount of money required to start a business. The mobilization of finance is an important task for an entrepreneur therefore; finance is one of the significant factors, which determine the nature, and size of any enterprise. This is to be noted that identification of sources of finance from time to time to finance the assets of an enterprise is critical as it avoids the financial hardships of an enterprise. The finance is required to acquire various fixed assets and current 1

assets. This course discusses the meaning of finance types of finance need of finances, objectives, and functions of financial management is detail. 1.2 MEANING OF FINANCE Finance is the study of money. Finance means to arrange payment for. It is basically concerned with the nature, creation, behavior, regulation and problems of money. It focuses on how the individuals, businessmen, investors, government and financial institutions deal. We need to understand what money is and does is the foundations of financial knowledge. In this content it is relevant to study the structure and behavior of financial system and the role of financial system in the development of economy and the profitability of business enterprises. 1.3 CLASSIFICATION OF FINANCE The finance is classified into three categories I. Personal finance II. Public finance III. Business finance I. Personal finance: - This deals with the mobilization of funds from own sources. Here funds may imply cash and non-cash items also. II. Public finance: - This kind of finance deals with the mobilization or administration of public funds. It includes the aspects relating to the securing the funds by the government from public through various methods viz. taxes, borrowings from public and foreign markets. III. Business finance: - Financial management actually concerned with business finance. Business finance is pertaining to the mobilization of funds by various business enterprises. Business finance is a broad term includes both commerce and industry. It applies to all the financial activities of trade and auxiliaries of trade such as banking, insurances, mercantile agencies, service organizations, and the manufacturing enterprises. The following are the basic forms of organizations a) Sole trading b) Partnership

c) Corporation d) Co-operative In olden days the individual as a sole trader used to bring in his capital and manage with the help of family members. This system has suffered with certain constraints like limited resources, lack of expertise etc. Later, partnership form come into existences to overcome some of the defects of sole trading. The partners used to contribute in the form of money, assets expertise, management etc and profits will be shared on agreed terms. With the growth of industrialization, many business establishments have preferred to set up corporate form of organization to overcome the major defects of sole trading and partnership form of organization. In case of corporate form of organization the finances are raised through shares, bonds, banks, financial institutions, suppliers etc. We do come across another form of organization i.e. co-operatives. The co-operatives raise funds through the members, government and financial institutions. Thus business finances can be classified into four categories, I. Proprietary finance II. Partnership finance III. Corporate finance IV. Industrial finance I. Proprietary finance This refers to the procurement of finds by the individuals, organizing themselves as sole traders. II. Partnership finance It is concerned with the mobilization of finances by the partners of a business organizations/partnership firms. III. Corporation finance It deals with the raising of finances by corporate organizations. It includes the financial aspects of the promotion of new enterprises and their administration during early period, the accounting, administration problems arising out of growth and expansion. IV. Industrial finance This deals with raising of finances from all sources. It is the study of principles relating to securing the finances from the financial institutions and other institutional sources like banks and insurance companies.

1.4 GROWTHS AND EVOLUTION OF FINANCE The Economics is the mother of finance. It emerged as a separate discipline few years back. Economics is used to deal with all the aspects of finance as an integral part of it. It is only in the recent past, i.e. 1920 it has emerged as an independent subject. Many authors like Thomas Greene and Edward S. Meade written on corporation finance. A landmark in this period by author S. Dewing titled Financial policy of corporations. Later period it is witnessed large scale corporate failures and therefore attention was focused on the financial aspects of liquidation, mergers and amalgamations. Finance during forties and fifties was dominated by issues like capital budgeting, capital structure and cost of capital. The sixties saw the portfolio theory in finance. The period of seventies and eighties saw working capital management, problems of small-scale industries and public enterprises. The development in this discipline is continuing. Day by day, it is gaining importance because it is useful to the business organization. To acquire all the factors of production, finance plays key role. One cannot think of setting up a business or an establishment without finance. For a business organization finance is lifeblood. In a corporate activity mobilization of funds and their administration pose a great challenge. The profitability is dependent on the optimal utilization of funds. A well financially managed company will have many advantage over other company in addition to earning higher rate of return moreover, the survival or closure will purely depend on the financial decisions. The corporation finance assumes further importance because of the dichtonomy between the ownership and management of the organizations, a feature of the corporate form of organization. All sections of the society will be benefited by the understanding of the principles of corporation finance. With effective principles of financial management, the consumers will get products at lower prices, workers can get higher wages and stockholders will get higher dividend.

1.5 FINANCIAL MARKETS INSTRUMENTS - INSTITUTIONS 1. Financial Markets

A financial market is a place where the business houses can raise their long and short-term financial requirements. The development of financial markets indicates the development of economic system. For mobilization of savings and for rapid capital formation, healthy growth and development of these markets are crucial. These markets help promotion of investment activities; encourage entrepreneurship and development of a country. The financial markets are broadly divided as: I. Capital market and II. Money market I. Capital market Capital market is defined as a place where all buyers and sellers of capital funds as well as the entire mechanism for facilitating and effecting long term funds. It provides the long-term funds that are needed for investment purpose. Thus, the capital markets are concerned with long-term finance. This also includes the institutions, facilities and arrangements for the borrowing and lending of long-term funds. Further the capital markets are divided into two categories one is primary market other one is secondary market. Primary market In the primary market only new securities are issued to the public. It is a place where borrowers exchange financial securities for long-term funds. It facilitates the formation of capital. The securities may be issued directly to the individuals, institutions, through the underwriters etc. Secondary market The shares subsequent to the allotment are traded in the secondary market. Any body can either buy or sell the securities in the market. Secondary market consists of stock exchange. In the stock exchange outstanding securities are offered for sale and purchase.

II. Money Market Money market deals with short-term requirements of borrowers. It is concerned with the supply and demand for a commodity or service. It handles transactions in short-term government obligations, bankers acceptances and commodity papers. In money market funds can be borrowed for short period varying from a day to a year. It is a place where the lending and borrowing of short-term funds are arranged and it comprises short-term credit instruments and individuals who participate in the lending and borrowing business. 2. Financial Instruments

There are mainly two kinds of securities namely ownership securities and loan securities. Further ownership securities are classified into two (a) common stock and (b) preference stock. These securities or instruments are being traded in capital markets. Common stock It is also known as equity shares, who are the real owners of the business will enjoy the profit or loss suffered by the company. Dividend payment is not compulsory as discussed in unit 2. Preferential stock By name these holders have two preferential rights I) to get fixed rate of dividend at the end of every year irrespective of profits / losses of the company II) to get back the investment first when the company goes into liquidation. Bonds Bondholders are the money suppliers to a business unit entitled for a fixed rate of interest at the end of each year. Their are stake is confined to the interest only.

FINANCIAL INSTRUMENTS

Owners
Common stock Preference stock

Loan
Bonds Transferability Bearer Registered

Cumulative

Noncumulative

Redeemable

Irred eemable

Convertible

Noneconvertible

Security

Secured Unsecured Redeemable

Redeemability Participating

Irredemandable Convertible

Non -participatin g

3.

Financial Institutions

The financial institutions include banks, development banks, investing institutions at national and international level that provide financial services to the business organizations. These financial institutions provide long-term, short-term finances and extend under writing, promotional and merchant banking services. 1.6 SOURCES OF CORPORATE FINANCE The finance required for any organization could be primarily divided into two one is ling-run finance to acquire the fixed assets that are useful to the business organization over a period of time i.e. more than a year, usually we call fixed capital. The other one is short-term finance which is required to keep running the fixed assets or to made them finance which is required to keep running the fixed assets or to make them working. This is called the working capital. Long-term sources The important long-term sources are common stock, preference stock bonds, loans from financial institutions and foreign capital. Short-term sources The short-term sources are bank loans, public deposits trade credits provisions and current liabilities.

The requirements of above nature could be financed either through external sources or internal sources if it is an existing company. I. External These are the funds drawn from outsiders. Among them the prominent are discussed below. a) Share Capital This is the primary source of finance to a corporate form of organization. It is the sale of equity or common stock and preference stock to the public. Which serves as a permanent capital to an organization. These holders will get dividend in return for their investment. Common stock The holders of these shares are owners of the company. They are the risk takers. They get dividend when the company earns profits, otherwise they do not get any dividend. Whatever profit is left after meeting all the expenses belongs to them. In the event of closure of the company they are the last people to get their claim. Preference stock Preference shares carry two preferential rights one is to get a fixed dividend at the end of each year irrespective of the profits, other one is to get back the original investment first when the company goes into liquidation. Change par bonds Another source of finance to a company is issue of bonds/ debentures. These holders are eligible to get fixed interest at the end of each year. The holders of these bonds do not wish to take any risk public deposits. The term is also mentioned while issuing bonds. Public deposits This is another mode of finance where the company will advertise and accept deposits for specified period at a fixed rate of interest. Borrowings The companies may borrow funds from banks, financial institutions etc for their requirements at the interest chargeable by the lender institution. Foreign capital The concept of liberalization is attracting many foreign companies to participate in the domestic companies. It can be either in the form of direct participation in the capital or collaboration in a project in the equity of the company and also provide loans some time. Trade credits The common means of short-term external finance is trade credits Normally, every company gets its raw material and other supplies on credit basis. This is known as trade credit. This is an important source of financing.

II. Internal Sources This is applicable for only those companies which are in existence. By virtue of their existence, they are in a advantageous position to generate some of the finance internally. a) Retained earnings These are the funds that are retained out of the profits for meeting future contingencies. It can be either to meet the uncertainty or future growth and expansion of business. The company would be free to utilize this source. The retained profits enable a company to withstand seasonal reactions and business fluctuations. The large accumulated savings facilitate a stable dividend policy and enhance the credit standing of the company. However, the quantum of retained earnings depend on the volume of the profits made by the company. b) Provisions Generally companies, in order to meet the legal and other obligations, create some funds for future use. These are known as provisions. They include depreciation, taxation, dividends and various current and non-current liabilities. The amount set apart in these form would be required to be paid only on certain dates. Till then the company can use them for its own purpose. For instance, taxes payable to the government are used in the business until these are paid on due date. Therefore, though for a short-while provisions would serve as a good source of internal finance.

Check Your Progress 1


1. What are the external sources of finance? . 2. List out the internal sources of finance?

1.7 SUMMARY

Finance is a study of money management and deals with the wages in which business men, investors, governments, individuals and financial institutions deal/ handle their money. There are various types of finance Viz. proprietor finance, partnership finance, business finance, public finance etc. The business unit requires capital for two kinds of needs namely long term requirement and short-term requirement. The external source of finance are share capital, bonds, borrowings, public deposits, trade credits and foreign capital. The internal sources of finance are retained earnings, provisions depreciation etc. 1.8 ANSWERS TO CHECK YOUR PROGRESS 1. c) d) e) f) g) h) i) 2. a) Common stock Preferred stock Bonds/debentures Public deposits Trade credits Banks/financial institutions borrowings Foreign capital Foreign Loans a) Retained earnings

b) Provisions c) Sale of unused assets 1.9 MODEL EXAMINATION QUESTIONS I. True or False _______1. Finance has no significance in the business organizations and in the society. _______2. Finance is the study of money management. _______3. Financial management is concerned with personal finance. _______4. The finance raised through the trade credits is an internal source of finance. II. Short answer Questions 1. What is a proprietary finance? 10

2. society? 3. 1.10 REFERENCES Kuchhal S.C. Pandey IM. Brigham EF Gitman L.J : : : :

How is an understanding of corporations finance relevant to the List out the features of preference stock.

Financial management, Chaitanya Publishing House Allahabad. Financial management, Vikas Publishing House Put Ltd. New Delhi. Fundamentals of Financial Management Dryden Press, Chicago Principles of Managerial Finance Harper Row, New York. Financial Management Theory and Practice Tata McGraw Hill, New Delhi.

Prasanny Chandra:

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UNIT 2: CORPORATE FINANCE - AN OVERVIEW Contents 2.0 Aims and Objectives 2.1 Introduction 2.2 Need of Corporate Finance 2.3 Evolution of Financial Management 2.4 Objectives of Financial Management 2.5 Relationship with other Disciplines 2.6 Functions of Financial Management 2.7 Conflict of Goals 2.8 Organization of Finance Department 2.9 Summary 2.10 2.11 2.12 Answers to Check Your Progress Model Examination Questions References

2.0 AIMS AND OBJECTIVES The purpose of this unit is to introduce you the need of study of financial management, its scope, objectives, functions and relationship with other disciplines. After going through this unit, you will be able to: understand the need of corporate finance list the objectives of financial management explain the functions narrate the relationship with other disciplines. 2.1 INTRODUCTION In the previous unit you have learned the meaning of finance and its relevance in the growth, expansion and diversification of activities. This unit will focus attention on certain vital aspects of financial management.

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2.2 NEED OF CORPORATE FINANCE You are aware that no business can be started without finance. Finance is a scarce resource which is not available freely and it has cost. All the resources that are useful to any business organization like men, material, machines and money or finance are in nature. Since, they are limited limited, we cannot waste them. These resources are to be used optimally for productive purposes. Finance is one of the resources vital for any business organization. It is scarce, has cost and also alternative uses. Finance is regarded as the lifeblood of a business enterprise. It is the guide for regularizing investment decisions and expenditure, and endeavors to squeeze the most out of every available birr. It is the sinew of a business activity. No business activity can ever be pursued without financial support. Production and distribution of goods and services in fact, will be a mere dream without flow of funds. Financial viability is perhaps the central theme of any business proposition. Thats why, it has been rightly said that business needs money to make more money. However, it is also true that money begets more money only when it is properly managed. Hence, efficient management of every business enterprise is closely linked with efficient management of its finances. Financial management involves the management of finance function. It is concerned with the planning, organizing, directing and controlling the financial activities of an enterprise. It deals mainly with raising funds in the most economic and suitable manner; using these funds as profitably as possible; planning future operations; and controlling current performance and future developments through financial accounting, cost accounting, budgeting, statistics and other means. It is continuously concerned with achieving an adequate rate of return on investment, as this is necessary for survival and the attracting of new capital. Thus, financial management means the entire gamut of managerial efforts devoted to the management of finance both its sources and uses of the enterprise. The importance of financial management cannot be over emphasized. In every organization, where funds are involved, sound financial management is necessary. It helps in monitoring the effective deployment of funds in fixed assets and in working capital. As Collins Brooks has

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remarked Bad production management and bad sales management have slain in hundreds, but fault financial management has slain in thousands. Hence, it can be said that sound financial management is indispensable for any organization, whether it is profit oriented or non-profit oriented. It helps in profit planning, capital spending, measuring costs, controlling inventories, accounts receivable etc., In addition to the routine problems, financial management also deals with more complex problems like mergers, acquisitions and reorganizations. 2.3 EVOLUTION OF FINANCIAL MANAGEMENT Financial management has undergone significant changes over the years as regards its scope and coverage. As such the role of finance manager has also undergone fundamental changes over the years. In order to have a better exposition to these changes, it will be appropriate to study both the traditional concept and the modern concept of the finance function. Traditional Concept: In the beginning of the present century, which was the starting point for the scholarly writings on Corporation Finance, the function of finance was considered to be the task of providing funds needed by the enterprise on terms that are most favorable to the operations of the enterprise. The traditional scholars are of the view that the quantum and pattern of finance requirements and allocation of funds as among different assets, is the concern of non-financial executives. According to them, the finance manager has to undertake the following three functions: j) arrangement of funds from financial institutions; ii) arrangement of funds through financial instruments, Viz., shares, bonds, etc iii) looking after the legal and accounting relationship between a corporation and its sources of funds. The traditional concept found its first manifestation, though not systematically, in 1897 in the book Corporation Finance written by Thomas Greene. It was further impetus by Edward Meade in 1910 in his book, Corporation Finance. Later, in 1919, Arthur Dewing brought a classical book on finance entitled The Financial Policy of Corporation.

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The traditional concept evolved during 1920s continued to dominate academic thinking during the forties and through the early fifties. However, in the later fifties the traditional concept was criticized by many scholars including James C. Van Horne, Pearson Hunt, Charles W. Gerstenberg and Edmonds Earle Lincoln due to the following reasons: 1. The emphasis in the traditional concept is on raising of funds, This concept takes into account only the investors point of view and not the finance managers view point. 2. The traditional approach is circumscribed to the episodic financing function as it places overemphasis on topics like types of securities, promotion, incorporation, liquidation, merger, etc. 3. The traditional approach places great emphasis on the long-term problems and ignores the importance of the working capital management. 4. The concept confined financial management to issues involving procurement of funds. It did not emphasis on allocation of funds. 5. It blind eye towards the problems of financing non-corporate enterprises has yet been another criticism. In the absence of the coverage of these crucial aspects, the traditional concept implied a very narrow scope for financial management. The modern concept provides a solution to these shortcomings. Modern Concept: The traditional concept outlived its utility due to changed business situations since mid-1950s. Technological improvements, widened marketing operations, development of a strong corporate structure, keen and healthy business competition all made it imperative for the management to make optimum use of available financial resources for continued survival of the firm. The financial experts today are of the view that finance is an integral part of the overall management rather than mere mobilization of the funds. The finance manager, under this concept, has to see that the company maintains sufficient funds to carry out the plans. At the same time, he has also to ensure a wise application of funds in the productive purposes. Thus, the present day finance manager is required to consider all the financial activities of planning,

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organizing, raising, allocating and controlling of funds. In addition, the development of a number of decision making and control techniques, and the advent of computers, facilitated to implement a system of optimum allocation of the firms resources. These environmental changes enlarged the scope of finance function. The concept of managing a firm as a system emerged and external factors now no longer could be evaluated in isolation. Decision to arrange funds was to be seen in consonance with their efficient and effective use. This systems approach to the study of finance is being termed as Financial Management. The term Corporation Finance which was used in the traditional concept was replaced by the present term Financial Management. The modern approach view the term financial management in a broad sense and provides a conceptual and analytical framework for financial decision-making. According to it, the finance function covers both acquition of funds as well as their allocation. 2.4 OBJECTIVES OF FINANCIAL MANAGEMENT Financial management, as an academic discipline, is concerned with decision-making in regard to the size and composition of assets and structure of financing. To make wise decisions, a clear understanding of the objectives which are sought to be achieved is necessary. The objectives provides a framework for optimum financial decision making. Let us now review the well known and widely discussed approaches available in financial literature viz., (a) Profit Maximization and (b) Wealth Maximization. Profit Maximization: According to this approach, actions that increase profits should only be undertaken. Here, the term Profit can be used in two senses: (1) As owner oriented concept it refers to the amount and share of national income which is paid to the owners of business, i.e., those who supply equity capital; (2) A variants for the term is profitability. It is an operational concept and signifies economic efficiency. In other words, profitability refers to a situation where output exceeds input, i.e., the value created by the use of resources is more than the total of the input resources. Used in this sense, profitability maximization would imply that a firm should be guided in financial decision-making by one test select assets, projects and decisions which are

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profitable and reject those which are not. In the current financial literature, there is a general agreement that profit maximization is used in this sense. The profit maximization theory is based on the following important assumptions: (a) This theory is bases purely on the rationality of the individuals and the firms. (b) It promotes the use of resources to the best of their advantage of gain maximum out of them. (c) It leads to the economic selection of the resources. (d) It enhances the National Income of the country through efficient and increased production. However, the profit maximization objective has been criticized in recent past it is argued that profit maximization is a consequence of perfect competition and in the context of todays imperfect competition, it cannot be taken as a legitimate objective of the firm. It is also argued that profit maximization, as a business objective, developed in the early 19 th Century when the characteristic features of the business structure were self-financing, private property and single entrepreneurship. The only aim of the enterprises at that time was to enhance the individual wealth and personal power, which could easily be satisfied by the profit maximization objective. The formation of joint stock companies resulted in the divorce between management and ownership. The business firm today is financed by owners the holders of its equity capital and outsiders (creditors) and controlled and directed by professional managers. The other interested parties connected with the business firm are customers, employees, government and society. In this changed business structure, the owner-management of the 19th century has been replaced by professional manager who has to reconcile the conflicting objectives of all the parties connected with the business firm. In this new business environment, profit maximization is regarded as unrealistic, difficult, inappropriate and immoral. Apart from the aforesaid objections, the other important technical flaws of this criterion are: a. There is a lack of unanimity regarding the concept of profit. There are various terms such as gross profit, net profit, earnings, short-term profit and long-term profit. b. Profits while enhancing the national income, may not contribute to the welfare of the poor, because they may lead to concentration of income and wealth.

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c. The assumptions on which it is based are untenable. There exists no perfect competition in the market. Similarly, all countries do not favor the idea of free enterprises economy. There exists certain controls, which will limit the profit maximizing capacity of the undertakings. d. This theory is also criticized for ignoring the timing of returns and risk. It doesnt take the returns in terms of their present value. Ex. 1 Period 1 2 3 Project A Benefits in Birrs 5, 000 10, 000 5, 000 20, 000 Project B Benefits in Birrs _ 10, 000 10, 000 20, 000

Though A, B generating some profit A is preferred quality of benefits Ex. 2 Uncertainty about expected profits Profits in Birrs State of Economy Recession Normal Boom Again we prefer A than B e. More so, the term profit is viewed contempt. Every section of the society feels that they are fleeced by the enterprise. For example, consumers may feel that they are charged high prices. Hence, the profit maximization has lost its relevance in the present day circumstances. Many financial experts like Van Horne, Weston and Brigham, Pondey, Gitman, Kuchhal, Khan, and Prasanna Chandra are now advocating for the maximization of wealth as the objective of the firm. A 1, 000 1, 000 1, 000 3, 000 B 0 1, 000 2, 000 3, 000

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Wealth Maximization: This approach is also known as Value Maximization or Nor Present Wealth Maximization. Wealth maximization means maximizing the net present value (NPV) of a course of action. The NPV of a course of action is the difference between the gross present value (GPV) of the benefits of that action and the amount of investment required to achieve those benefits. The GPV of a course of action is found out by discounting or capitalizing its benefits at a rate which reflects their timing and uncertainty. A financial action which has a positive NPV creates wealth and therefore, is desirable. A financial action resulting in negative NPV should be rejected. Between a number or desirable mutually exclusive projects, the one with the highest NPV should be adopted. The wealth or NPV of the firm will be maximized if this criterion is followed in making financial decisions. According to Ezra Solomon, the Wealth Maximization Approach provides an unambiguous measure of what financial management should seek to maximize in making investment and financing decisions. Using Solomons symbols and methods, the NPV can be calculated as shown below: i) W = V - C Where W = Net Present Wealth V = Gross Present Wealth C = Investment required to acquire the asset. ii) V =
E K

Where E = Size of future benefits available to the suppliers of the input capital. K = The capitalization (discount) rate reflecting the quality (certainty/uncertainty) and timing of benefits attached to E. = G (M+I+I) Where G = Average future flow of Gross Annual Earnings expected from the course of action, before providing for maintenance charges, taxes and interest and other prior charges like preference dividend. M = Average annual re-investment required to maintain G at the protected level. I = Expected flow of annual payments on account of interest, preference dividends and other prior financial charges.

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T = Expected annual outflow on account of taxes. The operational objective of financial management is the maximization of W. Alternatively W can be expressed symbolically by a short-cut method: W= An A1 A2 + + ...... + C 1 2 (1 + k ) (1 + k ) (1 + k ) n

Where W = Net Present Wealth A1, A2, An = Stream of cash flows expected to occur from a course of action over a period of time. K = Appropriate discount rate to measure risk and timing. C = Initial outlay to acquire that asset or pursue the course of action. From the above, it is clear that the wealth maximization criterion is based on the concept of cash flows generated by the decision rather than accounting profit which is the basis of the measurement of benefits in the case of profit maximization criterion. In addition to this, wealth maximization criterion consider both the quantity and quality dimensions of benefits. The wealth maximization objective is consistent with the objective of maximizing the owners economic welfare. Maximizing the economic welfare of owners is equivalent of the companys shares. Therefore, the wealth maximization principle implies that the fundamental objective of a firm should be to maximize the market value of its shares. The objective of shareholders wealth maximization has a number of distinct advantages. It is conceptually possible to determine whether a particular financial decision is consistent with this objective or not. If a decision made by a firm has the effect of increasing the long-term market price of the firms stock then it is a good decision. If it appears that certain action will not achieve this result then the action should not be taken. The wealth maximization objective acceptable as an operationally feasible criterion to guide financial decisions only when it is consistent with the interests of all those groups such as shareholders, creditors, employees, management and the society. From the above discussion, it can be said that wealth maximization is the most appropriate and operationally feasible decision criterion for financial management decisions. But, wealth maximization cannot be achieved by overnight. It takes years of sustained hard work, combined

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with patience and perseverance. In the opinion of NJ. Yasaswy even as companies vigorously pursue to maximize their wealth in the long-run, in the short-run they have to focus on four important objectives, viz., Survival, Cash Flow, Break Even Point and Minimum Profits.

Check Your Progress 1


1. List the objectives of financial management. 2. Why profit maximization is criticized? 2.5 RELATIONSHIP WITH OTHER DISCIPLINES You have learned in the previous unit that financial management is an integral part of over all management. It is not an independent area. It draws heavily on related fields of study namely economics, accounting, marketing, production and quantitative methods. We shall see the relationship with other disciplines. Finance and Economics: You are aware that the economics has two branches one is macroeconomics and the other is microeconomics. Financial management has close relationship with each of these. Macro-economics: The macro-economics is the study of the economy as a whole. It causes the institutional structure of the banking system money and capital markets, financial intermediaries monetary, credit and fiscal policies and economic policies dealing with and controlling level of activity within an economy. The financial manager is expected to know how monetary policy affects cost and availability of funds, undertake fiscal policy its affect on economy, aware the financial institutions and their modes of operations to tap financial sources so on and so forth. Micro-economics: It deals with the individual firms and will permit the firms to achieve success. The theories of micro-economics like demand supply relation and pricing strategies, 21

measurement of utility, preference, risk and determination of value are highly useful to a finance manager to take decisions to maximize profits. Finance and Accounting: There is close relationship between accounting and finance. Accounting is sub function of finance. The data / information supplied by the accounting like income statement, balance sheet will serve as basis for decision making in financial management. But there are certain key differences between the two. I. Treatment of funds: The income statement prepared in accounting is based on the accrual principle. Accounting records the expenditure as and when it incurs ignoring the payments made, similarly, the revenue is recognized at the time of sale irrespective of the cash receipt. Whereas financial management is based on cash flows which are necessary to satisfy the obligations and acquire assets. II. Decision-making: Accounting collects data, prepares financial statements and presents to the top management. Financial managements will make decisions on the basis of data supplied by accounting. It relates to financial planning, controlling and decision making. Finance and marketing, production, quantitative methods. The finance manager has to consider the impact of product development and promotion plans made in marketing will have impact on the projected cash flows. The new production process may entail additional capital expenditure. The tools that are developed by the quantitative methods are helpful in analyzing complex financial problems.

1. Investment analysis Financial Decision management 2. Working capital Areas 3. Sources and costs of funds 4. Capital structure decisions 5. Dividends policy 6. Analysis of risk and return Support

Primary Disciplines 1. Accounting 2. Macro economics 3. Micro-economics 22

Support

Other Related Discipline 1. Marketing 2. Production 3. Quantitative Methods

Resulting by Shareholder wealth maximization Source: Financial Management Mykhan & PkJam 2.6 FUNCTIONS OF FINANCIAL MANAGEMENT

The finance functions are very important in the management of a business organization. Irrespective of any difference in structure, ownership and size, the financial organization of the enterprise ought to be capable of ensuring that the various finance functions planning and controlling are carried at the highest degree of efficiency. The profitability and stability of the business depends on the manner in which finance functions are performed and related with other business functions. The finance functions may be broadly divided into two categories. I. II. Executive finance functions and Non-executive/Routine finance functions

The routine functions are repetitive in nature and the focus of financial management will be on the executive functions. The finance function mainly deals with the following three decisions: 1. Investment Decision. 2. Financing Decision. 3. Dividend Decision. Each of these functions must be considered in relation to the objective of the firm. The optimal combination of these finance functions will maximize the value of the firm to its shareholders.

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Fig. 1.1 given below, clearly depicts how the decisions relating to three finance functions lead to the maximization of the market value of the firm.

Investment Decisions Retur n Market Value of the firm Risk

Financing Decisions

Dividend Decisions

1. Investment Decision The investment decision relates to the selection of assets in which funds will be invested by a firm. The assets which can be acquired fall into two broad groups: (i) long-term assets which will yield a return over a period of time in future, (ii) short-term or current assets defined as those assets which are convertible into cash usually within a year. Accordingly, the asset selection decision of a firm is of two types. The first of these involving fixed assets is popularly known as Capital Budgeting. The aspect of financial decision-making with reference to current assets or short-term assets is designated as Working Capital Management. Capital Budgeting: Capital budgeting refers to the decision making process by which a firm evaluates the purchase of major fixed assets, including buildings, machinery and equipment. It deals exclusively with major investment proposals which are essentially long-term projects. It is concerned with the allocation of firms scarce financial resources among the available market opportunities. It is a many-sided activity which includes a search for new and more profitable investment profitable investment proposals and the making of an economic analysis to determine the profit potential of each investment proposal. Capital Budgeting involves a long-term planning for making a financing proposed capital outlays. Most expenditures for long-lived assets affect a firms operations over a period of years. They are large and permanent commitments, which influence firms long-run flexibility 24

and earning power. It is a process by which available cash and credit resources are allocated among competitive long-term investment opportunities so as to promote the highest profitability of company over a period of time. It refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. Capital budgeting decision, thus, may be defined as the firms decision to invest its current funds most efficiently in long term activities in anticipation of an expected flow of future benefits over a series of years. Because of the uncertain future, capital budgeting decision involves risk. The investment proposals should, therefore, be evaluated in terms of both expected return and the risk associated with the return. Besides a decision to commit funds in new investment proposals, capital budgeting also involves the question of recommitting funds when an old asset becomes non-profitable. The other major aspect of capital budgeting theory relates to the selection of a standard or hurdle rate against which the expected return of new investment can be assessed. Working Capital Management: Working Capital Management is concerned with the management of the current assets. The finance manager should manage the current assets efficiently for safe-guarding the firm against the dangers of liquidity and insolvency. Involvement of funds in current assets reduces the profitability of the firm. But the finance manager should also equally look after the current financial needs of the firm to maintain optimum production. Thus, a conflict exists between profitability and liquidity while managing the current assets. As such the finance manager must try to achieve a proper trade-off between profitability and liquidity. Another aspect to which the finance manager of a company has to pay attention is maintenance of a sound working capital position. He often times confronted with excess and shortages of working capital. While an excessive working capital leads to un remunerative use of scarce funds; inadequate working capital interrupts the smooth flow of business activity and impairs profitability. History is replete with instances where paucity of working capital has posed to be the major contributing factor for business failures. Nothing can be more frustrating for the operating managers of an enterprise than being compelled to function in a continuing atmosphere of lack of availability of funds to meet their important and urgent operating needs.

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Not only the inadequacy of working capital poses a threat to the finance manager, but also its abundance. Availability of more than required amount of funds causes an unchecked accumulation of inventories. Further, there may be a tendency to grant more and more credit without properly looking into the credentials or the customers. Moreover, idle cash earns nothing and it is unwise to keep large quantities of cash with the firm. Thus, the need to have adequate working capital in a firm need not be overemphasized. 2. Financing Decision: In this function, the finance manager has to estimate carefully the total funds required by the enterprise, after taking into account both the fixed and working capital requirements. In this context, the financial manager is required to determine the best financing mix or capital structure of the firm. Then, he must decide when, where and how to acquire funds to meet the firms investment needs. The central issue before the finance manager is to determine the proportion of equity capital and debt capital. He must strive to obtain the best financing mix or optimum capital structure for his firm. The use of debt capital affects the return and risk of shareholders. The return on equity will increase, but also the risk. A proper balance will have to be struck between return and risk. When the shareholders return is maximized with minimum risk, the market value per share will be maximized and firms capital structure would be optimum. Once the financial manager is able to determine the best combination of debt and equity, he must raise the appropriate amount through best available sources. The following points are to be considered while determining the appropriate capital structure of a firm: 1. Factors which have bearing on the capital structure. 2. Relationship between earnings before interest and taxes (EBIT) and earnings per share (EPS). 3. Relationship between return on investment (ROI) and return on equity (ROE). 4. Debt capacity of the firm. 5. Capital structure policies in practice. 3. Dividend Decision:

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It is a fact that in spite of the various other factors which influence the market value of shares, dividend payment has been considered to be the foremost. In this context, the finance manager must decide whether the firm should distribute all profits or retain them, or distribute a portion and retain the balance. Sometimes, the profits of the company are fully diverted towards its capital expenditure or establishment of new projects so as to minimize further borrowings. While there may be some justification in diverting profits to some extent, the claims of shareholders for dividends cannot be completely overlooked. The finance manager has to develop such a dividend policy which divides the net earnings into dividends and retained earnings in an optimum way to achieve the objective of maximizing the market value of firm. He should also concentrate his attention on issues like the stability of dividend, bonus issue etc. 2.7 CONFLICT OF GOALS In a corporate form of organization share holders will appoint the directors and managing director to carry on the business on their be half. They represent the management. In a complex organization various parties are interested in the affairs of a business. The parties interested in the business are owners, creditors, customers, government etc. The management may not necessarily act in the interest of owners and may pursue its personal goals. In addition, they have to strike a balance between the interest of owners and other parties interest, who has stake in the business organization. There can, however, arise situations where a conflict may occur between the shareholders and the management goals. For example, management may play safe and create satisfactory wealth for shareholders than the maximum.

2.8 ORGANIZATION OF FINANCE DEPARTMENT

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A well-organized finance department is absolutely essential for the efficient financial management of an enterprise. If finance department does not operate well, the whole organizational activity will be ruined. Hence, it is essential that the finance department should be well organized with nucleus staff from the time of project stage, so that expert guidance and advise regarding the various proposals are available to the management in planning and managing the project. The finance function, although, is controlled by the top management, there will be a separate team to look after these activities and this function will be sub-divided according to the needs. A common structure of the finance department cannot be evolved as the size of the firm and nature of the business vary, from firm to firm. A self-explanatory organization structure of finance department in a large organization is given below. PRESIDENT

V.P PRODUCTION

V.P FINANCE

V.P HUMAN RESOURCE S

V.P MARKETING

Controller Functions 1. Accounting 2. Cost Accounting 3. Budgeting 4. Internal Audit 5. Collections creditors 6. Financial planning 7. Profit planning 8. Investment decisions 9. Assets management 10. Economic Appraisal Role of Finance Manager:

Treasurer Functions 1. Cash and Bank management 2. Investments 3. Tax matters 4. Insurance 5. Investor Relations.

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The finance manager, who is mainly responsible for managing the finances of a firm, plays a dynamic role in the development of a modern organization. For the effective conduct of finance function he is responsible for assisting the managers and supervisors in carrying out these activities and for ensuring that their line instructions confirm to the relevant specialist policy. The Finance Manager besides supervising the routine functioning of his department, also keeps the Board of Directors informed on all phases of business activity, including the economic, technological, social, cultural, political and legal environment effecting business behavior. The finance manager generally holds one of the senior-most positions in the company, directly reporting to the President. He is primarily responsible for the entire cost, finance, accounting and taxation departments in addition to the overall administration and secretarial departments. The functions and responsibilities of the finance manager of a company generally include the following: i) To determine the extent of financial resources needed, and the way these needs are to be met; ii) To formulate programs to provide most effective profit volume-cost relationship; iii) To analyze financial results of all operations, reporting the fact to the top management and make recommendations concerning future operations; iv) To carry out special studies with a view to reducing costs and improving efficiency and profitability; v) To examine feasibility studies and detailed project reports mainly from the point of view of overall economic viability of the project; vi) To be the principal coordinating officer for preparing and operating long-term, annual and capital budgets; vii) To lay down suitable purchase procedures to ensure adequate control over all purchases of raw material and equipments, etc., viii) To advise the chief executive on pricing, policies, interdepartmental issues including charging of overheads to jobs, etc; ix) To advise on all service matters to staff, such as scale of pay, dearness allowance, bonus, gratuity etc; x) To act as principal officer in charge of accounts, including cost and stores accounts and internal audit; 29

xi) To ensure that annual accounts are prepared in time according to the provisions of the company law, and to attend to external audit; xii) To be the custodian of the cash and the principal disbursing officer of the enterprise; xiii) To be responsible for attending to all tax matters; xiv) To ensure that market surveys are carried out by the management; xv) To furnish prospective costs of products, to enable the management to determine the optimum product max; and xvi) To prepare various period reports to be submitted to various authorities including financial institutions government. 2.9 SUMMARY The subject financial management has undergone many changes due to the continuous resealed in western countries. The traditional concept is concerned with the provision of funds only. The modern concept trials finance as an integral part of the overall management rather than mere mobilization of funds. The wealth maximization is considered superior than profit maximization. The finance functions include a) investment decisions b) financing decisions and c) dividend decisions

2.10 ANSWERS TO CHECK YOUR PROGRESS 1. The objectives of financial management are a) Profit maximization b) Wealth maximization 2. The profit maximization criticized due to: book profit or accounting profit are in usage there is lot of ambiguity among those. 2. It will not take into account the present value of earnings. 3. It will not consider the quality of benefits etc. 1. Profit notions like gross profit, net profit, operating profit, profit before tad or after tax

2.11 MODEL EXAMINATION QUESTIONS

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1. Why do you need financial management? 2. How do you define wealth maximization? 3. Narrate the importance of financial management. 4. List out the functions of controller. 5. Draw the organization chart of finance function for a typical organization 2.12 REFERENCES Kuchhal S.C. Pandey IM. Brigham EF Gitman L.J : : : : Financial management, Chaitnya Publishing House Allahabad. Financial management, Vikas Publishing House Pvt Ltd. New Delhi. Fundamentals of Financial Management Dryden Press, Chicago Principles of Managerial Finance Harper Row, New York. Financial Management Theory and Practice Tata McGraw Hill, New Delhi.

Prasanny Chandra:

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UNIT 3: CORPORATE PLANNING Contents 3.0. Aims and Objectives 3.1. Introduction 3.2. Significance of Financial Planning 3.3. Long-term Financial Planning 3.4. Short term Financial Planning 3.5. Nature of Financial Requirements 3.6. Summary 3.7. Answers to Check Your Progress 3.8. Model Examination Questions 3.9. References 3.0. AIMS AND OBJECTIVE The main purpose of this unit is to present the need, importance of financial planning. The importance of financial planning and the financial needs of a corporate unit are also presented. After studying this unit, you will be able to understand the importance of planning explain long-term and short-term planning list out the financial requirements. 3.1. INTRODUCTION A business without planning is like a ship without a rudder. It will drift aimlessly, without any sense of purpose or direction, moving from one crisis to another. The management of any company should decide as to where it wishes the company to go. It should have an understanding of an internal and external factors affecting the companys operations, anticipate how these factors will change in the future and assess how they will affect the companys growth and prospects. The successful manager spends considerable time in planning and devotes the rest of the time to ensure that other people put his plans into action.

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The term Capitalization has attracted different interpretations. It is generally stated to refer to the total capital employed in the business. But what are the components of this capital? One view is that it will include share capital, reserves and surplus and long-term borrowings. Only long-term funds get reckoned in this case. Another view, which has gained considerable acceptance, asserts that all sources of finance that are used to raise the required amount of capital for the enterprise should be recognized as part of capitalization process. This will include long term as well as short-term sources of funds. Accountants refer to capitalization in certain other contexts too. For instance, when by an accounting process of transferring reserves to share capital, bonus shares are used, they explain it as capitalization of reserves. What is the value at which the firm should be capitalized? One theory, known as the cost theory, emphasizes that this should be done on the basis of the costs of the different assets to be acquired fixed and current, as also the promotional and other initial expenses that have to be incurred. The criticism of the theory argues that this only reflects the original cost and the subsequent book values of the assets from time to time, but fails to recognize the assets real capability at any given time in terms of its obsolescence, poor utilization or deteriorated condition. The earnings theory of capitalization stipulates that the firm should be capitalized on the basis of its expected earning. Its real value should be assessed on the basis of its earning capacity. To arrive at the average annual net earnings. And if the average rate of return on invested capital for similar firms is say, 20 percent, the capitalization will be determined at 5 times the average annual net earnings. Capitalization can also be viewed as a concern for the composition of funds in the capital structure of a firm. Here the emphasis is on the types of funds that are to be raised and the proportion in which these are to be obtained. This will be our focus in this lesson. Capital structure in its widest interpretation will cover share capital, reserves and surplus, long term borrowings and short-term borrowings of different categories. But with reference to new enterprises, the capital structure is normally regarded as comprising of share capital, debentures and long-term borrowings from term lending institutions.

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At any given time, two aspects of capital structure require attention. i) ii) iii) What should be the pattern of capital structure require attention. What should be the pattern of capital structure? Where are the sources to be obtained? In what proportion should these different types of funds be brought into the total capital structure? 3.2. SIGNIFICNCE OF FINANCIAL PLANNING The success of a business enterprise depends upon the careful preparation of a prudent financial plan for the business. By estimating in detail the current and future requirements of funds for operations and capital expenditure purposes, the management gets the information and, there by the ability, to utilize the resources to the optimal level and avoid wastage. Financial plan also helps to determine the optimal capital structure of the firm. It is the finical manager to prepare the financial plan taking into account the company policy and the far casts of his production and marketing colleagues. It is his responsibility to coordinate the plans of each area. Once the financial forecasts are ready, the management has an opportunity to review the projected plans and modify them to match the resources of the firm. Thus the maximum utilization of available funds can be ensured. The advantages of financial planning are: 1. It points out to management what funds are needed, and when, and for what duration, if the specific plans and programmes of the company are to be implemented. 2. It highlights to management what resources are needed, and enables management to consider suitable alterations to plans before commitments are made. 3. It also serves as a basis for review and control whereby deviations from the expected performance can be promptly identified and necessary corrective actions can be taken without delay. 3.3. LONG-TERM FINANCIAL PLANNING In planning for the future, an important aspect is the profitability of the companys operations at present and in future. The company has to make sufficient profits on a conservancy basis to

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reward shareholders with a dividend; pay employees good wages and generate funds for capital investment necessary to maintain the companys growth. On the basis of, say a five year forecast of the companys sales volume, costs and profit, together with capital investment proposals, a master financial forecast, can be prepared to show how the company is going to generate the funds, and how these funds are to be used. The companys funds requirements for the next five years can be thus foreseen and if any deficit is shown by the forecast, necessary action can be taken to raise long- term loans or go for fresh share capital issues or approach the bankers for short-or medium term loans, as may be necessary. If the deficit for any future period is small, the management can even consider delaying or staggering some of the capital investments or reducing the levels of stocks or debtors, rather than borrowing additional funds from banks or other sources. Once these alternatives have been examined and decisions taken, the five-year financial plan of the company can be drawn up, as the formal statement of intention. Often, the assumptions on the basis of which these plans have been prepared will undergo changes and accordingly the forecasts and plans will have to be modified and revised. Through this long- term planning effort, updated from time to time, the management acquires the ability to react promptly and effectively to changing circumstances. 3.4. SHORT-TERM FINANCIAL PLANNING: CASH BUDGET

It is also very essential that the flow of cash within the year, and this process is called cash budgeting. There is usually heavy dependence on bank borrowing, in most cases, and the banker expects the cash forecasts to be prepared and forwarded to him showing the position of overdraft from month to month. Apart from this, there is also the need for management to know how the cash position will shift from time to time in response to their decisions so that they can plan the operations accordingly. For a company operating a good system of budgetary control, the preparation of a cash budget is a relatively smooth exercise. Once the sales, production, materials and other functional budgets are ready, the details of the relevant monthly cash receipts or disbursements will be available for preparation of the cash budget. Certain particulars such as intended borrowings and loan repayments, issue of shares or debentures or payment of dividends will have to be separately

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determined and included in the cash budget. Estimates of sales, collections, purchases, payments, outputs and related expenses will have to be made in detail, with reliable data being available for weekly or periods, covering all phases of operations. Cash sales will have to be estimated separately from credit sales. The cash collections which are expected to flow from credit sales will then have to be determined on a weekly or any other chosen interval, giving due consideration to customer rejections and returns, customer willingness to avail cash discounts and similar relevant factors. The payment habits of customers as observed from their past dealings have to be examined and properly built in to the estimated pattern of collections. Receipts from miscellaneous sources other than regular sales will have to be estimated. These may include interest on short-term investments, dividends, rentals and commission receivables, which normally can be estimated without difficulty. Cash payments for raw materials, suppliers and services involving cash purchases or payments to trade creditors, have to be carefully estimated as to amount and timing. Where the materials consumption requirements have been clearly worked out and the purchase and inventory budgets have been prepared with reference to the proposed production and sales plans, the estimation of cash payments against purchases and settlement of dues to suppliers is not likely to pose much difficulty. The company practice regarding availing cash discount facilities and payment of advances against suppliers will have to be anticipated to the extent possible, as these will influence the pattern of cash payments. Payments under various heads of operating expenses including wages, salaries, power and similar items will have to be estimated in detail for the required time intervals. Possible implications of wage negotiations and the likely enhancement of power rates or levies, interest and other service charges, have to be anticipated with as much clarity as possible. Fixed expenses such as executive salaries and property insurance can be easily and accurately estimated. 3.5 NATURE OF FINANCIAL REQUIREMENTS The success of any business enterprise depends on a large extent on the care with which the financial requirements have been determined and provided for an continuing basis.

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What are the main purposes for which the funds have to be provided in the case of a new enterprise? And what will be the nature of financial requirements for an existing enterprise? When a new business is set up, the promoter will have to plan for the funds for acquiring the necessary equipment and facilities, commonly known as fixed assets. He should also find the resources for meeting the promotional, legal and other preliminary expenses in connection with the setting up of the business. Once the enterprise starts production, adequate funds will have to be constantly found for purchasing and holding raw materials stocks, for meeting the costs of labour and supervision and other expenses and for supporting stocks of finished goods and credits of customers. Looking at the nature of financial requirements of an enterprise, two distinct types of needs can be identified. (a) Funds for long-term investment in fixed assets, and (b) Funds for on-going recurring investment in current assets. For a new enterprise, substantial funds for initial investment in fixed assets will have to be organized. Once it starts operations, the financial support for purchasing and processing of materials and for the distribution and sale of manufactured goods will have to be provided regularly and continuously. When an existing business plans to expand it will become necessary and the required long-term funds will have to be organized. As and when the existing equipment and facilities wear out or become obsolete, funds will also have to be found for acquiring and replacing such equipment and facilities. We may now have a closer look at the different items and activities of a business that requires long term and short-term financial resources. 1. Long Term Financial Requirements We observed that funds are required for long term investment in fixed assets, What are fixed assets? And why long term investment? Assets, in the form of facilities and equipment, which are used production for long periods of time are known as plant assets. assets.

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Land and Buildings When a new enterprise is planned, the promoter should ensure that land is acquired at an appropriate location, not only to house the factory to be constructed initially but also to meet growth and expansion requirements in future. Buildings for the production shops and services, for storage of materials, components and finished goods and for offices will have to be properly planned and constructed. The cost of land can generally be ascertained without difficulty, but the construction cost of buildings will have to be carefully determined, taking the advice of the architects. Development of sites for construction of the factory and administrative buildings and special requirements of foundation and strength for different types of manufacturing and other activities should all receive due consideration at the planning stage so that the required financial resources can be organized in advance. Lack of attention to these essential details often results in stoppages and delays in construction work for want of funds or other critical materials. Plant and Machinery In relation to the products to be manufactured and the processes selected, the required plant and machinery will have to be chosen by the technical people, Wrong selection of machinery can prove to be very costly as the funds thus spent would have already been committed for a long time, but the expected output of products may fail to come and the income will also be affected adversely. Once the proper choice of machines has been made, their prices can be ascertained from the manufacturers and the required funds provided. Furniture, Fixtures, Vehicles etc., Furniture, fixtures, office equipment and vehicles are other types of long term assets essential for the proper functioning of the enterprise, and call for long term investment of funds. Intangible Assets Intangible assets refer to certain expenses incurred at the time of setting up of the business. For instance, promotion expenses include all expenses incurred from the time the business idea originated till the investigations about its commercial feasibility are carried out and action is initiated to assemble the required men, materials and money. Then there are organization expenses incurred at the time of incorporation of the enterprise, such as lawyer's fees, filing fees and incorporation fees. In connection with the raising of financial resources by issuing shares or 38

debentures, commission will have to be paid to the underwriters and brokers. These categories of expenses come to be termed assets for the reason that they are not operating and regular expenses like salaries, wages, rent etc., and are in the nature of initial heavy expenditure, as in the case of fixed assets. But these expenses do not create tangible assets like buildings, machines, furniture or vehicles and are there fore referred to as intangible assets, The initial financial requirements for these preparatory steps in establishing business will have to be properly estimated and the funds arranged, from long and medium term sources. 2. Short Term Financial Requirements Having decided on the funds needed for long term investment in fixed assets, the enterprise management's attention should turn to identify the requirements of funds for the smooth functioning of the regular manufacturing and related operations. The amount of money that company must have to finance its day to day operations is generally referred to as working capital. Another name for it is circulating capital. The important point to note is that these amounts are employed in short term operations. What is the nature of the requirements of day to day operations? We noted earlier that funds are required for investment in current assets. What are current assets? Current assets are items would get converted into cash in the short run, say, within a year, or within the normal operating cycle of the business. These includes stocks of raw materials and stores, work-in progress, stocks of semi- processed components, finished goods stocks, book debts and cash and bank balances. Let us have some appreciation of these components of current assets. Raw material is in most cases the major element of production cost. It is also in many instances the dominant part of current assets. It is not possible to purchase materials on a day to day basis to meet the daily requirements for production. We have necessarily to buy and stock raw materials and issue them for production as and when required. When prices are rising or when price concessions can be obtained for large volume of purchases, it might be found desirable to buy in bulk and stock. The cost savings on purchases will more than compensate the additional costs for carrying inventory some critical items of materials may take a long time to procure and to ensure that there is no hold up in production due to their non-availability, adequate stocks of 39

these items will have to be kept. Sudden changes in production programmes result in some materials being rendered surplus while the required materials are not readily available. The proper sources for purchases have not been established and the quality standards have not been clearly set, poor quality purchases of materials will lead to defective production adding to costs and affecting profits adversely. In taking note of all these aspects and taking necessary advance action, the aim is to reduce the locking up of funds in excessive or defective stocks. The factors that influence the levels of raw materials inventories are the expected production volumes, seasonal aspects of production, dependability of the sources of supply and the degree of efficiency of materials planning, and purchases. A planned effort at supporting a given production programme with the right quantity of materials, of required quality, made available at the right time, ensuring at the same time that the funds tied up in stocks are minimum and for short duration, can be said to be the essence of effective materials inventory management. If materials planning is weak and wrong purchases are made, there will be accumulation of redundant, non- moving and slow moving stocks blocking funds for long periods. Such inventories cannot be termed current assets and represent wasteful and expensive long-term investment of funds. Work- in- progress The stock of semi- manufactured items or work- in progress will depend on the nature of manufacturing operations, the number of operations and the time taken to perform the required number of operations. The technical people will constantly try to speed up operations by method changes, improved designs and other methods and thereby reduce the blocking of funds in work- in process inventories. If production flow is well organized, the financial requirements will be much less and for shorter duration. Finished Goods Inventories Why should finished stocks be maintained? We know that it is not possible to match production to day to day demand, particularly where the products have a seasonal demand, or even though the demand exists throughout they year, the raw materials are available only during a certain part of the year. Sometimes it is advantageous to produce in bulk to gain the economies of large scale production and, in this case, the products will have to be stocked and sold. If the customers' demands are to be promptly met, we should be in a position to hold adequate stocks

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at the various outlets so that they can be delivered from the shelf. This requires planned effort to hold adequate but not excessive stocks at the various selling points. Moreover, these inventories are to be held only for short periods so that there is no undue and prolonged locking up of funds. Without delay, the stocks should be converted into sales and money realized to support the company's operation. If due to faulty planning or wrong assessment of demand, excessive stocks pile up and remain unsold for long spells of time, wasteful investment in non-moving stocks will be the outcome, and to this extent there will be the need to find additional external funds for financing the ongoing activities of the business. This will not only mean additional costs and reduced profits, but will also upset the financial arrangements and health of the company adversely. The aim of effective management of the finished goods inventory should be to keep adequate stocks of the products at the required outlets to meet the market needs promptly, and yet avoid build-up imbalances such as excess stocks in certain outlasts and stock- outs in other areas. Book Debts Goods and services are often sold against promise of future payment, The extent and the quantum of credit will depend on a variety of factors such as the related commercial practice, the credit rating of the parties to whom the facility is being extended and the increase in sales that is expected to be achieved by providing attractive credit facilities. It must be noted that granting credit has the effect of diverting financial resources since there will be delays in realizing monies due on sales and the funds required for operations will have to be obtained from banks or other sources at considerable expense. It is, there fore, necessary to ensure that the right amount of credit is provided for the right duration. While too little credit might affect sales, too much of it can lead to serious financial problems as a result of long delays in collection of monies due and on account of bad or unrecovered debts. Well-administered credit can serve as an effective tool for sales promotion. It can win and keep new customers. But once credit is extended, the follow- up and collection of book debts should also be effective so that monies are promptly collected. If due attention is not given to this aspect, funds will get blocked upon in outstanding debts, and avoidable financial problems will have to be faced and tackled.

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Cash and Bank Balance The need for business to hold cash arises from the necessity to meet current cash obligations in the ordinary course of business. The operating needs have to be promptly met and any delay will effect production and profitability. The business can be viewed as a series of cash inflows and outflows. The cash inflows come from the collections from sales and the debtors, and the cash outflows relate to payments for purchases, payment of wages and other operating expenses. These inflows and outflows rarely match or synchronies and it is to be expected that there will be days when there will be surplus cash balance remaining unused while on other days there may be cash shortages causing much embarrassment. By preparing a cash budget, taking care to note the expected receipts and payments on a day to day, week to week and month to month basis, the requirements of funds to cover the excess of payments over receipts at different dates or periods can be determined and necessary resources can be mobilized in time. Some cash reserve should also be kept to meet the unexpected needs. In the absence of proper resource planning, payment of taxes and dividends may pose serious problems. The aim of effective cash management is to ensure smooth functioning of day to day business, by careful direction of the flow of cash into and out of the business, so that the operating and contractual payments are promptly made. In the absence of cash planning, steep cash surpluses and cash deficits may occur in unexpected manner, causing serious problems for organizing the necessary finances. We saw that current assets are short term assets. They are also referred to as working capital or circulating capital which emphasizes the circular flow nature of funds invested in current assets. Raw materials that have been purchased stay for a while as inventories and then move into the production streams. Labour and other manufacturing expenses enter the production process. The raw materials pass through the interim stage of work- in process to finished goods. Finished goods pass through the phase of book debts, until the collection of outstanding results in the reappearance of cash at the completion of the cycle. This cyclical process involving cash to cash journey repeats itself again and again. But it will be wrong to presume that the flow is steady and smooth all the time. Left to themselves, the flows are capable of violent fluctuations and unless they are carefully watched and regulated, they can cause serious financial problems and even lead to business failure. Effective management will involve pre-determination of the

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minimum funds required, study of the pattern of receipts and payments, and advance planning of short term borrowings and investments. 3. A Mix of Long Term and Short Term Funds Long term financial arrangements have to be made for financing the fixed assets. Are current assets to be financed entirely by short-term funds? Not necessarily. Every firm will have to maintain minimum level of current assets, in terms of minimum levels of raw materials stocks, minimum work- in - progress, minimum finished goods stocks, and minimum level of book debts, throughout the year. This part of current assets can be regarded as permanent working capital and long term financial arrangements will gave to be made for supporting this segment of current assets. It should be understood that unlike fixed assets, the permanent working capital constantly changes its form from one component of current assets to another and its size will be influenced by the pattern of growth of the enterprise. The fluctuating requirements of the working capital are short term in nature and will have to be found from short-term sources. The management will have to decide on a right mix of long term and short term sources of funds to finance current assets, besides organizing long term funds for the entire investment needs of the fixed assets. Check Your Progress-1 1. List out long-term financial assets required. 2. List at short term financial assets.

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3.6. SUMMARY Financial plan is essential to estimate the funds required for fixed assets as well as current

assets. Financial requirements are two kinds viz. Long term and short term. The firm needs funds to acquire fixed assets such as land and buildings, plant, machinery, furniture etc. Short term funds are required in the form of raw materials debts, cash and bank balances. 3.7. ANSWERS TO CHECK YOUR PROGRESS I. Land Buildings Plant, machinery, equipment Furniture etc. II. Raw material Work-in- process Finished goods Book debts Cash balance 3.8. MODEL EXAMINATION QUESTIONS 1. What is financial planning? 2. Explain the significance of financial planning 3. What do you mean by long term needs? 4. Explain finished goods inventory 5. What is meant by mix of long and short term funds? 3.9. REFERENCES Kuchhal, S.C Pandeg, I.M : : Corporate Finance Financial Management Financial management policy work-in-process, finished goods, book

Van Horne, James, C :

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UNIT 4: TIME VALUE OF MONEY Contents 4.0 Aims and Objectives 4.1 Introduction 4.2 Time Value of Money 4.3 Techniques of Present Value Vs Future Value 4.4 Problems and Solutions 4.5 Summary 4.6 Answers to Check Your Progress 4.7 Model Examination Questions 4.8 Reference 4.0 AIMS AND OBJECTIVES This unit will discuss the meaning of time value of money, its importance in our day-to-day life. After reading this unit, you will be able to: explain the meaning of time value of money understand future value and present value calculate the future and present values 4.1 INTRODUCTION This unit aims at providing basic concepts on the time value of money. This is very important for taking any financial decision. In a business we are investing huge amounts of money today in anticipation of uncertain future returns or revenues. You have already learned that capital is not only scarce but also has cost. Cost in simple terms is nothing but the interest. Suppose you would like to borrow Birr 1, 000 today and return the same after a month without any interest. Do you think some one is going to lend you Birr 1, 000? Definitely no. If you are prepared to pay interest of 3% for a month on the borrowed money, people will come forward to lend you money. The reason is simple money is not available freely and it is capable of earning interest

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i.e., Birr 30. It is evident that todays Birr 1, 000 is equivalent to Birr 1, 030 after a month. Here Birr 30 is called cost of capital in financial management. 4.2 TIME VALUE OF MONEY By experience, we all know that the value of a sum of money received today is more than its value received after some time this is called time value of money. Conversely, the sum of money received in future is less valuable than it is today. The present worth of birr received after some time will be less than a birr received today. Since, a birr received today has more value, individuals, as a rational human beings would naturally prefer current receipt to future receipts. The time value of money is also known as time preference for money. The time preference for money in business unit normally expressed in terms of rate of return or more popularly as a discount rate. In a business revenues are spread over a period of time i.e., the life of the project. It is nothing but we are trying to calculate the present value versus future value. 4.3 TECHNIQUES OF PRESENT VALUE VS FUTURE VALUE Compound value: where a sum of money deposited one time and earns interest for a specified period. The interest is paid on principal as well as on an interest earned but not withdrawn during earlier period is called compound interest. FV = PV + (interest X principal) For example you deposit Birr 100 @10% interest After one year = 100 + (100 x .10) = 110 After two years = 110 + (110 x .10) = 121 After three years = 121 + (121 x .10) = 133.10

FV1 = P(1+i) 46

FV2 = P(1+i)2 FV2 = FV1 + F1i P(1+i)2 FV3 = P(1+i)3 FV2 = F1(1+i)P FV2 = P Fn = P(1+i)n Here the term (1+i)n is the compounded value factor (CVF) of a lump sum of birr 1. The values may be directly traced from the present value tables. You have already learned the calculation of present value factors in financial accounting II. Hence, you can directly apply the present value factors and find out the values. The same may be written as below: FV = P(CVFn . i) FV = Future value P = Present value CVFn = Compounded value factor year i = rate of interest Suppose you deposit Br. 55, 650 in a bank which will pay you 12 percent interest for a period of 10 years. How much would the deposit grow at the end of ten year? FV = P(CVFn . i) FV = 55, 650 (CVF10 . 12) FV = 55, 650 (3 . 106) = 172, 849.90 Compound value of Annuity: An annuity is a fixed payment (or receipt) each year for a specified number of years. Assume that a sum of birr 1 is deposited at the end of each year for four years at 6% interest. This implies that 1(1+.06)3 1.191 1(1+.06)2 1.124 1(1+.06)1 1.06 1 4375 Birr 1 deposited at the end of year 1 grow for 3 years. Birr 1 deposited at the end of year 2 grow for 2 years. Birr 1 deposited at the end of year 3 grow for 1 year. Birr 1 deposited at the end of year 4 grow for no interest.

FV4 = A(1+i)3 + A(1+i)2 + A(1+i) + A 47

FV4 = A[(1+i)3 + (1+i)2 + (1+i)+1 (1 + i ) n 1 FVn = A i The same may be written as below FV = A(CVAFn i) FV = Future value A = Annuity CVAFn = Compounded Value Annuity Factor to yare 1 = rate of interest Assume that you deposit a sum of birr 5, 000 at the end of each year for four years at 6% interest. How much would this annuity accumulate at the end of fourth year. FV = A(CVAFn i) = 5, 000 (CVAF4 .06) = 5, 000 (4.375) = 21, 875 Sinking Fund: This is going to be in reverse to the compounded value annuity factor. Here we proceed that to create certain sum of money, how much we have to set aside every year for a specified period. FV = A(CVAFn.i) 1 A = FV CVAFn.i A = FV (SFFn i) i 1 A=F n (1 + i ) For instant to clear off a loan of birr 21, 875 after four years, how much we have to set aside? FV = A(CVAFn .1) 1 A = FV CVAFn.i 1 = 21, 875 FV 4.375 SFF = Sinking Fund Factor

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= 21, 875 x .2286 = 5, 000 Present Value: here, we calculate the present value of future earnings at a particular rate of interest. This may be further classified into two I) Present value of a lump sum. The present sum of money to be invested today in order to get birr 1 at the end of year 1, 2, 3 so on and so forth at the rate of 10% interest. We know F1 = P(1+i) at the end of year 1. 1 = P (1+10) P= 1 (1 + i )

1 (1 + .10) 1 = 1.10 = = 0.909 F2 = P(1+i)2 1 = P(1+.10)2 P= = 1 (1 + 10) 2 1 1.21

= 0.826 F3 = P(1+i)3 1 = P(1+.10)3 P= = 1 (1 + 10) 3 1 1.331

= 0.751 Fn = P(1+I)n

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P=

Fn (1 + i ) n

Fn = n (1 + i ) = Fn [(1+i)n] You wanted to know the present value of birr 50, 000 to be received after 15 years at the rate of interest 9% PV = FV (PVFn i) = 50, 000 (PVF15 .09) = 50, 000 (.275) present value table = 13, 750 Present value of Annuity: An investor some times may receive constant amount for a certain number of years. We may have to calculate the present value of such annuity to be received each year for a specific period. P= A A A An + + + 2 3 (1 + i ) (1 + i ) (1 + i ) (1 + i ) n

1 1 1 1n = A + + + 2 3 (1 + i )n (1 + i ) (1 + i ) (1 + i ) 1 1 (1 + i ) n P = A i (1 + i ) n 1 P = A n i (1 + i ) A company receives an annuity of birr 5, 000 for four year at the interest of 10 percent. Then the present value would be 1 1 (1 + i ) n P = A i

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1 1 (1.10) 4 P = 5, 000 .10 = 5, 000 x 3.170 = 15, 850 PV = A(PVAFn .i)

Simply, you can refer to the PV tables for PV factor.

= 5, 000(3.170) from PV table or using the above formulae = 15, 850 Capital Recovery: The reciprocal of the present value annuity factor is called capital recovery factor (CRF). It will give the annuity to repay certain amount of borrowed loan at a particular interest for a specified period. PV = A(PVAFn .1) 1 A = PV PVAFn.i A = PV (CRFn .i) i (1 + i ) n A = P n (1 + i ) 1 A company borrows Birr 1, 000, 000 at an interest rate of 15 percent and the loan is to be repaid in 5 equal installments payable at the end of each of the next 5 years. Prepare loan amortization table and the annual installment. PV = A (PVAFn .i) 1, 000, 000 = A (PVAF5 .15) 1, 000, 000 = A (3.3522) 1,000,000 =A 3.3522 298,311 = A CRF = Capital Recovery Factor

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Loan Amortization Table


Year Ope. Bala. Biirrs 1 2 3 4 5 1, 000, 000 851, 688 68, 129 484, 986 259, 422 Annu. Install. Birrs 298, 312 298, 312 298, 312 298, 312 298, 312 Interest Birrs 150, 000 127, 753 102, 169 72, 748 38, 913 Principal Birrs 148, 312 170, 559 196, 143 225, 564 259, 399 Closi. Balance Birrs 851, 688 681, 129 484, 986 259, 422 23

Birr 23 left because annuity is taken as 298, 312 instead of 298, 311. Multi period Compounding: Till now, we have seen the cash flows will occur once in a year. But, the cash flows may occur monthly, bi-monthly, quarterly, half yearly and yearly. In such instances we have to apply the following formulae. 1 Fn = P 1 + m
nm

You have deposited a birr of 1, 000 in Commercial Bank of Ethiopia at 12 percent interest per annum. It compound annually, semi-annually, quarterly and monthly for two years. How much does it grow? 1) Annual compounding n=2 FV = P(CVFn .i) = 1, 000 (CVF2 .12) = 1, 000 (1.254) = 1, 254
2)

i = .12%

Half-yearly

n=2x2=4

i=

12 = 6% 2

FV = 1, 000 (CVF4 .06) = 1, 000(1.262) = 1, 262

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3)

Quarters

n=4x2=8

i=

12 = 3% 4

FV = 1, 000 (CVF12 .03) = 1, 000 (1.267) = 1, 267


4)

Monthly

n = 12 x 2 = 24,

i=

12 = 1% 12

FV = 1, 000 (CVF24. .01) = 1, 000 (1.270) = 1, 270

Check Your Progress 1


1. If you invest Birr 5, 000 today at a compound interest of 9 percent, what will be its future value after 15 years? 2. You want to take a world tour which costs Birr 1, 000, 000, the cost is expected to remain unchanged in normal terms. Your can save Birr 80, 000 annually to fulfill your desire. How long will you have to wait of your savings earn a return of 14 percent annum? 4.4 PROBLEMS AND SOLUTIONS

Future Value
Compound value of Lump sum Future Value = Present value + (Rate of interest) (Present value)

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1. You deposit Br. 100 in a bank at 10% interest what would be amount after 3 years. FV = PV + (PV) (Rate of interest) = 100 + 100 (.10) = 100 + 10 = 110 = 110 + (110) (.10) = 110 + 11 = 121 = 121 + (121) (.10) = 121 + 12.10 = 133.10 Suppose Br. 1,000 are placed in SBA/C of a Bank at 5% interest what will be the future value after 5 years. Compound value factor Table A FV = PV (CVF5 .5) = 1,000 (1.266) = 1,276 2. If you deposit Br. 55,650 in a Bank at 12% interest for a period of ten years what will be the future value? FV = 55,650 (CVF10 .12) = 55,650 (3.106) = 172, 848.90 Compound Value of Annuity Suppose Br. 1,000 is invested in annuity for four years at the rate of 6% 0 1 2 3 4 1,000 1,060 1,124 Future sum = 1,191 4,375 54

F4 = A (1+I)3 + A(1+I)2 + A(1+I)+A F4 = A(1+I)3 + (1+I)2 + (1+I) (1 + I ) n 1 Fn = A I Fv = A (CVAFn I) (Compound value factor for annuity factor) 3. You deposit a sum of Br. 5,000 at the end of each year for four years at 6%. How much would this annuity accumulate at the end of the fourth year? FV = A (CVAF4, .06) = 5,000(4.375) = 21,875 4. Your father has promised to give you 100,000k, in cash on your 25 th birthday. Today is your 16th birthday. He wants to know two things a) He decides to make annual payments into a fund after one year, how much will each have to be if the fund pays 8%. b) If he decides to invest a lump sum in the account after one year and let it compound annually. How much will the lump sum? A) FV = A (CVAFn .I) 100, 000 = A(12.488) 100,000 =A 12,488 8,007.69 = A B) FV = PV (CVFn .2) 100,000 = PV (CVF9. .08) 100,000 = PV (1.999) 100,000 = PV 1.999 50,025 = P 5. CBE pays 12% interest and compounds quarterly. If Br. 1,000 are deposited initially, how much shall it grow at the end of 5 years? 55

The quarterly interest will be 3%, number period will be 20 FV = PV (1+ .12 nxm ) 4

= 1,000 (1.03)20 = 1,000 x 1.806 = 1,806 6. How long will it take to double your money if it grows at 12% annually? FV = PV (CVFn. .12) Br. 2 = Br. 1 (CVFn .12) From Table Br. 2 = CVFn .12) = 1.974 Therefore n = 6 7. Mohan bought a share 15 years age for Br. 10. It is now selling Br. 27.60. What is the compound growth rate the price of share FV = PV (CVFn .r) 27.60 = 10 (CVF15 .r) 27.60 = CVF15 .r) 10 From Table 2.760 = 7% 8. X is borrowing Br. 50, 000 to buy a house. If he pays equal installments 25 years and 4% interest on outstanding balances, what is the amount of installment? FV = A(CVAFn .r) 50,000 = A (CVAF25 .04) 50,000 = A(15.622) 50,000 =A 15,622 3,200.61 = A If it is quarterly payment FV = A(CVAF100. .01) 50,000 = A (63.029) 50,000 =A 63.029 793.28 = A

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9. A company issued 5,000,000 bonds to be repaid after 7 years. How much should it invest in sinking fund earning 12%, in order to repay bonds. FV = A (CFAn .r) 5,000,000 = A (CFA7 .12) 5,000,000 = A (10.089) 5,000,000 =A 10.089 495,589 = A 10. X will receive first payment of pension at the end of 10th year form now a Br. of 3,000 a year. The payment will continue for 16 years. How much is the pension worth now, If Xs interest rate is 10%? Table A-4 25 years 9.077 9 5.759 16 years 3.318 FV = A (CFAn .r) = 3,000 (3.318) = 9.954 11. A company has to retire Br. 500, 000 debentures of 8% interest 10 years from today. The company plans to put a fixed amount into a sinking fund each year for 10 years. A separate fund is created for the purpose. The first payment will be paid at the end of the current year. The company anticipates that the fund will earn 6% a year. What should be the installments to accumulate 500,000 from now? Table A-2 FV = A (CAF10. .06) 500,000 = A(CAF10. .06 i.e. 13.181) 500,000 =A 13,181 37,933.388 = A

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12. A limited company borrows form commercial bank Br. 1,000,000 at 12% interest to be paid in equal annual installments. What would be the size of the installment be? Assume the repayment period is 5 years. FV = A (CAF5 .12) 1,000,000 = A (3.605) 1,000,000 =A 3.605 277,392.51 = A 13. A sum of Br. 50,000 deposited in a fund which will earn 12% compound semiannually for the first 5 years and 8% interest compounded quarterly for the next 7 years. How much will be amount after 12 years. First 5 years n = 5 x 2 = 10 Interest 12 = 6% 2 8 = 2% 4

Second 7 years n = 7 x 4 = 28 interest FV = 50, 000 (CVF10. .06) = 50,000 (1.791) = 89,542 FV = 89,542 (CVF14. .02) = 89,542 (1.741) = 155,895

If A wanted to deposit cash in a saving account at the beginning of year 1, so that he will have Br. 45,000 at the end of 9 years. What is the money to be deposited by A at the beginning of the year 1, if the interest rate for the first five years is 10% compounded semi-annually and the interest rate for the last four years is 12% compounded quarterly? Last 4% FV = PV = (CVFn .I) 12 = 3% 4

45,000 = PV (CVFn 16 .3) 45,000 = PV (1.605) 45,000 = PV 1.605 28,037 = PV 58

First 5 year n = 10 FV = PV (CVFn.1) = PV (CVF10 .05) 28,037 = PV (1.629) 28,037 = PV 1.629 17,211 = PV 4.5 SUMMARY In our day-to-day life we prefer possession of a given amount of cash now, rather than the same amount at future time. This is time value of money or time preference for money, which arises because of (a) uncertainty of cash flows (b) subjective preference for consumption and (a) availability of investments. The last justification is the most sensible justification for the time value of money. Interest rate or time preference rate gives money its value and facilitates the comparison of cash flows accounting at different time periods. Two alternative procedures can be used to find the value of cash flows: compounding and discounting. In compounding, future values of cash flows at a given interest rate at the end of a given period of time are found. The future value (F) of a lump sum today (p) for n period at i rate of interest is given by the following formula: Fn = P(1+i)n = P(CVFn .i) The Compound Value Factor (CVFn i) can be found out form the tables. The future value for annuity for n periods at i interest may be calculated by the following formula. (1 + i ) n 1 Fn = P i = P (CVAFn .i) Compounded Value Annuity Factors (CVAFn .i) is also found from the tables interest = 10 = 5% 2

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4.6 ANSWERS TO CHECK YOUR PROGRESS 1. Since the table value for 75 years is not available we can take FV = P(CVFn i) = P (CVF30 .0.a) (CVF30 .0.a) (CVF15 . 09) = 5, 000(13.268) (13.268) (3.642) = 3, 205, 685.1 2. FV = A (CVAFn .i) 1, 000, 000 = 80, 000 (CVAFn . 14) 1,000,000 = CVAFn .14 80,000 12.5 Look into the table for equal or nearest value you will find between 7 and 8 years = 7.72 or 1, 000, 000 = 80, 000 (CVAFn .14) 1.14 n 1 = 80, 000 .14 1,000,000 x 0.14 = 1.14n 1 80,000 1.75 + 1 = 2.75 = 1.14n log 2.75 = n log 1.14 0.4393 = n x .0569 .4393 =n .569 7.72 = years 4.7 MODEL EXAMINATION QUESTIONS 1. What is meant by time value of money? 2. Explain the significance of present and future values in a business organization.

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4.8 REFERENCES Kuchhal S.C. Pandey IM. Brigham EF Gitman L.J : : : : Financial management, Chaitanya Publishing House Allahabad. Financial management, Vikas Publishing House Put Ltd. New Delhi. Fundamentals of Financial Management Dryden Press, Chicago Principles of Managerial Finance Harper Row, New York. Financial Management Theory and Practice Tata McGraw Hill, New Delhi.

Prasanny Chandra:

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UNIT 5: INVESTMENT DECISIONS Contents 5.0 Aims and Objectives 5.1 Introduction 5.2 Importance of Investment Decisions 5.3 Types of Investment Proposals 5.4 Data Required for Investment Decisions 5.5 Project Appraisal Methods 5.6 Problem and Solutions 5.7 Summary 5.8 Answers to Check Your Progress 5.9 Model Examination Questions 5.10 References

5.0 AIMS AND OBJECTIVES This unit aims at presenting the meaning, importance, need, types and various methods of project appraisals. After finishing this unit, you will be able to: understand the meaning of long-term investment explain the need of capital decision list out the methods of capital budgeting identify the major required steps to appraise a project. 5.1 INTRODUCTION You have learned in unit 2, that one of the important functions of financial management is investment decisions. The success of a business unit depends upon the investment of resource in such a way that bring in benefits or best possible returns from any investment. The investment in general means an expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying a net cash inflows or its equivalent in some future time period or periods. 62

The investment in any project will bring in desired profits or benefits in future. If the financial resources were in abundance, it would be possible to accept several investment proposals which satisfy the norms of approval or acceptability. Since, we are sure that resources are limited, a choice has to be made among the various investment proposals by evaluating their comparative merit. This would help us to select the relatively superior proposals keeping in view the limited available resources. For this purpose, we have to develop some evaluating techniques for the appraisal of investment proposals. 5.2 IMPORTANCE OF INVESTMENT DECISIONS The terms in financial management like investment decisions, investment projects, and investment proposals are generally associated with application of long-term resources. What is long-term? There is no hard and fast rule to define it, but by common practice and accordance with the financing policies, practices and regulations of the financial institutions and banks a period of ten years and above may be treated as long period. The decisions related to long-term investment is also known as capital budgeting techniques. It is important because of the following reasons: 1) The investment decisions are the vehicles of a company to reach the desired destiny of the company. An appropriate decision would yield spectacular results whereas a wrong decision may upset the whole financial plan and endanger the very survival of the firm. Even firm may be forced into bankruptcy. 2) Capital budgeting techniques involve huge amounts of funds and imply permanent commitment. Once you invest in the form of fixed assets it is not easy to reverse the decision unless you incur heavy loss. 3) 4) A capital expenditure decision has its effect over a long period of time span and Investment decision are among the firms most difficult decisions. They are the inevitably affects the companys future cost. predictors of future events which are difficult to predict. It is a complex problem investment. The cash flow uncertainty is caused by economic, political, social and technological forces.

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5.3 TYPES OF INVESTMENT PROPOSALS The long-term funds are required for the following purposes: Expansion: A company adds capacity to its existing product lines to expand existing operations. For example, a manufacturing unit producing one hundred thousand units per year. If it intends to double the output by two hundred thousands, this will obviously increase the need for funds for acquiring fixed and current assets. Diversification: Some times the management of a company may decide to add new product line to the existing product lines. Philips, a famous company for radio and electric bulbs etc. diversified into production of other electrical appliances and television sets. Replacements: Machines used in production may either wear out or may be rendered obsolete on account of new technology. The productive capacity of the enterprise and its competitive ability may be adversely affected. Extra funds are required for modernization or renovation of the entire plant. The investment obviously is going to be long terms. Research and Development: There has been an increased realization that the efficiency of production and the total operations can be improved by application of new and more sophisticated techniques of production and management. To acquire the technology huge funds are needed. The useful way of classifying investments is as under 1. Accept - Reject Decisions 2. Mutually Exclusive Decisions 3. Capital Rationing III. Accept-Reject Decisions

Under this, if a project is accepted, the firm is going to invest, otherwise it is not going to invest its funds. In general, the project proposals that yield a rate of return greater than the certain required rate of return or cost of capital are accepted and others are rejected. By applying this

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criteria more than one independent projects are accepted subject to availability of funds. Various appraisal techniques are used to evaluate each project.

Mutually Exclusive Decisions


These are the projects which compete with each other in such a way that the acceptance of one will exclude the acceptance of the other one. The alternatives are mutually exclusive one may be chosen. IV. Capital Rationing

We are aware that the financial resources are limited. But, a large number of investment proposals compete for those limited funds. The firm, therefore ration them. The firm allocates funds to projects in a manner that it maximizes long-run returns. Thus, capital rationing refers to the situation in which 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 out of making investment proposals acceptable under the accept-reject decision. The projects are ranked as per their merits of acceptance basing on certain predetermined criteria. 5.4 DATA REQUIRED FOR INVESTMENT DECISIONS Initial Investment: The total amount of cash required to buy various assets like land, buildings, plant, machinery, equipment, etc and there installation expenses have to be estimated. In addition to fixed cost, the cost of maintaining stocks, contingency reserves to cover the cost of supporting the additional receivables. Benefit of credit from suppliers will have the effect of reducing the quantum of additional working capital required. Subsequent Investment: The cost of maintenance, replacement and updating are to be treated as outflows during the period in which they are expected to be incurred.

Economic Life of the project:


The economic life of a project is to be distinguished from the life of an individual assets. The building may have life of fifty years, plant may have ten years, and some equipments may have five years only. The economic life of the project is determined by the duration of the earnings flow generated by the project. 65

The economic life may end: a) The cost of replacement becomes uneconomical in relation to the likely benefits. b) When the viability is adversely affected due to obsolescence. c) When maintenance costs exceed the disposable value, and d) When the development of new technology necessitates new investment Salvage Values: Some times the plant assets may have value for the enterprise at the end of the life of the project or there may be some anticipated sales value of the plant. Such amount is to be treated as an inflow at the end of the life of the project. Annual Cash Flows: The calculation of annual cash flows in investment appraisal plays a key role. The computation of cash flows is a simple task. The following areas are to be considered. Sales revenue: This is going to be the function of sales any wrong calculation in this regard will bear impact on the investment opportunity. Care has to be taken to forecast accurately and the additional revenue generated by the investment should be taken into account. The investment must also result into the reduction of operating cost either by modernization or replacement models where the savings benefit or cash flows will increase. In simple terms annual cash flow is equivalent to net profit after tax plus deprecation. Procedurally, ACF = Sales (Operating expenses + Non-operating expense + Tax) + Depreciation Ex: The following is the information related to ABC Ltd. The company has been asked to compute the annual cash flows.

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Machine A Birrs Cost of machine Estimated life in years Estimated income Estimated material cost Estimated supervision cost Estimated maintenance cost Estimated savings in wages Additional Information 15, 000 5 years 1, 000 800 1, 200 500 9, 000

Machine B Birrs 24, 000 6 years 1, 500 900 1, 600 1, 000 12, 000

1. Depreciation may be charged on straight line method 2. The tax rate may be assumed 50% and 3. Calculate Annual cash flows. Machine A Birrs Income: Savings in wages Total income / sales Cost: material costs Maintenance Supervision Profit before Depreciation & Tax Depreciation Profit Before tax Tax @ 50% Profit after tax (Net profit) Add back depreciation 1, 000 9, 000 10, 000 800 500 1, 200 2, 500 7, 500 3, 000 4, 500 2, 250 2, 250 3, 000 Machine B Birrs 1, 500 12, 000 13, 000 900 1, 000 1, 600 3, 500 10, 000 4, 000 6, 000 3, 000 3, 000 4, 000 67

Annual cash flows 5.5 PROJECT APPRAISAL METHODS

5, 250

7, 000

There are two important methods of evaluating the investment proposals Traditional methods Pay back period Accounting rate of return Discounted cash flow method Net present value Profitability Index method / Benefit cost Ratio Internal Rate of Return Pay Back Period: This is one of the widely used methods for evaluating the investment proposals. Under this method the focus is on the recovery of original investment at the earliest possible. It determines the number of years to recoup the original cash out flow, disregarding the salvage value and interest. This method do not take into account the cash inflows that are received after the pay back period. There are two methods in use to calculate the pay back period 1) Where annual cash flows are not consistent vary form year to year 2) Where the annual cash flow are uniform 1. Unequal cash flows P=E+ B C

where, P stands for pay back period. E stands for number of years immediately preceding the year of final recovery. B stands for the balance amount still to be recovered. C stand for cash flow during the year of final recovery.

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Ex: The following is the information related to a company Project A Year 0 1 2 3 4 5 Project A Year 0 1 2 3 4 5 Cash flow -700 100 200 300 400 500 P=E+ =3+ B C 100 400 B C Cash flow $ -700 100 200 300 400 500 Cumulative cash flow -700 -600 -400 -100 300 800 Year 0 1 2 3 4 5 Year 0 1 2 3 4 5 Project B Cash flow -700 400 300 200 100 0 Project B Cash flow $ -700 400 300 200 100 0 Cumulative Cash flow -700 -300 0 200 300 -

Calculate pay back period

= 3.25 year P=E+

=2+0 = 2 years Uniform cash flows: Where the annual cash flows are uniform 69

PB =

Original Investment Annual cash flows

Shorter is the payback period better is the product EX: A project requires an investment of $ 100, 000, it will generate annual cash flow of $25,000 per year. Calculate the pay back period. PB = = Original Investment Annual cash flows 100,000 25,000

= 4 years Accounting Rate of Return This method is based on the financial accounting practices of the company working out the annual profits. Here, instead of taking the annual cash flows, we take the annual profits into account. The net annual profits are calculated after deducting depreciation and taxes. The average of annual profits thus derived is worked out on the basis of the period ARR = Average annual profits after taxes 100 Average investment over the life of project

Average investment = Net working capital + Salvage value + 1 (Initial cost of plant salvage value) 2 Net working capital = current assets current liabilities Average profits = Total of annual profits Number of years

Ex: Initial investments of plant $ 10, 000 Installation costs Salvage value Working capital Life of plant Calculate ARR $ 1, 000 $ 1, 000 $ 1, 000 5 years

Annual profit per year $ 2, 500

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Average profit = 2, 500 x 5 = Average investment = Wc + Sal.V. + = 2, 000 + 1, 000 + = 3, 000 +

12,500 = 2, 500 5 1 (Cost + Inst. Charges Salv. Val) 2

1 (10, 000 + 1, 000 1, 000) 2

1 (10, 000) 2

= 3, 000 + 5, 000 = 8, 000 ARR = 2,500 x 100 8,000

= 31.25% 31.25% The ARR is compared to the predetermined rate. The project will be accepted if the actual ARR is higher than the desired ARR. Otherwise it will be rejected. Discounted cash flow techniques: This concept is based on the time value of money. The flow of income is spread over a few years. The real value of Birr in your hand today is better than value of birr you earn after a year. The future income, therefore, has to be discounted in order to be associated with the current out flow of funds in the investment. Two methods of appraisal of investment project are based on this concept. These are net present value and internal rate of return method. Net Present Value Net present value may be defined as the total of present value of the cash proceeds in each year minus the total of present values of cash outflows in the beginning NPV =
n

(1 + K )

CFt

Sn + Wn Co (1 + K ) n

where; NPV = Net present value CFt = Cash inflows at different periods Wn = Working capital adjustments Co = Cash outflow in the beginning K = Cost of capital 71

Sn = Salvage value at the end The decision rule here is to accept a project if the NPV is positive and reject if it is negative I) II) NPV > Zero NPV = Zero accept accept reject

III) NPV < Zero

EX: ABC PLC is considering to invest in a cement project. It has on hand $180, 000. It is expected that the project may work for seven years and likely to generate the following annual cash flows. Calculate the Net present value. Year 1 2 3 4 5 6 7 The cost of capital is 8% Solution: Year 1 2 3 4 5 6 7 - Original investment Net present value ACF 30, 000 50, 000 60, 000 65, 000 40, 000 30, 000 16, 000 PV factor .926 .857 .794 .735 .681 .630 .583 Present value 27, 780 42, 850 47, 640 47, 775 27, 240 18, 900 9, 328 221, 513 180, 000 41, 513 ACF 30,000 50,000 60,000 65,000 40,000 30,000 16,000

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I. The above problem the NPV is greater than zero hence, it may be accepted. You have already learned in financial accounting to calculate the time value of money and the usage of present value tables. Hence, you may directly use the present value factors from tables. Present value of birr 1 = 1 1 = n (1 + r ) (1 + .10)1 two year .826 three .751 Profitability Index Method / Benefit Cost Ratio B/C Ratio Profitability index method is the relationship between the present values of net cash inflows and the present value of cash outflows. It can be worked out either in unitary or in percentage terms. The formula is Profitability Index = PI > 1 PI = 1 PI < 1 Accept indifference reject Present value of cash inflows Pr esent value of cash outflows

The present value of 1 Birr @ 10 cost after one year .909

Higher the profitability index more is the project preferred. From the above example we can calculate the profitability index as below Present value of cash out flows $ 180, 000 Present value of cash inflows $ 221, 513 : - PI = 221,513 180,000

Internal Rate of Return (IRR) The internal rate of return is also known as yield on investment, marginal efficiency of capital, marginal productivity of capital, rate of return time adjusted rate of return and so on. Internal rate of return is nothing but the rate of interest which equates the present value of future earnings with the present value of present investment. Therefore, IR depends entirely on the initial outlay and the cash proceeds of the project which is being evaluated for acceptance or 73

rejection. The computation of IRR is difficult one; you have to start equating the two values i.e., present value of future earnings and present value of investment. It is possible through trial and error method. IRR can be calculated basing on the pay back period where annual cash flows are uniform, in case the annual cash inflows are different for the periods, the fake pay back period is calculate then adopt trial and error procedure. IRR = r PB DFr DFrL DFrH

where; PB = Pay back period DFr = Discount Factor for interest DFrL = Discount Factor for lower interest rate DFrH = Discount Factor for higher interest rate r = Either of the two interest rates used or IRR = LRD + NPVL R PV

where; IRR = Internal Rate of Return LRD = Lower Rate of Discount NPVL = Net present value at lower rate of discount (i.e., difference between present values of cash) PV = The difference in present values at lower and higher discount values at lower. R = The difference between two rates of discount. Ex: Nissan Plc. has $100, 000 on hand. This amount is invested in a project, where the annual benefits after taxes are as below. It would like to know the rate of return earned by the company at the end of the life of the project.

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Year 1 2 3 4 5 Solution

ACFS $ 40, 000 35, 000 30, 000 25, 000 20, 000

At Discount Factor 20% Year 1 2 3 4 5 ACFS 40, 000 35, 000 30, 000 25, 000 20, 000 PV Factor .833 .694 .579 .482 .402 PV in $ 33, 300 24, 300 17, 400 12, 100 8, 000 95, 100 IRR = LRD + = 10 + = 17.8 Check Your Progress 1 NPVL R PV

At Discount Factor 10% PV Factor .909 .826 .751 .683 .621 PV in $ 36, 400 28, 900 22, 500 17, 100 12, 400 117, 300

17,300 10 22,200

1. a) Capital investment is not necessarily an investment in tangible assets. T F b) All investment are expected to yield inflows. T F c) A comparison of the investment and the returns cannot be made unless all monetary amounts are stated on the same time basis. T F d) The net amount invested in the new machine is the cost of the new machine minus the net amount received from the sale of old machine. T F e) Total working capital that must be held to support the investment is a part of the total investment in an assets. T F

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f) Depreciation on the asset is included as a cost in computing DCF returns T F g) The networking capital released on the termination of a project is not a return (or inflow) of the final year. T F h) The cost incurred in the past have no bearing on the decisions to be made in future. T F 2. Western Europe Company is considering the replacement of one of its machines with a newer model, which supposedly will reduce the operating cost considerably. The company prepared the following analysis. Old Machine Depreciation Labor Other costs Total costs $ 10, 000 12, 000 10, 000 32, 000 New Machine $ 18, 000 6, 000 4, 000 28, 000

The old machine costs $ 80, 000 and has been operated for three years out of an estimated eightyear life. The new machine, which has an estimated life of five years, can be acquired for $ 90,000 less a trade in allowance of $ 20, 000 for the old machine. The other costs listed above consists of repairs, power, lubrication and others. Which of the following statements is False a) Depreciation on old machine is a sunk cost. b) Depreciation on the old machine may be disregarded in deciding whether to replace the old machine. c) Labor and other costs are out-of-pocket costs. d) The pay back period of the new machine is seven and one-half years.

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5.6 PROBLEMS AND SOLUTIONS EX: 1 The expected cash flows of a project are as followed Year 0 1 2 3 4 5 Cash flows $ 100, 000 20, 000 30, 000 40, 000 50, 000 30, 000

The cost of capital is 12 percent calculate the following a) b) c) d) e) Pay back period Discounted pay back period Net present value Profitability index Internal rate of return Solution: Year 0 1 2 3 4 5. Cash flow $ -100, 000 20, 000 30, 000 40, 000 50, 000 30, 000 PV factor .12% .893 .797 .712 .636 .567 17, 860 82, 140 23, 910 58, 230 28, 480 29, 750 31, 800 17, 010 119, 060 -100, 000 c) Net present value d) Profitability Index 19, 060 = 119, 060 100, 000 = 1.19 77 PV Cumulative cash flow

a) P = E + =3+ = 3.2 b) =3+

B C 10,000 50,000

29,750 31,800

= Apr. 4 e) 1 2 3 4 5 IRR 20, 000 30, 000 40, 000 50, 000 30, 000 18% .847 .718 .609 .516 .437 16,940 21,540 24,360 25,800 13,110 101,750 IRR = LRD + = 18 + NPVL R PV IRR 19% .846 .706 .593 .499 .419 16,920 21,180 23,720 25,800 12,570 100,190

1,750 1 2,530

= 18.69 EX: 2 An equipment A, has cost of $ 75, 000 and cash inflow of $ 20, 000 a year for six years. A substitute equipment B would cost $ 50, 000 and cash flow $ 14, 000 per year for six years. The required rate of return for both projects is 11%. Calculate NPU and IRR for each equipment which equipment should be accepted? Equipment A NPV = 20, 000 (ACF6 .11) 75, 000 = 20, 000 (4.231) 75, 000 = 84, 620 75, 000 = 9, 620

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Pay back period =

75,000 20,000

= 3.75 From present value annuity table 3.75 is between PVAF15 = 3.784 PVAF16 = 3.685 IRR = r IRR = r = 15 PB DFr DFrL DFrH 3.75 3.784 (3.784 3.685) 0.034 0.099

= 15.34% Equipment B NPV = 14, 000 (ACF6 .11) - 50, 000 = 14, 000 (4.231) 50, 000 = 59, 234 50, 000 = 9, 234 Pay back period = 50,000 14,000

= 3.571 From present value annuity table 3.571 lies between PVAF6 17 = 3.589 PVAF6 18 = 3.498 IRR = r PB DFr DFrL DFrH 3.571 3.589 (3.589 3.498) 0.18 0.09

= 17 = 17

= 17 + .002 = 17.20

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Equipment A has more NPV but lower IRR than B. A should be preferred because it will increase the wealth of shareholders. EX: 3 A company is faced with the problem of choosing between two mutually exclusive projects. Project A requires a cash outlay of $100, 000 and cash running expenses of $35, 000 per year. On the other hand project B will cost $150, 000 and requires cash running expenses of $20,000 per annum. Both the machines have eight years life. Project A has $4, 000 salvage value and project B has $14, 000 salvage value. The companys tax rate is 50 percent and has 10 percent required rate of return. Assume depreciation straight-line basis and no tax on salvage value of assets. Which project should be accepted? A Cost Exp. Cost Expenses 100, 000 35, 000 B A = 50, 000 B A = 15, 000 saving 150, 000 18, 750 10, 000 15, 000 6, 250 8, 750 4, 375 4, 375 4, 375 Add Depreciation Annual cash flow Terminal salvage value 6, 250 10, 625 = 10, 000 12, 500 (14, 000 4,000) = Saving - Depreciation Profit before tax Tax 50% Depreciation 100, 000 8 B 150, 000 20, 000

(B A) Net present value = 10, 625 (PVAF8.11) + 10, 000 (PVF8. 11) 50, 000 = 10, 625 (5.335) + 10, 000 (.467) 50, 000

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= 56, 684 + 4, 670 50, 000 = 61, 354 50, 000 = 11, 354 Project B may be accepted. It has positive NPV Ex. 4 Fairwell Company has recorded the following data related to two alternatives A and B. Both require an investment of $ 56, 125 A Year 1 2 3 4 5 Cost of Capital 10% Estimated life Estimated salvage value Tax rate 1) ARR 3) Net present value 5) Internal Rate of Return ARR = Average income 100 Average investment 36,875 = 7, 375 5 1 (cost of plant salvage value) 2 5 years $ 3, 000 55% 2) Pay back period 4) Profitability Index 5 years $ 3, 000 55% ACFs after depre. Tax $ 3, 375 5, 373 7, 375 9, 375 11, 375 36, 875 B ACFs after depre. Tax 11, 375 9, 375 7, 375 5, 375 3, 375 36, 875

Depreciation has been charged on straight line basis calculate:

Average income =

Average investment = Networking capital + salvage value + = 3, 000 + 1 (56, 125 3, 000) 2

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= 3, 000 +

1 (53, 125) 2

= 3, 000 + 26, 562.5 = 29, 562.5 ARR for both = 7,375 x 100 29,562.5 = 24.9%

ARR is same for A and B, because both have same annual incomes. The ARR may be compared to the desired one and if the actual is more, it has to be accepted otherwise it has to be rejected. 2) Pay Back Period: To calculate pay back period we have to add back the depreciation to ACFs after tax and depreciation A I. Depreciation: Cost -Salvage 56, 125 3, 000 53,125 5 10, 625 A 0 1 2 3 4 5 3, 375 + 10, 625 5, 375 + 10, 625 7, 375 + 10, 625 9, 375 + 10, 625 11, 375 + 10, 625 + 3, 000 P=E+ P=3+ 8,125 20,000 B C 14,125 18,000 56, 125 14, 000 16, 000 18, 000 20, 000 25, 000 42, 125 26, 125 8, 125 11, 375 + 10, 625 98, 375 + 10, 625 7, 375 + 10, 625 51, 375 + 10, 625 3, 375 + 10, 625 B 56, 125 22, 000 20, 000 18, 000 16, 000 17, 000 + 3, 000 34,125 14, 125 II. Salvage value at the end has to be added to the cash flow B 56, 125 3, 000 53,125 5 10, 625

2+

= 3 + 406 = 3.406

2 + 0.785 2.785 82

3. Net present value A Year


1 2 3 4 5

B PV Factor Present value


$ 22, 000 20, 000 18, 000 16, 000 17, 000 0.909 0.826 0.751 0.683 0.621

ACF
$ 14, 000 16, 000 18, 000 20, 000 25, 000 0.909 0.826 0.751 0.683 0.621

ACF

PV
19, 998 16, 520 13, 518 10, 928 10, 557 71, 521 56, 125 15, 396

Factor Present value


12, 726 13, 216 13, 518 14, 660 15, 525 69, 645 56, 125 13, 520

- origi. Invest.

Project B has more NPV than A hence, preferred 4. Profitability Index: PI = = Pr esent value of cash inflows Pr esent value of cash netflows = 71,521 56,125

69,645 56,125

= 1.241 5. Internal Rati of Return 17%


Year 1 2 3 4 5 CFAT $ 14, 000 16, 000 18, 000 20, 000 25, 000 PV Factor 0.855 0.731 0.624 0.534 0.456

= 1.274 20%
Present value 11, 970 11, 696 11, 232 10, 680 11, 400 59, 978 CFAT $ 22, 000 20, 000 18, 000 16, 000 17, 000 PV Factor 0.833 0.694 0.579 0.484 0.442 Present value $ 18, 326 13, 990 10, 422 7, 712 6, 834 57, 174 -56, 125 1049

- Orign. Invest.

-56, 125 853

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This is more, let us try higher interest. A 18%


Year 1 2 3 4 5 ACF $ 14, 000 16, 000 18, 000 20, 000 25, 000 PV Factor 0.847 0.718 0.609 0.516 0.437 Present value $ 11, 858 11, 488 10,962 10, 320 10,928 55,553 ACF $ 22, 000 20, 000 18, 000 16, 000 17, 000

B 22%
PV Factor $ 0.820 0.672 0.551 0.451 0.370 Present value $ 18, 040 13, 440 9,918 7, 216 6, 290 54,904 -56, 125 -1,221

- Orign. Invest.

-56, 125 -572

IRR = LRD + = 17 + 853 x1 1,425

NPVL R PV = 20 + 1,049 2 2,220

= 17 + 0.6 = 17.6%

= 20 + 0.9 = 20.9%

Note: A: 853 = 56,978 56,125 and 1,425 = 56,978 55, 553 B: 1,049 = 57,174 56,125 and 2,270 = 57,174 54,904 EX: 4. ABC Plc. Has got $ 20, 000 to invest. The following proposals are under consideration 4. Project A B C D E F G Initial outlay $ 10, 000 8, 000 4, 000 10, 000 5, 000 6, 000 2, 000 Annual cash flow $ 2, 500 2, 600 1, 000 2, 400 1, 125 2, 400 1, 000 Life Year 5 7 15 20 15 6 2

a) Rank the projects in order of desirability under pay back period. b) Rank these projects under net present value method assuming cost of capital 10%.

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a) Pay back period Project A B C D E F G


Net
A B C D E F G 10,000 8, 000 4, 000 10, 000 5, 000 6, 000 2, 000

Investment $ 10, 000 8, 000 4, 000 10, 000 5, 000 6, 000 2, 000
Present value
$ 2,500 2, 600 1, 000 2, 400 1, 125 2, 400 1, 000

ACF $ 2, 500 2, 600 1, 000 2, 400 1, 125 2, 400 1, 000

Payback period 4 3.1 4 4.2 4.4 2.5 2

Rank 4 3 4 5 6 2 1

PV Factor 10%
3.791 4.868 7.606 8.514 7.606 4. 355 1.736

Present Value
$ 9,478 12, 657 7.606 20, 434 8, 557 10, 452 1, 736

NPV
4, 657 3, 606 10, 434 3, 557 4, 452 -

Rank
2 4 1 5 3 -

Note: Project A & G result in negative NPV hence, may be rejected. Ex: 5. A company is considering to purchase a plant. Two plants are available X and Y each costing $ 50, 000. the annual cash flows are expected as below. ACFS Year 1 2 3 4 5 Plant X $ 15, 000 20, 000 25, 000 15, 000 10, 000 Plant Y $ 5, 000 15, 000 20, 000 30, 000 20, 000

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Further information: a) Depreciation is charged on straight line bases b) Cost of capital is 10% c) No salvage value Calculate 1) 2) 3) Pay back period Accounting rate of Return Net present value

1. Pay back period Year 0 1 2 3 4 5 X $ 50, 000 15, 000 20, 000 25, 000 15, 000 10, 000 P=E+ =2+ = 2.6 15,000 25,000 B C =3+ 10,000 30,000 -50, 000 -35, 000 -15, 000 Y $ 50, 000 5, 000 15, 000 20, 000 30, 000 20, 000 -50, 000 -45, 000 -30, 000 -10, 000

= 3.333

Plant X is preferred than Y because the pay back period is shorter. Discounted Payback Period A major shortcoming of payback periods is that it does not take into account the time value of money into account. To overcome this limitation the discounted payback period is suggested. Here, the cash flows are converted into their present values (applying suitable discounting factors) and then added to ascertain the period time required to recover the initial investment.

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EX.

Year 0 1 2 3 4 5 6 7

Cash flow $ -10, 000 3, 000 3, 000 4, 000 4, 000 5, 000 2, 000 3, 000 P=E+ =3+ B C 941 3,105

Discount factor 10% 0.909 0.826 0.751 0.683 0.621 0.565 0.513

Present value $ -10, 000 2, 727 2, 478 3, 004 2, 732 3, 105 1, 130 1, 539 -10, 000 7, 273 4, 795 1, 791 941

= 3.30 2. ARR = Average income Average investment

Here, you must differentiate between the annual income and annual cash flow. Annual income is after all the expenses like depreciation and tax. But, to arrive annual cash flows, you have to add back depreciation. In the above annual cash flows are given, to get annual income we have to deduct depreciation. Depreciation = = Investment Life of project

50,000 5 Plant Y = = 90,000 / 5 10,000 50,000 / 2 18,000 10,000 25,000

= 10, 000 Plant X = = 85,000 / 5 10,000 50,000 / 2 17,000 10,000 25,000

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7,000 100 25,000

8,000 100 25,000

= 28% 3. Net Present Value Year 1 2 3 4 5 ACF 15, 000 20, 000 25, 000 15, 000 10, 000 PV Factor 0.909 0.826 0.751 0.683 0.620 PV

= 32%

Year 1 2 3 4 5

ACF 5, 000 15, 000 20, 000 30, 000 20, 000

PV Factor 0.909 0.826 0.751 0.683 0.620

PV 4, 545 12, 390 15, 020 20, 490 12, 420 64, 865 50, 000 14, 865

13, 635 16, 520 18, 775 10, 245 6, 210 65, 385 50, 000 15, 385

- Original Investment

X is preferred because of higher net present value. 5.7 SUMMARY The management will achieve wealth maximization by using the long-term investment effectively. Decision effecting investments in long-term capital projects or assets have a major impact on the future well-being of the organization. Apart from being uncertain such decisions typically, involve large commitments of funds. The capital analysis will enable the management to rank and choose intelligently among the proposals competing for essentially scarce long-term funds. The commonly used appraisal methods are payback, accounting rate of return which are known as traditional methods. The major drawback of these methods is time value of money is not considered. To overcome those defects modern methods namely net present value, profitability index and internal rate of return have become popular and most commonly acceptable.

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5.8 ANSWERS TO CHECK YOUR PROGRESS 1. a) T b) F c) T d) T e) T f) F g) F h) T 5.9 MODEL EXAMINATION QUESTIONS 1. 2. 3. 4. What data you would seek before you appraise a project? Explain pay back period method. What do you understand by internal rate of return? The Great ways Company is considering replacing an old plant with a newer 2. a b c d

model having lower maintenance cost. The old plant has a current book value of $ 9, 000 and a (straight-line) depreciation charge $ 3, 000 per year for the remaining life of 3 years including current year. It will have no salvage value. However, at present the machine can be sold in the market for $ 6, 000. The existing machine requires an annual maintenance cost of $ 3, 000. The new machine will cost $ 12, 000 and require an annual maintenance cost of $ 12,000 and require an annual maintenance cost of $ 600. Its expected useful life is 3 years with no salvage value. Assume straight-line depreciation and tax 50% for new plot what is your replacement decision? 5. Year 1 2 3 4 Farewell company has an investment opportunity costing $ 30, 000 with the Net cash flow $ 4, 000 4, 000 4, 000 4, 000 following expected net cash flows (after taxes and before depreciation)

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5 6 7 8 9 10

4, 000 7, 000 9, 000 12, 000 9, 000 2, 000

Using 10% as the cost of capital determine the following a) b) c) d) e) Pay back period Net present value at 10% Accounting Rate of Return Profitability Index at 10% Internal rate of return with the help of 10% and 15% discounting factors 5.10 REFERENCES Kuchhal S.C. Pandey IM. Brigham EF Gitman L.J : : : : Financial management, Chaitanya Publishing House Allahabad. Financial management, Vikas Publishing House Put Ltd. New Delhi. Fundamentals of Financial Management Dryden Press, Chicago Principles of Managerial Finance Harper Row, New York. Financial Management Theory and Practice Tata McGraw Hill, New Delhi.

Prasanny Chandra:

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UNIT 6: CAPITAL STRUCTURE AND LEVERAGE Contents 6.0 Aims and Objectives 6.1 Introduction 6.2 Principles of Capital Structure 6.3 Optimal Capital Structure 6.4 Operating and Financial Leverage 6.5 Operating Leverage 6.6 Financial Leverage 6.7 Combined Leverage 6.8 EBIT EPS Analysis for Capital Structure 6.9 Modigliani Tax Factor 6.10 6.11 6.12 6.13 Summary Answer to Check Your Progress Model Examination Questions Reference

6.0 AIMS AND OBJECTIVES An attempt has been made in this unit to present the meaning and principles of capital structure. The various theories related to capital structure and the impact of operating and financial leverage on capital structure is discussed. After reading this unit, you will be able to: explain the term capital structure list out the factors that influence capital structure calculate operating, financial and combined leverage.

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6.1 INTRODUCTION The management of an enterprise has the responsibility to maximize the wealth of shareholders and minimize the cost of capital. As you are aware capital has cost. Whether it is own capital or borrowed capital. The financial manager has to design the capital structure in such a way that the composition of capital should minimize the cost and maximize the value of company's shares. So as to achieve this objective, every company has to define the proportion of various components of sources of finances, which is known as capital structure. Capital structure is a structure. mix or composition of common stock, preference and bond capital, which gives highest return to shareholders and keeps the cost of capital at low level. The mix of these components where the profit is optimal known as optimal capital structure. structure. The capital can be financed through a) common shares b) common shares and preference shares c) common shares, preference shares and bonds Capital structure is concerned with the choice to make amongst the above components. 6.2 PRINCIPLES OF CAPITAL STRUCTURE The financial manager has to pay considerable attention to the pattern of capital structure that he intends to select for a company. He has to keep in mind various factors including the general state of the economy, the specific circumstances of the industry to which his company belongs and the operating factors and prospects of his own company. For example, it is widely believed that it is preferable to raise as much of funds as possible by way of 'debt' rather than equity. Since, it has tax advantages but at the same time under adverse economic conditions or recessionary trends in the industry or continued poor performance of his own company, he may not be able to meet the interest obligations on large scale borrowings and may prefer to invite ownership capital. While selecting the capital structure the following factors may be kept in mind. A) Cost Principle: The management's primary aim is to minimize the

cost of financing. The financing mix in the capital structure should be such as would incur 92

the minimum average cost of capital. We have to decide as a source of finance is equity expensive? Or is debt expensive? For a progressive company, which is known to maintain a good dividend on share capital, equity is costlier source of finance than debt in view of tax implications. The interest payable on debt is an expense chargeable to revenue before determining taxable profits, dividend payable on shares has to come from after taxes. In other words dividend is not tax deductible expense and has to be paid out of the profits remaining after providing for or paying the corporate tax. B) Risk Principle: Debt involves permanent periodical payment of interest rate for the agreed term and attached a greater risk of the company fails to meet its interest obligation during a phase of continued poor working, the creditors may press for its liquidations: Even where the interest obligations are met but the profits are low and just sufficient to meet these interest commitments, the shareholders run risk of receiving low dividend or no dividend and during the poor performance non-payment of dividend will reflect in low market prices for the company's shares and the company will find it difficult to raise additional capital through the issue of shares. The deployment of excessive debt in the capital structure of the company will expose it to heavy risk in terms of declining performance, as the interest has to be ensured whether the company earns profit or not. C) Control Principle: Bond holders and lenders of money will not have voting rights and they cannot exercise control over the management of the company. So long as their debts are serviced regularly, they cannot complain. So, where the additional funds are required for the company, the management may resort for debt financing instead of ownership capital, if the intention is to retain the control with the existing shareholders. If the additional funds are raised through issue of shares there will be dilution of control, since, the new shareholders will have the voice in the company management. The extent of willingness of existing shareholders to share control with new shareholders thus becomes a relevant factor. Closely managed companies where the directors enjoy the patronage of the existing shareholders and are eager to retain their positions in the board will be very cautious in the matter of raising additional funds through the issue of shares to the wide public. They would rather issue bonds and raise funds. D) Flexibility Principle: The management should have a balanced approach in selection of source of finance. If it borrows by mortgaging all its fixed assets,

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then the flexibility is lost in case need of any additional funds, though the market conditions are favorable. It will have to go for unsecured debts which may not be easily forthcoming or it may have to invite shares. While making decisions regarding source of finance, the focus must be to maintain a degree of manouverability and bargaining strength for negotiations by ensuring that borrowed strength is sustained with an adequate equity base and availability of uncommitted collateral securities such as fixed and current assets. E) Timing: It is critical factor for approaching the market for raising funds either through capital or debt. The finance manager has to keep in mind several factors while launching his funds raising efforts. When the market is experiencing paucity of funds, he will have to commit higher interest charges. When the economic conditions are brighten up and companies perform better, raising funds through issue of capital will be easier. The external factrs will determine whether it is advisable to go for borrowed funds or capital funds. 6.3 OPTIMAL CAPITAL STRUCTURE The theory of capital structure is related to the firms cost of capital. The debate regarding the capital structure has been around the issue whether an optimal structure exists. This debate began in late 1950's and yet unresolved. Those who believe that optimal capital structure exists are known to take a traditional view, while the supporters of what is called MM approach (named after modigliani and miller, who advocated the approach) maintain that the optimal capital structure does not exist. What is an optimal structure? In the traditional approach of the capital structure, the value of the firm is maximized, when the cost of capital is minimized. Using the simple zero growth valuation model for determining the value of the firm. V= EBIT KO

where, V = Value of the firm EBIT = Earnings Before Interest and Taxes KO = Weighted average cost of capital

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If the earning before interest and taxes are constant, the value of the firm is maximized by minimizing the weighted average cost of capital or overall cost of capital of the firm. We have to depend on the weighted average cost of capital. We may state that maximization of value of firm (v) is achieved when weighted average cost of capital is minimized and that specific mix of capital at which the weight average cost of capital is minimized and value of the firm maximized is called optimal capital structure. structure. The basic relationship between overall cost of capital and value of the firm is "lower the firm's overall or weighted average cost of capital, the higher the returns to the shareholders", for a given capital budget of firm, lesser the costs of required funds or the greater the difference between the return of a project and the cost of required funds, greater the profits from the project. Reinvesting these increased profits will increase the firms future earnings and therefore its value.

Check Your Progress Exercise


1. Mention the factors while designing capital structure. 2. List two sources of long-term finance. 3. What is optimal capital structure? 6.4 OPERATING LEVERAGE AND FINANCIAL LEVERAGE A firm's capital has to be designed with the consideration of risk, because the risk effects the value of the firm. Risk can be seen in two ways. 95

i) and ii)

The capital structure should be consistent with the business risk of the firm The capital structure results in a certain level of financial risk to the firm.

Thus, on one hand, the business risk determines the capital structure decision of the firm, while on the other hand, the capital structure decision gives rise to certain financial risk. 6.5 OPERATING LEVERAGE Operating leverage is nothing but the business risk. It is a relationship between the firm's sales and its earnings before interest and taxes (EBIT). In general, the greater the firm's operating leverage i.e., the use of fixed operating costs, the higher the business risk. In addition to operating leverage, revenue stability and cost stability also affects the business risk of the firm. The revenue stability means the variability of the firm's sales revenues, which depends on the demand and price of the firm's products. Cost stability refers to the relative predictability of input prices such as labor and material. The more predictable these prices, the less the business risk. Business risk varies among firms. Whatever their lines of business, the business risk is not affected by capital structure i.e., decisions. In fact, capital structure decisions should depend on the business risk. Firms with high business risks, tend to have less levered capital structure i.e., they have less fixed operating costs. Example: Marckaitita Company expects sales for its printers 1000 2000 3000. The selling price per unit $100. Variable costs $50 per unit and fixed costs per annum $50,000.

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Case 1 - 50% Sales Sales Revenue Less Variable Cost Contribution Less Fixed Costs EBIT % Change in EBIT 1000 Br. 100,000 (1000 x 100) Br. Br. Br. 50,000 (1000 x 50) 50,000 50,000 0 - 100%

Ideal Situation 2000 200,000 (2000 x 100) 100,000 (2000 x 50) 100,000 50,000 50,000

Case 2 +50% 3000 300,000 (3000 x 100) 150,000 (3000 x 50) 150,000 50,000 100,000 + 100%

From the above table let us take the sales of 2000 units as ideal sales. If the sales increases from 2000 units to 3000 units as case 2 i.e., an increase of 50% will lead to an increase of EBIT from $50,000 to 100,000 i.e., 100%. Similarly, if the sales of ideal situation falls down to situation 1 from units 2000 to units 1000 i.e., a decrease of 50% will result in zero EBIT of $50,000 to 0 i.e., 100% negative. If the fixed cost remains constant, any increase in sales will result in magnified increase in EBIT. But, a marginal decline in sales will have greater negative effect on EBIT. The above table depicts that 50% of increase in sales results in 100% increase in EBIT, similarly 50% decrease in sales will result in negative 100 percent decrease in EBIT. The relationship between sales and earnings before taxes and interest is known as operating leverage which can be measured in two ways. I) Degree of operating leverage = = % charge in EBIT % charge in sales 100 50

=2

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II) Operating leverage = =

Contribution EBIT 100,000 50,000

=2 In fact both are someone is measuring the degree of change i.e., increase or decrease EBIT and sales. The second one will be used when only one situation is given. 6.6 FINANCIAL LEVERAGE Financial leverage will explain the relationship between profit before tax and earnings before interest and taxes. It will give the composition of capital i.e., mix of various components like equity, debt and preference, which give optimal profit i.e., higher earning per share. It may be defined as "the ability of a firm to use fixed financial charges to magnify the effects of changes in EBIT on the firms earnings per share". It is nothing but the use of funds obtained at a fixed cost in the hope of increasing the return to the shareholders. We may say favorable financial leverage or positive leverage occurs when the firm earns more on the assets purchased with the funds than the fixed cost of their use. It is unfavorable when the firm does as much as the funds cost. I. The degree financial leverage = Or The financial leverage = EBIT PBT
Where: PBT = Profit Before Tax EBIT = Earnings Before Interest and Tax

% charge in EPS % charge in EBIT

Where: EPS = Earnings Per Share EBIT = Earnings Before Interest and Tax

Let us take an example and calculate for it. Adams company has $100,000, 10% bonds and equity shares of 5,000 outstanding. The tax rate applicable to this company is 50%. Assuming three levels of EBIT. I) $30,000, II) $50,000 and III) $70,000 calculate EPS.

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Case 1 - 40% EBIT - Interest PBT - Tax 50% EPS (PAT/5000) 30,000 10,000 20,000 10,000 10,000 2 - 50% % change in EPS % change in EBIT

Ideal Case 50,000 10,000 40,000 20,000 20,000 4

Case 2 +40% 70,000 10,000 60,000 30,000 30,000 6 +50%

Degree of financial leverage = 50 40 1.25

50 40 1.25

In the above table let us assume $50,000 EBIT as ideal situation and an increase of EBIT from $50,000 to case 2 of $70,000 is 40% increase will bring in a change of EPS from $4 to $6 per share resulting in 50% change. On the other hand, if the EBIT from ideal situation i.e., 50,000 falls down to $30,000 i.e., a decrease of 40% will result in EPS decrease from $4 per share to $2 per share i.e., 50%. Financial leverage also like operating leverage will have forward i.e., increase and backward i.e., decrease. Financial Leverage = EBIT PBT 50,000 40,000 = 1.25 It is clear that degree of financial leverage and financial leverage are some except the calculation.

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6.7 COMBINED LEVERAGE It will give the combined effect of operating leverage and financial leverage. It may be exposed as below. % change in EBIT % change in Sales

Degree Combined Leverage =

Combined Leverage = Operating leverage x Financial leverage = Contribution EBIT

6.8 EBIT EPS ANALYSIS FOR CAPITAL STRUCTURE Assuming the EBIT is fixed, and the mix of debt and equity in different proportions will give different profits. The mix of capital where profit is high is known as optimal capital structure. Suppose in the above example Adams Company has $100,000 capital and EBIT of $100,000. It would further expands its business and needs additional $120,000. Assuming the face value of share is 10. Tax rate is 50%. The following plans are advocated. A. B. C. A EBIT - Interest - Tax 50% EPS 100,000 4,000 96,000 48,000 48,000 2.66 10% Debt Equity 1:3 10% Debt Equity 1:1 10% Debt Equity 3:1 PLANS B 100,000 6,000 94,000 47,000 47,000 2.94 C 100,000 8,000 92,000 46,000 46,000 3.28

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It is evident that as the debt proportion increases the EPS is also increasing. But, we have to note that the risk i.e., financial risk is also increasing. In case of any reduction in EBIT will cause havock on the profitability and effects adversely. As we have already seen the negative financial leverage.

Check Your Progress Exercise 1


1. a. What is a business risk? b. What is a financial risk? c. What is optimal capital structure? 6.9 MODIGLIANI-MILLER TAX FACTOR MM have analyzed the impact of corporate taxes. They found that the debt provides a benefit to the firm because of the tax deductibility of interest payments. At the same time there is no disadvantage of debt financing relative to equity financing. The MM theory advocates if the firm is not paying tax then financing through debt is a irrelevant. It does not matter whether debt is used or not. A company paying tax should use debt as it is superior to all other financing sources. 6.10 SUMMARY Capital structure is nothing but determining the mix of various sources of finances. A firm has to choose the mix in such a way that the firm is neither over capitalized nor under capitalized.

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The traditional approach to capital structure indicates that the optimal capital structure for the firm is one in which the overall cost of capital is minimized and the share value is maximized. Operating leverage is the use of fixed costs (e.g., debt or preference share) to increase the returns to the shareholders. Financial leverage is the ability f the firm to use fixed financial costs to enhance the effects of changes in earnings before interest and taxes on earnings per share. The higher the interest and preference dividends, which are fixed costs, the greater is the financial leverage. 6.11 ANSWERS TO CHECK YOUR PROGRESS EXERCISE 1. a. The business risk is the ability of a business organization to meet the fixed cost in case of fluctuating sales or decline in the volume. Since, the fixed cost is to be met irrespective of revenue. b. Financial risk is the risk involved in the employment of debt capital. As the EBIT increases it is not a problem. But, if there is any decrease, it will have totally negative impact on EPS. c. Optimal capital structure is one where cost of capital is low and the returns on shareholders capital are high. 6.12 MODEL EXAMINATION QUESTIONS 1. 2. 3. 4. 5. Fixed Cost Interest Tax rate Calculate 102 Explain the term risk. What is liquidity? What do you mean by control? Distinguish between business risk and financial risk. Sales $ 900 $ 450 $ 50 55% $1,500

Variable Cost

a) Operating Leverage b) Financial Leverage 6. 50%. 6.13 References Kuchhal S.C. Pandey IM. Brigham EF Gitman L.J : : : : Financial management, Chaitanya Publishing House Allahabad. Financial management, Vikas Publishing House Put Ltd. New Delhi. Fundamentals of Financial Management Dryden Press, Chicago Principles of Managerial Finance Harper Row, New York. Financial Management Theory and Practice Tata McGraw Hill, New Delhi. If a company has 30% debt and 70% equity earns 15% on its assets (before taxes)

what is the percent return on equity assuming it pays 10% for debt capital while tax rate is

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UNIT 7: COST OF CAPITAL AND CAPITAL STRUCTURE Contents 7.0 Aims and Objectives 7.1 Introduction 7.2 Cost of Capital Meaning 7.3 The Role of Total Cost in Capital Structure 7.4 The Cost of Specific Resource Funds 7.5 Cost of Debt 7.6 Cost of Preference Capital 7.7 Cost of Equity Capital 7.8 Cost of Retained Earnings 7.9 Summary 7.10 7.11 7.12 Answers to Check Your Progress Model Examination Questions References

7.0 AIMS AND OBJECTIVES The purpose of this unit is to discuss the meaning, role, calculation of cost of capital and its impact on the construction of capital structure. After reading this unit, you will be able to: understand the meaning of cost of capital calculate the cost of specific resources like cost of debt, preference

stock, equity stock and retained earnings. 7.1 INTRODUCTION The cost of capital is the average rate of return required by the investors on the securities they have invested. This average rate is often used by the company as the minimum acceptable rate of return for new investments being considered by the company. If the internal rate of return is greater than or equal to the company's cost of capital, the project is acceptable. It is very

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important financial concept. It connects the company's long-term decisions with the wealth of the shareholders as determined in the market place. The following conditions must be fulfilled to evaluate the cost of capital. a) b) The new investment considered has the risk as the average investment The financing policy of the company is not affected by the investment undertaken by the company. that are being made. 7.2 COST OF CAPITAL MEANING As we have seen in the previous unit every business organization is exposed to business i.e., operating leverage and financial risk i.e., financial leverage. The response of the company's earnings before interest and tax (EBIT) or operating profits to changes in sales indicate the business risk. If this degree of responsiveness of EBIT to change in sales is the same for new project as for the earlier ones, the business risk does not change. However, if the firm accepts a new project, which is considerably riskier than the average ones, the suppliers of funds will increase the cost of these funds to compensate themselves for the increased risk. The company's cost of capital will also increase thereby. Hence, for analyzing firms cost of capital, the business risk assumed to be unchanged. With regard to the financial risk as we have already seen the response of the firm's earnings per share (EPS) to changes in Earnings Before Interest and Taxes (EBIT) indicates the degree of financial risk of the company. The financial risk is affected by the capital structure (i.e., mix of long term sources). By increasing the proportion debt, preference shares, leases, the firm will increase its financial risk, as these are fixed cost sources and reduction in EBIT can effect EPS as we have observed in the previous unit. Finance costs will expect higher return to compensate for the increased risk. Hence, to analyze the cost of capital, the firms financial risk is assumed to be unchanged or unaffected i.e., the proportion of various types of funds in future is supposed to be same as one in the existing capital structure.

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7.3 THE ROLE OF TOTAL COST IN CAPITAL STRUCTURE The capital structure for any organization has to be structured in such a way that the internal rate of return is greater than the total cost of all components put together. Whenever the company estimates the investment and cash flows of capital expenditure, it must also estimate the cost of capital. The company will have a target capital structure though it raises money in lumps, sometimes by issuing bonds, sometimes equity shares. The company tends towards some desired mix of financing to maximize shareholders wealth. Hence, one should look at the overall cost of capital rather than the cost of specific source of finance. Example: Marckatta Company considering the following investment opportunity Project A Initial investment Life IRR Cost of Components $100,000 20 Years 12% 11%

Since, the firm earns 12% i.e., greater than the total cost it can be accepted. Let us presume after three months, there is an opportunity to invest in project B. Project B Initial Investment Life IRR Cost of Capital $ 100,000 20 Years 16% 18%

In the above case, the company would reject project B, as the financing cost is 18%, which is greater than the return i.e., 16%. The company's cost of capital is nothing but the weighted average of the costs of various sources of long-term funds. The following example will illustrate.

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Common Share Capital (45,000 shares @ 10$) Retained Earnings Preference share capital 9% Bonds

$ 450,000 $ 150,000 $ 100,000 $ 300,000 1,000,000

The company's after-tax component lists for the various sources of finance are as below. Common share capital Retained Earnings Preference share capital Bonds 14% 14% 10% 4.5%

Then weighted average cost will be as below: Amount (1) Common stock Retained earning Preference stock Bonds 450,000 150,000 100,000 300,000 Proportion (2) 0.45 0.15 0.10 0.30 After total cost (3) 0.14 0.14 0.10 0.045 Weight (4) = (2 x 3) 0.06300 0.02100 0.0100 0.0135 0.1075 Or 10.75% 7.4 THE COST OF SPECIFIC RESOURCE FUNDS The cost of each component is the input to measure the overall cost of capital of a company. As you are aware the basic sources of finance for an organization will be of four kinds a) common stock b) preference stock c) retained earnings, and d) bonds. It is not compulsory to tap finance from all the above sources to frame the capital structure. The specific cost for each source of funds is the after tax cost of financing. It can be before tax, provided the basis is the some for all the sources of finance being considered for calculating the 107

Weighted average cost:

cost of capital. The procedure for determining the cost of debt, preference and equity capital as well as retained earnings. 7.5 COST OF DEBT The cost debt finance can be defined in terms of the required rate of return that the debtfinanced investment must yield to prevent damage to stock holders position. Hence, the cost of bonds and long-term loans is the contractual interest rate adjusted further for the tax liability of the firm. Cd = R(1 T) Where Cd = Cost of debt R = Rate of Interest T = Tax rate applicable to the firm. A company issued 7% bonds to the public, the tax rate of the company is 55% then the cost of debt will be Cd = R(1 T) = 7(1 55) = 7 (0.45) = 3.15% 7.6 COST OF PREFERENCE CAPITAL Preference shares are the fixed cost bearing securities. Their rate of dividend is fixed well in advance at the time of their issue. So the cost of preferred capital is equal to the ratio of annual dividend income per share to the current market price of the preference shares. The ratio is often called a current dividend yield. If 9% preference shares of par value $100 is sold for $105 per share in the market and expense incurred $2 per share, then the cost of preference share would be:

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Cp = Where,

D NP

Cp = Cost of preference share D = Dividend per share NP = Net proceeds Therefore, CP = = 9 (105 2) 9 103

= 8.737% 7.7 COST OF EQUITY SHARE CAPITAL The cost of equity capital indicates the minimum rate, which must be obtained on the projects before their acceptance and rising of equity capital to finance. It is not an easy exercise to calculate because the calculation of equity cost raises a host of problems. Several models have been proposed by many experts. The prominent are explained below. I. D/P Ratio Approach It is based on the dividend paid in a year in relation its market price of the share quoted in the national stock exchange. Ce = D P Where, Ce = Cost of equity D = Current dividend rate P = Current market price of share Suppose Adams Company issued 50,000 shares of $10 each. Its current market price is $90 and the dividend per share is $4.50, then

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Ce = 4.5 90

= 0.05

= 5%

II. Price Earning Ratio Approach This establishes a relationship between earnings and market price f the shares. Some use current earnings in current market price for determining the capitalization rate, while others recommended an average of earnings and average of market price. III. D/P + G Approach This has been advocated by all prominent financial experts. Ce = D +G P

Where Ce = Cost of equity D = Dividend per share P = Market price of share G = Growth rate per annum. Let us take the same example, where the share par value is $10 market value $90. Current dividend is $4.50. It is estimated that it will grow at 7% per year. Ce = D + G P 4.50 + 0.7 = 90 = 0.05 + 0.07 = 0.12 = 12% 7.8 COST OF RETAINED EARNINGS As you know that whether it is own money or others money, it has cost. Retained earnings are also not without cost. Though, they do not have any explicit cost of the firm but their opportunity cost can be computed as well. The opportunity cost of retained earnings in a particular company is the rate of return the shareholder forgoes by not putting his funds

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elsewhere. If the management has the shareholders interest in mind, when it makes investment decisions, it should use the opportunity cost figure to determine the cut-off point. The opportunity cost of retained earnings to the shareholders is the rate of return that they can obtain by investing the after tax dividends in alternative opportunities. Cr = (1 Ti) D (1 Tc) D Where Cr = Cost of retained earnings Ti = Tax rate applicable to individuals Tc = Capital tax gain D = Dividend P = Market price of the share

Check Your Progress Exercise


1. What is cost? 2. What do you mean by capitalization? 3. What are the major sources of finance? 4. Retained earnings are the company's funds hence have no cost?

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5.

What is weighted average cost?

7.9 SUMMARY The cost of capital is used to evaluate the project. It is the minimum rate of return on new projects. The basic factors underlying the cost of capital for a firm are the risk associated with the firm, the taxes it pay and supply and demand of various sources of finance. The firm has to structure its capital in such a way where the total cost of capital is lower than the rate of return. Basically there are four sources of finance viz. common stock, preference stock, retained earnings and bonds of these components is presented in this unit. 7.10 ANSWERS TO CHECK YOUR PROGRESS EXERCISE 1. Cost is the minimum rate of return to be earned by new projects. It must be lower than the internal rate of return. 2. Capitalization is the sum total of financial sources which will be used in long-run. 3. The major sources of finance are a. Equity shares b. Preference shares c. Retained earnings d. Bonds 4. Retained earnings have cost i.e., opportunity cost. 5. Weighted average cost is total cost of capital i.e., by adding the specific costs of all sources. 7.11 MODEL EXAMINATION QUESTIONS 1. Why is the cost of capital calculated? 2. Explain business risk. 3. Explain finance risk. 112

4. What is a specific cost? 5. How do you calculate cost of debt? 6. What is weighted average cost of capital and how do you compute? 7.12 REFERENCES Kuchhal S.C. Pandey IM. Brigham EF Gitman L.J : : : : Financial management, Chaitanya Publishing House Allahabad. Financial management, Vikas Publishing House Put Ltd. New Delhi. Fundamentals of Financial Management Dryden Press, Chicago Principles of Managerial Finance Harper Row, New York. Financial Management Theory and Practice Tata McGraw Hill, New Delhi.

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UNIT 8: WORKING CAPITAL MANAGEMENT Contents 8.0 Aims and Objectives 8.1 8.2 8.3 8.4 8.5 8.6 8.7 8.8 8.9 8.10 Introduction Working Capital Concepts Operating Cycle Sources of Working Capital Financing Pattern of Working Capital Determinants of Working Capital Summary Answers to Check Your Progress Model Examination Questions References

8.0 AIMS AND OBJECTIVES This unit aims at discussing the concepts of working capital, operating cycle, sources of working capital and determinants of working capital. Once you go through this unit, you will be able to: 8.1 INTRODUCTION You have learned in the previous units that capital is required to finance the long-term and short-term assets. The long term finances are needed to acquire fixed assets. The amount spent on fixed assets is known as fixed capital. We need short-term finances to keep running or operate the fixed assets. The amount of money invested in the form of working assets is known explain the concepts of working capital understand the operating cycle list out the sources of working capital and, narrate the determinants of working capital.

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as working capital or short-term investment. This unit will discuss in detail the various aspects of working capital. 8.2 WORKING CAPITAL CONCEPTS The term 'working capital' has two concepts a) Gross working capital and b) Net working capital. Gross working capital is the sum of total current assets of a business unit. Immediately you may ask what is a current asset? Current asset is an asset, which can be converted into cash within a reasonable period of time. Again, what is a reasonable period? The reasonable period is a consensus agreed upon by the experts for the purpose of business. Normally a time period of less than a year is treated as reasonable period. So, the assets that can be liquidated or converted into cash within a year are known as current assets. We include cash balance, bank balance, assets. receivables, inventories, short-term investment , prepaid expenses, notes receivables etc., under current assets. Like current assets, we may have current liabilities i.e., obligations to be paid within a reasonable period of one year. The current liabilities could be suppliers, book loan, notes payable, outstanding expenses and other short term obligations and provisions. Once you are clear about the current assets and current liabilities, it is appropriate to introduce the second concept of working capital i.e., net working capital. The net working capital is defined as excess of current assets over current liabilities. The difference between current assets and current liabilities is net working capital. In corporation finance working capital refers to net working capital only. The emphasis of gross working capital is focused on two aspects: I) II) It has to be ensured that the investment in current assets is optional and, It has to be ensured that the investment in current asses is obtained through the least cost of source of finance. Excessive investment in the current assets should be avoided because it is going to affect adversely on the profitability of business. Inadequate working capital interrupts the smooth run of the business activity and impairs profitability. Hence, proper management of working capital is crucial to a business.

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Permanent and Variable Working Capital As you know the company's production and sales activity is subject to seasonal fluctuation like availability of raw material, market demand, the level of investment in current assets etc. However, there should be a minimum investment in current assets, which is absolutely necessary all the times. This minimum level is referred to permanent or fixed working capital. Further, the requirements which vary with changes in the levels of production and sales activity are known as "variable working capital". The finance manager of the company has to make arrangements for meeting the permanent and variable requirements through long and short term means so as to reduce the cost to the minimum. Therefore, effective management of working capital involves constant vigilance to ensure the right quantum and right composition of working capital available on a continuing basis to support and promote the activities of the company. 8.3 OPERATING CYCLE The process of transformation of cash into raw material, then work-in-process and the conversion of the same into finished goods followed by credit sales i.e., receivables and subsequent collections of debt is known as the 'operating cycle'. The length of time required to convert cash into resources, resources into finished goods, finished goods into receivable, receivables back into cash is called the operating cycle of a business enterprise. The length of operating cycle is a function of the nature of business. It covers four distinct stages, each of which requires a level of supporting investment. The sum total of the stage wise investment will be the total amount of working capital required. 1. Raw material /stock/ inventory 2. Work-in-process 3. Finished goods 4. Receivables The stages are sequential as detailed below a) b) Conversion of cash into raw material Conversion of raw material into work in process

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c) d) e)

Conversion of work-in-process into finished goods Conversion of finished goods into receivables Conversion of receivable into cash.

Cash Receivables Finished Goods

Raw Material

Work in process

The working capital stream is a link up of 'stocks' and 'flows'. It is a sequence of storages and releases. The company needs in the beginning some amount of cash to buy raw materials and par expenses. Further, it has to hold some cash to meet future exigencies. The raw material has to be stored adequately so as to avoid stoppage of production cycle. To meet the demands of customers, and sudden spurts in the demands it is necessary to carry stocks of finished goods. In a competitive situation, the company has to extend credit to facilitate customers in order to promote sales. Thus, to support a smooth and uninterrupted process of production and sales, investment of funds in current assets is unavoidable. But, through efficient management of current assets, it is possible to avoid excessive and unproductive investment in current assets.

Check Your Progress Exercise 1


1. What is current asset? 2. Explain gross working capital. 3. List out current assets.

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4. What is an operating cycle? 5. What is permanent working capital? 8.4 SOURCES OF WORKING CAPITAL It is wise to finance permanent working capital requirements through long term sources and the variable working capital through short term sources. Working Capital Permanent 1. Common stock 2. Perseverance stock 3. Bonds 4. Ploughing back profits 5. Long term loans 6. Public deposits Common Stock: This is widely used means of financing permanent working capital for any enterprise because of its proven advantages over other means. Preference Stock: The Company will also resort for preference stock. It is a hybrid nature and will not effect the interest of common stock holders. Variable W.C 1. Trade credits 2. Commercial Bank 3. Indigenous Bankers 4. Installment Credit

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Bonds: A company can raise funds by issuing bonds for working capital requirements. A bond is an instrument in writing issued under the seal of a company stating the principle amount borrowed, rate of interest applicable and the time of redemption. The company will pay a fixed rate of interest. Public deposit: Public deposits as a source of working capital is highly advantageous but it has its own limitations. The National Bank of the Country has to give permission. Ploughing Back of Profits: This refers to the re-investment of surplus earnings of a company in its business. It is an important internal source of finance and most suitable for established firms. This source has certain advantageous like no cost, no dilution of control over ownership, ensures stable dividend etc. Long Term Loans: This is suitable for medium term working capital requirements. The financial institutions of a country may provide term loans.

Variable Working Capital


Commercial Banks: In every country commercial bonds provide working capital loans. They include loans, cash credits, overdrafts and discounting of bills or notes. Indigenous Bankers: The private money lenders and other country bankers play an important role in financing the working capital requirements of a company. Normally they charge high rate of interest. Trade Credit: In the modern business world trade credits are very popular. By virtue of your regular purchase from a supplier, a sort of personal rapport is developed and credit is allowed for sometime. 8.5 FINANCING PATTERN OF WORKING CAPITAL The finance manager has to take care that the working capital is provided economically and used effectively. The following are important methods of financing. 1. Matching approach (Hedging approach) 2. Conservative approach

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3. Aggressive approach 1. Matching Approach The firm can adopt a financial plan which involves the matching of the expected life of asset with the expected life of the source of funds raised to finance assets. For example, a 120 days stock may be financed with a 120 days bank loan. A 10 year asset may be financed with 10 years loan. The justification for the exact matching is that since the purpose of financing is to pay for assets, the financing should be relinquished when the asset is expected to relinquish. Using long term financing for short-term asset is expensive, as the funds will not be utilized for the full period. Similarly financing long-term assets with short financing is costly as well as inconvenient as arrangement for the new short term financing will have to be made on continuing basis. Short term financing

Assets

Permanent Current Assets Fixed Assets 0 Time

Long term financing

2. Conservative Approach Under conservative approach the firm depends on long-term funds for its financing needs. The firm finances its permanent current assets and part of the temporary current assets also with long term funds. When the firm has no temporary current assets, it stores liquidity by investing the surplus funds in marketable securities.

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Short term financing

Assets

Permanent Current Assets Fixed Assets 0 Time

Long term financing

3. Aggressive Approach Sometimes a firm can adopt aggressive financing of its current assets. Aggressive approach is a situation where a firm uses more short term finances for current assets. An aggressive approach is one where the firm finances part of permanent current assets with short term financing. The extreme aggressive firms will finance their fixed assets also with short-term financing. Short term financing

Assets

Permanent Current Assets Fixed Assets 0 Time

Long term financing

8.6 DETERMINANTS OF WORKING CAPITAL How much working capital is required for a company depends on various factors that influence the investment in working capital. The factors are subject to shifts of emphasis so that their impact on working capital levels vary from time to time. These factors can be broadly classified into two i.e., internal and external.

Internal Factors:
1. Promotional and Formative Phase:

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During the initial stage or early years of a project, normally heavy amount of working capital is required. This is the most crucial phase for planning and provision of working capital funds. In practice, however, this fact is overlooked, as a result many new ventures run into financial difficulties. The general tendency is to under estimate the hurdles and set back that may arise in the formatting years of the company's operations. Facile assumptions are made in regard to ready availability of raw materials, availability of operative skills, adherence to norms and manufacturing cycle, overall competence to manufacture quality products, ready marketability and prompt settlement of dues from customer working capital needs are computed in broad terms when the operational pace and efficiency lag behind expectations, the financial plans go away and severe shortage of working capital funds is experienced. And the period of operations following the commissioning of the plant is marked by avoidable struggle to find funds to match needs and repeated threats to the company slovency. The working capital needs of a company to be realistic have to be drawn up in terms of raw materials, the specific source of supply and careful estimates of expected prices, particularly for the high value items. The proximity or otherwise, of the source of supply of raw material can make a substantial difference to funds requirements, depending on lead time for procurement and other factors. Nature of Business: The nature of a business has an important bearing on the requirement of working capital. For some ventures like trading, supermarket construction etc require nominal amount of fixed capital but they need higher amount of working capital. Contrarily, some industries like electricity generation; public utilities etc. have to invest huge amounts in the fixed assets and low amounts in working capital. Most of the manufacturing organizations have to finance substantial investment in current assets to support their operations. The relative importance of current assets to total assets will indicate the required degree of planning and control efforts in working capital management area. Size of Business:

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The size of an organization may be in terms of its assets, turnover has an impact on the working needs. Relatively a small firm requires small amount of working capital and may require additional current assets as a cushion against cash flow interruptions. Small firms having cash inflows from relatively fewer service more affected from relatively fewer services more affected by the defaults on the part of customers to pay on time. On the other hand larger firms with many sources of funds may require less working capital in relation to total assets or sales manufacturing cycle. The time gap between the acquisition of raw material and the completion of the manufacturing process yielding the finished product will obviously mean a larger tie-up of funds in the form enhanced working capital needs. Realization of this aspect may make the management attempt to reduce the intervening period and effect economy in working capital needs. Most products have alternative processes of manufacture and if working capital is considered a critical area, choice has to fall on those processes, which have shorter manufacturing cycle. This is a technological choice having impact on working capital economy. In other words, the longer the production manufacturing cycle, the larger will be the funds tied-up and therefore, the larger the working capital needed and vice-versa. Having selected the process of manufacture, care has to be taken to complete the cycle within the normal time. This necessitates the need for effective organization and coordination at all levels of the activity. Frequent changes in setups, waiting for materials, tools or instructions and accumulation of work-in-progress have the inevitable consequence of extending the cycle time and freezing up of more funds. Credit Terms to Customers: The credit terms allowed to customers influence the working capital by determining the level of investment in receivables. The management has to decide on suitable credit policy relevant to each customer based on merits of the case. Generally, liberal credit policy and stack collections procedures or permissible attitude in the matter of collections of out standings can lock up funds that would otherwise be available for operating needs.

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The amount of working capital is decided by the production policy. Whether the production is going to be continuous through out the year or seasonal. If the product has seasonal demand in such a case what should be production policy. This kind of fluctuations in demand will cause special working capital problems, a strategy for maintaining a steady rate of production through out the year as against a pronounced seasonal demand for manufactured goods has to be considered. To off-set the problem of having to find funds to support the mancting inventory levels of finished goods until they got off-loaded in the peak seasons, some companies resort to diversification of activities, enabling production of the main product to follow the seasonal pattern of demand. Growth and Expansion Programmes: As the business grows, additional working capital has to be found. In fact the need for working capital does not follow the growth in business activity but precedes it. A growing firm has to have advance planning as it expands its activity. Or else, the company may have substantial earnings but little cash. With fast growth, they may be under constant financial pressure for external funds to re-in force internal generation. Forward planning and continuous review there of are absolutely necessary for such companies. Price Levels: It may be observed in the market some business units have high profit may be due to effective way of organizing or its position in the market. Some others may have to struggle in a highly competitive environment. But, profits cannot be considered as available cash at the end of the period. Even as the company's operations are in progress cash is used for augmenting stocks, receivables and fixed assets. Elaborate planning and projection of expected activities and cash in flows, at short intervals, assume importance. For the projected surpluses, appropriate effective uses can be planned. The funds application, then occur by design and not by account. Dividend Policy: The management has to pay dividend to its shareholders to retain their investment and attract prospective investors, at the same time it has to preserve cash resources. During the periods of

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low profits, maintenance of steady dividends will involve draining of resources but may be needed to preserve the company's image. Reserve Policy: One of the major goals of financial manager is to build up the reserves to meet future contingencies out of profits. Besides cash or fund position, the urge to retain or plough back profits often acts as a major constraint on dividend and policy. In well established firms, the built up reserves constitute a strong base on which the corporate growth and expansion can be sustained. Depreciation Policy: Depreciation policy centers around the determination of the amount to be provided as depreciation charge to make up the ultimate resource for replacement of worn out or absolute assets. There are various approaches to the quantum and mode of charging depreciation. These various approaches are justified in terms of their impact on working capital position. Since, the depreciation charges do not involve any cash outflow. Enhanced rates of depreciation have the effect of reducing profit correspondingly, which in turn helps in holding back distribution of dividends. By this process cash is conserved. Depreciation policies, thus, exert influence on the status of working capital in the enterprise from time to time. Operating Efficiency: There is a close relationship between the operating efficiency of a company and its working capital position. Waste elimination, improved co-ordination to cut delays, higher efficiency in operations and fuller utilization of resources are among the initiatives taken to avert erosion of profits. They also have the effect getting more out of a given volume of working capital or obtaining the current levels of output with a reduced volume of working capital. Efficiency of operations accelerates the pale of the cash cycle, and improves the working capital turnover. It releases the pressure on working capital by improving profitability and adding internal generation of funds.

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External Factors
Business Cycles: The changes in business cycle bring about shifts in working capital position. In the event of economic prosperity, the upward swing is associated with spurt in sales and increase in levels of inventory and receivables. To cope up with the increased demand and production, the firm needs additional working capital. On the other hand if the economy experiencing recession, there will be decline in sales. Implying, low sales, lower inventory, lower receivables. Therefore, less working capital is needed. However, the firm needs additional cash to meet operating expenses as the funds are located in inventories. Thus, a business depression may give a misleading appearance of the financial position of the enterprise. With recovery, the cash position may decline and a shortage of working capital may develop. Technological Development: Technological developments in the area of production bring about changes in working capital needs. If a firm switches to a new manufacturing process and installs new machine, it may cut short the production cycle in converting the raw material into finished goods. As such the permanent working capital requirements will come down. Vagaries in Supply of Raw Materials: The sources of certain raw materials are few and irregular and pose problems in the matter of procurement and holding, using up more funds. Material that are available only in certain seasons have to be obtained and stored, in advance, for the lean months. The working capital requirements in such instances will show seasonal fluctuations. Shifts in Demand for Products: Some manufactured products are subject to seasonal fluctuations in sales. In the interest of utilization of capacity, steady production will have to be maintained, independent of shifts in demand for finished products. Finished goods inventories will therefore, pile up during offseason and will require increased amounts of working capital to be provided. Financial planning will have to this pattern of funds requirements associated with steady production and seasonal sales.

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Competitive Conditions: In a competitive market, winning and retaining customers satisfaction on a continuing basis will involve extra costs and present a variety of working capital problems. To offer the customer the benefit of choice, a variety of products will have to be manufactured and stocked. This means higher amount of inventories at all the levels and naturally additional capital funds. More generous credit terms may have to be extended and the investments in accounts receivables may require additional funds. The degree of competition is thus an important factor influencing working capital requirements. Taxation: Tax liability is an inescapable element in working capital planning. It is a short-term liability payable in cash. Advance taxes may have to be remitted in installments, on the basis of estimated profits. Periods of high taxation impose additional strain on working capital. To be able to get the best out of the available tax incentives, the finance manager has to draw up the operating plans of the company in advance and steer the resources towards research and development, exports or other directions which promise tax benefits and promote company earnings. Price Level Changes: The frequent rising prices create the need for more funds for maintaining the present volume of activity. For some levels inventories, higher cash out lags are needed. In an inflationary set up, even operating expenses will grow for given levels of activity. Some companies may be able to compensate parts of these cost increases through increases in prices for their products. The implications of changing price levels on working capital position will vary from company to company depending on the nature of its operations and its standing in the market. Transportation & Communication Developments: In a country, where the means of transport and communication are not well developed, industries may need additional funds to maintain large quantities of inventory of raw materials and other accessories. On the other hand, in a country where these facilities are well developed, the industries need not maintain large quantity of raw materials inventory.

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8.7 SUMMARY The amount of money/investment needed to finance the day-to-day requirements is known as working capital. It has two concepts namely gross working capital which represents the total of current asset and net working capital which represents the excess of current assets over current liabilities. Though the amount of investment in current assets fluctuates due to seasonal factors, there should be a bare minimum investment is current assets that is called the permanent working capital. The further requirements may vary with changes in the levels of production and sales activity is known as variable working capital. capital. The length of time required to convert cash into raw material work in process finished goods, receivables and back to cash is known as operating cycle. The sum total of investment stagecycle. wise in operating cycle will be the total of working capital requirements. While the required permanent working capital can be financed through long term sources like common stock, preference stock, bonds etc and the variable working capital may be financed through short term sources like bank loan, trade creditors, commercial papers etc. A wide variety of factors influence the total working capital requirements are promotional and formative phase, nature of business manufacturing cycle, credit terms to customers, production policies, growth and expansion of firm, profit levels, dividend policy, depreciation, operating efficiency etc. The external factors include business cycle, technological developments, shifts in demand, taxation, price level changes, vagaries in supply of raw material, competitive condition and transport and communication developments. 8.8 ANSWERS TO CHECK YOUR PROGRESS EXERCISE 1. Current asset is one the asset which can be converted into cash within a reasonable period of time normally a year is traded as reasonable period of time normally a year is treated as reasonable time. 2. The sum total of current assets is known as gross working capital.

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3. The following are current assets. Cash, bank, stock, receivables, prepaid expenses, short term investments etc. 4. Operating cycle is the time lag required to complete one cycle which takes place between the various activities like cash into raw material, raw material to work-in-process, work-in-process to finished goods, finished goods to receivable and finally receivable to cash. 5. The company's production and sales are subject to seasonal factors of availability of raw material, market demand etc, the level of investment in current assets also fluctuates in current assets all the time. This minimum level is called permanent working capital. 8.9 MODEL EXAMINATION QUESTIONS 1. The difference between current assets and current liabilities is

_____________________. 2. The operating cycle has _______________ stages. 3. Permanent working has to be financed through ____________________________. 4. The determinants of working capital are classified as ______________ factors and ___________________. 5. Current asset is an asset converted within a period of __________ year. 6. List out the Stages in operating cycle. 7. How do you provide variable working capital? 8. Mention the external determinants of working capital. 9. Explain the importance of working capital. 8.10 REFERENCE Kuchhal S.C. Pandey IM. Brigham EF Gitman L.J

: : : :

Financial management, Chaitanya Publishing House Allahabad. Financial management, Vikas Publishing House Put Ltd. New Delhi. Fundamentals of Financial Management Dryden Press, Chicago Principles of Managerial Finance Harper Row, New York.

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Prasanny Chandra:

Financial Management Theory and Practice Tata McGraw Hill, New Delhi.

UNIT 9: DIVIDEND DECISIONS Content 9.0 Aims and Objectives 9.1 Introduction 9.2 Residual Dividend Policy 9.3 Alternatives to Cash Dividend 9.4 Dividend Decisions 9.5 Dividend Policy 9.6 Nature of Dividends 9.7 Nature of Earnings 9.8 Dividend Theories 9.9 Factors Influencing Dividend Decisions 9.10 Stability 9.11 Forms of Dividends 9.12 Summary 9.13 Answers to Check Your Progress 9.14 Model Examination Questions 9.15 References 9.0 AIMS AND OBJECTIVES This unit concentrates on presenting the meaning of dividend, its importance in corporate sector, the theories related to payment of dividend and factors that influence the dividend decisions. After going through this unit, you will be able to: understand the meaning of dividend explain the theories of dividend distinguish between cash dividend and non-cash dividend and

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list out the factor influencing the dividend decision.

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9.1 INTRODUCTION Dividend is the amount of returns payable to the shareholders for their investment. The dividend is normally paid out of profits. If the company does not earn profit in a particular year, the chances of paying dividend is remote unless they have accumulated surplus. The company can use the earnings to pay dividends to the share holders or use the same funds for some other purpose. When dividends are paid to the shareholders the firm's cash is going to be increased. A company may reduce the dividends and use the same funds for expansion to clear off some debts or increase investment and return debt. 9.2 RESIDUAL DIVIDEND POLICY The most prominent dividend policy based on the internal financing which is cheaper than external financing is the "Residual Dividend Policy." Funds for corporate investment come from borrowing, retained earnings and sale of shares. Retained earnings and sale of securities form equity investment. In each period management determines the proportion of new investments to be financed by borrowing and by equity. The desired proportions depend on financial market conditions and on target debt level set by management. The dividend under a residual dividend policy equals the amount left over from earnings after internal financing. 9.3 ALTERNATIVES TO CASH DIVIDENDS Sometimes companies may follow low dividends or no dividends, but issue bonus shares (new allotment of shares to the existing shareholders in proportionate to their current holdings) from time to time (roughly equivalent to stock dividends in USA). Along with dividends, some gifts or coupons to buy the company's products at a confessional rate are also given. In USA, many companies allow the shareholders to request the company not to pay them a dividend but instead it should automatically re-invest the dividend in the company's shares. Another attraction to the existing shareholders is the offer to the shareholders the chance to purchase net shares at a discount below the shares market price.

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9.4 DIVIDEND DECISIONS One of the important functions of financial management is dividend decision. There is lot of discussion over the subject matter of dividend. Some argued that dividend is irrelevant, after all the common stockholders are the ultimate residual owners of an enterprise when the whole assets belong to them where is the need to pay dividend. As long as the return is more than the cost it is advisable to invest or divert the resources for expansion of the project so that wealth maximization could be achieved. There is another version who believe that the profit earned by a company will not become the property of shareholders until they are declared as dividends. You may recollect the business entity concept where the owners is totally different from business. The common stockholders in anticipation of some return they invest their money. If they are not paid any dividend at the end of year, naturally they are disappointed. Moreover, dividend is to be paid because of the following reasons. a) b) c) The management has to prove their professional ability to earn profits The management has retain the interest of investors in the company and The management has to attract the prospective shareholders by paying

dividends at consistent rate to the existing shareholders. However, the company has to formulate a sound dividend policy. The dividend policy of a company is concerned with the determination of the division of earnings between dividend payout and retained earnings. This will affect the company's structure, liquidity, the flow of funds, market prices of shares etc. Therefore, careful consideration and judgment are required in taking sound dividend decisions aimed at maximizing shareholders earnings. 9.5 DIVIDEND POLICY You are aware that dividend is a portion of earnings that is payable to the shareholders. Normally, the directors will declare in the annual general meeting of the company. Dividends represent a distribution of the book surplus accompanied by a distribution of assets or by a change in the form of equities or an increase in the liabilities of the corporation. In the words of

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J.J.Hanson the rate of dividend is the amount of distributed profit as percentage of the nominal value of the share capital to which it relates. The dividend policy of the company includes all aspects of dividend payout such as percentage of payment, retained earnings, stability of earnings, timing of dividend payments, methods of payment, cash, bonus shares etc. The dividend policy should be determined in terms of its impact on the shareholders earnings. The ideal dividend policy is one which maximizes the market value per share. 9.6 NATURE OF DIVIDEND DECISION The dividend decision plays a crucial role in financial management. The finance manager has to determine the amount of profit to be distributed among shareholders and the amount of profit to be retained in the business for financing its long-term growth. There is a reciprocal relationship between the cash dividends and retained earnings. The larger cash dividends smaller will be the retained earnings and vice-versa. While taking a dividend decision, the management has to take into account the effect of the decision on the maximization of shareholders earnings. In case the payment of dividend helps the management in achieving this objective, it would be advisable to pay dividend. In case the payment does not help in achieving this objective, it is better to retain and use them for financing investment programmes. Thus, dividend decision is essentially a financing decision. 9.7 NATURE OF EARNINGS The dividend decision is prepared by the measurement of earnings. The percentage of payment of dividend pay out ratio. It depends upon the approach followed in measuring the earnings. Some opine that the net earnings shown in final accounts do not reflect the true ability of the company to pay dividends as it does not take into account the cash flows (which is the sum of earnings and depreciation). Therefore, it is better to relate dividends directly to cash flows. If this is accepted automatically the percentage of payout will drop the lower levels because the cash receipts by the share holders will be less than the earnings per share. However, in the years to come the pay out ratio will become stable. Weston and Brigham states that the stability of

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payout ratio will depend on several other factors, it need not be attributed to the simple cash flow nature of earnings. 9.8 DIVIDEND THEORIES There are two popular schools debated on dividend decisions. They contradict each other regarding the impact of dividend decision on the valuation of firm. One school associate with Gorden and John Linter James Walter and Richard has advocated the residual dividend theory. According to them the shareholders prefer the retaining of earnings in the company instead of paying them out in dividends as long as the return is more than cost. For instance, if the company can earn 15% rate of return on reinvested fund, whereas it would earn only 8% outside in such a case the shareholder prefers the former one. Moreover, if the company wants to pay dividend and raise fresh capital, it will have to incur additional cost of floating associated with fresh issue. If the acceptable and profitable opportunities are plenty for the company and the dividend payout will be zero. The absence of opportunities force the company to pay out the profits to the shareholders. According to Gordon and other the firms dividend policy has a profound effect on the firm's position in the stock market. Higher the dividend the higher is the value of the shares and viceversa. This is because dividends testify the firm's profitability. A company must declare sufficient dividends to meet the expectations of the investors in order to maximize the net worth of the business. The second school of thought associated with Miller and Modiglani (MM) holds that the payment of dividends is irrelevant, the shareholders do not differentiate between dividends and capital gains. They argue that shareholders being the real owners of the firm need not be paid any dividends. Their basic desire is to earn higher returns on the investment than the cost of retained earnings; the investors will be content with the firm retaining the earnings. However, if the expected return on projects is likely to be less than what it cost, the investors prefer to secure dividends or capital gain. They further state that the value of the company is determined basically by its earnings or investment policy and not by its earnings or investment policy and not by the dividend policy. The company's decision as regards the dividend payout or retained earnings does not affect the value of the firm.

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Assumptions for MM Approach. 1. Capital markets are considered perfect: All investors are presumed to be rational and market information is available free of cost to all. Further, no single investor is going to influence the market price of share significantly. 2. Flowing and transaction costs are nil. 3. There are neither taxes nor any differences in the tax rates applicable to capital gains and dividends. 4. Investment policy of the firm will remain unchanged. 5. There does not exist any risk or uncertainty as to the profits of the company. The investors will be able to forecast the future prices and dividends with certainty. 9.9 FACTORS INFLUENCING DIVIDEND DECISION From the above discussions, two schools of thoughts of dividend decisions tell us that dividends do not affect the market price of shares. But, there is lot evidence that many factors are influencing the value of shares in the stock exchange. Therefore, there is need to know the factors which affect the dividend policy of a firm.

a) Stage of growth of the company


When a company is in a growing stage with profitable and acceptable investment opportunities promising higher rates of return than what shareholders could earn outside the company prefers to retain the major portion of earnings, otherwise there is no reason to withhold the earnings. It is clear that during the development stage. Companies resort for lower rate of dividend and higher amount of retained earnings. Stability of Earnings If a company is earning consistently stable earnings, it will be able to pay higher dividend than an enterprise with fluctuating earnings. The stability or otherwise depends upon the nature of business. A company, which is sure of future earnings can pay higher dividend, but, a company with fluctuating earnings should retain a major portion of its earnings in order to maintain its position during the years of insufficient or low profits.

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Economic Conditions The general state of economy to a great extent affects the managements decision to retain or distribute earnings of the firm. In uncertain economic conditions management prefers to retain earnings rather than distribution. Similarly, during depression funds are withhold to preserve company's liquidity position. In the periods of boom and prosperity, the management will not pay dividends, though the largeness of the earnings warrant it, because of the availability of larger profitable investment opportunity. Liquidity As you know that payment of dividends involve cash payment. When there is cash outflow, naturally the liquidity position of the company is impaired. Though a company has sufficient profits, it may not be in a position to pay dividends as it results in decrease of cash resources. If the company is in growing stage it requires huge investments in fixed and working capital. Then it may not find it viable to pay larger dividends. Company's Ability to Borrow A well-established organization with sound credibility in the market will have easy access to capital market and will not have any difficulty in the matter of borrowing from external sources. The greater the ability of the firm to borrow, the greater is its flexibility and its ability to pay cash dividends or to finance its investment opportunities. Tax Liability of Shareholders In a closely held corporation, if the tax liability of the shareholders is high in a particular year, they prefer to retain the profit in the company itself. Whenever the tax liability is low they prefer to have higher rate of dividend. The Interest Liability of the Company You have already learned that the cost of debt capital is cheaper than cost of equity capital. The interest on debt is tax exempted i.e., before tax. But, the dividend payable is after tax. However, debt capital has its own disadvantages when the company is not performing well. In such a case it is better to redeem the debt so as to get rid off from the interest payment liability. Naturally, this kind of situation is going to influence the dividend decision.

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Market Conditions The way the stock market would probably respond to various types of dividend. Dividend policies affects the dividend decisions. Shareholders are generally believed to prefer an increasing or at least constant fixed level of dividends and resent the decline in the dividends per share. Similarly, the stock market gives importance not only to a fixed or increasing level of dividend but also to a policy of continuous dividend payment. The skipping of dividends may lead to fall in the price of the share. Shareholders also view the firm's dividend payments as an indicator of future success. Thus, the stock market looks at the firm's dividend as a source of information. Legal, Contractual and Internal Constraints The contract between the company and its creditors or between the company and its preference share holders may include restraints on the firm's freedom to declare dividends and other activities for the protection of lender's or preference shareholders investment. For example term lending institutions in sanctioning the loan to a new sick company may restrict the amount of dividends (such as 6% or 10%) which could be paid to its shareholders. This is to ensure the recovery of loan as well as to prevent possible declining of funds. Preference stock contracts which provide cumulative dividends to preference shareholders stipulate that there will be no dividend payment to equity shareholders until current and all unpaid preference dividends have been paid. In USA, most state laws provide that dividends in the form of cash or property may not exceed retained earnings (accumulated profits) plus surplus. That is the company may not pay dividends if the owner's equity (Assets minus liability) is no greater than the outstanding stock's total par (legal) value. The requirement is imposed to ensure that the assets of the firm exceed liabilities by a minimum cushion in order to protect the lenders. The firm's ability to pay dividends is generally limited by the amount of extra cash available. Of course a firm may borrow cash and then pay dividend. However, in that case it is likely that the minimum dividends will be paid.

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9.10 STABILITY OF DIVIDENDS As already you have observed every shareholder of any company expects return over the investment in the form of dividend. The factors that will affect the dividends have been discussed. These factors were considered, will ensure the stability of dividends. Stability of dividends means a sort of consistency in the payment of dividends. It is a regular payment of certain amounts as dividends. It is believed that if a company pays out the relatively stable dividend over a longer period, the market price of the share will be relatively higher than that of the shares of a company whose dividends have been fluctuating every year. The stability could be in the following forms: Constant Dividend Per Share Whenever a company pays a fixed amount of dividend per share every year it is called constant dividend. For example, a company pays $3 per share having a face value of $10. This amount is paid irrespective of the level of earnings of the company year after year. Constant Percentage Sometimes the companies may pay dividend as a percentage of the face value of the share. Stable Dividend Plus Extra Dividend Under this method, the corporation usually pays a fixed dividend per share to the shareholders. However, in the years of prosperity additional or extra dividend is paid over and above the regular dividend. This extra dividend is frozen as soon as normal condition returns.

Check Your Progress Exercise


1. Dividend is the amount payable to a. b. c. d. a. b. Money suppliers Employees of an organization Trade unions Shareholders Profits Capital

2. Dividends are normally paid out of

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c. d. a. b. c. d. a. b. c. d. a. b. c. d. a. b. c. d. a. b. c. d. a. b.

Borrowings General reserve Existing shareholders Employees working in the organization Creditors of the company Directors of the company Decrease in cash Increase in cash No effect on cash None of the above Weston Brigham James C. Van Horne Miller and Modiglani None of the above Growth and expansion Legal constraints Stability of earnings All of the above Constant dividend per share Constant percentage Stable dividend plus extra dividend All of the above Extra financing Internal financing c. Long term financing d. Short term financing

3. Bonus shares are issued to:

4. Payment of dividends involve

5. Dividend theories are associated with the following

6. Which one of the following effect dividend decision

7. Stability of dividends could be achieved by

8. Residual dividend policy is concerned with

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9.11 FORMS OF DIVIDENDS There are various methods of paying dividends to the shareholders. As we have seen various factors are going to influence the dividend decisions. The company may resort for anyone of the following methods of dividend payment. 1. Cash Dividend This is the usual method of paying dividend to the shareholders. Sometimes a company may not have enough cash balance when cash dividends are declared, in such a case the company has to borrow funds. Whenever they follow stable dividend policy, it can foresee the future dividend requirements and accordingly the cash budget will be prepared. But, when it follows unstable dividend policy then it will become very difficult to meet in the absence of sufficient cash balance. The cash account and reserves account will be reduced when the cash dividend is paid. Thus, the total assets and net worth of the company are reduced when the dividend is paid. The market price of the share also drops in most cases by the amount of the cash dividend paid. 2. Bonus Shares An issue of bonus shares represents a distribution of share in addition to the cash dividend (stock dividend) to the existing shareholders. This has the effect of increasing the number of shares of the company. The shares are distributed proportionately. Thereby the shareholder retains his proportionate ownership of the company. It helps the firm to conserve cash balance and enhance company credibility. 3. Share Splits The stock split is not a form of dividend, but its effects are similar to the effects of bonus shares. A share split is a method to increase the number of outstanding shares through a proportional reduction in the par value of the share." A share split affects only the par value and the number of outstanding shares, the shareholders total fund remains unaltered. The main objectives are a) to make share attractive b) to indicate higher future profits and c) increased dividends.

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4. Reverse Split Under their situation of falling price of a company's share, the company may want to drop the market price per share. The reduction of the number of outstanding shares by increasing per share value is known as a reverse split. 9.12 SUMMARY The earnings after dividends have been paid become retained earnings. Retained earnings is source of long term financing, the dividend decision can also be considered as financing decision. The dividend decision is made by the company's board of directors. The amount or percentage has to be set by the board. The factors affecting dividend decisions are growth and expansion of the firm, stability of earnings, economy, liquidity, ability to borrow, tax position of shareholders and company, interest charge payment, legal constraints etc. The debate about the dividend policy is: Does dividend decision matter? Should a firm have dividend policy? Proponents of the view that the dividend policy is irrelevant, mainly Modiglani & Miller, maintain that tax biases favoring capital gains and transaction costs are not substantial. Gordon and others maintain that in the absence of its limiting assumptions M&M hypothesis fails. The residual dividend policy assumes that internal financing is cheaper than external financing and dividends are paid after required internal financing is met out of earnings. Firms sometimes pay low or zero dividends, compensating the shareholders by periodic bonus shares. Other dividend policies include, giving gifts, coupons to by firm's merchandise at discount and the offer of rights shares. 9.13 ANSWERS TO CHECK YOUR PROGRESS EXERCISE 1. d 2. a 3. a 4. a 5. c 6. d 7. a 8. b

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9.14 MODEL EXAMINATION QUESTIONS 1. What is the nature of dividend? 2. State the assumptions underlying the M&M theory. 3. What are the methods of identifying the stability of dividends? 4. Explain the residual theory of dividend. 5. What is the relevance of dividends? 9.14 REFERENCES Kuchhal S.C. Pandey IM. Brigham EF Gitman L.J

: : : :

Financial management, Chaitanya Publishing House Allahabad. Financial management, Vikas Publishing House Put Ltd. New Delhi. Fundamentals of Financial Management Dryden Press, Chicago Principles of Managerial Finance Harper Row, New York. Financial Management Theory and Practice Tata McGraw Hill, New Delhi.

Prasanny Chandra:

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