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amount of time. For example 100 Rupees of todays money held for a year at 5 percent interest is worth 105 Rupees, therefore 100 Rupees paid now or 105 Rupees paid exactly one year from now is the same amount of payment of money with that given interest at that given amount of time. This notion dates at least to Martín de Azpilcueta of the School of Salamanca. All of the standard calculations for time value money derive from the most basic algebraic expression for the present value of a future sum, "discounted" to the present by an amount equal to the time value of money. For example, a sum of FV to be received in one year is discounted (at the rate of interest r) to give a sum of PV at present: PV = FV — r·PV = FV/(1+r). Some standard calculations based on the time value of money are: Present Value The current worth of a future sum of money or stream of cash flows given a specified rate of return. Future cash flows are discounted at the discount rate, and the higher the discount rate, the lower the present value of the future cash flows. Determining the appropriate discount rate is the key to properly valuing future cash flows, whether they be earnings or obligations. Present Value of a Annuity An annuity is a series of equal payments or receipts that occur at evenly spaced intervals. Leases and rental payments are examples. The payments or receipts occur at the end of each period for an ordinary annuity while they occur at the beginning of each period for an annuity due. Present Value of a Perpetuity is a constant stream of identical cash flows with no end. Future Value is the value of an asset or cash at a specified date in the future that is equivalent in value to a specified sum today. Future Value of an Annuity (FVA) is the future value of a stream of payments (annuity), assuming the payments are invested at a given rate of interest. Compound Value – We have thus developed a logic for deciding between cash flows that are separated by one period, such as one year. But most investment decisions involve more than one period. To solve such complicated investment decisions, we simply need to extent the logic developed above. Present Value – This process work in the reverse direction of Compound Value – working from future cash flows to their present values. The present value of a future cash inflow maker, to a specified amount of cash to be received or paid at a future date. The process of determining present value of a future payment (or receipts) or a series of future payments (or receipts) is called discounting. The compound interest rate used for discounting cash flows is also called the discount rate.
DISCOUNTED CASH FLOW - Net Present Value Method - NPV compares the value of a Rupee today to the value of that same Rupee in the future, taking inflation and returns into account. If the NPV of a prospective project is positive, it should be accepted. However, if NPV is negative, the project should probably be rejected because cash flows will also be negative. Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms , where -- t - the time of the cash flow i - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.) Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t (for educational purposes, R0 is commonly placed to the left of the sum to emphasize its role as (minus the) investment. Acceptance Rule – Accept if NPV > 0 (positive), Reject if NPV < 0 (negative) Merits – consider all cash flows, true measure of profitability, based on the concept of the time value of money, satisfies the value-additivity principle, consistence with wealth maximisation principle Demerits – Requires estimates of cash flows which is a tedious task, Requires computation of the opportunity cost of capital which poses practical difficulties, sensitive to discount rates Internal Rate of Return Method (IRR) - The internal rate of return (IRR) is a capital budgeting metric used by firms to decide whether they should make investments. It is also called discounted cash flow rate of return (DCFROR) or rate of return (ROR). It is an indicator of the efficiency or quality of an investment, as opposed to net present value (NPV), which indicates value or magnitude. Instead of converting to the present we can also convert to any other fixed time; the value obtained is zero if and only if the NPV is zero. Acceptance Rule – Accept if IRR > k, Reject if IRR < k, Project may be accepted if IRR = k. Merits – considers all cash flows, true measure of profitability, based on the concept of time value of money, generally consistent with wealth maximisation principle. Demerit – requires estimates of cash flows which is a tedious task, does not hold the value-additivity principle, At times fails to indicate correct coice between mutually exclusive projects, At times yields multiple rates, Relatively difficult to compute Profitability Index - An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0 would indicate that the project's PV is less than the initial investment. As values on the profitability index increase, so does the financial attractiveness of the proposed project. Acceptance Rule – Accept if PI > 1.0, Reject if PI < 1.0, Project may be accepted if PI = 1.0 Merits – Considers all cash flows, Recognises the time value of money, Relative measure of profitability, Generally consistent with the wealth maximisation principle. Demerits – Requires estimates of the cash flows which is a tedious task, At times fails to indicate correct choice between mutually exclusive projects. NON DISCOUNTED CASH FLOW Payback (PB) - the number of years required to recover the initial outlay of the investment is called payback. PB = Initial Investment / Annual cash flow = Co / C Acceptance Rule – Accept if PB < standard payback, Reject if PB > standard… Merits – Easy to understand and compute and inexpensive to use, Emphasis liquidity, easy and crude way to cope with risk, Uses cash flows information Demerits – Ignores the tome value of money, ignores cash flows occurring after the payback periods, not a measure of profitability, no objective way to determine the standard payback, no relation with the wealth maximisation principle. Discount Payback – The number of years required in recovering the cash outlay on the present value basis is the discounted payable period. Except using discounted cash flows in calculating payback, this method has all the demerits of payback method. Accounting rate of return (ARR) – An average rate of return found by dividing the average profit [EBIT (1 – T)] by the average investment. ARR = Average profit / Average investment Acceptance Rule – Accept if ARR > minimum rate, Reject if ARR < minimum rate Merits – Uses accounting data with which executives are familiar, Easy to understand and calculate – Demerits – Ignores the time value of money, Does not use cash flows, Gives more weightage to future receipts, No objective way to determine the minimum acceptable rate of return.
Annuity Due - An annuity due requires payments to be made at the beginning of the period. For example, in many lease arrangements, the first payment is due immediately and each successive payment must be made at the beginning of the month. The concepts of compound value and present value of an annuity discussed earlier are based on the assumption that series of payments are made at the end of the year. In practice, payments could be made at the beginning of the year. Multi period Compounding – In practice, cash flows can occur more than once a year. For example, banks may pay interest on savings account quarterly. On bonds or debentures and public deposits, companies may pay interest on savings account quarterly. On bonds or debentures and public deposits, companies may pay interest semi-annually. Similarly, financial institutions may require borrowers to pay interest quarterly or half-yearly. Its also called as Continuous Compounding. Rate of Return - Rate of return (ROR), also known as Return on Investment (ROI), rate of profit or sometimes just return, is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principal, or the cost basis of the investment. ROI is usually expressed as a percentage rather than a fraction. Investment Decisions – Investment Decisions / Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures. Many formal methods are used in capital budgeting, including the techniques such as - Net present value, Profitability index, Internal rate of return, Modified Internal, Rate of Return, Equivalent annuity Features – the exchange of current funds for future benefits, the funds are invested in long-term assets, the future benefits will occur to the firm over a series of years. Importance – They have long-term implications for the firm, and can influence its risk complexion, They involve commitment of large amount of funds, They are irreversible decisions, They are among the most difficult decisions to make. Types – Expansion of existing business, Expansion of new business, Replacement and modernisation. Investment Evaluation Criteria – 3 Steps -> Estimation of cash flows, Estimation of the required rate of return Characteristics – It should -- consider all cash flows to determine the true profitability of the project, provide for an objective and unambiguous way of separating good projects from bad projects, help ranking of projects according to their true profitability.
Cash Flow Vs Profit – The estimation of cash flows, though difficult, is the most crucial step in investment analysis. Cash flows are different from profits. Profit is not necessarily cash flow; it is the difference between revenue earned and expenses incurred rather than cash received and cash paid. Also, in the calculation of profits, an arbitrary distinction between revenue expenditure and capital expenditure is made. Cash flows should be estimated on incremental basis. Incremental cash flows are found out by comparing alternative investment projects. The comparision may simply be between cash flows with and without the investment proposal under consideration when real alternatives do not exist. Three components of cash flow can be identified – (1) Initial investment with comprise the original cost (including freight and installation charges) of the project, plus an increase in working capital. (2) Annual net cash flow is the difference between cash inflows and cash outflows including taxes. Tax computations are based on accounting profits. Care should be taken in properly adjusting depreciation while computing net cash flows. Depreciation is a noncash item, but it affects cash flows through tax shield (3) terminal cash flows are those which occur in the project’s last year in addition to annual cash flows. They would consist of the salvage value of the project and working capital released (if any). In case of replacement decision, the foregone salvage value of old asset should also be taken into account. COST OF CAPITAL - The cost of capital is an expected return that the provider of capital plans to earn on their investment. Capital (money) used for funding a business should earn returns for the capital providers who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. In other words, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital. The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid. In practice, the interest-rate paid by the company will include the risk-free rate plus a risk component, which itself incorporates a probable rate of default (and amount of recovery given default). For companies with similar risk or credit ratings, the interest rate is largely exogenous. Components - Cost of debt - The cost of debt is computed by taking the rate on a risk free bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. Basically this is used for large corporations only. The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax rate and Rf is the risk free rate. Cost of equity - Cost of equity = Risk free rate of return + Premium expected for risk. Expected return - The expected return (or required rate of return for investors) can be calculated with the "dividend capitalization model", which is That equation is also seen as, Expected Return = dividend yield + growth rate of dividends. Capital asset pricing model - The capital asset pricing model (CAPM) is used in finance to determine a theoretically appropriate price of an asset such as a security. The expected return on equity according to the capital asset pricing model. The market risk is normally characterized by the β parameter. Thus, the investors would expect (or demand) to receive: Where: Es - The expected return for a security Rf - The expected risk-free return in that market (government bond yield) βs - The sensitivity to market risk for the security RM - The historical return of the stock market/ equity market (RM-Rf) - The risk premium of market assets over risk free assets. Weighted average cost of capital - The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital. The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company's market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes). Notice that the "equity" in the debt to equity ratio is the market value of all equity, not the shareholders' equity on the balance sheet. To calculate the firm’s weighted cost of capital, we must first calculate the costs of the individual financing sources: Cost of Debt Cost of Preference Capital Cost of Equity Capital. Capital structure - Because of tax advantages on debt issuance, it will be cheaper to issue debt rather than new equity (this is only true for profitable firms, tax breaks are available only to profitable firms). At some point, however, the cost of issuing new debt will be greater than the cost of issuing new equity. This is because adding debt increases the default risk - and thus the interest rate that the company must pay in order to borrow money. By utilizing too much debt in its capital structure, this increased default risk can also drive up the costs for other sources (such as retained earnings and preferred stock) as well. Management must identify the "optimal mix" of financing – the capital structure where the cost of capital is minimized so that the firm's value can be maximized. Modigliani-Miller theorem - If there were no tax advantages for issuing debt, and equity could be freely issued, Miller and Modigliani showed that, under certain assumptions, the value of a leveraged firm and the value of an unleveraged firm should be the same. Their paper is foundational in modern corporate finance.
RISK - A fundamental idea in finance is the relationship between risk and return. The greater the amount of risk that an investor is willing to take on, the greater the potential return. The reason for this is that investors need to be compensated for taking on additional risk. For example, a U.S. Treasury bond is considered to be one of the safest investments and, when compared to a corporate bond, provides a lower rate of return. The reason for this is that a corporation is much more likely to go bankrupt than the U.S. government. Because the risk of investing in a corporate bond is higher, investors are offered a higher rate of return. Techniques – Payback – It is one of the oldest and commonly used methods for explicitly recognising risk associated with an investment project. The merit of payback is its simplicity. Also payback makes an allowance for risk by (i) focusing attention on the near term future and thereby emphasising the liquidity of the firm through recovery of capital and (ii) by favouring short term projects over what may be riskier, longer term projects. Risk-Adjusted Discount Rate - In Portfolio Theory and Capital Budget analysis, the rate necessary to determine the Present Value of an uncertain or risky stream of income; it is the risk-free rate (generally the return on short-term U.S. Treasury securities) plus a risk premium that is based on an analysis of the risk characteristics of the particular investment or project. Evaluation – It is simple and can be easily understood, It has a great deal of intuitive appeal for risk-averse businessman, It incorporates an attitude (risk-aversion) towards uncertainty. Certainty Equivalent - This is useful in determining what return investors will require from your company. In other words, at what return would an investor in a certain (risk-free) investment be enticed to invest in your higher paying, yet more risky, investment. Evaluation – The certainty equivalent approach explicitly recognises risk, but the procedure for reducing the forecasts of cash flows is implicit and likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that will be made in his forecasts, may inflate them in anticipation. Second, if forecasts have to pass through several layers of management, the effect may be greatly exaggerate the original forecast or to make it ultra conservative. Third, by focussing explicit attention only on the gloomy outcomes, changes are increased for passing by some good investments. Sensitivity analysis - A technique used to determine how different values of an independent variable will impact a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that will depend on one or more input variables, such as the effect that changes in interest rates will have on a bond's price. Sensitivity analysis is a way to predict the outcome of a decision if a situation turns out to be different compared to the key prediction(s). Pros – It compels the decision maker to identify the variables which affect the cash flow forecasts. This helps him in understanding the investment project in totality. – It indicates the critical variables for which additional information may be obtained. The decision maker can consider actions which may help in strengthening the ‘weak spots’ in the project. Cons – It does not provide clear cut results. The terms ‘optimistic’ and ‘pessimistic’ could mean different things to different persons in an organisation. - It fails to focus on the interrelationship between variables. FINANCIAL LEVERAGE - Financial leverage (FL) takes the form of a loan or other borrowings (debt), the proceeds of which are (re)invested with the intent to earn a greater rate of return than the cost of interest. If the firm's rate of return on assets (ROA) is higher than the rate of interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow because assets = equity + debt (see accounting equation). On the other hand, if the firm's ROA is lower than the interest rate, then its ROE will be lower than if it did not borrow. Leverage allows greater potential returns to the investor that otherwise would have been unavailable but the potential for loss is also greater because if the investment becomes worthless, the loan principal and all accrued interest on the loan still need to be repaid. Margin buying is a common way of utilizing the concept of leverage in investing. An unleveraged firm can be seen as an all-equity firm, whereas a leveraged firm is made up of ownership equity and debt. A firm's debt to equity ratio is therefore an indication of its leverage. Measures of financial leverage – The Ratio of debt to total capital – i.e., L1 = (D / D+S) = D/V, where D is value of debt, S is value of equity and V is value of total capital. D and S may be measured in terms of book value or market value. The book value of equity is called net worth. The ratio of debt to equity i.e., L2 = D/S The ratio of net operating income (or EBIT) to interest charges, i.e., L3 = EBIT / Interest OPERATING LEVERAGE - The operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky (volatile) a company's operating income is. There are various measures of operating leverage, which can be interpreted analogously to financial leverage. Costs - One analogy is "fixed costs + variable costs = total costs ..similar to.. debt + equity = assets". This analogy is partly motivated because (for a given amount of debt), debt servicing is a fixed cost. This leads to two measures of operating leverage: One measure is fixed costs to total costs: (FC/TC) = FC / (FC+VC). Compare to debt to value, which is (Debt/Assets) = Debt / (Debt + Equity) Another measure is fixed costs to variable costs: FC/VC. Compare to debit to equity ratio: Debt/Equity Contribution: Contribution margin is a measure of operating leverage: the higher the contribution margin is (the lower variable costs are as a percentage of price), the faster profits increase with sales. Note that unlike other measures of operating leverage, in the linear Cost-Volume-Profit Analysis Model, contribution margin is a fixed quantity, and does not change with Sales.
CAPITAL STRUCTURE - A mix of a company's long-term debt, specific shortterm debt, common equity and preferred equity. The capital structure is how a firm finances its overall operations and growth by using different sources of funds. Debt comes in the form of bond issues or long-term notes payable, while equity is classified as common stock, preferred stock or retained earnings. Short-term debt such as working capital requirements is also considered to be part of the capital structure. A company's proportion of short and long-term debt is considered when analyzing capital structure. When people refer to capital structure they are most likely referring to a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually a company more heavily financed by debt poses greater risk, as this firm is relatively highly levered. The management of a company should seek answers to the following questions while making the financing decisions: - How should the investment project by financed, - Does the way in which the investment projects are financed matter, - How does financing affect the shareholders’ risk, return and value, - Does there exist an optimum financing mix in terms of the maximum value to share-holders of a company, - Can the optimum financing mix be determined in practice for a company, - What factors in practice should a company consider in designing its financing policy. Features: Profitability: The capital structure of the company should be most advantageous. With the constraints, maximum use of leverage at a minimum cost should be made. Solvency: The use of excessive debt threatens the solvency of the company. To the point debt does not add significant risk it should be used, otherwise its use should be avoided. Flexibility: The capital structure should not be inflexible to meet the changing conditions. It should be possible for a company to adapt its capital structure with a minimum cost and delay. Capacity The capital structure should be determined within the debt capacity of the company, and this capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash flows. It should have enough cash to pay creditors’ fixed charges and principal sum. Control The capital structure should involve minimum risk of loss of control of the company. The owners of closely-held companies are particularly concerned about dilution of control. Three common approaches – EBIT-EPS Analysis – The use of fixed cost sources of finance, such as debt and preference share capital to finance the assets of the company is known as financial leverage or trading on equity. If the assets financed with the use of debt yield a return greater than the cost of debt, the earnings per share increases when the preference share capital is used to acquire assets. Limitations – EPS variability – The EPS variability resulting from the use of leverage is called financial risk. Financial risk is added with the use of debt because of (a) the increase variability in the shareholders’ earnings and (b) the threat of insolvency. A firm can avoid financial risk altogether if it does not employ and debt in its capital increases in EPS. Therefore, a company may employ debt to the extent the financial risk perceived by shareholders does not exceed the benefit of increased EPS. The EPS criterion does not consider the long-term perspectives of financing decisions. It fails to deal with the risk-return trade-off. Operating Conditions – One very important factor on which the variability of EPS depends is the growth and stability of sales. EPS will fluctuate with fluctuations in sales. The magnitude of the EPS variability with sales will depend on the degrees of operating and financial leverages employed by the company. The firms with stable earnings and cash flows and thus, can employ a high degree of leverage as they will not face difficult in meeting their fixed commitments. Sale of the consumer goods industries show wide fluctuations, therefore, they do not employ a large amount of debt. On the other hand, the sales of public utilities are quite stable and predictable. Trade-off Theory - The Trade-Off Theory of Capital Structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the Pecking Order Theory of Capital Structure. An important purpose of the theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous payment terms, bondholder/stockholder infighting, etc). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Despite certain criticisms, the Trade-Off Theory remains the dominant theory of corporate capital structure as taught in the main corporate finance textbooks. Dynamic version of the model generally seem to offer enough flexibility in matching the data so, contrary to Miller's verbal argument, dynamic trade-off models are very hard to reject empirically.
Cash flow approach – One of the features of a sound capital structure is conservatism. Conservatism does not mean employing no debt or small amount of debt. Conservatism is related to the fixed charges created by the use of debt or preference capital in the capital structure and the firm’s ability to generate cash to meet these fixed charges. In practice, the question of the optimum (rather appropriate) debt-equity mix boils down to the firm’s ability to service debt without any threat and operating inflexibility. A firm is considered prudently financed if it is able to service its fixed charged under any reasonably predictable adverse conditions. The fixed charges of a company include payment of interest, preference dividends and principal, and they depend on both the amount of senior securities and the terms of payment. The amount of fixed charges will be high if the company employs a large amount of debt or preference capital with short-term maturity. Whenever a company thinks of raising additional debt, it should analyse its expected future cash flows to meet the fixed charges. It is mandatory to pay interest and return the principal amount of debt. Components – Operating cash flows relate to the operations of the firm and can be determined from the projected profit and loss statements. Nonoperating cash flows generally include capital expenditures and working capital changes. During a recessionary period, the firm may have to specially spend for the promotion of the product. Such expenditures should be included in the nonoperating cash flows. Financial flows includes interest, dividends, lease rentals, repayment of debt etc. DIVIDENDS - 1. A distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield. Also referred to as "Dividend Per Share (DPS)." 2. Mandatory distributions of income and realized capital gains made to mutual fund investors. 3. Dividends may be in the form of cash, stock or property. Most secure and stable companies offer dividends to their stockholders. Their share prices might not move much, but the dividend attempts to make up for this. High-growth companies rarely offer dividends because all of their profits are reinvested to help sustain higher-than-average growth. 4. Mutual funds pay out interest and dividend income received from their portfolio holdings as dividends to fund shareholders. In addition, realized capital gains from the portfolio's trading activities are generally paid out (capital gains distribution) as a year-end dividend. Types - Cash dividends (most common) are those paid out in the form of a cheque. Such dividends are a form of investment income and are usually taxable to the recipient in the year they are paid. This is the most common method of sharing corporate profits with the shareholders of the company. For each share owned, a declared amount of money is distributed. Stock or scrip dividends are those paid out in form of additional stock shares of the issuing corporation, or other corporation (such as its subsidiary corporation). They are usually issued in proportion to shares owned (for example, for every 100 shares of stock owned, 5% stock dividend will yield 5 extra shares). Property dividends or dividends in specie (Latin for "in kind") are those paid out in the form of assets from the issuing corporation or another corporation, such as a subsidiary corporation. They are relatively rare and most frequently are securities of other companies owned by the issuer, however they can take other forms, such as products and services. Other dividends can be used in structured finance. Financial assets with a known market value can be distributed as dividends; warrants are sometimes distributed in this way. For large companies with subsidiaries, dividends can take the form of shares in a subsidiary company. A common technique for "spinning off" a company from its parent is to distribute shares in the new company to the old company's shareholders. Constraints – Legal Constraints - Most state securities regulations prevent firms from paying out dividends from any portion of the company’s “legal capital” which is measured by the par value of common stock—or par value plus paid-incapital.--- Dividends are also sometimes limited to the sum of the firm’s most recent and past retained earnings— although payments in excess of current earnings is usually permitted. Contractual Constraints - In many cases, companies are constrained in the extent to which they can pay dividends by restrictive provisions in loan agreements and bond indentures. -- Generally, these constraints prohibit the payment of cash dividends until a certain level of earnings are achieved or to a certain dollar amount or percentage of earnings. Internal Constraints - A company’s ability to pay dividends is usually constrained by the amount of available cash rather than the level of retained earnings against which to charge them. Growth Prospects - Newer, rapidly-growing firms generally pay little or no dividends. -- Because these firms are growing so quickly, they must use most of their internally generated funds to support operations or finance expansion. Owner Considerations - As mentioned earlier, empirical evidence supports the notion that investors tend to belong to “clienteles” - where some prefer high dividends, while others prefer capital gains.
WORKING CAPITAL – 2 concepts – Gross concept and net concept – Gross – simply called as working capital, refers to the firm’s investment in current assets. Current assets are the assets which can be converted into cash within an accounting year (or operating cycle) and include cash, short-term securities, debtors, bills receivables and stock (inventory). Net refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year and include creditors, bills payable, and outstanding expenses. Net working capital can be positive or negative. A positive net working capital will arise when current assets exceed current liabilities. A negative net working capital occurs when current liabilities are in excess of current assets. The two concepts of working capital – gross and net – are not exclusive, rather they have equal significance from management viewpoint. The gross working capital concept focuses attention on two aspects of current assets management (a) optimum investment in current assets and (b) financing of current assets. Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Decision Criteria - By definition, working capital management entails short term decisions - generally, relating to the next one year period - which are "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or profitability. Management of working capital - Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable. Requirement – (1) Fixed assets alone cannot generate sales and profit. The managerial activities required to operate this assets in order to generate sales and profit are referred to as the firm’s operating activities. These activities require investments in the form of inventories and trade receivables that are generated by the firm’s operating cycle. (2) Operating cycle starts with procurement, the act of acquiring raw materials. It is followed by production, during which raw materials are transformed into finished goods. The cycle continuous with the sales of these goods, ending when cash is collected from customers. The cycle repeats itself as long as the firm’s production activity continuous. (3) Working capital is of two types; viz. Gross working capital and Net working capital. Gross working capital refers to the firm’s investment in current assets. Deducting current liabilities from Gross working capital results in Net working capital. (4) There are two primary sources of capital available to firms: the equity capital provided by owners (shareholders) and the debt capital provided by debt holders (lenders). Debt can be of short term, due to be repaid within a fiscal & of long term, due to be repaid after that fiscal. Thus, the firm’s total capital employed can be classified either as equity and debt capital or as Long-term financing and Short-term financing. CASH MANAGEMENT – Cash is the important current asset for the operations of the business. Cash is the basic input needed to keep the business running on a continuous basis; it is also the ultimate output expected to be realised by selling the service or product manufactured by the firm. The firm should keep sufficient cash, neither more nor less. Cash shortage will disrupt the firm’s manufacturing operations while excessive cash will simply remain idle, without contributing anything towards the firm’s profitability. Cash management is concerned with the managing of – (i) cash flows into and out of the firm, (ii) cash flows within the firm, (iii) cash balances held by the firm at a point of time by financing deficit or investing surplus cash. It can be represented by a cash management cycle. Sales generate cash which has to be disbursed out. The surplus cash has to be invested while deficit has to be borrowed. Cash management seeks to accomplish this cycle at a minimum cost. At the same, it also seeks to achieve liquidity and control. 4 facets of cash management – Cash planning, Managing the cash flows, Optimum cash level, Investing surplus cash. Why Hold Cash – transactions motive, precautionary motive, speculative motive. ACCURED EXPENSES - Accrual, in accounting, describes the accounting method known as accrual basis, whereby revenues and expenses are recognized when they are accrued, i.e. accumulated (earned or incurred), regardless when the actual cash is received or paid out. Accrued expense, in contrast, is a liability with an uncertain timing or amount, but where the uncertainty is not significant enough to qualify it as a provision. An example is an unpaid obligation to pay for goods or services received FROM a counterpart, while cash for them is to be paid out in a latter accounting period when its amount is deducted from accrued expenses. DEFERRED INCOME - Deferred income, in accrual accounting, (e.g. advance payment received from a client) is, according to revenue recognition, revenue not earned until the delivery of goods or services, which until then, is still owed to the payer, hence remaining a liability. Deferred income, sometimes referred to as deferred revenue or unearned revenue, shares characteristics with accrued expense with the difference that a liability to be covered later is cash received FROM a counterpart, while goods or services are to be delivered in a latter period, when such income item is earned, the related revenue item is recognized, and the same amount is deducted from deferred revenues.
INVENTORY - Possessing a high amount of inventory for long periods of time is not usually good for a business because of inventory storage, obsolescence and spoilage costs. However, possessing too little inventory isn't good either, because the business runs the risk of losing out on potential sales and potential market share as well. Inventory management forecasts and strategies, such as a just-in-time inventory system, can help minimize inventory costs because goods are created or received as inventory only when needed. Time – (1) The time lags present in the supply chain, from supplier to user at every stage, requires that you maintain certain amount of inventory to use in this "lead time". (2) Uncertainty - Inventories are maintained as buffers to meet uncertainties in demand, supply and movements of goods. (3) Economies of scale - Ideal condition of "one unit at a time at a place where user needs it, when he needs it" principle tends to incur lots of costs in terms of logistics. So bulk buying, movement and storing brings in economies of scale, thus inventory. All these stock reasons can apply to any owner or product stage. Buffer stock is held in individual workstations against the possibility that the upstream workstation may be a little delayed in long setup or change-over time. This stock is then used while that change-over is happening. This stock can be eliminated by tools like SMED. These classifications apply along the whole Supply chain not just within a facility or plant. TECHNIQUES - Economic order quantity is the level of inventory that minimizes the total inventory holding costs and ordering costs. The framework used to determine this order quantity is also known as Wilson EOQ Model. The model was developed by F. W. Harris in 1913. But still R. H. Wilson is given credit for his early in-depth analysis of the model. Assumptions - The ordering cost is constant., The rate of demand is constant., The lead time is fixed., The purchase price of the item is constant i.e no discount is available., The replenishment is made instantaneously, the whole batch is delivered at once., EOQ is the quantity to order, so that ordering cost + carrying cost finds its minimum. (A common misunderstanding is that formula tries to find when these are equal.) Ordering Costs - All costs associated with preparing a purchase order. These include the cost of preparing a purchase invoice, telephone, salaries of purchasing clerks, and stationery. Carrying Costs - Cost incurred for maintaining a given level of inventory are called carrying costs. They include storage, insurance, taxes, deteriorations and obsolescence. The storage costs comprise cost of storage space, clerical and staff service costs incurred in recording and providing special facilities such as fencing, lines, racks etc. ABC Analysis - ABC analysis is a business term used to define an inventory categorization technique often used in materials management. ABC analysis provides a mechanism for identifying items which will have a significant impact on overall inventory cost  whilst also providing a mechanism for identifying different categories of stock that will require different management and controls. When carrying out an ABC analysis, inventory items are valued (item cost multiplied by quantity issued/consumed in period) with the results then ranked. The results are then grouped typically into three bands. These bands are called ABC codes. ABC codes "A class" inventory will typically contain items that account for 80% of total value, or 20% of total items. "B class" inventory will have around 15% of total value, or 30% of total items. "C class" inventory will account for the remaining 5%, or 50% of total items. ABC Analysis is similar to Pareto in that the "A class" group will typically account for a large proportion of the overall value but a small percentage of the overall volume of inventory. TRADE CREDIT - Trade credit exists when one firm provides goods or services to a customer with an agreement to bill them later, or receive a shipment or service from a supplier under an agreement to pay them later. It can be viewed as an essential element of capitalization in an operating business because it can reduce the required capital investment to operate the business if it is managed properly. Trade credit is the largest use of capital for a majority of business to business (B2B) sellers in the United States and is a critical source of capital for a majority of all businesses. For many borrowers in the developing world, trade credit serves as a valuable source of alternative data for personal and small business loans. For example, Wal-Mart, the largest retailer in the world, has used trade credit as a larger source of capital than bank borrowings; trade credit for Wal-Mart is 8 times the amount of capital invested by shareholders. There are many forms of trade credit in common use. Various industries use various specialized forms. They all have, in common, the collaboration of businesses to make efficient use of capital to accomplish various business objectives. CREDIT TERMS - Standard or negotiated terms (offered by a seller to a buyer) that control (1) the monthly and total credit amount, (2) maximum time allowed for repayment, (3) discount for cash or early payment, and (4) the amount or rate of late payment penalty. The conditions under which credit will be extended to a customer. The components of credit terms are: cash discount, credit period, net period.
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