UNIT 20: Case Study

MBOF-912D

CE
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Financial Management
ES
UP
(c)

Financial Management

Course Design

CE
Advisory Council

Chairman
Dr Parag Diwan

Members
Dr Kamal Bansal Dr Anirban Sengupta Dr Ashish Bhardwaj

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Dean Dean CIO

Dr S R Das Dr Sanjay Mittal Prof V K Nangia
VP – Academic Affairs Professor – IIT Kanpur IIT Roorkee

SLM Development Team
Wg Cdr P K Gupta
ES
Dr Joji Rao
Dr Neeraj Anand
Dr K K Pandey

Print Production

Mr Kapil Mehra Mr A N Sinha
Manager – Material Sr Manager – Printing
UP

Author

Sudhindhra Bhatt

All rights reserved. No part of this work may be reproduced in any form, by mimeograph or any other means,
without permission in writing from MPower Applied Learning Enterprise.
(c)

Course Code: MBOF-912D

Course Name: Financial Management

Version: July 2013

© MPower Applied Learning Enterprise

UNIT 20: Case Study

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Contents
Block-I

Unit 1 Introduction to Financial Management ........................................................................ 3
Unit 2 Time Value of Money.................................................................................................... 21

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Unit 3 Computing Time Value of Money ................................................................................ 33
Unit 4 Short-term Sources of Financing ................................................................................. 49
Unit 5 Case Studies.................................................................................................................. 59

Block-II

Unit 6 Long-term Sources of Financing .................................................................................. 65
ES
Unit 7 Debenture/Bonds .......................................................................................................... 81
Unit 8 Venture Capital ............................................................................................................ 93
Unit 9 Factoring ..................................................................................................................... 105
Unit 10 Case Studies................................................................................................................ 117

Block-III
UP

Unit 11 Leasing ........................................................................................................................ 123
Unit 12 Economic Value Added ............................................................................................... 135
Unit 13 Risk and Return Analysis .......................................................................................... 145
Unit 14 Cost of Capital ............................................................................................................ 157
Unit 15 Case Studies................................................................................................................ 169

Block-IV

Unit 16 Capital Structure and Theories ................................................................................. 175
(c)

Unit 17 Leverages .................................................................................................................... 191
Unit 18 Fundamentals of Capital Budgeting ......................................................................... 201
Unit 19 Capital Rationing and Risk Factors in Capital Budgeting ...................................... 215
Unit 20 Case Studies................................................................................................................ 229

Financial Management
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Block-V

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Unit 21 Working Capital Management................................................................................... 237

Unit 22 Receivable Management ............................................................................................ 255

Unit 23 Inventory Management .............................................................................................. 267

Unit 24 Cash Management...................................................................................................... 279

Unit 25 Case Studies................................................................................................................ 293

Glossary ............................................................................................................................................ 299

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ES
UP
(c)

UNIT 1: Introduction to Financial Management

1

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Notes

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___________________

___________________

___________________

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___________________

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___________________

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ES
BLOCK-I
UP
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Detailed Contents Financial Management

2

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Notes
UNIT 1: INTRODUCTION TO FINANCIAL
___________________ UNIT 3: COMPUTING TIME VALUE OF MONEY
MANAGEMENT
z Introduction
___________________
z Introduction
z Calculation of the Compound Growth Rate
___________________
z Meaning of Financial Management
z Doubling Period
___________________
z Objectives of Financial Management
z Effective Rate of Interest in Case of Doubling Period
z ___________________
Scope of Financial Management
z Effective vs Nominal Rate
z ___________________
Finance Functions
z Sinking Fund Factor

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z Nature of Financial Management
___________________

Organization of the Finance Functions UNIT 4: SHORT-TERM SOURCES OF FINANCING
z ___________________

z Financial Goal – Profit Maximisation vs. Wealth z Introduction
___________________
Maximisation z Short-term Source of Finance
___________________
z Commercial Papers (CPs)
UNIT 2: TIME VALUE OF MONEY
z Inter-corporate Deposits (ICDs)
z Introduction
ES
z Concept of Time Value of Money UNIT 5: CASE STUDIES
z Valuation Concepts or Techniques
UP
(c)

The Sanskrit saying "arthah sachivah". we can say that "Finance is the backbone of every business". what Henry Ford had once ES remarked: "Money is an arm or a leg. it is also true that money begets more money. Problems include financial aspects of the promotion of new enterprises and their administration during early development. efficient management of finances. business needs money to make more money. the accounting problems connected with the distinction between . is quite meaningful. It has rightly been said that. though apparently simple. finance is one of the basic foundations of all kinds of economic activities. the students will be aware of the following ___________________ topics: -C ___________________ \ Meaning and importance of financial management \ Objectives and scope of the study of financial management ___________________ \ Organisation of finance function ___________________ ___________________ Introduction It would be worthwhile to recall. it is the master key which provides access to all the sources for being employed in manufacturing and merchandising activities. This statement. You either use it or lose it". However. only when it is properly managed. Meaning of Financial Management Business Finance is that business activity which is concerned with the acquisition and conservation of capital funds in meeting financial needs and overall objectives of business enterprises. hence. which means "finance reigns supreme".UNIT 1: Introduction to Financial Management Unit 1 3 CE Notes Activity What does corporate Introduction to Financial ___________________ finance mean? ___________________ Management ___________________ ___________________ Objectives ___________________ After completion of this unit. speaks volumes for the UP significance of the finance function of an organization. In conclusion. It brings home the significance of money or finance. In the modern money-oriented economy. (c) According to the Encyclopaedia of Social Sciences. Corporate finance deals with the financial problems of corporate enterprises.

Financial Management

4 capital and income, the administrative questions created by,

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Notes growth and expansion, and finally the financial adjustments
___________________ required for bolstering rehabilitation of a corporation which has
come into financial difficulties. Management of all these is
___________________
financial management. Financial management mainly involves,
___________________
rising of funds and their effective utilisation with the objective of
___________________ maximizing shareholders' wealth. To quote, Joseph and Massie,
___________________ "Financial Management is the operational activity of a business
that is responsible for obtaining and effectively utilising the funds
___________________
necessary for efficient operations".

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___________________
According to Van Horne and Wachowicz, "Financial Management
___________________
is concerned with the acquisition, financing and management of
___________________ assets with some overall goal in mind." Financial manager has to
___________________ forecast expected events in business and note their financial
implications. First, anticipating financial needs means estimation
of funds required for investment in fixed and current assets or
ES
long-term and short-term assets. Second, acquiring financial
resources-once the required amount of capital is anticipated, the
next task is acquiring financial resources i.e., where and how to
obtain the funds to finance the anticipated financial needs and the
last one is, allocating funds in business - means allocation of
available funds among the best plans of assets, which are able to
maximize shareholders' wealth. Thus, the decisions of financial
management can be divided into three viz., investment, financing
and dividend decision.
UP

Check Your Progress
Fill in the blanks:
1. Business Finance is wider than the ........................ .
2. ............................... Finance deals with the company
form of business.

Objectives of Financial Management
The objectives of financial management are:
(c)

Traditionally, the basic objectives of financial management have
been (1) Maintenance of liquid assets and (2) Maximization of
profitability of the firm. However, these days, there is a greater
emphasis on (3) Shareholders' wealth maximization rather than on
profit maximization.

UNIT 1: Introduction to Financial Management

5
1. Maintenance of Liquid Assets: Financial management aims

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Notes
at maintenance of adequate liquid assets with the firm to meet
its obligations at all times. However, investment in liquid ___________________
assets has to be adequate – neither too low nor too excessive. ___________________
The finance manager has to maintain a balance between
___________________
liquidity and profitability.
___________________
2. Maximization of Profit: "Profit maximization" is a term
___________________
which denotes the maximum profit to be earned by an
organization in a given time period. The profit maximization ___________________

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goal implies that the investment, financing and dividend policy ___________________
decision of the enterprise should be oriented to profit
___________________
maximization. It implies that the enterprise should select
assets, projects and decisions that are profitable and reject the ___________________

non-profitable ones. It is in this sense, that the term profit- ___________________
maximization is used in financial management.
3. Wealth Maximization: It is now widely and universally
ES
accepted that the objective of the enterprise should suitable
and operationally feasible. Wealth-maximization means
maximizing the present value of a course of action (i.e. NPV =
GPC of benefits – Investment). Any financial action which
results in positive NPV creates and adds to the existing wealth
of the organization.
Besides the above basic objectives, the following are the other
objectives of financial management:
UP

1. Ensuring a fair return to shareholders.
2. Building up reserves for growth and expansion.
3. Ensuring maximum operational efficiency by efficient and
effective utilization of finance.
4. Ensuring financial discipline in the management.

Check Your Progress
Fill in the blanks:
1. Modern Financial Management is concerned with
(c)

proper ..................., ..................., and ................... of
funds effectively.
2. 6As of financial management are ............., ................,
................, ..................., .................. and ..................... .

Financial Management

6
Scope of Financial Management

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Notes
Activity
___________________
What is the scope of financial Financial Management is broadly concerned with the acquisition
management? and use of funds by a business firm. Its scope may be defined in
___________________
terms of the following questions:
___________________

___________________

___________________

___________________

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___________________

___________________

___________________

___________________
ES
Figure 1.1: Framework of Financial Management

1. How large should the firm be and how fast should it grow?
2. What should be the composition of the firm's assets?
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3. What should be the mix of the firm's financing?
4. How should the firm analyze, plan and control its financial
affairs?
The entire gamut of management efforts concerned with raising of
funds at optimum cost and their effective utilization with a view to
maximize the wealth of the shareholders.
Financial Management is concerned with the efficient use of an
important economic resource namely, capital funds. As Modern
Financial Management performs several functions, it is a difficult
task to identify the functional areas of modern financial
(c)

management.
Thus, Financial Management includes – Anticipating Financial
Needs, Acquiring Financial Resources and Allocating Funds in
Business (i.e., Three A's of financial management).

UNIT 1: Introduction to Financial Management

7
Check Your Progress

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Notes
Activity
Fill in the blanks:
What are the various types of
___________________
finance functions?
1. Maximization of ................... is the main goal of
___________________
financial management.
___________________
2. ................... and ................... maximization are the goals
___________________
of financial management.
___________________

Finance Functions ___________________

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Financial Management is indeed, the key to successful business ___________________

operations. Without proper administration and effective utilization ___________________
of finance, no business enterprise can utilize its potentials for ___________________
growth and expansion.
___________________
Financial management is concerned with the acquisition, financing
and management of assets with some overall goals in mind. As
ES
mentioned in the contents of modern approach, the discussions on
financial management can be divided into three major decisions
viz., (1) Investment decision; (2) Financing decision; and (3)
Dividend decision (see Figure 1.2). A firm takes these decisions
simultaneously and continuously in the normal course of its
business. Firm may not take these decisions in a sequence, but
decisions have to be taken with the objective of maximizing
shareholders' wealth.
UP

Financial
Decisions

Investment Financing Dividend
Decision Decision Decision

Figure 1.2: Financial Decisions

1. Investment Decision: It is most important than the other two
(c)

decisions. It begins with a determination of the total amount of
assets needed to be held by the firm. In other words,
investment decision relates to the selection of assets, that a
firm will invest funds. The required assets fall into two groups:

Financial Management

8
(a) Long-term Assets (Fixed assets: plant & machinery, land

CE
Notes
and buildings, etc.): Which involve huge investments and
___________________
yield a return over a period of time in future. Investment
___________________ in long-term assets is popularly known as "capital
___________________ budgeting". It may be defined as the firm's decision to
invest its current funds most efficiently in fixed assets
___________________
with an expected flow of benefits over a series of years.
___________________
(b) Short-term Assets (Current assets: raw materials, working
___________________ in process, finished goods, debtors, cash, etc.): That can be

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___________________ converted into cash within a financial year without
diminution in value. Investment in current assets is
___________________
popularly termed as "working capital management". It
___________________ relates to the management of current assets. It is an
___________________ important decision of a firm, as short-survival is the
prerequisite for long-term success. Firms should not
maintain more or less assets. More assets reduce return
and there will be no risk, but having fewer assets is more
ES
of a risk as well as more profitable. Hence, the main
aspects of working capital management are the trade-off
between risk and return. Management of working capital
involves two aspects. First, determination of the amount
required for the running of the business and secondly
financing these assets. It is discussed in detail in the
chapter on Working Capital Management.
2. Financing Decision: After estimation of the amount required
UP

and the assets that require purchasing, comes the next
financing decision into the picture. Here, the financial
manager is concerned with make up of the left hand side of the
balance sheet. It is related to the financing mix or capital
structure or leverage and he has to determine the proportion of
debt and equity. It should be optimum finance mix, which
maximizes shareholders' wealth. A proper balance will have to
be struck between risk and return. Debt involves fixed cost
(interest), which may help in increasing the return on equity
along with an increase in risk. Rising of funds by issue of
equity shares is one permanent source, but the shareholders
(c)

expect higher rates of earnings. The two aspects of capital
structure are: capital structure theories and determination of
optimum capital structure.
3. Dividend Decision: This is the third financial decision, which
relates to dividend policy. Dividend is a part of profits that are

UNIT 1: Introduction to Financial Management

available for distribution, to equity shareholders. Payment of 9

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dividends should be analyzed in relation to the financial Notes
decision of a firm. There are two options available in dealing ___________________
with the net profits of a firm, viz., distribution of profits as
___________________
dividends to the ordinary shareholders' where, there is no need
of retention of earnings or they can be retained in the firm ___________________

itself if they require, for financing of any business activity. But ___________________
distribution of dividends or retaining should be determined in
___________________
terms of its impact on the shareholders' wealth. The Financial
___________________
manager should determine optimum dividend policy, which

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maximizes market value of the share thereby market value of ___________________
the firm. Considering the factors to be considered while ___________________
determining dividends is another aspect of dividend policy.
___________________

Inter-relation among Financial Decisions ___________________

Although the above-discussed financial management decisions are
of three different kinds, they are not independent, but are
ES
interrelated as the underlying objective of all the three decisions is
(same) maximisation of shareholders' wealth.
UP

Figure 1.3: Inter-relationship among Financial Decisions

1. Inter-relation between "Investment and Financing
Decisions": While taking the investment decision, the
financial manager decides the type of asset or project that
should be selected. The selection of a particular asset or project
helps to determine the amount of funds required to finance the
project or asset. For example, suppose the investment on fixed
assets is `10 crore and investment in current assets or working
(c)

capital is ` 4 crore. So the total fund required to finance the
total assets is ` 14 crore.

Once the anticipation of funds required is completed then the
next decision is financing decision. Financing decision means
raising the required funds by various instruments.

Financial Management

10
There is a inter-relation between investment decision and

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Notes
financing decision, without knowing the amount of funds
___________________
required and types of funds (short-term and long-term) it is
___________________ not possible to raise funds. To put it in simple words,
___________________ investment decision and financing decisions cannot be
independent. They are dependent on each other.
___________________
2. Inter-relation between "Financing Decision and
___________________
Dividend Decision": Financing decision influences and is
___________________ influenced by dividend decision, since retention of profits for

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___________________ financing selected assets or projects, reduces the profit
___________________
available to ordinary shareholders, thereby reducing dividend
payout ratio. For example, in the illustration above, we have
___________________
decided the amount required to finance a project is `14 crore. If
___________________ the financial manager plans to raise only `7 crore from outside
and the remaining by way of retained earnings, and if the
dividend decision is 100% payout ratio, then the financial
ES
manager has to depend completely on outside sources to raise
the required funds. So, dividends decision influences the
financing decision. Hence, there is an interrelation between
financing decision and dividend decision.
3. Inter-relation between "Dividend Decision and
Investment Decision": Dividend decision and investment
decision are interrelated because retention of profits for
financing the selected assets depends on the rate of return on
UP

proposed investment and the opportunity cost of the retained
profits. Profits are retained when return on investment is
higher than the opportunity cost of retained profits and vice-
versa. Hence, there is interrelation between investment
decision and dividend decision.
The financial manager has to take an optimal joint decision after
evaluating the decisions that will affect the wealth of the
shareholders, if there is any negative affect on the wealth it should
be rejected and vice versa.
The importance of Financial Management in an enterprise may
(c)

very well be realized by the following words. "Financial
Management is properly viewed as an integral part of the overall
management rather than as a staff specialty concerned with fund
raising operation. In addition to raising funds, financial
management is directly concerned with production, marketing and

UNIT 1: Introduction to Financial Management

other functions within an enterprise, whenever decisions are made 11

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about the acquisition or distribution of assets". Notes
Activity
Thus, financial management has attained a good deal of List ___________________
the two approaches of
financial management.
importance in modern business. ___________________

___________________
Nature of Financial Management
___________________
From the below discussion it is evident, that financial management ___________________
as an academic discipline has undergone notable changes over the
___________________
years, with regard to its scope and areas of coverage. At the same

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time, the financial manager's role also has undergone fundamental ___________________

changes over the years. Study of the changes that have taken place ___________________
over the years is known as "scope of financial management." In
___________________
order to have an easy understanding and better exposition to the
___________________
changes, it is necessary to divide the scope into two approaches.
1. Traditional Approach: The traditional approach, which was
ES
popular in the early stage, limited the role of financial
management to raising and administering of funds needed by
the corporate enterprises to meet their financial needs. It deals
with the following aspects:

(a) Arrangement of funds from financial institutions.

(b) Arrangement of funds through financial instruments like
share, bonds etc.

(c) Looking after the legal and accounting relationship
UP

between a corporation and its sources of funds.
Thus, the finance manager had a limited role to perform, He
was expected to keep accurate financial records, prepare
reports on the corporation's status and performance and
manage cash in a way that the corporation was in a position to
pay its bills on time.
The term "Corporation Finance" was used in place of the
present term "Financial Management".
The traditional approach to the scope of the finance function
(c)

evolved during the 1920s and 1930s, dominated the academic
thinking during the 40s and through the early 50s. It has now
been discarded as it suffers from serious limitations. Following
are the main limitations:

These are: (a) Should an enterprise commit capital funds to certain UP purposes? (b) Do the expected returns meet financial standard of performance? (c) How should these standards be set and what is the cost of capital funds to the enterprise? (d) How does the cost vary with the mixture of financing methods used? In the absence of the coverage of these crucial aspects. i. short term or working capital was ignored in the approach. ___________________ (d) Ignored working capital financing: The problems related to financing. mergers. (e) No emphasis on allocation of funds: The approach confined financial management only to procurement of funds. It followed an ___________________ outsider-looking-in approach and not the insider-looking- out approach. 2. investors etc. ___________________ outsiders.e. It did not emphasis on allocation of funds. The approach focuses mainly on the ES problems of long term financing. what Solomon aptly describes as the central issues of financial management. etc. the term financial management provides a conceptual and analytical framework for financial decision-making. The conceptual framework of the traditional treatment ignored. ___________________ (c) Ignored non-corporate enterprise: The approach focused ___________________ mainly on the financial problems of corporate enterprises. The modern approach provides a solution to these shortcomings.. ___________________ (b) Ignored routine problems: The subject of financial ___________________ management was mainly confined to the financial ___________________ problems arising during the course of incorporation. Financial Management 12 (a) External approach: The approach treated the subject of CE Notes finance only from the view point of suppliers of funds. since it completely ignored the view point ___________________ of those who had to take internal financing decisions. Modern Approach: According to the modern approach. That . bankers.. the traditional approach implied a very narrow scope for financial (c) management. and the subject did not give any importance -C ___________________ to day-to-day financial problems of the business. viz.

___________________ can be divided into four major decisions as functions of finance.e. Profitability: While ascertaining profitability. . ___________________ The main contents of the modern approach are as follows: ___________________ (a) What is the total volume of funds. 1. matching the inflows against the cash outflows. in the modern sense of the term. It is viewed as an ___________________ integral part of the overall management. (a) Forecasting cash flows → i. They are: ES (a) The investment decision (b) The financing decision (c) The dividend policy decision (d) The funds requirement decision The functions of financial management may be classified on the basis of Liquidity. acquisition of funds as 13 CE well as their allocation. an enterprise should ___________________ commit? -C ___________________ (b) What specific assets should an enterprise acquire? ___________________ (c) How should the funds required be financed? ___________________ Thus. UNIT 1: Introduction to Financial Management means the finance function covers both. The new approach views the term Notes financial management in a broader sense... Liquidity: It is ascertained on the basis of three important UP considerations. (c) Managing the flow of internal funds. (b) Raising funds → i. Profitability and Management. ___________________ The new approach is an analytical way of viewing the ___________________ financial problems of a firm.e. financial management. financial manager will have to ascertain the sources fro which funds may be raised and the time when these funds are needed. 2. the following factors are taken into account: (c) (a) Cost control (b) Pricing (c) Forecasting future profits .

...... Profit maximisation ignores. Financial Management 14 (d) Measuring cost of capital CE Notes ___________________ 3... (b) the management of short-term funds.. If finance function does not operate well...... . mentioned above following ___________________ subsidiary functions are also performed by the finance ___________________ management.... ___________________ 2. ___________________ are the 7 Ms of management.......... ....... Organization of the Finance Functions ES Like any other functional management in a firm.... ___________________ Check Your Progress -C ___________________ Fill in the blanks: ___________________ 1.... the whole organizational activity will be ruined. Routine matters are looked after by the "Treasurer" and special UP matters are managed by the "Controller of Finance"... 'finance' is a vital functional organ of the firm.. . It includes: (a) the management ___________________ of long-term funds. Management: Asset management has assumed an important role in financial management.............................. So........... .. That is why every company will have a separate department to look after the financial aspects of the company..... ..4: Flow Chart of Financial Department . The following chart will give an idea about the finance department: (c) Figure 1.. inefficient financial management paralyses the activity of the firm... ....... ___________________ Apart from the main functions. ..... and .

UNIT 1: Introduction to Financial Management 15 CE Financial Goal – Profit Maximisation vs. that the term profit- UP maximization is used in financial management. Profit as the owner-oriented concept. Profitability-maximization implies that the enterprise should select assets. Optimum Utilization: Optimum utilization of available resource is possible. Best Criterion on Decision-Making: The goal of profit maximization is regarded as the best criterion of decision- making as it provides a yardstick to judge the economic performance of the enterprises. as the owner-oriented concept and the second. projects and decisions that are profitable and reject the non-profitable ones. Merits of Profit Maximization 1. financing and ___________________ dividend policy decision of the enterprise should be oriented to profit maximization. Though ___________________ the objective of the financial management is same as the objective of the company i. Profit as the operational concept means profitability. to earn the profits but is not the sole objective ___________________ -C of the company. 3. as the operational concept. . Maximum Social Welfare: It ensures maximum social welfare in the form of maximum dividend to shareholders. in terms of profitability. It is in this sense. 4. refers to the amount of net profit. which goes in the form of dividend to the shareholders. are the most (c) desirable.e. It is commonly agreed that the objective of the ___________________ firm is to maximize the wealth or value. 2. Wealth Notes Maximisation ___________________ ___________________ Profit Maximisation ___________________ The financial goal of the business now-a-days is the shareholders ___________________ wealth maximisation rather than the profit maximisation. which is an indicator of economic efficiency of the enterprise. ___________________ Profit maximisation is a term which denotes the maximum profit ___________________ to be earned by an organization in a given time period. The profit maximization goal implies that the investment. The term "Profit" can be used in two senses – ES first. Efficient Allocation of Resources: It leads to efficient allocation of scarce resources as they tend to be diverted to those uses which.

It is also a dynamic surplus or profit is a reward for innovation. The Term 'Maximum' is also ambiguous: The term 'maximum' is also not clear. . higher wages. ___________________ However. profit is UP a reward for risk and uncertainty bearing. Wealth Maximization It is now widely and universally accepted that the objective of the enterprise should suitable and operationally feasible. It Ignores the Risk Factor: According to economists. It ignores the fact that the rupee earned to day is more valuable than a rupee earned later. better quality and CE Notes lower prices. Owing to the various drawbacks of the profit maximization objective. Precise and clear cut and should give weightage to the time value and risk factors. Time Factor Ignored: The term 'Profit' does not speak anything about the period of profit-whether it is short-term ___________________ profit or long-term profit. 5. not possible to maximize what cannot be known. the profit-maximization objective suffers from several drawbacks which are as follows. Financial Management 16 timely payment to creditors. The choice of a more worthy project lies in the study of time value of future inflows of cash earnings. ___________________ 2. The concept of profit is also not clear. ___________________ ___________________ 3. It is Vague: The term 'Profit' is very vague. ES 4. ___________________ ___________________ 1. But when can the organization maximize profits? Profit-maximization objective does not make this clear. It is therefore. more employment opportunities to the society ___________________ and maximization of capital to the owners. Professor Ezar Solomon rejected it as inappropriate and (c) unsuitable and suggested the adoption of wealth-maximization objective which removes all the drawbacks of the profit maximization objective. It Ignores Time Value: The profit maximization objective fails to provide any idea regarding the timing of expected cash earnings. It is also called value maximization. The value of the firm is represented by the market price of the company's common stocks. It is not clear in -C ___________________ what exact sense the term profit is used. whether it is ___________________ Accounting profit or Economic profit or profit after tax or profit before tax.

Prices in the share markets are largely affected by many factors like general economic outlook. the dividend policy of the firm and many other factors that bear upon the market price of the stock. -C ___________________ as they add to the existing wealth and help in wealth- maximization. technical factors and even mass psychology. Wealth-Maximization takes care of: 1. The likely earning per share (EPS) depends on the assessment as to how the profitably a company is growing to operate in the future. The anticipated rate if earnings per share of the company. reduces the existing ___________________ wealth and hence be given up. outlook of the particular company.UNIT 1: Introduction to Financial Management The wealth or 'net present worth' of a course of action is the 17 CE difference between gross present worth and the amount of capital Notes investment required to achieve the benefits. ___________________ In simple words. Market price acts as the performance index or report card of the firms' progress. ___________________ ___________________ Significance of Wealth Maximization ___________________ The company. It takes into the account present and prospective future earnings per share. The capitalisation rate reflects the liking of the investors for the company. The capitalization rate. All positive actions can be adopted. Gross Present-worth ___________________ represents the present value of expected cash benefits. This value function is given by two factors: 1. Public or Society 4. Any financial action which results in positive NPV ___________________ creates and adds to the existing wealth of the organization and the ___________________ course of action which has a negative NPV. Workers or Employees 3. NPV = GPC of benefits – Investment). the timings and the risk of these earnings. Thus. wealth-maximization means maximizing the ___________________ present value of a course of action (i. Management or Employer The market price of the firms stock represents the focal judgement UP of all market participants as to what the value of the particular firm is. Lenders or Creditors 2. .e. cannot forget the others who directly or ES indirectly work for the overall development of the company. (c) 2. although it-cares more for the economic welfare of the shareholders.

... by the corporate UP enterprises to meet their financial needs... raising... allocation and earning the profit and maintaining ___________________ the same is itself is a challenging task. -C ___________________ decision are the three decisions of finance.. ........... controlling and administering of the funds used in the business.. Investment decision relates to the selection of assets. Lesson End Activity If wealth maximisation is the objective of financial management...... Financial Management 18 In challenging dynamic global environment planning..... Financial Management is concerned with the acquisition.. Traditional concept of finance was limited to ...... decision...... Corporation is an association of many persons who contribute ES money or money's worth to a common stock and employs it in business... . investing and dividend decisions of a company can help to attain this objective? (c) Keywords Business Finance: It is that business activity which is concerned with the acquisition and conservation of capital funds in meeting financial needs and overall objectives of business enterprises.... decision... then how the financing.... procurement of funds as well as their allocation.... and who share profit and loss arising from the business equally.... the role of financial management is limited to fund raising and administering needed. .. CE Notes procurement... ___________________ ___________________ Summary ___________________ Corporate finance is the activity concerned with planning.. ___________________ 2... .. that a firm will invest funds.... financing and management of assets with some overall goal in mind... ___________________ Check Your Progress ___________________ Fill in the blanks: ___________________ ___________________ 1. In the traditional approach. Financing Decision relates to the financing mix or capital structure or leverage and he has to determine the proportion of debt and equity.. The scope of financial management can be studied under two approaches........ The scope of modern approach covers both..

Elucidate the ways in which you will do it. Questions for Discussion 1. "Financial Management is properly viewed as an integral part of the overall management rather than as a staff specialty concerned with fund raising operation. In your opinion. Analyse the ways in which the financial management has undergone a sea change over the years. controlling and administering of the funds used in the business. 7. 3.UNIT 1: Introduction to Financial Management 19 Corporate Finance: Corporate finance is the activity concerned CE Notes with planning. NPV = GPC of benefits . You are the finance manager of a firm & asked to organise all the financial decisions of the firm. raising. ___________________ Corporation: It is an association of two or more persons who ___________________ contribute money or money's worth to a common stock and employs ___________________ it in business. . Investment Decision: Investment decision is related with the ES selection of assets that a firm will invert. ‘Finance is considered to be the blood of the enterprise’. Justify. financing and dividend decisions are all interrelated.e. ___________________ Financial Management: It is the operational activity of a -C ___________________ business that is responsible for obtaining and effectively utilising the funds necessary for efficient operations. wealth (c) maximisation or profit maximisation? Why? 6.Investment). Analyse the changing scenario of financial management in India. ___________________ Dividend: Dividend is a part of profits that are available for ___________________ distribution to shareholders. Wealth Maximization: It is maximizing the present value of a course of action (i. and who share profit and loss equally. UP 2. Comment. ___________________ ___________________ Financing Decision: It is related to the financing mix or capital structure or leverage and the determination of the proportion of ___________________ debt and equity. Investment. which one do you suggest. 5." Comment. 4.

New Delhi.." Do you agree? Justify. J. htm www. p. 2002. Taking the practical example of any company. ___________________ 10./Ross_Sample_ ch01. Elucidate. ___________________ 11. Ltd. 1996.org/wiki/Financial_management tutor2u. Tata McGraw Hill Publishing Company Ltd.Theory and Practice.. ___________________ 12.M. show how the financing..com/financial-management.financialmanagement.managementstudyguide. J. and Wachowicz. Elucidate the role of the financial manager in India. the allocation of capital and ___________________ valuation of the firm". Financial Management 20 8. "………Finance has changed ………from a field that was ___________________ concerned primarily with the procurement of funds to one that ___________________ includes the management assets. UP Chandra.. Financial Management . New Delhi. investment and ___________________ dividend decisions of a company can help to attain this -C ___________________ objective.mcgraw-hill. ___________________ 9. Prentice Hall of India Pvt. financing and dividend decisions are interrelated? ES Further Readings Books Sudhindra Bhat.in/ highered. P. 3. Fundamentals of Financial Management.pdf (c) . 2.net/business/accounts/finance_management_ intro. New Delhi. Excel Books..C. Van Horne.htm www. Financial Management.wikipedia. p. "The profit maximisation is not an operationally feasible CE Notes criterion. analyse the ___________________ ways how the investment.com/sites/dl/free/. 2008. Jr. Assuming wealth maximization to be the objective of financial management.. Web Readings en.

All these concepts are basically based upon the fact that. viz. All this requires that the finance manager knows about the various valuation concepts. Example: 1. The value of a rupee today is different from (c) what it will be. 2. While taking these decisions. When interest on funds is raised. Whether it will be received on a consistent basis or otherwise etc. Factors Contributing to the Time Value of Money Money has a time value because of the following reasons: 1. the students will be aware of the following topics: ___________________ \ Time value of money ___________________ -C \ Various valuation concepts ___________________ \ Various values based on different valuation concepts ___________________ ___________________ Introduction ___________________ It has been explained in the preceding unit that maximization of the shareholder's wealth is the basic objective of the finance manager of a firm. This requires him to take appropriate decisions ES on financing.UNIT 2: Time Value of Money Unit 2 21 CE Notes Activity What are the factors Time Value of Money ___________________ contributing to the time value of money? ___________________ ___________________ Objectives ___________________ After completion of this unit. the finance manager must keep the concept of economic value added and time factor in mind. Compound Value Concept. Annuity Concept. say. Individuals generally prefer current consumption to future . will have to be paid. after one year. When return on investment will be received. money has time value. investment and dividends. UP 3.. Present Value Concept etc. Concept of Time Value of Money "Money has time value" means that the value of money changes over a period of time.

000 in the 'zero year' and cash inflows of ` 20. has ___________________ more purchasing power than money to be received in future. This may be because. One involves an outlay of ` 10 crore with a return of 12% from the first year onwards. -C ___________________ Thus. for ten years. This will be clear with the following examples. ___________________ 3. he will prefer ` 10. is worth more ___________________ than if the same is received after some time. It is expected to give a return of ` 20. This is because of the ___________________ uncertainty connected with the future. the fundamental principle behind the concept of time value ___________________ of money is that.00. for six years.000.000 p. people consider a rupee today. today. A firm has to choose between two projects.000. In order to .000 now or after six months. for 15 years commencing with the beginning of the sixth year of the project. say.00. the money received today. The project thus involves a cash outflow of ` 1.000 per year. for six years. worth more than a rupee in the future.000. after a year.00. whether to accept or reject the project. The other requires an investment of ` 10 crore with a return of 14% p. It becomes important and is of vital consideration in decision making.000 now.a. at the end of each year. An investor can profitably employ a rupee received today. it is necessary.00. The firm will accept the project only when the present value of the cash inflows at the desired rate of interest is at least equal to the initial investment of ` 1. Time value of money or time preference of money is one of the central ideas in finance. (c) 2. a sum of money received today. to CE Notes give him a higher value to be received tomorrow or after a ___________________ certain period of time. In an inflationary economy. A project needs an initial investment of ` 1. that the present value of cash inflows received annually for six years is ascertained and compared with the initial investment of ` 1. ___________________ Example: If an individual is given an alternative either to receive ` 10. In order to decide.a. ___________________ 4. Financial Management 22 2. Examples: UP 1. he may be in a position to purchase more ES goods with this money than what he is going to get for the same amount after six months. 'A bird in hand is worth two in the bush' : This statement ___________________ implies that.

the interest earned on the initial principal amount becomes a part of the principal at the end of a compounding period. it is List ___________________ the valuation concepts necessary that the two variables are strictly comparable.100] Amount at the end of 2nd year will be: 1. ___________________ The above examples reflect the need of comparing the cash flows ___________________ arising at different points of time in decision-making. ___________________ is possible only when the time element is incorporated in the relevant calculations. In order to make a meaningful comparison. Illustration 1: ` 1. This techniques. a person will have to pay in future more.UNIT 2: Time Value of Money make a choice between these two projects. Compound value and future value both. Compound Value Concept 2. Valuation Concepts or Techniques ES The time value of money implies that: 1. Discounting or Present Value Concept Compound Value Concept In this concept. ___________________ ___________________ Check Your Progress -C ___________________ True or False: ___________________ 1. Solution: (c) Amount at the end of 1st year will be: 1.000 invested at 10% is compounded annually for three years. Current consumption is one of the reasons for time preference of money. ___________________ ___________________ 2. calculate the compounded value after three years.100 [1000 × 110/100 = 1. it is necessary to 23 CE compare the cash outflows and the cash inflows resulting from Notes Activity the project.210 [1100 × 110/100 = 1. for a rupee received today 2. a person may accept less today. are same.210] . for a rupee to be received in the future The above statements relate to two different concepts: UP 1.

the compound value of ` 1000 will amount to: 10001 × 331 = ` 1331 Future Value of Series of Cash Flows: So far we have considered only the future value of a single payment made at time zero.500. compounded annually.a. Manoj invests ` 500. at the end of 3 years as 1. ` 1. 1 at 10% p.331] ___________________ This compounding process will continue for an indefinite time period. For instance. ` 1. Illustration 2: Mr. when the interest charged is 5% p. after 'n' UP years for a wide range of combination of 'i' and 'n'.331 Computation by this formula can also become very time consuming if the number of years increase. The table gives the compound value of Re. the above illustration we get ES A = P (1 + i)n A = 1000 (1 + . . ___________________ Compounding of Interest over 'N' years: The compounding of ___________________ Interest can be calculated by the following equation. ___________________ i = Interest rate.000. hence. An investor investing money in instalments may wish to know the (c) value of his savings after 'n' years.a. the above illustration gives the compound value of Re. ` 2. -C ___________________ ___________________ A = Amount at the end of period 'n'. ___________________ P = Principal at the beginning of the period. say 10.331. By taking into consideration. In such cases to save upon the computational efforts. Financial Management 24 Amount at the end of 3rd year will be: CE Notes ___________________ 1.331 [1210 × 110/100 = 1. The transactions in real life are not limited to one.500 at the end of each year. 20 or more.000 and ` 2.10)3 A = 1. Calculate the compound value at the end of 5 years. Compound Value table* can be used. N = Number of years. 1. ___________________ A = P (1 + i)n ___________________ In which.

he will have at the end of the 5th year.500. compounds for four years.00 ___________________ -C 5 2.158 [`1000 (1+0.000 1 1.500 0 1.000 3 1.100.316 Contd… .654.000 at the end of every year for 45 years in his saving account.500 `2.50 ` 1.000 2.1: Graphic Illustration of Compounding Values Compound Sum of an Annuity: An annuity is a stream of equal annual cash flows.00 ___________________ Amount at the end of the 5th Year ` 8020. ` 500 ___________________ put at the end of the first year.654.00 ` 1.100.158.050 2.500 2 1.00 ` 2.05)3] and so on. paying 5% interest compounded annually.50 UP Figure 2. that we are making use of the Compound ___________________ interest formula for each payment separately.50 4 2. For instance.50 ___________________ It may be noted here. Illustration 3: Mr.000 `1.000 deposited at n = 2 compounds for 3 years.158 1158. Solution: (c) Amount Number of Compounded Future Sum End of Year Deposited Years Interest factor ( `) ( `) compounded 1 2 3 4 5 1 2.000 4 1.020.000 ` 2. Annuities involve calculations based upon the regular periodic contribution or receipt of a fixed sum of money.216 608. ES ` 1.000 3 1. amounts to ` 1.432 2 2. Determine the sum of money.00 2 1.103 1. Similarly.500.00 ` 8.05)4].158 2. and has a future value of ` 608 at 5% interest [` 500 (1 + 0. Ramesh deposits ` 2. 0 1 2 3 4 5 ` 500 ` 1.00 ___________________ 3 1.00 ` 608.UNIT 2: Time Value of Money 25 Solution: CE Notes Statement of the Compound Value ___________________ Amount Number of Compounded Future Value End of ___________________ deposited years Interest year (2) × (4) (`) (`) compounded Factor from ___________________ 1 2 3 4 5 ___________________ 1 500 4 1.216 2.

when three equal yearly payments of ` 25. IF = represents the appropriate factor for the sum of the annuity of Re.000 1 1. at a stated rate of compound interest. Banking as they guide the depositors and investors as to what sum amount (X) paid for number of years.000 2.000 0 1.054 ___________________ The above illustration depicts that in order to find the sum of the -C ___________________ annuity.000 ___________________ = ` 2.000) ___________________ = ` 2.215. Thus.000 (5.206 CE 4 2.103+1.000 are deposited into an account that yields 7% compound interest.158 +1. n.526(IF). UP Sn = represents the compound sum of annuity. Thus. From the table. A = is the value of annuity.000 is: (c) Sn = IF × A Sn = 3. Illustration 4: Find the compound value of annuity.215 × 2000 Sn = 6.054 ___________________ Finding the common factor of ` 2. Such calculations are ___________________ available for a wide range of I and n. when multiplied by ` 2. Symbolically Sn = IF × A Where. we find that the sum of annuity of ` 1 deposited at the end of each year for 5 years is ES 5.527) ___________________ = ` 11.000 (1.100 Notes 5 2.103 2.000 annuity (A).050 2.000 ___________________ Amount at the end of 5th Year ` 11.054. the annual amount must be multiplied by the sum of the ___________________ appropriate compound interest factors. we find the total sum as ` 11. Financial Management 26 3 2. Solution: The Annuity Table gives the compound value as 3.000 2 1. will accumulate to.430 .216 +1. To find the answer to the annuity question of illustration 3 we are required to look for the ___________________ 5% column and the row for the five years and multiply the factor by annuity amount of ` 2000. when Re.1.1 is paid every year for 3 years at 7%.050 +1. the compounded value of annuity of ` 2.

UNIT 2: Time Value of Money 27 CE Discounting or Present Value Concept Notes The concept of present value is the exact opposite of that of a sum ___________________ of money or series of payments. the amount he will have to forego at present can be calculated as follows: A PV = ( 1 + i )n 100 (c) PV = = ` 90. X.10) Similarly. the present value of the future ___________________ Rupee will always be lower. This return is termed as 'discounting rate'. Example: If Mr. The technique for finding the present ___________________ value is termed as 'discounting'. we estimate the present worth or a future ___________________ payment/instalment or series of payment adjusted for the time value of money. with a time preference rate or discount rate of x%. Present value after 'n' Years: ___________________ A Formula: PV = ES ( 1 + i )n Where. -C ___________________ Given a positive rate of interest. A = Amount at the end of the period 'n'. we can directly calculate the amount any depositor would be willing to sacrifice at present. PV = Principal amount the investor is willing to forego at present. That is to say. the present value of an amount of inflow at the end of 'n' years can be computed. i = Interest rate. expects to get ` 100 after one year. the opportunity cost ___________________ exists for money lying idle. depositor. that interest can be ___________________ earned on the money. . while in case of present value ___________________ concept. UP With this formula. at the rate of 10%.90 (1 + . N = Number of years. ___________________ The basis of present value approach is that.

.000 2 2..000 4 4. to the present sum he is going to ___________________ sacrifice. a project may involve a series of cash inflows and outflows.. Cn = Cash flows after period 1.e. Financial Management 28 Present Value of a Series of Cash Flows: In a business CE Notes situation. i = Discounting rate.000 (c) 3 3. PV = Sum of individual present values of each cash flow: C1.000 . ___________________ The present value of series of cash flows can be represented by the ___________________ following: ___________________ C1 C2 C3 Cn PV = 1 + 2 + 3 + (1 + i ) (1 + i ) (1 + i ) ( 1 + i )n ES n Ct PV = Â T=1 ( 1 + i )n Where. ___________________ In order to take this decision he needs to equate the total ___________________ anticipated future returns.... UP However. the present value of each expected inflow will be -C ___________________ calculated. the discounting factor). you are required to find out the present value of future cash inflows that will be received over the next four years. C3. Illustration 5: Given the time value of money as 10% (i.n. in anticipating of returns he expects to earn over a number of years. The estimate of the present value of future series of returns. Every businessman will like to know ___________________ whether it is worthwhile to invest or forego a certain sum now. it is very natural that returns received by a firm are ___________________ spread over a number of years. C2.. Year Cash flows (`) 1 1...2. The computation of the present value of inflows by the above equation is a tedious problem. An investment made now may fetch ___________________ returns a certain time period.3………….

909 454. Illustration 6: Calculate the present value of annuity of ` 500 received annually for four years. An individual or depositor may ___________________ receive only constant returns over a number of years.UNIT 2: Time Value of Money 29 Solution: CE Notes Year Cash flows Present Value Present Value ___________________ Factor at 10% ___________________ 1 2 3 4(2×3) ___________________ 1 1.826 1. we can find the present value of each cash ES flow or use the annuity table.e.751 375.827 413.909 909 ___________________ 2 2.50 3. The annuity table gives the present value of an annuity of Re. Formula for calculation of the present value of an annuity can be derived from the formula for calculating the present value of a series of cash flows: .732 ___________________ -C Present value of series of Cash flows 7.170 Present value of series of Cash flows 1. the cash flows are equal in amount. (c) i.000 0.546 ___________________ ___________________ Present value of an Annuity: In the above case there was a mixed stream of cash inflows. 3.000 0. Solution: UP Present Value of Annuity of `500 Year Cash flows Present Value Present Factor at 10% Value 1 2 3 4(2×3) 1 500 0. To find out the present value of annuity either.253 4 4.683 2. when the discounting factor is 10%.585.000 0.585.652 ___________________ 3 3.50 4 500 0.00 This basically means to add up the Present Value Factors and multiply with ` 500.000 0. 1 for interest rate 'r' over number of years 'n'.751 2. This implies ___________________ that.683 341.50 3 500 0.50 2 500 0.170 × 500 = ` 1.

170 has been picked up directly from the Annuity Table for present value.585. UP Check Your Progress True or False: 1. Summary Time value of money means that the value of money changes over a time. -C ___________________ PVAn = Present value of an annuity having a ___________________ duration of 'n' periods. In compound value concept. ___________________ i = Rate of interest. ___________________ A = value of single instalment. as stated earlier. The Figure of 3. PVAn = A × ADF Where ADF denotes Annuity Discount Factor. . the interest earned on the initial principal amount becomes a part of the principal at the end of a compounding period. It is the sum of money received today is worth more than if (c) the same is received after some time. Rule 73 is one of the rules of doubling period. a more practical method of computing the present value would be to multiply the annual instalment with ES the present value factor. Effective rate of interest is more than the nominal rate of interest in single period compounding. The PVAn in the above example can be calculated as 500 × 3. 2. Financial Management 30 C1 C2 C3 Cn CE Notes PVAn = + + + 1 2 3 ___________________ (1 + i ) (1 + i ) (1 + i ) ( 1 + i )n ___________________ Ê 1 1 1 1 ˆ = CÁ 1 + + + ˜ ___________________ Ë (1 + i ) ( 1 + i ) ( 1 + i ) ( 1 + i )n ¯ 2 3 ___________________ Ê n Ct ˆ = C ÁÂ n˜ ___________________ Ë t=1 (1 + i ) ¯ ___________________ Where.170 = ` 1. However.

Calculate the ___________________ number of monthly payments and the amount paid every month.00. P. "Time value of money is helpful in capital budget. UP 3. He wants to know his series of deposits value at the end of 5 years with 6 per cent rate of compound interest. X deposited ` 1. (c) . for a period of 5 years." Explain. ES Questions for Discussion 1. Mr. so ___________________ that from that moment on. Mr. What is the total deposit amount at the end of 5 years? 4.00. Mr. A deposits at the end of each year ` 2000. How can he know this? 5. What is his accumulated interest? 2. is ___________________ $2. Calculate the future value if his required rate of returns is 10 per cent.UNIT 2: Time Value of Money 31 CE Lesson End Activity Notes Consider a 10-year mortgage where the principal amount. ` 4000. the interest that has been added also -C ___________________ itself earns interest.000 and the annual interest rate is 6%. ` 3000. ___________________ ___________________ Time Value of Money: Time value of money is that the value of money changes over a period of time. at 5 per cent simple interest for a period of 5 years. Suppose you deposit ` 1.000 in a savings bank account today. ` 5000 and ` 6000 for the consequent 5 years respectively. which pays 10 percent interest with semi annual compounding.00.000 with an investment company. X invested ` 40. ___________________ ___________________ Keywords ___________________ Compound Interest: When interest is added to the principal.000 today. ___________________ Compound Value: The interest earned on the initial principal becomes a part of the principal at the end of a compounding period.

.Theory and Practice.ppt UP (c) .M. New ___________________ Delhi. ___________________ Van Horne. Financial Management.investopedia. 2.pitt. P. Fundamentals of ___________________ Financial Management..html www. 2008. ___________________ Web Readings ___________________ en.asp ES www.edu/~gray/INFSCI1026/lectures/. Prentice Hall of India Pvt. New Delhi. ___________________ Ltd.. 1996.. 2002. New Delhi.sis.C.getobjects. p. 3. Excel Books. p.com/Components/Finance/TVM/concepts. Financial Management . and Wachowicz. -C ___________________ Chandra.. J.org/wiki/Time_value_of_money www.. Tata McGraw Hill Publishing Company Ltd.wikipedia./tvomPearsonEd. Jr. Financial Management 32 CE Notes Further Readings ___________________ Books ___________________ ___________________ Sudhindra Bhatt. J.com/articles/03/082703.

The ultimate principle suggests that a certain amount of money today has different buying power than the same amount of money in the future. The time value of money is the central concept in finance theory. dividend at the end of year '0'). sales.UNIT 3: Computing Time Value of Money Unit 3 33 CE Notes Activity Give formula for computing Computing Time Value of Money time___________________ value of money. (1 + r)n = Growth rate. UP Calculation of the Compound Growth Rate Compound growth rate can be calculated with the following formula: gr = Vo(1 + r)n = Vn where.. gr = Growth rate in percentage. Vn = Variable value (amount) at the end of year 'n'. ___________________ ___________________ Objectives ___________________ After completion of this unit. Vo = Variable for which the growth rate is needed (i. thus changing the "value" of the money. (c) revenue. This notion exists both because there is an opportunity to earn interest on the money and because inflation will drive prices up. . the students will be aware of the following topics: ___________________ \ Calculation of the compund growth rate ___________________ -C \ Doubling Period ___________________ \ Effective Rate of Interest in Case of Doubling Period ___________________ \ Effective vs Nominal Rate ___________________ \ Sinking Fund Factor ___________________ Introduction ES The time value of money is the value of money figuring in a given amount of interest earned or inflation accrued over a given amount of time.e.

ES Solution: CVn = 5000(1 + 0.080 CV can also be calculated in the following ways: UP Year Amount paid No.910 3 15. of years Compound Future value ( `) compounded interest factor ( `) (1) (2) (3) (4) (5) = (2) × (4) 1 5000 4 1. ___________________ Solution: ___________________ 21 (1 + r)5 = 31 ___________________ ___________________ (1 + r)5 = 31 / 21 = 1. see first above it to get the -C ___________________ growth rate.080 Compound Value of Annuity (Even Cash Flows) (c) Illustration 3: Mr.476 ___________________ Note: See the compound value one rupee Table for 5 years (total years . Determine Ram's money value at end of 6 years.050) + 25000(1.06)4 + 10000(1 + 0. Bhatt deposits each year ` 5000.06)2 + 20000(1 + 0.000 0 1.000 TOTAL 81. CE Notes calculate compound rate of growth for period (1998-2003). Ram deposits ` 500 at the end of every year.124) + 20000(1.06)1 + 25000(1 + 0. after finding the closest value.310 2 10.00) = 6310 + 11910 + 16860 + 21000 + 25000 = ` 81.000 1 1.000 3 1. for 6 years at 6 per cent interest. ` 10000.124 16.191 11.191) + 15000(1. ___________________ Compounded/Future Value of Series of Cash Flows (Annuity) ___________________ Illustration 2: Mr.05 21. He wants to know his future value of deposits at the end of 5 years.00 25.000 2 1.one year) till you find the closest value to the compound ___________________ factor.000 5 25. Solution: FVn = P1 (1+I)n–1 + P2 (1+I)n–2 + … Pn-1 (1+I)+Pn–n .860 4 20.06)3 + 15000(1 + 0. ` 20000 and ` 25000 in his savings bank account for 5 years at the interest rate of 6 per cent.262) + 10000(1. Financial Management 34 Illustration 1: From the following dividend data of a company. ___________________ ` 15000.262 6.06)0 CV5 = 5000(1.

124) + 500(1.n) (FVIFAIn) = Future value for interest factor annuity at 'I' interest and for 'n' years.50 4 500 2 1. of years Compound Future Paid (`) compounded interest value ___________________ factor (`) -C 1 500 5 1.124 562. Compound Value of Annuity Due Illustration 4: Suppose you deposit ` 2500 at the beginning of every year for 6 years in a saving bank account at 6 per cent .06)2 + 500(1 + 0.262 631.50 Note: See the compound value of annuity table of one rate for 6 (c) years at 6 per cent interest.UNIT 3: Computing Time Value of Money 35 FV6 = 500(1 + 0.06)6 – 1 0.06)3 + 500(1 + CE Notes 0.5 ___________________ By using table format ___________________ ___________________ Year Amount No. CV6 = 500 (1 + 0.975] = ` 3487.06 530.487.00 ___________________ 6 500 0 1.19) + 500(1.00 ___________________ 2 500 4 1.06)4 + 500(1 + 0.060) + 500(1.06)0 ___________________ = 500(1.50 ES Short-cut formula È ( 1 + I )n – 1 ˘ CVn = P Í ˙ ÍÎ I ˙˚ Where.06)1 + 500 (1 + 0.00 TOTAL 3.06 = 500 [6.338 669.00 ___________________ 5 500 1 1.262) + 500(1.00 ___________________ 3 500 3 1.06)5 + 500(1 + 0.00 500.338) + 500(1.191 595.5 + 562 + 530 + 500 = ` 3487.00) ___________________ = 669 + 631 + 595. P = Fixed periodic cash flow I = Interest rate UP n = Duration of the amount = (FVIFAI.

00 Check Your Progress ES True or False: 1. Solution: ___________________ CV6 = 2500 (1+0.50 2 2500 5 1.650. (c) I = Interest rate.124 2.345.262 3. in how many years will this amount double? .810.50 ___________________ 5 2500 2 1.000 at 6 per cent interest. Dp = Doubling period in years. of times Compound Compound ___________________ Year (`) compounded factor value (`) -C ___________________ 1 2500 6 1. and it takes 12 years to double the amount. Illustration 5: If you deposit ` 500 today at 10 per cent rate of interest. to double the amount invested at a given rate of interest. Doubling Period Doubling period is the time required. Rule of 72: To get doubling period 72 is divided by interest rate.06) ___________________ = 2500(6.75 ___________________ Through the Table Format ___________________ Cash outflow No.00 6 2500 1 1.06 2. Financial Management 36 compound interest.977. (See compound value for one rupee Table at 6 per cent till you finds the closest value to 2). namely: 1.00 ___________________ TOTAL 18. What is your money value at the end of the 6 CE Notes years? Activity ___________________ Define doubling period.191 2. 2.547. Doubling period can be computed by adopting two rules. Compound growth rate formula is Vo(1 + r) = Vn.338 3. if you deposit UP ` 10.00 4 2500 3 1.00 ___________________ 3 2500 4 1. Doubling period (Dp) = 72 ÷ I Where.419 3.06) = ` 18. A series of unequal cash flows are called Annuity.483. For example.975) (1+0.485.155.

Rule of 69: Rule of 72 may not give the exact doubling period. ___________________ Solution: Dp = 0. A.) CE Notes 2.25 years.35 + 69 / I ___________________ Illustration 6: Take the above problem as it is and calculate ___________________ doubling period. who is interested to make a deposit. where the institute pays double the amount invested in the institute by the end of 8 years. Calculate.2 years (approx. UP Illustration 7: A financial institute has come with an offer to the public. -C ___________________ ___________________ Effective Rate of Interest in Case of Doubling Period ___________________ Sometimes investors may have doubts as to what is the effective ___________________ interest rate applicable. Solution: ERI = 72 ÷ Dp = 72 ÷ 8 years = 9 per cent (b) In case of rule of 69 69 ERI = + 0. ___________________ but rule of 69 gives a more accurate doubling period.35 8 years . Mr.35 (c) Dp Take the above example 69 ERI = + 0. The ___________________ formula to calculate the doubling period is: ___________________ Dp = 0. if a financial institute pays double amount at the end of a given number of years. (a) In case of rule of 72 ERI = 72 per cent Doubling period (Dp) where. ES Effective rate of interest can be defined by using the following formula. ERI = Effective rate of interest. Dp = Doubling period. wants to know the affective rate of interest that will be given by the institute.35 + 69 / 10 = 7.UNIT 3: Computing Time Value of Money 37 Solution: Dp = 72 ÷ I = 72 ÷ 10 = 7.

000 4. calculate the present value at 10 per cent interest rate.10 ) (1 + 0. ___________________ Present Value of a Series of Cash Flows ___________________ Illustration 9: From the following information.000 5.000 3.10 )5 = 2000 + 2727 + 3304 + 3755 + 3073.00 2000.10 ) (1 + 0.10 ) (1 + 0.98 per cent or 9 per cent CE Notes ___________________ Present Value ___________________ Illustration 8: An investor wants to find the present value of ` 40.000 [0.0 1 3000 0.751] = ` 30.5 + 3415.000 4.826 3304. Financial Management 38 = 8.0 3 5000 0.500 5.621 3415.000 ___________________ = ` 40.5 Total present value 18275. ES Year 0 1 2 3 4 5 Cash inflow 2.10 ) (1 + 0.5 UP = ` 18.0 2 4000 0.0 4 4500 0.909 2727.0 (c) Present Value of Even Cash Flows (Annuity) (c) Present Value of Deferred Annuity CIF1 CIF2 CIFn CIF PVAn = 1 + 2 +… n-1 + (1 + I ) (1 + I ) (1 + I ) ( 1 + I )n .040 -C ___________________ Note: Present value of one rupee Table at 3 years for the rate of 10 ___________________ per cent.500 (`) Solution: PV = 2000 3000 4000 5000 4500 5500 0 + 1 + 2 + 3 + 4 + (1 + . His interest rate is 10 per cent. due 3 years.10 ) (1 + 0.5 5 5500 0.683 3073.000. ___________________ Solution: ___________________ PV = FV3 ___________________ = ` 40.275 Present value can also be calculated by the following way: PV Factor 10 Years Cash inflow (`) Present value (`) per cent 0 2000 1.751 3755.

355 = ` 17.621 2484.826 3304.564 2256.n ES = ` 4000 × 4. ___________________ The rate of interest he can earn from this investment is 10 per ___________________ cent.420 Note: See present value of annuity table for 6 year at 10 per cent.91 3640 2 4000 0.000 per annum for 6 years.UNIT 3: Computing Time Value of Money 39 Ê (1 + I )n . ___________________ PVA = Present value of annuity.683 2732. ___________________ ___________________ CIF = Cash inflows.n ) Ë 1 (1 + I) ¯ ___________________ Or Where. ___________________ Solution: = ` 40. -C ___________________ Illustration 10: Mr.0 UP 3 4000 0.355 17.420 Alternate Way Years Cash inflow (`) PV factor at 10 percent PV (`) 1 to 6 4000 4.0 6 4000 0.0 PV of Annuity 17. Bhatt wishes to determine the PV of the annuity consisting of cash flows of ` 40.000 × PVIFAI.0 5 4000 0.1 ˆ CE Notes CIF Á n ˜ = CIF (PVIFA1.751 3004. Alternate way to Find Present Value Years Cash inflow (`) PV Factor 10 Present value (`) per cent 1 4000 0.420 Present value of Annuity Due PVAn = CIF (FVIFI – n) (1 + I) or (c) Ê 1 – (1 + I )-n ˆ PVAn = CIF Á ˜ (1 + I ) Ë I ¯ . ___________________ n = Duration of the annuity. ___________________ I = Discounting factor or interest rate.0 4 4000 0.

5 ___________________ PV of Annuity 1743. Financial Management 40 Illustration 11: Mr.0 2 500 0. X deposited ` 1000 in a bank at 10 per cent of the rate of interest with quarterly compounding.38 per cent. but there will be a difference.0 Effective vs Nominal Rate ES The nominal rate of interest or rate of interest per year is equal.751 375.10 ˆ (c) Ê ERI = Á 1 + –1 Ë 4 ˜¯ =1. m Ê Iˆ ERI = Á 1 + ˜ – 1 Ë m¯ UP Where. Calculate personal value of annuity due. m = Frequency of compounding per year.1038 – 1 = 0. Effective and nominal rate are equal only when the compounding is done yearly once.1038 or 10. .826 413.170) × (1.0 ___________________ Alternatively ___________________ Years Cash inflow (`) PV Factor at 10 Present value (`) ___________________ per cent -C ___________________ 1 500 1.5 ___________________ 3 500 0. ___________________ Solution: ___________________ PVA4 = ` 500 (3. of interest. Illustration 12: Mr.0 ___________________ 4 500 0. I = Nominal rate of interest.00 500. He wants to know the effective rate of interest. Bhatt has to receive ` 500 at the beginning of CE Notes Activity each year. Solution: 4 0. Give___________________ formula for effective rate assuming 10 percent rate of interest. that is. effective rate is greater than the nominal rate for shorter compounding periods. Effective rate of interest can be calculated with the following formula.909 454.10) = ` 1743. for 4 years.

5 (c) 1 Ap = 1.35 + 69/I is the formula used to calculate present ___________________ value of perpetuity. 00. Ap = Annual payment VAn = Future value after 'n' years I = Interest rate Ê I ˆ Á n ˜ = FVIFA I.00.65 . Solution: Ê 0.10y 1 = 1. ___________________ Ê I ˆ A p = FVA n Á n ˜ Ë (1 + I ) . if his savings earn an interest rate of 12 per cent per annum.1 ¯ UP Illustration 13: The finance manager of a company wants to buy an asset costing ` 1.1058) = ` 5698. 548 = ` 5698.12 ˆ Ap = 1.n Ë (1 + I ) . The following ___________________ formula is useful to calculate the annual payment. 1. ___________________ 2. ___________________ Sinking Fund Factor ___________________ -C ___________________ The financial manager may need to estimate the amount of annual payments so as to accumulate a predetermined amount after a ___________________ future date.00..000 (0.1 ¯ = 1. 000 × FVIFA 12%.1 ¯ ES Where.12 or 2 / 2.00. There are two rules available to find out double ___________________ period. 0.000 × 17.00.000 at the end of 10 years. He requests to find out the annual payment required.000 Á 10 ˜ Ë (1 + 0.12 ) .UNIT 3: Computing Time Value of Money 41 Check Your Progress CE Notes Activity True or False: ___________________ Explain sinking fund factor. to purchase assets or to pay a liability.

I = Interest rate. It may be expressed ___________________ as: ___________________ PVµ = CIF × PVIFAIµ ___________________ Where.08 = ` 12. . expects a perpetual ___________________ amount of ` 1000 annually from his investment. I Where. an investor. ___________________ ___________________ CIF = Constant annual cash inflow. Financial Management 42 Present Value of Perpetuity CE Notes Perpetuity is an annuity of infinite duration. (c) PA = Principal amount. LI = Loan installment. -C ___________________ ___________________ PVµ = CIF / I ___________________ Illustration 14: Mr. A financial manager may take a loan and he may be interested to know the amount of equal installment to be paid every year to repay the UP complete loan amount including interest. Installment can be calculated with the following formula: Ê I (1 + I)n ˆ LI = PA Á n ˜ Ë (1 + I) – 1 ¯ Or LI = PA ÷ PVIFAn . The repayment of loan is known as amortisation.µ = PV interest factor for a perpetuity. PVIFAI. Bhatt. ___________________ PVµ = Present value of a perpetuity. n = Loan repayment period.500 Loan Amortisation Loan is an amount raised from outsiders at an interest and repayable at a specified period (lump sum) or in installments. What is his present value of this perpetuity if the interest rate is 8 per cent? Solution: ES PVµ = CIF/I = 1000/0.

687. PVGA = PV of growing annuity. Formula n Ê ( 1 + g) ˆ Á1– n ˜ PVGA = CIF Á ( 1 + I) ˜ (1 + g ) ÁË (1 – g ) ˜¯ Where.000 ÷ PVIFA7%.000 Á ___________________ 6 ˜ Ë (1 + 0. n = Duration of the annuity. of series of cash flows to get total PV of a growing annuity.769 = ` 2. UP 3. 6y ___________________ = 10. Calculate the series of cash flows.1 ¯ -C ___________________ Or ___________________ LI = 10. g = Growth rate. (c) CIF = Cash inflows. Notes Illustration 15: ABC Company took a loan of ` 10. ___________________ Solution: ___________________ 6 Ê 0. the cash flow grows at a component rate.00.I = PV interest factors at loan repayment period at a 43 CE specified interest rate. In others.06 (1 + 0.00. ___________________ The amount has to be repaid in 6 equal annual installments. Steps involved in calculation: 1. 2. Add all the present values.UNIT 3: Computing Time Value of Money PVIFAn. Convert the series of cash flows into present values at a given discount factor.000 lakh for ___________________ an expansion program from IDBI at 7 percent interest per year. ___________________ Calculate the per installment amount.56 ___________________ Present Value of Growing Annuity ES Growing annuity means the cash flow that grows at a constant rate for a specified period of time.000 ÷ 4. .06) . I = Discount factor.00.09.00.06) ˆ LI = 10.

000 × (1 + 0. I = Discount rate (annual). CIFn = Cash inflow after 'n' year.500 0. If the ___________________ agency's required rate at return is 14 per cent. What is the PV of ___________________ expected (annuity) rent? ___________________ Solution: ___________________ Step 1: Calculate on Series of Annual Rent ___________________ Year Amount of rent (`) -C ___________________ 1.000 ___________________ 3.30.303. like. monthly or daily. 6.0 2 630.75 Step 2: Calculate Present Values ES Years Cash inflow (`) Discounting Rate 14 per cent Present value (`) 1 600.30.592 411188. of times per year discounting is done. The general formula used for calculating the PV in the case of shorter discounting period is: m×n Ê 1 ˆ PV = CIFn Á Ë 1 + I/m ˜¯ Where.00. (c) m = No.877 526200.00.00.94.05) = 6.303. 6.61.55 Shorter Discounting Periods Generally cash flows are discounted once a year.75 0. quarterly.29.500 ___________________ 4.000 2. 6.500 × (1 + 0. . semi-annually.6 Total PV of Annuity 22.94.05) = 7.0 3 661. 6.05) = 6.000 0.05) = 6.575 0. 6. PV = Present value.675 446512.879. but sometimes UP cash flows have to be discounted less than one (year) time.575 ___________________ 5.61.000 with the ___________________ stipulation that.46.000 0. rent will increase by 5 per cent every year.519 378508.769 484470.000 × (1 + 0. Financial Management 44 Illustration 16: XYZ real estate agency has rented one of their CE Notes apartments for 5 years at an annual rent of ` 6.4 5 729.5 4 694.575 × (1 + 0.

___________________ ___________________ Solution: ___________________ PV = 1. An investor investing money in installments may wish to know the value of his savings after 'n' years. Lesson End Activity "A rational human being has a time preference for money". 3. Loan payment is called amortization.000 × 0. His required rate of return is 12 percent and he wants to know PV of ` 1.000 at the end of CE Notes 4 years.000 ___________________ = 1. The nominal rate of interest is equal. finite period of time Interest: It is a fee paid on borrowed assets. Keywords Annuity: It is a stream of equal annual cash flows.00. Cash flows are divided with interest (per cent) rate to ___________________ calculate future value of perpetuity. This is called future value of series of cash flows.00. It is usually measured during a specified. Give reasons.UNIT 3: Computing Time Value of Money 45 Illustration 17: Mr. In case of present value concept. or a financial product.000 × PVIF3per cent 4y ___________________ = 1.000 with quarterly discounting. Cash Flow: It is the movement of cash into or out of a business. It is the price paid for the use of borrowed money. we estimate the present worth UP adjusted for the time value of money. ___________________ 2.00.00.00. . ES Summary Interest can be compounded even more than once a year. A expected to receive ` 1.300 ___________________ -C Check Your Progress ___________________ True or False: ___________________ 1. a (c) project.623 = ` 62.

The amount has to be paid back in 5 equal installments. What amount will she receive at the end of 6 years? 6. at a compound interest of 9 per cent. How much can he withdraw annually for a period of 10 years? 5. that the needed amount is available on the required date? 8.000. ___________________ ___________________ Questions for Discussion ___________________ 1. What annual payment must the firm make to ensure. Ramesh deposits ` 20. where company can earn 10 per cent interest p. Calculate your deposits value if you get 7 per cent compound interest and assume you have deposited in the -C ___________________ beginning of each year." Discuss. A company has raised a loan of ` 50 lakhs from an industrial finance bank at 9 per cent p. ` 400 and ` 500 ___________________ respectively. UP 7. Financial Management 46 Present Value: In case of present value concept. The company plans to redeem debentures by establishing sinking fund.000 in a bank account that pays 8 ES percent interest.a. at 8 per cent per year. "Cash flows of different years in absolute terms are incomparable. Calculate the installment amount. we estimate the CE Notes present worth of a future payment/instalment or series of payment ___________________ adjusted for the time value of money. calculate the present value if the cost of capital is 10 per cent. the ___________________ deposit amount of ` 100. ` 300. Explain the meaning and importance of valuation concept. How does valuation concept help in decision making? 4. ABC Company has ` 10.a. If you invest ` 500 today. Mrs. (c) Year 0 1 2 3 4 5 6 Cash flow (`) 250 400 700 900 1000 1100 1400 .00. 9. 8 per cent debentures redeemable after 5 years. ___________________ what will be its future value after 60 years? ___________________ 3. X deposits ` 5000 at the end of each year. Assume you have been depositing each year for 5 years. ` 200. From the following information.00. ___________________ 2.

com/articles/03/082703.sis.. 2002. Financial Management .C. ___________________ Van Horne. Fundamentals of ___________________ Financial Management.. J.com/Components/Finance/TVM/concepts. New Delhi.edu/~gray/INFSCI1026/lectures/. ___________________ Chandra. p. New -C Delhi. New Delhi.getobjects.Theory and Practice.. Jr. 2.. 3. Financial Management.asp www.pitt.. ___________________ Ltd. J.ppt UP (c) .investopedia. Excel Books./tvomPearsonEd.org/wiki/Time_value_of_money ___________________ www.wikipedia.M. ___________________ 2008.UNIT 3: Computing Time Value of Money Further Readings 47 CE Notes Books ___________________ Sudhindra Bhat. 1996. p. Tata McGraw Hill Publishing Company Ltd. and Wachowicz. Prentice Hall of India Pvt. ___________________ ___________________ Web Readings ___________________ en.html ES www. P..

Financial Management 48 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

Keeping in view the type of requirement the finance sources are chosen. many organisations have to look for short term capital in the way of overdraft or loans in order to provide a cash flow cushion.new ES machinery or the construction of a new building or depot. In this day and age of tight liquidity. Traditional areas of need may be for capital asset acquirement .UNIT 4: Short-term Sources of Financing Unit 4 49 CE Notes Activity List the various short-term Short-term Sources of Financing ___________________ sources of finance. The various sources of short-term financing (c) are as follows: Trade Credit Trade credit refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of business. In the present days there exist several sources of finance. whereas capital for the acquisition of machinery may come from external sources. both internal and ___________________ external -C ___________________ \ Advantages and disadvantages of the different sources of funds \ Factors governing the choice between different sources of funds ___________________ ___________________ Introduction ___________________ Sourcing money may be done for a variety of reasons. Trade credit occupies very important position in short-term . Find below various types of finance source. Short-term Source of Finance Sources of short-term funds have to be used (exclusively) for meeting the working capital requirements only and not for financing fixed assets and for meeting the margin money for working capital loans. Interest rates can vary from organisation to UP organisation and also according to purpose. The development of new products can be enormously costly and here again capital may be required. Normally. such developments are financed internally. the students will be aware of the following topics: ___________________ \ Different sources of finance available to management. ___________________ ___________________ Objectives ___________________ After completion of this unit.

Building confidence in suppliers is possible only when the buyer discussing his/her financial condition future plans and payment record. Flexibility is another benefit. One. Easy availability when compared to other sources of finance (except financially weak companies). Getting trade credit may be easy to the well-established or well- reputed firm. 3. if the company is not able to avail cash discount it should pay only at the end of last day of credit period. As such trade credit constitutes a ___________________ very important source of finance. the buyer should have acceptable and ___________________ dependable credit worthiness and reputation in the market. but for a new or the firm with financial problems will ES generally face problem in getting trade credit. Trade credit involves some benefits and costs. Informality as we have already seen that it is an automatic finance. it does not affect the credit standing. Advantages of Trade Credit UP The main advantages are: 1. Trade credit is a spontaneous source of finance that ___________________ arises in the normal business transactions of the firm without ___________________ specific negotiations (automatic source of finance). cost of trade credit is very high beyond the cash discount period. Almost all the traders and CE Notes manufacturers are required to extend credit facility (a portion). where supplier -C ___________________ sends goods to the buyer for the payment to be received in future ___________________ as per terms of the sales invoice. even if it can delay by one or two days. Trade credit generally extended in the format open account or bills of ___________________ exchange. (c) company should not have cash discount for prompt payment and Second. Open account is the form of trade credit. In order to get ___________________ this source of finance. . ___________________ without which there is no possibility of staying back in the business. Financial Management 50 financing due to the competition. Generally suppliers look for earning record. The above discussion on trade credit reveals two things. it represents 25 per cent to 50 per cent of the total short-term sources for financing working capital ___________________ requirements. liquidity position and payment record which is extending credit. 2. as the credit increases with the growth of the firm's sales.

.. since it does not involve any payment of interest. wages.... .. but showed in the balance sheet as income received in advance. Check Your Progress Fill in the blanks: 1. ES Hence..... But in actual terms. Similarly. accruals represent a liability that ___________________ a firm has to pay for the services or goods...UNIT 4: Short-term Sources of Financing Accruals 51 CE Notes Accrued expenses are those expenses which the company owes to the other persons or organisations.. (c) 2. Salaries and wages are usually paid on monthly and ___________________ weekly basis respectively. great demand for its products and services and if the firm is manufacturing a special product on a special order... Deferred Income Deferred incomes are incomes received in advance by the firm for supply of goods or services in future period... since payment of salaries and wages is determined by ___________________ provisions of law and industry practice..... interest and taxes are the major constituents of ___________________ accruals........... .. In other words. tax payment governed by laws and delay in payment of tax leads to pay penalty....... which it has already ___________________ received. The amounts of salaries and wages have ___________________ owed but not yet paid and shown them as accrued salaries and -C ___________________ wages on the balance sheet at the end of financial year.. These income receipts increase the firm's liquidity and constitute an important source of short-term source finance.... These payments are not showed as UP revenue till the supply of goods or services....... Advance payment can be demanded by only firms having monopoly power.... working capital are the two types of working capital. a firm must be noted that use of accruals as a source of working capital or it may not be possible to delay in payment of these items of expenses... it may ___________________ not be true... and .. ___________________ Accruals are treated as "cost free" source or finance... source of short-term finance.. Salaries. It is spontaneous and interest-free sources of financing... but not yet due and not yet ___________________ paid the amount.. Trade credit is a .....

Reserve Bank of India ___________________ introduced CP on the recommendations of the Vaghul Working Group on money market. 4. ___________________ 2. CP is a source of short-term finance to ___________________ only large firms with sound financial position. 1. 5. RBI has laid down the UP following conditions to determine the eligibility of a company that wishes to raise funds through the issue of CPs. It is sold at a discount from its face value and redeemed at its ___________________ face value. Eligibility Criteria for Issuing CP CP is unsecured promissory note. 3. The size of any single issue should not be less than ` 1 crore. . A-2 form ICRA. the issue of CP is being regulated by the Reserve Bank of India. In India. 3. 2.). It may be sold directly to investors or indirectly (through) dealers. note issued by firms that have a fairly high credit (standing) ___________________ rating. Financial Management 52 Commercial Papers (CPs) CE Notes Activity Commercial paper represents a short-term unsecured promissory ___________________ Define commercial papers. (c) 4. Company's CPs receives a minimum rating of (P2 from CRISIL. Return on CP is the difference between par value and ES redeemable value. There is no developed secondary market for CP. ___________________ Features of CP -C ___________________ ___________________ 1. 6. It was first introduced in USA and it was an important ___________________ money market instruments. Company can issue CPs amounting to 75% of the permitted bank (working capital limit) credit. as per latest audited balance sheet should not be less than ` 4 crore. etc. 5. The maturity period of CP ranges from 15 to 365 day (but in India it ranges between 91 to 180 days). The company should have been sanctioned as a fund based limit for bank(s) finance and/or the All India Financial Institutions. The Tangible Net worth (TNW) of the company. The minimum size of each CP is ` 5 lakhs or multiples thereof.

have been solicited by the firms (both large and small) from general public primarily for the purpose of financing their working capital requirements. Company point of view UP (a) Simple procedure involved in issuing public deposits. (c) No security is offered against public deposits. (b) Funds available only for a short period. Investors point of view (a) Higher interest rates when compared to other investment avenues. ___________________ ___________________ Public Deposits Public deposits or term deposits are in the nature of unsecured ES deposits.UNIT 4: Short-term Sources of Financing 53 7. The CP is in the form of usance promissory note negotiable by CE Notes endorsement and delivery. It is available only for large and financially sound companies. It is a cheaper source of short-term finance when compared to ___________________ the bank credit. It cannot be redeemed before the maturity date. It is an alternative source of finance and proves to be helpful ___________________ during the period of tight bank credit. 2. Disadvantages (c) These also can be studied from two different points: 1. ___________________ 2. Company point of view (a) Limited amount of funds can be raised. (b) Short maturity period. ___________________ Advantages of CP ___________________ 1. . ___________________ 2. Advantages Advantages of public deposit can be studied from two different views. ___________________ -C Disadvantages of CP ___________________ 1. 1. (d) Cheaper (post-tax cost is fairly reasonable). (b) No restrictive covenants are involved.

But. The interest rate on these types of deposits is around 14 per cent per annum. Such deposits may be of three -C ___________________ types: ___________________ 1. but in practice lender lends money based on personal contacts. Inter-corporate deposits are given and taken in secrecy. Commercial Banks (c) Commercial banks are the major source of working capital finance to industries and commerce. Investor point of view CE Notes Activity (a) Risk since there is no security against PD. Financial Management 54 2. UP Features of ICDs 1. which make an ICD transaction very convenient. 3. these deposits are usually ___________________ made for a period up to six months. In ___________________ other words. ES 2. 3. Call Deposits: Deposits are expected to be payable on call. Three Months Deposits: These deposits are more popular among companies for investing the surplus funds. in actual practice. ___________________ (b) Income received (interest) is taxable. whenever its repayment is demanded on just one days notice. Generally. Getting bank loan is not an easy task since the lending bank office may ask number of questions about the prospective borrower's financial position and its plans for the . There are no legal regulations. ___________________ Inter-corporate Deposits (ICDs) ___________________ A deposit made by one firm with another firm is known as Inter- ___________________ corporate Deposits (ICDs). Inter corporate deposits generally have 12 per cent interest per annum. Granting loan to business is one of their primary functions. Six Months Deposits: Generally. The borrower takes this type of deposits for tiding over a short- term cash inadequacy. the lender has to wait for ___________________ at least 2 or 3 days to get back the amount. Inter-corporate deposits are given based on borrower's financial sound. Mention the types of ICDs ___________________ present in the market. 2. These types of deposits are usually given to 'A' category borrowers only and they carry an interest rate of around 16% per annum. the inter-corporate deposits are made for a maximum period of six months.

factoring has evolved as an innovative portfolio of ___________________ complementary financial services.. (c) Deferred Incomes are income received in advance by the firm for supply of goods or services in future period..... Cash ___________________ flow is necessary to meet commitments ............. ES which they traditionally get from commercial banks...... Trade credit is a spontaneous source of finance that it arises in the normal business transactions of the firm without specific negotiations (automatic source of finance). Commercial Papers (CPs) represent a short-term unsecured promissory note issued by firms that have a fairly high credit (standing) rating......... At the same time bank will want to monitor of the 55 CE borrower's business progress. CPs is sold at . Poor ___________________ bookkeeping and collection mechanisms along with inadequate and ___________________ delayed institutional credit hasten their untimely sickness.. Accrued expenses are those expenses which the company owes to the other persons or organisations. Public Deposits or term deposits are in the nature of unsecured deposits.. In this backdrop. because investor know that ___________________ convince banks is very difficult.. income is income received in advance by the firm for supply of goods in future.. and redeemed at .. . but not yet due to pay the amount..statutory or otherwise.... unfortunately for the sellers of goods and services. But there is a good side to this that Notes is borrower's share price tends to rise.. worldwide.. ....... Check Your Progress Fill in the blanks 1... The most vulnerable segments -C are the small and medium sector enterprises....UNIT 4: Short-term Sources of Financing future.... ___________________ Factoring ___________________ Cash lubricates the wheels of trade. credit sale ___________________ is the order of the day. ___________________ But...... UP Summary Working capital should be financed by suitable and optimal mix of short-term source of funds and long-term source of funds.... business and industry. 2. It is an alternative way of providing post-sales working capital finance to trade and industry.. Delayed realization ___________________ of the sales receivables elongates their working capital cycles...

Discuss. ___________________ ___________________ Lesson End Activity ___________________ Analyse the quasi-credit facilities available to the firms in course ___________________ of business. Taking the example of the Indian corporate. 2. analyse the importance of issuing the CPs for the firm and to the investors. Commercial banks are the major source of working capital finance to industries and commerce. 4. ___________________ -C ___________________ Keywords ___________________ Accruals: Accrued expenses are those expenses which the ___________________ company owes to the other persons or organisations. 3. Comment. Financial Management 56 have been solicited by the firms (both large and small) from CE Notes general public primarily for the purpose of financing their working ___________________ capital requirements. "Is Trade Credit is source of working capital finance". (c) 5. but not yet ___________________ due and not yet paid the amount. Deferred Income: Deferred incomes are incomes received in advance by the firm for supply of goods or services in future period. Elucidate the sources of short term but cost free finances available to the firm. Commercial Paper: It represents a short-term unsecured promissory note issued by firms that have a fairly high credit ES (standing) rating. Inter-corporate Deposits (ICDs): A deposit made by one firm with another firm is known as Inter-corporate Deposits (ICDs). Questions for Discussion 1. "Accruals are a free source of finance". . Trade Credit: It refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of UP business. What are the sources of working capital finance? Discuss.

Tata McGraw Hill Publishing Company Ltd.pdf www. 2002... p... J. P.economywatch..jsp UP (c) .org/docrep/W4343E/w4343e08. J.nos. ___________________ 2008 ___________________ Van Horne. Financial Management .C..htm ___________________ www. and Wachowicz. New -C Delhi. Fundamentals of ___________________ Financial Management.M. Financial Management.fao. New Delhi. 2 ___________________ Chandra. 3. 1996. Prentice Hall of India Pvt. New Delhi./sourcesoffinance.in/timessme/faces/jsp/. p.UNIT 4: Short-term Sources of Financing Further Readings 57 CE Notes Books ___________________ Sudhindra Bhat.com/finance/sources-of-finance. Excel Books. ___________________ ___________________ Web Readings ___________________ www.org/srsec319/319-19. Jr. ___________________ Ltd.html ES www.Theory and Practice.bizxchange.

Financial Management 58 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

But. rather than a narrowing. in other UP words. The greater efficiency was shown in the higher rate of return for those with surplus money and a lower cost for those in need of money. Analyze the case. ___________________ ___________________ Case Study 1: Maximising Profits -C ___________________ The conflict between the private short-term interest of the ___________________ financial intermediaries in maximizing profits and the public interest of effective financial intermediation was an important ___________________ contributing factor to the making of the financial crises. a widening. the student will have an appreciation of the concept of topics studied in this Block. Comment on the nature of problem and strategy for solution.com) (c) . possibly sharp widening that often occurs in the context of a financial crisis. of the intermediation spread. (Source: cctv. according to the claim. to me at least. Hong ___________________ Kong's weathered monetary chief Joseph Yam said Monday." Yam said. 18 in ES Hong Kong. which runs from Sept. or presages. Question 1. "greater profits for financial institutions and larger bonuses for those employed in them mean.UNIT 5: Case Studies Unit 5 59 CE Notes Case Studies ___________________ ___________________ ___________________ Objectives ___________________ After analyzing these cases. Yam told the big shots at the conference. 14 to Sept. a future. or SWIFT International Banking Operations Seminar. Speaking at the SIBOS. lower financial efficiency. The observed narrowing of the intermediation spread comes at the expense of. Yam said there was an internal contradiction in the claim that the handsome rewards the financial intermediaries received for their innovations were justified by greater financial efficiency.

where the money is deposited in Bhatt’s account. fiscal year just ended) ` (c) Revenues from operations 50. As a result of this scheduling. ` 19 each.20.00.000. the second 100.INCOME STATEMENT (August 31. the third 100. ___________________ Bhatt Industries has been manufacturing fireworks at a small facility just outside Greensboro.000 or `3. that the whole of next year’s production can be sold for ` 25 a case. The firms’ sales occur in February through May. Mr. UP Mr. the company’s only costs are directly related to the production of fireworks. Bhatt is the only full-time employee of his company and he and his family hold all the common stock. the sixth 100. During this time.000 Operating expenses 40. The customers send their checks directly to Kenmy National Bank. ` 18 each and the fourth 100.000 cases. ES The firm’s production cycle revolves around the seasonal nature of the fireworks business. ___________________ On September 7.000 cases would be `1.000 Revenues from interest on government bonds 9. ___________________ with peak consumption in the summer.000 Earnings before taxes 18. the total of 200.70. ` 17 each.000 cases.000 Total revenues 59. ___________________ Bhatt keeps a tight rein on the firm’s cash and invests any excess cash in treasury bonds that pays a 12 percent return and involve no risk of default.000 cases. North Carolina.50. Mr.000.700. Financial Management 60 Case Study 2: Bhatt Industries Basic Planning CE Notes This case will help the reader and develop an approach to ___________________ structuring a case solution.000 Contd… . `21 each.000 cases.000 cases annually. The firm ___________________ has a policy against borrowing. The costs are affected by the law of variable proportions. the owner of the firm. It requires a logical approach to ___________________ solving a general financial problem.300.000 plus `1. it has the capacity to produce 800. the company has ` 8. The firm is ___________________ known for the high level of quality control in its production process and is generally respected by distributors in the states. when its employees return to farming. The firm is fairly -C ___________________ confident. a policy first established by William Bhatt. the firm closes from June 1 to Labour Day.000 cases. BHATT INDUSTRIES .600. The first 100. the fifth 100. to finance its production. Thus. Its selling market is fairly well defined. ` 20 each. ___________________ where fireworks are legalized.000 cases cost `16 each. Bhatt visits his grandchildren in New York and Pennsylvania. the firm pays all its expenses during September and in May receives all its revenues from its distributors within 6 weeks after the 4th of July. depending on the production level. As an example.20. Production begins right after Labour Day and runs through May.000 in cash.

He does ___________________ not invest for shorter periods. because of the paperwork involved.48. What should be the level of production to maximize the profit? ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) . ___________________ Questions ___________________ 1. Mr.21.400 61 CE Net income after taxes 9.UNIT 5: Case Studies Taxes 9. Bhatt invests his excess cash on September 6 in one year treasury bonds.600 Notes Bhatt Industries is a corporation and pays a 30 per cent tax on ___________________ income. How does this level affect long-term prospects of wealth maximization? ___________________ 2.

Financial Management 62 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

UNIT 6: Long-term Sources of Financing 63 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES BLOCK-II UP (c) .

Detailed Contents Financial Management 64 CE Notes UNIT 6: LONG-TERM SOURCES OF FINANCING ___________________ Types of Venture Capital Funds Introduction Venture Capital in India ___________________ Types of Long-term Sources of Financing Eligibility for VC ___________________ External Financing Sources ___________________ UNIT 9: FACTORING UNIT 7: DEBENTURE/BONDS ___________________ Introduction Introduction ___________________ Concept and Features of Factoring Concept of Debentures/Bonds -C ___________________ Mechanics of Factoring Features of Debentures Types of Factoring ___________________ Advantages/Merits of Debentures or Bonds Factoring in India ___________________ Disadvantages/Demerits of Debentures or Bonds ___________________ UNIT 10: CASE STUDIES UNIT 8: VENTURE CAPITAL Introduction ES Concept of Venture Capital UP (c) .

Internal . maybe they have a new product that they want to develop and maybe they want to buy another company. The reasons for needing long term finance are generally different to those relating to short term finance. A new company can raise the required long-term funds from external sources. but an undertaking. advantages & disadvantages of equity shares ___________________ \ Features. this is based on the generation of finance source.UNIT 6: Long-term Sources of Financing Unit 6 65 CE Notes Activity List the various long-term Long-term Sources of Financing ___________________ sources of finance. the students will be aware of the following topics: ___________________ \ Types of long-term sources of financing ___________________ -C \ Retained earnings ___________________ \ Features. ___________________ ___________________ Objectives ___________________ After completion of this unit.generally over a year. and 2. Long term finance may be needed to fund expansion projects - maybe a firm is considering setting up new offices in a European capital. which is well established. Types of Long-term Sources of Financing The following are the sources of long-term working capital or long- term sources of finance: 1. The methods of financing these types of projects will generally be quite complex UP and can involve billions of pounds. External Financing Sources Internal Financing Sources (c) As we have classified source of finance as internal and external. maybe they want to buy new premises in another part of the UK. advantages & disadvantages of preference shares ___________________ Introduction ___________________ Long term sources of finance are those that are needed over a ES longer period of time . Internal Financing Sources. can generate funds not only from external sources but also from internal sources.

In other words. Retained earnings are influenced by a number of factors: 1. It is known as capitalization of profits or issue of bonus shares. ___________________ Accumulation of profits by a firm is meant for financing ___________________ developmental programmes. which are ploughed back -C ___________________ in the company. Retained earnings are part of equity. Hence. In this source of finance companies. Factors Influencing Retained Earnings: As we have read that use of internal funds as a source of finance is only for well- established companies. ___________________ The following discussion gives clear view about the internal ___________________ sources of finance. when the management capitalizes profits. modernisation of plant and equipment. replacement of obsolete assets. In other words. the process of accumulating ___________________ company profits regularly and their utilisation in the business is known as retained earnings or ploughing back of profits or internal financing or self-investment. a retained earning depends on the dividend policy adopted by the top . This becomes a main source of long-term finance. Financial Management 66 source of finance is available only for firms that exist and well CE Notes established. Retained earnings may be used for expansion programmes of UP company. 2. larger are the ploughing back (c) of profits. Earnings Capacity of a Company: Ploughing back of profits arise only when the company has sufficient (profits) earnings. Retained earnings are the portion of ___________________ earnings available to equity shareholders. Types of Dividend Policy: Ploughing back of profits depends on the dividend policy of a firm. redemption of preference shares or debentures. Larger the earnings. loans etc. which are sacrificed by equity ES shareholders. It can be supported by Psychological Law of Consumption given by Keynes who is a famous economist. ___________________ Retained Earnings/Ploughing Back of Profits ___________________ Retained earnings are an important source of internal financing of ___________________ well-established companies. generally retained or ploughed back about 20 per cent to 70 per cent of earnings available to equity shareholders for the purpose of financing of the growth of the company. a part of earnings available to equity shareholders are retained for future investment. since they are part of equity.

Profitable Investment Opportunities: A firm that has more ___________________ profitable investment opportunities feels to retain profits for financing of that investment and vice versa. UP Advantages/Merits of Retained Earnings: The advantages of retained earnings may be studied under three view points: 1. when compared to other sources of long- term finance (equity shares. since it does not involve flotation cost. (c) (c) It increases credit worthiness of the company because retained earnings increases owners’ equity.UNIT 6: Long-term Sources of Financing management (BODs) with regards to distribution of earnings. less retained earnings. where the shareholders who are depend on ___________________ regular income. Other Factors: Apart from the above-discussed factors. i. (d) No dilution of control. since there are no obligations involved with shareholders. ___________________ 4. which intended to retain more earnings. . the following will also affect retained earnings: (a) Top management attitude and philosophy (b) Custom of the industry (c) Economic and social environment of the country (Prevailing) (d) Industry life cycle. 67 CE A company. expects to retain profits. Taxation Policy of the Government: Earnings available to -C shareholders are the profit after taxes minus preference ___________________ shareholders dividend. expects more dividends. Advantages/Merits to Company (a) Firm can raise funds easily. (b) It is less costly. needs to Notes follow conservative dividend policy. ES 5. when a company depends on retained earnings. ___________________ ___________________ 3. and debentures). ___________________ When there is more percentage of shareholders who are in high income tax bracket. etc. When there is high tax rate less profit ___________________ after tax and less retained earnings and vice versa. On the ___________________ other hand..e. preference shares. The retained earnings ___________________ policy is also affected by the expectation of shareholders.

3. which indirectly helps to promote economic development of the nation. ___________________ (f) It helps in improving efficiency. (d) It reduces income tax burden. when the retained earnings are invested in profitable investment avenues. ___________________ 2. credit worthiness etc. improvement of efficiency. producing good quality products at reasonable prices. by internal financing. by the use of retained ___________________ earnings to replace the depletion and obsolescence assets. (c) It enhances (earnings) dividends. (d) It helps to increase productivity. and increase in productivity. (b) It stimulates industrialization. long-term loans. (c) It provides employment. recession. efficient use of scarce resources. which help to utilize the scarcely available resources optimally. the company can use to retain earnings ___________________ to pay uniform dividend. ES (b) Increase in the collateral value of shares. which is needed to be paid if dividends are declared. preference shares. Advantages/Merits to Shareholders/Owners ___________________ ___________________ (a) It increases in the value of shares in the long-run of stable dividend policy. since the value of share price increased and it is accepted by the lenders as collateral security. replacement of old machineries and formulation of new companies. ___________________ (h) It acts as a cushion to absorb hazards refers to the down -C ___________________ in the trade cycle (depression. Advantages/Merits to the Society/Nation UP (a) It increases the rate of capital formation. by establishment of more industries (profitable investment avenues). . which involve a fixed cost. ___________________ (g) It enables to redeem long-term liabilities such as ___________________ debentures. (c) (e) It improves standard of living by providing employment. since retained earnings used for modernization. declining). Financial Management 68 (e) It helps to maintain stable dividend policy in the year of CE Notes less or no profits.

It is out of pocket cost.000 (`1. retained earnings are the dividends foregone by ordinary shareholders. Creation of monopolies. ___________________ 5. it is considered as an internal source of finance. The cost of retained earnings is high. shareholders may sell ___________________ their shares for meeting their expenditure. a machinery costing ` 1.00. since retained earnings in bigger ___________________ organisations helps to grow bigger which may lead to the monopoly. Limited funds available by way of retained earnings. There is a lot of debate among academicians and business executives regarding the treatment of depreciation as source of finance. Hence. The management may misuse the retained earnings. But it is only book entry and not cash outflow. If the machine is depreciated based on straight line method of depreciation. over the estimated useful life of the asset in a systematic and rational manner. depreciation is UP the allocation of capital expenditure to various periods over which the capital expenditure is expected to benefit the company. . the depreciation charge for a year is ` 20. In other words. Depreciation Charges Depreciation is the distribution cost or the basic value of tangible capital assets. Continuous retention of profits may lead to over capitalization.00. which is ___________________ not helpful to maximize shareholders wealth. ___________________ 2. has 5 years life period with no scrap value.UNIT 6: Long-term Sources of Financing 69 Disadvantages/Demerits of Retained Earnings: The following CE Notes are the important disadvantages of retained earnings: ___________________ 1. 7.000. when a firm pays less dividends or no ___________________ -C dividends due to retained earnings.000 / 5). Retained earnings leads to evasion of super profit tax. but one (c) thing is clear that it is an out of pocket cost or non-cash item of expense. which is the revenue loss to the Government.000. ___________________ 3. ___________________ 4. Loss to shareholders. ___________________ 6. which is shown in profit & loss account debt side and it reduces profit by ` 20. which involve an ES opportunity cost. For example. Whatever may be the arguments either for or against.

preference shares.... which is fully paid up.. preference shares..000 profit last year and assume it may earn a loss of ` 10... According to Section 94 (i) (c) of the Companies Act.. For example. Section 2 (46) of the Companies Act.. Ploughing back of profits depends on the .. larger are the ploughing back of ___________________ profits..000 of ` 10 each. ___________________ 3... ___________________ 2.. Kinds of Shares In our country Companies used to raise funds (before Companies Act.. Here. Equity share is a share that (c) gives equal right to holders....000 equity shareholders and it has earned ` 10....000/`10).e. Equity Shares: Equity means ‘equal’...000 in the next year.” For example... the shareholder will get Re... 1956 stock means...... It is a legal definition of share. Financial Management 70 Check Your Progress CE Notes Activity Fill in the blanks: ___________________ What are the components of external sources of financing? 1. i.. share capital of a company (planned to raise) divided into number ES of equal parts is known as share.. In other words.000 shares (i... 1 as . `1.... ABC Company has 10. defines share as. Then the capital is divided into 10.. 1956) by issue of three types of shares. equity (ordinary) shares...00.. Stock and share have different meanings. of ___________________ a firm..... and equity (ordinary) shares. Shareholder is a person who buys one or more shares in the company... as “A share is that proportionate part of capital to which a member is entitled. Equity shareholders have to share the reward and risk associated with ownership of company.e. But the Companies Act has limited the type of shares into two . 1956. and deferred shares. “a share in the share capital of a company and includes stock.. except when a distinction between stock and share is expressed or implied”.. Larger the .. Earnings available to shareholders are the profit after ___________________ taxes minus.. a share.. Lord Justice James Lindley gives a good definition. XYZ company has share UP capital of ` 1.00.. -C ___________________ ___________________ External Financing Sources ___________________ Share Capital ___________________ A share is a small unit of capital of a company.

but he/she can sell shares in the stock market to others.00.e. if he/she wants to get back his/her money. Residual Claim to Income: Equity shareholders have a UP residual claim to the income of a company. 1 loss in the coming year’s loss. The equity shareholders take more -C risk when compared to preference shareholders. if the earnings available to equity shareholders are ` 1.. The dividend rate depends on the profits. Residual claim means the income leftover after paying all outsider claims. ___________________ term or permanent source of finance. Equity shareholders are the Notes owners of the company. since the BoDs have the right to decide the portion of earnings available to shareholders that will be paid as dividends. 2. no dividends will be payable. then the remaining 50 percent (i. They can be redeemed or refunded only at the time of liquidation that ES too from the residue left after meeting all the obligations. But some companies pay ___________________ dividends even if the company has no profits to maintain dividends ___________________ stability. In other words.000 and the (c) BoDs decide to retain 50 percent of them. . there is no agreement between equity shareholders and the company with regard to refund of capital. Payment of dividend depends on retention or plough back of profits. But the total residual income may or may not be paid as dividends. If there are no ___________________ profits. who have control over the working of the ___________________ company. it is permanent source of finance for company. more profits more dividends and vice versa. ` 50. They are paid dividend at the rate recommended by ___________________ Board of Directors (BoDs). Shareholders cannot sell shares to company.UNIT 6: Long-term Sources of Financing profit from last year and Re. ___________________ Features of Equity Stock: The following are the features of ___________________ equity stock: ___________________ 1. For example. The amount required to pay dividends will be transferred ___________________ from general reserve account. It is 71 CE also called as ordinary share capital. The residual income is also known as earnings available to equity shareholders.000) is paid as dividends. Permanent Capital: An equity source is the main long. which is equal to profit after tax minus preference dividend. Hence. There is no legal obligation to pay dividends even if residual income is available.

For example. since they are scattered and they are unorganized. equity shareholders have voting right in appointing Directors and Auditors of the company. Residual Claim to Assets: Equity shareholders have a CE Notes residual claim on firm’s assets. their liability is limited to the extent of the investment in the share. which ___________________ helps to control the company. The number of additional shares offered depends on the number of UP shares owned in relation to the total shares outstanding and on the issue new shares. Financial Management 72 3. the assets are used first to settle the claims of ___________________ outside creditors and preference shareholders. if anything ___________________ left that is equity shareholders residue. before offering to the public. because the major decisions are taken by BoDs. ___________________ participate and vote in annual general meeting. So the ES control over the company is ineffective. BoDs have the control ___________________ power of company. ___________________ their capital become cushion to absorb losses on ___________________ liquidation. In other words. equity shareholders are the owners of the company. B is entitled the pre-emptive right to buy 2 per cent [(4/200) 100 = 2 per cent] additional shares to be offered by the company. Voting right/Right to Control: As real owners of the -C ___________________ company. ___________________ 4. equity shareholders have last priority on assets. The shareholder can exercise or sell in the market or leave the option partially or fully. B owns four shares of a company having 200 shares of equity outstanding. (c) 6. Pre-emptive right is the option given to the shareholders to buy a specified number of shares at a given price. In an event of liquidation ___________________ of a firm. Although. Pre-emptive Right: Equity shareholders have pre-emptive right. Mr. which means they have legal right to buy new issues. . hence. Section 81 of the Companies Act 1956 puts company under legal compulsion to offer new shares to the existing shareholders before offering to the public. Mr. But in actual practice majority of individual shareholders never bother to utilize the voting right. Limited Liability: This is the prime feature of equity share. 5.

Advantages/Merits to Company ___________________ (a) It is permanent long-term source of finance. ___________________ (c) It does not create any obligation to pay dividend. ___________________ (b) There is no repayment liability. Disadvantages/Demerits of Equity Shares: The advantages of equity shares can be discussed from the point of view of company and investors. ___________________ (d) This capital can be issued without creating any ___________________ -C charge over assets of the company. (c) Issue of additional shares dilutes control. (b) Involves high flotation costs. (e) It makes capital structure rigid. ES (b) Equity shares gives right to participate in the control and management of the company. Disadvantages/Demerits to Company UP (a) High cost source of fund. Disadvantages/Demerits to Investors (a) No guarantee and regularity in receipt of dividend (b) No guarantee in receipt of principle amount of investment (c) (c) Loss of capital due to fluctuations in share prices Preference Share Capital: Preference share capital gives certain privileges to its holders on the equity shareholders. 2. ___________________ 1. 1. ___________________ (e) Issue of equity share capital increases the credit ___________________ worthiness of the company.UNIT 6: Long-term Sources of Financing 73 Advantages/Merits of Equity Shares: The advantages of CE Notes equity shares can be discussed from the point of view of company and investors. Advantages/Merits to Investors ___________________ (a) Equity share provides more income (residual income). (c) Capital appreciation (if share price increased when compared to purchase price). (d) No tax advantage (dividends are not tax deductible). ___________________ 2. Preference shareholders have privileges in two ways: .

Preference share resembles equity in the following ways: ___________________ 1. 2. A preferential privilege in payment of a fixed dividend. Claim on Income: Not only the prior claim on assets at the time of liquidation. the preference shareholders are (c) paid. 5. fixed amount per share. ___________________ 3. Features of Preference Shares: The features of preference share/capital are as follows: 1. 3. Financial Management 74 1. It has prior claim on assets like debenture capital. Payment of preference dividend depends on the discretion ___________________ of BoDs. Preference dividend must be paid in full before payment of any dividend on the equity share . 4. It normally does not have voting rights. CE Notes Activity State the features of The fixed dividend may be in the form of fixed rate or ___________________ preference shares. and ___________________ 2. Preference dividends are payable only after tax profits -C ___________________ (PAT). (it is not an obligatory payment). 4. Preference dividend is not a tax deductable payment. they also have prior claim on income or profits. It is redeemable in nature (if it is redeemable preference UP share). 2. ___________________ Preference share capital is a hybrid form of long-term finance. It does not have right to share residual profits/assets. ___________________ 2. Preferential right as to repayment of capital in case of ___________________ liquidation/winding up of the company. It carries a fixed rate of dividend. ___________________ since it has the features of equity and debentures. Irredeemable preference shares are long-term in nature ES (they have no maturity date). Claim on Assets: Companies does not create any charge on assets while issue of preference shares. It means before payment of ordinary shareholders. Preference share capital is similar to debenture capital in the following ways: 1. still preference shareholders have prior claim on assets of the company in the event of liquidation.

As preference share capital lies between 75 CE debenture capital and equity share capital with regards Notes to claim on assets and income of the company. In India. The fixed dividend rate may be UP lower when compared to ordinary shareholders dividend. Hence. It provides flexibility in capital structure. Convertible: Convertible preference shares capital has the feature of conversion of preference shareholders investment into fully or partly paid equity shares at a pre-determined ratio within a given/specified period. Fixed Rate of Dividend: Issue of preference shares are at a fixed rate of dividend.UNIT 6: Long-term Sources of Financing capital. 5. which is beneficial to the company. ES 4. it helps the company to maximize equity shareholders wealth. in this case the ` 10 is carried to the ___________________ next year. It means that all the unpaid/arrears dividends are carried forward for the next ___________________ year and paid with the current year’s dividend before ___________________ payment of any dividend to equity shareholders. It helps the management to avoid the provision of equal participation in earnings. If there are any profits in next year the ___________________ company has to pay last year’s dividend and the current year’s dividend. in the beginning of the financial year. 6. Here. But there is no legal obligation and failure to pay will not force bankruptcy. For ___________________ example. Accumulation of Dividend: Most of the preference shares ___________________ dividend is cumulative. The company needs to pay ` 10 as dividend but due to loss it ___________________ was not able to pay. it is ___________________ called as “senior security”. The rate is at par value basis. surplus profits means the amount of profits left out after payment of a fixed/stable rate of dividend to equity shareholders. Hence. Same case preference shareholders . ___________________ 3. (c) 7. company A issues 10 per cent preference shares -C ___________________ of ` 100 each. Participation in Surplus Profits: Sometimes preference share capital is in the nature of participation in surplus profits. Redeemable: Preference share capital has limited maturity period (if issued as redeemable) after that the share capital has to be refunded. we have a preference share that has convertibility and cumulative features but so far no company has issued. Thereby the total dividend is ` 20.

(b) Prior claim on assets. 1956. (c) They provide flexibility in capital structure by issue of redeemable preference shares. (c) Less risk when compared to equity shareholders. ___________________ 8. they are ___________________ companies and investors. -C ___________________ Advantages/Merits of Preference Shares: The advantages ___________________ of preference shares can be studied under two heads. UP (e) Preference shares provide long-term capital for the company. Advantages/Merits to Company (a) There is no legal obligation to pay preference dividend. 2. (d) It enhances credit worthiness. 1. but Section 97 of the Companies Act. because preference share capital is generally treated as a part of net worth. (f) Mortgageable assets are conserved. Disadvantages/Demerits of Preference Shares: The (c) disadvantages of preference shares can be studied under two heads. Disadvantages/Demerits to Company . so they can not control working of ___________________ company. due to the issue of preference share capital without pledging assets. Financial Management 76 participate in surplus assets in the event of liquidation. Voting Rights: Generally preference shareholders do not ___________________ have voting rights. Advantages/Merits to Investors (a) Stable rate of preference dividend. ___________________ entitled to vote on a resolution that directly affects the rights to be attached to their preference shares. CE Notes Share of surplus assets arises only when the company ___________________ goes to liquidation by court order (when assets value is greater than the liabilities value) to protect public ___________________ interest. they are companies and investors. ___________________ 1. ES (b) There is no share in control of the company through participation in voting.

the preference shareholders cannot ask (or cumulate) from the next years’ profit. Even if the company is not able to pay the last year’s dividend in the next year. and ___________________ shareholders cannot force management to pay more dividends. Thus it is the right to claim unpaid dividends will lapse. which makes preference share capital as costly source of finance. because preference dividend is CE Notes not a tax deductible. Classification of Preference Shares: Preference shares are may be of several types: 1. which is arbitrary. which the amount of dividend payable goes on accumulating until it is fully paid. the same can be paid out of future profits. ___________________ (b) The rate of preference dividend is generally less than ES the rate of dividend on equity shares. Preference shares are generally cumulative unless otherwise expressly stated in the Articles of Association or if there are terms of the issue of those shares. If the UP full dividend or partial dividend cannot be paid in any year (due to less profits). . Disadvantages/Demerits to Investors ___________________ -C ___________________ (a) Limited return. ___________________ 2. as preference shareholders do not have voting rights. It (c) means in any year. the same is cumulated for the future period till the full payment. the company fails to earn profit to pay fixed dividend for that year. their return depends on ___________________ managerial decision. 2. ___________________ ___________________ (c) Permanent burden of payment of dividends. if the preference shares are cumulative in nature. (c) The market prices of preference shares fluctuate more when compared to debentures.UNIT 6: Long-term Sources of Financing 77 (a) Tax disadvantage. Cumulative Preference Shares: Cumulative preference shares are those shares on. Non-cumulative Preference Shares: Non-cumulative preference shares are those shares on which the unpaid dividend does not cumulate to the next year’s dividend. if the company avoids payment of dividend. ___________________ ___________________ (b) Adverse effect on creditworthiness.

6. Financial Management 78 3. which ___________________ is stated while issue of such a share. Not only share in surplus profits. 8. Non-convertible Preference Shares: The preference shares that do not enjoy the option of converting their holdings into equity are known as non-convertible preference shares. Participatory Preference Shares: These are the shares ___________________ that enjoy the right to participate in surplus profit that is ___________________ left out after payment of a fixed rate of dividend to equity shareholders. ___________________ 4. which are having the right to convert their holdings into equity shares with a specific period. Generally. 7. which can be redeemed or repaid ___________________ to the holders after a lapse of the stipulated period. preference shares are non- convertible in nature unless otherwise stated in Articles of Association or in the terms of issue of the shares. they may also participate in surplus assets of the firm at the time of liquidation. Non-participatory Preference Shares: The preference shares that have no claim in the surplus profit or assets of the firm are deemed to be non-participatory preference shares. if there is no clear provision in Articles of Association or in the terms stated while issue of shares. (c) The long-term sources of financing also include debentures and bonds which have been discussed in the next unit. Redeemable Preference Shares: Redeemable preference CE Notes shares are those shares. if articles permit. Irredeemable Preference Shares or Perpetual Shares: Perpetual preference shares that is not repayable and ___________________ redeemable only at the time of liquation. are known as convertible preference shares. -C ___________________ 5. These shares ___________________ are also called perennial shares. ES preference shares are deemed to be non-participatory. A company limited ___________________ by a share may redeem. Convertible Preference Shares: Here convertible means UP into equity not into cash. The preference shares. Generally. . This is the additional return apart from ___________________ getting a fixed rate of preference dividend.

Non-convertible Preference Shares: The preference shares that do not enjoy the option of converting their holdings into equity are known as non-convertible preference shares. The kind of shares will be issued according to the needs of the company and preferences of the investors. These shares are the best source because they are only paid back on winding up of company. The preference shares that have no claim in the surplus ___________________ profit or assets of the firm are deemed to be. . There are two types of shares one is right shares. Lesson End Activity Give comparison between internal and external sources of long- term financing.... Equity ES shareholders are the real owners of the company...... ___________________ 2.. A company can now issue different classes and kinds of shares to raise its owned capital... the issuing of equity ___________________ shares is the most important source for raising the long term capital by the company.. Equity shareholders get dividend when the company is earning profits........ Which one do you find more cost-effective? Keywords Convertible Preference Shares: Here convertible means into (c) equity not into cash.. One ___________________ of the most commonly used is Equity Shares......... ___________________ ___________________ Summary -C ___________________ There are different sources of long term finance which can be used ___________________ to generate the finance for the business for long period of time.....UNIT 6: Long-term Sources of Financing 79 Check Your Progress CE Notes Fill in the blanks: ___________________ 1. Right shares are offered to the shareholders in proportion to their UP present holding often at a price which is less than the currently quoted price on the stock exchange.... A public company may increase its subscribed capital by issue of right shares. The preference shares that do not enjoy the option of ___________________ converting their holdings into equity are known as ..

1996. State the advantages and disadvantages of preference shares. J.pdf www.com/finance/sources-of-finance.htm www.bizxchange. J. 3. and Wachowicz. What are the factors influencing retained earnings? Further Readings Books UP Sudhindra Bhat. ___________________ Non-participatory Preference Shares: The preference shares ___________________ that have no claim in the surplus profit or assets of the firm are ___________________ deemed to be non-participatory preference shares. 4.nos. 2002. 2008 Van Horne. which is the best source of finance available to the firm for raising money from the public? ES 2. New Delhi. Financial Management 80 Non-cumulative Preference Shares: Non-cumulative preference CE Notes shares are those shares on which the unpaid dividend does not ___________________ cumulate to the next year’s dividend. New Delhi. Prentice Hall of India Pvt.Theory and Practice. -C ___________________ Retained Earnings: These are the portion of earnings available ___________________ to equity shareholders. In your opinion. 3 Web Readings (c) www.jsp . Ltd.. Jr. Tata McGraw Hill Publishing Company Ltd. Fundamentals of Financial Management. p. Excel Books.org/srsec319/319-19. Describe the features of equity shares.M. P.fao. ___________________ ___________________ Questions for Discussion 1. p./sourcesOf Finance. New Delhi. Financial Management.economywatch.html www...in/timessme/faces/jsp/.. 2 Chandra.C. Financial Management .org/docrep/W4343E/w4343e08. ___________________ Participatory Preference Shares: These are the shares that enjoy the right to participate in surplus profit that is left out after ___________________ payment of a fixed rate of dividend to equity shareholders. which are ploughed back in the company...

It is not clear or does not explain fully what is . In some countries the term is used interchangeably with bond.loan stock or note. the term is used for a medium. bonds and other security of a company. Raising of funds by issue of debentures/bonds is allowed to public limited Companies. Companies Act of 1956 defines 'debenture' as including debenture stock. it does not become share capital. whether constituting a charge on the assets of the company or not. Meaning of Debenture (c) The term 'Debenture' is derived from the Latin word 'debere'. Senior debentures get paid before UP subordinate debentures.UNIT 7: Debenture/Bonds Unit 7 81 CE Notes Activity List the various long-term Debenture/Bonds ___________________ sources of finance. and it is a debt without collateral. A debenture is thus like a certificate of loan or a loan bond evidencing the fact that the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company's capital structure. ___________________ ___________________ Objectives ___________________ After completion of this unit. which means 'to be a debtor'. Concept of Debentures/Bonds Debenture/bonds are an important source of long-term finance. In corporate finance. the students will be aware of the following topics: ___________________ \ Concept of debenture and bonds ___________________ -C \ Features and types of debentures and bonds ___________________ \ Advantages of debentures ___________________ \ Disadvantages of debentures ___________________ Introduction ___________________ A debenture is a document that either creates a debt or ES acknowledges it. if Memorandum of Association is (MoA) permitted. and there are varying rates of risk and payoff for these categories.to long-term debt instrument used by large companies to borrow money.

it can be done by creation of debenture redemption reserve. The rate of interest is on face value of the debenture that will be paid out annually or semi-annually. Call and Put Option: Debentures may have 'call' option. According to Naidu and Datta. 4. It is compulsory for all debentures whose maturity period exceeds 18 months. 3. which may be fixed or floated. The maturity UP period may vary between 1 year and 20 years. the debentures are issued ___________________ at a fixed rate of interest. ___________________ ___________________ Features of Debentures -C ___________________ The features of debentures/bonds are as follows: ___________________ 1. In India. debentures may also put an option. Company should create Dividend Redemption Reserve (DRR) equivalent to at least 50 per cent of the amount of issue before commencement of repayment. The interest payable on debentures is tax ES deducible. The fixed rate ___________________ debentures are more popular in India. non- convertible debentures are redeemed after 7-10 years. In other words. they are issued and are to be paid". but it should be repaid after a specific period. which is known as premium on redemption. The period in which the debentures are issued or the period after which the debenture capital is repaid is known as maturity period. In other words. The buy back (call) price may be more than the face value of debenture generally 5 per cent. Financial Management 82 debenture. debentures are issued for a specific period (i.. Redemption: Debentures can be repaid either in instalment wise or lump sum. at premium or at a discount. A person who buys debentures ___________________ is debenture holder and creditor of the company. If it is repaid in one lump sum amount. but they may also issued at a floating rate of interest or a zero interest. which gives a right to the . Maturity: The debenture capital is a cheapest source of long- term finance. (c) which gives the right to 'buy' to issuing company at a certain price before the maturity period. Fixed Rate of Interest: In general. Sometimes. Company is free to determine the interest rate.e. 2. they can be ___________________ issued at face (par) value. Debenture can be ___________________ priced as the same manner as share. 10 years or 5 years debentures). "a debenture is an CE Notes instrument issued by the company under its common seal Activity List ___________________ the features of acknowledging a debt and setting forth the terms under which debentures.

___________________ 6. ___________________ The indenture gives the responsibility to the trustee to protect -C ___________________ the interest of debenture holders by fulfilling the above stated descriptions. debenture interest is paid from (c) Earnings before Interest and Taxes (EBIT) or operating profit. Notes 5. Investment Information and Credit Rating Agency of India Limited (ICRA).UNIT 7: Debenture/Bonds debenture holder to seek redemption at specified times and at 83 CE pre-decided prices. preference dividend and equity dividend. FITCH India and Duff & Phelps Credit Rating India Pvt. which specifies the rights of both the issuing ___________________ company and the debenture holder. The interest is payable before payment of tax. Security Interest: Debenture may be either secured or ___________________ insecure. Debenture Indenture: A debenture indenture is a legal ___________________ document. 9. Failure of interest forces the company into bankruptcy. Claim on Income and Assets: Debenture interest is tax deductible. these are known as naked debenture. So. Credit Analysis and Research Limited (CARL). Credit Ratings: Before issue of debentures to the public. ___________________ various standard and restrictive provisions. UP 8. . In India most of the debenture is secured debentures. At the same time they also have priority of claim on company assets at the time of winding up. An unsecured debenture is one which is without any charge on firm assets. The four credit rating agencies are: Credit Rating Information Services of India Limited (CRISIL). 7. Convertibility: Companies can also issue convertible debentures. debenture holders have priority of claim on income. ___________________ A secured debenture is a debenture which is secured by a charge on the company's immovable assets and a floating ES charge on other assets. and frequently ___________________ sinking fund requirements and security interest provisions. Ltd (DCRI). The conversion ratio and the period during which conversion can be affected are specified at the time of issue of debentures. In other words. It is the debenture that is convertible into equity shares at the option of the debenture holder. the issuing company needs to get the debentures rated by anyone of the credit rating agencies. The debenture indenture ___________________ includes descriptions of the amount and timing of the interest and principle amount payments (instalments or lump sum).

even though they carry a low rate of interest when compared to non-convertible debentures. The charge may be fixed or floating or on particular assets. From the redemption point of view. suggests that the debenture does not carry the option of conversion into equity. 2. 3. This type of debentures is attractive. In case of failure in payment of interest or principle amount. Financial Management 84 Types of Debentures CE Notes Activity The following are the different types of debentures: ___________________ What are the various types of debentures? 1. ___________________ (b) Irredeemable Debenture: Irredeemable debentures are not ___________________ redeemable during the existence (life) of the company. The debenture capital may be Fully Convertible Debentures (FCDs) or Partially Convertible UP Debentures (PCDs). From the security point of view. the debentures are sub- ___________________ divided into two: ___________________ (a) Redeemable Debenture: Redeemable debentures are those ___________________ debentures. the debentures are sub- divided into two: (a) Convertible Debenture: Convertible debentures are those debentures that are convertible into equity shares at the option of the debenture holders after stating period at a predetermined price. From the conversion point of view. These types of debentures are also known as ES perpetual debentures. (b) Non-convertible Debenture: As the name itself. the debentures are sub- divided into two: (a) Secured or Mortgaged Debenture: Secured or Mortgaged debentures are those debentures that are issued with a (c) charge on the immovable assets of the company. debenture holders can sell the assets in order to satisfy their claims. ___________________ They are repayable either if the company fails to pay interest on them or at the time of liquidation of the company. which are to be repaid by the company at the ___________________ end of specified period or within the specified period at the option of the company by giving a notice to debenture ___________________ holders with the intention to redeem debentures either -C ___________________ lump sum or instalments. .

having a maturity period of 10 years. addresses and other particulars of holders are ___________________ recorded in debenture register. they are issued at a discount from their maturity/redeemable value. ___________________ 4. 5. -C Names. at the time of transfer of ___________________ such debentures. A has purchased a debenture at ` 50. The interest is paid only to the person on whose name the debenture is registered. ES (b) Bearer Debenture: Bearer debentures are those debentures that are payable to the bearer and transferable by delivery only. This type of debenture does not carry any interest (coupon) rate. which is kept by the ___________________ issuing company. (c) (b) Deep Discount Debenture/Bond (DDB): Deep discount bond is the same as zero coupon bond. But being creditors of the company. From the transfer or registration point of view. Hence. The interest is paid to the bearer of debenture. The return for the holders of this type of debenture is the difference between purchase (issue) price and maturity (redeemable) value. ___________________ they have general charge on the assets of the company. Example: Mr. the debentures ___________________ are sub-divided into two: ___________________ (a) Registered Debenture: Registered debentures are those ___________________ debentures that are registered with the issuing company. Generally.UNIT 7: Debenture/Bonds 85 (b) Necked or simple or Unsecured Debenture: Necked CE Notes debentures do not carry any charge on company's assets as regards to the payment of interest and repayment of ___________________ principle amount. and debenture redeemable value is ` 200. Bearer debentures are negotiable instruments and the company keeps no records for them. In India. the return to holder is ` 150 (` 200 – ` 50). DDBs are being issued by the . but deep discount bond is issued at a deep discount from its redeemable (maturity) value. Transfer of this type of debentures ___________________ needs a regular transfer deed. Other Types of Debentures (a) Zero Interest (Coupon) Debentures (ZID): Zero interest UP (coupon) debentures are of the innovative debt instruments.

It is like zero interest debenture. Floating rate bonds provide protection against inflation risk to investors or bondholders. which is receivable at the end of every year. Financial Management 86 public financial institutions. the issuing company need not serve the debt ___________________ by paying interest. in addition ` 75 in each year as interest and redemption on premium. ___________________ However. DDBs exposed to high risk since the entail a ___________________ balloon payment at the end of maturity period. DDBs enable the issuing ___________________ company to consume cash during maturity period.700. ___________________ (c) Floating Rate Bonds (FRBs): Floating rate bonds are those bonds in which the rate of interest is not fixed. since UP there will be no interest payment in the lock-in-period. (e) Guaranteed Debentures: These are the one type of debentures on which the payment of interest and principle amount is guaranteed by third party at the time . Tata Iron & Steel Company (TISCO) issued this type of notes in 1992. Later. In India. For example. IDBI also issued this type of debentures. face value of ` 300. No interest would accrue during the first year after allotment. The interest rate is floating and its linked interest rate on Treasury Bills (TBs) and Bank Rate (BR) are considered ES as benchmark. SPNs are tradable instruments. During 4-7 years the principle amount will be repaid in instalments of ` 75. In other words. For example in the year 1992 IDBI sold deep discount bonds at deep ___________________ discount price of ` 2. with maturity value of `1 lakh ___________________ and its maturity period is 25 years. Small Industries ___________________ Development Bank of India (SIDBI). etc. They are Industrial CE Notes Development Bank of India (IDBI). The buyer was (c) given an option to sell back SPNs at the ` 300. (d) Secured Premium Notes (SPNs): SPN is a type secured debenture redeemable at a premium over the face or purchase price. It was the first ___________________ institution to issue DDB. SPN holders have the option to sell back the debenture/note to the issuing firm at face value after the given lock-in-period. State Bank of India (SBI) was the one of earliest financial institution to successfully sell floating rate bonds. It reduces the risk of reinvestment of -C ___________________ interest.

are the one type of debentures on which the ___________________ payment of interest and principle amount is guaranteed ___________________ by third party at the time of their issue... (c) Debentures enable the company to take advantage of trading on equity. etc. Notes Activity (f) Callable Bonds: Callable bonds are those bonds that can ___________________ Mention the advantages of debentures/bonds... payments to them are limited to interest and principle amount. ... if they are issued as redeemable or if not also.. 87 CE government. since they do not entitled voting right. .... 2.... be called in and purchased at a price. (b) Issue of debenture does not dilute control.. (e) Debenture holders does not participate in the surplus profits of the company since.. since interest payment on debentures is a tax-deductible expenditure and low flotation cost.. . Companies ___________________ generally call back bonds only when the interest rates fall ___________________ in the market less than the bond's interest rate....... Advantages/Merits of Debentures or Bonds The advantages of debentures/bonds may be studied under two heads: 1...... are those bonds that can be called in and ES purchased at a price.. Advantages/Merits to Company (a) Debenture capital is one of the cheapest sources of long- UP term finance... which results shareholders wealth maximization. Companies redeem high interest bonds and raise funds ___________________ by issue of low interest bonds... The third parties are financial institutions..UNIT 7: Debenture/Bonds of their issue. ___________________ -C Check Your Progress ___________________ Fill in the blanks: ___________________ 1.... since they (c) have call option. IDBI was the first bank to ___________________ issue bonds with call features in 1992. (d) Debenture capital provides flexibility in capital structure.

___________________ 2. when the rate of inflation decreases. (e) This is not stable source of long-term finance for a firm with variable earnings. which raise the cost of equity according to Capital Assets Pricing Model (CAPM) of the company. (c) Table 7. ___________________ (b) Debenture holders' investment is safe and secured since. Since the interest rate comes down in the market. (d) Debenture (irredeemable) capital is costly one. regular and stable source of ___________________ income. Advantages/Merits to Debenture holders ___________________ (a) Debentures provide a fixed. Disadvantages/Demerits to Company (a) Raising debenture capital is risky one. which are legal obligations of the issuing company failure to (pay) honour. -C ___________________ (d) Debentures holders' interests (payment of interest and ___________________ principle amount) are protected by the debenture ___________________ indenture. (c) Raising debenture capital involves restrictions. like limit the borrowing. it may lead to bankruptcy. the interest rate is fixed.1: Difference between Equity Shares and Debentures Point of Distinction Equity Shares Debentures Nature of Security Ownership security Creditorship security Form of Return Dividend Interest Contd… . ___________________ debentures with a charge on company is assets. limit dividend payment etc. ___________________ Disadvantages/Demerits of Debentures or Bonds The following are the important disadvantages of debentures: ES 1. ___________________ (c) Debentures are issued for a definite maturity period. since it involves payment of fixed interest charges and repayment of principle amount. Financial Management 88 (f) Debenture capital provides protection against inflation CE Notes since. (b) Raising debenture capital increases financial leverage UP (risk perception on investors).

.... UP Check Your Progress Fill in the blanks: 1.. (e) Debenture prices are vulnerable with changes interest rates.. is one of the cheapest sources of long-term finance. and income.. before payment of ___________________ tax). if the inflation increases... Disadvantages/Demerits to Debenture holders' ___________________ (a) Debentures do not carry any voting rights. ___________________ (b) Debenture holders' does not have claim on surplus profits ES since they are not the owners of the company. They are considerably safe investment instruments.. No voting right. ___________________ Exemption of return Not exempted from tax Exempted from tax ___________________ from tax (dividend is paid after (interest is paid payment of tax). ___________________ Voting Rights Have voting rights... of the company Summary (c) Bonds and Debentures are debt instruments which guarantee to repay the principal of the loan plus interest to the bondholder... since interest payment on debentures is a tax-deductible expenditure and low flotation cost.... Claim on assets and Equity holder does not Debenture holders ___________________ -C income have claim on assets have claim on assets ___________________ and income.. (d) Debenture holders' loose interest charges.... 2. (c) Receipt of debentures is fully taxable under the head income from other sources.. Debenture holders does not participate in the . ___________________ 2..........UNIT 7: Debenture/Bonds Rate of Return Not fixed (no guarantee) Fixed rate 89 CE Refund of principle May be refunded at the Refunded at the end Notes amount time of liquidation of maturity period.. apparition account. . Charge of Return Dividend is a charge Interest is a charge on ___________________ against profit & loss profit& loss account. which give no controlling power on the working of the company... especially if you're going to stay with high-quality . They are considered to be long-term debt and have to be paid back by their maturity date...

2002. P. ___________________ Debenture: It is a document that either creates a debt or acknowledges it. UP 3. New Delhi. Explain the concept of debenture and bonds... whether it's big corporations or the government. Questions for Discussion 1. Give a brief report on ___________________ it.C.. p. p. Describe the features and types of debentures and bonds. They offer a fixed rate of return on maturity and are independent of market fluctuations. J. Excel Books. 2008 Van Horne. Tata McGraw Hill Publishing Company Ltd. New Delhi. Financial Management. Financial Management . and Wachowicz.M. Maturity period: The period in which the debentures are issued ES or the period after which the debenture capital is repaid Premium on redemption: When the buy back (call) price may be more than the face value of debenture. J. 2. Fundamentals of (c) Financial Management. Investing CE Notes in bonds and debentures is advisable for investors who have a very ___________________ low risk appetite. Prentice Hall of India Pvt. 2 Chandra. New Delhi. Further Readings Books Sudhindra Bhat. ___________________ -C ___________________ Keywords ___________________ 'Call' option: It gives the right to 'buy' to issuing company at a ___________________ certain price before the maturity period. Jr.Theory and Practice.. ___________________ ___________________ Lesson End Activity ___________________ Compare debentures with preference shares. 3 . and it is a debt without collateral. 1996. Ltd. Explain the various types of debentures. What are the advantages and disadvantages of debentures? 4. Financial Management 90 lenders.

bizxchange.in/timessme/faces/jsp/.fao.UNIT 7: Debenture/Bonds 91 CE Web Readings Notes www.htm ___________________ www.pdf ___________________ www..html ___________________ www.org/srsec319/319-19../sourcesOf Finance.jsp ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .com/finance/sources-of-finance.nos.economywatch.org/docrep/W4343E/w4343e08.

Financial Management 92 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

Venture capital is a subset of private equity. software. etc. the students will be aware of the following topics: ___________________ \ Concept of Venture Capital ___________________ -C \ Objective of Venture Capital ___________________ \ Importance of Venture Capital ___________________ \ Types of Venture Capital Funds ___________________ \ Venture Capital in India ___________________ Introduction ES Venture capital (VC) is financial capital provided to early-stage. . which usually have a novel technology or business model in high technology industries. (c) development/expansion or purchase of a company. high-potential. all venture capital is private equity. etc. Venture capitalists finance innovation and ideas which have potential for high growth but with inherent uncertainties. clean technology. infrastructure. Venture Capital ___________________ ___________________ ___________________ Objectives ___________________ After completion of this unit. The typical venture capital investment occurs after the seed funding round as growth funding round (also referred to as Series A round) in the interest of generating a return through an eventual realization event.UNIT 8: Venture Capital Unit 8 93 CE Notes Activity Explain venture capital. Concept of Venture Capital Venture Capital funding is different from traditional sources of financing. Venture capital is a means of equity financing for rapidly-growing private companies. such as biotechnology. such as an IPO or trade sale of the UP company.g. high risk.). Therefore. health/life sciences. IT. The venture capital fund makes money by owning equity in the companies it invests in. but not all private equity is venture capital. IT. Venture Capital firms invest funds on a professional basis. Finance may be required for the start-up. growth startup companies. often focusing on a limited sector of specialization (e.

The risk envisaged may be very high may be so high as to result in ___________________ total loss or very less so as to result in high gains. made in new or untried concepts. Rather.straight or conditional. Objective of Venture Capital The objective of the VC scheme is to provide a window to entrepreneurs who have thought of ventures having special characteristics to be innovative but at the same time may not qualify for assistance through the conventional route of loans and financing. When venture capitalists invest in a business they typically require a seat on the company's board of directors. They tend to take a minority share in the company and usually do not take day- to-day control. -C ___________________ With venture capital financing. quasi-equity and sometimes debt . Venture ___________________ capital means risk capital. venture capital investors are therefore ES exposed to the risk of the company failing. professional venture capitalists act as UP mentors and aim to provide support and advice on a range of management. both ___________________ equity and debt. It is "patient" capital that seeks a return ___________________ through long-term capital gain rather than immediate and regular interest payments. which carries substantial risk and uncertainties. promoted by a ___________________ technically or professionally qualified entrepreneur. Venture capital is an investment in ___________________ the form of equity. the venture capitalist acquires an ___________________ agreed proportion of the equity of the company in return for the ___________________ funding. as in the case of debt financing. It refers to capital investment. Projects involving new and untried/untested processes and technologies which have scope for commercial application with (c) characteristics of high risk and high return are one example of the type of projects which a VC looks for. risky finance to new ventures based on ___________________ innovative entrepreneurship. Equity finance offers the significant advantage of having no interest charges. sales and technical issues to assist the company to develop its full potential. Importance of Venture Capital Venture capital is valuable not just because it makes risk capital available at the early stages of a project but also because of the . As a result the venture capitalist must look to invest in companies which have the ability to grow very successfully and provide higher than average returns to compensate for the risk. Financial Management 94 Venture capital has developed as a result of the need to provide CE Notes non-conventional. Given the nature of equity financing.

.. Venture capital is valuable not just because it makes risk capital available at the early stages of a project but also because of the . such as in recruiting key personnel. 4.... -C ___________________ Venture capital has a number of advantages over other forms of finance... of venture capitalist that leads to superior product development... (c) 2. ___________________ This will also protect smaller investors.. ___________________ Investors also get enticed into public offerings of unproven and at ___________________ times dubious quality. It injects long term equity finance which provides a solid ___________________ capital base for future growth.. funding is different from traditional sources of financing... Check Your Progress Fill in the blanks: 1.. In the present ___________________ situation.. . providing contacts in international markets. 5... sharing both the risks and rewards.. . Venture capitalists are rewarded by ES business success and the capital gain.. The venture capitalist is able to provide practical advice and assistance to the company based on past experience with other companies which were in similar situations. 3.. such as: ___________________ 1.. an individual investor becomes a venture capitalist of a sort by financing new enterprises and undertaking unknown risk...... The venture capitalist also has a network of contacts in many areas that can add value to the company... The venture capitalist is a business partner.. and if needed co- UP investments with other venture capital firms when additional rounds of financing are required.. ___________________ 2..... The venture capitalist may be capable of providing additional rounds of funding should it be required to finance growth. This situation can be corrected by venture ___________________ capital backed successful enterprises accessing the capital market.UNIT 8: Venture Capital expertise of venture capitalist that leads to superior product 95 CE development. Development of a proper venture capital industry Notes particularly in the Indian context is important for bringing to ___________________ market high quality public offerings (IPOs). introductions to strategic partners...

venture capital subsidiaries of corporations and private venture capital ___________________ firms/funds. VCFs promoted by the foreign banks or private sector UP companies and financial institutions such as Indus Venture Fund. 4. VCFs promoted by Public Sector banks such as Canfina by Canara Bank and SBI-Cap by State Bank of India. 2. Venture Capital in India In India the Venture Capital plays a vital role in the development and growth of innovative entrepreneurship. Venture funds in India can be classified on the basis of the type of promoters. by ICICI. -C ___________________ ___________________ 1. VCFs promoted by the State Government-controlled ES development finance institutions such as Andhra Pradesh Venture Capital Limited (APVCL) by Andhra Pradesh State Finance Corporation (APSFC) and Gujarat Venture Finance Company Limited (GVCFL) by Gujarat Industrial Investment Corporation (GIIC). that is. ___________________ venture capital funds: venture capital funds set up by angel ___________________ investors. These institutions promoted entities in the private sector with debt as an instrument of funding. And with the minimum paid up capital requirements being raised for listing at the stock exchanges. Venture capital subsidiaries are established by major ___________________ corporations. For a long time funds raised from public were used as a source of Venture Capital. VCFs promoted by the Central Government controlled development financial institutions such as TDICI. high net worth individual investors. This source however depended a lot on the market vagaries. Credit Capital Venture Fund and Grindlay's India Development Fund. ___________________ Risk Capital and Technology Finance Corporation Limited ___________________ (RCTFC) by the Industrial Finance Corporation of India (IFCI) and Risk Capital Fund by IDBI. it became difficult for smaller firms with . Financial Management 96 CE Notes Activity Types of Venture Capital Funds ___________________ Describe the types of venture Generally there are three types of organised or institutional capital funds. ICICI and State Financial (c) Corporations. commercial bank holding companies and other ___________________ financial institutions. Venture Capital activity in the past was possibly done by the developmental financial institutions like IDBI. 3.

India certainly needs a large pool of risk capital both from home and abroad. ___________________ and APIDC Venture Capital Ltd. Recent phenomena. India has a vast pool of scientific and technical research carried ES out in research laboratories. In 1973 a committee on Development of ___________________ small and medium enterprises highlighted the need to faster VC as ___________________ a source of funding new entrepreneurs and technology. The quality of enterprise in India is on an ascending curve. and CSIR for improvement in infrastructure and R&D. A conducive environment including incubation facilities can help a great deal in identifying and actualizing some of this research into commercial production. More focused attempts will be required in all these directions. In India. Certain NRI organisations are taking initiatives to create a corpus of US$500m to strengthen the infrastructure of IITs. the need for 97 CE Venture Capital was recognised in the 7th five year plan and long Notes term fiscal policy of GoI.promoted by ICICI and UTI. Taiwan and Israel clearly show that this can happen provided there is right regulatory. There are success stories within India also. Steps are being taken at the level of Government. Ministry of Information and Technology. It is also necessary that startups have UP access to R&D flowing out of laboratories and universities with infrastructure support such as telecom. At the same time increasing number of internationally savvy. The atmosphere thus is ripe for creating the right . Examples of US. At the same time Gujarat Venture Finance Ltd. VC financing really started in India in 1988 with the formation of ___________________ Technology Development and Information Company of India Ltd. Sources of these funds were the financial institutions. Credit Capital ___________________ Venture Fund. Asian Development Bank and the -C Commonwealth Development Corporation viz. The first private VC fund ___________________ was sponsored by Credit Capital Finance Corporation (CFC) and ___________________ promoted by Bank of India. foreign institutional investors or pension funds and ___________________ high net-worth individuals. were started by state level ___________________ financial institutions. ___________________ (TDICI) . provide the indications of a growing (c) number of young.UNIT 8: Venture Capital viable projects to raise funds from public. partly ignited by success stories of Indians in US and other places abroad. tax and institutional environment. senior managers have been leaving established multinationals and Indian companies to start new ventures. defence laboratories as well as in universities and technical institutes. technology parks etc. legal. technically qualified entrepreneurs in India.

strategic and financial roles. While great ideas. Nature of Assistance: The nature of assistance would depend upon needs and requirement of the project. and favourable market conditions are good reasons. It is also to be noted that the quality and quantity of research conceptualized in startups competes favourably with research undertaken by big firms. even if it is new and untested. easy entry-exit and ownership patterns to suit global needs. ___________________ Information Technology and Internet have brought about the trend ___________________ of what can be called the "death of distance" and operation across ___________________ the countries can be seamlessly integrated. In the Indian context with developing IT and internet technology coupled with close -C ___________________ linkages of Indian technocrats and entrepreneurs located in India ___________________ and abroad. ___________________ Another important area is the need for multi country integration. VCs after investment remain actively involved in board membership and help in a variety of functional. This phenomenon is seen even ES in India. A VC invests in the company and expects that the venture company would go in for an (c) IPO within a reasonable period of time to offer an exit route or buy back. innovative technologies. the primary factor is strong and diverse management team with solid operational experience and deeply rooted domain expertise. This will of course ___________________ need further regulatory and policy support to provide operational ___________________ flexibility. No . Financial Management 98 regulatory and policy environment for sustaining the momentum CE Notes for high-technology entrepreneurship. but generally any entrepreneur has a good idea or invention in terms of process or product that is different from existing thing. Ventures involving UP high risk and high return are preferred. The Indians abroad have Activity ___________________ State the eligibility for venture leapfrogged the value chain of technology to its highest levels. Eligibility for VC Though the requirement and eligibility criteria differ among different VCs. there are interesting possibilities. By capital. bringing venture capital and other supporting infrastructure this ___________________ can certainly happen at home also. Extent of Assistance: Extent of assistance shall be decided on a case-to-case basis on detailed assessment of the requirements.

grants. 5. cost factor comparison. ___________________ Business Plan: The primary document. (c) 4. If a statement of novelty and innovation is outlined separately and the difficulty in the field is mentioned. this can make a UP good impact. Innovative content of the product/service and technology with its distinct characteristics. project cost and financial requirements. But it is expected that the promoters have reasonable stake in the venture. qualification) of the promoters and management team with references from experts of the field if possible. which an entrepreneur ___________________ should be ready with. target users. A comparison with the existing product or analogous field will be helpful along with geographical comparison. what exists in the market as on date. loans if any. Detailed shareholding and stakes within the company (existing and proposed). special legislation prevailing. a student with an Aerospace Engineering degree builds a prototype of a equipment finding use in aviation so a reference letter of his supervisor or lab in charge will be helpful. ___________________ Security: In normal situations the VCs don't insist for security ___________________ -C and collateral but sometimes security requirements are considered ___________________ in some cases. is a Business Plan that should cover the ___________________ following aspects: 1. for example. 2. what benefit it accrues to the users. Notes Promoters Contribution: The promoter's contribution in terms of ___________________ involvement and finance is very important in deciding the fate of ___________________ the venture. Briefly outline his objective. Resume (with brief write up on the interest. 3. experience. . and other details that are necessary for the product. Executive summary giving objective and brief details of the ES project. The quantum of promoters' contribution is not fixed ___________________ and vary from case to case basis.UNIT 8: Venture Capital minimum/maximum limits are fixed in respect of the quantum of 99 CE assistance. their own ___________________ resource raising capacity. this would be a handy document. availed by the promoter from any bank/Financial Institution. his contribution or innovation. etc. Details of credit facilities. organization.

14. Present status of the proposed project. if ___________________ any. Details of operations like sales office. Existing Clients added major orders executed for them. or any other stage. 12. Total cost of machinery. prototype. ___________________ experience. overseas site offices. Human resources and requirement in future and mode of CE Notes acquiring and special training. ___________________ 7. Details of ratings (if any) certifications from a trusted third party about worthiness of the company. hardware. Financial projections with underlying assumptions: Like the minimum sales and expenses. minimum education criteria. ___________________ 8. Details of technical tie ups/collaborations. Implementation schedule: This is very important yet difficult to make. Financial Management 100 6. intended geographical areas and time frame within ES which the targets are to be covered. 16. 11. Marketing strategy: How will the product or service reach to target customers is a very important ingredient in a business plan. and proposed means of finance and possible vendors or suppliers to give timely supplies. products developed. if applicable. 15. since these are interdependent and can change with various unrelated factors. subsidiary/associate companies set up abroad for marketing/offshore development. -C ___________________ 9. Quality systems documentation adopted and milestones ___________________ achieved in obtaining Quality certifications like ISO 9000. Details of performance of the company during the preceding ___________________ years (where applicable) covering financial performance. ___________________ if any. . if any. Online marketing mode and special adaptations are the special marketing strategies used for the same. ___________________ 10. like marketing target will change if the purchase of required machinery is delayed. (c) 17. whether it is in idea stage. existing or proposed. projects completed. UP 13. ___________________ nature/type of operation. competitive strength etc.

VCFs charge royalty ranging between (c) 2 to 15 percent. or (d) Purchase of the venture capitalist's share by an outsider. thus. They buy shares of an enterprise with an intention to ultimately sell them off to make capital gains. they are: UP 1. effective control and majority ownership of the firm remains with the entrepreneur. be ___________________ desirable for a venture capitalist to get involved in the day-to. He also gets involved in shaping of the ___________________ direction of the venture. actual rate depends on other factors of the venture such as gestation period. Exit plan: Venture capitalists generally want to cash-out their gains in five to ten years after the initial investment. No interest is paid on such loans. ___________________ the venture capitalist generally assumes the role of a partner ___________________ and collaborator. 2. ___________________ day operation of the venture. 3. A venture may exit in one of the following ways: ES (a) Initial Public Offerings (IPOs) (b) Acquisition by another company (c) Purchase of the venture capitalist's shares by the promoter. If a financial or managerial crisis ___________________ occurs.UNIT 8: Venture Capital and so on. Methods of Venture Financing: Venture capital is typically available in three forms in India. In India. the venture capitalist may intervene. ___________________ They play a positive role in directing the company towards ___________________ particular exit routes. Conditional Loan: It is repayable in the form of a royalty after the venture is able to generate sales. but it is advisable as the time overrun will affect the 101 CE cost of the project. however. Equity: All VCFs in India provide equity but generally their contribution does not exceed 49 percent of the total equity capital. cost-flow patterns. It may not. riskiness and other factors of the enterprise. ___________________ 19. The degree of the venture capitalist's involvement depends on his policy. The . and even install a -C ___________________ new management team. Once the deal has been structured and agreement finalised. Income Note: It is a hybrid security which combines the features of both conventional loan and conditional loan. Notes 18.

high risk.... shall be decided on a case-to-case basis on ___________________ detailed assessment of the requirements... Venture capital: It is financial capital provided to early-stage. Financial Management 102 entrepreneur has to pay both interest and royalty on sales. in addition to a portion of the equity. Lesson End Activity Explain the objective of a venture capital for an organisation. State the importance of venture capital. What are the objectives of venture capital? 3...... .... Explain the concept of venture capital..... This form of raising capital ES is popular among new companies or ventures with limited operating history.. ___________________ 2. Most venture capital comes from a group of wealthy investors.. but CE Notes at substantially low rates.. investment banks and other financial institutions that pool such investments or partnerships....... high-potential... growth startup companies. -C ___________________ ___________________ Summary ___________________ Venture capital can also include managerial and technical ___________________ expertise. which cannot raise funds by issuing debt. . would depend upon needs and requirement ___________________ of the project. ___________________ Check Your Progress ___________________ Fill in the blanks: ___________________ 1.... is a Business Plan Security: In normal situations the VCs don't insist for security and collateral but sometimes security requirements are considered in some cases.... The downside for entrepreneurs is that venture capitalists usually get a say in company decisions. (c) Questions for Discussion 1. UP Keywords Business Plan: The primary document. 2. ... which an entrepreneur should be ready with.

com/finance/sources-of-finance.fao.C. Tata McGraw Hill Publishing Company Ltd.bizxchange.org/docrep/W4343E/w4343e08. p.. Prentice Hall of India Pvt.htm www. Excel Books. New Delhi. P... Comment on the state of Venture Capital in India.org/srsec319/319-19..in/timessme/faces/jsp/.. Jr.M. p. ___________________ 2008 ___________________ Van Horne. J. and Wachowicz. J.UNIT 8: Venture Capital 103 4.jsp UP (c) . Financial Management. 1996. 2 ___________________ Chandra./sourcesOf Finance. What are the types of venture capital funds? CE Notes 5.pdf www. Fundamentals of -C ___________________ Financial Management..economywatch.html www. 2002. New Delhi.Theory and Practice. ___________________ Ltd.nos. Financial Management . ___________________ ___________________ Further Readings ___________________ Books ___________________ Sudhindra Bhat. New Delhi. 3 ___________________ Web Readings ES www.

Financial Management 104 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

in underwriting the loan.e. It aims at exonerating the supplier from the burden of complicated administrative and financial tasks involved in receivables management. net of the factor's discount fee (commission) and other charges. ___________________ ___________________ Objectives ___________________ After completion of this unit. with the balance of the purchase price being paid. the factor makes no advance on the purchased accounts. the value attributable to non-accounts collateral owned by the borrower. the purchase price is paid on or about the average maturity date of the accounts being purchased in the UP batch. Concept and Features of Factoring Factoring is a financial service covering the financing and collection of book debts and receivables arising from credit sale of (c) goods and services. In "maturity" factoring. The emphasis is on the value of the receivables (essentially a financial asset). whereas a bank focuses more on the value of the borrower's total assets. In "advance" factoring. the factor provides financing to the seller of the accounts in the form of a cash "advance.UNIT 9: Factoring Unit 9 105 CE Notes Activity Explain the features of Factoring ___________________ factoring. and often also considers. Factoring differs from a bank loan in several ways. invoices) to a third party (called a factor) at a discount. the students will be aware of the following topics: ___________________ \ Concept and features of factoring ___________________ -C \ Mechanics of factoring ___________________ \ Types of Factoring ___________________ \ Factoring in India ___________________ Introduction ___________________ Factoring is a financial transaction whereby a business sells its ES accounts receivable (i. both in the domestic as well as international market. . upon collection from the account client." often 70-85% of the purchase price of the accounts. rather..

Thus. ___________________ 2. the factor approves 'credit limits' on individual debtors. Credit Protection: In "without recourse factoring". the UP client bears the credit risks. Advisory Services: With his pool of expertise. 3. This enables him to advise his clients accordingly. 5. under 'recourse factoring'. For example. 4. Based on the credit information of customers. he provides credit insurance facility against possible losses arising from insolvency/bankruptcy . the factors' personnel with extensive manufacturing experience can provide guidance on workload analysis.financial failure of the debtors. machinery replacement programmes (c) and other technical aspects of clients' business. His staff is trained in the assessment of creditworthiness and has access to extensive information on the financial standing and credit ES rating of individual customers. The -C ___________________ service charges paid by the client to the Factor are more than ___________________ offset by the host of administrative expenses saved on account of debt administration by the Factor. as a professional. has the ___________________ wherewithal for credit intelligence on customers. the Factor assumes credit risk. the Factor also offers consultancy services to the clients in areas of production. Financing of Receivables: Factor advances funds to the client to the extent of about 80% of the outstanding debts ahead of maturity. Maintenance of sales ledgers and collection of ___________________ receivables: The factor takes up the responsibility of sales ___________________ ledger administration. It includes (a) Bookkeeping (b) Invoice ___________________ raising (c) Follow-up and monitoring (d) Collection of receivables (e) Liaisoning with clients and customers by ___________________ informing them periodically about collection and outstanding ___________________ (f) Maintaining a Management Information System (MIS). Credit Control: A factor. we can derive that the main functions of CE Notes a factor comprise: ___________________ 1. This credit input helps the client to expand his business. . However. finance and marketing. Financial Management 106 From the above definition.

a factor can entertain with.UNIT 9: Factoring 107 CE Mechanics of Factoring Notes By now you have understood that there are three players in a ___________________ domestic factoring service viz. retaining a margin of 20%. 3. UP 5. the seller (the ___________________ Client) approaches the Factor for establishing factoring ___________________ relationship. The invoice is accounted for in the buyer's account in the sales ledger maintained by the Factor. the factor decides the coverage of factoring services to be provided. ___________________ average outstanding invoices. 4. The seller furnishes information about his business. 8. Factor fixes limits to the client aggregating individual limits to buyers. names and addresses of regular customers. Based on the information supplied by client and additional information collected from other sources. ___________________ size. Client sells the goods/services to the buyers. the last few years' financial statements. Factor checks the credit credentials and approves the buyers. ES 2. Client assigns the debt in favour of the factor. The system of a domestic factoring is ___________________ as follows: ___________________ -C 1. the Client (the seller of goods/services for whom the ___________________ Factor provides facilities) and the Customer (who purchases goods/services). The factor sends the notice of assignment/copy of invoice to the (c) buyer. 6. their bankers. a direction to the customer to pay the invoice value to the factor. ___________________ recourse factoring services. The factor provides credit to the client to the entitled extent say 80% of invoice value. range of factoring service required etc. The factor periodically sends details of collections and outstanding dues to the client and customer. the Factor (who provides the ___________________ services). turnover. Client notifies in the invoice. 9. For each approved buyer. Presently. in India. The invoice is sent to the Factor along with receipted delivery challans. 7. a credit limit and the period up to which credit can be given are fixed. . On receiving order from the buyer (Customer). his banker and credit facilities availed.

But this 'non-recourse' aspect is only towards financial inability of the debtors because... Factor assumes the debt risk (within the approved limit). the Factor takes recourse to the ___________________ client under recourse factoring.. credit protection and financing of receivables...." This classical form of factoring is most comprehensive and includes services such as maintenance of sales ledger. ___________________ Check Your Progress ___________________ Fill in the blanks: -C ___________________ 1... credit control.. . quantity..e. Full Factoring: This is also called "without recourse factoring" or "old-line factoring.. If the customer does not pay.. advances funds to the client to the extent of about 80% of the outstanding debts ahead of maturity.. factoring can be of six different types: 1. Then the Factor pays to List ___________________ the various types of the seller the margin money retained after recovery of interest factoring.. ___________________ 11.... Corresponding to the types of services provided.... Financial Management 108 10. the Factor's charges include the following: (a) Charge for rendering sales ledger administration and debt collection . collection of receivables. ES Types of Factoring Depending on the arrangement between the Factor and the Client.. On the expiry of the agreed credit period. recourse will be available to the Factor (c) against the client. the buyer makes the CE Notes Activity payment of the invoice to the Factor.. Client is free to exceed limit at his risk...... ___________________ 2. invoices) to a ___________________ third party (called a factor) at a discount. Here the UP Factor approves the customers for credit risks based on his credit worthiness. ___________________ and other charges. counter-claim etc. if payment is withheld for reasons of dispute regarding quality..... . The client is totally absolved of his responsibilities as the invoice representing the receivables/trade debts are assigned to the factor on a 'without recourse' basis up to a specified limit only. is a financial transaction whereby a ___________________ business sells its accounts receivable (i........

pays the client. Maturity Factoring: This is also called 'Collection Factoring. UP No financing is done ab initio. Thus the factor assumes no credit risks. the client can produce proof of insolvency and claim from the Factor. the corresponding ___________________ invoice is assigned back to the client.' It is akin to the original factoring charges levied on all trade debts. ___________________ A concept in recourse factoring is 'Refactoring Charges. Accordingly. Hence no drawing limit is made available. Factor's charges -C are limited to charges for sales ledger administration and debt ___________________ collection and interest on finance provided. after recovering factoring charges. If the trade-debts ___________________ are not realised within the agreed period. 3. the (c) Factor. it ___________________ may not approve customers or fix credit limits. If a customer becomes insolvent. irrespective of its collection. The amount of each invoice is made out to the client at the end of credit term or on the agreed maturity date. The Factor provides administrative services. There is no 'client risk' to the factor. This maturity date is decided upon at the commencement of the factoring agreement with reference to the average time taken by the client to collect a debt. outstanding beyond 60-90 days after due date.' Maturity factoring could also be without recourse or with recourse. Recourse Factoring: Under this factoring. Of course.UNIT 9: Factoring 109 (b) Premium for taking risk of debt-default CE Notes (c) Interest on funds provided to client from date of drawing ___________________ to maturity date of the invoice. The Factor's fee will include charges for debt administration. This situation ES arises when the client requests the Factor not to reassign the invoices and to continue recovery efforts. premium for risk of default and interest on funds outlay. all the facilities of ___________________ full factoring except that of credit protection are available to the client. the entire cost of such recovery measures is borne by the client. Under without recourse maturity factoring. Under with recourse . This maturity date bears no relation to the date on which the debt is actually due for payment as it is an 'estimated date of collection. including legal proceedings. Hence.' The Factor administers clients' sales ledger and renders debt collection service. ___________________ 2. It acts merely ___________________ as a collection agent of the supplier besides providing finance ___________________ and maintaining sales ledger.

___________________ Unlike the factoring charges under without recourse. credit control and collection of receivables. Credit Factoring: It is also known as 'Invoice Discounting. Financial Management 110 maturity factoring. the Factor purchases all or selected ___________________ invoices of its clients at a discount. (b) Of course. 5. (d) Factor maintains the age-wise analysis of debts of the client. (c) Debt collection is organised by the client who makes over UP payment of each invoice to the Factor. if advance has been received against such invoices. The client obtains liquidity by taking -C ___________________ advance without having to commit itself to regular factoring ___________________ services. as desired. (c) The client himself undertakes sales ledger administration. the Factor gets a copy of the invoice. Under this factoring. here there will be no charge relating to premium for risk of debt- ___________________ default.' ___________________ Under this arrangement. Thus the special features of such an undisclosed factoring are as follows: ES (a) Debts are assigned to Factor but client maintains sales ledger. Customers are not notified of Factor's involvement. the Factor provides finance to the client only after notification to the debtors (customers) to make payment to the Factor. Bulk factoring: It is a kind of Invoice Discounting. the Factor will either pay the client on CE Notes collection of invoice or on maturity date with recourse later on. The debtor (customer) is not aware that the seller (client) has availed factoring facility because there is no notice ___________________ of assignment to him. . It only provides finance. ___________________ 4. Thus this is a type of undisclosed ___________________ factoring or confidential factoring. (e) Factor's charges vary with the range of service provided to client. The Factor neither ___________________ maintains the sales ledger nor undertakes debt collection. which it accounts for and provides the client with either debt- default cover or finance or both. This arrangement runs on with-recourse basis.

There could be any variation ___________________ of services. Approach Specific and limited to Total service approach providing finance which. agency factoring operates on a without recourse basis. (c) collection of receivables. Agency Factoring: Under this arrangement. it amounts to ___________________ bulk factoring with additional facility of insurance against ___________________ credit risk. Mode of Advance is given Outright purchase of Lending against Bills of trade debt Exchange Contd… . But the client carries out sales ledger administration. A comparative picture is given below. includes sales ledge administration. These types are ___________________ -C only illustrative and not exhaustive. ___________________ ___________________ Comparative Position: The above types of factoring show the range of factoring services offered and availed. unlike bulk factoring. credit protection. ___________________ Types of Factoring Types of Services ___________________ Sales Ledger Credit Credit Protection or Finance Advisory Administration & Control Risk Absorption Services ___________________ Collection of Book Debts Full factoring (without P P P P P ES recourse) Recourse factoring P P X P P Maturity factoring P P P X P Credit factoring X X X P P (without notification) Bulk factoring X X X P P (without notification) Agency factoring X X P P P (sometimes) UP 9 indicates availability and × indicates non-availability of facility Comparison with Bill Finance Both Bill Financing and Factoring provide finance by discounting receivables. Let us discuss their dissimilarities. finance and advisory services 2. credit control. Thus. But they differ in some aspects. the Factor CE Notes provides prepayment facility and protection against bad debts. ___________________ collection of receivables and credit control.UNIT 9: Factoring 111 6. Area Bill Finance Factoring 1. inter alia. Moreover.

ES one type of misuse Check Your Progress Fill in the blanks: 1. recommended the introduction of factoring services in India to solve the financial problems of small- scale enterprises......... the Factor provides finance to the client only after notification to the debtors (customers) to make payment to the Factor... the Reserve Bank of India set up a Study Group under the Chairmanship of C S Kalyansundaram to examine the scope and need of factoring in India........ factoring ___________________ client finance is an off- balance sheet item ___________________ 7. is a kind of Invoice Discounting.... Security Generally additional Purchase of debt is the security is provided consideration ___________________ 8.. Under this factoring. .. UP 2... inter alia. Existence of Known to the drawee of It is unknown to the arrangement the bill in all cases debtor (customer) only ___________________ is cases of undisclosed or credit or invoice ___________________ factoring 6. arising out of delayed realisation of their receivables.. Financial Management 112 3. Misuse Misuse of bill facility Factoring provides occurs. In 1988.. advances ___________________ 4. . For example...' Factoring in India The Working Group on Money Market (1986). built-in-checks to prevalence of prevent and detect accommodation bill is misuse. Treatment in On balance sheet item In cases of without -C ___________________ Balance Sheet reflected in both sides recourse factoring/full of balance sheet of the factoring.. .. Registration of Registration is There is no need of CE charges compulsory except with registration as the Notes Activity relating to case of documents Factor is the owner of company against payment the debt ___________________ Explain factoring in India. is also known as 'Invoice Discounting.... had highlighted the inadequacy of institutional credit against high percentage of Open Account Sales of the small and medium (c) scale enterprises. under the Chairmanship of N Vaghul... Principles of Bill by bill basis Total (bulk financing) Transaction evaluation and is available against ___________________ unpaid and trade generated invoices ___________________ 5. The Sukhamoy Chakravarti Committee also..

Factoring can play a complementary role to the existing bill ___________________ financing system. Ltd. The main ___________________ recommendations/observations of the Committee are as follows: ___________________ 1.UNIT 9: Factoring 113 CE Kalyansundaram Committee Notes The Committee submitted its report in November 1989. Factoring service has relevance in India. 8. Four or ___________________ five such subsidiaries could be floated by banks. the RBI suggested setting up four factoring subsidiaries on a zonal basis. Initially. The honour of initiating factoring in India goes to the State Bank of India when it set up on February 26. In line were the four banks ready to provide factoring services. lines of concessional credit from banks etc. (SBI Factors) to serve industrial and commercial . 7. which were the State Bank of India in Western Region. the RBI amended the Banking Regulation Act 1949 in July 1990. Canara Bank in the Southern Region. Punjab National Bank in the Northern Region and Allahabad Bank in the Eastern (c) Region. Factors need to have fund raising windows like rediscounting. State Bank of Saurashtra and State Bank of Indore. the commercial banks have a distinct -C advantage in setting up factoring services subsidiaries. Accepting the Kalyansundaram Committee's report. ES 6. Factored invoices should be treated on par with other negotiable instruments for initiating legal UP proceedings. a new subsidiary called SBI Factors and Commercial Services Pvt. With considerable expertise in bill financing and with large ___________________ network of branches. SSI units need factoring. especially finance and credit protection services of factors. 1991. ___________________ 4. There should be linkage between banks and factors to avoid ___________________ double financing against some current asset. ___________________ 5. Comprehensive legal framework should be developed to encourage factoring. ___________________ 2. Export factoring should be started concurrently with the domestic factoring. ___________________ 3. It directed that domestic factoring could be undertaken by banks through specialized subsidiaries. in collaboration with the Small Industries Development Bank of India (SIDBI). Union Bank of India.

___________________ On representation by the SBI. To provide ___________________ further impetus to factoring. Banks should issue letter of disclaimer to the Factor on book debts factored to facilitate assignment of debt. Factors/Departments doing factoring services should intimate UP the bank extending working capital facility about the factoring limit of the client. was CE Notes established by Canara Bank with SIDBI and Andhra Bank as co- ___________________ promoters. paving the way for these factoring companies to operate in centres outside their allotted zones. Banks and Factors should exchange information on the client. 5. In the South. The ___________________ RBI also recommended certain other guidelines as follows: -C ___________________ 1. should route the proceeds through the banks. departmental factoring is yet to take off. A bank's exposure through factor financing should not exceed 10% of its total advances. (c) Summary The cost of factoring is higher and compared to other sources of short-term working capital finance. the zonal restrictions were removed ___________________ by the RBI in 1993. 4. Asset Classification. Since factoring services require special skills and adequate ___________________ infrastructure. The Factor. in turn. The guidelines on Income Recognition. However. it should be undertaken only by certain select branches of banks. 3. Canbank Factors Ltd. The Factor financing should not result in double-financing client's receivables. it may be restricted to receivable finance availed from banks and factor finance may be excluded from the ambit of Credit Monitoring Arrangement. the RBI directed in February 1994 ___________________ that banks could undertake factoring activity departmentally. 6. For the purpose of propagation of bill culture. 7. Financial Management 114 units in western region. ___________________ 2. Factoring of debt may be . It is like loans and advances and should be assigned 100% risk ___________________ weight for Capital Adequacy Purpose. ES Provisioning and Exposure Norms as applicable to banks will also apply for factor financing.

___________________ Credit Factoring: Under this arrangement. and reduces 115 CE future sales due to strict collection policy of factor. Factoring: Factoring is a financial service covering the financing and collection of book debts and receivables arising from credit sale of goods and services. credit control. Maturity Factoring: The Factor administers clients' sales ledger and renders debt collection service. Describe the various types of factoring. credit protection and financing of receivables. the Factor assumes credit risk.UNIT 9: Factoring perceived as an indication of financial weakness. Throw light on factoring in India. both in the domestic as well as international market. (c) 2. Questions for Discussion 1. as a professional. ___________________ ___________________ Keywords ___________________ Agency Factoring: Under this arrangement. -C ___________________ Bulk factoring: It is a kind of Invoice Discounting. . Full Factoring: This classical form of factoring is most comprehensive and includes services such as maintenance of sales UP ledger. the Factor purchases all or selected invoices of its clients at a discount. ES Credit Protection: In "without recourse factoring". has the wherewithal ___________________ for credit intelligence on customers. ___________________ Credit Control: A factor. Notes ___________________ Lesson End Activity ___________________ Highlight the features of Kalyansundaram Committee. 4. the Factor provides ___________________ prepayment facility and protection against bad debts. collection of receivables. Recourse Factoring: Under this factoring. all the facilities of full factoring except that of credit protection are available to the client. Explain the mechanics of factoring 3. Explain the concept and features of factoring.

p. New -C ___________________ Delhi...nos. p. New Delhi.com/finance/sources-of-finance. Excel Books.fao. J. P.M. Prentice Hall of India Pvt.Theory and Practice.. 2 ___________________ Chandra. Tata McGraw Hill Publishing Company Ltd. 1996. Fundamentals of ___________________ Financial Management. and Wachowicz.in/timessme/faces/jsp/. New Delhi..economywatch../sourcesOf Finance. J. 3 ___________________ ___________________ Web Readings ___________________ www. Financial Management 116 Further Readings CE Notes ___________________ Books ___________________ Sudhindra Bhat.pdf www. 2002.jsp UP (c) . Financial Management ..C. Jr.html ES www. Ltd.org/docrep/W4343E/w4343e08.org/srsec319/319-19. ___________________ 2008 ___________________ Van Horne. Financial Management.bizxchange.htm www.

which were allowed and the Trustee was found liable to reimburse the complainants. and this too would be a charge secured by the debentures. who have not paid (c) any money for the services of the Trustees. It was agreed and undertaken to redeem the debentures in full on the expiry of three years from ES the date of allotment. ___________________ ___________________ Case Study 1: Synergy Financial Exchange Ltd -C ___________________ Synergy Financial Exchange Ltd. All such compound interest was a charge secured by the debentures.UNIT 10: Case Studies Unit 10 117 CE Notes Case Studies ___________________ ___________________ ___________________ Objectives ___________________ After analyzing these cases. They claimed that their duty as Trustee ended immediately on filing a suit against the company for recovery of the debenture amounts on the basis of the Mortgage Deed. the student will have an appreciation of the concept of topics studied in this Block. the company would have to pay liquidated damages of a further compound interest of 2% per annum for the period and the amount of the default. Appeals to the various state commissions against these orders were dismissed. The financial safety of the debentures was to be ensured by the UP company and the trustee as creating a Debenture Redemption Reserve by transferring suitable amounts from time to time. are not consumers. The Facts The company failed to pay the interest or the redemption amount as agreed. So the debenture holders filed complaints before various district forums. subject to deduction of tax. In case of default in redemption. The debentures carried interest of 15% per annum payable on June 30 and December 31 each year. a non-banking financial ___________________ company. Failure to pay the interest would result in an additional levy of compound interest at the same rate. there was no privity of contract between the Trustees and the debenture holders. Also. The Trustee contended that debenture holders. The Trustee then filed revision petitions before the National Commission. One of the clauses in the agreement required the ___________________ company to pay all amounts of principal and interest due under ___________________ the debenture by crossed account-payee cheques or bank drafts drawn on a bank in Mumbai. had issued debentures with Central Bank of India as the Trustee. Thereafter no further proceedings would be maintainable. Contd… . The proof of such transfer was to be furnished by the company to the Trustee in the form of a certificate issued by the auditors.

the National ___________________ Commission held Central Bank as the Debenture Trustee liable to ___________________ compensate the complainant debenture holders for the default of Synergy Financial Exchange Ltd. Hence the debenture holders were consumers ___________________ and entitled to approach the consumer fora. UP (c) . It held that the services of the Trustee were not free but were paid for by the company to protect the interest of the ___________________ debenture holders. Question ES Recommend a solution for the case mentioned above. The Revision Petition was thus ___________________ dismissed and the orders of the District Forum and State Commission were upheld. Accordingly. The Commission found that -C ___________________ in the present case the Trustee Bank had not done anything except merely write letters. Financial Management 118 Findings CE Notes The National Commission overruled the arguments of the Trustee ___________________ Bank. The Commission relied on Halsbury's Laws of England which ___________________ state that "a higher duty of care is due from a trust corporation ___________________ which carries on specialised business of trust management and a professional corporate trustee is liable for breach of trust if loss is ___________________ caused to the trust fund through neglect to exercise special care and skill which it professes to have''.

This brought out the institutional inadequacies with respect to the evolution of venture capital. entrepreneurship occurs in nearby every society. potentially ___________________ high-reward projects [Gompers and Lerner 2002]. Venture capital evolved as a response to this felt need. ___________________ The sensitivity of venture capital process to government policies and other factors that influence entrepreneurship and innovation ___________________ was highlighted in a study by the US General Accounting office on behalf of the Joint Economic Committee [Premus 1985]. 2000]. Entrepreneurs have long had ideas that require substantial capital to implement but lacked the funds to finance ___________________ these projects themselves [Gompers and Lerner 2002]. venture capital is a special form of venture financing. Smith and Smith 2002]. but venture capital can only exist when there is a constant flow of opportunities that have great upside potential. Technology Development Fund was started to provide financial support to innovative and high risk Contd… . At some level. one of the most admired institutions among industrialists and economic policy makers around the world has ___________________ been the US venture capital industry [Dossani and Kenney 2002]. The first origins of modern venture capital in India can be traced to the setting up of a Technology Development Fund in the year 1987-88. z Industrial credit and investment corporation of India State Finance Corporations and (c) z z Small Industries Development Bank of India. generally known as capital gap problem [Premus 1985. through the levy of access on all technology import payments [IVCA. the capital market has to be conducive for supporting venture funding. It also indicated that on the whole there is a need to revive the equity cult among the masses by ensuring competitive return on equity investment. In the case of venture capital. Though venture capital can meet this gap to some extent.UNIT 10: Case Studies 119 CE Case Study 2: Venture Capital and Innovation: The Indian Notes Experience ___________________ Background of the Industry ___________________ In the last decade. Venture capital ___________________ represents one solution to financing the high risk. Evolution of VC Industry in India UP The first major analysis on risk capital for India was reported in 1983 [Chitale 1983]. Taiwan and Israel show that technological innovation and the growth of venture capital markets are closely interrelated ES [Premus 1985]. ___________________ -C Venture capital entrepreneurship and innovation have been ___________________ closely connected. The experience of US. It has been reported that capital markets overlook small business opportunities because of high information and transaction costs. It indicated that new companies often confront serious barriers to entry into capital market for raising equity finance which undermines their future prospects of expansion and diversification. The role of venture capital was met initially by the following institutions: z Industrial Development Bank of India.

Financial Management 120 technological programmes through the Industrial Development CE Notes Bank of India. management and exit should be ES as simple and flexible as needed and driven by global trends z venture capital should become an institutionalized industry that protects investors and investee firms. Subsequently. Israel and Taiwan. enterprise and conversion of ___________________ scientific technology and knowledge based ideas into commercial production. Question Analyse the case and recommend a solution for the situation. The committee (The committee is known as Chandrasekhar Committee) identified five critical success factors ___________________ for the growth of VC in India. tax and legal environment should play an enabling role as internationally venture funds have evolved in ___________________ an atmosphere of structural flexibility. ___________________ Major recommendations of the VC committee ___________________ The committee came to the conclusion that the venture capital ___________________ industry in India is still at a nascent stage. identified strategies for growth and how to bridge the gap between ___________________ traditional means of finance and the capital needs of the high -C ___________________ growth start-ups. investment. This is necessary for faster conversion of R&D and technological innovation into commercial products. Government of India gave the procedures that can be used for starting venture funding. namely: ___________________ z the regulatory. it is very important to promote venture capital ___________________ activity in India. operating in an environment suitable for raising the large amounts of risk capital needed and for spurring innovation through start-up firms in a wide range of high growth areas z in view of increasing global integration and mobility of capital it is important that Indian venture capital funds as well as venture finance enterprises are able to have global exposure and investment opportunities infrastructure in the form of incubators and R&D need to be UP z promoted using government support and private management as has successfully been done by countries such as the US. The report prepared a vision. fiscal neutrality and operational adaptability z resource raising. It also stated that with a view to promote innovation. (c) .

UNIT 11: Leasing 121 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES BLOCK-III UP (c) .

Detailed Contents Financial Management 122 CE Notes UNIT 11: LEASING ___________________ UNIT 13: RISK AND RETURN ANALYSIS z Introduction z Introduction ___________________ z Leasing as a Source of Finance z Types of Investment Risk ___________________ z Types of Lease z Measurement of Risk ___________________ z Lease Evaluation z Portfolio Diversification and Risk ___________________ UNIT 12: ECONOMIC VALUE ADDED ___________________ UNIT 14: COST OF CAPITAL Introduction -C z ___________________ z Introduction z Concept of Economic Value Added (EVA) z Cost of Capital – Concept ___________________ z Calculating EVA z Basic Aspects on the Concept of Cost of Capital ___________________ z Need for EVA z Importance/Significance of Cost of Capital ___________________ z Implementation z Classification of Cost z Economic Value Added (EVA) vs. z Computation of Specific Cost of Capital Earning Per Share (EPS) ES z How Companies have used EVA UNIT 15: CASE STUDIES z Four Ms of EVA z Advantages of EVA UP (c) .

Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual. The consideration for the lease is called rent. tax deductible payments. The subject of leasing falls in the category of finance. tax deductable payments. a leasing company is defined as one having the business of hiring plants or equipment or of financing their hire by others. periodic.UNIT 11: Leasing Unit 11 123 CE Notes Activity Explain leasing as a source of Leasing ___________________ finance. periodic. Legally. ___________________ ___________________ Objectives ___________________ After completion of this unit. A gross lease is when the tenant pays a flat rental amount and the landlord pays for all property charges regularly incurred by the ownership from lawnmowers and washing UP machines to handbags and jewellery. Leasing as a Source of Finance Lease financing denotes procurement of assets through lease. and can be for a fixed or an indefinite period of time (called the term of the lease). the students will be aware of the following topics: ___________________ \ Leasing as a Source of Finance ___________________ -C \ Term of a Lease ___________________ \ Lease Evaluation ___________________ ___________________ Introduction ___________________ Leasing is a process by which a firm can obtain the use of a certain fixed assets for which it must pay a series of contractual. ES The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. The . The relationship between the tenant and the landlord is (c) called a tenancy. and can be for a fixed or an indefinite period of time (called the term of the lease). The consideration for the lease is called rent. The lessee is the receiver of the services or the assets under the lease contract and the lessor is the owner of the assets. The relationship between the tenant and the landlord is called a tenancy.

. Therefore. usually on a monthly or weekly basis. offices. such as the death of a specified ___________________ individual. apartments. most of us are familiar with leases of houses. the lease rate never changes. no matter how well the business does. you still pay the same rate as when you began the lease. As the costs go up over five years. the lease is not connected to the (c) success of the business. The lessee does not have to pay the cost of asset at the time of signing the contract of leases. and no notice needs to be given. (In addition. etc. -C ___________________ ___________________ The term's duration may be conditional. To day. you lease and pay for equipment only for the time you need it. Advantages of Lease Financing Leasing industry plays an important role in the economic UP development of a country by providing money incentives to lessee. the term ends automatically ___________________ when the period expires. therefore making your dollar stretch farther. which normally converts the tenancy to a periodic tenancy on a month by month basis. Leasing is inflation friendly. periodic or of indefinite ___________________ duration. The lessee can also pass on the risk of obsolescence to the lessor by acquiring those appliances. It is common for a lease to be extended on a "holding over" basis. which have high technological obsolescence. ___________________ A periodic tenancy is one which is renewed automatically. and be terminated without penalty by either party. Leasing contracts are more flexible so lessees can structure the leasing contracts according to their needs for finance. ___________________ If it is for a specified period of time. in the absence of legal requirements. ES A tenancy at will lasts only as long as the parties wish it to.) Leasing better utilizes equipment. ___________________ Term of a Lease ___________________ The term of the lease may be fixed. in which case it lasts until some specified event occurs. Financial Management 124 International Finance Corporation promotes leasing as a method of CE Notes financing industrial development in the developing countries as a ___________________ part of its capital market development strategies.

the renter is responsible for UP paying off the lease. 1. leases may not be terminated before the original term is completed. 2. ___________________ Disadvantages of Lease Financing ES Leasing is a preferred means of financing for certain businesses. For example. 1. ___________________ For this reason leasing is very advantageous.UNIT 11: Leasing 125 One of the reasons for the popularity of leasing is the steady CE Notes stream of new and improved technology. The type of industry and type of equipment required also need to be considered. at which point the equipment has depreciated significantly. There are a variety of ways in which a lease can be ___________________ -C structured. By the end of a calendar Activity year. You have no equity until you decide to purchase the equipment at the end of the lease term. This provides greater flexibility so that the lease is ___________________ structured to best accommodate the individual cash flow ___________________ requirements of a specific business. step up or step down payments. Typically. 3. Failure to do so can prove costly. You have an obligation to continue making payments. This can pose a major financial problem for the owners of a business experiences a downturn. you may have balloon payments. ___________________ Leasing can also help you enhance your status to the lending ___________________ community by improving your debt-to-equity and earnings-to-fixed assets ratios. However it is not for everyone. Tax implications also need to be compared between leasing and purchasing equipment. much of your technology will be deemed "dinosaurs." The cost ___________________ Explain various types of leasing of continually buying new equipment to meet changing and ___________________ growing business needs can be difficult for most small businesses. deferred ___________________ payments or even seasonal payments. Therefore. Operating Lease: An operating lease is particularly attractive to companies that continually update or replace . Types of Lease (c) The most common types of leases are operating leases and finance leases. you are still responsible for maintaining the equipment as specified by the terms of the lease. Although you are not the owner.

finance . The ownership of the asset leased out remains with the manufacturer itself. It can also result in higher reported earnings in the early years of the lease. non-cancellable agreement. nearly covering the useful life of the equipment. ___________________ selected from a manufacturer/Supplier of lessee's choice and to ___________________ suit the lessee's requirements. but CE Notes also want to return equipment at lease-end and avoid ___________________ technological obsolescence. The other variations in lease agreements are: Sale and lease back. 1. while the lessor retains ownership of the asset. Finance Lease: A Financial Lease is a means of financing -C ___________________ capital equipments. The term of a finance lease tends to be longer. plus certain additional (c) criteria. Finance leases are most attractive in cases where the lessee wants the tax benefits of ownership or expects the equipment's residual UP value to be high. The major types of direct lessor include manufacturers. It ___________________ typically qualifies for off-balance sheet treatment and can ___________________ result in improved Return on Asset (RoA) due to a lower asset ___________________ base. Leveraged leasing and Direct leasing. The lessee has possession of the asset and uses the same on payment of specified rentals and other usual charges/fees. Under direct leasing. in which the lessee is responsible for maintenance. Direct Lease: A non-leveraged lease by a lessor (not a manufacturer or dealer) in which the lease meets any of the definitional criteria of a capital lease. maintenance and other related costs and expenses for the leased equipment. Financial Management 126 equipment and want to use equipment without ownership. taxes and insurance. These leases are structured as equipment financing agreements with residuals up to 10 percent. It is a contract between the Bank (Lessor) ___________________ and the Customer (Lessee) for the hire of a specific asset. a firm acquires the right to use an asset from the manufacturer directly. The lessee is to bear the costs of insurance. A finance lease is a full- payout. The lessee purchases the equipment upon lease termination at a pre-agreed amount. All the risks (major or minor) and rewards of ES ownership are normally transferred to the lessee and the obligations are non-cancellable. ___________________ 2. An operating lease usually results in the lowest payment of any financing alternative and is an ___________________ excellent strategy for bypassing capital budgeting restraints.

UNIT 11: Leasing

companies, independent lease companies, special purpose 127

CE
leasing companies, etc. Notes
Activity
2. Leveraged Lease: In this type of lease, the lessor provides an ___________________
What do you mean by lease
evaluation?
equity portion (usually 20 to 40 percent) of the equipment cost ___________________
and lenders provide the balance on a non-recourse debt basis.
___________________
The lessor receives the tax benefits of ownership. Under
leveraged leasing arrangement, a third party is involved ___________________

beside lessor and lessee. The lessor borrows a part of the ___________________
purchase cost (say 80%) of the asset from the third party i.e., ___________________
lender and the asset so purchased is held as security against

-C
___________________
the loan. The lender is paid off from the lease rentals directly
by the lessee and the surplus after meeting the claims of the ___________________
lender goes to the lessor. The lessor, the owner of the asset is ___________________
entitled to depreciation allowance associated with the asset.
___________________
3. Sale and Lease Back: It is a sub-part of finance lease. This is
a situation where a company has purchased and is using the
ES
equipment, which they then sell to a leasing company, who in
turn charges rent for the usage. The main reason for doing a
sale/leaseback is so that a company, which has recently paid
cash for a piece of equipment, realizes that they could have put
the cash to better use. Under this, the owner of an asset sells
the asset to a party (the buyer), who in turn leases back the
same asset to the owner in consideration of lease rentals.
However, under this arrangement, the assets are not
physically exchanged but it all happens in records only. This is
UP

nothing but a paper transaction. Sale and lease back
transaction is suitable for those assets, which are not
subjected depreciation but appreciation, say land. The
advantage of this method is that the lessee can satisfy himself
completely regarding the quality of the asset and after
possession of the asset convert the sale into a lease
arrangement.

Lease Evaluation
A leasing transaction has to be beneficial to both the lessee and
(c)

lessor. Each party evaluates the transaction from his points of view
and arrives at the cost-benefit analysis. Let us understand their
viewpoints and techniques used to evaluate a lease transaction.
1. Lessee's View: There are many models to evaluate a lease
from lessee's angle. Some treat leasing as a finance decision

Financial Management

128 and compare the advantages of buying and leasing according

CE
Notes to discounted cash flow technique, using either Net Present
___________________ Value (NPV) or Internal Rate of Return (IRR) method. Some
treat leasing as an investment decision while some others
___________________
treat leasing as financial-cum-investment decision.
___________________
After establishing the economic viability of acquiring an asset,
___________________
a lessee has to weigh the various options to finance such
___________________ acquisition. The cost of alternative sources of finance - through
___________________ cash accrual, hire-purchase, leasing, public deposits, share
capital, debentures, term loans, deferred credit, etc. - has to be

-C
___________________
kept is mind. Broadly the decision variables boil down to 'buy'
___________________
or lease'.
___________________
2. Buy or Lease: The following features of 'buying' and 'leasing'
___________________ are noted for comparing both the options.
Features Buying Leasing
Initial cost/Deposit Incurred (cash outflows) Not incurred
ES
Depreciation charges Available (cash inflows) Not available
Residual value Available (cash inflows) Not available
Management fees and lease Not payable. Payable (cash
rentals. outflows).

Once the lessee accepts leasing as a financing proposition, for
the sake of comparison, we limit ourselves to after-tax cash
flows.

3. NPV Method: Under this method, the present value of cash
flows associated with the buying and leasing alternatives are
UP

independently ascertained and compared. The alternative that
shows higher NPV is preferred. But the basic question is to
decide the rate at which the cash flows will be discounted to
arrive at the Net Present Values. However, we can evaluate a
'Buy or Lease' preposition by assuming certain discount rate
as worked out in the following cases.

Example: A firm wishes to acquire a machine costing `12000/-.
It has two options. It can acquire the machine by borrowing
`10000/- and meeting the balance as margin from own sources.
The loan is repayable in 5 year-end instalments at an interest
(c)

rate of 15% p.a. Alternatively, it can lease-in the asset at
yearly rental of `3200/- payable at year-end. The firm can
claim 25% depreciation on WDV method. It also has an
effective tax rate of 50% and expects a discounting rate of 18%.
Let us assume that at the end of 5th year, the machine is sold
for `4000 and the excess realization, if any over the written

UNIT 11: Leasing

down value is subject to tax. Which option is advisable for the 129

CE
firm? Notes

Since there is no cash inflow, the net post-tax discounted cash ___________________
flow under lease' option is `5003.47 which is lesser than the ___________________
net post-tax discounted cash outflow of `5191.91 under 'Borrow
___________________
and Buy' option. Hence, leasing should be advisable for the
firm in the above example. ___________________

___________________
4. IRR Method: Under this method, a lessee's evaluation will
proceed as follows: ___________________

-C
(a) IRR under the 'buying' alternative is computed. ___________________

(b) IRR under the 'leasing' alternative is computed. IRR ___________________

computation is made based upon the post-tax net cash ___________________
outflows. ___________________
(c) A choice between buying and leasing is taken by
comparing the IRR under the two alternatives. The
ES
alternative having a higher IRR is preferred.
In the IRR analysis, the lessee's evaluation is based on cash
flows associated with various options. But the effect of other
variables like lease management fee, sales tax on lease rental,
lessee's tax position, issues relating to flexibility of lease
agreement in the event of contingencies, alternative sources
and cost of capital, lessee's capital structure, urgency of
finance, etc., will influence the decision to 'buy or lease.'
UP

5. Lessor's Perspective: While evaluating a lease, a lessor faces
a problem of whether to accept a lease plan or not, or which
plan among the various alternatives to accept, or how to quote
lease rates. In answering these questions, lessors commonly
adopt the technique of Internal Rate of Return (IRR). This
simple analytical technique of capital budgeting is used since a
lessor's expected cash inflows and outflows are known with
near certainty. IRR is the rate which discounts these cash
flows to zero. If this IRR is higher than the weighted after-tax
average cost of capital (of the lessor), the lease plan is
accepted.
(c)

(a) Cash Inflows: The lessors' inflows from a financial lease
are: (i) Initial/security deposit, (ii) Lease rentals, (iii)
Management fees, (iv) Tax benefit on account of

Financial Management

130 depreciation, etc. (v) Salvage/residual value at the

CE
Notes termination of agreement.
___________________
(b) Cash Outflows: The following outflows are most
___________________ perceptible in a lease deal. (i) Purchase cost of the asset,
___________________ (ii) Financing cost, (iii) Administrative charges, (iv) Tax
outflows, including sales tax.
___________________
(c) Cost of Capital: A lease deal entails initial outflow in year
___________________
O on the acquisition of the asset. The lessor receives cost-
___________________ free initial deposit from the lessee, wherever available.

-C
___________________ Apart from this the balance outflow has a cost.
___________________ (d) Lease Rentals: While pricing, the lessor has to consider
___________________ the following:

___________________ (i) The rates should be competitive;

(ii) The rates should be adequate to earn a reasonable
(risk adjusted) rate of return on investment.
ES
The lessor calculates as follows the present value of cash inflows
arising from his ownership of the asset.
n
Dt(T) (SV)n
∑ (1 + K)
t =1
t
+
(1 + K)n

D = Depreciation charge for year 't' which varies from 1 to n
T = Lessor's tax-rate
UP

K = Lessors' post-tax required rate of return
n = Duration of the primary lease period
SVn = Net Salvage/residual value after the primary lease
period.

The net recovery through lease rentals should be equal to cost of
leased asset (net of initial deposit) minus the present value of
ownership benefits.

The Post-Tax Lease Rental (PTLR) can be worked out as:
Net recovery of lease rentals
(c)

PTLR =
PVIFA

Where
K = required post-tax rate of return duration of the primary
lease period Present Value Interest Factor for Annuity.

UNIT 11: Leasing

131
n = duration of the primary lease period

CE
Notes
PVIFA = Present Value Interest Factor for Annuity
___________________
The actual return of the lessor will also depend upon the timing of
___________________
rental payments. So the cash inflows by way of lease rentals may
be discounted at appropriate post-tax rate of return. The present ___________________

value of all these lease rentals should be equal to the net recovery ___________________
through lease rentals. ___________________
Post tax lease rentals are adjusted for the tax factor to get the ___________________
lease rentals (LR) as follows:

-C
___________________
PTLR ___________________
LR =
1 – tax rate
___________________
Example: KSBS Ltd. is planning to install a captive generator set
___________________
at its plant. Its finance manager is asked to evaluate the
alternatives either to purchase or acquire generator on lease basis.
ES
Buying Initial cost ` .5,00,000 Residual Value ` 1,60,000
Leasing for 5 Annual lease rentals Residual value ` 90,000 returned to Lessee
years ` 1,50,000 in 5 years time

Depreciation @ 20% p.a. is on written down value. Corporate tax
rate 40%. After tax cost of debt is 14%. The time gap between the
claiming of the tax allowance and receiving the benefit is one year.
Evaluate the lease or buy decision based on the above information.
Solution:
UP

Alternative 1: Buying
Year Cost or W.D.V Depreciation @ 20% Corporate Tax @ 40%
1 5,00,000 1,00,000 40,000
2 4,00,000 80,000 32,000
3 3,20,000 64,000 25,600
4 2,56,000 51,200 20,480
5 2,04,800 - -
Less: Residual Value 1,60,000 - -
44,800 44,800 17,920

CALCULATION OF NET PRESENT VALUE
Year Cost ` Tax relief ` Net cash flow ` P.V. Factor @ P.V. `
14%
0 (5,00,000) - (5,00,000) - (5,00,000)
(c)

1 - - - 0.8772 -
2 - 40,000 40,000 0.7695 30,780
3 - 32,000 32,000 0.6750 21,600
4 - 25,600 25,600 0.5921 15,158
5 (1,60,000) 20,480 1,80,480 0.5194 93,741
6 - 17,920 17,920 0.4556 8,164
NPV = (3,30,557)

Financial Management

132
Alternative 2: Leasing

CE
Notes
Lease rentals ` Tax Relief Net cash flow ` P.V. Factor @ P.V. `
___________________ Year
14%

___________________ 0 (1,50,000) - (1,50,000) - (1,50,000)
1 (1,50,000) - (1,50,000) 0.8772 (1,31,500)
___________________ 2 (1,50,000) 60,000 (90,000) 0.7695 (69,750)
3 (1,50,000) 60,000 (90,000) 0.6750 (53,289)
___________________
4 (1,50,000) 60,000 (90,000) 0.5921 77910
___________________ 5 90,000 60,000 (1,50,000) 0.5194 10,934
6 (Share residual 60,000 24,000 0.4556
___________________ value) 36,000
Tax on residual

-C
___________________ value
NPV = (3,76,030)
___________________
Analysis: From the above analysis, by applying the discounted
___________________
cash flow technique, we can observe that the net present value of
___________________ cash outflow is higher in case of leasing decision i.e., `3,76,030 as
compared to buying decision it is only `3,30,557. The company may
go for purchase of the generator instead of acquiring on lease basis.
ES
Check Your Progress
Fill in the blanks:
1. The Post-Tax Lease Rental (PTLR) can be worked out as
...................
2. Under ................... method, the present value of cash
flows associated with the buying and leasing
alternatives are independently ascertained and
UP

compared.
3. ................... is a sub-part of finance lease.

Summary
The term of the lease may be fixed, periodic or of indefinite
duration. If it is for a 'tenancy for years', the term ends
automatically when the period expires, and no notice needs to be
given, in the absence of legal requirements. The term's duration
may be conditional, in which case it lasts until some specified
(c)

event occurs, such as the death of a specified individual. A periodic
tenancy is one which is renewed automatically, usually on a
monthly or weekly basis.

Questions for Discussion 1. Operating Lease: An operating lease is particularly attractive to ES companies that continually update or replace equipment and want to use equipment without ownership. ___________________ Leveraged Lease: Under leveraged leasing arrangement. ___________________ ___________________ Finance Lease: A Financial Lease is a means of financing capital equipments. You are an exporter and wanted to raise finance for the working capital requirements. 4. a firm acquires the right to -C use an asset from the manufacturer directly. Now you want to purchase an ___________________ asset costing crores of rupees. Analyse the importance of lease financing in modern scenario. Analyse the sources of finance UP available to you. But your friend gave you the ___________________ suggestion for the lease financing. a third ___________________ party is involved beside lessor and lessee. 2.UNIT 11: Leasing 133 CE Lesson End Activity Notes You are the owner of the company. Explain the types of leasing. ___________________ Keywords ___________________ ___________________ Direct Lease: Under direct leasing. but also want to return equipment at lease-end and avoid technological obsolescence. (c) . Do you think there is any difference between hire & purchase & lease financing? Comment giving the pros and cons of both the methods. 3. Analyse the various agreements ___________________ you will consider for financing the assets through lease.

New Delhi.Theory and Practice. and Wachowicz./sourcesOfFinance. J..fao. Fundamentals of ___________________ Financial Management. ___________________ 2008 ___________________ Van Horne. Financial Management . Tata McGraw Hill Publishing Company Ltd.jsp UP (c) .. Jr. J. Prentice Hall of India Pvt.org/docrep/W4343E/w4343e08. P. New -C ___________________ Delhi.pdf www. 3 ___________________ ___________________ Web Readings ___________________ www.in/timessme/faces/jsp/. p. 1996.C. Financial Management. New Delhi.com/finance/sources-of-finance. Ltd. Financial Management 134 Further Readings CE Notes ___________________ Books ___________________ Sudhindra Bhat.. p.economywatch.M. 2 ___________________ Chandra.nos.bizxchange..htm www.. Excel Books.. 2002.html ES www.org/srsec319/319-19.

This will lead to an increase in the market value of the company.UNIT 12: Economic Value Added Unit 12 135 CE Notes Economic Value Added ___________________ ___________________ ___________________ Objectives ___________________ After completion of this unit. Value that has been created or destroyed by the firm during the period can be measured by comparing profits with the cost of capital used to produce them. the students will be aware of the following topics: ___________________ \ Economic value added ___________________ -C \ EVA calculation ___________________ \ Need for EVA ___________________ \ EVA & EPS ___________________ Introduction ___________________ Economic Value Added was developed to promote value- ES maximizing behaviour in corporate managers. It is a single. capital projects and to maximize long-term shareholders wealth. Concept of Economic Value Added (EVA) Financial Statement Analysis (FSA) and Economic Value Added (EVA) are tools to ascertain the financial health of the organization (c) and its capacity to generate shareholder 'value' respectively. Economic Value Added (EVA) sharpens the view of corporate governance by redefining its goal. Focusing solely on shareholder's wealth might jeopardize a firm reputation and profitability in the long run. value- based measure that was intended to evaluate business strategies. activities that do not UP increase shareholders value might be critical to customer's satisfaction or social responsibility. For example. acquiring expensive technology to ensure that the environment is not polluted might not be of high value from a shareholder's perspective. Therefore. However. The term "Economic Value Added (EVA)" is a registered trademark of Stern Stewart & Co. managers can decide to withdraw value-destructive activities and invest in projects that are critical to shareholder's wealth. a consulting firm which implements the EVA concept for large companies. It .

UP Calculating EVA There are four steps involved in the calculation of EVA. the ___________________ lifestyle is operational. EVA is not a metric but a ___________________ way of thinking.WACC% * (TC) (c) The first step. Rewards will be given to managers who are able to turn investor's money and capital into profits efficiently. The single goal of maximizing shareholder value helps to overcome the traditional measure problem.NOPAT . According to Erik EVA? Stern. ___________________ The firm's cash flow is subtracted from the required profits. Calculating EVA . requires conversion of the company's accrual to cash accounting. "Although EVA is ___________________ based on accounting. one can simply refer to the . Calculating the net operating profit after tax (NOPAT). operational and investing decision allowing them to be motivated to behave like owners. While the language is technical. and 4. For publicly traded US companies and others which follow US GAAP. Under some accounting regimes. However this behaviour might lead to some managers pursuing their own goal and shareholder value at the expense of customer satisfaction. when implemented the system must be ___________________ simple and operational or it is irrelevant. 3. which are as follow: 1. based ___________________ on the rate of return. a mindset. 2. a step by step add-back of cash items is required if cash statements are not available. Determine a cost of capital (WACC)." Central to the concept is the idea of opportunity cost. Capital is used in each division of the ___________________ organisation. to give economic profits. Economic Value Added (EVA) uses accounting information Activity ___________________ What do you understand by to improve decisions and motivate employees. where different measures are used for different purposes with inconsistent ES standards and goal. That division is required to earn a rate of return -C ___________________ based on the amount of capital it uses and the cost of that capital. ___________________ EVA sets managerial performance target and links it to reward systems. Researches have found that managers are more likely to respond to EVA incentives when making financial. calculating NOPAT. Financial Management 136 has long been accepted that companies should seek to maximize CE Notes profits. Calculating total invested capital (TC). president international of Stern Stewart.

one of the four required financial 137 CE statements. Market capitalisation (price × number of shares) corresponds to free cash flow. The difference is that the former subtracts opportunity costs. The EVA concept believes that for every performance measure there is a corresponding wealth measure. EVA is the Net Operating Profit after Taxes (NOPAT) minus the money cost of capital. In its basic form. An alternative would be to take the information from the firm's cash flow statement. Shareholders of the company receive positive value added when the return from the capital employed in the business operations is greater than the cost of that capital. To calculate NOPAT. a "fair" rate of return on investment. Economic Value Added (EVA) concentrates only on one -C ___________________ of the factors of production i. Many large firms.UNIT 12: Economic Value Added required statement of cash flows. while total shareholder return corresponds to cash flow return on investment.e. Next. The same ___________________ applies to non-US accounting where statement of cash flows is not ___________________ required. ___________________ ___________________ Need for EVA ES There is a long history in economics of preferring "economic" over "accounting" profits. EVA starts with income before income taxes (c) and minority interests. in particular. Accounting profits do not. Then it adds interest expense to get Earnings before Interest and Taxes (EBIT). By dividing NOPAT with capital. Non-public and small companies may not fall under Notes GAAP requirements. it adds and subtracts non-cash items to put EBIT on a cash basis. It adds back to the accounting profits the amortization of goodwill or capitalisation of brand advertising. First. ___________________ ___________________ Check Your Progress ___________________ True or False: ___________________ 1. For example the P/E ratio is the wealth measure that corresponds to return on equity. will include it voluntarily with their financial statements. it makes two adjustments. ___________________ 2. . Money cost of capital means the rupee value of that cost rather than a rate of return. Then. There are other similar adjustments of intangibles which EVA UP considers important. if available. Capital. so the add-back may be required. however. we get returns in percentage.

in converting to a cash basis. the company subtracts cash taxes ES paid. One can do this by subtracting increases in deferred tax liability and adding tax subsidy on deductible expenses. Incentive . The key to it all is successful implementation. It takes an off- ___________________ balance sheet type of financing (the operating lease) and puts it ___________________ back onto the converted balance sheet. a reasonable discount rate can be estimated based on the firm's cost of debt and equity capital. It is a basic part of accounting and finance. That is.its ratio of lease payments for the year to total lease ___________________ obligations. If not available. The effect of this is to move certain expense items to ___________________ the balance sheet. the standard way is to look at debt costs on the income statement and divide by the total debt outstanding on the balance sheet. An example of capitalizing debt/equity ___________________ equivalents is to convert operating to capital leases. ___________________ Examples of converting accrual information to cash are adding ___________________ increases in LIFO reserves. Financial Management 138 it capitalizes expenses which it believes should be treated as CE Notes investments. ___________________ The interest rate for the discounting is usually available from the ___________________ company . In the absence of such problems. (c) calculating the numbers and then committing management to act on them. This is the "opportunity cost" concept that is at the heart of the economic profits approach. such as to increase funding to divisions with positive EVA. The result is cash operating taxes. Estimating the cost of debt is relatively straightforward. Another important implementation is to reward or punish managers for generating positive or negative EVA. Another way is to estimate the cost of debt from the company's debt rating from rating agencies such as Moody's or Standard and Poor's. Implementation The EVA concept is not a new one. Next. and to harvest (sell) divisions with negative EVA. The exception is if the debt is not publicly traded UP and therefore hard to value (such as CDO debt). The preferred way to do this is to take the present value of the lease payments for the -C ___________________ period of the lease. A key step is to determine the weighted average cost of capital and multiply it times the capital that the company uses. Another is adding increases in the allowance for bad debts.

e. the size of the business increases without necessary increasing the profitability.and finds out the difference between the earning and the cost of the capital employed. EVA takes into consideration the UP total capital employed by the company . Also. ___________________ businesses. EVA-based compensation mimics the ownership mindset and encourages the ___________________ company manager to take decisions as would the franchise owner. How Companies have used EVA Name Timefr Use of EVA ame The Coca-Cola Early Focused business managers on increasing shareholder Co. Earning Per Share ___________________ (EPS) ___________________ EPS is calculated by dividing the net profits after interest. According to Notes Activity Stern. 1994 Used EVA as the lead indicator of a performance (c) measurement system that included "people value added" and "customer value added" IBM 1999 Conducted a study with Stern Stewart that indicated that outsourcing IT often led to short-term increases in EVA Herman Late Tied EVA measure to senior managers' bonus and Miller Inc.UNIT 12: Economic Value Added schemes based on the EVA are shown to be more motivating than 139 CE other company-wide or accrual-based incentives. ___________________ Successful implementation requires a substantial commitment by -C ___________________ managers and employees at all levels of an organisation. it assumes that equity capital comes to the company for free). "EVA attempts to bring the concept of the franchisee into Give___________________ two points of difference the corporate world. Naturally." ___________________ Economic Value Added (EVA) vs. Ownership makes a difference.total shareholders' fund (equity and accumulated profits) and total debt ." ___________________ Orpurt gives his take on implementation: "EVA is an incentive ___________________ system so employees need a reward for creating and sustaining it. 1990s compensation system . This measure is flawed because it does not consider the equity cost of capital employed (i. 1980s value AT&T Corp. EPS can be improved without corresponding improvement in performance simply by issuing further equity at a premium. Most franchises outperform company operated between EVA and EPS. ES depreciation and taxation by the number of equity shares issued by the company to find out the profits earned per share. when more funds are pumped into the company.

Financial Management 140 CE Notes Activity Check Your Progress List ___________________ the 4 Ms of EVA. EVA= (Return on Capital – Cost of Capital) × Total ___________________ Capital ___________________ 2. UP allocating capital. the EVA financial management and incentive compensation system transforms a . the only way managers can make more money for themselves is by creating even greater value for shareholders. the happier shareholders will be. True or False: ___________________ 1. basing incentive compensation on improvements in EVA is the source of the greatest power in the EVA system. The EVA system covers the full range of managerial decisions. including strategic planning. It is more useful than Rate of Return (ROI) or Internal Rate of Return (IRR) in evaluating operations of an ___________________ enterprise. setting annual goals-even day-to-day operating decisions. EVA is a measure of "total factor productivity" whose growing popularity reflects the new ES demands of the information age. pricing acquisitions or divestitures. Stern Stewart designs cash bonus plans that cause managers to think like and act like owners because they are paid like owners. ___________________ -C ___________________ Four Ms of EVA ___________________ There are four main applications of EVA with four words ___________________ beginning with the letter M: ___________________ 1. its true value comes in using it as the foundation for a comprehensive financial management system that encompasses all the policies. Indeed. under EVA the greater the bonus for managers. Management System: While simply measuring EVA can give companies a better focus on how they are performing. Motivation: To instil both the sense of urgency and the long- term perspective of an owner. Measurement: EVA is the most accurate measure of corporate performance over any given period. 2. (c) This makes it possible to have bonus plans with no upside limits. methods and measures that guide operations and strategy. Under an EVA bonus plan. In fact. 3. 4. Mindset: When implemented in its totality. procedures.

EVA covers all aspects of the business cycle. Check Your Progress True or False: 1. The EVA framework is. EVA provides for better assessment of decisions that affect balance sheet and income statement or trade-offs between each through the use of the capital charge against NOPAT.UNIT 12: Economic Value Added corporate culture. 3. ___________________ Advantages of EVA ES Several advantages of EVA are: 1. 2. Provision of correct incentives for capital allocations. By putting all financial and operating 141 CE functions on the same basis. EVA facilitates communication and ___________________ cooperation among divisions and departments. Long-term performance that is not compromised in favour of short-term results. The EVA system also ___________________ facilitates decentralized decision making because it holds ___________________ managers responsible for-and rewards them for-delivering ___________________ value. it links strategic planning with the operating divisions. Short term financing refers to the capital employed by the firm. Even though the cost of capital is high. in effect. and it ___________________ eliminates much of the mistrust that typically exists between ___________________ operations and finance. 5. a ___________________ system of internal corporate governance that automatically ___________________ guides all managers and employees and propels them to work -C for the best interests of the owners. . still it is advantageous to use EVA. EVA eliminates economic distortions of GAAP to focus decisions on real economic results. the EVA system effectively Notes provides a common language for employees across all ___________________ corporate functions. 6. (c) 2. UP 4. EVA decouples bonus plans from budgetary targets.

___________________ EVA = Net Operating Profit after Tax (NOPAT) – Cost of Capital. Net Asset Value: It is a term used to describe the value of an entity's assets less the value of its liabilities. adjusted for items that move the profit ___________________ measure closer to an economic measure of profitability. including shareholders and debt holders. Weighted Average Cost of Capital: It is the rate that a company is expected to pay on average to all its security holders to finance its assets. -C ___________________ EVA focuses on ends and not means as it does not state how ___________________ manager can increase company's value as long as the shareholders wealth are maximized. . Corporate Finance: It is an area of finance dealing with the UP financial decisions corporations make and the tools and analysis used to make these decisions. Lesson End Activity ES You are the finance manager in the company. NOPAT is calculated as net operating ___________________ income after depreciation. Financial Management 142 Summary CE Notes ___________________ Economic Value Added (EVA) is a tool to ascertain the financial ___________________ health of the organization and its capacity to generate shareholder 'value'. Firms that earn higher returns ___________________ than financing costs benefit shareholders and account for increased ___________________ shareholder value. Analyse the steps for calculating the EVA. including deducting the opportunity cost of equity capital. (c) NOPAT: It is a company's after-tax operating profit for all investors. Market Value Added: It is the difference between the current market value of a firm and the capital contributed by investors. EVA is based on the concept that a successful firm should ___________________ earn at least its cost of capital. Economic Value Added: It is an estimate of economic profit by after making adjustments to GAAP accounting. Keywords Capital Employed: It is the capital investment necessary for a business to function.

" Comment. P.com › Tutorials www. Calculate EVA.wikipedia. Fundamentals of Financial Management.& tax paid by the firm is ` 50000/-. 2002. and Wachowicz. ___________________ ___________________ Further Readings ___________________ Books ES Sudhindra Bhat.000/-.500. Financial Management. cost of goods- ` 2. Given sales of a company.896.investopedia.C. 3 UP Web Readings en. ___________________ 2. ___________________ 3.. p.net/methods_eva. Tata McGraw Hill Publishing Company Ltd. 2008 Van Horne. J. p.600/.valuebasedmanagement. Ltd. Prentice Hall of India Pvt. Excel Books. 1996. ___________________ 4.Theory and Practice. New Delhi.M..investopedia. The cost of capital is ` 12%.UNIT 12: Economic Value Added 143 Questions for Discussion CE Notes 1. Financial Management . J. "Successful implementation of EVA requires a substantial ___________________ commitment by managers and employees at all levels of an ___________________ organisation. Calculate ___________________ NOPAT from the given data.857. New Delhi.org/wiki/Economic_Value_Added www.000 & return on ___________________ -C capital is 15%. Critically appraise the Economic value added approach.com › Dictionary www.` 4. 2 Chandra... If XYZ employs a total capital of ` 15. Jr.html (c) . New Delhi.

Financial Management 144 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

a general (market) component and a specific (issuer) component. while unsystematic risk is specific to an industry or the company individually. Types of Investment Risk Systematic versus Non-systematic Risk Modern investment analysis categorizes the traditional sources of risk causing variability in returns into two general types: those that are pervasive in nature. or just a UP particular industry.UNIT 13: Risk and Return Analysis Unit 13 145 CE Notes Activity What are the different types of Risk and Return Analysis ___________________ systematic and unsystematic risks? ___________________ ___________________ Objectives ___________________ After completion of this unit. we must consider these (c) two categories of total risk. The first three risk factors discussed below are systematic in nature and the rest are unsystematic. Systematic risk is for the market as a whole. ES Uncertainties could be due to the political. such as market risk or interest rate risk. we have systematic risk and non-systematic risk. Dividing total risk into its two components. and those that are specific to a particular security issue. Risk could be systematic in future depending upon its source. Therefore. which are additive: Total risk = General risk + Specific risk . economic and industry factors. the students will be aware of the following topics: ___________________ \ Types of Investment Risk ___________________ -C \ Measurement of Risk ___________________ \ Portfolio Diversification and Risk ___________________ ___________________ Introduction ___________________ Risk can be defined as the probability that the expected return from the security will not materialize. Every investment involves uncertainties that make future investment returns risk-prone. such as business or financial risk. Political risk could be categorised depending on whether it affects the market as whole. The following discussion introduces these terms.

Variability in a security's total returns that is directly ___________________ associated with overall movements in the general market or economy is called systematic (market) risk. If the stock market declines sharply. Non-systematic Risk: The variability in a security's total returns not related to overall market variability is called the non- systematic (non-market) risk. Financial Management 146 = Market risk + Issuer risk CE Notes ___________________ = Systematic risk + Non-systematic risk ___________________ Systematic Risk: An investor can construct a diversified portfolio and eliminate part of the total risk. that is. ___________________ Virtually all securities have some systematic risk. whether bonds -C ___________________ or stocks. market risk is critical to all investors. wars. Market risk is sometimes used synonymously with systematic risk. market. most stocks will ES appreciate in value. This risk is unique to a particular security and is associated with such factors as business and financial risk as well as liquidity risk. security prices move inversely to interest rates. The investor cannot escape this ___________________ part of the risk because no matter how well he or she diversifies. Although all securities tend to have some non-systematic risk. other things being equal. the diversifiable or non-market ___________________ part. and inflation risks. because systematic risk directly encompasses interest ___________________ rate. structural changes in the economy. Interest Rate Risk: The variability in a security's return resulting from changes in the level of interest rates is referred to as interest rate risk. Market Risk: The variability in a security's returns resulting from fluctuations in the aggregate market is known as market risk. tax law changes and even changes in consumer preferences. as in the last few months of 1982. ___________________ the risk of the overall market cannot be avoided. Different types of systematic and unsystematic risks are explained as under: 1. it is generally connected with UP common stocks. Clearly. Such changes generally affect securities inversely. All securities are exposed to market risk including recessions. The reason for this . These movements occur regardless of what any single investor does. (c) 2. What is left is the non-diversifiable portion or the market ___________________ risk. most stocks will be adversely affected. if it rises strongly.

because lenders demand additional inflation premiums to compensate ___________________ for the loss of purchasing power. than what they originally bargained for. since -C ___________________ interest rates generally rise as inflation increases. Similarly. With uncertain inflation. Reinvestment Risk: The YTM calculation assumes that the investor reinvests all coupons received from a bond at a rate equal to the computed YTM on that bond. ___________________ 3. Regulation Risk: Some investments can be relatively ___________________ attractive to other investments because of certain regulations or tax laws that give them an advantage of some kind. As interest rates ___________________ change. ___________________ 4. pay interest that is exempt from local. in effect. To make matters worse. Prices for many limited partnerships tumbled when investors were left with different securities. Purchasing Power Risk: A factor affecting all securities is ___________________ purchasing power risk. This risk is related to interest rate risk. 6. Steel faces unique problems. as one of the largest steel producers.UNIT 13: Risk and Return Analysis movement is tied up with the valuation of securities. In 1987.S. tax law changes dramatically lessened the attractiveness of many existing limited partnerships that relied upon special tax considerations as part of their total UP return.g. there was no extensive secondary market for these illiquid securities and many investors found themselves unable to sell those securities at anything but 'fire sale' prices if at all. For example. The risk of a regulatory change that could adversely affect the stature of an investment is a real danger. 5. a ___________________ Treasury bond). This is the possibility that the purchasing power of invested dollars will ___________________ decline. General Motors faces unique problems as (c) a result of such developments as the global oil situation and Japanese imports. state and federal taxation. municipals can price bonds to yield a lower interest rate since the net after-tax yield may still make them attractive to investors. Business Risk: The risk of doing business in a particular industry or environment is called business risk. also known as inflation risk. for example. ES Municipal bonds. thereby earning . bond prices change in the opposite direction. the real (inflation-adjusted) ___________________ return involves risk even if the nominal return is safe (e. U. Interest 147 CE rate risk affects bonds more directly than common stocks and Notes is a major risk that all bondholders face. As a result of that special tax exemption..

Measurement of Risk Volatility (c) Of all the ways to describe risk. ………… is the range of the movement from the expected level of return. ___________________ 7. 3. 9. 2. Errors made by the management can harm those who invested in their firms. is the probability that an investor will not get UP the expected return. ………… is the measure of the total risk of an asset or a portfolio including both systematic & unsystematic risk. The bull market ends ___________________ when the market index reaches a peak and starts a downward trend. Default Risk: It is that portion of an investment's total risk that results from changes in the financial integrity of the investment. called a trough. The period during which the market declines to the next -C ___________________ trough is called a bear market. In effect. the simplest and possibly most accurate is "the uncertainty of a future outcome.." The anticipated return for some future period is known as the expected return. The actual return over some past period is known as the realized return. is made ___________________ up of people who are mortal. Financial Management 148 interest on interest over the life of the bond at the computed CE Notes YTM rate. over a period of time. all said and done. fallible and capable of making a ___________________ mistake or a poor decision. Management Risk: Management. Forecasting errors is difficult work and may not be worth the effort and. ___________________ 8. imparts a needlessly sceptical outlook. this ___________________ upward trend is called a bull market. Bull-bear Market Risk: This risk arises from the variability ___________________ in the market returns resulting from alternating bull and bear market forces. ………. as a ES result. The simple fact that dominates investing is that the realized return on an asset with any risk attached to it may be . Check Your Progress Fill in the blanks: 1. this calculation assumes that the ___________________ reinvestment rate is the yield to maturity. When security index rises fairly consistently ___________________ from a low point.

Given that investors must deal with the uncertain future." Probability Distributions To deal with the uncertainty of returns. Beta is a relative measure of risk – the risk of an individual stock relative to the market portfolio of all stocks. investors need to keep in mind that. relative to a (c) benchmark. or fluctuations in price. ___________________ -C Standard Deviation ___________________ Investors and analysts should be at least somewhat familiar with ___________________ the study of probability distributions.UNIT 13: Risk and Return Analysis different from what was expected. investors need to think explicitly about a security's distribution of probable TRs. ___________________ Example: The more a stock goes up and down in price. Being able to measure and determine ___________________ the past volatility of a security is important in that it provides ___________________ some insight into the riskiness of that security as an investment. An ___________________ investor may expect the TR (total return) on a particular security to be 10% for the coming year. the beta is 1. Since the return an investor ___________________ will earn from investing is not known. increased volatility can be equated with increased risk. it must be estimated. on . Volatility may be described as 149 CE the range of movement (or price fluctuation) from the expected Notes level of return. for example. If the security's returns move more (less) than the market's returns as the latter changes. although they may expect a security to return 10%. occur. If the slope of this relationship for a particular security is a 45-degree angle. but in truth this is only a "point ES estimate. Beta Beta is a measure of the systematic risk of a security that cannot be avoided through diversification. this is only a one- point estimate of the entire range of possibilities. the market portfolio of all stocks. In other words. the more ___________________ volatile that stock is. Because wide price swings create more ___________________ uncertainty of an eventual outcome. Securities with different slopes have different sensitivities to the returns of the market index. It is important to note that beta measures a security's volatility. a number of UP possible returns can. This means that for every one per cent change in the market's return. the security's returns have more (less) volatility (fluctuations in price) than those of the market. and will.0.

Investors can avoid or eliminate the unsystematic risk by investing funds in wide range of securities and by having well diversified portfolio. Stocks can be ranked by their betas. Stocks having a ___________________ beta of less than 1. Beta coefficient is a measure of the volatility of stock price in relation to movement in stock index of the market. The market related risk.0 would be considered more conservative ___________________ investments than the overall market. Financial Management 150 average this security's returns change 1%. security returns are 1. ___________________ Beta is useful for comparing the relative systematic risk of different stocks and. This would be considered an aggressive ___________________ security because when the overall market return rises or falls 10%. therefore. The systematic risk of an individual security is measured in terms of its sensitivity to market movements which is referred to as security’s beta. on ___________________ average. is used by investors to judge a -C ___________________ stock's riskiness. UP Cov im σ iσ mCorim σ iσ mCorim βI = = = Varm σ m2 σm Where.5 times as volatile as market returns. Stocks with high betas are said to be high-risk securities. in practice. both up and down. βI = Beta of individual security Covim = Covariance of returns of individual security with market portfolio Varm = Variance of returns of market portfolio (σm3) (c) Corim = Correlation coefficient between the returns of individual security and the market portfolio σi = Standard deviation of returns of individual security σm = Standard deviation of returns of market portfolio . on average.5 indicates that. beta is the index of systematic risk. would rise or fall 15%. Because the ___________________ variance of the market is constant across all securities for a ___________________ particular period. The risk of an individual security can be estimated under CAPM ES model. ___________________ this security.’ is unavoidable even by diversification of the portfolio. The market portfolio CE Notes has a beta of 1. ranking stocks by beta is the same as ranking ___________________ them by their absolute systematic risk. A security with a beta of 1. which is also called ‘systematic risk.0.

the average risk profile. If beta is more than one. rather than as a portfolio. The degree of volatility is expressed as follows: -C ___________________ 1. The beta factor is the measure of volatility of ___________________ systematic risk of a security or investment in the portfolio. ___________________ 2. The beta factor of the market as a whole is 1. it is not as sensitive to systematic ___________________ or market risk as the average investment. If the beta is one. Thus.0 indicates ___________________ average level of risk while more or less than that the security’s ___________________ return fluctuates more or less than that of market portfolio. it follows that the beta coefficient of the market portfolio must be 1. A zero ___________________ beta means no risk. it is more sensitive to the market or ES systematic risk than the average investment. if the return from the market portfolio rise by says 2%. If the beta is less than one. then it has the same risk profile as the ___________________ market as a whole. for estimation of beta factor the following regression equation is used: Ri = αi + βi Rm + ei . the beta coefficient of a security is the security’s ___________________ covariance with the market portfolio divided by the variance of the ___________________ market portfolio. (c) In practice. Mathematically.UNIT 13: Risk and Return Analysis 151 A beta coefficient is a relative measure of the sensitivity of an CE Notes assets’ return to changes in the return on the market portfolio.0. the coefficient would be: Increase in return on investment 2% = =1 Increase in return on market portfolio 2% CAPM indicates the expected return of a particular security in view of its systematic or market risk. and all other betas are viewed relative to this value. 3. The beta factor of an investor’s portfolio is the total of the weighted average beta factors of each security in the portfolio. As the market portfolio represents all shares on the UP stock market. The amount of this corresponding rise or fall depends on the beta factor of the share. A beta of 1. The value of a share price is determined in relation to investment in shares of individual companies. Beta Factor of a Market Portfolio If the return from the market portfolio rises or falls. we should expect a corresponding rise or fall in the return from an individual share.

which reflects the diversifiable risk of ___________________ individual security -C ___________________ ___________________ Portfolio Diversification and Risk ___________________ In an efficient capital market. if the series move in opposite directions. In order to diversify project risk and thereby reduce the firm's overall risk. By combining negatively correlated projects. both having the same expected return. they are positively correlated. In order to understand portfolio diversification. the overall variability of returns or risk can be reduced. If the two series move together. if any. CE Notes Activity What___________________ is portfolio Ri = Rate of return of individual security diversification? ___________________ αi = The intercept that equals the risk free rate (Rf) ___________________ βi = Beta factor of he individual security ___________________ Rm = Market of return ___________________ Ei = Random error. It shows that a portfolio is containing the negatively corrected projects A and B. they are negatively correlated. This type of risk is sometimes described as diversifiable or alpha risk. one must understand ES correlation. The creation of a portfolio by combining two perfectly correlated projects cannot reduce the portfolio's overall risk below (c) the risk of the least risky project. between series of numbers representing anything from cash flows to test data. The Figure 13. which in certain situations may be zero. investors should not hold all their eggs in one basket. investor should hold a well-diversified portfolio. the important principle to consider ___________________ is that. less variability of return) than either of the projects taken separately. the projects that are best combined or added to the existing portfolio of projects are those that have a negative (or UP low positive) correlation with existing projects.e. . The existence of perfectly correlated especially negatively correlated-projects is quite rare. while the creation of a portfolio combining two projects that are perfectly negatively correlated can reduce the portfolio's total risk to a level below that of either of the component projects. E. Financial Management 152 Where. but less risk (i.1 illustrates the result of diversifying to reduce risk. Correlation is a statistical measure that indicates the relationship.

. The …….……………. ……………… is the measure of the volatility of systematic risk of a security or investment in the portfolio. and many operate both nationally and internationally. ……………… helps in reducing the risk & uncertainties associated with the portfolio. is the balance between the desire UP for the lowest possible risk & the highest possible return. the judgment factor still dominates (c) investment decisions. economic and industry factors. Risk can be defined as the probability that the expected return from the security will not materialize.UNIT 13: Risk and Return Analysis 153 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES Figure 13. Summary Corporations operate in a highly dynamic and competitive environment..1: Reduction of Risk through Diversification Check Your Progress Fill in the blanks: 1. 2. As a result. Uncertainties could be due to the political. 3. Every investment involves uncertainties that make future investment returns risk-prone.

___________________ ___________________ Lesson End Activity ___________________ Elucidate the mechanism for the calculation of minimum risk -C ___________________ portfolio with two assets. . Risk: Probability that the expected return from the security will not materialize. Financial Management 154 Systematic risk is for the market as a whole. Elucidate the methodology for the measurement of historical return and risk. Rf = 9%. 3. Rakesh provides you following information compute expected return by using CAPM (c) Rm = 16%. Portfolio: It is a collection of securities. ___________________ ___________________ Keywords ___________________ Beta Coefficient: It is a relative measure of the sensitivity of an assets return to changes in the return on the market portfolio. while unsystematic CE Notes risk is specific to an industry or the company individually. Analyse the effect of Beta in the investment decision-making process. 2. Beta is a relative measure of risk - ___________________ the risk of an individual stock relative to the market portfolio of all stocks. Beta: It is a measure of the systematic risk of a security that ES cannot be avoided through diversification. Analyse the relationship between CAPM & SML. Mr. Beta is ___________________ a measure of the systematic risk of a security that cannot be ___________________ avoided through diversification. Questions for Discussion 1. βi = 0.8% 4. Non-systematic Risk: The variability in a security is total returns not related to overall market variability. Systematic Risk: Variability in a security is total returns that are UP directly associated with overall movements in the general market or economy is called systematic risk.

tax4india.M. p.liu.PDF UP (c) . ___________________ Ltd. 2002. and Wachowicz. Fundamentals of Financial Management.edu/schung/FIN450/Risk.ppt www. New Delhi. J. New ES Delhi. 2 Chandra.com/637/37iursk. 3 Web Readings myweb. ___________________ 2008 ___________________ Van Horne.brooklyn. J. Financial Management. ___________________ 7.com/i-reader/ftp/Ch12. Elucidate the methodology for measuring risk and return..C.UNIT 13: Risk and Return Analysis 155 5. Excel Books.html www." CE Notes why? ___________________ 6. p.com/risk-and-return-analysis. "It is risky for an investor to hold all their eggs in one basket. P. ___________________ Further Readings ___________________ ___________________ Books -C ___________________ Sudhindra Bhat. Analyse the ways in which the portfolio diversification help in ___________________ reducing risk.Theory and Practice. 1996.. Jr. New Delhi.morevalue. Financial Management ...htm www. Tata McGraw Hill Publishing Company Ltd.informationweek. Prentice Hall of India Pvt.

Financial Management 156 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

that a firm’s cost of capital is constant and it is independent of the method and level of financing. Cost of Capital – Concept The term cost of capital is a concept having many different (c) meanings.UNIT 14: Cost of Capital Unit 14 157 CE Notes Activity What are the three viewpoints Cost of Capital ___________________ of cost of capital? ___________________ ___________________ Objectives ___________________ After completion of this unit. It has received considerable attention from both theorists and practitioners. Cost of capital is still largely an academic term and the problem of measuring it in operational terms is a recent phenomena. the problem was either ignored or by passed. In modern times. In UP both the camps. It is also viewed as one of the corner stones in the theory of financial management. In another camp (traditionalists) cost of capital is varying and dependent on capital structure. In one camp. Cost of capital is a central concept in financial management. it is widely used as basis of investment projects and evaluating the alternative sources of finance. Prior to this development. the students will be aware of the following topics: ___________________ \ Significance/importance of cost of capital ___________________ -C \ Basic aspects of the concept of cost of capital ___________________ \ Classification of the costs ___________________ \ Factors that affect cost of capital ___________________ Introduction ___________________ The cost of capital is an important concept in formulating a firm’s ES capital structure. optimal policy is taken as the policy that maximizes the value of a company. Two major schools of thought have emerged having basic difference on the relevance of cost of capital. Modigliani Miller argued. regarding the cost of capital is given below: . The three viewpoints.

Cost of capital represents the rate of return that the firm must pay to the fund suppliers.Hunt. The sources are equity.00. Firms Point: It is the minimum required rate of return ___________________ needed to justify the use of capital.Solomon Ezra “A cut-off rate for the allocation of capital to investments of projects (c) is the rate of return on a project that will leave unchanged the market price of the stock. ___________________ 3. an investor invested ` 1. Here he had sacrificed 7 per cent interest for not having invested in the bank. ___________________ 2. -C ___________________ Example: A firm raised ` 50 lakhs through the issues of 10 ___________________ per cent debentures.” . A.” . who have provided the capital.James C. Example: Firm ‘A’ is planning to invest in a project that requires ` 20 lakh as initial investment and provides cash flows for a period of 5 years. William and Donaldson “Cost of capital is the minimum required rate of earnings or the cut- off rate of capital expenditures. So for the conversion of future 5 years cash flows into present value.” ___________________ Example: Mr. the hurdle or target rate or the cut off rate or any discounting rate used to value cash ES flows. Financial Management 158 1. In other words. a minimum rate ___________________ of return it has to earn is 10 per cent. Van Horne . preference.” .000 in a ___________________ company’s equity shares instead of investing in a bank at the ___________________ rate of 7 percent interest. Capital Expenditure Point: The cost of capital is the minimum required rate of return. cost of capital is the weighted average cost of various UP sources of finance used by the firm. cost of capital is needed. From Investors’ View Point: Investor may define it as “the CE Notes measurement of the sacrifice made by him in capital ___________________ formation. for justifying this issue. “The rate that must be earned on the net proceeds to provide the cost elements of the burden at the time they are due. long-term debt and short-term debt.

.. required rate of return expected by investors.. Minimum Rate of Return: Cost of capital of any firm is that minimum rate of return that will at least maintain the market value of the shares... Rates of Return: Cost of capital is not a cost.. Cost of capital is the . John J ___________________ Thus. we can say..” ___________________ ... 2.......... with regard to capital formation............. -C ___________________ Basic Aspects on the Concept of Cost of Capital ___________________ ___________________ The above definitions indicate that the following are the three basic aspects of the concept of cost of capital: ___________________ 1. ___________________ composite cost of capital or combined cost of capital..Hampton.. (b) and UP (c) The financial risk premium (f) Symbolically..... cost of capital may be represented as: Ko = rj + b + f Check Your Progress Fill in the blanks: 1.. It is expressed ___________________ in terms of percentage...... ___________________ It is also known as Weighted Average Cost of Capital (WACC)... it is the rate of return that a firm requires to earn from its investment ES projects. 2 Cost of capital. in fact.UNIT 14: Cost of Capital 159 “The rate of return the firm requires.... Cost of capital comprises three components: (a) The risk less cost of the particular type of financing (rj) (b) The business risk premium. which a firm must and is expected to earn on its investments so as to maintain the market value of its shares.... ... as defined above. 3..... from investment in order to CE Notes increase the value of the firm in the market place. is the measurement sacrifice made by (c) . that cost of capital is that ___________________ minimum rate of return.

In the Net Present Value (NPV) method. The decisions in which ___________________ it is useful are as follows: ___________________ 1. The financial standard is Cost of Capital. Financial Management 160 Importance/Significance of Cost of Capital CE Notes Activity The concept of cost of capital is very important and the central ___________________ Signify the significance of cost of capital. an investment project is accepted. If a firm adopts Internal Rate of Return (IRR) as the technique for capital budgeting evaluation. 3. the financial ___________________ executives always keep in mind minimisation of the over all ___________________ cost of capital and to maximise value of the firm. if it is to be useful as a cut-off rate for capital expenses. investment should be accepted only when cost of capital is less than the calculated IRR.M. 2. The debt policy of a firm is significantly influenced by the cost consideration.. Financial Performance Appraisal: Cost of capital framework can be used to evaluate the financial performance of top management. he/she can choose the best and most economical source of finance and can succeed in designing a sound and viable capital structure. The present values of cash inflows are calculated by discounting the rate known as Cost of Capital. Capital budgeting decisions require a financial standard (cost of capita) for evaluation. ___________________ While designing a firm’s capital structure. if the present value of cash inflows is greater than the present value of cash outflow. Capital expenditure means investment in long-term projects like investment on new UP machinery. the concept of cost of capital is very much useful in capital budgeting (c) decisions. particularly if a firm is adopting discounted cash flow methods of project evaluation. Hence. By comparing various (sources of ES finance) specific costs. It is also known as Capital budgeting expenditure. The measurement of specific costs of each source of funds and calculation of weighted average cost of capital help to form a balanced capital structure. Investment Evaluation/Capital Budgeting: Wilson R. concept in financial management decisions. which should be expressed in quantitative terms.S. Financial performance evaluation . Designing Optimal Corporate Capital Structure: This ___________________ concept is helpful in formulating a sound and economical ___________________ capital structure for a firm. states that the Cost of Capital is a concept. Capital ___________________ structure involves determination of proportion of debt and -C ___________________ equity in capital structure that provides less cost of capital.

If the actual profitability is more than ___________________ Briefly list the relevance costs. ___________________ capitalization of profits. Average Cost/Composite/Overall Cost: It is the average of various specific costs of the different components of equity. (c) 2. ___________________ -C ___________________ Classification of Cost ___________________ ___________________ ___________________ ES Figure 14. retained earnings of capital structure at a given time and this is used as the acceptance criteria for (capital budgeting) investment proposals. . then the financial performance may be said to be satisfactory and vice versa. it is wise to know various relevant costs associated with the problem of measurement of cost of capital. the projected cost of capital. The marginal cost of capital is a very important concept in investment decisions (capital budgeting decisions). debentures. Apart from the above areas ___________________ (decisions). It refers to the change in the total cost of capital resulting from the use of additional funds.UNIT 14: Cost of Capital involves a comparison of actual profitability of the investment 161 CE project with the project overall cost of capital of funds raised Notes Activity to finance the project. ___________________ The above discussion clearly shows the role of cost of capital in ___________________ financial management decisions. preference shares. cost of capital is also useful in (distribution of profits). The relevance costs are: 1. making to rights issue and investment in owner assets.1: Classification of Cost UP Before going to discuss the computation of specific cost of each source of funds and cost of capital. Marginal Cost of Capital: A marginal cost is the additional cost incurred to obtain additional funds required by a firm.

cost of equity (Ke) or cost of ___________________ preference share (Kp). ___________________ For example. a firm raises ` 1. Distinction between explicit and implicit is important from the point of view of computation cost of capital. cost of capital may be computed based on the book value of the components of capital structure. It is also called as the internal rate of return. Historic Cost/Book Cost: The book cost has its origin in the CE Notes accounting system in which book values. There will be a cash inflow . the project rate of interest (banks) is at 6 per cent. In other words. For example. An explicit cost of any source of capital is the discount rate that equates the present value of the cash inflows that are incremental to the taking of the financing opportunity with present value of its (c) increments cash outflows. For example. an investor had invested in a company’s equity shares (100 shares. the opportunity cost to the investor is (6-4) 2 per cent. 7. Future Cost: It is the cost of capital that is expected to raise ___________________ funds to finance a capital budget or investment proposal. ___________________ 4. Explicit Cost: Cost of capital can be either explicit or implicit. but due to capital requirements it retains its investment on one project that is having return on investment (RoI) of 4 per cent. Opportunity Cost: The opportunity cost is the benefit that the shareholder foregoes by not putting his/her funds elsewhere because they have been retained by the management. or cost of debt (Kd). now it is 6 per cent is the spot cost. etc.000 through the sale of 12 percent perpetual debentures. 6. as maintained by the ___________________ books of accounts. They are related to ___________________ the past. Spot Cost: The costs that are prevailing in the market at a certain time. the discount rate that equates the present value of cash inflows with present value of cash outflows. few years back cost of bank loans ES (house loans) was around 12 per cent.00. 8. It is in common use for computation of cost of capital. Here. The company decided to declare dividend of 10 per cent on book UP value of share. Elsewhere. Financial Management 162 3. Specific Cost: It is the cost associated with particular ___________________ component/source of capital. -C ___________________ 5. are readily available. For example. It is also known as component ___________________ cost of capital. Historical ___________________ costs act as guide for future cost estimation. each share at ` 10). For example.

....00... capital appreciation. implicit ES costs may also be viewed as opportunity costs........ Funds raised by any form of financing have implicit capital costs once they are invested.00. if the projects presently under consideration by the ___________________ firm were accepted. The company may resort to different financial sources (equity share.. The implicit cost of capital of funds ___________________ raised and invested by the firm. dividend.. Generally.000 per year) would ___________________ be the explicit cost. with one difference..... Implicit Cost: It is the cost of opportunity... in a sense...000 and a cash outflow of ` 12... The explicit cost is the . when its cash flows are discounted by the implicit cost of capital. retained earning public deposits. Check Your Progress Fill in the blanks: 1. Computation of explicit cost is almost ___________________ similar to the computation of IRR. The rate that equates the PV of cash inflows Notes (` 1... preference share.. Investors required rate of returns are interest.. earnings per share on equity shareholders. preference and public deposits)..... discount on debt. The cost of retained earnings is an ___________________ opportunity cost of implicit cost for a shareholder... This implies that a project reflects negative PV... or it may prefer internal source (retained earnings) or external source (c) (equity.....UNIT 14: Cost of Capital of ` 1. It is also known as ___________________ implicit cost of capital. who is ___________________ deprived of the opportunity to invest retained earnings elsewhere. which is given up in order to pursue a particular action. Thus... which equates the present value of cash inflows with present value of UP cash outflows.. Computation of Specific Cost of Capital The financial manager has to compute the specific cost of each type of funds needed in the capitalisation of a company. the component cost of a specific source of capital is equal to the investors’ required rate of returns. therefore may be defined as ___________________ “the rate of return associated with the best investment -C ___________________ opportunity for the firm and its shareholders that would be foregone. ___________________ 9.000) and PV of cash outflows (` 12... dividend and share of profit on preference .. debentures. 2 An average of the cost of each source of funds employed by the firm for capital formation is known as .000 every year for an 163 CE indefinite period.

Financial Management 164 shareholders funds. So. But issue of additional equity shares to the public involves a floatation cost. They involve opportunity cost. since in both cases. The -C ___________________ cost of equity or the returns required by the equity shareholders is ___________________ the same in both the cases. But investors’ required rate of returns should CE Notes be adjusted for taxes in practice for calculating the cost of a specific ___________________ source of capital. retained earnings and issue of equity shares to the UP public). But it is not so. because the management has . because there is nothing legally binding the firm to pay dividends to equity shareholders and the (c) company has its own entity different from its stockholders.e. Retention of earnings involves an opportunity cost. Cost of Retained Earnings (Kre) Retained earnings are one of the internal sources to raise equity finance.. equity.. issue of additional equity shares to the public for raising equity finance involves a bigger cost when compared to the retained earnings. retained earnings. preference ___________________ shares. public deposits is discussed below: ___________________ ___________________ Cost of Equity ___________________ Firms may obtain equity capital in two ways (a) retention of earnings and (b) issue of additional equity shares to the public. irrespective of whether a firm raises equity finance by retaining earnings or issue of additional equity shares. debentures. Retained earnings are those part of (amount) earnings that are retained by the form of investing in capital budgeting proposals instead of paying them as dividends to shareholders. Hence. ___________________ Compensation of specific source of finance. the cost of equity is same. the shareholders ___________________ are providing funds to the firm to finance their investment ___________________ proposals. Corporate executives and some analysts too normally consider retained earnings as cost free. whereas there is no floatation cost for retained earnings. In the following cost of equity is computed in both sources point of view (i. The shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable risk to earn ES returns. to the firm. viz. The opportunity cost of retained earning is the rate of return the shareholder forgoes by not putting his/her funds elsewhere.

...... UP Summary The cost of capital is viewed as one of the corner stones in the theory of financial management... Notes ⎛ ( 1 – Ti ) ⎞ ___________________ K re = K e ⎜ × 100 ⎜ ( 1 – T ) ⎟⎟ ⎝ b ⎠ ___________________ Where... ___________________ Ke = Cost of equity capital [D ÷ P or E/P + g].. It comprises the risk less cost of the particular type of financing (rj)..... The opportunity cost can be well computed 165 CE with the following formula....UNIT 14: Cost of Capital retained the funds. The cost of capital is useful in designing optimal capital structure. ___________________ g = Growth rate in (%).. ___________________ D = Expected dividend per share... Cost of capital may be viewed in different ways.... investment evaluation... Check Your Progress ES Fill in the blanks: 1.. ................. (b) and the financial risk premium (f). is one of the approaches available to calculate cost of equity capital. is the cost associated with particular component at capital structure....... ___________________ -C ___________________ Tb = Cost of purchase of new securities/broker.. Retained earnings are one of the internal sources to raise equity finance.... Cost of capital is the weight average cost of various sources of finance used by the firm.... ___________________ NP = Net proceeds of equity share/market price... The financial manager has to compute the specific cost of each type of funds needed in the capitalisation of a company... the business risk premium.. The opportunity cost of retained earning is the rate of ... is the additional cost incurred to obtain additional funds required by a firm..... 3 ...... 2 Bond yield plus ... and (c) financial performance appraisal........... ___________________ ___________________ Ti = Marginal tax rate applicable to the individuals concerned.

Future Cost: It is the cost of capital that is expected to raise the funds to finance a capital budget or investment proposal. Explicit Cost: It is the discount rate that equates the present value of the cash inflows with the present value of its increments cash outflows. Marginal cost of capital shall be equal ___________________ to WACC. Opportunity Cost: The benefit that the shareholder foregoes by not putting his/her funds elsewhere because they have been retained by the management. Specific Cost: It is the cost associated with particular component or source of capital. The ___________________ marginal cost of capital is the weighted average cost of new capital ___________________ using the marginal weights. Marginal Cost of Capital: The additional cost incurred to obtain additional funds required by a firm. which a firm ES must earn on its investments so as to maintain the market value of its shares. Implicit Cost: It is the cost of opportunity which is given up in UP order to pursue a particular action. ___________________ ___________________ Keywords Cost of Capital: It is that minimum rate of return. . Spot Cost: The cost that are prevailing in the market at a certain (c) time. when a firm employs the existing proportion of capital ___________________ structure and some cost of component of capital structure. CE Notes Cost of equity capital. ___________________ Lesson End Activity -C ___________________ ___________________ Critically evaluate the different approaches to the calculation of cost of equity capital. Financial Management 166 return the shareholder forgoes by not putting his funds elsewhere. is the minimum rate of return that a firm ___________________ must earn on the equity financed portions of an investment project in order to leave unchanged the market price of the shares.

"Marginal cost of capital nothing but the average cost of ___________________ capital". Ltd..investorwords.org/wiki/Cost_of_capital www. ___________________ 2. Further Readings Books Sudhindra Bhat. "Evaluating the capital budgeting proposals without cost of capital is not possible. AMC Engineering Company issues 12 per cent. p. Jr. Financial Management. and Wachowicz.com/1153/cost_of_capital.. J. ` 100 face ___________________ value of preference stock. Examine the relevance of cost of capital in capital budgeting ___________________ decisions.org/ajayshah/MEDIA/2000/costofcapital.com/terms/w/wacc. ___________________ 5. It involves a flotation cost of 5 ___________________ per cent per share. which is repayable with 10 per cent premium at the end of 5 years.." Comment. New Delhi. 2002. Financial Management .html .investopedia. J. ___________________ 3. Analyse the concept of flotation costs in the determination of -C ___________________ cost of capital. Prentice Hall of India Pvt.Theory and Practice. Fundamentals of Financial Management. New Delhi. with 5 per cent dividend tax? ES 6. What is the cost of preference share capital. 2008 UP Van Horne. p. Elucidate the importance of CAPM approach for calculation of ___________________ cost of equity. 1996. ___________________ 4. New Delhi.asp (c) www.. Explain. Tata McGraw Hill Publishing Company Ltd.mayin. 2 Chandra.html www. 3 Web Readings en.C. Excel Books. P.M.wikipedia.UNIT 14: Cost of Capital 167 CE Questions for Discussion Notes 1.

Financial Management 168 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

– Lease Option -C ___________________ DLF Ltd. Securities Ltd. uses a cost of capital of 15% to evaluate the investments of this type. manufacturers process system for food processing. A Ltd. the manager of the technology centre has requisitioned for the acquisition of computerised sophisticated equipment for conducting important UP tests.a. The finance manager of A Ltd. is engaged in the business of leasing and hire purchase.a. The cost of the equipment is `10 crore. would be `4 crore. payable in the beginning of each year. plate. It has pilot plant facilities and a modern laboratory for chemical. custom fabricated equipment for exotic metals. A Ltd. (WDV). ___________________ The company also functions as a merchant banker equity researcher. portfolio manager. Repayment of the loan would be made at the end of each year in three equal instalments. etc. corporate financier. (on the outstanding amount in the beginning of the year). The lessee may exercise its option to purchase the equipment for `4 crore at the termination of the lease. The equipment is depreciable at 33. ES pharmaceuticals. (straight line method). P. Mumbai. ___________________ ___________________ Case Study 1: DLF Ltd. has suggested that the company should take a loan for three years from a commercial bank.. The ___________________ company provides fund based as well as non-fund based financial ___________________ solutions to both wholesale and retail segments. A Ltd. Contd… . Securities Ltd. discounts its cash flows @ 14%. The company has also set up a technology centre with advanced testing facilities.3% p. spray drudgers. and (ii) interest at 10% p. dairy and chemical industries. One of the major strengths of the company is project management. has agreed to give the equipment to the (c) company on a three-year lease. for financial help. the student will have an appreciation of the concept of topics studied in this Block. A wide range of centrifugal separators. refrigeration compressors. The repayments would comprise of the (i) principal. P. Recently.3% p.UNIT 15: Case Studies Unit 15 169 CE Notes Case Studies ___________________ ___________________ ___________________ Objectives ___________________ After analyzing these cases. metallurgical and mechanical analyser. DLF Ltd. has a well-equipped R&D centre. is also manufactured by the company. engineering. The equipment will be depreciated @ 33.a. The scrap value of the equipment at the end of its useful life will be zero for the company. The annual rental for the lease. has been approached by A Ltd. The equipment is likely to have the useful life of three years.

insurance and other charges CE Notes in both the alternatives.322 2.792 0.914 2.909 0.873 0.877 0.816 0.935 0. would bear all maintenance.673 2. You are approached by the Managing Director of A Ltd. to help the company in ___________________ evaluating the proposal. showing the effect of the lease alternative on the wealth of its shareholders.870 ES 2 1.877 0.592 0.769 0.1 is: Year 6% 7% 10% 14% 15% 1 0.624 2.283 4 3.487 2. ___________________ Support your answer with appropriate calculations. ___________________ Question ___________________ You are a practicing Company Secretary.935 0.465 3.626 3 2.826 0.170 2.855 UP (c) .572 ___________________ Present value of an annuity of Re. ___________________ Note: Present value of Re.756 3 0.870 ___________________ 2 0.675 0.909 0.833 1.763 0.647 1.943 0.658 ___________________ 4 0.683 0. Both the companies pay tax @ 35%.751 0.1 is: -C Year 6% 7% 10% 14% 15% ___________________ 1 0. ___________________ Prepare a report for the Managing Director of A Ltd.808 1.387 3.736 1.840 0. Financial Management 170 A Ltd.943 0.890 0.

Nike sells sport ___________________ balls. I believe.5 per cent of the revenue.0 per cent: Capital sources Book Values Debt Current portion of long-term debt $ 5.291.7 per cent.4 percent: ___________________ Single or Multiple Costs of Capital ___________________ The first question I considered was whether to use single or ___________________ multiple costs of capital given that Nike has multiple business segments. Nike also sells some non-Nike ___________________ branded products such as Cole-Haan dress and casual footwear. hockey jerseys and ___________________ other products under the Bauer trademark.5 → 72.6 -C per cent of revenue. I did not think it necessary to compute a separate cost of capital. time-pieces. The rare is lower than Treasury yields but that is because Nike raised a portion of its funding needs through Japanese yen notes.0% of total capital Cost of Debt My estimate of Nike’s cost of debt is 4. Nike also sells apparel (30 percent of revenue) that complements its footwear products. I used the Weighted Average Cost of Capital (WACC) method. which carry rates between 2. since Cole-Haan makes up only a tiny fraction of the revenues.3 Long-term debt 435. I decided to compute only one cost of capital of the whole company.0 per cent to 4. they are sold through the same marketing and distribution channels and are often marketed in “collections” of similar design. which I obtained by adding state Contd… . As for the apparel and footwear lines. the cost of debt comes to 2. WACC Since Nike is funded with both debt and equity. eyewear. debt as a proportion of total capital makes up 27. I used a tax rate of 38 per cent. After adjusting for tax. which makes up 62 percent of ___________________ revenue.3 per cent.4 Notes payable 855. skates. as such.0 per cent and equity accounts for 73. Were their profiles really different? I concluded that it was only the Cole-Haan line that was somewhat different: the rest were all ES sports-related businesses.UNIT 15: Case Studies Case Study 2: Nike’s Cost of Capital 171 CE Notes Based on the following assumptions.3 per cent. hockey sticks.494. Based on the UP latest available balance sheet.9 $ 1. Aside from footwear. my estimate of Nike’s cost of capital is 8. Finally.2 → 27. However. Equipment products account for 3. they face the same risk factors. I arrived at this estimate by taking total interest expense for the year 2001 and (c) dividing it by the company’s average debt balance.0% of total capital $ 3. and ice stakes. I asked myself. non-Nike brands ___________________ account for 4. bats and other equipment ___________________ designed for sports activities. skate blades. In addition. whether Nike’s different business segments shad ___________________ enough risks from each other to warrant different costs of capital. Methodology for Calculating the Cost of Capital.

statutory tax rate. Historically. ___________________ WACC = Kd (1 – t) × D/(D + E) + Kc × E/(D + E) = 2. my estimate of Nike’s cost of capital is 8.0% ES = 8.5 per cent to 3. and ___________________ the compound average premium of the market over Treasury bonds (5.5 per cent I used the current yield on 20-year Treasury bonds as my risk-free rate.0% + 20.9 per cent) as my risk premium.S. Cost of Equity ___________________ I estimated the cost of equity.7% × 27. I took the -C ___________________ average of Nike’s beta from 1996 to the present. the CAPM ___________________ is the superior method. ___________________ Putting it all Together ___________________ After inputting all my assumptions into the WACC formula. For beta. ___________________ My estimate of Nike’s cost of equity is 10. CE Notes Nike’s state taxes have ranged from 2.5% × 73. Other methods such as the Dividend Discount ___________________ Model (DDM) and the Earnings Capitalization Ratio can be used to estimate the cost of equity. Financial Management 172 taxes of 3 per cent to the U. using the Capital Asset Pricing ___________________ Model (CAPM).4 per cent.4% Question What is the importance of cost of capital for any firm? UP (c) . in my opinion. However.5 per cent.

UNIT 16: Capital Structure and Theories 173 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES BLOCK-IV UP (c) .

Detailed Contents Financial Management 174 CE Notes UNIT 16: CAPITAL STRUCTURE AND THEORIES ___________________ z Features of Capital Budgeting Decisions z Introduction z Significance of Capital Budgeting ___________________ z Meaning of Capital Structure z Obstacles for Capital Budgeting ___________________ z Optimum Capital Structure z Process/Steps of Capital Budgeting ___________________ z Features of an Appropriate Capital Structure z Ranking of Capital Budgeting Proposals or ___________________ Classification of Investment Proposals z Computation of Optimal Capital Structure ___________________ z Capital Budgeting Appraisal Methods z Determinants of Capital Structure -C ___________________ z Assumption of Capital Structure Theories UNIT 19: CAPITAL RATIONING AND RISK ___________________ FACTORS IN CAPITAL BUDGETING z Theory of Capital Structure ___________________ z Introduction UNIT 17: LEVERAGES ___________________ z Meaning of Capital Rationing z Introduction z Steps Involved in Capital Rationing z Concept of Leverages z Risk Analysis in Capital Budgeting ES z Types of Leverages z Techniques of Capital Rationing UNIT 18: FUNDAMENTALS OF CAPITAL BUDGETING z Certainty Equivalent Coefficient Method z Introduction UNIT 20: CASE STUDIES z Meaning and Definition UP (c) .

long-term debt. as revealed in the maintenance of net current assets. The term 'Financial Structure' refers to the left hand side of the balance sheet as represented by "total liabilities" consisting of current liabilities. Hence. Once anticipation of required funds is completed then the next step is financial for the manager to make decisions related to the finance or the selected investment decisions. A firm can easily estimate the required funds by a detailed study of (c) the investment decision. so as to equip itself with an appropriate combination of fixed assets and current assets. preference share and equity share capital. The financial structure. therefore. firms are expected to follow a prudent financial policy. Normally.UNIT 16: Capital Structure and Theories Unit 16 175 CE Notes Capital Structure and Theories ___________________ ___________________ ___________________ Objectives ___________________ After completion of this unit. Generally capital . long-term sources of UP funds are required to finance for both (a) long-term assets (fixed assets) and (b) networking capital (positive current assets). The long-term financial strength as well as profitability of a firm is influenced by its financial structure. This net positive current asset must be financed by long-term sources. includes both short-term and long- term sources of funds. anticipation of the required funds may be estimated by analyzing the investment decision. In other words. The required funds may be raised from short-term sources or long-term sources or a combination both the sources of funds. Current assets to a considerable extent are financed with the help of short-term sources. the students will be aware of the following topics: ___________________ \ Capital structure ___________________ -C \ Differentiation between capital structure and financial structure ___________________ \ Theories of capital structure ___________________ \ Optimum capital structure ___________________ \ Features of appropriate capital structure ___________________ Introduction ES Every organisation requires funds to run and maintain its business.

i. capital structure refers to the composition of capitalisation.equity proportion.. the financial manager's job is to come out with an optimum capital structure. such as equity shares capital. Ezra. Optimum Capital Structure In taking a financing decision. "optimum leverage is that mix of debt and equity which will maximise the market value of the company and minimise the company's overall cost of capital. The same to quote. In other words." The study of capital structure involves a discussion of the nature of the industry and specific circumstances of the . to ES the proportion between debt and equity that make up capitalisation. debenture. "Capital ___________________ structure may consist of a single class of stock. The term capital structure refers to the -C ___________________ mix of long-term sources of funds. The inherent financial stability of an enterprise and risk of insolvency to which it is exposed. Financial Management 176 is raised from two prime sources (a) equity and (b) debt. ___________________ reserves and surpluses. ___________________ ___________________ Meaning of Capital Structure ___________________ Capital structure is that part of financial structure. The term capital structure is ___________________ generally defined to include only long-term debt and total ___________________ stockholder investment. Than the CE Notes question is what should be the proportion of equity and debt in the Activity ___________________ Define capital structure. capital structure of a company. Capital structure indicated by the following equation: Capital Structure = Long-term Debt + Preferred Stock + Net worth Or Capital Structure = Total Assets – Current Liabilities Thus. the characteristics of which may vary considerably". long-term debt from outside sources and preference share capital. where the market value per share is maximum and the (c) cost of capital is minimum. are primarily dependent on the source of its funds as well as the type of assets it holds and relative magnitude of such asset categories. To quote Bogen. the capital structure of a firm consists of the shareholder UP funds and debt. Optimum capital structure is that capital structure at that level of debt. which represents long-term sources. or it may be ___________________ complicated by several issues of bonds and preferred stock.e.

. the marginal real cost of each ___________________ available method of financing is the same". from a strictly financial point of view. which is helpful to maximise shareholder wealth. The primary reason for the employment of debt by an enterprise can be stated as upto a certain point. the interest of the other groups. employees. "In the optimum capital structure. Capital structure should be planned. A Notes Activity company's capital structure is a function of the nature of its List ___________________ the features of an business and how risky the particular business is. and therefore. However. This in -C turn produces that maximum market value for the total securities ___________________ issued against a given amount of corporate income. Features of an Appropriate Capital Structure Construction of optimum capital structure is very important for a firm. It is difficult to define an ideal capital structure. a appropriate capital. The study of capital structure involves a study of the debt-equity mix (c) with the object of lowering the overall cost of capital and with a view to maximizing the market value of the firm's securities. customers. ___________________ so as to achieve the lowest average cost of long-term funds. Hence.UNIT 16: Capital Structure and Theories business enterprise in question. ___________________ matter of business judgment. As observed by Van Horne. the ___________________ optimum capital structure is achieved by balancing the financing. a less expensive source of funds than equity capital. are properly analysed and balanced. The optimum ___________________ capital structure keeps balance between share capital and debt ___________________ capital. As Guthmann and ___________________ Dougall rightly remark. optimum capital structure keeps a ES balance between debt capital and equity capital. There is no tailor-made capital structure for all business enterprises. the financial manager or the concerned person should develop an appropriate capital structure. There are certain common characteristics that categorise industries. creditors. debt is from the ___________________ point of view of the ownership. besides the general theory of 177 CE finance. such as. keeping in view the interest of ordinary shareholder because they are the ultimate owners of a business enterprise and have the right to select the directors. since its value depending on the capital structure. Hence. society and government should also receive reasonable consideration. This can be done only when all those factors UP which are relevant to the company's capital structure decision.

4. Conservation/Capacity: Capital should be conservative in the sense that the debt capacity of a firm should not be exceeded. Profitability/Return: As we have seen in the above ___________________ capital. Further. The Firm should also repay the funds if not required. Financial Management 178 An appropriate capital structure should have the following CE Notes Activity features: ___________________ Give the formula for calculating overall cost of 1. The above stated are the general features of an appropriate capital structure. 5. Debt should be used till the point ___________________ where. discussion the appropriate capital structure is one. The competitors from (closely held firms) are particularly concerned about the dilution of control. which may be additional. construction of capital structure should not involve the risk of loss of control over the firm. debt does not add significant risk. There may be particular features for a firm. It should have UP enough cash to pay its fixed charges and principal sum. maximum use of ___________________ leverage at a minimum cost should be made. otherwise use of debt ___________________ should be avoided. ___________________ 2. the weight given to each of these features will differ from firm to firm. In other words. With the constraints. Hence. ___________________ 3. It should also be ES possible for the firm to provide funds whenever needed to finance its possible activities. which is ___________________ most advantageous. Flexibility: Flexible capital structure means it should allow the existing capital structure to change according to the changing conditions without increasing cost. Control: Use of more equity may lead to loose my control of the company. In other words. Solvency/Risk: The use of more or excessive debt threatens -C ___________________ the solvency of the firm. The debt capacity of a firm depends on its ability to generate future cash inflows. (c) Computation of Optimal Capital Structure As we already know that optimum capital structure is that capital structure at debt equity proportion where the market value per . it should generate maximum returns to the owners without ___________________ adding additional cost. the capital structure should be determined within the debt capacity of the firm and not beyond the firm's capacity.

20 0. Determinants of Capital Structure (c) Capital structure may be determined at the time of promotion of the firm or during the latter stages. ___________________ Illustration 1: In considering the most desirable capital structure ___________________ of a company.30)] × 100 = 9.10 × 0.07 × 0.65 0.00 0.06 × 0. Hence.0 ___________________ 30 11.0 6. According to NI approach the cost of debt and the cost of equity change with a change in the leverage ratio.40)] × 100 = 10 Here optimal capital structure is one.90) + (0.06 × 0.5 40 12.00 0.equity mix or ___________________ optimal capital structure by the calculation of overall cost of ___________________ capital.110 0. a financial manager has estimated the following: ___________________ Debt as a % of total Capital Cost of Equity (%) Cost of Debt (%) Employed ___________________ 0 10.06 × 0.0 ___________________ You are required to determine the optimal debt . But determining optimal capital structure at the time of promotion is very important and it should be designed very carefully.68 0.065 × 0. ___________________ Mention the determinants of capital structure is calculated based on overall cost of capital.12 × 0.0) + (0.11 × 0. Solution: Calculation of Overall Cost of Capital ES Equity Debt Cost of Cost of Overall cost of Capital (Ko = %) Weight Weight Equity Debt Ko = [ Ke (We) + Kd (Wd) ] × 100 (We) (Wd) (Ke) (Kd) 1.07 [(0.065 [(0.0)] × 100 = 10 0.0 -C 20 10.70 0.100 0. 2.10 × 1.70) + (0.06 [(0.120 0.60) + (0.30 0.90 0.5 6. Net income approach of capital structure was propounded by David Durand.40 0.10)] × 100 = 9.06 [(0.6 0.UNIT 16: Capital Structure and Theories share and value of the firm is maximum or the overall cost of 179 CE capital is minimum.0 ___________________ 10 10.100 0.105 × 0. capital structure. calculation of market value of Notes Activity share or value of the firm is beyond the scope of this book.06 [(0. Management of any firm should set a target capital structure and the subsequent financing .6).80 0.10 0. since.80) + (0.105 0.20)] × 100 = 9. But here. Check Your Progress True or False: 1.60 0. with 90 per cent equity and UP 10 per cent debt since K is less (9.0 6.0 7.0 6.

whenever there are surplus funds. If the management wants to have total control on the firm then. It might be better to sacrifice a measure of control by some additional equity finance rather than run the risk of loosing all control to creditors by employing too . (c) Otherwise the creditors may seize the assets of the firm to satisfy their claims (interest). -C ___________________ which helps in shareholder wealth maximisation. In this situation management would lose all control. The above two conditions are fulfilled only when there is a flexible capital structure. ___________________ 2. Tax benefit of Debt: Debt is the cheapest source of long-term ___________________ finance. Financial Management 180 decisions should be made with a view to achieve the target capital CE Notes structure. Raising funds by way of issue of new equity shares to the public may lead to loss of control. when compared with other source equity. Construction of capital structure is difficult. since it ___________________ involves a complex trade off among several factors or considerations. Flexibility: Flexibility is one of the most important and ___________________ serious factors. which is considered in determining capital ___________________ structure. the financial plan of a firm should be able to change according to their operating strategy and needs. the firm should be able to rise without delay and less cost. The following factors ___________________ affect optimal capital structure. Control: The equity shareholder have voting right to elect the directors of the company. the firm should be able to repay them. because the ___________________ interest on debt finance is a tax-deductible expense. ___________________ 1. But the firm needs to pay interest compulsory on debt finance. Whenever there is a need to have more funds to finance profitable investments. Flexibility is the firm's ability to adopt its capital structure to the needs of changing conditions. Keeping the objective of wealth maximisation in ___________________ mind. On the other hand. debt can be accepted as a tax-sheltered source of finance. In other words. need of more funds for investments or ES having substantial funds that are already raised. it may require raising funds through non-voting right instrument that is debt source of finance. Debt finance is preferred only when the firm's debt service capacity is good. Changing conditions may be. the covenants and debt capacity of the firm. 3. The flexibility of capital structure depends on the UP flexibility in fixed charges. capital structure has to be determined. Hence.

Widely held companies can raise funds by way of 181 CE issue of equity shares. It does not mean that -C ___________________ all firms in the industry are having optimum capital structure. home appliances industry. On the other hand. since the shares are widely scattered Notes and majority of shareholder are interested in the return. industries requires less debt capital in their capital structure. When. . because of competition. On the other hand. which have an inelastic demand are not likely to be subject to wide fluctuations in sales can use more debt in their capital structure. soaps. since they can sell more products at higher prices. competitive firms have to use more equity in their capital structure. which would lead to financial distress. industries involved in business. like consumer non-durable UP products (food items. the firms can use less equity or more debt in their capital structure. Example. (c) electricity. etc. Seasonal Variations: Use of more or less financial leverage ES depends on the seasonal variations of the business. Industry Leverage Ratios: The Industry standards provide ___________________ benchmark. air coolers. they may be using more leverage or less ___________________ leverage. since they are able to earn regular profit. At ___________________ the same time if they are not satisfied with the firm. but it suggests that whether the firm is out of line or ___________________ not. if it is it should know the reasons why and be satisfied ___________________ with the reasons. garment industry. where they expect higher return. public utility corporations like gas. Low degree of financial leverage (less debt) is preferable when a firm's business is seasonal in nature. Degree of Competition: Competition in the industry also determines the capital structure. Use of more debt may make the firm unable to pay interest obligations in lean years. they will ___________________ switch over to some other firm. there is no or less competition then. fans. etc) or with items in habitual use (cigarette) or all those products.UNIT 16: Capital Structure and Theories much debt. they may not be able to sell more units and cannot earn more profits. Businesses such as production and sale of umbrellas. Because industry ___________________ standard may be appropriate to the firm. 5. ___________________ 4. for example. for example. Firm can use industry leverage ratio as standard ___________________ for construction of capital structure. Put it simple. where there is no seasonality. 6.

Public offering should be made at a time when. On the other hand. The industry in infancy should use less debt capital or ___________________ more equity capital in capital structure. which are having low credit rating. Company Characteristics: Characteristics like size and credit standing among other companies (within or outside industry). which ___________________ involve costs that are called agency costs. that state of the economy as well as capital market is ideal to provide the funds. For example during 2003 to 2004 period. many firms like Vijaya Bank. by way of employing an external agent who specialises in low-cost ES monitoring. IOC. investors perceive that investment in small firms is UP more risky than the large firms. it can go ___________________ for more debt or less equity that helps to maximise ___________________ shareholder wealth. maturity stage and declining ___________________ stage. The financing strategy of a firm should seek to minimise the agency costs. Because investors and creditors prefer to invest and grant loans to high credit rating firms. Management should use debt finance to the extent that it maximises the wealth of shareholders. 10. NTPC come up with IPO due to ideal capital market and . since the profit ___________________ earning capacity is less due to less sales where as when a firm is in its growing stage (fast) and having more profits. debenture holders and the ___________________ management. large firms are forced to make use of different sources of funds. IOB. ___________________ 8. Conflict may arise due to the transferring of wealth to debt holders in their favour. When it comes to the credit rating characteristics a firm enjoying high credit rating may get funds easily from the capital market. Small firm's ability to raise funds from outside is limited when compared to large firms. Industry Life Cycle: The Industry life cycle consists of CE Notes introduction stage. since the risk is less. In other words. Union Bank. because no single source is sufficient to their needs. The agency problem is ___________________ handled through monitoring and restrictive covenants. as compared to other firms. growth stage. not beyond that. Timing of Public Issue: Timing of public offer is also one of (c) the most important factors considered while planning the capital structure. 9. Agency Costs: Agency costs arise when there is a conflict of -C ___________________ interest among owners. Financial Management 182 7. TCS. Small firms have to depend on owners' funds for financing activities.

(c) 9. 6. Prices as well as yields on securities depend on 183 CE the money policy pursued by the government. ___________________ 11. 3. Definitions and Symbols Used S = Total market value of equity shares. Business risk is constant over time and assumed to be independent of its capital structure and financial risk. Therefore. On the other hand. 8. who prefer stable ES returns and share in profits. who prefer capital gains and control and ___________________ hence. 7. All the investors are assumed to have the same expectation about the future profits. Some investors are ready to take risk (bold investors. B = Total market value of debt . Investors ___________________ may be institutional investors (LIC. Scarcity of debt Notes money and equity funds leads to high interest rates and low ___________________ price earnings (P/E) ratios. prefer to invest in debentures. Assumption of Capital Structure Theories 1. either by selling the shares and retiring UP debt or by issuing debt and redeeming equity.e. 5. The total financing remains constant. The total assets of the company are given and do not change.UNIT 16: Capital Structure and Theories the economy. debt and equity. Dividend payout ratio = 100%. Operating profits (EBIT) are not expected to grow. Requirements of Investors: Before going to issue a ___________________ particular instrument to the public or investors to raise funds. since satisfying their needs and preference share are more suitable to the investors (less cautious). GIC. 4. company has to decide ___________________ whether to finance infancy stage with equity funds and latter stages (except declining) with debt funds or vice versa.). Corporate tax does not exit. There are only two sources of funds i . 2. ___________________ investors (cautious). The company has infinite life. equity shares are suitable to them. The firm can change the degree of leverage. and UTI) as well as -C ___________________ individual investors. who are interested in the safety of their ___________________ investment and stable returns. ___________________ there is a need to know the investors requirements.

___________________ V = B+S ___________________ Cost of debt ( Kd) = 1/ B ___________________ Value of debt (B) = 1/ Ke ___________________ Cost of equity capital (Ke) = D1/P + g -C ___________________ Because of assumption no-4 growth rate =O.1 Ke = or NI P× N S Net income available to the shareholder Ke = Total market value of equity shares Overall costs of Capital (Ko) Ko= W1 Kd + W2 Ke (W1 & W2 are weights. Understanding the relationship between financial leverage and cost of capital is extremely important for taking capital structure . So.) B S (K ) B/V(K d ) + S/V (K e ) or (K d ) + e B+ S B+ S UP or 1 + NI EBIT Ko = = V V so EBIT V= Ko Theory of Capital Structure The long-term source of finance. Kd= E/P ___________________ Multiplying both. They are debt capital and equity capital. Ke= D/P and since ___________________ payout ratio = 100% D= earnings or dividends. Financial Management 184 I = Total interest payments. The financial manager must determine the proportion of debt and equity and financial leverage. numerator and denominator by the number of shares. we get: ES E× N EBIT . CE Notes ___________________ V = Total market value of the firm ___________________ NI = Net income available to equity shareholders. which a company may use for (c) investments. ___________________ Therefore. may be broadly classified into two types.

The formula to calculate the average cost of capital is as follows: Ko = Kd (B/ (B+S)) + Ke (S/ (B+S)) (c) Where. is known as optimum capital structure. the cost of debt and the cost of equity do not change with a change in the leverage ratio. Net Income approach (NI) ___________________ 2. a change in the capital structure causes a change in the overall of capital as well as the value of the firm. cost of capital and valuation of the firm. gets a higher weightage in UP the calculation of the cost of capital.UNIT 16: Capital Structure and Theories decisions. however. Theoretically the value of a firm can be maximized when 185 CE the cost of capital in minimized. which is lower than the cost of equity. Ko is the average cost of capital Kd is the cost of debt B is the market value of debt . This approach has been suggested by David Durand. That capital structure. Modigliani-Miller approach ES In this unit. Net Income Approach (NI) According to this approach. ___________________ There exist extreme views. As a result. The first viewpoint strongly supports the argument that. ___________________ Existence of optimum capital structure is not accepted by all. we will focus only on net income approach. the financing or debt equity mix has a major ___________________ impact on the shareholders wealth. ___________________ There are four major theories explaining the relationship between ___________________ capital structure. Traditional approach 4. Net Operating Income approach (NOI) ___________________ 3. where the Notes cost of capital is minimum. capital structure decision is relevant to the valuation of the firm. capital structure is irrelevant. According to the theory it is possible to change the cost of capital by changing the debt equity mix. The second. the cost of debt. the average cost of capital declines as the leverage ratio increases. In other words. This is because when the leverage ratio increases. They -C ___________________ are: ___________________ 1. According to this approach. is of the ___________________ opinion that.

even if the cost of debt and cost of equity remains same regardless of leverage. As a result. So the overall cost of capital will be minimum when the proportion of debt in the capital structure is maximum. Financial Management 186 S is the market value of equity CE Notes ___________________ Ke is the cost of equity ___________________ The NI approach is based on the following assumptions: ___________________ 1. cost of equity is assumed to be less than the cost of debt. maximize the value of the firm. debenture. The use of debt does not change the risk of investors and ___________________ therefore. The corporate income tax does not exist. . According to NOI theory. the overall cost of capital ___________________ will decline and the value of the firm will increase. optimum structure exists when the firm employs 100% debt or maximum debt in the capital UP structure. the weighted average cost of capital tends to decline leading to an increase in the total level of the firm. The implications of the 3 assumptions of NI approach is that. -C ___________________ ___________________ According to the theory. ___________________ ___________________ 2. Hence. such as equity shares capital. the proportion of a cheaper source of ES funds (debt) in the capital structure increases. 3. therefore. Thus. Summary Capital structure refers to the mix of long-term sources of funds. as the degree of leverage increases. cost of debt (Kd) and cost of equity (Ke) remains the same irrespective of the degree of leverage. 3. reserves and surpluses. According to NI theory. Cost of debt is less than the cost of equity. 2. Net Operating Income (NOI) theory is propounded by David Durand. Check Your Progress True or False: 1. cost of debt is assumed to be less than the cost of equity. when the financial leverage is increased ___________________ (proportion of debt in the total capital). the market value of the firm (c) is not affected by the capital structure changes. increased use of low cost debt will result in the decline of overall cost of capital and thereby.

187 CE Capital structure = Long-term debt + Preferred stock + Net worth Notes or capital structure = Total assets . and preference share capital. Ko depends on business risk. the cost of debt and the cost of equity do not change with a change in the leverage ratio. the EPS ___________________ is same for two alternative capital structures. So. In financing ___________________ decisions the financial manager's job is to come out with an ___________________ optimum capital structure. According to the theory. which represents long-term sources. optimum capital structure exists when the firm borrows maximum. . firm's debt ___________________ capacity. Ko does not change when leverage is changed.UNIT 16: Capital Structure and Theories long-term debt from outside sources. Appropriate capital structure can be determined by adopting: EBIT-EPS approach. solvency. So. Keywords Capital Structure: It is that part of financial structure. EBIT-EPS Approach: This approach determines the impact of debt on earnings per share. which is assumed to be constant. ___________________ According to the NI approach overall cost of capital continuously decreases as and when the debt content is increased in the capital ES structure. Indifference point is that EBIT level at which. The construction of capital structure is ___________________ difficult. Net Income Approach: According to this approach. there is a trade-off between the UP interest tax shield and bankruptcy. Lesson End Activity "As the debt-equity ratio increases. and control. NOI is just opposite to NI approach and argues that capital structure is irrelevant. since it involves a complex trade off among several -C ___________________ factors. causing an optimum capital structure. which maximizes market value per share by minimizing cost of capita. MM Theory: According to this theory the value of the firm is (c) independent of its capital structure. valuation Approach and cash flow ___________________ approach.Current liabilities." Do you agree with the statement? Give reasons. flexibility of capital structure. ___________________ An appropriate capital structure should take into consideration ___________________ profitability.

Financial Management 188 NOI Approach: According to this approach. 100 Assets 100 200 .5 Equity cost (Ke %) 14 14 14. From the following information calculate EPS.5 7 7. ___________________ ___________________ Optimum Capital Structure: It is that capital structure where market value per share is maximum and the cost of capital is ___________________ minimum. Particulars Plan 1 Plan 2 Plan 3 Plan 4 Plan 5 Plan 6 Plan 7 Debt as a percentage of total capital 0 0. 4. From the following information determine optimal capital ___________________ structure by the calculation of cost of capital.2 0. Critically analyse the different theories of capital structure.0000. sales = ` 50. (c) 9.000.5 15 16 18 19 3.1 0. ___________________ ___________________ Questions for Discussion -C ___________________ 1. List down the approaches available to determine the capital structure of the firm. Critically analyse the differences between capital structure ___________________ and financial structure.5 8. 6. ___________________ WACC Approach: It is midway between NI and NOI approaches. Analyse the different forms of capital structure. Calculate EPS if: (a) Total capital required. 5. Calculate EBIT.000. It is proposed to start a business and so required a capital of ` 10 lakh and an assured return of 15 per cent on investments. 8. Elucidate the relationship between the leverage & cost of capital according to the NI & NOI approach. the market value of CE Notes the firm is not affected by the capital structure changes. ___________________ 2. Variable cost = ` 25. Particulars Venkat Ltd (` in lakh) Sai Ltd (` in lakh) Equity (shares of ` 10 each) 200 100 Debentures at 12 % .6 ES Debt cost (Kd %) 6 6 6 6. by way of ` 100 equity UP (b) If 50 per cent of equity capital and 50 per cent.000. Interest = ` 5.4 0. 10 per cent debentures.5 0.3 0. 7. Fixed cost = ` 15.

Tata McGraw Hill Publishing Company Ltd.html (c) . 8% preference shares of ` 100 each.utsa.wikipedia.Theory and Practice.. 2 Chandra.svtuition.business.000 equity shares of ` 100 each. There is nothing like optimum capital structure for a firm.net/..C. Prentice Hall of India Pvt. ___________________ ___________________ (a) To issue 25../capital-structure-theory . New Delhi..000. UP Ltd.000 equity shares of ` 100 each. Fundamentals of Financial Management. Further Readings Books Van Horne. Elucidate the procedure for EBIT-EPS analysis.edu/kfairchild/classes/. ___________________ consisting of 15.org/2010/05/theories-of-capital-structure. The ___________________ management is planning to raise another ` 25 lakh to finance -C ___________________ a major expansion programme and is considering three alternative methods of financing. has currently adopted an all equity structure. Financial Management . 8% debentures of ` 100 each...doc www. (c) To issue 25. and Wachowicz. 1996. J. ___________________ (b) To issue 25.UNIT 16: Capital Structure and Theories 189 Calculate EPS assume (a) 20 per cent before tax rate of return CE Notes of assets. P. Critically evaluate the statement.org/wiki/Capital_structure www. 3 Web Readings en. company is in 50 per cent tax bracket. determine the EPS. Jr. (b) 10 per cent before tax return on assets.. J.000. ___________________ 10. ES The company's expected EBIT will be ` 8 lakh.M.United States faculty.. p. p./Leverage Theory. New Delhi. Assuming a corporate tax rate of 46 percent. Penta Four Ltd.slideshare. ___________________ 12. ___________________ ___________________ 11. 2002.

Financial Management 190 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

UNIT 17: Leverages Unit 17 191 CE Notes Leverages ___________________ ___________________ ___________________ Objectives ___________________ After completion of this unit. . Delivering is the action of reducing borrowings. the action of a lever and mathematical advantage gained by it. the students will be aware of the following topics: ___________________ \ Meaning of leverage ___________________ -C \ Types of leverage ___________________ \ Financial leverage and its impact on EPS ___________________ \ Appropriate combination of operating and financial leverage ___________________ Introduction ___________________ A firm can raise its required finance either equity or debt or both ES the sources. In other words. The concept is valid in business also. "the employment of an asset or sources of funds for which the firm has to pay a fixed cost or fixed return. According to James Home." Here fixed cost (operating cost) or fixed returns (financial cost) remains (c) constant irrespective of the level of output. as this practice can maximize gains (and losses). From the financial management point of view. In macroeconomics. the term leverage is commonly used to describe the firm's ability to use fixed cost assets or sources of funds to magnify the returns to its owners. leverage allows accomplishing certain things that are otherwise not possible. While constructing capital structure. Companies usually leverage to increase returns to stock. a firm can use fixed cost bearing securities for maximisation of shareholder wealth. a key measure of leverage is the debt to GDP ratio. Concept of Leverages UP Leverage has been defined as. leverage is. Leverage refers to the use of debt to supplement investment.

The operating costs are categorised into three: One – fixed costs. they must be paid regardless of the amount of revenue available. which is partly vary and is partly fixed. for the change in percentage of sales revenue. Example. Operating leverage is associated with investment (assets acquisition) activities. Second – variable costs that varies directly with the level of production. etc. insurance. when revenues are rising and bad when they are falling. raw materials. Hence. They ___________________ must be paid regardless of the amount of revenue available. Third– Semi-variable costs. These fixed costs do not vary with sales. Financial Management 192 CE Notes Activity Types of Leverages What___________________ are the two types of There are two types of leverages. UP The degree of operating leverage may be defined as the change in the percentage of operating income (EBIT). Financial leverage ___________________ Now let us discuss about types of leverages. That is Percentage change in EBIT Degree of Operating Leverage = Percentage change in sales or (c) Contribution DOL = Operating Profit (EBIT) Operating leverage may be favourable or unfavourable. which do not vary with the level of production. . operating leverage results from the present ES fixed operating expenses with in firm's income stream. direct labour costs. buildings. Hence.. for example. The degree of operating leverage at any level of output is arrived at by dividing the percentage change in EBIT with percentage change in sales. It is good. High degree of operating leverage indicates high degree of risk. such as: leverages? ___________________ 1. Operating Leverage: Operating leverage is present any time a firm has operating costs regardless of the level of -C ___________________ production. ___________________ ___________________ 1. operating leverage may be defined as the firm's ability ___________________ to use operating costs to magnify the effects of changes in ___________________ sales on its earnings before interest and taxes. Operating leverage ___________________ 2. etc. depreciation plant and machinery.

000 EBIT 1.50.000 Operating leverage = = 2.50.00.00. The firm has paid interest ` 50.00.000 at the rate of 5 per cent and ` 1.000 Contribution 4.00.66 1. there is a need to know the ___________________ calculation of earnings available to equity shareholder from the sales revenue. Calculate operating leverage.000 units. produced and sold 100.00.000 debt.000 . The larger the Notes magnitude.50. Solution: Contribution DOL = EBIT or Operating profit (EBIT) Particulars Amount (` ) Sales Revenue (1.000 Less: Variable cost (1.000 4.000 × ` 6) 6.00. it has spent a variable cost of ` 6.UNIT 17: Leverages Operating risk (business risk) is the risk of the firm not being 193 CE able to cover its fixed operating costs.000 units of a product at the rate of `100.00.000. The following table clearly gives a picture ___________________ about the calculation of earnings available to ordinary ___________________ shareholder.000 × ` 100) 10. the larger is the volume of sales required to cover ___________________ all fixed costs. For production of 100. ___________________ -C Particulars Amount (` ) ___________________ Sales Revenue (units sold × selling price pu) XXXX ___________________ Less: Variable cost XXX [Units produced × cost per unit] ___________________ Contribution XXXX ___________________ Less: Fixed cost XXX Earnings Before Interest & Taxes (EBIT) XXXX ES Less: Interest XXX Earnings Before Tax (EBT) XXXX Less: Tax XXX Earnings After Taxes (EAT) XXXX Less: Preference Dividend XXX Earnings available to Equity shareholder (EAES) XXXX Illustration 1: XYZ Ltd.000 at the rate of ` 6 per unit and a UP fixed cost of ` 2. ___________________ Before solving the problems.00..000 (c) Less: Fixed cost 2. 50.

000 ___________________ ___________________ Solution: ___________________ Calculation of EBIT on a Percentage Change -C ___________________ Particulars 2002 2004 % change Sales Revenue 10.000 12.00. Hence.50. to magnify the rate of return as equity shares.000 7.50. In other words.50. 2.000 2. diversification.50.50. Application of Operating Leverage (a) It is helpful to know how operating profit (EBIT) would change with a given change in units produced.000 ___________________ Variable cost 6.000 25 ___________________ Less: Variable cost 6.67 Operating leverage 2.50.50.667 times.00. According to Lawrence.00. (b) It will be helpful in measuring business risk.667 indicates that when there is 25 percent ES change in sales. sources of funds such as debt and preference share capital along with the equity share capital in capital structure is described as financial leverage. Financial Management 194 Illustration 2: From the following particulars of ABC Ltd. Use of various sources to compose capital is known as financial structure. ___________________ Particulars Previous Year 2003 Current Year 2004 ___________________ Sales revenue 10.000 7. the financial managers’ job is to compose funds. financial leverage may be defined as the (c) payment of fixed rate of interest for the use of fixed interest bearing securities. Financial Leverage: A firm may need long-term funds for long-term activities like expansion.00.000 5. The fixed charges do not vary with . Financial leverage associates with financing activities.000 12.000 Fixed cost 2.00. financial leverage results from the presence of fixed financial charges in the income statement.000 25 ___________________ Contribution 4. etc.000 25 ___________________ Less: Fixed cost 2.000 66. It is also known as "trading as equity".50.50. The required funds may be raised by two sources: equity and debt. financial leverage is the ability of the firm to use fixed financial charges to magnify the effects of changes in EBIT on the firm's earnings per share.000 EBIT 1. the change in EBIT is 2. The use of fixed charges. CE Notes Calculate operating leverage.000 2.50..000 2. UP modernization.00.

000 Less: Variable cost (10.00. The financial risk refers to the risk of the firm ___________________ not being able to cover its fixed financial costs. Financial leverage is computed by the ___________________ following formula: ___________________ EBIT or operating profit Financial (Leverage ) = EBT or taxable income ___________________ or Percentage change in EPS ___________________ Degree of Financial Leverage (DFL) = Percentage change in EBIT ___________________ -C A Financial leverage may be positive or negative. Favourable ___________________ leverage occurs when the firm earns more on the assets ___________________ purchased with the funds.00.00.000 at 20 percent interest.000 Less: Fixed cost 2. Solution: Calculation of EBT Particulars Amount (`) Sales Revenue (1.000 .u) 10.000 units × ` 10 P.00. Illustration 3: A firm has sales of 100. the level of ES EBIT and fixed charges while preparing the firm's financial plan.000 (c) EBIT 2.000 Contribution 4. Since the terms used are the same throughout. The two measures are related.UNIT 17: Leverages firm's EBIT.00.00.000.000 × 20 /100) 1. High degree of financial leverage leads to high financial risk.60) 6.00.000 Earning before tax (EBT) 1. than the fixed cost of their use and ___________________ vice versa.000 Less: Interest (5. Fixed cost is ` 2. They must be paid regardless of the amount of 195 CE EBIT available to the firm.000 units at ` 10 pu variable cost of the produced products is 60 percent of the total sales revenue.00. debt-to-equity is equal to gearing times debt over assets: D/E = (A/E) × (D/A).00.000 × 0. The firm has used a debt of UP ` 5. Hence.00.00. Calculate the operating leverage and financial leverage.00. It indicates the effect on EBIT Notes created by the use of fixed charge securities in the capital ___________________ structure of a firm. the financial manager should take into consideration.

00.000 7.000 25 Less: Variable cost 9.000 lakh and sales are expected to increase by 25 percent.000.000 1. The fixed cost is ` 2.000 UP Less: Preference dividend --.375 0.000 2. 10 per ___________________ cent debt capital.00.000 = ` 11.00. Financial Management 196 Operating leverage = Contribution of EBIT CE Notes ___________________ = 4.000 18.00.00. The company's current ___________________ sales revenue is ` 15. ___________________ calculate operating and financial leverages.000 Less: Fixed cost 2.000 1.000 3.000 ÷ 1.000 = 2 ___________________ Illustration 4: From the following particulars of PQR Company.000 EBIT 3.25.000 + 2.000 42. 50.25.000 EPS 0.000 × 60/100 = 2. --- Earnings available to shareholder 75.000 ÷ 2.50.000 5.25.00.00.000 2.50.000 . Calculate operating leverage and financial ___________________ leverage at ` 10 equity and 50 percent tax rate.50.000 × 100 = × 100 = 42.00.50.000 EBT 1. ` 9.00.000 11.000 Less: Tax 50% 75.000 Total variable cost = 9.000 1.00. The -C ___________________ company has ` 20 lakh equity shares capital and ` 20 lakh.000 VC% = × 100 = × 100 = 60 per cent Sales 15.000 Contribution 6.75.86 Less: Interest 2.000 (c) (2) Percentage change in EBIT: Increase or decrease in EBIT 1.000 Increase in variable cost = 3.00.000 incurred on variable expenses for ___________________ generating `15 lakh sales revenue.75 100% Working Notes (1) Variable cost in percentage of sales: Total variable cost 9.86 per cent Base EBIT 3.50.00.50.75.000 = 2 ___________________ Financial leverage = 2.50.00.000 EAT 75.25.50.00.00. 50. ___________________ Solution: Calculation of EPS ES Percentage of Particulars Current position Expected change change Sales Revenue 15.00.50.

UNIT 17: Leverages 197 (3) Interest on Debt: CE Notes Activity 20 20. 50. 50.75 ___________________ -C Contribution % change in EBIT ___________________ (a) Operating leverage = or EBIT % change in Sales ___________________ 6. the sum of both.00. (b) It will be helpful for measuring the financial risk. (c) The degree of combined leverage may be defined as the percentage change in EPS due to the percentage change in sales.00. 50.333 1. 3.375 ___________________ Expected change = 1.86 Application of Financial Leverage: (a) It is helpful to know.000 42.714 3. Combined Leverage: The operating leverage has its effects on operating risk and is measured by the percentage change in UP EBIT due to the percentage change in sales.00.50.000 × = ` 4.000 100 = or = 2.000 = 0. Since.000 ___________________ What do you understand by 100 combined leverage? ___________________ (4) EPS ___________________ Earnings available to shareholders EPS = No.00.000 = 0.86 ___________________ = or = 1. of ordinary shares ___________________ Current position = 75000/ 2. how EPS would change with a change in operating profit (EBIT). The financing leverage has its effects on financial risk and is measured by the percentage change in EPS due to the percentage change in EBIT.00. both these leverages are closely related with the ascertainment of the firm's ability to cover fixed charges (fixed operating costs in the case of operating leverage and fixed financial costs in the case of financial leverage).000 25 ___________________ EBIT % change in EPS (b) Financial leverage = or EBT % change in Sales ES 3. Thus the combined leverage is: % Change in EBIT % Change in EPS % Change in EPS × = % Change in Sales % Change in EBIT % Change in Sales .000 42. gives us the total leverage or combined leverage and the risk associated with combined leverage is known as total risk.000/ 2.

The Degree of UP Operating Leverage (DOL) may be defined as the change in the percentage of operating income (EBIT). Financial Management 198 Contribution EBIT Contribution = CE Notes × EBIT EBT EBT ___________________ Check Your Progress ___________________ True or False: ___________________ 1. ___________________ 4. (c) Lesson End Activity Calculate the degree of operating leverage. for the change in percentage of sales revenue. and in measuring business risk. Operating Leverage (OL) refers as the firm's ability to use operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. ___________________ 5. Financial leverage is also known as "trading as equity". Fixed cost is affected by the level of output of firm. and for measuring financial risk. Financial Leverage (FL) is the ability of the firm to use fixed financial charges to magnify the effects of changes in EBIT on the firm's earnings per share. OL is helpful in knowing. The degree of combined leverage is the percentage change in EPS due to the percentage change in sales. ___________________ 2. Financial leverage indicated the ability of firm to use fixed financial charges to magnify the effects of changes in EBIT on firm's earnings per share. degree of financial leverage. -C ___________________ 3. There are two types of leverages: (i) operating leverage and (ii) financial leverage. Financial leverage is helpful to know how EPS would change with a change in operating profit (EBIT). how the operating profit ___________________ (EBIT) would change with a given change in units ___________________ produced. Higher risk is accompanied by the higher degree of ___________________ operating leverage. and the degree of combined leverage for the following firms and interpret the results: . ES Summary Leverage has been defined as the firm's ability to use fixed cost assets or sources of funds to magnify the returns to its owners.

Operating leverage is associated with the investment activities.00.000 5. 40.000 40.00.000 75. Operating Income: It is a measure of a firm's profitability that excludes interest and income tax expenses.00 0.5 0. 4.000 75. Fixed cost ` 2. ___________________ Financial Leverage: It is the payment of fixed rate of interest for ___________________ the use for the fixed interest bearing securities. Operating Leverage: It results from the present fixed operating expenses within firm's income stream.000.000 Notes Fixed Cost (`) 3.50 ___________________ Keywords ___________________ ___________________ Debt: It is that which is owed. Operating Risk: It is the risk of the firm not being able to cover UP its fixed operating costs. Comment.00. Fixed interest charges ` 1. variable cost ` 200. Selling price ` 300. usually referencing assets owed. to magnify the rate of return as equity shares. AMC Company Ltd. -C ___________________ Degree of Operating Leverage: It is the change in the percentage of operating income (EBIT) for the change in ___________________ percentage of sales revenue. Given. (b) operating BEP (Q). .000 ---- ___________________ Selling Price per unit (`) 3. Return on Assets: This percentage shows how profitable a company's assets are in generating revenue.000 7.00. 3.50.000 ___________________ Variable Cost per unit (`) 1. provided the following information and requested you to Calculate (a) Operating leverage with 4000 and 6000 quantity of sales.00 25.000 (c) 2. Questions for Discussion 1.00 7. Find out the operating profit. Given: Financial leverage is 2. Analyse the importance of the financial leverage for a firm.1 ___________________ Interest Expenses (`) 25.UNIT 17: Leverages Particulars P Q R 199 CE Output (Units) 3. ES Leverage: It allows accomplishing certain things that are otherwise not possible.

Financial Management.000 -C ___________________ 8.000 ___________________ 1999 70000 3.000. Interest = ` 5. Tata McGraw Hill Publishing Company Ltd. Ltd. Prentice Hall of India Pvt. and Wachowicz.org/wiki/Leverage_(finance) dictionary. Variable cost = ` 25. New Delhi.60.org/wiki/Leverage en... New Delhi. 2008 Van Horne. Financial Management 200 5.00.investopedia. New UP Delhi..reference.0000. J. 2002. 2 Chandra.com › Dictionary (c) .C. Financial Management . From the following data.wikipedia. Analyse the importance of the concept of leverage in modern ___________________ scenario. Jr. Fundamentals of Financial Management.25. P. ___________________ 9. Analyse the ways in which trading on equity maximizes the ___________________ equity earnings.000. Further Readings ES Books Sudhindra Bhat. sales = ___________________ ` 50.M. Given the operating income ` 2. 3 Web Readings en. ___________________ 7. p.000.00.wikipedia. J..000. calculate operating leverage.000 and taxable income CE Notes ` 1. calculate the financial leverage. Excel Books. Fixed cost = ` 15.com/browse/leverage www. ___________________ 6. ___________________ Year EBIT (`) Sales in units ___________________ 1998 60.000 3. p. 1996. Calculate operating leverage.Theory and Practice.

In a competitive economy. the students will be aware of the following ___________________ topics: -C ___________________ \ Concept of capital budgeting \ Importance of capital budgeting ___________________ \ Different capital budgeting appraisal methods ___________________ \ Different kinds of capital investment proposals ___________________ Introduction ES Capital project planning is the process by which companies allocate funds to various investment projects designed to ensure profitability and growth. it involves a current outlay or series of outlay of cash resources in return for an anticipated flow of future benefits. Capital budgeting is the process to identify analysis and select investment projects. UP Meaning and Definition Capital budgeting refers to planning the deployment of available capital for the purpose of maximizing the long-term profitability of the firm. In other words. Firm's investment decisions would . It is the firm's decision to invest its current funds most efficiently in long-term activities in anticipation of flow of future benefits over a series of years. Therefore. whose returns (cash flows) are expected to extend beyond one year. capital budget may be defined as the firm's decision to invest its current funds most efficiently in the long- (c) term assets in anticipation of an expected flow of benefits over a series of years. Evaluation of such projects involves estimating their future benefits to the company and comparing these with their costs. the economic viability and prosperity of a company depends upon the effectiveness and adequacy of capital expenditure evaluation and fixed assets management.UNIT 18: Fundamentals of Capital Budgeting Unit 18 201 CE Notes Fundamentals of Capital ___________________ ___________________ Budgeting ___________________ ___________________ Objectives ___________________ After completion of this unit.

3. ___________________ modification and replacement of fixed assets. acquisition. 3. we may identify the basic features of capital budgeting capital budgeting? viz. and a relatively long-time period between the initial outlay ___________________ and anticipated return. They have the effect of increasing the capacity. CE Notes replacement of fixed assets or long-term assets. 4. span of life regarding future benefits. Funds are invested in long-term activities. It involves the firm's decision to invest its current funds for addition. 5. From the above Activity ___________________ What are the main features of definition. ___________________ In simple. Replacing and modernizing a process. They benefit future periods. Mechanization of process. -C ___________________ Capital budgeting may be defined as the firm's formal process for ___________________ the acquisition and investment of capital. disposition. 4. It involves exchange of current funds for future benefits. potentially large anticipated benefits. ___________________ Features of Capital Budgeting Decisions ES Capital budgeting decisions have the following features: 1. Example: Some of the examples of capital budgeting decision UP are: 1. efficiency. 2.. selecting and following upon capital ___________________ expenditure alternatives. and modernization. Financial Management 202 generally include expansion. Introduction of a new product. Choice between alternative machines. Significance of Capital Budgeting (c) Capital budgeting decisions are significant due to the following reasons: Growth: The fixed assets are earning assets. since they have decisive influence on the rate of return and direction of firm's . capital budgeting refers to the total process of ___________________ generating. relatively a high degree ___________________ risk. 2. Expansion of business by investing in plant and machinery. evaluating.

The availability of capital assets has to be phased properly. which are 203 CE already running under profits. then firm will ___________________ become more risky. (c) 3. if it is not economically independent. for the results continue over an extended period of time. its cash flow affects the projects under consideration. ___________________ More Risky: Investment in long-term assets increases average ___________________ profit but it may lead to fluctuations in its earnings. Asset expansion is related to future sales. Effect on other Projects: Whenever long-term asset investment is a part of the expansion programme. Hence. In other words unwanted or Notes unprofitable investments will result in heavy operating costs. with much financial loss to the firm. firm will incur more loss in that type ES of capital assets. ___________________ ___________________ Huge investments: Long-term assets involve more initial cash outflows. He has to make a commitment for the future. Hence. The decision-maker loses some of his flexibility. Difficult Decision: Capital budgeting decision is very difficult due to (a) decision involves future years cash inflows. due to difficulties in finding out market for such capital items once they have been used. while taking investment in long-term assets. the decision maker has to check the impact of this project on other projects.UNIT 18: Fundamentals of Capital Budgeting growth. (b) uncertainty of future and more risk. So. investment decision decides the future of the business concern. which makes it imperative for the firm to plan its ___________________ -C investment programmes very carefully and make an advance ___________________ arrangement of funds either from internal sources or external ___________________ sources or from both the sources. 4. A wrong decision can affect the other projects. . ___________________ Irreversibility: Long-term asset investment decisions are not ___________________ easily reversible and that too. if the effect is in terms of increase in profits then he/she has to accept the UP project and vice versa. 2. Other reasons regarding the significance of capital budgeting are: 1. Asset expansion typically involves the allocation of substantial amounts of funds. The effect may be increased in profits or decrease in profits.

....... Financial Management 204 5. which shoot from three principle sources: (c) Measurement Problem: Evaluation of project requires identifying and measuring its costs and benefits.... and ......................... advised or excessive capital spending may create excessive capacity and increase in operating costs ES limits the viability of company funds and reduce its profit earning capacity.. at the same time..... Check Your Progress Fill in the blanks: 1... 2 . The most important reason for capital budgeting decisions is that..... ___________________ 7.. The effects of ___________________ a capital budgeting decision extends into the future and have -C ___________________ to be put up with. elements..... Decision relating to capital investment is among the most ___________________ difficult and.. ___________________ 6.. without .......... These decisions require an ___________________ assessment of the future events which are uncertain.. most critical that a ___________________ management has to make. but they pose difficulties.......... Fixed assets represent . Capital budgeting is an important function of the management ___________________ because it is one of the critical determinants of success or failure of the company........ because they involve the allocation of CE Notes substantial amount of funds.. they have long-term implications for a firm.. for a longer period than the consequences of ___________________ current operating expenditures.. which is difficult since they involve tedious calculations and lengthy process.... ___________________ 8... Many firms fail... 3 Capital budgeting decisions are ..... Obstacles for Capital Budgeting Capital budgeting decisions are very important.. is the firm's decision to invest its UP current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years........ Majority of replacement or expansion programmes have impact on some other activities of the company (introduction of new product may result ......

In other words the planning phase of a firm's capital budgeting process is concerned with articulation of its broad investment strategy UP and the generation and preliminary search of project proposals. study of local materials and resources. identity unfulfilled psychological needs. which is 10-20 years for industrial ___________________ -C projects and 20-50 years for infrastructure projects. 1. ___________________ are associated with a particular capital expenditure project spread out over a long period of time.. execution/implementation and review. study plans outlays and government guidelines. Figure 18. explore the possibility of reviving sick units. performance analysis of existing industries. analysis of economic and social trends. review of import and export data. which are expected. examination of input and output of various industries. ___________________ ___________________ Process/Steps of Capital Budgeting ES The process of Capital budgeting may be divided into six broad phases/steps. attending trade fairs. looking at the suggestions of financial institutions and developmental agencies. It involves a careful study from many different angles. Identifying a new worthwhile project is a complex problem. financing. depends on expected costs and benefits in the future. The temporal ___________________ spread creates some problems in estimating discount rates for ___________________ conversation of future cash inflows in present values and establishing equivalences. ___________________ Temporal Spread: The costs and benefits.1 depicts the relationship among phases of capital budgeting. study of new (c) technological developments. viz. it is impossible to predict the future cash inflows. Notes Activity Uncertainty: Selection or rejection of a capital expenditure project List ___________________ the steps of capital budgeting. draw clues from the consumption abroad. Future is ___________________ uncertain. stimulate creativity for generating new product ideas among the employees. Planning/Idea Generation: The search for promising project ideas is the first step in capital budgeting process. evaluation/analysis.UNIT 18: Fundamentals of Capital Budgeting in the decrease in sales of the other existing product) or have some 205 CE intangible consequences (improving morale of the workers). planning or idea generation. it will be childish ___________________ or foolish. selection. . if anybody tries to predict the future. Ideas can be generated from the sources like. Hence.

The acceptance rules are ES different for each and every method. Selection: Selection or rejection follows the analysis phase. preparing. standard deviation. ___________________ financial. Apart from the use of techniques of evaluation. Risk. Capital should consist of debt and equity. Under this phase financing arrangements have to be made. While deciding the capital structure. and working capital advances). project and engineering designs. the decision maker has to keep in mind some factors. construction. Selection and rejection of a project depends on the technique used to evaluate and its rule of acceptance.paid up share capital. there are few techniques available for measurement (range. This phase focuses on gathering data. Control. Generally the amount required is UP known after the selection of the project. ___________________ Analysis has to consider aspects like. if the project is worthwhile. There are two broad sources available such as equity (shareholders' funds . Financing of the Project: After the selection of the project. probability distribution approach and decision tree approach) in capital budgeting. certainty equivalent. Implementation of an industrial project involves the stages. Costs and benefits are determined based on the information gathered about other alternative projects. 5. then it is required to go for evaluation/analysis. after using a wide range of ___________________ evaluation techniques which are divided into traditional/non- ___________________ discounted and modern/discounted techniques. economic and ecological analysis. training. marketing. share premium. 4. and retained earnings) and debt (loan funds . The factors are Flexibility. technical. -C ___________________ ___________________ 3. Execution/Implementation: Planning of paper work and (c) implementation is physically different in implementing the selected project. and Tax benefits (referred to by the acronym FRICT). coefficient of variation) and incorporation of risk (risk adjusted discount rate. debentures. Evaluation/Analysis: In the preliminary screening. the next step is financing. which influence capital structure. summarizing relevant ___________________ information about various alternative projects available. Financial Management 206 2.term loans. when a CE Notes project proposal suggests that the project is prima facie ___________________ worthwhile. Income. Translating an investment proposal from . negotiations and contracting. which ___________________ are being considered for inclusion in the capital budgeting ___________________ process. and plant commissioning.

the need to accept the other is ruled out. Performance review should be done periodically. there are 5 pieces of equipment available in the market to carry out a job. Adequate formulation of project. Contingent Investment Proposals There is certain projects utility which is contingent upon the acceptance of others. there is need to review the ___________________ project.UNIT 18: Fundamentals of Capital Budgeting paper work to concrete work is complex. are very much helpful for the ___________________ implementation of a project at reasonable cost. If the management chooses one piece of the equipment. the need for the shop does not arise. employee's quarters and a co-operative shops. it should rank the proposals. . For Example. then. -C ___________________ ___________________ Ranking of Capital Budgeting Proposals or ___________________ Classification of Investment Proposals ___________________ A firm should select its own projects after considering the advantages and disadvantages of each one of them. In case one proposal is accepted. Example: Management of an enterprise may be contemplating to construct. If the management decides to construct quarters but not shops. the (c) employees will have no shop to make purchases. Proposals are ranked on the basis of the following considerations: Mutually Exclusive Investment Proposals This kind of Proposal connotes those proposals which represent alternative methods of doing the same job. For this ES purpose. actual performance is compared with ___________________ the predetermined or projected performance. ___________________ 6. If it decides not to build quarters. time consuming and a 207 CE risky task. These are contingent projects. use of the Notes principle of responsibility accounting and use of network ___________________ techniques (PERT and CPM). UP others will not be required because they are mutually exclusive projects. under ___________________ this performance review. Review of the Project: Once the project is converted from paper work to concrete work.

___________________ Check Your Progress Fill in the blanks: ES 1. Choosing among several alternatives.. are termed as replacements. There are many methods for evaluating and ranking the capital investment proposals. ___________________ -C ___________________ Replacement ___________________ The investments.. by the management for performing different tasks with in the ___________________ organization. Capital Budgeting Appraisal Methods In view of the significance of capital budgeting decisions.. buildings..... ___________________ parking lot. In all these methods. Financial Management 208 CE Notes Activity Independent Investment Proposals List___________________ the capital budgeting It includes all such investment proposals as are being considered appraisal methods.... Traditional techniques of capital budgeting evaluation is also known as .... that bigger benefits are preferable to smaller ones and early benefits are preferable to later ones. 3.. the basic method is to . 2.... 4. A basis of distinguishing between acceptable and non- acceptable projects. Recognizing the fact........... it is UP absolutely necessary that the method adopted for appraisal of capital investment proposal is a sound one... which are contemplated for replacing.... Ranking of projects in order of their desirability. Acceptance of each of these ___________________ projects is done on its own merit without depending on other projects. old and ___________________ antiquated equipment so that the job could be performed more efficiently.. Any appraisal method should provide for the following: 1. Capital budgeting evaluation techniques are divided into .... Investments in machinery.. A criterion which is applicable to any conceivable project... broad categories.... 2. .... (c) 5....... automobiles. and recreation centre and so on are the examples of ___________________ the independent investment proposals....

Pay back period may be defined as that period required to recover the original cash outflow invested in a project. In other words it is the minimum required number of years to recover the original cash outlay (c) invested in a project. depends upon the relevant circumstances of the proposed project under evaluation. Pay Back Period Pay back period is one of the most popular and widely recognized techniques of evaluating investment proposals. Discounted Cash Flow Methods: ___________________ (a) The net present value of method ___________________ (b) Internal rate of return -C ___________________ (c) Profitability index or benefit-cost-ratio ___________________ ___________________ ___________________ ES Figure 18. Which method is appropriate to a specific project of the firm. Pay back period can be calculated in two ways. Traditional Methods: ___________________ (a) Payback period method ___________________ ___________________ (b) Accounting rate of return method ___________________ 2. Notes 1.1: Techniques of Project Valuation It should be kept in mind that different firms may use different UP methods. The first method can be applied when the cash flows stream of each year is equal/annuity . The cash flow after taxes is used to compute pay back period.UNIT 18: Fundamentals of Capital Budgeting compare the investments in the projects regarding the benefits 209 CE derived. (i) Using formula (ii) Using Cumulative cash flow method.

Financial Management 210 in all the years’ or projects life. In this ___________________ situation.e. cumulative process goes up to the period where cumulative cash flows equals to the actual cash outflows. Cost involvement in calculating pay back period is very less as compared to sophisticated methods. i. It is very simple and easy to understand. Put it simple Accept: Cal PBP < Standard PBP UP Reject: Cal PBP > Standard PBP Considered: Cal PBP = Standard PBP Advantages Pay Back Period The merits of pay back period are: 1. . pay back period is calculated through the process of ___________________ cumulative cash flows. (c) Limitations of Pay Back Period Payback period method suffers from certain limitations such as: 1. 2. It ignores cash flows after pay back period. Put it simple: ES PBP = Year before full recovery + (Unrecovered Amount of Investment¸ Cash flows during the year) Accept-Reject Rule Acceptance or rejection of the project is based on the comparison of calculated PBP with the maximum or standard pay back period. ___________________ Pay Back Period = Original Investment ÷ Constant Annual Cash ___________________ Flows after Taxes ___________________ Or ___________________ Initial investment (cash outlay) ___________________ Initial investment cash outlay Payback period = Annual cash inflow -C ___________________ ___________________ The second method is applied when the cash flows after taxes are unequal or not uniform over the projects’ life period. uniform cash flows for all the CE Notes years.. In this situation the following formula is used to calculate ___________________ pay back period.

........ Summary One of the important problems confronting the top management of (c) a firm is to determine whether the firm should invest funds in fixed assets........ It is not an appropriate method of measuring the profitability CE Notes of an investment.... There is no rationale basis for setting a minimum pay back period. 2...... -C ___________________ For calculating payback period. Pay back period and Accounting rate of return methods are .. we need Cash Flows after Taxes ___________________ (CFAT) ___________________ Particulars (`) ___________________ Sales revenue xxx Less: Variable cost xxx Contribution xxx ES Less: Fixed cost xxx Earning Before Depreciation and Taxes (EBDT) xxx Less: Depreciation xxx Earning Before Taxes (EBT) xxx Less: Taxes xxx Earnings After Tax (EAT) xxx Add: Depreciation xxx Cash Flows After Tax (CFAT) or xxx Earnings After Taxes but Before Depreciation (EATBD) UP Check Your Progress Fill in the blanks 1... ___________________ 5. Profitability index is equal to one the project should be .. . . ___________________ ___________________ 4... ___________________ 3.. .. It is not consistent with the objective of maximizing ___________________ shareholders’ wealth........ It does not take into consideration time value of money...UNIT 18: Fundamentals of Capital Budgeting 211 2..... Capital budgeting is the firm's decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years.. Share value does not depend on pay back ___________________ periods of investment projects... as it does not consider all cash inflows yielded by the investment........

-C ___________________ economic analysis.000 to install new milling controls. since the selection of profitable project will help to maximize value ___________________ of the firm through the maximization of profits. The process of ___________________ capital budgeting may be divided into six broad phases/steps. and ecological analysis.000 25. which are contemplated for replacing. A Company is considering an investment proposal of ` 50. Elucidate. A project expected cash flows are as follows: Year 0 1 2 3 4 5 (c) CFAT (`) 50. financial analysis.000 10. Questions for Discussion 1. The facility has a life expectancy of 5 years and his salvage value. Project evaluation ___________________ involves market analysis. Mutually Exclusive Investment Proposals: Those proposals UP which represent alternative methods of doing the same job.000 20. Financial Management 212 Capital budgeting decisions are important since growth of the firm CE Notes depends on fixed assets. The capital budgeting process may be ___________________ more or less depended on the type of the project. it is a more risky decision as huge ___________________ investments are involved. Replacement Investment: The investments. Contingent Investment Proposals: There are certain projects which are contingent upon the acceptance of others. ___________________ The methods of evaluation capital investment play a vital role. 2. old and antiquated equipment so that the job could be performed more efficiently. are termed as replacement investment.000 15. technical analysis. ES Keywords Capital Budgeting: It refers to planning and deployment of available capital for the purpose of maximizing long-term profitability of the firm. ___________________ ___________________ Lesson End Activity ___________________ When cash flows after taxes are unequal then cumulative cash flow method is used to compute pay back period.000 20. The company’s tax .000 Calculate pay back period.

3.000 Wages per running hour 1.000 14. The net income before depreciation and tax is estimated as follows: (c) Year 1 2 3 4 5 IBDT (`) 10. 000 ` 50.000 Other expenses p. A company is planning to consider any one of the three alternatives A. The life of the machine is estimated to be 10 ___________________ years.000 16.000 3.50 2. Bharat Industrial Limited purchased a machine five ___________________ years ago.00 Indirect material p.UNIT 18: Fundamentals of Capital Budgeting rate is 55% and no investment tax credit is allowed. which will need an investment of ` 40. A proposal is under consideration to replace it by a -C new machine.a. is proposing to take up a project. Tax rate is 50 per cent.25 1.080 3. ABC Ltd.750 0 5.000. The firm 213 CE uses straight – line depreciation.000 Depreciation is to be charged according to the straight-line method. 12.000 1. .000 5. The estimated Cash Flow Notes before Tax (CFBT) from the proposed investment proposal is ___________________ as follows ___________________ Year 1 2 3 4 5 ___________________ CFBT(`) 10000 11000 14000 15000 25000 ___________________ Compute the Payback period ___________________ 3.a.080 C 5.000 2.000 20. Calculate ARR.000 12. As cost accountant of the company you are ___________________ required to submit your recommendations based on the following information: ___________________ Existing (Old) New machine machine ES Initial cost ` 25. M/s.000 12. 000 Machine hours per annum 2. The existing (old) machine can be sold at its written ___________________ down value. of units produced per hour 12 12 Selling price per unit 2 2 UP Interest to be paid at 10per cent on fresh capital invested. 4.25 Power per hour 0. Calculate the Accounting rate of return.000 Cost of materials per unit 1 1 No.000 0 6. B and C.610 B 5. Alternatives CFAT(`) 0 1 2 A 5.

wikipedia. Jr.fao. ___________________ Ltd.org/docrep/W4343E/w4343e07. p. J. Financial Management . 3. Excel Books.org/wiki/Capital_budgeting www. New Delhi....com › Dictionary ES www. P. 1996. Financial Management 214 CE Notes Further Readings ___________________ ___________________ Books ___________________ Sudhindra Bhat.htm www.morevalue. Financial Management. Prentice Hall of India Pvt. Tata McGraw Hill Publishing Company Ltd. J.. 2 -C ___________________ Chandra. New Delhi. Fundamentals of ___________________ Financial Management.com/i-reader/ftp/Ch9.PDF UP (c) . 2008 ___________________ Van Horne.investopedia. 2002. New ___________________ Delhi.C.M. ___________________ Web Readings ___________________ en. p. and Wachowicz.Theory and Practice.

all the profitable investment .UNIT 19: Capital Rationing and Risk Factors in Capital Budgeting Unit 19 215 CE Notes Capital Rationing and Risk Factors ___________________ ___________________ in Capital Budgeting ___________________ ___________________ Objectives ___________________ After completion of this unit. The acceptable criteria under these methods are: UP 1. No doubt. a concern may not have enough funds to undertake all profitable projects. That is. in real situation. 2. the net present value of the project must be more than zero. The profitability of a capital project can be determined under any of the discounted cash flow techniques. the students will be aware of the following ___________________ topics: -C ___________________ \ Meaning of capital rationing \ Objective and the effects of capital rationing ___________________ \ Steps involved in capital rationing ___________________ \ Risk analysis in capital budgeting ___________________ \ Techniques used for in corporation of risk factor in capital budgeting decision ES Introduction Theoretically speaking. if a concern has more funds it can accept and implement all profitable projects. a concern should accept all profitable capital projects which add to the wealth of the owners and increase the market value per share. the internal rate of return should be more than the cost of capital. (c) However. in such a situation. In such a situation. Further. profitability index method or internal rate of return method. In the case of internal rate of return method. such as the net present value method. there may be restrictions imposed by the management on the amount of funds that could be used for financing capital projects during a specified period. 3. In the case of profitability index method. there arises the need for rationing of capital. the profitability index must be more than 1. In the case of net present value method.

it will be possible for the firm to maximize the wealth of the owners and to maximize the market value per share. UP Effect of Capital Rationing The effects of capital rationing are: 1. It has to accept only some of the profitable investment proposals and reject the other profitable investment proposals. it means the ___________________ selection of only some of the profitable investment proposals and the rejection of the other profitable investment proposals due to limited availability of funds or other considerations. the preference of the management to safety and control as compared to profit. say. In short. ___________________ ___________________ Meaning of Capital Rationing ___________________ Capital rationing means the allocation of the limited funds ___________________ available for financing the capital projects to only some of the -C ___________________ profitable projects in such a manner that the long-term returns are ___________________ maximized. When there is capital rationing. When there is capital rationing. 2. In other words. a firm will not be able to undertake all the profitable investment proposals. the desire ES of the management to keep the growth of the firm within limit. capital rationing capital rationing? arises in a situation where a concern has more profitable ___________________ investment proposals than it can finance. So. Financial Management 216 proposals or projects cannot be taken up. to ensure the selection of only those profitable investment proposals that will provide the maximum long-term returns. it means the selection of only some of the profitable investment proposals or projects out of the several ___________________ profitable investment proposals available. In short. Objective of Capital Rationing The main objective of capital rationing is. (c) . Only some of the CE Notes profitable proposals or projects have to be taken up and the other Activity ___________________ What do you understand by profitable proposals have to be given up. the objective of capital rationing is to maximise the value of the firm.

___________________ 2.UNIT 19: Capital Rationing and Risk Factors in Capital Budgeting 217 CE Steps Involved in Capital Rationing Notes ___________________ Capital rationing involves two important steps.000 1. Ranking of the different investment proposals: First. the different investment proposals or capital projects available.10 III 4 1.000. Selection of some of the profitable investment proposals: -C ___________________ Then. on the ___________________ basis of their net present value or profitability index or the ___________________ internal rate of return).05 The available fund amount is ` 4.00. the selection of that combination of profitable ___________________ investment proposals.e. Illustration 1: A firm has the following investment opportunities: ES Proposal Initial outlay (`) Profitability index 1 3.000 1. However.000 1.000 1. . Which proposals the firm should accept? UP Solution: First Step: Ranking of the proposals in the descending order of their Profitability Index.e. They are: ___________________ 1. all the proposals are profitable or acceptable. i.. on the basis of their profitability in the descending order. above one.15 3 2.10 4 2. in the descending order. as the funds available are limited.50. ___________________ should be ranked on the basis of their profitability (i.15 II 3 1. Proposal Profitability index Rank 1 1.00. there should be capital rationing and only the most profitable combination of the proposals should be accepted.20 2 1.20 I 2 1. As such.05 IV Second Step: Selection of the proposals: Here.00. should be made subject to the budget constraint ___________________ for the period. the profitability (c) index of all the proposals is above unity.50.. which would provide the highest ___________________ profitability.

the net present value of the first combination is the highest.000 × (1. Proposals 2 and 3 involving capital outlay of `(1.000 + UP 2.000 has a net present value of zero.000 and yielding a net present capital outlay of ` (22. Proposal involving a capital outlay of ` 3. the net present value of each of the various ___________________ investment proposals is: -C ___________________ Proposal Net Present Value of the Proposal ___________________ 1 3.50. this combination has to be selected.00.20 – 1) i. = ` 22. the selection of the combination which will yield the highest total net present value has to be made.500 + 10.000 and yielding total net present value of ` (22.500 + 10.000 (1.000 available for investment. Note: It is assumed that the uninvested capital of `.00.00.000 (1.000 ES After the ascertainment of the net present value of each of the various profitable proposals.50.00.00. Illustration 2: A firm has ` 5.000 and yielding a net present value of ` 60. The firm's cost of capital 10%. CE Notes we should determine the net present value of the various ___________________ acceptable proposals.000) 350.000 ___________________ 2 1.15 – 1) i. = ` 60.000) 32. = ` 25.000) 32.e.500 3. = ` 10.00.50. first.00.000 + 2.000 (1.000) 4.00.000) 1.10 – 1) i.(4.50. The investment opportunities available are as follows: .50. Such a combination of proposals can be: Various Possible Combinations of Proposals 1. So.000 4 2.00. Financial Management 218 For determining the most profitable combination of proposals.e. The net present value of each of the various ___________________ acceptable proposals can be computed with the help of the ___________________ following formula: ___________________ Net present value of a proposal = Initial capital cost of a project × Profitability index of the proposal – 1 ___________________ Accordingly.000 – (c) 3.e.000 2.e.05 –1) i.500 ___________________ 3 2.500 Of the three possible combinations. Proposals 2 and 4 involving capital outlay of ` (1.

here.20.00. So.000 + 1.000 ___________________ 6 1. proposals 2. 4 and 5 are acceptable or profitable.000 Notes 2 2.70.08.00.5.000) 4.000 ___________________ 3 1.70.000 + 1. all these proposals cannot UP be selected because of the limited availability of funds and credit rationing.000 18% 70.000 12% 18.000 + 70.000 to invest wishes to select (c) from the following project those that maximize the present value of cash inflows: .90..80.UNIT 19: Capital Rationing and Risk Factors in Capital Budgeting Proposal Cost of the Project (`) Internal Rate of Return Net present value (`) 219 CE 1 1. and the internal rate of return of proposals 1 and 6 is less than the cut-off rate of 10%.000 5% -14.00.80. 3.000 – 4.50.000 + 18.000 20% 1. only the combination of proposals 4.00.000) 2.50.000 4 1. Second Step: Selection of the proposals: Here.90.000 9% 12. 4 and 5 is above the cut-off rate or firm's cost of capital of 10%. Under credit rationing. Accordingly.20. to be rejected).e. 3.000 ___________________ 5 1. only that combination of acceptable proposals.000 has zero net present value.000 11% 3. though proposals 2.000) 30.000 should be selected.000 and yielding a total net present value of `(1. which will yield the highest total net present value has to be selected. Note: It is assumed that the uninvested capital of ` (5.00.000 ___________________ Solution: ___________________ First Step: Ranking of the proposals in the descending order of ___________________ Internal Rate of Return -C ___________________ Proposal Internal Rate of Return Taking Rank 10% as Cut-off Rate ___________________ 1 5% - ___________________ 2 11% IV 3 12% III ___________________ 4 20% I 5 18% II ES 6 9% - Note: the internal rate of return of proposals 2. and 3 involving a capital expenditure of ` (1. 3. Illustration 3: A firm having ` 15. 4 and 5 are profitable or acceptable and proposals 1 and 6 are not acceptable (i.

no doubt.00.00.00. Calculate the present value of cash flow of each project. That means.30 ___________________ 5 5.000 1.00.00.10 4 8.00. all the projects are acceptable. ___________________ 2. above 1.45 II Note: Here.20 ___________________ 2 2. we should ascertain the net present value of each of the various .10 VI 4 1.30 ___________________ 8 7.000 1. Proposal or Project B/C Ratio or Profitability Rank Index of the Proposal 1 1.000 1.e.40 III 3 1. So.50 ___________________ 6 4. there should be capital rationing.00.20 ___________________ 7 9.00. For selecting the most profitable group of proposals.20 V 7 1. the B/C ratio or the profitability index of all the projects is above unity. Using a trial and error approach.000 1. select the group of projects ___________________ that maximize the firm's present value of cash inflows. Solution: ES First Step: Ranking of the proposals in the descending order of their profitability.30 IV UP 5 1.000 1. The firm earns zero return on any uninvested portion of the ___________________ budget.50 I 6 1. But the funds available for capital investment are limited.45 -C ___________________ 1. i.000 1.000 1.40 ___________________ 3 3..000 1. first. all the projects are profitable or acceptable. Financial Management 220 Project Initial Cost Investment (`) B/C Ratio CE Notes 1 6. Second Step: Selection of the proposals: Here.20 V 2 1. (c) Under capital rationing. only the most profitable group or combinations or proposals should be selected.30 IV 8 1.

000 × (1.000 ___________________ 6 4.50. are 5.00.00. in this case. The net present value of each of the various proposals 221 CE can be ascertained as follows: Notes Activity Initial cost of the project × (Profitability of index – 1).15.50.00.10 – 1) = ` 30.000 ___________________ 3 3.00.000 + 2.000 and yielding the highest total net present value of ` (2.000) 1.000 × (1.20.45–1) = ` 3. Such a combination of proposals.UNIT 19: Capital Rationing and Risk Factors in Capital Budgeting proposals.45.00.00.00. 8 and 2 involving the capital expenditure of ` (5.000 × 1.000 + 3.000. 2.40.. Note: It is assumed that the uninvested capital of ` (15.00.00.e. Capital rationing is the selection of the most profitable investment projects with maximum long term returns.000 - 14. Risk Analysis in Capital Budgeting (c) Need for Risk Analysis in Capital Budgeting If a capital budgeting decision is made on the assumption that the capital project or investment proposal does not involve any risk (i. there is certainly regarding the future estimate of cash .30–1) = ` 2.000 + 80.15.00.000 × (1.000 × (1.70. 3.000 ___________________ -C 5 5.00.00.000 + 7.50–1) = ` 2.000 ___________________ After ascertaining the net present value of the various proposals.000 × (1.000 4 8.30–1) = ` 2. Capital rationing has no effect on the maximization of the shareholders wealth.000 ___________________ 7 9.000) 14.000 × (1.20–1) = ` 80.20 – 1) = ` 1.40 – 1 = ` 80. Accordingly ___________________ Explain the need for risk analysis in capital budgeting.000 ___________________ 8 7.00. Check Your Progress UP True or False: 1. the selection of the most profitable combination or group of ES proposals has to be made.00.000) 6.000 has zero net present value.000 ___________________ 2 2. NPV of the project must be more than zero for the project to be accepted.00.000 × (1. the net present value of the various proposals is as follows: ___________________ Proposal Net Present Value of the Proposal ___________________ 1 6.

It may be noted that the incorporation of the risk factor in capital budgeting decisions is a difficult task. Now. the assumption that the investment ___________________ proposal does not involve any risk does not hold good. the management of a firm must take the risk factor into account. ES Incorporation of the Risk in Investment Proposal As stated earlier. UP There are a number of techniques used for the incorporation of the risk factor in capital budgeting decisions. cyclical fluctuation. then. risk is involved in very capital budgeting decision. the actual return from an investment proposal will be ___________________ usually different from the estimated returns. 2.. let us consider the various techniques used for the (c) incorporation of the risk factor in capital budgeting decisions. In other words. economic. there is risk in capital budgeting or -C ___________________ investment decision. ___________________ However. ___________________ it is necessary to take into account the risk factor. such as (a) risk adjusted discount rate and (b) certainly equivalent coefficient. there ___________________ is uncertainly regarding the future estimation of cash inflows from capital project. in real situation. As risk is involved in every capital budgeting proposal. while taking the capital budgeting decision. . (Of course. Quantitative techniques such as (a) sensitivity analysis. while determining the returns or cash inflows and the profitability of a project for the purpose of capital budgeting. Financial Management 222 inflows from capital project during its estimated life). financial. Ordinary techniques or general techniques. (c) standard deviation. In real ___________________ situation. there is CE Notes no question of risk analysis is capital budgeting. ___________________ taxation etc. such as technical. In short. owing to a number of reasons.) ___________________ As risk is involved in every investment proposal. foreign exchange. some proposals will be less risky ___________________ and some may be more risky. (b) probability assignment. The most popular techniques are: 1. in real saturation. (d) coefficient of variation and (e) decision tree. political.

(c) Let us consider the risk-adjusted discount rate with an example. ___________________ The risk adjusted discount rate is based on the assumption that -C ___________________ investors expect a higher rate of return on more risky projects and a lower rate of return on less risky projects. viz. Suppose there are two investment proposals X and Y. risk-free rate. and Proposal Y is more risky. the risk adjusted discount rate is the usual or normal discount rate for the time factor plus the extra or additional discount rate for the risk factor.. So. the future cash flow from capital projects are discounted at the risk adjusted discount ___________________ rate and decision regarding the selection of a project is made on ___________________ the basis of the net present value of the project computed at the ___________________ risk adjusted discount rate.. surplus rate or extra rate that takes care of the risk factor. usual discount rate or unity rate that takes care of time element and 2. for a less risky investment proposal. Risk-free rate is the rate at which the future cash flows of a project which is not subject to risk are discounted. The normal discount rate for the time factor is 5%. So. In short. it is the UP normal or usual discount rate at which the future cash flows of a risk less project are discounted.e. The extra discount rate for the risk factor is 5% for proposal X and 10% for proposal Y. a higher ___________________ discount rate is used for discounting the cash flows of more risky ___________________ project and a lower discount rate is used for discounting the cash ___________________ flows of less risky project. The risk- premium rate or the extra discount rate for the risk factor varies with the degree of risk involved in the capital projects. risk premium rate. the extra discount rate will be lower and for a more risky investment proposal.UNIT 19: Capital Rationing and Risk Factors in Capital Budgeting 223 CE Techniques of Capital Rationing Notes ___________________ Risk Adjusted Discount Rate Method ___________________ Under the risk adjusted discount rate method. normal rate. ES 1. In this case. the normal . Risk premium rate is the extra or additional discount rate at which the future cash flows of a risky project are discounted. the risk- adjusted discount rate for proposal X will be 10% (i. Proposal X is less risky. The risk adjusted discount rate comprises two rates. and so. the extra discount rate for the risk factor will be more.

Riskless cash flow means the cash flow which the management expects. when there is no risk in investment proposal. Contd… .000 Check Your Progress True or False: 1.. 14. the PI should not be more than zero.000. For the project to be accepted. Risky cash flow means the cash flow which the management expects when there is risk in investment proposal. there is (c) absolute certainty about the cash inflows estimation in those projects.efficient is : = 0. ___________________ ___________________ Certainty Equivalent Coefficient Method ___________________ Certainty equivalent co-efficient method is a method which makes ___________________ adjustment against risk in the estimates of future cash inflows for ___________________ a risky capital investment project.7 20.000 and the riskless cash flow is ` 14. Due to absence of risk in certain projects. Financial Management 224 discount rate of 5% plus the extra discount rate for the risk factor CE Notes 5%) and the risk-adjusted discount rate for proposal Y will be 15% Activity Give___________________ the formula for certainty (i.. ES The certainty equivalent coefficient is the ratio of riskless cash flow to risky cash flow.e. The certainty equivalent coefficient can be calculated with the help of the following formula: UP Riskless cash flow Certainty equivalent coefficient = Risky cash flow Suppose the risky cash flow is ` 20. reducing) to a conservative level the estimated cash flows of a ___________________ capital investment proposal by applying a correction factor termed as certainty equivalent coefficient. adjustment against risk is made in the estimates of ___________________ future cash inflows of a risky capital project by adjusting (i. the normal discount rate of 5% plus the extra discount rate for equivalent coefficient the risk factor 10%).000 The certainty equivalent co .e. 2. -C ___________________ Features of certainty equivalent coefficient method: Under ___________________ this method.

Investors expect a higher rate of return on more risky CE Notes projects. ___________________ There are several techniques used for incorporation of risk factors ___________________ in capital budgeting decisions. probability assignment. Risk premium rate is the additional discount rate at which present cash flows of a risky project are ___________________ discounted. ___________________ 4. How does portfolio diversification help in reducing risk? UP Keywords Adjusted Discount Rate Method: The future cash flow from capital projects are discounted at the risk adjusted discount rate and decision regarding the selection of a project is made on the basis of the net present value of the project computed at the risk adjusted discount rate. ___________________ ___________________ Summary ___________________ Capital rationing means the selection only some of the profitable ___________________ investment proposals out of the several profitable investment -C ___________________ proposals available. Capital rationing involves two important ___________________ steps: (i) ranking of the different investment proposals. coefficient of Variation & decision tree. and (ii) selection of some of the profitable investment proposals. General Techniques are: (a) Risk adjusted discounting rate and (b) Certainty equivalent coefficient ES Quantitative Techniques includes sensitivity analysis. Certainty Equivalent Coefficient Method: A method which makes adjustment against risk in the estimates of future cash inflows for a risky investment project. . standard deviation. Lesson End Activity Discuss the steps involved in the process of measuring risk and return. Capital Rationing: The allocation of the limited funds available for financing the capital projects to only some of the profitable projects in such a manner that the long term returns are (c) maximized.UNIT 19: Capital Rationing and Risk Factors in Capital Budgeting 225 3.

A company has 2 projects C & D under consideration. ___________________ Riskless Cash Flows: The cash flows which the management ___________________ expects when there is risk in investment proposal. -C ___________________ Risky Investment: Risk in an investment refers to the variability ___________________ that is likely to occur between the estimated returns and the actual returns.19 D 3000 0. . 6.1 E 8000 0.12 9000 0. Examine the ways in which capital projects be ranked under capital rationing. ___________________ Risk-free Rate: It is the rate at which the future cash flows of a ___________________ project which is not subjected to risk are discounted.details given are: Project C Project D Possible Cash inflows Probability Cash inflows Probability assigned events (`) assigned (`) UP A 5000 0. Taking the example of Ques.3. 3. Critically examine the ways in which you will use the "Decision Tree Analysis" approach in investing in a project. Both the projects have equal initial cash outlay of ` 8000/. Elucidate the technique of "Certainty Equivalent Coefficient".18 B 8000 0. ___________________ ___________________ Questions for Discussion 1. (c) 5. calculate the coefficients of variation and suggest which project is more risky.5 C 4000 0.4 8000 0. 2. 4.1 5000 0.6 7000 0.3 10000 0.4 Find out which project is more risky by adopting standard deviation technique. Financial Management 226 Certainty Equivalent Coefficient: It is the ratio of the riskless CE Notes cash flows. ___________________ Risk Premium Rate: The extra at which the future cash flows of ___________________ a risky project are discounted. Compare the risk factor of two capital projects with the help of ES standard deviation techniques.

p.. Financial Management.org/stable/2583501 www. Tata McGraw Hill Publishing Company Ltd. 3 ___________________ ___________________ Web Readings ___________________ www..morevalue..org/stable/1058914 ES professional-edu. New Delhi. Fundamentals of ___________________ Financial Management. P./206-investment-decisions-under- ca. Jr.. Excel Books. New Delhi. Financial Management . 1996. Prentice Hall of India Pvt. and Wachowicz.UNIT 19: Capital Rationing and Risk Factors in Capital Budgeting 227 CE Further Readings Notes ___________________ Books ___________________ Sudhindra Bhat..com/i-reader/ftp/Ch11.jstor.Theory and Practice. 2002..jstor. New ___________________ Delhi. J.. ___________________ 2008 ___________________ Van Horne. J. Ltd.PDF UP (c) . www.C. p. 2 ___________________ -C Chandra.com/.M.blogspot..

Financial Management 228 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

He was on a trip through Pennsylvania. ___________________ George Thomas was finishing some weekend reports on a Friday afternoon in the downtown office of Wishart and Associates. ___________________ ___________________ Case Study 1: Wishart and Associates — Financial -C Alternatives ___________________ ___________________ This case provides the opportunity to match financing alternatives with the needs of different companies. who were considering the flotation of securities with the assistance of Wishart and Associates. As George picked up the phone to make the first call. APT. Common stock trades over the counter. Packaging firm with high growth rate in tri-state area. Meenda. he suddenly realized that the potential clients were not matched with the investment alternatives. (5) callable debentures STOP. visiting five potential clients. a secretary handed George the following telegram. New machinery should Contd… . (4) convertible bonds. an ES investment-banking firm. In the front of each (c) folder were some handwritten notes that Meenda had made on Monday before he left. George knew that Meenda would be recommending different types of securities for each of the five clients to meet their individual needs. had not been in the New York office since Monday.UNIT 20: Case Studies Unit 20 229 CE Notes Case Studies ___________________ ___________________ ___________________ Objectives ___________________ After analyzing these cases. a partner in the firm. He also knew Meenda wanted him to call each UP of the clients to consider the recommendations over the weekend.m. Meenda had called the office on Wednesday and told George's secretary that he would cable his recommendations on Friday afternoon. Good management. Willing to accept any type of security. At 4:00 p. George Thomas. George found folders on each of the five firms seeking financing. Expects moderate growth. (2) preferred stock. George was waiting for the cable. Inc. George read each of the notes in turn. Stock is depressed but should rise in year to 18 months. needs $8 million now and $4 million in four years. It allows the ___________________ reader to demonstrate a familiarity with different types of securities. In Meenda's office. George was prepared to make these calls as soon as the cable arrived. See you Wednesday STOP Meenda. Wishart and Associates STOP Taking advantage of offer to go skiing in Poconos STOP Recommendations as follows: (1) common stock. the student will have an appreciation of the concept of topics studied in this Block. (3) debt with warrants.

Seeks additional shareholder but not willing to stock at discount. Sound growth company. Relatively high profits. (c) George pondered over the situation. Cannot raise ___________________ more than $12 million with straight debt. Very good earnings. Banks could be willing to lend money for long-term needs. that's it. he could still call the firms by 6:00 P.. George said. Good ___________________ growth prospects. Sandford Enterprises ___________________ Needs $16 million. Financing gimmicks and chance to turn quick profit on investment would appeal to those likely to invest in this company. he had wasted his week. As George was looking over the folders. ___________________ Sharma Brothers. Relatively low debt-equity ratio. that he was invited to go skiing at the company lodge up there". Fair management. Cannot issue debt without UP permission of bondholders and First National Bank of Philadelphia. Money to be used to finance machinery for ___________________ plumbing supplies.M. Excellent growth and profits forecast in ___________________ the next two year. Retains bulk of earnings and pays ___________________ low dividends. Management would like to sell common stock at $21 or more willing to use debt to raise $ 28 million. "No. Needs $20 million to expand cabinet and woodworking business. Meenda called early this morning and said that he verified the facts in the folders. and is traded over the counter. except of course. Needs long-term money. If he could determine which firm matched each recommendation. Recently retired $7 million in debt. -C ___________________ Started as family business but now has 1200 employees. Inc. Crusty management. $50 ___________________ million in sales. but I think those notes should be useful. Manufactures boat canvas covers and needs funds to expand operations. Low debt-equity ratio. Management not interested in surrendering voting control to outsiders. Sacheetee Energy Systems ES The firm is well respected by liberal investing community near Boston area. Ranbaxy Industry Needs $25 million. Stock selling for $16 per share. Should spark investor's interest. He also said that he learned nothing new on the trip and he sort of indicated that. George decided to Contd… . He could always wait until next week. Strong management with minor weaknesses in sales and promotion areas. Good prospects for growth. when he could be sure that he had the right recommendations and some of the considerations that outlined each client's needs and situation. Financial Management 230 increase profits substantially. Closely held ownership reluctant surrender control. Stock price depressed ___________________ but expected to improve. CE Notes Has virtually no debt remaining except short-term obligations. "Did Meenda leave any other material here on Monday except for these notes?". Meenda's secretary entered the office. as the firm has record of retiring debt prior to maturity. and meet the original deadline. She responded. but this is second choice.

What types of securities must be issued by a firm which is on the growing stage in order to meet the financial ___________________ requirements? ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) . Which type of financing is appropriate to each firm? ___________________ 2. Notes Questions ___________________ 1.UNIT 20: Case Studies return to his office and match each firm with the appropriate 231 CE financing.

Lee was told that the firm could raise money from two sources under the current Contd… . Two items have been of particular interest. ES RKV has been investigating the addition of a number of new product lines to be sold through its existing distribution channels.85 million. To finance the new projects. multicoloured canvas with fringe and would be aimed at the residential market.000 in the current year on sales of $8 -C ___________________ million and is forecasting sales of $13 million next year. $8 in equity ___________________ (300.3 million in sales for the umbrellas on annual (c) basis. It is likely. Financial Management 232 Case Study 2: RKV – Leverage CE Notes This case provides the reader with the opportunity to apply ___________________ different concepts of leverage to the planning process of the firm. although a relatively simple concept. would require an investment of $6 million for efficient production. The second new item would be a patio umbrella. no debt. Company A has an EBIT of $2.000 and $ 650. ___________________ Lucid products reach its market mostly by truck. At a recent meeting. George Lee recognized that. respectively. Len haton. Fixed costs would be $400. The first would involve the production and sale of chaise lounges for use around swimming pools. This means that production could begin by January 1st. the firm would have to build new facilities to produce each product. $18 million. has prepared sales estimates for the two products. but could be sold through hardware and discount stores as a residential product. and $8 in equity (300. He forecasts $4 million in sales for the lounges and $ 4. The firm is located in a semi-urban area. The firm's primary markets are ___________________ hardware and discount stores located in five North-eastern states.8 million which would include the purchase and installation of manufacturing and packaging machinery. Lee has recently prepared financial statements ___________________ estimating next year's operating results. The lounges would require an investment of $3. The umbrellas. 12-rib. The tax rate is 35 per cent. In his analysis regarding the new product proposals. the firm's vice-president of sales.3 and sales of debt at 11 per cent. The product would be aimed at commercial users. The report from the cost accounting department estimates variable costs of two-third of the sales value for the lounge unit and 61 per cent for the umbrellas.000 shares). He believes that. that variable costs will remain at approximately the same ___________________ percentage of sales next year as this year. the firm will earn just over $800. Most of RKV's financial planning is done by George Lee. such as hotels. ___________________ RKV is an important manufacturer of swimming pools. an EBIT of $2. GM of ___________________ finance. Company B has the same level of sales. The umbrella would be a large.000.6 million. $3. For both products. Both products would fit in with RKV's existing product line and neither would require any increase in UP networking capital.000 shares). Lee has been working with Lucid's investment bankers. Fixed costs will ___________________ probably rise to 12 per cent next year. it would take 80 days to install the equipment.

650.325.217 UP Variable Costs 5.520 EBT 1.000 Marginal contribution 2. The issue would have to be cumulative with respect to dividends.926. First.425. it could borrow on an 11 year note at 12 233 CE per cent for either or both the projects in an amount not exceeding Notes $ 8.UNIT 20: Case Studies market conditions.520 Fixed Costs 1.800.000 Question ES What would be the effect of acceptance of each project on leverages? Would it give a favourable financial leverage to RKV? EBIT 1.536.000.000 ___________________ Accounts receivables 750.000 (c) .000 ___________________ $ 9. Second.000 -C Fixed Assets 7.000 ___________________ $ 9.000 ___________________ Long-term debt (10%) 3.043.030.325.000 ___________________ Inventory 500.303 Sales $ 8.480 Interest 390.970.000 Current liabilities $ 600.000 ___________________ Common stock ($3 par) 1.027.5 million.000 Net Income 1.000 Retained earnings 3. ___________________ RKV Balance Sheet (Projected through December 31 ___________________ this Year) Cash $ 425. Common stock ___________________ financing would not be a possibility at present. the investment bankers felt confident that they could underwrite a preferred stock issue with a 12 per cent ___________________ dividend upto a dollar amount of $6 million.000 Taxes 509.500.

Financial Management 234 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

UNIT 21: Working Capital Management 235 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES BLOCK-V UP (c) .

Detailed Contents Financial Management 236 CE Notes UNIT 21: WORKING CAPITAL MANAGEMENT ___________________ UNIT 23: INVENTORY MANAGEMENT z Introduction z Introduction ___________________ z Concepts of Working Capital z Inventory ___________________ z Kinds of Working Capital z Components of Inventory ___________________ z Components of Working Capital z Inventory Management Motives ___________________ z Importance of Working Capital z Inventory Management Objectives ___________________ z Aspects of Working Capital Management z Need for Balanced Investment in Inventory -C ___________________ z Objectives of Working Capital Management z Costs of Holding Inventories ___________________ z Operating Cycle and Cash Cycle z Risks of Holding Inventory z ___________________ Need to Maintain Balanced Working Capital z Benefits of Holding Inventory z ___________________ Factors Influencing Working Capital UNIT 24: CASH MANAGEMENT UNIT 22: RECEIVABLE MANAGEMENT z Introduction ES z Introduction z Nature of Cash z Characteristics of Receivables z Motives for Holding Cash z Accounts Receivables Management z Objectives of Cash Management z Objectives of Accounts Receivables Management z Aspects of Cash Management z Costs of Accounts Receivables Management z Factors Determining Cash Needs z Benefits of Accounts Receivables Management z Cash Planning or Cash Budget z Modes of Payment z Managing Cash Flows UP z Factors Influencing the Size of Investment in Receivables UNIT 25: CASE STUDIES z Credit Policy (c) .

. It acts as grease to run the wheels of fixed assets. the required capital can be divided into two categories. without which there is no body. therefore.UNIT 21: Working Capital Management Unit 21 237 CE Notes Working Capital Management ___________________ ___________________ ___________________ Objectives ___________________ After completion of this unit. the students will be aware of the following topics: ___________________ \ Meaning. where as UP working capital required to utilize fixed assets. without which it cannot be promoted. Working capital plays a key role in a business enterprise just as the role of heart in human body. Investment decision is concerned with investment in current assets and fixed assets. Every business requires capital. concepts and kinds of working capital ___________________ -C \ Components of working capital ___________________ \ Need for maintaining adequate working capital and list out the dangers of excessive and inadequate working capital ___________________ \ Operating and cash cycle ___________________ ___________________ Introduction Working capital management is significant in financial ES management due to the fact that it plays a vital role in keeping the wheel of the business running. In other words. Fixed capital required for establishment of a business. Working capital management. Fixed assets cannot be utilized without current assets. is one of (c) the important facets of a firm’s overall financial management. efficiency of a business enterprise depends largely on its ability to manage its working capital. It is just like a blood in the human body. In other words. Its effective provision can ensure the success of a business while its inefficient management can lead not only to loss but also to the ultimate downfall of what otherwise might be considered as a promising concern. There are two assets required to be financed by fixed capital and working capital. such as fixed capital and working capital. definition.

Each concept of working capital has its own significance – the ES ‘gross concept’ emphasizing the ‘use’ and the ‘net concept’ the ’source’ – an integration of both these concepts is necessary in order to understand working capital management in the context of risk. This concept also called as ‘quantitative or broader approach’. accounts receivables and inventories”. marketable securities. etc. accounts receivables. short term securities. Field. ___________________ Both these concepts of working capital have operational ___________________ significance. return and uncertainty. “Use of this concept is helpful in providing for the current amount of working capital at the right time so that the firm is able to realise the greatest return on investment”. inventory. cash. advance payment of tax. prepaid expense. it is likely to -C ___________________ become insolvent and may even be forced into bankruptcy. Gross Working Capital Concept According to this concept. If a firm cannot maintain a satisfactory level of working capital. “Gross Working Capital refers to firm’s investments in short term assets such as cash. Financial Management 238 CE Notes Activity Concepts of Working Capital List ___________________ the various concepts of Working capital refers to short-term funds to meet operating working capital. Total current UP assets include. ___________________ expenses. the total current assets are termed as the gross working capital or circulating capital. which a ___________________ company must possess to finance its day-to-day operations”. According to Walker. Each has its relevance in specific situations from the management point of view. current liabilities and ___________________ their inter-relationship that exists between them. “It refers to the funds. It is concerned with the management of the firm’s current assets and ___________________ current liabilities. . The concept helps in making optimum investment in current assets and their financing. The two concepts are not to be regarded as mutually ___________________ exclusive. argue that the management is very much concerned with the total current assets as they constitute the total funds available for operating process. To quote Ramamoorthy. and (c) Baker and Malott. The supporters of this concept like Mead. It relates with the problems that arise in ___________________ attempting to manage the current assets. To quote Weston and Brigham.

the excess of current assets over current liabilities represents net working capital. Inadequate working capital can ___________________ disturb production and can also threaten the solvency of the ___________________ firm. Lincoln. current assets investment should not be ___________________ inadequate or excessive. The UP famous economists like. Similar view is expressed by Guthmann and Dougall. excessive investment in current assets should be ___________________ avoided. which financed with long-term funds. and Stevens. and Myer in their distinguished works. It will be positive. Net Working Capital Concept As per this concept. Financing of Current Assets: Need for working capital ___________________ arises due to the increasing level of business activity. there is a need to provide/arrange it quickly. On the other -C hand. It may be either positive or negative. fully supported this concept and viewed that the net working capital helps creditors and investors to judge the financial soundness of a firm. some times surplus funds may arise. Similarly. Net Working Capital Concept represents the amount of the current assets. they are: ___________________ 1. Park and Gladson. ___________________ 2. Sailer. which would remain after all the current liabilities were paid. if it fails to meet its current obligations. if current assets exceed the current liabilities and negative. They should not be kept as idle. Goel. ___________________ Therefore. To quote Roy .UNIT 21: Working Capital Management 239 Significance CE Notes Gross Working Capital Concept focuses attention on the two ___________________ aspects of current assets management. since it impairs the firm’s profitability. ‘Accounts Hand Book’ has also fully supported this view. Net Working Capital Concept indicates or measures the liquidity and also suggests the extent to which working capital needs may be financed by the permanent source of funds. Another alternative definition is that net working capital refers to that (c) portion of firm’s current assets. thus they ES should be invested in short-term securities. Kennedy and McMullen. if the current liabilities are in excess of current assets. Gerstenberg. Optimum Investment in Current Assets: Investment in ___________________ current assets must be just adequate to the needs of the firm. In other words.

.. To decide upon the Extent of Long-term Capital in Financing Current Assets: Net Working Capital (NWC) means the portion of current assets that should be financed by long-term funds....... This is the amount that is supposed to be financed by long-term funds.. Maintaining Liquidity Position: For maintaining liquidity -C ___________________ position there is a need to maintain current assets sufficiently ___________________ in excess of current liabilities.. NWC helps management to decide the extent to which current assets should be financed with equity capital and borrowed funds.. Hence... excess current ___________________ assets help in meeting its financial obligation within the ___________________ operating cycle of the firm. and (ii) To decide upon the extent of long-term capital in ___________________ financing current assets.. As discussed above... This concept helps to decide the extent of long-term funds required in finance current assets..00.000 current liabilities. ___________________ Significance ___________________ Net Working Capital Concept focuses attention on the two aspects ___________________ of current assets management.... “Net Working Capital indicates the liquidity of the CE Notes business whilst gross working capital denotes the quantum of ___________________ working capital with which business has to operate”. (c) 2. Total of all current assets ... 2. both are ES bad to the firm....000 current assets and ` 75........ for example... the extent of current assets should be UP decided by the NWC base... The excess of current assets over current liabilities ... .000..... In the above example NWC is ` 25. if there are ` 1. Check Your Progress Fill in the blanks 1. 1.......... they are: (i) Maintaining liquidity ___________________ position. In other words. The NWC is the difference between current assets and current liabilities. Financial Management 240 Chowdary... Generally for every one rupee of current asset there will be one rupee of current liability.... negative and excess working capital.

work-in-process. It may increase or decrease over a period of time. it may be ___________________ classified into gross working capital or net working capitals.1: Kinds of Working Capital Permanent Working Capital Permanent working capital is the minimum investment kept in the form of inventory of raw materials. which were already explained in detail. Temporary Working Capital A firm is required to maintain additional current assets temporarily over and above permanent working capital to satisfy cyclical demands. The variable working capital is again bifurcated ___________________ into seasonal and special working capital. stores and spares. additional . ___________________ ___________________ Gerstenberg has conveniently classified the working capital into regular or permanent working capital and temporary or variable ___________________ -C working capital. In other words. The minimum level of current assets maintained in a firm is usually known as permanent or regular working capital.1. fluctuating or variable working capital. ___________________ ___________________ ___________________ ES Figure 21. Any additional working capital apart from permanent working capital required to support the changing (c) production and sales activities is referred to as temporary or variable working capital.UNIT 21: Working Capital Management 241 CE Kinds of Working Capital Notes Activity The categorization of working capital can be made either based on ___________________ What are the different kinds of working capital? its concept or the need to maintain current assets either ___________________ permanently and/or temporarily. an amount over and above the permanent level of working capital is temporary. At times. finished goods. See Figure 21. and book debts to facilitate uninterrupted operation in a firm. As per conceptual view. Though this investment is stable in short run. UP it certainly varies in long run depending upon the expansion programmes undertaken by a firm.

. permanent working capital also changes with the additional funds. But for the growing firms Figure 21. ___________________ Distinction between Permanent and Temporary Working Capital ___________________ The difference between permanent and temporary working capital ___________________ can be shown in the following Figures 21. Financial Management 242 working capital is required to meet the unforeseen events like CE Notes floods.2 The above figure depicts the permanent or regular working capital that is stable over a period. or showing ups and down – some times working capital requirement has increased or decreased. and price hike tendencies and contingencies. where as temporary or variable working capital is oscillating. fire. ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES Figure 21.2 and 21.3 Over a long period.2 will hold good to those firms. required for expression programs. strikes. The above Figure 21.3.3 will be suitable as follows: UP (c) Figure 21. where there is no development and have seasonal or cyclic fluctuations.

... short-term borrowings..UNIT 21: Working Capital Management 243 CE Check Your Progress Notes Activity Fill in the blanks ___________________ Mention the components of working capital. one year fixed deposits with banks... Total current assets consists of cash. marketable securities... It aims at protecting the purchasing power of assets and maximise the return on investment.. bank over-draft.. Components of Current Liabilities: Current liabilities are those liabilities intended to be paid in the ordinary course of business within a reasonable period (normally within a year) out of the current assets or revenue of the business. The importance of working capital management is reflected in the fact that financial managers spend most of their time in managing current assets and current liabilities...... 1.... sundry debtors. loans and advances..... The UP current liabilities consist of sundry creditors. 2..... Gross operating cycle equal to inventory conversion ___________________ period plus .. inventories. Components of Current Assets: Current assets are those ___________________ assets that in the ordinary course of business can be or will be turned into cash within an accounting period (not exceeding ES one year) without undergoing diminution in value and without disrupting the operations.... Importance of Working Capital Working capital is considered as central nervous system of a firm. The time elapses between the receipt of raw materials ___________________ and payment to suppliers ... ___________________ 2.... which are the main components of working capital....... and prepaid expenses.... ___________________ ___________________ Components of Working Capital -C ___________________ Efficient management of working capital involves effective control ___________________ over the current assets and current liabilities..... taxes and proposed dividend.. Management is ..... ___________________ 1.. Adequate working capital needs to be maintained in order to discharge day-to-day liabilities (c) and protect the business from adverse effects in times of calamities and emergencies. the goal of working capital management is to minimize the cost of working capital while maximizing a firm’s profits... In other words.

To evolve suitable policies. “The efficiency of firm to earn profits depends ___________________ largely on its ability to manage working capital. . Hence. To determine the various sources of working capital. 2. To ensure adequate flow of funds for current operations. For determining the sources of working capital (short-term and long-term) capital the net concept becomes useful. determination of the level of current assets).. To ensure optimum investment in current assets. ___________________ Aspects of Working Capital Management Management of working capital involves the following four aspects: ES 1. However. 3.e. 2.e. Objectives of Working Capital Management The objectives of working capital management could be stated as. receivables and inventory). 3. for determining the level and composition of working capital it is the gross concept. working capital -C ___________________ plays a crucial role in earning a reasonable rate of return. (c) 1. Working capital ___________________ management has acquired paramount importance in the recent ___________________ past. procedures and reporting systems for controlling the individual components of current assets (Mainly cash. the proportion of long-term and short-term capital to finance current assets). The working capital Activity ___________________ What are the various aspects management is concerned with determination of relevant levels of of working capital current assets and their efficient use as well as the choice of the ___________________ management? financing mix. and UP 4. To strike a balance between the twin objectives of liquidity and profitability in the use of funds. To decide the structure of current assets (i. especially in view of tight money conditions prevailing in the economy”. which becomes more meaningful. Determining the total funds required to meet the current operations of the firm (i. ___________________ working capital has to be effectively planned. Financial Management 244 required to be vigilant in maintaining appropriate levels in the CE Notes various working capital accounts. Working capital management policies have a crucial ___________________ effect on firm’s liquidity and profitability. Thus.. systematically ___________________ controlled and optimally utilised.

to inventory... 4.. There is invisible time lag between the sale of goods and receipt of cash.. Conversion of work-in-process into finished goods. The time that elapses to convert raw materials into cash is known as operating cycle. But if. ___________________ 2... (c) If firm sells goods on cash basis with (4) operating cycle then returns to the operating cycle (1). -C ___________________ Operating Cycle and Cash Cycle ___________________ ___________________ Maximization of shareholders’ wealth of a firm is possible only when there are sufficient returns from their operations.. therefore. a need for working capital. But profits ___________________ can be earned will naturally depend... To speed up the flow of funds or to minimize the stagnation of CE Notes funds. . among other things..... Conversion of cash into raw materials..... Conversion of raw materials into work-in-process. To quote Joy. sufficient working capital is necessary to sustain sales activity. Activity Explain operating cycle and ___________________ cash cycle.. firm sells goods on credit basis then there will be another cycle that is.. There is.. Check Your Progress ___________________ Fill in the blanks ___________________ 1.. Conversion of debtors into cash........ The operating cycle concept penetrates to the heart of working capital management in a more dynamic form. successful sales activity is ES necessary for earning profits.. In other words. Sales do not convert into cash immediately.... upon the magnitude of the sales.. 3.....UNIT 21: Working Capital Management 245 4. The continuing flow from cash to suppliers... In other words.. In other words the time that elapses between the purchase of raw materials and the collection of cash for sale is UP referred to as the operating cycle.. to accounts receivables and back into cash is what is called the operating cycle. 2....... Conversion of finished goods into sales [debtors and cash].. Net operating cycle equal to gross operating cycle less ___________________ ...... The efficiency of firm to earn profits depends largely ___________________ on its ability to manage .. The operating cycle involves the following procedure: 1...

4 ___________________ Stock of raw material is held in order to ensure smooth production.5 gives their operating cycle. which do not have manufacturing process. the following Figure 21. CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ Figure 21. In other words. (c) Figure 21. The operating cycle will be different in different types of business units: 1. If they sell goods on credit. Goods are sold on credit for competitive reasons. 2. Operating Cycle of a Non-manufacturing Firm: Non- UP manufacturing firms are wholesale sellers and retailers.5 .4 shows the operating cycle. they will purchase finished goods from manufacturing firm and sell them either on cash or credit. Thus. They will have the direct conversion of cash into finished goods and then into cash. ___________________ Similarly. Operating Cycle of Manufacturing Firm: The above stated cycle will be suitable to a manufactures firm. Financial Management 246 The following Figure 21. stocks of finished goods have to be carried to meet the demand from the consumers on the continuous basis. adequate amount of ES funds has to be invested in current assets for a smooth and uninterrupted production and sales process.

___________________ AAI = Average Age of Inventory ___________________ ARP = Account Receivables Period. APP: Average Inventory AAI = Cost of Goods Sold/365 Average Accounts Receivables ARP = Annual Sales/365 Average Accounts Payables APP = Cost of Goods Sold/365 UP Purchase of Collection of Sales of Goods Raw Materials Accounting on Credit on Credit Receivables Average Age of Accounts Receivables Inventory (AAI) Period (ARP) Accounts Payable Period (APP) Payment to (c) Receipt of Suppliers Invoice Operating Cycle (OC) Cash Conversion Cycle (CCC) Figure 21. ACP. it receives the cash from its ___________________ customers. it can be determined as the constituents of Cash Conversion Cycle.e. i.6: Depicts Operating and Cash Cycle .. ___________________ Calculation of Cash Conversion Cycle (CCC) [See Figure 21. ___________________ In other words the time period between the dates when the amount is paid to the suppliers to the date. AAI. ES From the financial statements.6] ___________________ CCC = OC – APP ___________________ -C where: ___________________ OC = Operating Cycle APP = Accounts Payable Period OC = ___________________ AAI + ARP.UNIT 21: Working Capital Management 247 Cash Conversion Cycle CE Notes The amount of time a firm’s resources are tied up calculate by ___________________ subtracting the average payment period from the operating cycle.

theft and losses in ES increase. which leads to mishandling of inventories. In other words. Excessive working capital means idle funds that can earn -C ___________________ no profit but involve costs. This type of speculation makes the firm to follow liberal dividend policy and difficult to cope with in future is unable to make speculative profits. waste. It results in unnecessary accumulation of inventories. there is a ___________________ need to maintain a balance in working capital. It should not be ___________________ excessive or inadequate. (c) 2. it should manage adequate working capital to run its business. It is indication of defective credit policy and slack in collection period. 3. It stagnates growth. 3. It becomes difficult to implement operating plans and achieve the firm’s target profit. Financial Management 248 CE Notes Need to Maintain Balanced Working Capital ___________________ For maximization profits or minimization of working capital cost or ___________________ to maintain balance between liquidity and profitability. It becomes difficult for the firm to undertake profitable or the firm to undertake profitable of the firm to understand profitable projects for non-availability of working capital. and inadequate working capital ___________________ disturbs production and impairs the firm’s profitability. ___________________ Dangers of Excessive Working Capital ___________________ The dangerous excessive working capital is as follows: 1. 2. Operating inefficiencies creep in when it becomes difficult even to meet day-to-day commitments. . These lead to higher bad debt losses that reduce profits. Excessive or ___________________ inadequate working capital. Accumulation inventories tend to make speculative profits UP grow. 4. both are dangerous from firm’s point ___________________ of view. It makes management complacent which degenerates in to managerial inefficiency. Dangers of Inadequate Working Capital The following are the dangers of inadequate working capital: 1.

. 3.... affects need for working (c) capital. which has bearing on the quantum of working capital.... Also the relative importance of these factors changes even in the same firm UP in course of time.... It leads to inefficient utilisation of fixed assets. Size of Business: It may be argued that a firm’s size. Therefore... A firm when depends on more long-term funds for ___________________ financing needs .. ___________________ 5.. The proportion of current assets needed in some lines of business activity varies from other lines.. These factors. The total working capital requirement is determined by a wide variety of factors. ES Factors Influencing Working Capital A business undertaking should plan its operations in such a way that it should have neither too much nor too little working capital. 2.... ___________________ 6. measured in terms of assets or sales.. is the production cycle.. It renders the firm to avail attractive credit opportunities etc. firm should maintain the right amount of working capital on a continuous basis. firm’s CE Notes profitability would deteriorate. A brief description of the general factors influencing the working capital needs of a firm is as follows: 1... A firm's financial plan that matches the expected life ___________________ of assets with the expected life of funds raised to finance that asset is referred as ....UNIT 21: Working Capital Management 249 4. Firm loses its reputation when it is not in a position to honor ___________________ its short-term obligations....... Thus. an analysis of relevant factors should be made in order to determine the total investment in working capital.... Production Cycle Process: This is another factor.. ___________________ 2. Therefore... Size may be measured in terms of a scale of operation.......... Nature of Business: The amount of working capital is basically related to the nature of business...... however. The term production or manufacturing cycle refers to the time involved in the manufacturing of goods... There are no set of rules or formulae to determine the working capital requirements of a firm... . ___________________ ___________________ Check Your Progress ___________________ Fill in the blanks: -C ___________________ 1. affect different firms’ differently..

Growth and Expansion: As company grows. since it is appropriation profits. Credit Policy or Terms of Purchase and Sales: The credit ___________________ policy relating to sales and purchases also affects the working -C ___________________ capital. ___________________ 5. The amount of taxes to be paid is determined by the tax authorities. ___________________ 6. Financial Management 250 4. either they confine their ___________________ production only to periods when goods are purchased or they follow a steady production policy throughout the year and ___________________ produce goods at a level to meet peak demand. UP 9. Scarce Availability of Raw Materials: The availability of certain raw materials on a continuous basis without interruption would sometimes affect the working capital requirement. It is very difficult to determine the relationship between the growth in the volume of business of a company and increase in its working capital required. Some firms enjoy a dominant position. Level of Taxes: The net profit is calculated after deduction of tax. If a company purchases raw materials in cash and ___________________ sells goods on credit. it is logical to ES expect that a larger amount of working capital in required. Production Policy: Production policy means whether. affects working capital to that extent. Profit Level: Firms may differ in their capacity to generate profit from business. . Dividend Policy: Dividend has a bearing on working capital. So the management has no discretion in this respect. it is CE Notes continuous or seasonal demand for products. Business Cycle: The amount of working capital requirements ___________________ of a firm varies with every movement of business cycle. 8. 7. it will require larger amount of working capital. due to quality product or good marketing management or monopoly power in the market and earn a high profit margin. 10. The payment of dividend (c) reduces cash resources and thereby. What kind of ___________________ production policy should be followed in above cases? There are ___________________ two options to such companies. 11.

and to decide upon the extent of long-term capital in financing current assets. ___________________ ___________________ Summary ___________________ Working capital management is concerned with the problems that ___________________ arise in attempting to manage the current assets. The time that elapses to convert raw materials into cash is known as operating cycle. Working capital is the part of current assets that are ___________________ supposed to be financed by long-term sources of ___________________ finance. ES Working capital management goal is maintain a satisfactory level of working capital. ___________________ 3. Gross working capital concept focuses attention on the two aspects of current assets management. Net working capital concept focuses attention on maintaining liquidity position. Elucidate that statement.. ___________________ 2..UNIT 21: Working Capital Management 251 CE Check Your Progress Notes True or False: ___________________ 1. Net working capital is the excess of current assets ___________________ over current liabilities. current liabilities and their inter-relationship that exists between them. they are optimum investment in current assets. Permanent working capital refers to the minimum level of current UP assets maintained in a firm. . The working capital management is concerned with determination of relevant levels of current assets and their efficient use as well as the choice of the financing mix. and financing of current assets. Lesson End Activity "Working capital deals with the decisions regarding the (c) appropriate mix and level of current assets and current liabilities". Temporary working capital refers to additional current assets temporarily over and above permanent working capital to satisfy cyclical demands. Negative working capital is the excess of current -C assets over current liabilities.

for the UP next year. Financial Management 252 CE Notes Keywords ___________________ Gross Working Capital: The total current assets are termed as ___________________ the gross working capital. Working Capital: It refers to short-term funds to meet operating expenses.000 units of production after adding a five per cent safety contingency. Amount (per unit) Raw materials 160 Direct labour 60 Overheads (including depreciation of `10) 130 Total cost 350 Profit 50 (c) Selling price 400 Additional Information Average raw materials in stock: one month . stores and spares. work in progress.. the expected life of ___________________ an asset is matched with the source of finance period with which an asset is financial. Questions for Discussion 1. and book debts to facilitate ___________________ uninterrupted operation in a firm.08. ___________________ Hedging Approach: That approach in which. From the following information RRR Company Ltd. -C ___________________ Permanent Working Capital: It is the minimum investment ___________________ kept in the form of inventory of raw materials. ___________________ ___________________ Net Working Capital: The excess of current assets over current liabilities represents net working capital. you are required to estimate the working capital needed to finance a level of activity of 2. ___________________ finished goods. Temporary Working Capital: Any additional working capital apart from permanent working capital required to support the ES changing production and sales activities is referred to as temporary working capital.

You are the businessman.47 lakhs ES Opening inventory – `856. 4.25 lakhs closing inventory `1037.8 Overheads (including depreciation ` 5) 32.0 .000 units) for the firm after adding 10% contingency. While preparing a project report on behalf of a client. Analyse the factors you will consider in determine the working capital requirement of your business.96 lakhs.50.000. You may assume that production is carried on evenly -C ___________________ throughout the year and wages and overhead expenses accrued similarly.5 Direct labour 11. ___________________ 2.88 lakhs Accounts Payables: Opening – ` 832. ___________________ Sales – ` 3782.UNIT 21: Working Capital Management 253 Average materials-in-process (50 per cent completion stage): CE Notes half a month ___________________ Average finished goods in stock: one month ___________________ Credit allowed by suppliers: one month ___________________ Credit allowed to customers: two months ___________________ Time lag in payment of wages: one and half weeks ___________________ All sales are credit sales. Estimate working capital required (for the level of activity 1. (c) Amount (per unit) Raw materials 38. you have collected the following information.73 lakhs Accounts Receivables: Opening – ` 852 lakhs. Cash balance is expected to be ___________________ ` 75. You may assume that production is carried on evenly throughout the year and wages and overhead expenses accrued similarly.79 lakhs Cost of Goods sold – ` 3444. DP Mills Limited has the following information as for the year ___________________ 2003. Closing – 84689 lakhs Calculate (a) OC and (b) CCC UP 3. Closing – ` 636.

P. 2 Chandra. Jr. and Wachowicz. New Delhi.. Prentice Hall of India Pvt. New Delhi. All ___________________ sales are credit sales. Cash at bank is expected to be ` 1. J.studyfinance. average materials-in- ___________________ process (50 per cent completion stage): half a month. Tata McGraw Hill Publishing Company Ltd. p. Financial Management. 2002.00. ES 2008 Van Horne. ___________________ ___________________ Further Readings Books Sudhindra Bhat.com/art/WorkingCapitalManagement.com/lessons/workcap/ (c) .caalley.000.org/wiki/Working_capital www.C. Financial Management . 3 Web Readings UP en.. New Delhi. p. credit allowed to debtors: eight weeks.M. Ltd. 1996. Excel Books. Financial Management 254 Total cost 823 CE Notes ___________________ Profit 17.Theory and Practice.pdf www.wikipedia. lag in payment of -C ___________________ wages: two weeks. credit allowed by suppliers: one ___________________ month.7 ___________________ Selling price 100 ___________________ Additional Information ___________________ Average raw materials in stock: four weeks.. average finished goods in stock: four weeks.. J. Fundamentals of Financial Management.

When the firm sells its products services on credit. and Bills Receivables (BRs) on the asset side of balance sheet. and costs of receivables management ___________________ ___________________ Introduction ___________________ Accounts Receivables occupy an important position in the structure of current assets of a firm. but would be collected in near future. It is also known as Trade Debtors (TDs). the students will be aware of the following topics: ___________________ \ Accounts receivables and their characteristics ___________________ -C \ Accounts receivables management ___________________ \ Objectives. Till collection they form as current assets. (c) Characteristics of Receivables The accounts receivables arising out of credit sales have the following characteristics: . Therefore. It is not possible to increase sales without credit facility. But investment on accounts receivables involves certain costs and risks. They are the outcome of rapid growth of credit sales granted by the firms to their customers. Trade credit is most prominent force of modern business. Accounts Receivables (ARs). Firm grants credit to protect its sales from the competitors and attract the potential customers.UNIT 22: Receivable Management Unit 22 255 CE Notes Activity Receivable Management What___________________ are the characteristics of receivables? ___________________ ___________________ Objectives ___________________ After completion of this unit. It is considered as a marketing tool acting as a bridge between production and customers. a great deal of attention is normally paid to the effective and efficient management of accounts receivables. increase in sales UP also increases profits. and it does not receive cash for it immediately. The term receivable is defined as "debt owed to the firm by customers arising from sale of goods or services in the ordinary course of business". Credit sales ES are reflected in the value of Sundry Debtors [SDs in India]. benefits.

Management of receivable. Implies Futurity: Buyer will make cash payment of the ___________________ goods or services received by him/her in a future period. the objective being maximization of ES return on investment in receivables. The economic value in goods or services ___________________ passes to the buyer currently in return the seller expects an equivalent value from the buyer latter. i. Risk Involvement: Receivables involve risk.e. In simple words. but sales must return a profit". The offer of goods on credit should not only optimise sales but also lead to maximization UP of overall return on investment. ___________________ ___________________ Accounts Receivables Management ___________________ Accounts Receivable Management implies making decisions relating to the investment in these current assets as an integral part of operating process. . and future is uncertain so they should ___________________ carefully analyze. "The purpose of any commercial enterprise is the earning of profit. Objectives of Accounts Receivables Management The following are the main objectives of accounts receivables management: 1. Based on Economic Value: Accounts receivables are based ___________________ on economic value. ___________________ 3. and the debtor’s collection. since payment CE Notes takes Bajaj in future. Efficient management of receivables expands sales by retaining old customers and attracting new customers. According to Joseph. Maximizing the Value of the Firm: The basic objective of debtors' management is to maximise the value of the firm by achieving a trade off between liquidity (risk) and return. The (c) main purpose of receivables management is to minimise the risk of bad debts and not maximisation of order. accounts receivables management involves maintenance of receivables of optimum level. should be based on sound credit policies and practices. ___________________ 2. the degree of credit sales to be made. Credit in itself is utilized to increase sales. Financial Management 256 1. In other words. the key function of credit management is to optimize the sales at the minimum possible cost of credit. therefore. -C ___________________ generally after credit period.

___________________ Check Your Progress ___________________ Fill in the blanks: ___________________ 1. investment in receivables.... records.... but increasing ___________________ investment in receivables results in increased costs. Control and Dr... The following are the main costs associate with accounts receivables UP management: 1. Costs of Accounts Receivables Management Management of accounts receivables is not cost free.. The costs are ___________________ discussed below... postage they are . If receivables are financed by shareholder funds. which can be reduced by optimum Define the cost of accounts ___________________ receivable management..... ___________________ 3. it involves payments of interest. that have an Activity opportunity cost. But credit sale increases profits. staff.. The collection costs may include.... It is possible only when ___________________ -C the firm is able to keep the costs at minimum... These blocked funds or investment in receivables need to be financed. but they involve block of funds. Bhatt the Cost of Trade Credit: When ___________________ there are no credit sales. Collection Cost: Collection of receivable is one of the tasks of receivables management.... If they are financed by borrowed funds... They involve some cost. Debt owed to the firm by customers arising from sale of goods or services in the ordinary course of business is known as . Optimum Investment in Sundry Debtors: Credit sales CE Notes expand... which is also a cost. stationary.. (c) 2.. Providing liberal credit increases ___________________ sales consequently profits will increase.. there involves opportunity cost to shareholders. the increased level of accounts receivables is an investment in current assets..... In other words. there will not be any trade credit cost..... In India accounts receivables are known as . Collection costs are those costs that are increased in collecting the debts from the customers to whom the credit sales have been granted.. by shareholders funds or from short-term borrowings.UNIT 22: Receivable Management 257 2. ES 2.. Opportunity Cost/Capital Cost: Providing goods or services on credit involves block of firm's funds.

... in UP both cost per unit comes down and the profit will be increased. the firm may decide to provide credit facility. . is a formal document issued by a bank on behalf of its customers. (c) Modes of Payment After evaluation and selection of individual customers or accounts... 2... but complete avoidance is not possible.. stating the conditions under which the bank will honor the commitments of the customer (Buyer). ___________________ 3..... if the firm properly evaluates customer before granting credit.. The benefits are: 1. leads to increase in profits. Check Your Progress Fill in the blanks: 1. because. Increase in Profits: Increased sales.. Market Share Increase: When the firm's able to retain old customer and attract new customer automatically market share will be increased to the extent of new sales. it need to produce more products with a given fixed cost and sales of products with a given sales network... Increased Sales: Providing goods or services on credit ES expands sales... Bad Debts: Some times customer may not be able to honour the dues to the firm because of the inability to pay. Activity ___________________ What are the benefits of from specialized agencies....... Such costs ___________________ are referred as bad debts. The economic value of goods or services that have ..... it may be unlimited or limited..... by retaining old customers and attraction of prospective customers.. Financial Management 258 related to maintenance credit department.. and exposes details CE Notes involved in collecting information about prospective customers. for evaluation of prospective accounts receivable customer before going to grant credit.. 3. ___________________ because they cannot be collected.. 2. -C ___________________ ___________________ Benefits of Accounts Receivables Management ___________________ Accounts receivables management involves not only costs but also ___________________ benefits. These costs can be reduced to ___________________ some extent... and they have to be written off.. ___________________ management.. involvement is one of the characteristic features of receivables. .

The invoice is generally acknowledged by the buyer. if the payment is made on or before 15th days. cash discount for early payment. ___________________ Receipt of advance is necessary whenever the goods are manufactured on a special order. ___________________ Cash Mode ___________________ -C Whenever a firm sells goods or services on cash terms. and the period of cash discount offer. The economic value of goods or services ___________________ sold on credit will be paid by adoption of different modes.UNIT 22: Receivable Management provided under credit. Buyer pays a part of ___________________ goods or services purchased seller puts his/her own amount a part and the remaining by financial institute all these financing will be ___________________ done in the trade cycle. For example. will be paid in future. It means that discount of 2 per cent is allowed. ___________________ buyer. the value of ___________________ goods or services will be received either cash in advance (before the ___________________ goods are shifted) or on delivery (after the goods are delivered). Immediate cash payment will take Bajaj only when the ES seller has high bargaining power due to monopoly power or the customer is risky customer. It is for financing productions ___________________ and to avoid the non-acceptability goods ordered by the order or buyer. after the sale and purchase agreement between seller and buyers. credit period UP allowed. If the firm is 259 CE financially sound it may extend liberal credit to the buyer and vice Notes versa. Open account means. Investment in receivable will be financial by three people. Cash Discount: It is the discount [some percentage] allowed to buyer for an early payment. not 45". a seller has given "2/15. (c) Bill of Exchange A bill of exchange represents an unconditional order issued by the seller asking the buyer to pay the amount maintained on it as per demand at a certain future date. the seller first shifts goods and he sends the invoice (bill). other wise full payment is due by the 45th day. Credit Period: It is the period allowed by seller to customer to pay economic value of goods. This type of demand is made only when the seller does not have strong evidence of the buyer's . Open Account Majority of the credit sales takes Bajaj on an open account mode. quantity of goods with their total value and so on. seller and financial intermediary. which consists of credit terms.

Generally. if the seller wants a clear Activity What ___________________ are the factors commitment from the buyer. (ii) It serves as a written -C ___________________ evidence of a definite obligation. (iii) It provides safety to the buyer. consignor (seller) sends goods to consignee (agent of the seller). since letter of credit issued by good standing bank. but now days it has been used in domestic trade also. stating the conditions under which the bank will honor the commitments of its customer (buyer). When the buyer accepts a bill. influencing size of investment seller can arrange a commercial draft. In other words. Payment through the ES letter of credit arises whenever trade takes Bajaj at international level. Consignment In consignment business. Functions of the letter of credit are. In other words. whenever trade takes Bajaj in the absence of Bajaj-to- Bajaj unknown people. The advantages of bills of exchange are (i) It ___________________ represents negotiable instrument. (ii) It reduces uncertainty. before he/she delivers the goods. which may be hold till the maturity or get it discounted. ___________________ Letter of Credit ___________________ Letter of credit is a formal document issued by a bank on behalf of customer. there is a need of secured arrangement in the CE Notes form of bills of exchange. issue of letter of credit [L/C] arises. then it becomes a ___________________ trade acceptance. (iii) It helps in reducing cost of ___________________ finance to some extent. Hence. In this consignment only sales proceeds are remitted to the consignor by the consignee. as the seller knows the conditions that should be fulfilled to receive payments. (i) It eliminates risk. Financial Management 260 obligation. In this case goods sent are just shipped but not sold to the consignee since the consignor retains the title of the goods till they sold by the consignee to a third party. the bill ___________________ in receivables? accompanied by documents (shipping or some other transport ___________________ documents) that are delivered to the drawee when he/she pays or ___________________ accepts the bill. (c) Factors Influencing the Size of Investment in Receivables The level of investment in receivables is affected by the following factors: . since it can be discounted. UP who wants to ensure that payment is made only in conformity with the conditions of the letter of credit.

Credit Policy of the Firm: There are two types of credit ___________________ policies such as lenient and stringent credit policy. Investment in receivable increases when the firm sells major ___________________ portion of goods on credit base and vice versa. On the other (c) hand. refrigerators. . In other words ___________________ an increase in credit sales. A firm's liberal collection policy will not be able to reduce investment in receivables. 4. which will increase the size of ___________________ receivables. Collection Policy: Collection policy is needed because all customers do not pay the firm's bill in time. For example. the collection policy should aim at accelerating collections from slow payers and reducing bad debt base. because in season firm will sell goods on cash basis only. 3. a firm that following stringent ___________________ credit policy will have low size of receivables because the firm is very selective in providing of stringent credit. then the investment in receivables will be more. Trade Terms: It is the most important factor (variable) in ES determining the level of investment in receivables. When the firm UP provides credit automatically the level of investment in receivables will increase with the comparison of the level of receivables in the season. ___________________ 2. Volume of Credit Sales: Size of credit sale is the prime CE Notes factor that affects the level of investment in receivables. The important credit terms are credit period and cash discount. Seasonality of Business: A firm doing seasonal business has to provide credit sales in the other seasons. but it may reduce future sales. 5. A firm that is following lenient credit policy tends to sell on credit to ___________________ -C customers very liberally. On the other hand. may be able to collect debts ___________________ promptly this will keep the level of receivables under control. Cash discount reduces the investment in receivables because it encourages early payments.UNIT 22: Receivable Management 261 1. air- cooling products will be sold on credit in the winter season. Therefore. a firm that follows stringent collection policy will definitely reduce receivables. and on cash in summer season. A firm that is ___________________ providing string one credit. increase the level of receivables and ___________________ vice versa. If credit period is more when compared to other companies/industry. but in future sales may be increased.

Financial Management

262
6. Bill Discounting and Endorsement: Bill discounting and

CE
Notes
Activity endorsing bill to the third party, which the firm has to pay,
___________________
Define credit policy. will reduce the size of investment in receivables. If the bills are
___________________ dishonored on the due date, again the investment in receivable
___________________ will increase because discounted bills or endorsed bills have to
be paid by the firm.
___________________

___________________ Check Your Progress
___________________ True or False:

-C
___________________ 1. Receivables constitute to a significant potential
___________________ current assets.

___________________ 2. Credit period is one of the terms of credit.

___________________ 3. Letter of credit is one of the modes of payment.

Credit Policy
ES
A firm's credit policy is concerned with its credit standards, credit
period, cash discounts, and collection procedures. The credit policy
may be lenient or stringent (tight).

Lenient Credit Policy
It is that policy where the seller sells goods on very liberal credit
terms and standards. In other words, goods are sold to the
customers whose creditworthiness is not up to the standards or
UP

whose financial position is doubtful.

Advantages of Lenient Credit Policy
1. Increase in Sales: Lenient credit policy expands sales
because of the liberal credit terms and favorable incentives
granted to customers.
2. Higher Profits: Increase in sales leads to increase in profits,
because higher level of production and sales reduces permit
cost.
(c)

Disadvantages of Lenient Credit Policy

Apart from the advantages it has some disadvantages:
1. Bad Debt Loss: A firm that follows lenient credit policy may
suffer from bad debt losses that arise due to the non-payment
credit sales.

UNIT 22: Receivable Management

263
2. Liquidity Problem: Lenient credit policy not only increases

CE
Notes
bad debt losses but also creates liquidity problem, because
when the firm is not able to receive the payment at a due date, ___________________
it may became difficult to pay currently maturing obligations. ___________________

___________________
Stringent Credit Policy
___________________
Stringent credit policy seller sells goods on credit on a highly
selective basis only i.e., the customers who have proven ___________________
creditworthiness and financially sound. ___________________

-C
Advantages of Stringent Credit Policy ___________________

___________________
1. Less Bad Losses: A firm that adopts stringent credit policy
will have minimum bad debt losses, because it had granted ___________________
credit only the customers who are creditworthy. ___________________

2. Sound Liquidity Position: The firm that follows stringent
credit policy will have sound liquidity position, due to the
ES
receipt of all payments from customers on due date, the firm
can easily pay the currently maturing obligations.

Disadvantages of Stringent Credit Policy
1. Less Sales: Stringent credit policy restricts sales, because it is
not extending credit to average creditworthiness customers.
2. Less Profits: Less sales automatically reduces profits, because
firm may not be able to produce goods economically, and it
UP

may not be able to use resources efficiently that leads increase
in production cost per unit.
In fact, firms follow credit policy that lies between lenient and
stringent credit policy. In other words, they follow optimum credit
policy. Optimum credit policy involves a balance between costs and
benefits. The major considerations in costs are liquidity and
opportunity costs. The optimum credit policy occurs at point where
there is a trade off between liquidity and profitability. Therefore,
the management has to strike a balance between easy credit to
promote sales and profit and tight credit to improve liquidity. The
(c)

important variables of credit policy should be identified before
establishing an optimum credit policy.

Financial Management

264

CE
Notes Check Your Progress
___________________ True or False:
___________________ 1. Optimum credit policy occurs where there is a trade of
___________________ between liquidity and profitability.

___________________ 2. Bad debt loss is the losses of receivables management.

___________________

___________________
Summary
Accounts Receivables occupy an important position in the structure

-C
___________________
of current assets of a firm. The term receivable is defined as debt
___________________
owed to the firm by customers arising from sale of goods or services
___________________ in the ordinary course of business. The management of accounts
___________________ receivables is not cost free. It involves cost and its association with
accounts receivables results in: Opportunity Cost/Capital Cost,
Collection Cost, and Bad Debts.
ES
Liberal credit policy is that policy where the seller sells goods on
very liberal credit terms and standards, which increase in sales,
higher profits. Stringent credit policy seller sells goods on credit on
a highly selective basis only, which reduces bad losses, sound
liquidity position.

Lesson End Activity
Green Land Company Ltd., is considering tightening up its credit
UP

standards by reducing credit period from 40 days to 20 days. Such
tight credit policy would be to reduce sales from `15 lakhs to `13
lakhs and bad-debt loss ratio also reduces from 3% to 1%. The
company's variable cost ratio to sales is 70%, tax rate is 40% and
required rate of return is 10%. Determine change in net profit.

Keywords
Receivables: It is defined as debt owed to the firm by customers
arising from sale of goods or services in the ordinary course of
business.
(c)

Receivables Management: It involves decision areas: credit
standards, credit period, cash discounts and collection procedures.
Credit Terms: It means the stipulations under which goods or
services are sold on credit.

UNIT 22: Receivable Management

265
Stringent Credit Policy: Seller sells goods on credit on a highly

CE
Notes
selective basis.
___________________
Lenient Credit Policy: It is that policy where the seller sells
goods on very liberal credit terms and standards. ___________________

___________________
Collection Policy: It is the procedures passed to collect amount
receivables, when they become due. ___________________

Credit Standards: It refers to the minimum criteria for the ___________________
extension of credit to a customer. ___________________

-C
___________________
Questions for Discussion
___________________
1. Analyse the benefit of the receivables management to the ___________________
corporates.
___________________
2. Hare Ram & Co, produces 1,00,000 units and sells at `80 per
unit. 70 per cent of sales are credit sales. Average receivables
ES
amount is `2,00,000. Determine average collection period
(ACP).
3. Calculate the interest cost (on annual percentage basis)
associated with the following credit terms for the sellers and to
the buyers.
(a) 2/10 net, 50 (b) 2/15 net, 45
(c) 2/5 net, 25 and (d) 3/20 net, 80
UP

4. Dream Well Company's credit sales for the year 2004 are
` 1,50,000. The company was started 2004 year with opening
balance of receivables ` 15,000 and 2004 year business is
closed with ` 11,000 receivables. Calculate receivables
turnover and ACP.
5. "The credit policy of a firm is criticized because the bad debt
losses have increased". Discuss under what situations this
criticism may not be justified.
6. VST Co. produces plastic home appliances and it has annual
credit sales of ` 20 lakhs, the average accounts receivables
(c)

amount to ` 4,00,000. Compute ACP assuming 365 day year.

Financial Management

266

CE
Notes Further Readings
___________________
Books
___________________
Sudhindra Bhat, Financial Management, New Delhi, Excel Books,
___________________
2008
___________________
Van Horne, J.C. and Wachowicz, Jr, J.M., Fundamentals of
___________________ Financial Management, New Delhi, Prentice Hall of India Pvt.
___________________ Ltd., 1996, p. 2

-C
___________________ Chandra, P., Financial Management - Theory and Practice, New
___________________ Delhi, Tata McGraw Hill Publishing Company Ltd., 2002, p. 3

___________________ Web Readings
___________________ www.coface.com
www.hovservices.com/bpo/accounts_receivable_ management.asp
ES
aegisglobal.com/section_level2.aspx?cont_id=QKlu5QBggj4=
www.nexvue.com/pdfs/GP_Docs/.../GPReceivablesMgmt.pdf
UP
(c)

UNIT 23: Inventory Management

Unit 23
267

CE
Notes

Inventory Management
___________________

___________________

___________________
Objectives
___________________
After completion of this unit, the students will be aware of the following
topics: ___________________

\ Meaning and components of inventory ___________________

-C
\ Objectives and need for balanced investment in inventory ___________________
\ Various techniques to manage inventory
___________________

___________________
Introduction
___________________
Inventory management occupies the most significant position in
the structure of working capital. Management of inventory may be
defined as the sum of total of those activities necessary for the
ES
acquisition, storage, disposal or use of materials. It is one of the
important components of current assets. Inventory management is
an important area of working capital management, which plays a
crucial role in economic operation of the firm. Maintenance of large
size of inventories by a firm required a considerable amount of
funds to be invested on them. Efficient and effective inventory
management is necessary in order to avoid unnecessary
investment and inadequate investment.
UP

A considerable amount of funds is required to be committed in
inventories. It is absolutely imperative to manage inventories
efficiently and effectively in order to optimize investment in them.
Prudent inventory management is one of the challenging tasks of
the financial manager. Efficient management of inventory reduces
the cost of production and consequently increases the profitability
of the enterprise by minimizing the different types of costs
associated with holding inventory. An undertaking, neglecting the
management of inventories, will be jeopardizing its long term
profitability and may fail ultimately. It is possible for a firm to
(c)

reduce its level of inventories to a considerable degree, i.e., 10 to 20
per cent of current assets without adverse effects on production
and sales by using simple inventory planning and control
techniques. If business planning can be perfect, a firm may succeed
even in attaining the "Zero inventories" norm which as the
Japanese management seems to suggest, is not too unrealistic a

Financial Management 268 goal. Raw Materials: Raw materials are those inputs that are (c) converted into finished goods through a manufacturing or conversion process. (b) are in the process of production for ___________________ such sales. they are very much needed for uninterrupted production.1 gives the components: 1. spares and others stocked in order to meet an unexpected demand or distribution in the UP future. finished packaging. work-in-process. Components of Inventory From the above definitions. The efficiency of inventory Activity ___________________ Define inventory and list its management in any firm depends on the inventory management components. work-in-process and finished goods. . The various forms in which inventories exist in a manufacturing company are: (i) raw materials. inventory usually includes stores. The reduction in inventories carries a favourable impact on CE Notes the company's profitability. However. or (c) are to be currently consumed in the production of ___________________ goods or services to be available for sale. finished goods. The term inventory refers to the stockpile of the products a firm is offering for sales and the components that make up the product. manufacturing for sale and the components that make up the product. practices adopted by it. Inventories are the stocks ES of the product of a company. and (iv) stores & spares. (ii) work-in process. The term inventory includes materials . In other words. and stores & spares. which implies a list of ___________________ things found.raw materials in process. (iii) finished goods. The various forms in which inventories exist in a manufacturing firm are raw materials. we can draw the components of inventory. These form a major input for manufacturing a product. in commercial parlance. The following Figure 23. The term inventory has been defined by the -C ___________________ American Institute of Accountants as the aggregate of those items ___________________ of tangible personal property which (a) are held for sale in the ordinary course of business. raw materials. ___________________ ___________________ Inventory ___________________ The term "Inventory" is originated from the French word ___________________ "Inventaire" and the Latin "Inventariom".

.... assets.. Stores and Spares: Stores and spares inventory (include office and plant cleaning materials like. soap. 4.. The stock of finished goods provides a buffer between production ES and market.. Inventory Management Motives Managing inventories involves lack of funds and inventory holding costs...... Check Your Progress Fill in the blanks: UP 1. fuel..UNIT 23: Inventory Management 269 2. Inventory is one of components of .. 2... Transaction Motive: Transaction motive includes production of goods and sale of goods... .. bulbs etc.... ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ Figure 23...... oil..... Finished Products: Finished products are those products.. Transaction motive facilitates uninterrupted production and delivery of order at a given time (right time). Work-in-process inventories are semi-finished products. ___________________ which are completely manufactured and ready for sale... Work-in-Process: Work-in-process is a stage of stocks CE Notes between raw materials and finished goods... then why should firms hold inventories? There are three general motives for holding inventories: (c) 1. Maintenance of inventory is expensive..... "Inventoried". and the Latin ........ brooms.....1: Components of Inventory ___________________ 3..) are purchased and stored for the purpose of maintenance of machinery... They represent ___________________ products that need to under go some other process to become ___________________ finished goods. The term inventory is originated from the .. light...

the following are also objects of inventory (c) management. and efficient customer service. inventory management? ___________________ 3. Financial Management 270 2. such that smaller the inventory the lower the carrying cost and vice versa. But inventory facilitates (benefits) the smooth functioning of the production. Control investment in inventories and keep it at an optimum level. ___________________ ___________________ Inventory Management Objectives The objectives of inventory management may be viewed in two -C ___________________ ways and they are operational and financial. . provide data for short-term and long- term for planning and control of inventories. Apart from the above. Maintain sufficient stocks of raw materials in periods of short supply and anticipate price changes. The operational ___________________ objective is to maintain sufficient inventory. and financial view is to minimise inefficient inventory and reduce inventory-carrying costs. Precautionary Motive: This motive necessitates the holding CE Notes Activity of inventories for unexpected changes in demand and supply What___________________ are the objectives of factors. 2. Maintain sufficient finished goods inventory for smooth sales operation. 5. 4. The firm should maintain investments in inventory which implies that maintaining an inventory involves cost. An effective inventory management should: 1. to meet demand for ___________________ product by efficiently organizing the firm's production and sales ___________________ operations. supply of right quality of goods of reasonable prices. Ensure a continuous supply of raw materials and supplies to UP facilitate uninterrupted production. These two conflicting objectives of inventory management can also ES be expressed in terms of costs and benefits associated with inventory. Minimize the carrying costs and time. elimination of duplication in ordering by centralization of purchasers. 3. Control of materials costs. Speculative Motive: This compels to hold some inventories to ___________________ take the advantage of changes in prices and getting quantity ___________________ discounts.

. finished goods and stores and spares are the components of ... This will ___________________ not only help in achieving higher return on investment by minimizing tied-up working capital. ___________________ ___________________ Check Your Progress -C ___________________ Fill in the blanks: ___________________ 1.... motive necessitates the holiday of inventories for unexpected changes in demand and supply factors.. recording. and they involve an opportunity costs........... To achieve higher ___________________ operational efficiency and profitability of a firm. The optimum level of investment in UP inventories lies between excess investment and inadequate investment.. management of inventory needs careful and accurate CE Notes planning so as to avoid both excess and inadequate inventory in relation to the operational requirement of a firm... obsolescence cost..... but will also improve the ___________________ liquidity position of the enterprise... inspection... capital cost (interest on capital in inventories. handling. Raw materials. ES Need for Balanced Investment in Inventory Management of optimum level of inventory investment is the prime objective of inventory management. 1. it is very essential ___________________ to reduce the amount of capital locked up in inventories.... ___________________ ___________________ 2.... Inadequate or excess investment in inventories is not healthy by for any firm. (b) The excessive investment in inventory increases carrying (c) cost that includes cost of storage..... work-in-process.. In other words a firm should avoid inadequate (under) investment or excess (over) investment in inventory.. .. These costs will reduce the firm's profits). The investment in inventories should be sufficient.. .UNIT 23: Inventory Management 271 Therefore........ insurance. they cannot be used for any purpose since they have locked in inventory.. Dangers of Excessive (over) Investment in Inventory: The following are the dangers of excessive investment in inventory: (a) The excessive level of inventories consumes funds of the company.. and taxes.....

waste and -C ___________________ mishandling of inventories. . dispatch. which will lead to loss of customers permanently. ES (b) When the firm is not able to produce goods without interruption that leads the inadequate storage of finished goods. (d) Cost of transportation of goods (items). It has some ___________________ negative points. (c) (b) Cost of preparation of purchase order (i. In other words. Dangers of Inadequate Investment in Inventories: Under ___________________ investment in inventory is also not healthy one. there are three costs involved in the management of inventories. they are: (a) Inadequate raw materials and work-in-progress inventories will disturb production. the costs that are spend from placing an order to raw materials to the receipt of raw materials. Costs of Holding Inventories UP Minimizing cost is one of the operating objectives of inventory management. 1. They include the following: (a) Cost of requisitioning the items (raw materials). ___________________ 2. ___________________ (d) Another danger of carrying excessive inventory is the ___________________ physical deterioration of inventories while in storage. The costs (excluding merchandise cost). (c) Cost of sending reminders to get the dispatch of the items expedited. It may not be possible to sell the ___________________ Explain the costs of holding inventories in time without loss. ___________________ (e) Excess purchases or storage leads to theft. drafting typing. If finished goods are not sufficient to meet customer demand. postage etc. Financial Management 272 (c) Carrying excessive inventory over a long-period leads to CE Notes Activity the loss of liquidity. In ___________________ case of certain goods or raw materials deterioration occurs with the passage of time or it may be due to ___________________ mishandling and improper storage facilities. inventory..e. the customers may shift to the competitors. Ordering Costs: Ordering costs are those costs that are associated with the acquisition of raw materials.).

UNIT 23: Inventory Management 273 (e) Cost of receiving and verifying the goods. ___________________ (d) Cost of placing and arranging/stacking of the items in the ___________________ store etc. (a) Shortage of inventories of raw materials affects the firm in one or more of the following ways: . If the firm maintains small inventory levels. in case of items manufactured in house the ordering ___________________ costs would comprise the following costs: ___________________ (a) Requisitioning cost. ___________________ (b) Set-up cost. ___________________ -C (c) Cost of receiving and verifying the items. then the number of orders ES will increase. against fire and theft insurance] (d) Obsolescence cost and deterioration (e) Taxes Carrying costs usually constitute to around 25 per cent of the value of inventories held. either shortage of raw (c) materials or finished goods. CE Notes (f) Cost of in unloading of the (items) of goods. Shortages Costs [Costs of stock out]: Shortage costs are those costs that arise due to stock out. irrespective of ___________________ the amount of the order but ordering costs increases in proportion to the number of orders placed. UP utilities serving costs] (c) Insurance [on inventory . which are associated in carrying or maintaining inventory. maintenance on building. ___________________ However. there by ordering cost will increase and vice versa. 3. The following are the carrying costs of inventory: (a) Capital cost [interest on capital locked in the inventories] (b) Storage cost [insurance. ___________________ (g) Storage and stocking charges. 2. Inventory Carrying Costs: Inventory carrying costs are those costs. ___________________ Ordering costs are fixed as per order placed.

. What___________________ risks are involved in holding inventories? (ii) The firm may have to compulsorily resort to some ___________________ different production schedules... Risks associated with inventory management are as follows: 1..... we may have to arrive at the optional level of inventory cost.. a decrease in the general market demand when supply remains the same way also cause prices to decrease. which may not be as ___________________ efficient and economical. we have to determine Economic Order Quantity ___________________ (EOQ). ___________________ In other words. Check Your Progress ES Fill in the blanks: 1. decrease in demand may be due to change in consumer buying habits..... they also exposes the firm to take some risks... Generally.... The time required to process and execute an order is called . 2....... Financial Management 274 (i) The firm may have to pay some higher prices. CE Notes Activity connected with immediate (cash) procurements.. Price Decline: Price decline is the result of more supply and less demand. On the demand side.. Risk in inventory management refers to the chance that inventories cannot be turned over into cash through normal sales without loss.... Risks of Holding Inventory UP Holding of inventories involves above said cost. costs are those costs that are associated with the acquisition of raw materials. at that level in which the total inventory [ordering plus ___________________ carrying less] cost is minimum. time. to loss of rules. In other words..... ___________________ Thus.... with a view to keep inventory costs of minimum level. This is also a long run management problem.... prices are not controllable in the short-run by the individual firm... its total -C ___________________ order's cost plus carrying costs is minimum.. tastes and incomes. Controlling inventory is the only way that a firm can counter (c) act with these risks. ___________________ (b) Stock of finished goods ..may result in the dissatisfaction ___________________ of the customers and the resultant lead... . ... because... it may be the result due to introduction of competitive product.

___________________ Deterioration usually prevents selling the product through normal channels. 2. This risk ___________________ may prove very costly for the firms whose resources are ___________________ limited and tied up in slow moving inventories. For ___________________ example: Cadbury's chocolate. It eliminates duplication in ordering stocks by centralizing the source from which purchase requisitions emanate. It permits better utilisation of available stocks by facilitating (c) inter-department transfers within a firm. Product Obsolescence: Product may become obsolete due to ___________________ improved products. 3. particularly in ___________________ -C high style merchandise. minimizes stock outs and shortages and avoids costly interruptions in operations. Inventory management ensures an adequate supply of materials and stores. changes in requirements etc. inventory carrying costs. It facilitates purchasing economies through the measurement of requirements on the basis of recorded experience. it was due to improper storage.UNIT 23: Inventory Management 275 2. Proper management of inventory will result in the following benefits to a firm: UP 1. ___________________ Thus. Recently. Product Deterioration: Holding of finished goods for a long CE Notes period or storage under improper conditions of light. It keeps down investment in inventories. inventories are risk assets to manage in an effective way by minimizing risks. 5. and obsolescence losses to the minimum. changes in customer tastes. there were some live ___________________ worms in the chocolate. ___________________ 3. humidity and pressure lead to product deterioration. It provides a check against the loss of materials through carelessness or pilferage. 6. ES Benefits of Holding Inventory Optimum level of inventory is that level where the total costs of inventory is less. Obsolescence cost risk is least controllable except by reduction in inventory ___________________ investment. 7. heat. 4. The major benefits of inventory are the basic function of inventory. . Perpetual inventory values provide a consistent and reliable basis for preparing financial statements a better utilisation.

. Financial Management 276 Check Your Progress CE Notes Fill in the blanks: ___________________ ___________________ 1... Efficient ___________________ management of inventory reduces the cost of production and consequently increases the profitability of the enterprise by minimizing the different types of costs associated with holding ES inventory.. refers to the level of inventory at which the total inventory cost is minimum.. ___________________ 2... The production cost per unit is `24 per unit – `10 for raw materials and `14 as overhead cost. storage.000 units per order. of inventory is less. Since the customer may buy at least 15.... Management of optimum level of inventory investment is the prime objective of inventory management. Inadequate or excess investment in inventories is not healthy by for any firm... ___________________ ___________________ Summary -C ___________________ Inventory management occupies the most significant position in ___________________ the structure of working capital.000 units and inventory-carrying cost is 20 per cent of the production cost. disposal or use of materials.500 to set up for one run of 1... the company would like to avoid making five different production runs. It costs `1.. Determine most economic production run. Keywords (c) Economic Order Quantity (EOQ): It refers to that level of inventory at which the total cost of inventory is minimum Inventory: The stockpile of the products a firm is offering for sales and the components that make up the product. An effective inventory management should ensure a continuous supply of raw materials and supplies to facilitate uninterrupted production... Management of inventory may be ___________________ defined as the sum of total of those activities necessary for the acquisition. .000 units at the rate of 1.. Optimum level of inventory is that level where the ___________________ ……………...000 this year. Lesson End Activity UP A company received an order for 15.

___________________ ___________________ Shortage costs: It is the cost that arises due to stock out.00. What is the (c) EOQ? 4. Component Y: 900 units 2. and average stock level. The product cost is `18 per unit. A manufacturing company has an expected usage of 1.UNIT 23: Inventory Management 277 Optimum level of inventory: It is the level where the total costs CE Notes of inventory is less. Its estimated carrying cost is 25 percent of inventory value and ordering cost is `10 per order.000 units of certain product during the next year. Explain. The cost of an . minimum level. "There are two dangerous situations that management should usually avoid in controlling inventories". either shortage of raw material or finished goods. compute re- order level. bins or groups. From the following information of VST Company. Analyse the technique for the computation of EOQ. stock of each ___________________ item is separated into two piles. Component Y: 2 to 8 weeks Re-order quantity = Component X: 600 units. ___________________ Raw materials: It is the input that is converted into finished goods through a manufacturing or conversion process. ___________________ -C VED Classification: According to this classification. 3. ___________________ Questions for Discussion ES 1. 5.000 units of a product in the next 12 months. The company uses two components X and Y for manufacturing a product. ___________________ Work-in-progress: It is the stage of stocks between raw materials ___________________ & finished goods. maximum level. ___________________ Two-Bin Technique: According to this technique. Normal usage = 100 units per week. The Management of Shesha Sai Textiles has predicted sales of 100. Minimum usage = 50 units per week Maximum usage = 150 per week UP Re-order period = Component X: 4 to 10 weeks. Essential and Desirable. inventories ___________________ are grouped into: Vital.

You are required to calculate (a) EOQ and (b) the Re-order point (assuming 250- ___________________ day year). 2008 Van Horne. Best of Luck Company Ltd. What will ___________________ be the economical number of units to order and how often will an order needs to be placed? -C ___________________ ___________________ 7. New Delhi..org/wiki/Inventory www.. ___________________ 6. New Delhi. J. J. Financial Management 278 order is ` 40 and carrying cost is Re.iimm.C. Finance Department of RRR Cement Company gathered the following information. ES Further Readings Books Sudhindra Bhat. Tata McGraw Hill Publishing Company Ltd. 1996.. Its estimated carrying cost ___________________ is 14 per cent and its ordering cost is ` 20 per order.inventorymanagement.org/knowledge.5 per unit for one year. Financial Management . UP Ltd. 2002./6_purpose-of-inventory-management.com/ (c) . Excel Books. 3 Web Readings en.h www.M.effectiveinventory. ordering cost `20. P. uses annually 80. Fundamentals of Financial Management. p. 2 Chandra. You are required to compute EOQ. CE Notes Lead-time on an order is five days and company will keep a ___________________ reserve supply of two days' usage. p.. ___________________ number of orders in a year.com/ www.. New Delhi.300 units of raw ___________________ materials at a price of ` 8 per unit..wikipedia. Prentice Hall of India Pvt. Monthly usage 150 units..Theory and Practice. Financial Management. and Wachowicz. 0. cost of purchase of the component ` 5 and carrying cost are 16 percent. the time gap between the two ___________________ orders and the total cost of ordering and carrying. Jr.

Shortage of cash will disrupt the firm's manufacturing process while excess cash will remain idle without any contribution towards profit. It is a medium of ES exchange for purpose of goods and services and for discharging liabilities. inventories. It is the most liquid asset and the basic input required to keep the business running on a continuous basis. (c) Therefore. It implies a proper balancing between the two conflicting objectives of the liquidity and profitability.UNIT 24: Cash Management Unit 24 279 CE Notes Cash Management ___________________ ___________________ ___________________ Objectives ___________________ After completion of this unit. Efficient management of the inflow and outflow of cash plays a crucial role in the overall performance of a firm. so excessive cash balance simply lowers the total assets turnover. thereby reducing the risk of a liquidity crisis". To quote Brigham. "liquid assets provide a pool of funds to cover unexpected outlays. receivables and cash. but is a means to achieve the end." The steady and healthy circulation of cash throughout the entire business operation is the business solvency. gives vitality and strength to the firm. It is like blood stream in the human body. effective management of cash involves an effort to minimise investment in cash without impairing to liquidity of the firm. "Cash is a non-earning asset. Adequate UP availability of cash is essential to meet the business needs. . procedure and purpose of cash budget ___________________ Introduction ___________________ Cash is one of the components of current assets. Cash is not an end itself. the students will be aware of the following topics: ___________________ \ Objectives of cash management ___________________ -C \ Aspects of cash management ___________________ \ Factors determining cash needs ___________________ \ Cash budget. Cash management is one of the key areas of working capital management as cash is both beginning and the end of working capital cycle-cash. thereby reducing both the rate of return on net worth and the value of the stock. To quote Gitman.

Transaction Motive This motive arises due to the necessity of having cash for various disbursements like purchase of raw materials. ___________________ 2. cheques. services. and for discharging liabilities. payment of tax. The unexpected cash needs . Here. Hence. The need to hold cash would not arise. The transaction motive. (c) Precautionary Motive Apart from the non-synchronization of anticipated cash flows in the ordinary course of business. The marketable security can be easily sold and converted into cash. refers to the holding of cash to meet anticipated obligations whose timing is not perfectly synchronized with cash receipts. viz. Financial Management 280 Nature of Cash CE Notes Activity ___________________ Briefly explain the nature of Cash is the medium of exchange for purchase of goods and cash. cash management is in ___________________ broader sense. There are bank's time deposits and ___________________ marketable securities. as every transaction results either in an inflow or outflow of cash. the firm must have an adequate cash balance particularly when payments are in excess of receipts to meet its obligations. Broad Sense: Here. Cash has no earning power. ___________________ Motives for Holding Cash ES Cash is the most crucial component of the working capital of a firm. demand drafts and ___________________ banks demand deposits. cash includes not only the above stated -C ___________________ but also cash assets. thus. Narrow Sense: Under this cash covers currency and generally ___________________ accepted equivalents of cash. if there is perfect synchronization between the cash receipts and the cash payments. In cash management the ___________________ term cash has been used in two senses: ___________________ 1. firm may require cash for the payment of unexpected disbursements. payment of business UP expenses. The requirement of cash to meet routine cash needs is known as the transaction motive and such motive refers to the holding of cash to meet anticipated obligations whose timing is not perfectly synchronized with each receipts. then why does a firm need cash? John Maynard Keynes puts forth that there are three possible motives for holding cash. payment of dividend and so on..

strikes and failure of 281 CE important customers.. this motive comes from a desire of holding cash to gain in speculative transactions such as... Optimum cash means it should not be excess or inadequate.. by establishing and maintaining good lasting link with -C progressive banking institutions........... The amount set aside for precautionary ___________________ motive is not expected to earn anything.. So it will reduce profit. Objectives of Cash Management One of the prime responsibilities of the financial manager is that managing cash to make balance between profitability and (c) liquidity.. it is a motive of holding cash relates for investing in profitable opportunities as and when they arise.... dealing in commodities in bulk purchasing and selling when rates are considered favourable. In other words... may carry UP additional liquidity.. slow down in collection of accounts receivables. 2.. ___________________ Speculative Motive ___________________ It refers to the desire of a firm to take advantage of opportunities..UNIT 24: Cash Management at short-notice may be the result of floods..... On the other ... Cash is one of the components of . The precautionary balance may be held in near-money assets like ___________________ marketable securities. It provides a cushion or ___________________ buffer to withstand some unexpected emergency..... bills may be presented for settlement earlier Notes than expected. ___________________ sharp increase in cost of raw materials. which present themselves at unexpected moments and that are ES typically outside the normal course of business... As matter of abundant ___________________ caution.. many companies had learnt the art of 'cultivating the rich ___________________ uncle'. and idle cash earn nothing. which have such speculative dealings... he/she has to maintain optimum cash balance.. Cash is the most .... the excess cash will remain idle.. Ready borrowing power is the ___________________ best antidote to emergency cash drains and facilities release ___________________ available cash resources for remunerative applications. Maintenance of excess cash reserve to meet the challenges... but involves cost......... asset. Hence firms. Check Your Progress Fill in the blanks: 1. purchase of raw materials at reduced price on payment of immediate cash... In other words. In simple words..

To Maintain Minimum Cash Balance (Reserve) This is second important objective of cash management. one of the cash management objectives is to meet the payments with the maintenance of sufficient cash. To maintain minimum cash balance. Firm should maintain cash balances to meet the payments. payment of electricity bills. Hence. the process grinds to a stop". Financial Management 282 hand. such as: 1. Hence. we can trace the following as the objectives of cash management: ___________________ 1. On the other hand. The payments are like payment to supplier of raw materials. (c) 2. In other words. Aspects of Cash Management The aspects or problems of cash management can be examined under three heads. ___________________ -C ___________________ To Meet Cash Payments ___________________ The prime objective of cash management is to meet various cash ___________________ payments needed to pay in business operations. they may be excess or less over cash outflows. Surplus cash arise . the aim of cash management is to maintain optimum cash balance. ___________________ ___________________ From the above. It means the firm should not maintain excess cash balances. Cash balances held at the point of time. Hence. maintenance of low level of cash balance may not help to pay the obligations. ES "Cash is an oil to lubricate the ever-turning wheels of business: without it. there should not be management? excess cash or inadequate cash. To meet cash payment needs. but if the excess balance will remain idle. as cash is a non-earning asset and the firm will have to forego profits. otherwise it will not be able to run business. To quote Bollen. there is need to maintain balance between Activity What are the aspects of cash ___________________ profitability and liquidity. and ___________________ 2. payment of wages and ___________________ salaries. Cash inflows and outflows. Excess cash UP balance may ensure prompt payment. telephone bills and so on. having inadequate cash balance will affect the liquidity of CE Notes the firm. and 3. Cash inflows (receipts) and outflows (payments) may not match. Cash flow within the firm.

.... there is a need to manage cash balance for managing synchronisation.. we can say that a firm has to decide the cash balance based on their needs..... Short Costs: This is another factor to be considered while determining the cash needs..... Otherwise...... Synchronization of Cash Flows: Synchronization of cash flows arises only when there is no balance between the expected cash inflows and cash outflows.. Shortage of cash can be found through preparation of cash budget... which is determined after taking into ES consideration of the following factors: 1.... Short costs are those costs that arise with a short fall of cash for the firm requirements. There is no need to manage cash balance... and ......... The expenses incurred as a result of shortfall are called short costs........... The two types of cash forecasting are ___________________ ... ___________________ ___________________ Factors Determining Cash Needs ___________________ From the above.... Cash shortage is not cost free.UNIT 24: Cash Management when the cash inflows are excess over cash outflows and deficit will 283 CE arise when the cash inflows are less than the cash outflows....... A UP well-prepared cash budget will definitely point out the months or periods when the firm will have surplus or deficit cash... it involves cost whether it is expected or unexpected shortage........ They include the (c) following: (a) Cost of Transaction: Whenever there is a shortage of cash it should be financed... ___________________ Check Your Progress ___________________ Fill in the blanks: ___________________ 1.... if there is perfect match between cash inflows and cash outflows. Financing may be done through the borrowings from banks or sale of marketable securities (if the firm has)..... The Notes balance known as synchronization firm should develop appropriate ___________________ strategies for resolving the uncertainty involved in cash flow ___________________ prediction and in balance between cash receipts and payments.... Surplus cash is ... If the firm is .. 2.. This synchronisation is forecasted through the preparation of cash budget for a period of 12 months or the planning period.. -C ___________________ 2......

commitment charges and other expenses relating ___________________ to the loan. since they ___________________ cannot raise the required amount from the public. ___________________ ICRA and CARE). salary. ___________________ (b) Cost of Borrowing: If the firm does not have marketable ___________________ securities with it. loss of image and attendant decline in sales and profits. ES (d) Cost of Loss of Cash Discount: Sufficient cash helps to get cash discount benefits. then it prefers borrowing as a source of financing. ___________________ (c) Cost of Deterioration of the Credit Rating: Generally -C ___________________ credit rating is given by credit rating agencies (CRISIL. Financial Management 284 planning to finance the deficit cash by sale of CE Notes marketable securities. Low credit rating firms may have to go for bank loans with high interest charges. demands for cash payment refusal to sell. Low ___________________ credit rating may also leads to the stoppage of supplies. handling cost of security and so on. It involves costs like interest ___________________ on loan. which in turn demand penalty. storage. (c) Cash Planning or Cash Budget Cash planning and control of cash is the central point of finance functions. Surplus cash funds are idle. These costs are generally fixed over a period. shortage of cash. Cash is not an earning asset. Management Costs: Management costs are those costs involved with setting up and operating cash management staff. and are mainly include staff. which would otherwise have been earned. 4. but shortage of cash cannot help to obtain cash discounts. (e) Cost of Penalty Rates: Whenever there is shortage of cash firm may not be able to honour currently returned obligations. then the firm is expected to spend Activity ___________________ What is cash budgeting? some expenses for brokerage. It means that the cost associated with excess or surplus cash UP balance. Maintenance of adequate cash is one of the prime . an impact of idle cash is that the firm losses opportunities to invest those funds and thereby lose interest. Surplus Cash Balance Costs: It is self-explanatory. 3.

is the anticipation of the financial condition of the firm. Cash budget is also known as short-term cash forecasting. Large firms. prepare -C ___________________ daily and weekly forecasts. It is possible only through 285 CE preparation of cash planning. Medium size firms prepare weekly and monthly forecasts. Since planning and List ___________________ the elements of cash budget. A projected cash flow statement ___________________ prepared based on expected cash receipts and payments. cash in flows and cash outflows) at different stages and offers the management an advance notice to take appropriate and timely action.. weekly. Scheduling payments. It pinpoints the surplus or deficit cash of a firm as it moves from one period to another period. Estimating cash requirements 2. In other words.e. Notes Activity Cash control is also included in cash planning. The ___________________ period for which the cash planning is prepared depends on the size ___________________ of the firms and managements philosophy. Purpose of Cash Budget Cash budget has proved to be of great help and benefit in the following areas: (c) 1. in respect of acquiring capital goods 4. Cash planning ___________________ may be prepared on daily. Cash budget is an important tool for the flow of cash in any firm over a future period of time. plan for the financing of those needs and exercise control over the cash and liquidity of the firm. The surplus of deficit data helps the financial manager to determine the future cash needs of the firm. Cash planning is a technique ___________________ to plan and control the use of cash. Planning and phasing the purchase of raw materials . Cash Forecasting and Budgeting ES Cash forecast is used as a method to predict future cash flow because it deals with the estimation of cash flows (i.UNIT 24: Cash Management responsibilities of financial manager. But in a ___________________ short period they may service but over a long period they have to ___________________ prepare cash planning for the success of the firm. control are the twins of management. Small firms may not prepare cash forecasts due ___________________ to non-availability of data and less scale of operations. monthly or quarterly basis. it is a statement showing the estimated cash inflows and cash outflows over a UP planning period. Planning short-term finance planning 3.

factory expenses. ___________________ ___________________ Preparation of Cash Budget or Elements of Cash Budget ___________________ The above benefit areas clear that the main aim of preparing cash budget is to predict the cash flows over a given period of time and ___________________ to determine whether at any point of time there is likely to be ___________________ surplus or deficit of cash. ___________________ Planning horizon is that period for which cash budget is prepared. There are no fixed rules for cash budget preparation. Then how to determine planning horizon? It is determined on the basis of situation and the necessity of a particular case. The factors that generate cash flows are divided into two broad categories: (a) Operating. administrative expenses. dividend received. and (b) Financial. refund of tax. wages. A firm whose business is affected by seasonal variations may prepare monthly cash budgets. Financial Management 286 5. which becomes expensive. collection of accounts receivables and disposal of fixed assets and the operating cash outflows are bills payables. Financial Cash Flows: Loans and borrowings. Evolving and implementing credit policies CE Notes ___________________ 6. 1. repurchase of shares. interest paid and dividend paid. Cash budget period should not be too short or too long. if it is too long the estimates will be inaccurate. If the cash flow fluctuates. depending upon the size of the firm. On the other hand. purchase of raw materials. sale of securities. interest received and issue of new shares and debentures cash outflows are redemption of loan. Operating Cash Flows: Operating cash inflows are cash sales. daily or weekly cash budgets should be prepared. Step 2: Selection of factor that has bearing on cash flows. Preparation of cash budget involves the -C ___________________ following steps: ___________________ Step 1: Selection of period of time (planning horizon). (c) 2. If it is too short many important events may ES come out in the planning period and cannot be accounted for the preparation of cash budget. rent received. income tax payments. Planning ___________________ horizon of a cash budget may differ from firm to firm. Longer period cash budgets may be UP prepared when the cash flows are stable in nature. maintenance expenses and purchase of fixed assets. . Checking and verifying the accuracy of long-term cash forecasting.

. firm wants to pay accounts payables late without affecting credit standing with suppliers. ___________________ 2. That financial manager will have the ___________________ control on collection of receipts and cash disbursements... Hence. In other words... it has to borrow money.. for that efficient cash management is must..... Both collections and disbursements exercise a joint impact on the overall efficiency of cash management... and (B) it has to delay the accounts payables without affecting credit standing. Accelerating Cash Collections Accelerating speedy cash collection can conserve cash and reduce its requirements for cash balances of a firm. The seller has to inform to .. the first hurdle could be the firm itself. The idea is that speed collection of accounts receivables so that the firm can use money sooner....... is the time taken by the bank in ___________________ collecting the payment from the customer's bank... . the various collection and disbursement methods can be employed to improve cash management efficiently constitutes two sides of the same coin.... otherwise.......... the time taken in processing the ___________________ cheques within the company and sending them to ___________________ bank for deposit. Cash inflow process can be accelerated through systematic planning.. then the next financial manager's ___________________ job is to ensure that there should not be more deviation between ___________________ the projected cash flows and the actual cash flows.. so that firm can make use of the money it already has.. wherein costs are UP involved..UNIT 24: Cash Management 287 CE Check Your Progress Notes Activity Fill in the blanks: How___________________ can cash flows be managed? 1..... . Prompt payment by customers will be possible by prompt billing. for efficient cash management firm has (A) to collect accounts receivables as early as possible........ It may take a long time to process the invoice. Conversely... ___________________ Managing Cash Flows -C ___________________ After estimation of cash flows..... The following are (c) the methods of accelerating cash collections: 1...... Prompt Payment of Customers: In speed collection.. As the objectives of cash management is to accelerate cash receipts as ES much as possible and decelerate or delay cash payments as much as possible.

collectively known as "deposit float".Collection within the bank or the time taken by the bank in collecting the payment from the customer's bank. viz.time taken in ES processing the cheques within the company and sending them to bank for deposit and (iii) Bank Float . There is a time lag between the time a cheque is -C ___________________ prepared by customer and the time the funds are credited to ___________________ firm's account. The other way of prompting customers to pay earlier is ___________________ to offer cash discount. Automation of billing and enclosure of ___________________ self-addressed enveloped. Concentration Banking or Decentralised Collections: A firm operating its business spread over a vast area and its (c) branches located at different places would do well to decentralise its collections. deposit float as the sum of cheques written by the customer that are not yet usable by the firm. There are two important methods available to use in a decentralised collection network. The postal float. Conversion of cheques into cash is the second hurdle.. they are concentration banking and Lock-Box system. lethargy and bank float. Early Conversion of Payments into Cash: After using ___________________ cheques by customer in favour of the firm collections can be ___________________ quickened. Accelerated collection of cash is possible when a firm reduces the transit. will be helpful for speed payment of cash. Cash cycle is the ___________________ time required to convert the raw materials into cash. (i) Mailing time-The time taken by the post offices in transferring the cheques from the customer to the firm. The decentralised collection procedure in US is called as "concentration banking. 3. (ii) Lethargy . Financial Management 288 customers about the amount of payment and period of CE Notes payment in advance. instead of a single collection . Cash discount helps customer to save ___________________ money and they would readily avail discounts." Concentration banking is a system of operating through a number of collection centres. How can the deposit float be reduced? It is possible through the options of decentralised collection policy. It is also known as cash cycle. In India deposit float can assume sizeable opportunities as cheques normally UP take a longer time to get realised than in most countries. ___________________ 2. lethargy and bank float. To quote Rama Moorthy. The time lag is referred to as "postal float". There ___________________ are three steps involved in the cash cycle.

but all the areas may not have ___________________ collection centres. There are four motives for holding cash. . Customers are billed with instructions to mail remittances to the box. It is more popular in USA and European ES countries. ___________________ 4. ___________________ Hence. 3. There is no time gap between cash inflows and outflows. The time taken by post offices in transferring the cheques from the customer to the firm is referred to as postal float. concentration banking reduces float. (c) 4. This system should be adopted only when the savings are higher than the cost. 2. Under this arrangement. at the respective places pick up the mail several times a day and the same deposits into the firm's account. 289 CE Under this system. Opening it collection centre depends on the ___________________ volume of business. a firm will have a large number of bank Notes accounts in the operated areas. which saves time ___________________ and reduces in the operating cash needs. these ___________________ may be remitted for credit to the Head Office Account. a firm rents a post office box and authorises its bank to pick up remittances in the box. daily or weekly. The local authorised bank of the firm. Conversion cost is the cost of converting securities into cash. In this system. Lock-Box System: This is another technique of accelerating collection of cash. On realisation of the proceeds of the cheques. Check Your Progress True or False: 1. The boxes will be placed at different centres on the basis of number of consumers. After the collection of cheques the bank. send a deposit slip UP along with the list of payments and other required encloses. by way -C of telegraphic transfer. the customers' are instructed to send their payments to the collection centre ___________________ covering the area under which they come and these are ___________________ deposited in the local account of the concerned collection ___________________ centre. as per the quantum of ___________________ collections and the local requirements of funds for expenses.UNIT 24: Cash Management centre centralised at the company's head office premises.

Float: It is the amount of the money tied up in cheques that have (c) been written but not yet collected. ES Lesson End Activity You have to determine the cash balance for your organisation that is optimal for covering all transactions & costs. Opportunity Costs: It is the forgone cost benefit by holding idle cash. Money market: It refers to the market for short-term securities. and to maintain minimum cash balance. Financial Management 290 CE Notes Summary ___________________ Cash is one of the components of current assets and it is a medium ___________________ of exchange for purpose of goods and services and for discharging ___________________ liabilities. Cash: It is one of the components of current assets and a medium of exchange for the purpose of transactions. How will you do that? Keywords UP Cash Budget: It is a statement showing the estimated cash inflows and cash outflows over a planning period. ___________________ Objectives of cash management are to meet cash payment needs. Conversion Costs: It is the costs that are associated with the sales of marketable security. Cash planning is a ___________________ technique to plan and control the use of cash. inventories. A projected cash flow statement prepared based on expected cash receipts and payments. receivables and cash. Cash Planning: It is a technique to plan and control the use of cash. ___________________ It is the most liquid asset and the basic input required to keep the ___________________ business running on a continuous basis. Efficient management of -C ___________________ cash involves an effort to minimise investment in cash without ___________________ impairing to liquidity of the firm. Cash management is one of the key areas of working capital management as cash is both beginning and the end of ___________________ working capital cycle – cash. . anticipation the financial condition of the firm.

5. "Cash budgeting or short-term cash forecasting (budgeting) is ___________________ the principal tool of cash management. ___________________ ___________________ Questions for Discussion ___________________ 1./CashManagement TrendsInIndia_GT_N. New Delhi. ___________________ 2." Discuss. Jr. 2008 Van Horne. Fundamentals of UP Financial Management. ___________________ 4. p. Analyse the importance of the preparation of the cash budget ES for the corporate.inc. Excel Books. P. Discuss. 1996. Financial Management .nucleussoftware. Tata McGraw Hill Publishing Company Ltd.. J. Web Readings en.com › Money and Finance › Basic Accounting www. (c) www. New Delhi. Briefly discuss the various avenues or opportunities available ___________________ to the companies to park their surplus funds for a short-term. 2 Chandra. New Delhi. 2002.C. Discuss.. Further Readings Books Sudhindra Bhat.com/.org/wiki/Cash_management www. J. 3. p. Ltd. -C ___________________ 3. Financial Management.. Prentice Hall of India Pvt..Theory and Practice. "Management of cash flows plays a very important role in cash ___________________ management".com › Wholesale Banking › Corporates .. Efficient cash management will aim at maximizing the cash ___________________ inflows and slowing cash outflows".wikipedia..UNIT 24: Cash Management 291 Optimal Cash Balance: It is that cash balance where the firm's CE Notes opportunity cost equals transactions cost and the total cost is minimum.. and Wachowicz.M.hdfcbank.

Financial Management 292 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

Although he is ___________________ employed as an engineer in one of the large engineering concerns in Lahore (Pakistan). He would need to rent a small place for ` 1. The minimum equipment required would cost ` 11. ___________________ ___________________ Case Study 1: Creative Promotion Company -C ___________________ Mr.000. He proposes to buy the component from other parties and keep the UP production activity to a minimum. Bhatt has already spent ` 30. he has commercially provided a domestic appliance called Lavex. he has to manufacture and sell the new products on ad hoc basis so as to demonstrate the commercial superiority of his products and thereby. he releases that till he succeeds in selling the patent rights at the price he expects. He is not interest in manufacturing and selling his new products. the student will have an appreciation of the concept of topics studied in this Block. which ___________________ would be a great convenience kitchen to help housewives. to induce the parties to buy the patents from him. he will supervise and guide ‘Lavex’ production and sales during his spare time.UNIT 25: Case Studies Unit 25 293 CE Notes Case Studies ___________________ ___________________ ___________________ Objectives ___________________ After analyzing these cases. However. he is currently thinking of manufacturing and selling ‘Lavex’. He has budgeted ` 20. Bhatt proposes to introduce the product in Chennai city only. He proposes to use his residence as office for sales activity. Bhatt is a young man of bright ideas. He will not give up his full- time job. His sales projections are as follows: January 60 February 40 March 110 April 140 (c) May 220 June 180 He is not interested in pushing sales beyond 220 units per month as he cannot cope with the production.000 in developing the product. his only interest in developing new products is to make money by way ES of selling patent rights to some established concerns. which will be spent mostly for demonstration Contd… .200 per month for production. With this objective. he spends all his spare time developing new ___________________ products in his private laboratory at home. Currently.000 for sales promotion.

Questions 1. Mr. Discuss the nature of the financial problem involved. 3. sales supervisor for ` 880 per month. Wages per month will be ` 6000.000 ___________________ February 7. Overhead expenses are estimated at ` 2800 per month. He rules out cash sales. Wages will be paid weekly. There will be inventory of finished goods or goods in process as the production will be strictly against firm orders.000 ___________________ April 3. Financial Management 294 in leading department stores in the city. 2. He calculates that about 50 unit ___________________ will be needed for “demonstration and display” in the leading sores at his cost.000 ___________________ March 3. so that he may plan accordingly. Although the sales to dealers will be made on -C ___________________ one month’s credit.000 ___________________ This selling price per units will be ` 280 and the dealers will be given 15 percent trade discount. How can the above-mentioned problem be sorted out? (c) . Prepare the monthly cash budget for the first six months UP period of the proposed venture. The production capacity per month will be 220 units. Bhatt wants to know how much finance will be needed for his first six months of operation and when. Components and materials. he knows that the actual collections will be ___________________ realized in about 4 weeks’ time. ___________________ Assembling is one of the activities in the production process. Materials and components need to ES be ordered at least one month in advance. The promotion budget is CE Notes scheduled as follows: ___________________ ` January 7. which will be purchased from outside ___________________ parties strictly on 30 days credit will cost ` 160 per unit. Bhatt proposes to employ a full-time production.

applied for a ___________________ $200. the President and Principal Stockholder of Agarwal cast. ___________________ According to Gupta. if he were willing to wait until completion of the job for payment. Gupta told the loan officer that he had monitored his firm's financial status closely and that he had financial reports prepared every six months. He finally -C decided to "work for himself" and he formed the company with ___________________ Berry Hook. (c) . 2006. This information seemed to be consistent with the Dun and Bradstreet report obtained by the ___________________ bank. he had worked in Frankfert and Michigan. ___________________ Gupta. Since he was relatively new in the ES business. To show that his operation was sound. Instead. the purpose of the loan was to assist him in carrying his receivables until they could be collected. he could quote for higher profits. he was willing to file a personal financial statement with the bank. He said that he would send a copy to the bank. The application was forwarded to the bank's commercial ___________________ loan department. He also included a list of current receivables. but that he had considerable prior experience in flooring and carpets since he had ___________________ worked as an individual contractor for the past 20 year. UP Question Prepare your recommendation on Agarwal Cast Company.000 loan from the main office of the National bank of New York. he did not feel that he could compete if he had to require a sizeable deposit or payment in advance. He told the loan officer that he had ___________________ been in business since February 1976. a former co-worker. Most of ___________________ this time. In addition. applied for the loan in person..UNIT 25: Case Studies 295 Case Study 2: Loan Approval CE Notes On August 30. He ___________________ explained that the flooring business required him to spend considerable cash to purchase materials but his customers would not pay until the job was done. Agarwal Cast Company Inc. he included a list of customers and projects with his loan application.

100) ΔNet Profit = (` 63.50.06) = 1.000 – `7.200 UP (b) To determine if it is profitable to reduce inventory to ` 21 million.000 -C ___________________ Spoilage costs 4.60) = `9. Contd… .000 ΔSpoilage cost = (`4.000 – 1.50.800) ΔNet Profit = `1.500)(365)(0.000 – `3.60) = 15. ___________________ ` 25 million ` 23 million ` 21 million ___________________ Storage costs 7.000 – ` 7.06.06) = 1.60) = (1.14.25.19.000)(0.000 Δ Profit on sales = (`1.000 – 1. Financial Management 296 Case Study 3: Inventory Levels CE Notes ___________________ The Storage Corporation currently carries ` 25 million of inventory.20.000 (c) ΔProfit on sales = (` 1.000 7.67. (b) Would it be profitable for the company to reduce its inventory to ` 21 million? (Calculate the change in after-tax income.25.00.300) Given the choices.000)(0.) ES (a) Reducing inventory from ` 25 to ` 23 million causes net income to: ΔStorage cost = (`7.500 ___________________ (a) Would it be profitable for the company to reduce its inventory ___________________ from ` 25 million to ` 23 million? (Calculate the change in after-tax income).60) = `15.20.20. That is.20)(0.000)(0.19. The ___________________ company's after-tax discount rate that is used to evaluate current ___________________ asset policies is 6%.00.00.10.67. you know that ` 23 million is better than ` 25 million and the decision is now whether to reduce it further to ` 21 million.000)(0.000 – ` 3.19.20.000 ΔSpoilage cost = (` 3.000)(365) (0. Reducing inventory from ` 23 to ` 21 million causes net income to: ΔStorage cost = (` 7.000)(0.10.20)(0.000 3.000 7. ` 23 million is the most profitable level of inventory. determine the change in profits associated with reducing from ` 23 million.60) = 4.97.000 ___________________ Daily sales 1.60) = (43.800 ΔFinancing cost = (` 20. The company earns a contribution margin of 20% on sales.000)(0.000 1.25. Remember that decisions depend on incremental costs and benefits.00.14.75.000 1.000 3.000 ΔFinancing cost = (`20. The finance manager is considering whether to ___________________ recommend a reduction in inventory costs at the following information about inventory costs at various levels.75.75.

6 ___________________ 6 0.000 per tonne per year. Accounting and Finance for Managers. The probability distributions of the daily usage rate and the lead time ___________________ for procurement are given below: ___________________ These distributions are independent ___________________ Daily usage Probability Lead time in days Probability rate in tonnes ___________________ 4 0. Excel Books.000 per tonne.2 -C ___________________ The stockout cost is estimated to be ` 4.2 ___________________ 8 0. ___________________ Question ___________________ (a) What is the optimal level of safety stock? ___________________ (b) What is the probability of stockout? Source: Nitin Balwani.3 5 .2 15 .5 10 . ES New Delhi UP (c) .UNIT 25: Case Studies 297 Question CE Notes Fabrication Company requires steel for its fabrication work. The carrying cost is ` 1.

Financial Management 298 CE Notes ___________________ ___________________ ___________________ ___________________ ___________________ ___________________ -C ___________________ ___________________ ___________________ ___________________ ES UP (c) .

Cash Budget: It is a statement showing the estimated cash inflows and cash outflows over a planning period.Glossary Glossary 299 CE Notes ___________________ Accruals: Accrued expenses are those expenses which the company owes ___________________ to the other persons or organisations. Bulk factoring: It is a kind of Invoice Discounting. the Factor provides prepayment facility and protection against bad debts. ___________________ Adjusted Discount Rate Method: The future cash flow from capital projects are discounted at the risk adjusted discount rate and decision ___________________ regarding the selection of a project is made on the basis of the net present ___________________ value of the project computed at the risk adjusted discount rate. Beta: It is a measure of the systematic risk of a security that cannot be ES avoided through diversification. Business Finance: It is that business activity which is concerned with the acquisition and conservation of capital funds in meeting financial needs and overall objectives of business enterprises. Business Plan: The primary document. but not yet due and not yet paid the ___________________ amount. Capital Budgeting: It refers to planning and deployment of available capital for the purpose of maximizing long-term profitability of the firm. which (c) represents long-term sources. Capital Employed: It is the capital investment necessary for a business to function. Capital Rationing: The allocation of the limited funds available for financing the capital projects to only some of the profitable projects in such a manner that the long term returns are maximized. . which an entrepreneur should be ready with. -C ___________________ Agency Factoring: Under this arrangement. Capital Structure: It is that part of financial structure. is a Business Plan UP 'Call' option: It gives the right to 'buy' to issuing company at a certain price before the maturity period. ___________________ Annuity: It is a stream of equal annual cash flows. ___________________ Beta Coefficient: It is a relative measure of the sensitivity of an assets ___________________ return to changes in the return on the market portfolio.

CE Notes or a financial product. ___________________ Certainty Equivalent Coefficient Method: A method which makes adjustment against risk in the estimates of future cash inflows for a risky ___________________ investment project. ___________________ Collection Policy: It is the procedures passed to collect amount receivables. Contingent Investment Proposals: There are certain projects which are contingent upon the acceptance of others. Financial Management 300 Cash Flow: It is the movement of cash into or out of a business. controlling and administering of the funds used in the business. so that from that moment on. raising. Conversion Costs: It is the costs that are associated with the sales of UP marketable security. It is usually measured during a specified. ___________________ Cash: It is one of the components of current assets and a medium of ___________________ exchange for the purpose of transactions. the interest that has been added also itself earns interest. which a firm must earn on its investments so as to maintain the market value of its shares. a project. . ES Compound Interest: When interest is added to the principal. Corporation: It is an association of two or more persons who contribute money or money's worth to a common stock and employs it in business. when they become due. Convertible Preference Shares: Here convertible means into equity not into cash. finite ___________________ period of time ___________________ Cash Planning: It is a technique to plan and control the use of cash. Compound Value: The interest earned on the initial principal becomes a part of the principal at the end of a compounding period. (c) Cost of Capital: It is that minimum rate of return. It is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. Corporate Finance: Corporate finance is the activity concerned with planning. and who share profit and loss equally. ___________________ Commercial Paper: It represents a short-term unsecured promissory note issued by firms that have a fairly high credit (standing) rating. -C ___________________ Certainty Equivalent Coefficient: It is the ratio of the riskless cash ___________________ flows.

___________________ Debenture: It is a document that either creates a debt or acknowledges ___________________ it.Glossary 301 Credit Control: A factor. has the wherewithal for CE credit intelligence on customers. Economic Order Quantity (EOQ): It refers to that level of inventory at which the total cost of inventory is minimum Economic Value Added: It is an estimate of economic profit by after making adjustments to GAAP accounting. Explicit Cost: It is the discount rate that equates the present value of the cash inflows with the present value of its increments cash outflows. including deducting the opportunity cost of equity capital. ___________________ Credit Standards: It refers to the minimum criteria for the extension of ___________________ credit to a customer. Notes Credit Factoring: Under this arrangement. usually referencing assets owed. and it is a debt without collateral. (c) Finance Lease: A Financial Lease is a means of financing capital equipments. Financial Leverage: It is the payment of fixed rate of interest for the use for the fixed interest bearing securities. EBIT-EPS Approach: This approach determines the impact of debt on UP earnings per share. ___________________ Debt: It is that which is owed. ___________________ Credit Terms: It means the stipulations under which goods or services -C are sold on credit. the Factor assumes ___________________ credit risk. Dividend: Dividend is a part of profits that are available for distribution to shareholders. the Factor purchases all or ___________________ selected invoices of its clients at a discount. as a professional. a firm acquires the right to use an asset from the manufacturer directly. Direct Lease: Under direct leasing. Factoring: Factoring is a financial service covering the financing and collection of book debts and receivables arising from credit sale of goods and services. . to magnify the rate of return as equity shares. both in the domestic as well as international market. ___________________ Deferred Income: Deferred incomes are incomes received in advance by the firm for supply of goods or services in future period. ___________________ Credit Protection: In "without recourse factoring". ES Degree of Operating Leverage: It is the change in the percentage of operating income (EBIT) for the change in percentage of sales revenue.

a third party is (c) involved beside lessor and lessee. Leverage: It allows accomplishing certain things that are otherwise not possible. ___________________ Full Factoring: This classical form of factoring is most comprehensive -C ___________________ and includes services such as maintenance of sales ledger. ___________________ Future Cost: It is the cost of capital that is expected to raise the funds to ___________________ finance a capital budget or investment proposal. credit protection and financing of receivables. ___________________ Gross Working Capital: The total current assets are termed as the gross working capital. credit control. Market Value Added: It is the difference between the current market value of a firm and the capital contributed by investors. Investment Decision: Investment decision is related with the selection of assets that a firm will invert. collection of receivables. ___________________ Financing Decision: It is related to the financing mix or capital structure or leverage and the determination of the proportion of debt and ___________________ equity. UP Inventory: The stockpile of the products a firm is offering for sales and the components that make up the product. ___________________ Float: It is the amount of the money tied up in cheques that have been ___________________ written but not yet collected. Interest: It is a fee paid on borrowed assets. the expected life of an ES asset is matched with the source of finance period with which an asset is financial. It is the price paid for the use of borrowed money. Financial Management 302 Financial Management: It is the operational activity of a business that CE Notes is responsible for obtaining and effectively utilising the funds necessary ___________________ for efficient operations. Inter-corporate Deposits (ICDs): A deposit made by one firm with another firm is known as Inter-corporate Deposits (ICDs). Implicit Cost: It is the cost of opportunity which is given up in order to pursue a particular action. Hedging Approach: That approach in which. Lenient Credit Policy: It is that policy where the seller sells goods on very liberal credit terms and standards. . Marginal Cost of Capital: The additional cost incurred to obtain additional funds required by a firm. Leveraged Lease: Under leveraged leasing arrangement.

the market value of the firm is not affected by the capital structure changes. Operating Lease: An operating lease is particularly attractive to (c) companies that continually update or replace equipment and want to use equipment without ownership. -C ___________________ Net Asset Value: It is a term used to describe the value of an entity's assets less the value of its liabilities. Non-cumulative Preference Shares: Non-cumulative preference shares are those shares on which the unpaid dividend does not cumulate to the next year’s dividend. ___________________ Mutually Exclusive Investment Proposals: Those proposals which ___________________ represent alternative methods of doing the same job. including shareholders and debt holders. UP Non-participatory Preference Shares: The preference shares that have no claim in the surplus profit or assets of the firm are deemed to be non-participatory preference shares.Glossary 303 Maturity Factoring: The Factor administers clients' sales ledger and CE renders debt collection service. Operating Income: It is a measure of a firm's profitability that excludes interest and income tax expenses. but also want to return equipment at lease-end and avoid technological obsolescence. . ___________________ Money market: It refers to the market for short-term securities. ___________________ Net Working Capital: The excess of current assets over current liabilities represents net working capital. NOPAT: It is a company's after-tax operating profit for all investors. ES NOI Approach: According to this approach. Notes Maturity period: The period in which the debentures are issued or the ___________________ period after which the debenture capital is repaid ___________________ MM Theory: According to this theory the value of the firm is independent ___________________ of its capital structure. Operating Leverage: It results from the present fixed operating expenses within firm's income stream. ___________________ Net Income Approach: According to this approach. Non-systematic Risk: The variability in a security is total returns not related to overall market variability. Non-convertible Preference Shares: The preference shares that do not enjoy the option of converting their holdings into equity are known as non-convertible preference shares. the cost of debt and ___________________ the cost of equity do not change with a change in the leverage ratio.

-C ___________________ Optimum level of inventory: It is the level where the total costs of ___________________ inventory is less. credit period. are termed as replacement investment. ES stores and spares. ___________________ ___________________ Optimal Cash Balance: It is that cash balance where the firm's opportunity cost equals transactions cost and the total cost is minimum. which are contemplated for (c) replacing. . which are ploughed back in the company. Permanent Working Capital: It is the minimum investment kept in the form of inventory of raw materials. Portfolio: It is a collection of securities. Present Value: In case of present value concept. Receivables Management: It involves decision areas: credit standards. work in progress. ___________________ Optimum Capital Structure: It is that capital structure where market ___________________ value per share is maximum and the cost of capital is minimum. and book debts to facilitate uninterrupted operation in a firm. Retained Earnings: These are the portion of earnings available to equity shareholders. Financial Management 304 Operating Risk: It is the risk of the firm not being able to cover its fixed CE Notes operating costs. Receivables: It is defined as debt owed to the firm by customers arising from sale of goods or services in the ordinary course of business. all the facilities of full factoring except that of credit protection are available to the client. ___________________ Participatory Preference Shares: These are the shares that enjoy the right to participate in surplus profit that is left out after payment of a ___________________ fixed rate of dividend to equity shareholders. Recourse Factoring: Under this factoring. Premium on redemption: When the buy back (call) price may be more than the face value of debenture. Replacement Investment: The investments. cash discounts and collection procedures. old and antiquated equipment so that the job could be performed more efficiently. ___________________ Opportunity Cost: The benefit that the shareholder foregoes by not ___________________ putting his/her funds elsewhere because they have been retained by the management. finished goods. UP Raw materials: It is the input that is converted into finished goods through a manufacturing or conversion process. we estimate the present worth of a future payment/instalment or series of payment adjusted for the time value of money.

Trade Credit: It refers to the credit extended by the supplier of goods or services to his/her customer in the normal course of business. ___________________ Risky Investment: Risk in an investment refers to the variability that is ___________________ likely to occur between the estimated returns and the actual returns. ES Shortage costs: It is the cost that arises due to stock out. Systematic Risk: Variability in a security is total returns that are UP directly associated with overall movements in the general market or economy is called systematic risk. Specific Cost: It is the cost associated with particular component or source of capital. bins or groups. Time Value of Money: Time value of money is that the value of money changes over a period of time. ___________________ Risk: Probability that the expected return from the security will not ___________________ materialize. stock of each item is separated into two piles. . ___________________ Risk-free Rate: It is the rate at which the future cash flows of a project ___________________ which is not subjected to risk are discounted. inventories are grouped into: Vital. Spot Cost: The cost that are prevailing in the market at a certain time. either shortage of raw material or finished goods. (c) Two-Bin Technique: According to this technique. VED Classification: According to this classification. Essential and Desirable. ___________________ Riskless Cash Flows: The cash flows which the management expects -C when there is risk in investment proposal. ___________________ Security: In normal situations the VCs don't insist for security and ___________________ collateral but sometimes security requirements are considered in some cases. Temporary Working Capital: Any additional working capital apart from permanent working capital required to support the changing production and sales activities is referred to as temporary working capital. Notes Risk Premium Rate: The extra at which the future cash flows of a risky ___________________ project are discounted.Glossary 305 Return on Assets: This percentage shows how profitable a company's CE assets are in generating revenue. Stringent Credit Policy: Seller sells goods on credit on a highly selective basis.

growth startup companies. -C ___________________ Work-in-progress: It is the stage of stocks between raw materials & ___________________ finished goods. ___________________ Wealth Maximization: It is maximizing the present value of a course of ___________________ action (i. ___________________ Weighted Average Cost of Capital: It is the rate that a company is ___________________ expected to pay on average to all its security holders to finance its assets.e. Financial Management 306 Venture capital: It is financial capital provided to early-stage. ___________________ WACC Approach: It is midway between NI and NOI approaches. high- CE Notes potential. ___________________ ___________________ ES UP (c) . high risk. NPV = GPC of benefits .Investment). ___________________ Working Capital: It refers to short-term funds to meet operating expenses.