Disha Institute of IT & Management

Financial Management Unit I Meaning of Financial Management:Financial Management is such a managerial process which is concerned with the planning and control of Financial resources. It is being studied as a separate subject in 20th century. Till now it was used as a part of economics. Now, its scope has undergone some basic changes from time to time. In present time, it analyses all financial problems of a business. Financial Manager estimates the requirements of funds, plans the different sources of funds and perform functions of collection of funds and its effective utilisation. Finance is such a powerful source that it performs an important role to operate and coordinate the various economic activities of business. Finance is of two types:(1) Public finance. (2) Private finance. 1. Public Finance:means government finance under which principles and practices relating to the procurement and management of funds for central government, state government and local bodies are covered. 2. Private Finance:means procurement and management of funds by individuals and private institutions. Under it we observe as to how individuals and private institution procure funds and utilise it. Scope:What is finance? What are a firm’s financial activities? How are they related? Firm create manufacturing capacities for production of goods, some provide services to customers. They sell goods or services to earn profit and raise funds to acquire manufacturing and other facilities. Thus, the 3 most important activities of business firm are:(1) Production (2) Marketing I

Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org

Disha Institute of IT & Management
(3) Finance. A firm secures whatever capital it needs and employs it (finance activity) in activities which generate returns on invested capital (production and marketing activities.) Real and financial Assets:A firm acquire real assets to carry on its business. Real assets can be tangible or intangible. Plant, machinery, factory, furniture etc. are examples of tangible real assets, while technical know-how, patents, copy rights are examples of intangible real assets. The firm sells financial assets or securities such as shares and bonds or debentures, to investors in capital market to raise necessary funds. Financial assets also include borrowings from banks, finance institutions and other sources. Funds applied to assets by the firm are called capital expenditure or investment. The firm expects to receive return on investment and distribute return as dividends to investors. EQUITY AND BORROWED FUNDS:There are two types of funds that a firm can raise:- Equity funds and borrowed funds. A firm sells shares to acquire equity funds. Shares represent ownership rights of their holders. Buyers of shares are called share holders and they are legal owners of the firm whose share they hold share holders invest their money shares of a company in expectation of return on their invested capital. The return on shares holder’s capital consists of dividend and capital gain by selling their shares. Another important source of securing capital is creditors or lenders. Lenders are not the owners of the company. They make money available to firm on a lending basis and retain title to the funds lent. The return on loans or borrowed funds is called interest. Loans are furnished for a specified period at a fixed rate of interest. Payment of interest is a legal obligation. The amount of interest is allowed to be treated as expense for computing corporate income taxes. Thus the payment of interest on borrowings provides tax shied to a firm. The firm may borrow funds from a large number of sources, such as banks, financial institutions, public or by issuing bonds or debentures. A bond or I

Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org

Disha Institute of IT & Management
debenture is a certificate acknowledging the money lent by a bond holder to the company. It states the amount, the rate interest and maturity of bonds or dentures. FINANCE AND OTHER MANAGEMENT FUNCTIONS:-

There exists an inseperable relationship between finance on the one hand and production, marketing and other functions on the other. Almost, all kinds of business activities, directly or indirectly, involve acquisition and use of funds. For example, recruitment and promotion of employees in production is clearly a responsibility of production department but it require payment of wages and salaries and other benefits and thus involve finance. Similarly, buying a new machine or replacing an old machine for the purpose of increasing productive capacity affects flow of funds. A company in tight financial position will of course, give more weight to financial considerations and devise its marketing and production strategies in light of financial constraint. On other hand, management of a company, which has a regular supply of funds, will be more flexible in formulating its production and marketing policies. In fact, financial policies will be devised to fit production & marketing decision of firms in practice. OBJECTIVES OF FINANCIAL MANAGEMENT:It is the duty of management to clarify the objectives of business so that the departmental objectives could be determined accordingly. Financial objectives of a firm provide a concrete framework within which optimum financial decisions can be made. The main objective of any firm should be to maximise the economic welfare of its shareholders. Accordingly, there are 2 approaches in this regard. (A) Profit maximisation Approach. (B) Wealth maximisation Approach. (A) PROFIT MAXIMISATION APPROACH:According to this approach, a firm should undertake all those activities which add to its profits and eliminate all others which reduce its profits. This objectives highlights the fact that all decisions:- financing, dividend and investment, should result in profit maximisation. Following arguments are given in favour of profit maximisation approach:I

Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org

in fact. which profits can be maximised under profit maximisation approach. social & economics welfare is also maximised. Now the question arises.000 in 3 years and according to this approach both will be considered equally profitable.000 10. (3) Risk Factor:I Disha Institute of IT & Management Delhi Office: +91-11-65238118.232800 E-mail : info@dishainstitute. the profits of 2 different projects are:Example:YEAR 1 2 3 PROJECT1 5. It helps in efficient allocation and utilisation of scarce means because only such resources are applied which maximise the profits.65238119 Bahadurgarh Office : 01276-324593.org . the value of income received in the first year will be greater from that which will be received in later year e. the value of rupee today will be greater as compared to the value of rupee receivable after one year. under this approach income of different years get equal weight.g.e it can be short term or long term or it can be profit before tax or after tax or it can be gross profit or net profit. (2) Time Value of Money This approach is also criticised because it ignores time value of money i.000 PROJECT2 10. However this approach has been criticised on various counts:(1) Ambiguity:- Profit can be expressed in various forms i.Disha Institute of IT & Management (i) (ii) (iii) (iv) (v) Profit is a yardstick of efficiency on the basis of which economic efficiency of a business can be evaluated. Profit acts as motivator which helps the business organisation to be more efficient through hard work.000 5.000 10. By maximising profits. is more profitable in terms of value of income. The profits earned in initial years can be reinvested and more profits can be earned. But. The rate of return on capital employed is considered as the best measurement of the profits. But Project 1 has greater profits in the initial years of the project & therefore.000 Both the projects have a total earnings of Rs 20. In the same manner.e.232700.

they wanted to increase their assets by maximising profits. all 3 main decisions of financial manager-financing decision. In such a situation profit maximisation approach does not appear proper and practicable for financial decisions. According to this approach .Disha Institute of IT & Management This approach ignores risk factor.65238119 Bahadurgarh Office : 01276-324593. Net present worth can be calculated with the help of following equation. Less income with more certainity is considered better as compared to high income with greater uncertainity.232700. financial institutions etc.+ (1+k)n An -c n At = ∑ -C t t=1 (1+k) I Disha Institute of IT & Management Delhi Office: +91-11-65238118. financial management should take such decision’s which increase net present value of the firm and should not undertake any activity which decrease net present value. This approach eliminates all the 3 basic crificisms of the profit maximisation approach. As the value of an asset is considered from view point of profit accruing from it. High uncertainity increases risk and less uncertainity reduces risk. this approach was more significant for sole trader & partnership firms because at that time when personal capital invested in business. one of the major responsibilities of business management is to co-ordinate the conflicting interest of all these parties.232800 E-mail : info@dishainstitute. Thus to maximise net present worth means to maximise the market price of shares. the greater will be value of firm and more it will be in the interest of share holders.org . B Wealth Maximisation Approach Value Maximisation Approach or Maximum net present worth. the market price of equity shares also increase. The certainity or uncertainity of income receivable in future can be high or less. Therefore. in the same manner the evaluation of an activity depends on the profits arising from it. debenture holders. A1 W= (1+k) + (1+k)2 A2 + --------------------. Thus. Companies are now managed by professional managers and capital is provided by shareholders. investment decision dividend decision affect net present value of the firm. When the value of firm increases. The greater the amount of net present value.

K = Discount rate to measure risk & timing. Although in case of companies.An= Stream of expected cash benefits from a course of action over a period of time. On the basis of above explanation. we can conclude that wealth maximisation approach is better to profit maximisation approach to establish mutual relation among the various data. higher rate of interest will be used to calculate present value of expected future cash benefits where as the interest rate will be lower for the projects with low risk & uncertainity. it would mean that it does not add or reduce the present value of the asset. This approach gives due consideration to the time value of expected income receivable over different period of time.232800 E-mail : info@dishainstitute. to perform the functions of finance. Any decision regarding financial policy should be in line with the laws of the country. A2--. Cash and inventory management. A. Organisation of Finance Function The organisation of finance function implies the division and classification of functions relating to finance because financial decisions are of utmost significance to firms. If W is Zero. credit policy decision all are based on the advanced techniques of statistics. the decision should be taken & vice versa. Therefore. risk and uncertainty is analysed with the help of interest rate. the main responsibility to perform finance function rests with the top management yet the top management (Board of Directors) for convenience can delegate its powers to any subordinate executive I Disha Institute of IT & Management Delhi Office: +91-11-65238118. C= Initial outlay to acquire that asset If W is positive. this approach uses cash flows instead of accounting profits which removes ambiguity associated the term profit. Under this approach.org . forecast of financial needs. Finance is also related to law. This approach is considered good for the companies in present situation. It is possible only through statistics. Besides.65238119 Bahadurgarh Office : 01276-324593.Disha Institute of IT & Management Where W = Net present worth. we need a sound and efficient organisation. If uncertainity & time period are greater.232700.

232700.65238119 Bahadurgarh Office : 01276-324593. There are various reasons to assign the responsibility to the Board of Directors. collecting debtors etc. deputy chairman (finance). The organisation of finance function for a business depends on the nature. The loan paying capacity of the business depends upon the financial operations. Chief Financial Controller. examination of all receipts and payments. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. For such large organisations it is not possible for a finance manager to perform all the finance functions or to co-ordinate with the various departments.232800 E-mail : info@dishainstitute. Each of them have various sub-units under them.Disha Institute of IT & Management which is known as Director Finance. Owner of the business himself looks after the functions of finance including the estimation of requirements of funds. explains the organisation of finance function. For a medium sized business. It includes the financial Manger. Managing Director is the chairman of the committee. preparation of cash budget and arrangement of the required funds. a finance committee is established between the Board of Directors and Managing Director. Financial planning and financial control are quite significant for a large sized organisation. Therefore. preparation of credit policy. For the ‘finance’ sub-department treasurer is appointed and for the ‘financial control’ sub department. no separate officer is appointed for the finance function. In a large sized company the finance function has become more difficult and complex and the position of financial manager has become very important. specialists were appointed for the finance function and the decentralisation of the finance function began.1. Financial Manger or Vice President of Finance. Therefore. The growth and expansion of business is affected by financing policies. The organisation of finance function is not similar in all businesses but it is different from one business to another. with the increase in the size of business.org . Financing decisions are quite significant for the survival of firm. finance executive or treasurer. He is the member of top management of an organisation. Its main function is to advise the Board of Directors on financial planning and financial control and coordinate the activities of various departments. The following chart 1. the responsibility of the finance function is given to a separate officer who is known as financial controller. For a small business. financial controller is appointed. finance and financial control are separated and allocated to two different sub-departments. size financial system and other characteristics of a firm. Besides it is finally the duty of Board of Directors to perform the finance functions. representatives of the directors and departmental heads of various departments. finance manager.

232700. management etc.1. banking. their utilisation.org . pension. investment. controller is responsible for I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Financial Manager is responsible to the Managing Director for his actions. Corporate Accounting & Cost Annual Reports Internal Auding Planning & Budgeting Statistics Treasurer performs the functions of procurement of essential funds. it is clear that treasurer and financial control work under finance Manager. Financial. Credit Analysis Assets Protection Securities Mgt.232800 E-mail : info@dishainstitute. dividend distribution.65238119 Bahadurgarh Office : 01276-324593.Disha Institute of IT & Management From the chart 1. Board of Directors Managing Directing Finance Committee Production Manager Personnel Manager Financial Manager Marketing Manager Treasurer Controller Banking Relations Cash Magt. cash management credit management.

social and political events on industry and company. (5) Business Forecasting:. He gets the reports prepared. auditing.Financial manager examines whether the work is being performed as per pre-determined standards or not. economic.He determines the capital structure and prepares financial plan. He collects necessary data and information and sends them to the Managing Director.It includes the management of assets. international. In India the function of financial manager is given to secretary in most of the companies. (4) Control:.65238119 Bahadurgarh Office : 01276-324593.org . Chief Financial manager is the top officer of finance department.Disha Institute of IT & Management general accounting. Functions of the Chief Financial Manager.232700. cost accounting. (3) Co-ordination:. He performs the functions of treasurer and financial controller along with the routine functions of secretary. budget. controls the cost and analyses profits. I Disha Institute of IT & Management Delhi Office: +91-11-65238118.Financial manager makes the necessary funds available from different sources. He performs following functions: (1) Financial Planning :. arrangement of data and management of bank deposits etc. (2) Procurement of Funds:. management of inventory. He is a member of finance committee. In America he is known as Vice-president finance and in India he is called Chief Financial Controller.Financial manager evaluates the effects of all national. (6) Miscellaneous Functions:.Financial manager establishes co-ordination among the financial needs of various departments. Functions of Treasurer The following are the functions of treasurer. reporting and preparing financial statement etc.232800 E-mail : info@dishainstitute.

232800 E-mail : info@dishainstitute.Controller determines the accounting system and arrangements for costing and management accounting systems and prepares financial statements.org . He advises the management to correct the deviation between the standard performance and actual performance.The treasurer is the custodian of funds and securities. agreement and other letters of company forecasts cash receipts and payments. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. issuing the securities and managing debt etc. (6) Insurance:.65238119 Bahadurgarh Office : 01276-324593. payment of company liabilities. (5) Investments: It involves the investment of surplus funds.The controller prepares plan for controlling the business activities which are the main constituents of management and in which proper arrangement regarding profit planning.232700. (4) Management of credit and collection:.The treasurer signs the cheques.Controller prepares financial reports according to various needs and presents them to the managers.Controller prepares statement on tax liability. (3) Auditing:. capital expenditure planning.Controller Manages internal auditing. (2) Banking Function:.Disha Institute of IT & Management (1) Provisions of finance:.It includes the estimation of funds necessary for procurement preparing programmes and implementing them. (6) Tax Administration :. sales forecasting and expenditure budgeting is made.It includes opening bank accounts. (4) Reports :. establishing relation among various sources of funds. (3) Custody:. accounting cash receipts & payments. (5) Government Reporting :. (2) Accounting:.The treasurer determines credit risk of customers and arranges for collection. Functions of controller The controller performs the following functions:(1) Planning:. pay property taxes and follows government regulations. responsibility for transacting actual assets etc.Controller sends essential information’s to the government by obeying the legal requirement. depositing cash.

(iii) There may be investment opportunities available if the amount is received today which cannot be exploited if equivalent sum is received after one year.org . This concept is called time value of money.a. As such. on Rs 10000) after one year. (ii) The purchasing power of cash inflows received after the year may be less than that of equivalent sum if received today.232800 E-mail : info@dishainstitute. The pecularity of evaluation of capital expenditure proposals is that it involves the decision to be taken today where as the flow of funds. the real value of same in terms of today is not Rs 10000 but something less than that. either outflow or inflow.If Mr.000 if received today.He determines and analyses the effect of economic and social factors on business. the question which arises is “that is the value of flows arising in future the same in terms of today. is the value of this cash inflow really Rs 10. if choice is given to him.000) only after one year. he will like to receive Rs 10000 today or Rs 11000 (i. he will most obviously select the first option why? Because. It goes without saying that for a meaningful comparison between cash outflows and cash inflows.a As such.Disha Institute of IT & Management (7) Economic Appraisal :. Time Value of money: Example:.” For Example:.? The ideal reply to this question is ‘no’. Rs 10000 plus interest @ 10% p.65238119 Bahadurgarh Office : 01276-324593. The value of Rs 10000 received after one year is less than Rs 10. If he has jto receive Rs 10. may be spread over a number of years.232700.000 after one year. if he receives Rs 10000 today he can always invest the same say in fixed deposit with the bank carrying interest of say 10% p. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. X is given the option that he can receive an amount of Rs 10000 either on today or after one year.if a proposal involves cash inflow of Rs 10. Time Value of Money:The evaluation of capital expenditure proposals involves the comparison between cash outflows & cash inflows.e. The reasons for this can be stated as below:- (i) There is always an element of uncertainety attached with the future cash flows.000 as on today when capital expenditure proposal is to be evaluated. both the variables should be on comparable basis.

The assets in which funds can be invested are of 2 types (a) Fixed assets:. it is required to comply with various legal & procedural formalities. wants to raise funds from different sources. the organisation can go for internal & external sources. (b) What are the various sources available to organisation for raisaing the required amount of funds? For this purpose.are decisions regarding application of funds raised by organisation.232800 E-mail : info@dishainstitute. (e) What kinds of changes have taken place recently affecting capital market in the country? (b) Investment decisions:.Disha Institute of IT & Management Finance Functions:(a) Financing decisions (b) Investment decisions (C) Dividend policy decision (d) Liquidity Decision (a) Financing Decisions are decisions regarding process of raising the funds.are the assets which bring returns to organisation over a longer span of time. These relate to selection of the assets in which funds should be invested. The investment decisions in these types of assets are “capital budgeting decisions. This function of finance is concerned with providing answers to various questions like (a) What should be amount of funds to be raised.” Such decisions include 1 How fixed assets should be selected to make investment ? What are various methods available to evaluate investment proposals in fixed assets? 2 How decisions regarding investment in fixed assets should be made in situation of risk & uncertainity? I Disha Institute of IT & Management Delhi Office: +91-11-65238118.org . (c) What should be proportion in which internal & external sources should be used by organisation? (d) If organisation.232700.65238119 Bahadurgarh Office : 01276-324593.

In order to ensure that neither insufficient nor unnecessary funds are invested in current assets. Business will either distribute its net profit among share holders or retain it in business. DIVIDEND POLICY Meaning: Dividend is that part of business income which is distributed among share holders.232700.Disha Institute of IT & Management (b) Current assets:.65238119 Bahadurgarh Office : 01276-324593. Therefore. But it is paid at fixed rate on preference shares where as no rate is fixed for equity shares. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. there is inverse relationship between the amount to be distributed as dividend and amount of profits to be retained in business.org . they will not invest in it in future. Dividend is given to share holders as a return on their investment in the company. Dividend can be paid in the form of shares or securities or cash.232800 E-mail : info@dishainstitute.are assets which get generated during course of operations & are capable of getting converted in form of cash with in a short period of one year.Current assets should be managed efficiently for safe guarding firm against of liquidity & insolvency.Such decisions include (1) What are forms in which dividend can be paid to share holders? (2) What are legal & procedural formalities to be completed while paying dividend different forms? (d) Liquidity Decisions:. If a company does not pay regular dividend to its share holders. Dividend is paid on equity as well as preference shares. Such decisions include (1) What is meaning of Working Capital management & its objectives? (2) Why need for working capital orises? (3) What are factors affecting requirements of working capital? (4) How to quantity requirements of working capital? (5) What are sources available for financing the requirement of working capital? (c ) Dividend Policy Decisions:. The part of profit which is retained in business is called retained earning & it is source of funds for business. the financial manager should develop sound technique of managing current assets.

B Internal Factors. during depression company will like to hold dividend payment in order to preserve its liquidity position. A External Factors:1) Phase of trade cycle:During the phase of boom. determine as proper dividend policy.Disha Institute of IT & Management Business should.232700. Similarly. 5) Restrictions Imposed by Lending Institutions.65238119 Bahadurgarh Office : 01276-324593.232800 E-mail : info@dishainstitute. 4) Nature of Business 5) Growth Rate of Company 6) Liquidity Position 7) Customers & Traditions. Factors determining Dividend Policy A External factors 1) Phase of Trade cycles 2) Legal Restrictions 3) Tax Policy 4) Investment Opportunities.org . 1) Attitude of Management 2) Composition of share holding 3) Age of Company. company may not like to distribute huge amount of profit by way of dividend though earning capacity is more because company will like to retain more profit which can be used during depression. 2) Legal Restrictions:I Disha Institute of IT & Management Delhi Office: +91-11-65238118. therefore. Definition Dividend policy means that decision of the management through which it is determined how much of net profits are to be distributed as dividend among the share holders and how much are to be retained in the business.

232700.A stable company may follow long term dividend policy where as an unstable company may like to retain its profits during boom to ensure dividend policy is not affected by cyclical variations. dividend received by them considered to be a taxable income which increases their individual tax liability. provisions of companies act 1956. 4) Nature of Business:.65238119 Bahadurgarh Office : 01276-324593.From companies point of view dividend can be paid out of profit after fax from share holders point of view. relevant SEBI guide lines are required to be followed by the company. Tax Policy:. it may decide to pay more dividend as the management is interested in increasing income of share holders. If the company wants to issue bonus shares. 5) Growth rate of Company :. Internal Factors:1) Attitude of Management:. the company having less number of shareholders.232800 E-mail : info@dishainstitute. care I Disha Institute of IT & Management Delhi Office: +91-11-65238118. 3) Composition of Share Holders:. Company having less number of shareholders. the company will like to retain more profits and reduces dividend. tax brackets of individual shareholders may not have significant impact on dividend policy of company.Disha Institute of IT & Management If a company wants to pay dividend in cash. the company will like to retain profits to be invested in these projects.org . If the company is a public limited company.A growing concern will like to retain maximum profit in business in order to raise the funds while old company may follow high dividend policy. are required to be followed by company. 4) Investment Opportunities:.If attitude of management is aggressive.If investment opportunities involve higher rate of return than cost of capital. lending banks or financial institutions impose certain restrictions on the company preventing payment of dividend if certain conditions are not fulfilled such as interest on loan is not regularly paid by company. Where as if the attitude of management is conservative.Sometimes. 2) Age of Company:. company will like to retain more profits to take care of contingencies. However.If a company is private ltd. 5) Restrictions imposed by lending institutions:.A rapidly growing company may like to retain majority of its profits in order to take care of its expansion needs.

Indications:I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Unit III Leverages:The term leverages measures relationships between 2 variables. but it may need cash within a short time to pay installments of term loans or to pay creditors for materials.e Contribution) Earnings before interest and tax.It measures effect of change in sales quantity on Earning Before Interest and Taxes (EBIT).232800 E-mail : info@dishainstitute. the term leverage represents influence of one financial variable over some other financial variable. 6) Liquidity Positions:. In financial analysis. In such case.if the company is following stable dividend policy for 20 years.Before formulating dividend policy due considerations should be given to liquidity position of company. 7) Customs & Traditions:.org . 2) Financial leverage. 3) Combined leverage. it may like to maintain trend in 21st year also. In financial analysis generally 3 types of leverages maybe computed:1) Operating leverage. inspite of adverse profitability or liquidity situations. It is Computed As: Sales. finance manager may not like to impair its liquidity for making dividend payment.232700.also affect dividend policy.Disha Institute of IT & Management should be taken by management to invest only in those projects which yield more returns than its cost of capital. For example:. company’s cash position may be comfortable. Eg At present.Variable Cost (i. 1) Operating Leverage:.65238119 Bahadurgarh Office : 01276-324593.

For Example I Disha Institute of IT & Management Delhi Office: +91-11-65238118. As such. it measures the impact of % increase or decrease in sales on earning before interest and taxes. the EBIT has became Rs 4000 instead of Rs 5000 Financial Leverage:It indicates firm’s ability to use fixed financial charges to magnify effects of changes on EBIT on firm’s EPS. In other words. A low degree of financial leverage indicates less use of fixed income bearing securities is capital structure of company.232700. It indicates the extent to which Earnings per Share (EPS) will be affected with change in Earnings Before Interest and Tax (EBIT).65238119 Bahadurgarh Office : 01276-324593.Interest Indications:A high degree of financial leverage indicates high use of fixed income bearings securities in capital structure of the company. It is computed as:EBIT __________ EBIT. For Example:Sales= Rs 20000 Contribution = Rs 10000 Earnings before interest and tax Rs 5000 As such operating leverage is – Contribution = Rs 10000 ____________________ = 2 EBIT Rs 5000 It means that every 1% increase in contribution will increase the EBIT by 2% and vice versa.e. the contribution is reduced by 10% the EBIT is reduced by 20% i. A low degree of operating leverage means that the component of fixed cost is less in over all cost structure.Disha Institute of IT & Management A high degree of operating leverage means that the component of fixed cost is too high in the overall cost structure. when contribution = Rs 9000 Instead of Rs 10000 I.e.org .232800 E-mail : info@dishainstitute.

65238119 Bahadurgarh Office : 01276-324593. Ltd. It means that in case of A Ltd every 1% increase in EBIT will increase EPS by 1. is Rs 20.50 to Rs 15.22% and vice versa.e. As the use of debt capital in capital structure increase EPS.232800 E-mail : info@dishainstitute. EBIT is Rs 5000 and interest on debentures is Rs 900. the company may like to use more & more debt capital in its capital structure by using financial. As such degree of financial leverage can be computed as EBIT ______________ EBIT-Interest Financial Leverage = A. When sales are Rs 20000 where as in case of B. As such. 20% reduction).22 B.40% reduction) Uses of Financial Leverage The degree of financial leverage gives an indication regarding extent to which EPS may be affected due to every change in EBIT. gets reduced from Rs 20.02 High degree of financial leverage is supported by knowledge of fact that in capital structure of A Ltd 90% is the debt capital component.org .6 (i. when EBIT is reduced from Rs 5000 to Rs 4000 (i.24. Ltd Rs 5000 = Rs 5000. For Example:EPS in case of A Ltd.e 20. But in case of B Ltd EPS is only Rs 2. where as in case of B Ltd 10% is debt capital component.Rs 900 =1. gets reduced from Rs 2. Ltd Rs 5000 Rs 5000-Rs900 = 1. The EBIT is Rs 5000 and interest on debentures is Rs 100 when sales are Rs 20000.72 to Rs 21.50 when sales are Rs 20000 as 90% of its capital is debt capital.50 (i.72 when sales are I Disha Institute of IT & Management Delhi Office: +91-11-65238118.e.Disha Institute of IT & Management In case of A Ltd.40 % reduction) & EPS of B Ltd.232700. EPS of A Ltd.

e.232800 E-mail : info@dishainstitute. which may not be maximising share holder’s wealth. Sales-Variable Cost _______________ EBIT Sales-Variable Cost = __________________ EBIT. interest.Disha Institute of IT & Management Rs 20000 as only 10% of its total capital is debt capital. Financial leverage also acts as a guide line in setting maximum limit upto which the company should use the debt capital. as such market price of shares may decline. It assumes that the use of debt capital may be useful so long as company is able to earn more than cost of debt i. Before considering capital structure. the phase is often used that financial leverage magnifies both profits and losses.232700. 3) Combined Leverage:The combined effect of operating leverage & financial leverage measures the impact of change in contribution on EPS. With every increase in debt capital.org . implicit cost of debt should be considered. As such. 2) It assumes that cost of debt remain constant regardless of degree of leverage which is not true. Increasing use of debt capital makes the investment in the company a risky proposition.Interest For Example:EBIT X___________ Ebit-Interest = I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Limitations:1) It ignores implicit cost of debt. But it is not always connect. interest rate goes on increasing due to increased risk involved with the same. It is computed as:- Operating leverage X Financial leverage.65238119 Bahadurgarh Office : 01276-324593.

Variable Cost (i. High Financial Leverage:It indicates very risky situation as a slight decrease in sales and contribution may affect EPS to great extant.org .72 to Rs 2. Every 1% increase in contribution. 10% reduction.50 to Rs 15. EPS of A Ltd gets reduced from Rs 20.4 reduction) Indications:(1) High Operating Leverage.e. So.04%.232700.50 ( i. This situation may be considered an ideal situation.4% reduction) & EPS of B Ltd gets reduced from Rs 2. 24. As such combined leverage can be Sales.65238119 Bahadurgarh Office : 01276-324593. (3) Low Operating Leverage.e.Disha Institute of IT & Management In case of both A Ltd & B Ltd when sales are Rs 20000 contribution is Rs 10000 but earnings after interest and before tax are Rs 4100 and 4900. Contribution) ______________________________ EBIT-Interest A Ltd. As such when contribution gets reduced from Rs 10000 to Rs 9000 i. 20. High Financial Leverage It indicates decrease in sales/contribution will not affect EBIT to great extent.04 = = It Means that in case of A Ltd every IX increase in contribution will increase EPS by 2. (2) High Operating Leverage. _____ 10000 ______ 4100 = 2. this situation is should be avoided. I Disha Institute of IT & Management Delhi Office: +91-11-65238118.e. will increase EPS by 2.e. _____ 10000 ______ 4900 = 2.16 (i.232800 E-mail : info@dishainstitute.44% & vice versa while in case of B Ltd. Low Financial Leverage it indicates that a slight decrease in sales and contribution may affect EBIT to great extent due to existence of high fixed cost but this possibility is already taken care by low proportion of debt capital in overall capital structure.44 B Ltd.

It is easy to compute before tax cost of debt issued & to be redemed at par. A debenture or bond may be issued at per or at discount or premium.65238119 Bahadurgarh Office : 01276-324593. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. the firm’s cost of capital will be overall. Thus:Kd= I= INT ___ Bo Where. a company decides to sell a new issue of 1 years 15% bond of Rs 100 Each at par. The minimum acceptable rate or required rate of return is a compensation for time and risk in use of capital by project.232700. each one of them will have its own unique cost of capital. the before tax cost of debt will simply be equal to rate of interest of 15%. It may borrow funds from financial institutions or public either in form of public deposits or debentures for a specified period of time at certain rate of interest. For example. The firm represent aggregate of investment projects under taken by it.232800 E-mail : info@dishainstitute. it is simply equal to contractual interest.org . required rate of return on aggregate of investment projects. Determining Component Cost of Capital:1) Cost of Debt:A Company may raise debt in various ways. Since investment projects may differ in risk. (a) Debt issued at Par:The before tax cost of debt is rate of return required by lenders. Therefore.Disha Institute of IT & Management (4) Low Operating Leverage. If company realises full face value of Rs 100 bond & will pay Rs 100 Principal to bond holders at maturity. or average. Low Financial Leverage It indicates decrease in sales/contribution will not affect EBIT to great extent as the component of fixed cost is negligible in overall cost structure. Unit II Cost of Capital The project’s cost of capital is minimum acceptable rate of return on funds committed to the project.

2).65238119 Bahadurgarh Office : 01276-324593. of interest. After-tax cost of debt = kd (I-T) Where T= Corporate tax rate. Irre Deemable Preference share:The preference share may be treated as a perpetual security if it is irredeemable Thus.232700.e. This equation is used to find out whether cost of debt issued at par or discount or premium. Cost of Preference Capital:The measurement of cost of preference capital poses some conceptual difficulty. i.232800 E-mail : info@dishainstitute. there is binding legal obligation on the firm to pay interest & interest constitutes basis to calculate cost of debt. the lower will be amount of tax payable by the firms. INT = amt. (B) Debt issued at Discount or Premium:n INTt ∑ _________ t=1 (1+kd)t Bn + _________ (1+ kd)n Bo = Where Bn= repayment of debt on maturity and other variable as defined earlier. In case of debt. its cost is given by following equation:I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Bo= f or Bo>f or Bo<F. rather it is a distribution or appropriation of earnings to preference share holders. it is not a charge on earnings. This implies that the government indirectly pays a part of lender’s required rate of return. kd should therefore. The before tax cost of debt. payment of dividends is not legally binding on the firm & even if the dividends are paid. be adjusted for tax effect as follows. I = coupan rate of interest. B = Issue price of debt.Disha Institute of IT & Management KD= before-tax cost of debt. after tax cost of debt to the firm will be substantially less than investor’s required rate of return. Tax adjustment:The interest paid on debt is tax deductible. in case of preference capital. However. As a result the interest tax shield.org . The higher the interest charges.

Disha Institute of IT & Management PDIV KP= _______ PO Where.A firm whose dividend are expected to grow at a constant rate of g is as follows I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Normal Growth:. Kp= Cost of Preference share PDIV= expected preference dividend Po= Issue price of preference shares.65238119 Bahadurgarh Office : 01276-324593. Preference dividends do not save any taxes. however.232700. Cost of Retained Earnings:The opportunity cost of retained earnings (internal earnings) is the rate of return on dividends foregone by equity shareholders. Redeemable Preference Share:n PDIVt =∑ ____ T=1 (1+Kp)t PN ________ (1+Kp)n PO + Cost of Preference share is not adjusted for taxes because preference dividend is paid after corporate taxes have been paid. Thus cost of Preference share is automatically computed on an after tax basis. The required rate of return of shareholder can be determined from dividend valuation model. There is. a difference between retained earnings & issue of equity shares from firms point of view.232800 E-mail : info@dishainstitute. shareholder are providing funds to the firm to finance their capital expenditures. Alternatively. the after tax cost of preference is substantially higher than after tax cost of debt. 3) Cost of Equity Capital:Firms may raise equity capital internally by retained earnings. Therefore. equity shareholders required rate of return will be same whether they supply funds by purchasing new shares or by for going dividends which could have been distributed to them. they could distribute the entire earnings to equity share holders & raise equity capital externally by issuing new shares. In both cases.org . The shareholders generally expect dividend and capital gain from their investment. Since interest is tax deductible & preference dividend is not.

at end of year n and therefore it is equal to :- Pn = DIV n+1 ________ Ke-gn Zero growth DIVl Ke =______ Po The growth rate g will be zero if firm does not retain any of its earnings.Disha Institute of IT & Management Divl Po = Ke-g Where DWl= DIVo (1+g) Super normal growth:Dividends may grow at different rates in future. it may become normal indefinitely in future.232800 E-mail : info@dishainstitute. it may. beginning in year n+1 & growing at a constant. I Disha Institute of IT & Management Delhi Office: +91-11-65238118.232700.65238119 Bahadurgarh Office : 01276-324593. at a normal perpetual growth rate of In beginning in year n+1 then cost of equity can be determined by following formula. perpetual rate gn. n DIV0 (1+gs)t Po= ∑ __________ t=1 (1+ke)t Pn ________ (1+ke)n + Pn= Discounted value of dividend stream.org . The dividend valuation model can be used to calculate cost of equity under different growth assumptions. If the dividends are expected to grow at a super normal growth rates g for n year & there after. For example. The growth rate may be very high for a few years & after wards.

I Disha Institute of IT & Management Delhi Office: +91-11-65238118.232700. then its weighted average cost of capital. If we assume that a firm has only debt & equity in its capital structure. 3) Add weighed components costs to get firm’s weighted average cost of capital. cost of equity.org .Disha Institute of IT & Management Cost of External Equity The minimum rate of return which equity share holders require on funds supplied by them by purchasing new share to prevent a decline in existing market price of equity share is the cost of external equity. It is relevant in calculating over all cost of capital. cost of preference capital etc). S= amount of equity. 2) Multiply cost of each sources by its proportion in capital structure. cost of capital is the weighted average of costs of various sources of funds. The composite. The firm can induce existing or potential share holders to purchase new shares when it promises to earn a rate of return equal to:Divl Ke= ______ + g Po Weighted Average (Cost of Capital) After calculating costs.65238119 Bahadurgarh Office : 01276-324593. cost of debt. In order to calculate weighted cost of capital component cost should be ofter tax costs.e. The following steps are involved to calculate weighted average cost of capital:1) Calculate cost of specific sources of funds (i. they are multiplied by weights of various sources of capital to obtain a weighted cost of capital (WACC). (Ro) Will be:- Ko= kd (1-T) Wd+kewe Ko= Kd (1-T) D+ + ke S ____ ___ D+S D+S Where Ko= Weighted average cost of capital Kd(1-t) ke are after tax cost of debt & equity D= amount of debt.232800 E-mail : info@dishainstitute.

Consequently. Ans. The first assumption implies that if ke & kd are constant.org . ko will decrease. as a result equity capitalisation rate (kc) & debt-capitalisation rate (kd) remain constant with changes in leverage. V increases. will result in higher value of the firm via higher value of equity.232800 E-mail : info@dishainstitute. Write notes on the following. overall or weighted average cost of capital.e. kd < ke) 3) The corporate income taxes do not exist.232700. increased use of debt by magnifying the shareholders earnings. NET OPERATING INCOME APROACH I Disha Institute of IT & Management Delhi Office: +91-11-65238118.Disha Institute of IT & Management Unit. The overall cost of capital is measured by EqX Noi Ko= ___ =___ V V Thus.65238119 Bahadurgarh Office : 01276-324593.III Theories of Capital Structure (1) Net Income Approach:The essence of net income approach is that the firm can increase its value or lower the overall cost of capital by increasing proportion of debt in capital structure. 2) The debt capitalisation rate is less than equity-capitalisation rate ( rate (i. with constant annual net operating income (NOI) overall cost of capital of capital would decrease as the value of firm. The assumption of this approach are:1) The use of debt does not change the risk perception of investors. Ques6.

It is mostly dept is circulation by releasing it back after selling the products and reinvesting it in further production. overall cost of capital is a constant. the differences lies in the rate of their recovery. If the business risk is assumed to remain unchanged. which is constant. Thus. This causes the equity capitalisation rate to increase. The critical assumptions of the NOI approach are: a) The market capitalizes the value of the firm as a whole. The overall capitalisation rate depends on the business risk of the firm. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Working capital shall be recovered much more quickly as compared to fixed capitals which would last for several years. both fixed and working capitals shall be recovered from the business.232800 E-mail : info@dishainstitute.65238119 Bahadurgarh Office : 01276-324593. Thus the split between debt and equity is not important. e) The corporate income taxes do not exist. It is independent of financial mix. If NOI and average cost of capital are independent of financial mix. Thus. Ans. the advantage of debt is offset exactly by the increase in the equitycapitalisation rate.Disha Institute of IT & Management According to the net operating income (NOI) approach the market value of the firm is not affected by the capital structure changes. The market value of the firm is found out by capitalizing the net operating income at the over all or the weighted average cost of capital. Explain the concept of working capital.org . we find that the weighted cost of capital is constant and the cost equity increase as debt is substituted for equity capital. Discuss the working capital need of a manufacturing firm. As the process of production become more round about and complicated the production to fixed working capital increase correspondingly. Though. b) The market uses an overall capitalisation rate. Working capital is used in operating the business. Money required by the company to meet out day today expenses to finance production and stocks to pay wages and other production etc is called the working capital of the company. market value of firm will be a constant are independent of capital structure changes. Overall cost of capital depends on the business risk. d) The debt capitalisation rate is constant. c) The use of less costly debt funds increases the risk to shareholder.232700. Ques7. It is because of this regular cycle that the working capital requirements are usually for short periods. to capitalize the net operating income.

which is also known as an intermediate approach. or acceptable. an optimum capital structure exists. the weighted average cost of capital will decrease with the use of debt. According to this view. Working capital.65238119 Bahadurgarh Office : 01276-324593.3 I Disha Institute of IT & Management Delhi Office: +91-11-65238118. however. The cost of capital declines with leverage because debt capital is cheaper than equity capital within reasonable. working capital management refers to the management of current assets and current liabilities. marketable securities. the manner in which the overall cost of capital reacts to changes in capital structure can be divided into three-stages.232700. This approach very clearly implies that the cost of capital decreases within the reasonable limit of debt and then increases with leverage. the value of the firm can be increased or the cost of capital can be reduced by a judicious mix of debt and equity capital. represents investment in current assets. inventories and bills receivables. Thus. According to the traditional position. limit of debt. is a compromise between the net income approach and the net operating approach. plus the increased cost of equity. Current liabilities mainly Cost of Capital (Percent) ke ko kd Leverage Figure 18.Disha Institute of IT & Management Therefore.2 The effect of leverage on the cost of capital (NOI approach) EXISTENCE OF OPTMUM CAPITAL STRUCTURE: THE TRADITIONAL VIEW The traditional view. The statement that debt funds are cheaper than equity funds carries the clear implication that the cost of debt.2 In other words. together on a weighted basis.org .232800 E-mail : info@dishainstitute. such as cash. will be less than the cost of equity which existed on equity before debt financing. and it occurs when the cost of capital is minimum or the value of the firm is maximum.

K0 = X/V= Ke (S/V) + kd (D/V). remains constant or rises negligibly since the market view the use of debt as a reasonable policy.232700.KdD V=S+D = Ke + kd kdD = ke X . or the cost of capital of the firm. increases or the overall cost of capital. p. Alexander. cit. remains constant or rises slightly with debt.. 94. ke. Under the assumption that Ke remains constant within the acceptable limit of debt.65238119 Bahadurgarh Office : 01276-324593. But when it increases. Solomon. (Ke-Kd)/Ke. During this stage. cit. i. with ke>Kd. When equation(9) is solved for X/V. p. Second Stage: Optimum Value Once the firm has reached a certain degree of leverage. Inc. The traditional capital structure theory has been popularised by Ezra Solomon. This is so because the increases in the cost of equity due to the added financial risk offsets I D Disha Institute of IT & Management Delhi Office: +91-11-65238118. op. the cost of equity. we get [See equation(6): X = ko=ke-(ke-kd) V V This Implies that.232800 E-mail : info@dishainstitute.kdD +D= ke X + ke (ke-kd)D Thus. the value of the firm V increases at a constant rate. 1963. so long as Ke and Kd are constant. Barges. it does not increase 1.. Kd.org . as the amount of debt increases. The Effect of Capital Structure on the Cost of Capital. Prentice-Hall. the cost of debt. the rate at which the shareholders capitalise their net income. op. increases in leverage have a negligible effect on the value. As a result.e. Fast enough to offset the advantage of low cost debt. V. 2.Disha Institute of IT & Management First Stage: Increasing Value In the first stage. the value of the firm will be: X . 3. the average cost of capital will decline with leverage.11. the value of the firm. falls with increasing leverage..

This precise point defines the optimum capital structure. This implies that there SECTOR 15 of MARKET. The relation between costs of capital and leverage is graphically shown in Figure 18. the value of the firm will be maximum or the cost of capital will be minimum. I Disha Institute of IT & Management Ke Delhi Office: +91-11-65238118. In Figure 18. Third stage: Declining value Beyond the acceptable limit of leverage.Disha Institute of IT & Management the advantage of low cost debt.4 the cost of capital curve is shown to be U-shaped. the value of the firm decreases with leverage or the cost of the capital increases with leverage. SCF-54 (B’MNT) is a range saucer-shaped with a horizontal range. This happens because investors perceive a high degree of financial risk and demand a higher equity-capitalisation rate which offsets the advantage of low-cost debt.65238119 Bahadurgarh Office : 01276-324593. capital structures in which the cost of capital is minimised. Within that range or at the specific point.232800 E-mail : info@dishainstitute. Ke Cost of capital ( per cent) Ko Kd Leverage 0 L L Figure 18.org Ko . It declines with leverage and after reaching a minimum point or range starts rising. Under such a situation there is a precise point at which the cost of capital would be minimum.3 wherein the overall ITS STUDY CENTRE ko is cost of capital curve.232700. ke is assumed to FARIDABAD PH 5002194-95 increase slightly in the beginning and then at a faster rate.3 The costs of capital behaviour (traditional view) The overall effect of these three stages is to suggest that the cost of capital is a function of leverage.

232700.3 To illustrate the traditional approach.4. Assume that Rs 300000 debentures can be raised at 6 per cent interest rate. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. whereas Rs 600000 debentures are raised at a rate of interest of 7 per cent.00. but it would increase to 10. as a number of different cost of equity curves can be consistent with a declining average cost of capital curve. Whether are cost of equity function is horizontal or rising slightly is not very pertinent from the theoretical point of view.00000 and. assume that a firm is expecting a net operating income of Rs 1. to 12. The market value of the firm.000 The equity capitalisation rate is 10 per cent.6.3 and 18.org . As indicated in Figures 18. ILLUSTRATION 18. 1 All the supporters of the traditional view agree that the cost of capital declines with debt. The relevant issue is whether or not the average cost of capital curve declines at all as debt is used.4 The costs of Capital behavior (traditional view-a variation) Many variations of the traditional view exist. some writers imply the cost of equity function to be horizontal over a certain level and then rising. value of shares and the average cost of capital are shown in Table 18.56 per cent when the firm substitutes equity capital by issuing debentures of Rs 3.5 per cent when debentures of Rs 600000 are issued to substitute equity capital.50000 on a total investment of Rs 10.Disha Institute of IT & Management -+ Cost of Capital (Per cent) Figure 18.65238119 Bahadurgarh Office : 01276-324593.232800 E-mail : info@dishainstitute. while others assume the cost of equity function rising slightly in the beginning and then at a faster rate. if the firm has no debt.

097 7%Rs 6.000 0. S= (X.00.64. Therefore..32. However. op. It simply changes the way in which the income is distributed between equity holder and debt-holders.000 18.50.INT 1. but differing in their modes of financing.00.000 Debt 1.00.50. Barges. X. The form of financing can neither change the net operating income nor the risk attached to it. the argument of the traditional theorists that an optimum capital I Disha Institute of IT & Management Delhi Office: +91-11-65238118. V= S+D 15.00.50.000 Cost of equity. They do not accept the contention that moderate amounts of debt in ‘sound’ firms do not really add very much to ‘riskiness’ of the shares.103 Net operating income.125 8.000 Total cost of debt.000 42. p.000 1.65238119 Bahadurgarh Office : 01276-324593. INT = KdD 0 Net income.000 0.6 MARKET VALUE AND THE COST OF CAPITAL OF THE FIRM (TRADIATIONAL APPROACH) No Debt 6% Rs 3.org . The traditional view it criticised because it implies that totality of risk is distributed among the various classes of securities. Ko = X/V 0.232800 E-mail : info@dishainstitute.64.232700.000 0. Table 18.50.000 Debt 1.15.00.10 Criticism of the Traditional View The validity of the traditional position has been questioned on the ground that the market value of the firm depends upon its net operating income and risk attached to it.000 15.000 14.10 Market value of shares.000 3.00. They assert that sufficient justification does not exist for such and assumption. Ke 0. They criticise the assumption that the cost of equity remains unaffected by leverage up to some reasonable limit.50.000 INT)ke Market value of debt. firms with identical net operating income and risk.000 Average cost of capital.08.50.12. should have same total value. D 0 Total value of firm.000 0.000 6. X 1.1056 12.000 1.Disha Institute of IT & Management 1. cit.1 Modigliani and Miller also do not agree with the traditional view.

and (c) they behave rationally. This specifically means that (a) investors are free to buy or sell securities. the cost buying d selling securities. 229-30. pp...e. as described below. IRRELEVANCE OF CAPITAL STRUCTURE: THE MODIGLIANI-MILLER HYPOTHESIS WITHOUT TAXES The Modigliani-Miller (M-M) hypothesis is identical with the net operating income approach. particularly relate to the behaviour of investors and capital market.1 • • I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Risk The risk of investors is defined in terms of the variability of the net operating income (NOI). It is also implied that the transaction cost.232800 E-mail : info@dishainstitute. • Perfect capital markets Securities (share and debt instruments) are traded in the Perfect capital market situation. 1. 261-297. cit. (M-M) argue that. It is generally implied under the M-M hypothesis that firms within same industry constitute a homogenous class. in the absence of taxes. 2. be noticed that their propositions are based on certain assumptions. Assumptions The M-M hypotheses can be best explained in terms of their Propositions I and II. It should. The risk of investors depends on both the random fluctuations of the expected NOI and the possibility that the actual value of the variable may turn out to be different than their best estimate. op. and reject any other capital structure theory as incorrect. Firms would be considered to belong to a homogenous risk class if their expected earnings have identical risk characteristics. (b) they can borrow without restriction at the same terms ad the firms do.65238119 Bahadurgarh Office : 01276-324593. Durand. Homogeneous risk classes Firms can be grouped into Homogenous risk classes. however. In their 1958 article. pp.Disha Institute of IT & Management structure exists can be supported on two counts: the tax deductibility of interest charges and market imperfections. i. the actions of the firm and the tax environment. These assumptions. do not exist.org .2 they provide analytically sound and logically consistent behavioural justification in favour of their hypothesis. and Miller op. Modigliani. cit..232700. a firm’s market value and the cost of capital remain invariant to the capital structure changes.

P.2 This is their Proposition I and can be expressed as follows: Value of the firm = Market value of equity + Market value of debt Expected net operating income = Expected overall capitalization rate X V=(S+D)= ko Where V= the market value of the firm S= the market value of the firm’s ordinary equity D= the market value of debt X= the expected net operating income on the assets of the firm K0 = the capitalisation rate appropriate to the risk class of the firm. Proposition I can be stated in an equivalent way in terms of the firm’s average cost of capital which is the ratio of the expected earning to the market value of all its securities. the total market value is independent of the debt-equity mix and is given by capitalizing the expected net operating income by the rate appropriate to that risk class. Full payout Firms distribute all net earnings to the shareholders.65238119 Bahadurgarh Office : 01276-324593. A. Optimal Financing Decisions. PP. Myers. which means a 100 per cent payout. 1. Prentice-Hall. Modigliani and Miller op. for firms in the same risk class. M-M argue that. 2. Robichek.Disha Institute of IT & Management • • No taxes In the original formulation of their hypothesis. 31-34. Proposition I Given the above stated assumptions. 266. M-M assume that no corporate income taxes exist. cit. That is: X = (S+D) V X = ko = ko NOI I Disha Institute of IT & Management Delhi Office: +91-11-65238118. and S.232700..232800 E-mail : info@dishainstitute.org . 1965.

then expected net operating income is given as follows: X=KoV=keS+kdD As given in Equation (5). as hypothesized by M-M through Proposition I. I Disha Institute of IT & Management Delhi Office: +91-11-65238118.org .232700. and since M-M conclude that the total market value of the firm is unaffected by the financing mix. Since the cost of capital is defined as the expected net operating income divided by the total market value of the firm.5 The cost of capital under M-M proposition I Equation (5) expresses Ko as the weighted average of the expected rate of return of equity and debt capital of the firm.Disha Institute of IT & Management If we define Kd as the expected return on the firm’s debt and Ke as the expected return on the firm’s equity.232800 E-mail : info@dishainstitute.65238119 Bahadurgarh Office : 01276-324593. it follows that the cost of capital is independent of the capital structure and is equal to the capitalisation rate of a pure-equity stream of its class. by definition X ko = V S Ko = ke S+D + kd S+D D Cost of capital (per cent) ko Ke D/V Leverage Figure 18. The cost of capital function.

00. You can now buy 10 per cent of the unlevered firm U’s shares.10 (10000.10 (X-INT) = 0.232800 E-mail : info@dishainstitute. Their opinion is that if two identical firms. The value of the levered firm (V) is Rs 11000 the value of equity shares (Su)=Vu) is Rs100000.000) Rs 1. have different market values.000 And your return will be: Return = 0. Your investment will be: Investment = 0. What is your return from your investment in the shares of firm L? Since you own 10 per cent of the shares. Arbitrage Process Why should proposition I hold good? The simple principle of proposition I is that two firms identical in all respects except for their capital structures.10 (1000-50000)= Rs 6000 You can earn same return at less investment through an alternate investment strategy.10 (10.000) = 0.4 Suppose two firms: unlevered firm U and levered firm L – have identical expected net operating income (x) of Rs 10000.Disha Institute of IT & Management is shown in Figure 18. Assume further that you hold 10 per cent shares of the levered firm L.10 (10000-0. and by borrowing on your personal account an amount equal to your share of firm L’s corporate borrowing at 6 percent rate of interest 010(50000) = Rs5000. It is evident from the figure that the average cost of capital is a constant and is not affected by leverage. This you can do by selling your investment in firm L’s Share for Rs 6000. ILLUSTRATION 18.06X 50.65238119 Bahadurgarh Office : 01276-324593. you are entitled to 10 per cent of the equity income: Return = 0. Firm L has borrowed at the expected rate of return (Kd) of 6 per cent.000 I Disha Institute of IT & Management Delhi Office: +91-11-65238118.000) Rs= 10. You have Rs 11000 with you. arbitrage (or switching) will take place to enable investors to engage in personal or home-made leverage as against the corporate leverage to restore equilibrium in the market. Consider an example. except for the degree of leverage. cannot command different market value or have different cost of capital.org . M-M do not accept the NI approach as valid.10 (1.5.3000= Rs 700 (where INT= KdDt) and the value of your investment is: investment = 0.232700.

Let us assume that Vu=Su= Rs 1.000) Add : Borrowing.000) Remaining cash Rs 6. you will have to pay an interest of Rs 300: Interest =0.000.000 And your investment will be: Investment = 0.10 (1.000+ Rs 50. a number of investors will be induced towards it they will sell their shares in firm L and buy shares and debentures of firm U. You sell your shares in firm U for Rs 10.1 (1.1 (60.232700.000) = Rs 10.65238119 Bahadurgarh Office : 01276-324593.000) 1. suppose that you own 10 per cent shares in the unlevered firm U: Your return will be: Return= 0.10 (10.00.000= Rs 300 Thus your net return is Rs 700 as shown below: Rs 1.00.06X5. = 0. you have borrowed Rs 5.1 (50. Therefore. The arbitrage would work in the opposite direction if we assume that the value of the unlevered firm U (Vu) is greater than the value of the levered firm L (Vl).000 Due to the advantage of the alternate investment strategy.000 and Vl=Sl+Dt=Rs 40.000 300 700 Equity return from U Less: Interest on personal borrowing Net Return Note that you are also left with cash of Rs 1.Disha Institute of IT & Management However.000) Less: Investment in firm U=0.000: Sale of firm L’s shares. I Disha Institute of IT & Management Delhi Office: +91-11-65238118.org . It will continue until the equilibrium price for firm U’s and firm L’s shares is reached. Further. Now you buy 10 per cent of firm L’s share and debt. Your investment in firm L is Rs 9.000 5. this arbitrage will tend to increases the price of firm U’s shares and to decline that of firm L’s shares. 0.000.000 at 6 per cent.000 You can design a better investment strategy.000) = Rs 1.000.000 = Rs 90.00.232800 E-mail : info@dishainstitute.000 (10.

000 Equity income. 1. 1 In the first instance.1 (50.65238119 Bahadurgarh Office : 01276-324593. As a result of this switching. 0. the market value of the levered firm’s shares will increases and that of the unlevered firm will decline. pp. your return will include both equity income and interest income.Disha Institute of IT & Management Investment= 0. M. X. let Vt>Vu Both firms earn the same expected net operating income. but his alternative investment strategy costs him less since Vt<Vu.000) = Rs 1.000 (4.000) (5.000 You can also calculate your return as follows: Rs 700 300 1. 0. 0.000) 1.000 Since you own 10 per cent of equity and debt of firm L.000) =4. In such a situation.000) Investment in firm L’s share.000) Remaining cash Both strategies give the investor same return. 0. marginal investors will sell their shares in the unlevered firm and buy the shares and debentures of the levered firm.000 cash.org . F and Miller.1 (40. His investment and return will be as follows: Investment I Investment Disha Institute of IT & Management Delhi Office: +91-11-65238118.06 (5. In the equilibrium Vt=Vu. 59 (Sept 1969).000+50.000) Return Note that your alternative investment strategy pays you off the same return at a lesser investment. Rs 10. You are left with Rs 1. The borrowing and lending Rate is Kd.000) Investment in firm L’s debt.10 (10.000= Rs 9.592-95.000) Interest income.Reply to Heins and Sprenkle. Assume that an investor hold  (alpha) fraction of firm L’s shares.000-3.10 (40.H. We can generalize our discussion as follows..00. 0.1(1. Thus your return is Rs 1.10 (10.000 Sale of firm U’s shares.232700. Modigliani.000: Return = 0. American Economic Review.232800 E-mail : info@dishainstitute.000+5.

and henceforth. market ITS STUDY CENTRE values of the two firms will reach equilibrium. Investors will therefore sell shares of firm U and buy shares of firm L.65238119 Bahadurgarh Office : 01276-324593. The rational investors at the margin would prefer switching from levered to unlevered firm. The increasing demand for the unlevered firm’s shares will decreases their market price.Disha Institute of IT & Management Investment in L’s share  )Vt-Dt) (X-kdDt) The investor in our example can design the following alternative investment strategy: Investment  Vu - Dt (Vu-Dt) Investment X -kdDt (X-kdDt) Buy fraction of U’s share Borrow equal to fraction of L’s debt Total The investor obtains the same return. It does not have any impact on the I Disha Institute of IT & Management Delhi Office: +91-11-65238118. This arbitrage will cause the price of firm U’s shares to decline and that of firm L’s shares to increases. in equilibrium Vl=Vu.org . Thus. FARIDABAD PH 5002194-95 Let us take the opposite case where Vu>Vl. but his first investment strategy costs more since V1> Vu. Suppose our investor holds  fraction of firm U’s shares. M-M conclude that the market value of a firm (or its cost of capital) is not affected by leverage. His investment and return will be as follows: Investment in U’s shares Investment  Vu Return X The investor can design an alternate investment strategy as follows: Investment  (Vl-Dt) + Dt  Vt Return  (X-kdDt) +  kdDt X Buy fraction of L’s shares Buy equal to fraction of L’s debt Total If you can earn the same return with less investment. MARKET. On the basis of the arbitrage process.232800 E-mail : info@dishainstitute. Ultimately. It will continue until the price of the levered firm’s shares equals that of the unlevered firm.  (X-Kd D1). other can also benefit similarly. in both the cases. the financing (or capital structure) decision is irrelevant.232700. Thus. arbitrage will not15 SCF-54 (B’MNT) SECTOR be beneficial.

Proposition II M-M’s Proposition II. Ke is equal to the constant average cost of capital. measured by the market value I Cost of capital Cost of Capital ke ko kd D/S Disha Institute of IT & Management 0 Leverage Delhi Office: +91-11-65238118. the cost of equity. which defines the cost of equity.Disha Institute of IT & Management maximisation of market price per share.232700. follows from their Proposition I. the following equation: X=koV=ko(S+D) Substituting Equation (10) into Equation (3). This implies that one capital structure is as much desirable as the other. Ko.232800 Figure 18. the cost of equity. for any firm in a given risk class. (Ko-Kd) D/S. Ke. plus a premium for the financial risk.6 Cost of equity under the ME-mail : info@dishainstitute. which is equal to debtequity ration times the spread between the constant average cost of capital and the cost of debt. The cost of equity Formula can be derived from M-M’s definition of the average cost of capital.org M . we have Ko(S+D)-kdD Ke = S = S KoS+koD-kdD =Ko+(ko-kd) S D Equation (7) states that. The expected yield on equity or the cost equity is defined as follows: X-kdD Ke = S Since we know from Equation (4) that X ko = V And Ko and V are constant by definition. is a linear function of leverage.65238119 Bahadurgarh Office : 01276-324593.

I FARIDABAD PH 5002194-95 Disha Institute of IT & Management Delhi Office: +91-11-65238118. and consequently. Criticism of the M-M Hypothesis The arbitrage process is the behavioural foundation for the M-M thesis. is valid irrespective of any particular valuation theory. Thus. Ke declines. while according to the more popular traditional view Ko is a function of leverage.’ Op. Due to the existence of imperfections in the capital market. ke=ko+(ko-kd) D/S. But in practice Kd increases with leverage beyond a certain acceptable. or reasonable level of debt. they are able to borrow at CENTRE ITS STUDY lower rates of interest than individuals. M-M insist that the arbitrage process will work and that as Kd increases with debt. leverage will result not only in more earnings per share to shareholders but also increased cost of equity. firms have a higher credit standing. It should. the firm’s market value will remain unaffected. cit. remains constant for any degree of leverage. then the equalization process will fall short of completion. own the firm’s assets and bear some of the firm’s business risk. however. Kd. increases Ke will increases at a decreasing rate and may even turn down eventually.65238119 Bahadurgarh Office : 01276-324593. M-M maintain that even if the cost of debt. be noticed that the functional relationship. Ke will become less sensitive to further borrowing. 1. Kd. M-M assume Ko to be constant. Since the risk of shareholders is transferred to debt-holders.232800 E-mail : info@dishainstitute. “The Cost of Capital…. The benefit of leverage is exactly taken off by the increased cost of equity. Modigliani and Miller. However. D/S. As a result. arbitrage may fail to work and may give rise to discrepancy between the market values of levered and unlevered firms.Disha Institute of IT & Management of debt to equity. If the cost of borrowings SCF-54 (B’MNT) SECTOR 15the to an investor is more than firm’s borrowing rate. The arbitrage process may fail to bring equilibrium in the capital market for the following reasons:1 Leading and borrowing rate discrepancy The assumption that firms and individuals can borrow and lend at the same rate of interest does not hold good in practice. Because of the substantial holding of fixed assets. For example.org . This conclusion could be valid if the cost of borrowings.1 This is illustrated in Figure 18. The crucial part of the M-M thesis is that Ko will not rise even if very excessive use of leverage is made.232700. In MARKET.6. The reason for this is that debt-holders. The shortcomings of this thesis lie in the assumption of perfect capital market in which arbitrage is expected to work. in the extreme situations.

Capital Structure and the Cost of Capital.4. Unit IV I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Thus. if the investors can borrow at 9 per cent. Because of the costs involved in the buying and selling securities. cit. 1.. simply because they are not allowed to engage in the “home-made” leverage. (May 1963). Journal of Finance. Institutional restrictions Institutional restrictions also impede the working of arbitrage. Consequently. then in the event of the firm’s insolvency. VU.4 if the investor keep his investment in the levered firm. Vikas. he can lose his principal investment of Rs 5000 and will also be liable to return Rs 5000 borrowed by him on the personal account. if an investor creates personal leverage.org . If a levered firm goes bankrupt. Non-substitutability of personal and corporate leverages It is incorrect to assume that “personal (home-made) leverage” is a perfect substitute for “corporate leverage. it does not follow that market opportunities and forces will lead Vl into equality with Vu. The M-M hypotheses have been widely debated and criticised. the levered firm will have a higher market value.65238119 Bahadurgarh Office : 01276-324593. it would become necessary to invest a greater amount in order to earn the same return. For example. Leverage and the Cost of Capital. if the cost of debt paid by the firm is less than that paid by the investor.” The existence of limited liability of firms in contrast with unlimited liability of individuals clearly places individuals and firms on a different footing in the capital markets. he would lose not only his personal loan. his returns after switching will be only Rs 550. XVIII. Thus. must exceed the value of the unlevered firm. I. and Ezra Solomon. in illustration 18. As a result. But if he engages in the arbitrage transactions and invests in the unlevered firm. Also see Pandey. then the value of the levered firm. it is more risky to create personal leverage and invest in the unlevered firm than investing directly in the levered firm. reprint 1996. all investors stand to lose to the extent of the amount of the purchase price of their shares. op. Vl. for total return to be equal.232800 E-mail : info@dishainstitute. The basic criticisms of the M-M hypotheses are contained in Durand. But. his loss in the event of bankruptcy will be Rs 6000.232700.Disha Institute of IT & Management illustration 18. Transaction costs The existence of transaction costs also interferes with the working of arbitrage.M. Durand point out that “home-made” leverage is not practically feasible as a number of institutional investors would not be able to substitute personal leverage for corporate leverage.

The reduction in ‘Excessive’ inventories carries a favourable impact on a company’s profitability. light bulbs etc.org . They may be in form of cotton waste.Management of inventory constitutes one of the major investments in current assets. brooms.65238119 Bahadurgarh Office : 01276-324593.g. 4) Stores and Supplies: These represents that part of inventory which does not become a part of final product but are required for production process.232700. by using simple inventory planning and control techniques. Nature of Inventories:. It may not be possible for the company to procure the raw material whenever I Disha Institute of IT & Management Delhi Office: +91-11-65238118. It is possible for a company to reduce its level of inventories to a considerable degree e. inventories are approximately 60% of current assets in public limited companies in India. The various forms in which a manufacturing concern may carry inventory are: 1) Raw Material: These represents inputs purchased and stored to be converted into finished products in future by making certain manufacturing process of the same. oil and lubricants. It is. Because of the large size of inventories maintained by firms. Normally they form a very major part of total inventory and do not involve significant investment. a considerable amount of funds is required to be committed to them.232800 E-mail : info@dishainstitute. 3) Finished Goods: These represents the finished products ready for sale in market. therefore absolutely imperative to manage inventories efficiently in order to avoid unnecessary investment. A firm nelegecting the management of inventories may fail ultimately. soaps. 10 to 20% without any adverse effect on production and sales. MOTIVE/NEEDS OF HOLDING INVENTORY A Company may hold the inventory with the various motives as stated below: 1) Transaction Motive: The company may be required to hold the inventory in order to facilitate the smooth and unintrupped production and sale operations. 2) Work in Process: These represent semi-manufactured products which need further processing before they can be treated as finished products. On an average.Disha Institute of IT & Management INVENTORY MANAGEMENT Inventories constitutes the most significant part of current assets of large majority of companies in India.

3) Speculative Motive: The Company may like to purchase and stock the inventory in the quantity which is more than needed for production and sales purpose. the demand for finished goods may suddenly increases (especially in case of seasonal type of products) and if the company is unable to supply them. Similarly. Hence it is needed to hold the raw material inventory.65238119 Bahadurgarh Office : 01276-324593.org . They need to hold work in progress may arise due to production cycle. There may be a time lag between the demand for the material and its supply.Disha Institute of IT & Management necessary. it should keep adequate inventory to operate the production & sales activities efficiently. The main objective of inventory management is to maintain inventory at appropriate level so that it is neither excessive nor short of requirement Thus.232700. management is faced with 2 conflicting objectives. 2) Precaution Motive: In addition to the requirement to hold the inventory for routine transactions. company will like to maintain sufficient supply of finished goods. Objectives of Inventory Management Through the efficient Management of Inventory of the wealth of owners will be maximised. management should maximise stock turnover so that investment in inventory could be minimised and on the other hand. hence the company should maintain sufficient level of inventory to take care of such situations. transport. To reduce the requirement of cash in business. This may be with the intention to get advantage in term of quantity discounts connected with bulk purchasing or anticipating price rise. arising from its being out of stock. it may mean gain of competition. Eg. Similarly it may not be possible to produce the goods immediately after they are demanded by the customers. The supply of raw material may get delayed due to factors like strike. lengthy processes involved in import of raw material etc. Both in adequate & excessive quantities of inventory are undesirable for business.232800 E-mail : info@dishainstitute. (1) To keep inventory at sufficiently high level to perform production and sales activities smoothly. (2) To minimise investment in inventory at minimum level to maximise profitability. the company may like hold them to guard against risk of unpredictable changes in demand and supply forces. Hence it is needed to hold the finished goods inventory. Hence. On the other hand. short supply. disruption. inventory turnover should be maximised and management should save itself from loss of production and sales. These mutually conflicting objectives of inventory management can be I Disha Institute of IT & Management Delhi Office: +91-11-65238118.

232700.232800 E-mail : info@dishainstitute.org . (iii) To keep investment in inventory at optimem level. (iii) In category ‘C’ all those items are included which are low priced but their number is highest.C.B. all items are classified into 3 categories A. (iv) To reduce the losses of theft. obsolescence & wastage etc.C. Analysis A.65238119 Bahadurgarh Office : 01276-324593. (v) To make arrangement for sale of slow moving items. only those items of inventory are paid more attention which are significant for business. the items of inventory can be classified as under:I Disha Institute of IT & Management Delhi Office: +91-11-65238118. (vi) To minimise inventory ordering costs. In a manufacturing organisation. In actual practice. thousands of items are included in business as inventories.B. But all these items are not equally important.Disha Institute of IT & Management explained is from of costs associated with inventory and profits accruing from it low quantum of inventory reduces costs and high level of inventory saves business from being out of stock & helps in running production & sales activities smoothly. Techniques of Inventory Management (i) A. According to this technique. The objectives of inventory management can be explained in detail as under:(i) To ensure that the supply of raw material & finished goods will remain continuous so that production process is not halted and demands of customers are duly met.B. (ii) To minimise carrying cost of inventory. and C. In ‘A’ category those items are taken which are very precious and their quantity or number is small. The rate of use of items of category ‘A’ is the highest and that of category ‘C’ is the lowest. (ii) In ‘B’ category those items are reserved which are less costly than the items of category ‘A’ but their number is greater. According to this technique. analysis is a selective technique of controlling different items of inventory.

232700. The items in category ‘C’ is 55% but their value is just 10% of total. Therefore. Therefore this category will be paid less attention. the number of items of category ‘A’ are 15% but their value is 70% of total inventory. Effort are made to minimise investment items of this category.65238119 Bahadurgarh Office : 01276-324593.org .Disha Institute of IT & Management Example:Class A B C Number of items in terms % as per their value of their % 15 70 30 20 55 10 100 100 Thus. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. analysis can be presented by following diagram also. The % of number of items in category ‘B’ is 30 but their value is 20%.232800 E-mail : info@dishainstitute.B.C. These items are purchased in bulk quantity once in 2-3 years. Therefore. management need not spend much time for control of this class of inventory because very little investment is made in them. these item should available in time A. The management must be aware that theses items may be less important in terms of value but their non-availabetety can break down the production process. Therefore. costs associated with inventories maybe reduced. % of Costs 0 10 20 30 40 50 60 70 80 90 100 Y 10 20 30 40 50 % of Units 60 70 80 90 100 X Advantages of ABC Analysis (1) A Close and strict control is facilitated on the most important items which constitute a major portion of overall inventory valuation or overall material consumption & due to this. inventory management can be made more effective by concentrating control on this category.

232800 E-mail : info@dishainstitute. cost of storage and insurance etc.Disha Institute of IT & Management (2) The investment in inventory can be regulated in proper manner & optimum utilisation of available funds can be assured. iv) Prices for material v) Availability of funds. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. 2) FIXATION OF INVENTORY LEVELS: Fixation of various inventory levels facilitates initiating of proper action in respect of the movement of various materials in time so that the various materials may be controlled in a proper way. iii) Storage facilities available. it may involved unnecessary blocking of funds in inventory while fixing this level. i) Maximum usage. However. the following propositions should be remembered.232700. ii) Lead time. If it exceeds. (i) Only the fixation of inventory levels does not facilitates the inventory control.65238119 Bahadurgarh Office : 01276-324593. The various levels which can be fixed are as below.org . (ii) The various levels fixed are not fixed on a permanent basis and are subject to revision regularly. These has to be a constant watch on the actual stock level of various kinds of materials so that proper action can be taken in time. (3) A strict control on inventory items in this manner help in maintaining a high inventory turnover rates. following factors are considered. 1) Maximum level: It indicates the level above which the actual stock should not exceed.

org . vii) Economic order Quantity. Maximum level:Re-order level + Re order Quantity. the company may not be able to make the purchases in the systematic manner but may have to make rush purchases which may involve higher purchase cost.Disha Institute of IT & Management vi) Nature of material eg If a certain type of material is subject to government regulation in respect of import of goods etc maximum level may be fixed at a higher level. ii) Rate of consemption 3). 2).232700. it indicates the need to take urgent action in respect of getting the supply. At this stage. CALCULATION OF VARIOUS LEVELS: The various levels can be decided by using the following mathematical expressions.(Minimum Usage X Maximum lead time) I Disha Institute of IT & Management Delhi Office: +91-11-65238118.232800 E-mail : info@dishainstitute. If the stock reaches this level. 1). Re-Order level:Maximum lead time X Maximum usage. This is the level falling in between the two existences of maximum level and minimum level and is fixed in such a way that the requirements of production are met properly till the new lot of material is received. i) Lead time. Re-order level It indicates that level of material stock at which it is necessary to take the steps for the procurement of further lots of material. 2) Minimum Level: It indicates the level below which the actual stock not reduce.65238119 Bahadurgarh Office : 01276-324593. While fixing this level. If it reduces. DANGER LEVEL: This is the level fixed below minimum level. it may involve the risk of non-availability of material whenever it is required. 4). following factors are considered.

Current assets are those assets which are normally converted into cash within an accounting year.Disha Institute of IT & Management 3). EOQ:.65238119 Bahadurgarh Office : 01276-324593. 4. Net working capital is the excess of current assets over current liabilities here.org . Average inventory held can be calculated as: Opening stock + closing stock __________________________ 2 Inventory turnover can be indicated in terms of number of days in which average inventory is consumed.closing stock. It is calculated as below: Value of Material Consumed _______________________ Average inventory held Where value of material consumed can be calculated as: Opening stock + purchases.(Normal usage + Normal lead time) 4). Danger level:Normal Usage X Lead time for emergency Purchases. 3).Economic order Quantity as per notes include bills payable. notes payable and miscellaneous accruals. and current liabilities are usually paid within an accounting year.232800 E-mail : info@dishainstitute. INVENTORY TURNOVER: Inventory turnover indicates the ratio of materials consumed to the average inventory held. Average level:Minimum level + Maximum level 2 5). What for is working capital required by firm very much depends on the nature of the business which the firm is conducting. Minimum level:Re-order level. If the firm has business which deals I Disha Institute of IT & Management Delhi Office: +91-11-65238118. It can be done by dividing 365 days (a year) by inventory turnover ratio.232700.

without much difficulty and complication. MANUFACTURING FIRM We now come to manufacturing firm. It is primarily because the amount becomes available as soon as services are sold and also the services arranged by the firm and immediately sold. If it is complex and complicate. Ans. Longer it take to produce a good. store. Obsolescence losses. Ques. the of course depends on the nature of commodities which are being manufactured. 8 Define EOQ. the higher will be the inventory carrying cost and vice versa. obviously the requirement will be low. etc. II ORDERING COST It is the cost of placing an order and securing the supplies.keeping cost.Disha Institute of IT & Management with public utility services.232700. more will be its cost and more working capital will become unavoidable.org . INVENTORY CARRYING COST It is the cost of keeping items in stock. The economic ordering quantity can be determined by any of the following two methods. Many manufacturing concerns will also need sufficiently heavy amounts. In this complex process obviously more capital will be needed and goods will be produced after considerable delays. it will be another determinant. How is it computed ? Give an example. When the companies are engaged in the production of heavy machinery and equipment. Similarly many industrial units will also need heavy amounts for carrying on their business. insurance premium. It various from time to time depending upon the number or orders placed and the number of times ordered. the greater will be the ordering cost and vice versa. On the other hand trading concerns need heavy amounts because these require funds for carrying goods traded. Economic order quantity refers to the size of the order which gives maximum economy is purchasing any item of raw materials or finished product. It includes interest on investment. It is fixed mainly after talking into account the following costs: I. 1) FORMULA METHOD I Disha Institute of IT & Management Delhi Office: +91-11-65238118. the larger the volume of inventory.65238119 Bahadurgarh Office : 01276-324593. a way out is found out by demanding some advance money from the party or parties which plea orders or which usually take away the goods.232800 E-mail : info@dishainstitute. The more frequently the order are placed and fewer the quantities purchased an each order.

III. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. On account of these reasons.232800 E-mail : info@dishainstitute. The above assumption may also be called as limitation of EOQ modes.232700. S= Annual cost of storage of one unit.000)=200 units EOQ model is based on the following assumptions: I. P= Cost of placing an order. the assumptions as to constant usage or sale of inventories and instantaneous replenishment of inventories are also of doubtful validity. (2*1. The order the replenishment of inventory are placed exactly when inventories reach the zero level. Similarly. TABULAR METHOD This method is to be used in those circumstances where the inventory carrying cost per units is not constant.65238119 Bahadurgarh Office : 01276-324593. (40. The rate at which the firm uses the inventories or makes sales is constant through out a year. The firm knows with certainly the annual usage or demand of the particular item of inventories.: Calculating the Economic Ordering Quantity using Tabular Method on the basis of data given. His annual usage is 1600 units. (2u*p)/s = Sqrt.600*100)/8 = Sqrt. U= Quantity purchase in a year. There is every likelihood of a discrepancy between actual and estimated demand for a particular items of inventory. For Example:A refrigeration manufacture. 2.Disha Institute of IT & Management In this case the EOQ can be determined as per the following for formula: E= Economic ordering quantity. purchase 1600 units of a certain component from 13. This will be clear with the following. Calculate the economic ordering qty by formula method: E = Sqrt.org . EOQ model may sometimes give wrong estimate about economic order quantity. The order placing cost is Rs 100 and the cost of carrying one unit for a year is Rs 8. II.

Disha Institute of IT & Management

Annual Orders Requirement per year

Units per order

Order placing costs

1600

1 2 3 4 5 6 7 8 9 10

1600 800 533 400 320 267 229 200 178 160

100 200 300 400 500 600 700 800 900 1000

Avg. stock in units (50% of order placed) 800 400 267 200 160 134 115 100 89 80

Carrying costs

Total amount cost

6400 3200 2136 1600 1280 1072 920 800 712 640

6500 3400 2436 2000 1780 1672 1620 1600 1612 1640

The above table shows that total cost in the minimum when each is of 200 units. Therefore, economics ordering quantity is 200 units only. As graphic presentation of the economic ordering quantity on the basis of figures given in the above table will be as follows:

_____________ _____________

Total cost on inventory management

Inventory carrying costs.

_________

Ordering cost [ EOQ =2000 units]

I

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Disha Institute of IT & Management
Cost in thousand (Rs)

0 1 2 3 4 5 6 7 8 9 10

(5) Bill of Materials: In order to ensure proper inventory control, the basic principle to be kept in mind is that proper material is available for production purpose whenever it is required. This aim can be achieved by preparing what is normally called as “Bill of Materials”. A bill of material is the list of all the materials required for a job, process or production order. It gives the details of the necessary materials as well as the quantity of each item. As soon as the order for the job is received, bill of materials is prepared by Production Department or Production Planning Department. The form in which the bill of material is usually prepared is as below: BILL OF MATERIALS No. Date of Issue Department authorized S. No Description of Material Code No Qty. For Department Use Only Material Requisition No Date Quantity Demanded Remarks Production/Job Order No

I

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Disha Institute of IT & Management

The function of bill of materials are as below: (1) Bill of materials gives an indication about the orders to be executed to all the persons concerned. (2) Bill of materials gives an indication about the materials to be purchased by the Purchase Department if the same is not available with the stores. (3) Bill of material may serve as a base for the Production Department for placing the material requisition slips. (4) Costing/Accounts Department may be able to compute the material cost in respect of a job or a production order. A bill of material prepared and valued in advance may serve as base for quoting the price for the job or production order. (6) Perpetual Inventory System: As discussed earlier, in order to exercise proper inventory control, perpetual inventory system may be implemented. It aims basically at two facts. (1) Maintenance of Bin Cards and Stores Ledger in order to know about eh stock in quantity and value at any point of time. (2) Continuous verification of physical stock to ensure that the physical balance and the book balance tallies. The continuous stock taking may be advantageous from the following angles: (1) Physical balances and book balance can be compared and adjusted without waiting for the entire stock taking to be done at the year end. Further, it is not necessary to close down the factory for Annual stock taking. (2) The figures of stock can be readily available for the purpose of periodic Profit and Loss Account. (3) Discrepancies can be located and adjusted in time. (4) Fixation of various levels and bin cards enables the action to be taken for the placing the order for acquisition of material. I

Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org

I Disha Institute of IT & Management Delhi Office: +91-11-65238118. 1. Activities such as changes in the methods of sales distribution or undertaking an advertisement compaign or a research and development programme have long-term implication’s for the firm’s expenditure and benefits and therefore. and safety stock is 500 units. ILLUSTRATIVE PROBLEMS (1) A company uses annually 50. minimum and average inventory. The long term assets are those which affect the firm’s operations beyond the one year period. Features:1) The exchange of current funds for future lengths. 2) The funds are invested in long term assets.65238119 Bahadurgarh Office : 01276-324593. the procurement time is 10 days. maximum. they may also be evaluated as investment decisions. Find reorder level. acquisition. (6) Stock details are available correctly for getting the insurance of stock. 3) The future benefits will occur to the firm over a series of year. A capital budgeting decision may be defined as 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 year.232800 E-mail : info@dishainstitute. (a) Find EOQ (b) If the company operates 250 days a year.org . Unit II Investment decisions The investment decisions of a firm generally known as capital budgeting or capital expenditure decisions.20 Each order costs Rs.000 units of an item each costing Rs. Sale of a division or business (Investment) is also analysed as an investment decision. 45 and inventory carrying cost 15% of the annual average inventory value. The firm’s investment decision would generally include expansion. modernisation and replacement of long term assets.Disha Institute of IT & Management (5) A systematic maintenance of perpetual inventory system enables to locate slow and non-moving items and to take remedial action for the same.232700.

unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On other hand. A wrong decision can prove disastrous for continued survival of firm. 4) Irreversibility: It is difficult to find a market for such capital items once they have been acquired.232700. 5) They are among the most difficult decisions to make. 3) Funding: Investment decisions generally involve large amount of funds which make it imperative for firm to plan its investment programmes very carefully and make an advance arrangement for procuring finance internally or externally.org . 2) They affect the risk of the firm. 2) Risk: A long-term commitment of funds may also change risk complexity of the firm.Disha Institute of IT & Management Importance of Investment Decisions Investment decision require special attention because of the following reasons: 1) They influence the firm’s growth in the long turn. 5) Complexity: I Disha Institute of IT & Management Delhi Office: +91-11-65238118. 4) They are irreversible or reversible at substantial loss.232800 E-mail : info@dishainstitute.65238119 Bahadurgarh Office : 01276-324593. If the adoption of an investment increases overage gain but causes frequent fluctuations in its earnings the firm will become more risky. The firm will incur heavy losses if such assets are scrapped. inadequate investment in assets would make it difficult for the firm to complete successfully and maintain its market share. 1) GROWTH: A firm’s decision to invest in long term assets has a decisive influence on rate and direction of its growth. 3) They involve commitment of large amount of funds.

it present value is equal to the amount invested in the project. Later.org .65238119 Bahadurgarh Office : 01276-324593. In case investment is made only in beginning of the project. Techniques of Capital Budgeting: it may be grouped in the following two categories:(A) Discounted cash flow (DCF) Criteria. political. (1) Net Present Value (NPV) This method take into account time value of money.Disha Institute of IT & Management Investment decisions are an assessment of future events which are difficult to predict. The rate of interest is called cost of capital and is equal to minimum rate of return which must accrue from the project. present value of cash out flows is calculated in same manner and subtracted from present value of cash inflows. In this method present value of cash flows is calculated for which cash flows are discounted. Taking this assumption. (1) Net present value (NPV) (2) Internal Rate of Return (IRR) (3) Profitability Index (PI) (4) Discounted Payback Period.232700. The uncertainty in cash flow is caused by economic. social and technological forces. It is really a complex problem to correctly estimate future cash flow of an investment.232800 E-mail : info@dishainstitute. NPV can be calculated as under: NPV = CF1 + (1+k)1 (1+k)2 CF2 +-(1+k)n Cfn -C n = ∑ Cft -C I Disha Institute of IT & Management Delhi Office: +91-11-65238118. This difference is called Net Present value or NPV. (B) Non-discounted Cash flow Criteria: (1) Pay back period (PB) (2) Accounting rate of return (ARR) (A) Discounted Cash Flow (DCP) Criteria – These techniques are considered good because they take into account time value of money.

Similarly. (2) In calculating NPV. NPV is Positive) 2) Reject if NPV <O (i. it will be added to initial cost of project and to cash flows of last year. calculate & understand. Different authors have their different opinions regarding its calculation. Disadvantages: (1) Difficult to use. Cf2 represent cash inflows K = Cost of Capital C = Cost of investment proposal n = Expected life of Proposal If the project has a salvage value also. discount rate is most significant because with different discount rates NPV will be different. NPV is Negative) 3) May accept if NPV= O Advantage: 1) It takes into account time value of money. 2) It considers cash inflows form project throughout its life. Thus comparable profitability of projects will change with the change in discount rate.65238119 Bahadurgarh Office : 01276-324593.232700. To determine required rate of return which is called cost of capital. 3) In this method variable discount rates can be used for the projects with longer life period. 5) True measure of profitability.Disha Institute of IT & Management t=1 (1+k)t Where Cf1. is a difficult task.org . it should be added in cash inflows of last year. Acceptance Rule:1) Accept if NPV >O (i. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. 4) This method is more closely related to firm’s objective of maximising wealth of shareholders.232800 E-mail : info@dishainstitute. if some working capital is also needed.e.e.

The initial cost of project is Rs 40. whereas under NPV method both the projects will be considered equally profitable. In such cases. This method considers all benefits during the life time of the project. this method is not very useful because we will accept or project whose NPV is higher and such a project may have more initial cost as compared to other.000.org . NPV of the project with longer life may be more.232800 E-mail : info@dishainstitute. Normally. This method evaluates absolute profitability rather than relative profitability. (4) When life of 2 projects is dissimilar.232700. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Thus NPV is an absolute measure of evaluating projects and PI is an absolute measures. The NPV of two project is equal ie.0 PI MERITS • • • • Considers all cash flows. NPV method is considered good when the initial cost of different projects is the same. This method takes into account the time value of money. 3) PROFITABILITY INDEX It is Benefit –Cost ratio (B/C Ratio) or Profitability Index (P1). project with less life time is preferred. Pl can be calculated as under:Present Value of Cash Inflows _________________________ Present Value of Cash outflows Acceptance rule • • • Accept if Pl>1.0 Reject if Pl<1. and thus finds will be blocked for a longer period. Project should be selected on the basis of profitability index. PI method should be adopted when the initial costs of projects are different.000 and that of project B Rs 20. Rs 5000. in this project.0 Project may be accepted if Pl= 1. But as per this method.Disha Institute of IT & Management (3) When the initial cost of 2 projects is different. this method does not give satisfactory results. NPV method may not present actual worth of alternate projects.65238119 Bahadurgarh Office : 01276-324593. Pl method is considered better to NPV in case when the initial costs of projects are different for eg. It is the ratio of value of future cash benefits at required rate or return to the initial cash outflow of the investment.

Disha Institute of IT & Management • Generally consistent with the wealth maximisation principle.org . It is difficult to understand and implement this method. If actual pay back period is less than the standard. Requires estimates of the cash flows which is a tedious task. 2). The investment proposal. if the investment required for a project is Rs 20.232700. “Pay Back Period is the number of year required for the original investment to be recouped. which has the least pay back period is considered profitable. First method is used when cash flows remains the same during the life time of the project. Discounted Pay Back Period: This is an improvement over the pay back period method in the sense that it considers time value of money. Actual pay back period is compared with the standard one.000 and it is likely to generate cash flow of Rs 10. Thus.232800 E-mail : info@dishainstitute. In such a case payback (PB) is calculated as under:- INVESTMENT PB = _______________________ CONSTANT ANNUAL CASH FLOW I CO =___ C Disha Institute of IT & Management Delhi Office: +91-11-65238118. its payback period will be 2 years. the project with the least payback period is considered profitable.000 for 5 years. Pay Back Method: Under this method the pay back period of each project/ investment proposal is calculated. Thus discounted pay book period indicates that period with which the discounted cash inflows equal to the discounted cash outflows involved in a project. At times fails to indicate correct choice between mutually exclusive projects. actual payback period is more than the standard pay back period. the project will be accepted and in case.65238119 Bahadurgarh Office : 01276-324593. The calculations in this method are complex as compared to traditional methods. There are two methods of calculating payback period. 4). 4). 3). the project will be rejected. For eg. Disadvantages/ Demerits 1). It means that investment will be recovered in first 2 year of the project.

000 will be recovered by the business in 5 years. if the investment for a machinery is Rs 50. ACCEPTANCE RULE • • Accept if PB < standard pay back. MERITS 1. therefore useful for the companies which faces the problem of liquidity. Accept if PB > standard pay back. Emphasis liquidility.000. Its life 10 years and cash flows every year are Rs 10.Disha Institute of IT & Management For eg. Then its Pay back period will be 5 years. Demerits 1. then its Pay Back period will be:Rs 50000 PB = _________ = 5 Years Rs 10000 For the pay back period of 5 years. The time value of money is the interest on investment. Easy to understand and compute.000 such year for 10 years.232800 E-mail : info@dishainstitute.org . The payback period of two projects may be the same but a project may get more CFAT in the I Disha Institute of IT & Management Delhi Office: +91-11-65238118. the obsolescence are minimum. Such companies will invest their funds in such projects in which investment can be recovered in minimum time. 2. Used to find out internal Rate of Return. 2. But the cash inflows of Rs 50. Easy and crude way to cope with risk. 3. it can be observed that the investment of Rs 50. 3.000 and it will generate Rs 10. 4. This method also does not take into account the time value of money. Ignores the cash flows occurring after the pay back period. Uses cash flow information. 7. Suitable for those organisations which emphasise on short-term investments rather than long terms development.65238119 Bahadurgarh Office : 01276-324593.000 during the last 5 years have been taken into account. 4. Ignores the value of money. Thus does not take into account the whole profitability of the project. 5. 6.232700. as a result.000. This method follows short terms view point. No objective way to determine the standard payback. For eg: investment in a project is Rs 50.

Of years Average Investment = Original Investment + Salvage Value ________________________________ 2 or Original Investment – Salvage Value ________________________________ + Salvage Value 2 If working Capital is also required in the initial year of the project.Salvage Value). This method does not take into account the total life time of the project. This method is based on accounting information rather than cash flows.232700. But this method ignores this fact.232800 E-mail : info@dishainstitute. 5. 7. There are various ways of calculating Average Rate of Return. 6. In such a case the cash flows in the initial years can fetch additional income of interest.org . Such a project may become more profitable than the others. In another method instead of average investment original cost is used. the average investment will be= Net working Capital + Salvage value + ½ (initial cost of Machine. No relation with the wealth maximisation principle. I Disha Institute of IT & Management Delhi Office: +91-11-65238118.65238119 Bahadurgarh Office : 01276-324593. not a measure of profitability. It can be calculated as:Average annual Profit after Tax ARR = ___________________________X100 Average Investment Average Annual Profit = Total of after tax profit of all the year ___________________________ No.Disha Institute of IT & Management initial years and less in the later years. Average Rate of Return Method: This method is also called Accounting Rate of Return Method. II.

232800 E-mail : info@dishainstitute. Unit IV MANAGEMENT OF RECEIVABLE “Receivables are asset accounts representing amounts owned to a firm as a result of sale of goods or services in ordinary course of business. Accept if ARR > minimum rate. Easy to understand and calculate. bills receivable etc. This method does not account for the profits arising on sale of profit on old machinery on replacement.232700.65238119 Bahadurgarh Office : 01276-324593. It may be time that the competing ARR of two projects may be the same but they may require different average investments. It becomes difficult for the management to decide which project should be implemented. Accept if ARR < minimum rate. No objective way to determine the minimum acceptable rate of return. Management of I Disha Institute of IT & Management Delhi Office: +91-11-65238118. accounts receivables. 2). to evaluate the project all those projects are accepted on which average rate of return is more than the predetermined rate. Does not use cash flow. Give more weightage to future receipts. 4). 5). 2). Thus. 5).Disha Institute of IT & Management In this method. This method takes into account all the profits during the life time of the project. whereas pay back period ignores the profits accruing after the pay back period 3). Necessary informations to calculate average rate of return are available easy. sundry debtors. Easy to understand. 4). ARR method does not consider the size of investment for each project.” Receivables are also turned as trade receivables. Acceptance Rule • • Merits 1).org . customer receivables. Ignore the time value of money. Uses accounting data with which executives are familiar. Demerits 1). 3). the project is given more significant on which the average rate of return is the highest.

firm can make high sales by selling on credit. Purpose of Receivables There a 3 purposes of investing or maintaining Receivables. Therefore.org . financing costs etc. Some of the customers may have deficit of cash.232700. (2) Increased Profits:Due to credit sale of goods and services. administrative expenses. (1) Growth in Sales:In comparison to cash sales. Thus. following are the main objectives of receivables management:(1) To optimise the amount of sales. If a firm does not follow credit policy of it competitors. it is. Objectives of Receivable Management From creation of receivables the firm gets a few advantages & it has to bear bad debts. Efficient credit management helps to increase the sales of the firm. Management of receivables is a process under which decisions to maximise returns on the investment blocked in them are taken. In the management of receivables financial manager should follow such policy through which cash resources of the firm can be fully utilised. significant to maintain proper level of receivables. The receivable arising from credit sales contain risk element.Disha Institute of IT & Management receivable is also called management of trade credit. the total sales of business can increases. As a result of it. In other words. therefore. (3) Meeting Competition:Various firm sell goods on credit to their customer only because their competitors are doing so. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. it profits also start increasing. if any firm does not sell on credit. Thus. the main objectives of management receivable is to maximise the returns on investment in receivables & to minimise risk of bad debts etc. its total sales will decrease because its customers will be attracted towards other firms.65238119 Bahadurgarh Office : 01276-324593. it sales may go down. Because investment in receivables affects liquidity and profitability.232800 E-mail : info@dishainstitute. the basic objectives of receivables management is to maximise the profits. because many customers do not want to pay cash.

232800 E-mail : info@dishainstitute. Though credit policies. (3) To optimise investment in receivables. the main objective of receivable management is to establish a balance between profitability and risk (cost).65238119 Bahadurgarh Office : 01276-324593. management can control its receivables. credit terms.Disha Institute of IT & Management (2) To minimise cost of credit.Financials statement Credit Credit Standards.Credit Bureau Report Terms . economic conditions.Past Experience a) Credit period b) Cash Discount c) Cash Discount Period Turnover of Accounts Receivable Aging schedule of Receivable (A) Formulation of Credit Policies:I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Therefore.Bank References . credit standards and collection procedures.org .232700. seasonal factors. rate of competition etc. Although the level of receivables is affected by various external factors like standards of industry. Aspects/Areas/Variables of RM Formulation of Credit Policies Credit Analysis Collection Polices Evaluation of Credit Policies .Trade References . A business can afford to invest in its receivables unless the marginal costs and marginal profits are the same.

Disha Institute of IT & Management
Credit Policy means such factors which affect the amount of investment in receivable and about which management has to take decisions for example credit period, cash discount period etc. Following are the main constituents of credit policy(1) Credit Terms:- are these terms on the basis of which credit sales are made to customers. These are also called terms of repayment of receivable. These are 3 main constituents of credit terms. They are: (a) Credit Period:It is the period for which goods are sold on credit to customers i.e. the period after which payment is to be made by customers. For example, if customers are required to pay before the end of 30 ITS STUDY CENTRE it will days from date of sale, SCF-54 (B’MNT) standard of be written as ‘Net 30’. Credit period normally depends on the SECTOR 15 the MARKET, industry. By raising credit period, not only the sales and profits of firm rise but its costs also rise. Similarly, by reducing the credit FARIDABAD& profits decline on period sales PH 5002194-95 one hand & cost of fund & bad debt go down on the other. Therefore, on optimum credit policy should be determined by establishing balance in costs and profits of different credit periods. (b) Cash Discount:A Firm gives cash discount to encourage its customers to pay quickly. In terms of cash discount, we include rate of cash discount and period for cash discount. The customers who do not to avail of cash discount, they have to make payment before expiry of general credit period. Due to availability of cash discount average collection period is reduced. As a result, the amount locked up in receivables declines. Cash discount is a loss to the firm. Therefore, decision to allow cash discount or to change its rate should be undertaken on the basis analysis of its costs and benefits. (c ) Cash Discount Period:is the period during which cash discount is available. The period of cash discount affects average collection period. Thus, the terms of credit collectively include credit period, cash discount and period of cash discount. For example, if terms of credit are expressed as ‘2/10, Net 30’ , it means that if the payment is made with in 10 days, 2% cash I

Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org

Disha Institute of IT & Management
discount will be paid. If this cash discount is not avaited of, the payment has to be made with in 30 days of date of sale. (2) Credit Standards:The term ‘Credit standard’s is basic yardstick of making credit sales to the customers. On the basis of credit standard it is determined to whom goods are to be sold or not to be sold. The credit standards followed by a firm affect sales, profits, investment in receivable & costs. If a firm follow loose credit standards, its sales and receivables will be more as standards, its sales and receivables will be more as compared, to firm which uses tight credit standards. (B) Credit Analysis:is made to evaluate ability of the customers before making credit sales. A firm should determine procedure to evaluate applications for credit. On the basis of credit analysis only, a firm should decide to whom it will sell on credit & for how much amount. To sell on credit, all customers should not be treated a like. Each customer should be examined properly before selling goods on credit to him. 1) Trade Refrences:Firm can ask its customers to mention such names/firms with which they are dealing at present. This is an important source of credit information after receiving trade references, firm should get desired informations from them. Sometimes, customer provides names of wrong persons, therefore, before believing the informations received, the honesty and sincerity of traders should be examined. 2) Bank References:The bank of the customers can also provide important credit information’s about the customer. Such information’s are obtained by the firm with the help of its bank. Sometimes, firm ask customers to direct his bank to provide necessary information’s to it. The information’s like average bank balance of customer, loan given to customer, experience with customer etc can be obtained from bank of customer. Normally, bank does not give clear answer to firm’s question Therefore the firms should collect information’s from other sources. 3) Financial Statements:This is one of easiest way to obtain information’s about credit worthiness of prospective customers. If prospective customer is a public limited company, I

Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org

Disha Institute of IT & Management
there may not be any difficulty in getting financial statements, in form of profit & loss Account & balance sheet. However, getting financial statements may be difficult in case of Private Limited companies of partnership firms. Past Experience:This can be considered to be most reliable source of getting information about credit-worthiness of customer who is dealing with company presently. If there is the question of extending further credit to existing customer, the company should inevitable consider pas experience while dealing with that customer. (c ) Collection Policies:are needed because all customers do not pay in time. Some customers pay at slow rate and some do not make payment at all. The objective of collection policy is to fasten the collection of debt. If the collection from debtors is delayed, additional funds have to be procured for smooth operation of selling and production activities. Delay in realisation from debtors also increases possibility of bad debts. Thus, the main objectives of realisation policy is to reduce the ratio of bad debt & reduce average collection period. The collection policy means the steps which are taken to realise the debts from debtors for their default in non payment with in the stipulated time. Proper coordination in sales and accounting department should be established to determine clear collection policy. Another aspect of collection policy is the methods employed to realise the over dues. After the end of credit period, firm should undertake necessary steps to make collection from debtors. Initially the efforts should be polite but with the passage of time they can be made stringent. Among these methods following are included:(1) Reminder letters (2) Telephone (3) Telegram (4) Extension of Payment Period (5) Legal Action Before taking any action, difficulties of customers should be examined. Therefore, following points must be considered for determining collection procedures:I

Disha Institute of IT & Management Delhi Office: +91-11-65238118,65238119 Bahadurgarh Office : 01276-324593,232700,232800 E-mail : info@dishainstitute.org

The objective of this ratio is to measure liquidity. the nature of the customers and their business connections should be considered.Disha Institute of IT & Management (1) Collection procedure must be clear.org . Credit Sales during the Year Turnover of Accounts Receivable =________________________ Average Accounts Receivable. past experience should be considered. legal action should be avoided. (2) Before Starting action for collection. (1) Turnover of Accounts Receivable:This ratio is calculated by dividing annual credit sales by average accounts of receivables. (6) While estimating collection cost. (5) The expenses incurred on collection should not exceed the amount of collection of debt. seasonal customers etc. It should neither be too liberal nor too strict. To observe whether credit policy followed by firm is suitable or not. Proper adjustment in credit policies should be made according to changing ciramstances.65238119 Bahadurgarh Office : 01276-324593.232800 E-mail : info@dishainstitute. (3) The time gap between due date and action for realisation of debts should be determined separately for different classes of customers like regular customers. following methods can be used. (D) Evaluation of Credit Policies/ Monitering Receivable:The collection policy followed by firm should be optimum.232700. (4) So far as possible. Average collection Period = Months or Days in a year _____________________ Turnover of Accounts Receivable 2) Aging Schedule of Receivable:I Disha Institute of IT & Management Delhi Office: +91-11-65238118.

5 2.org .00 100.2 20000 9.9 21.7 5.6 43. Thus management can reduce possibility of bad debts.2 80000 41.Disha Institute of IT & Management In this schedule.4 5000 2. total 30000 23.232700. The main objective of preparing this schedule is to find out how much old are the receivable. if cash receipts match with cash payments business does not need cash for transactional purpose.Business needs cash for various payments in ordinary course of its operation which includes payment for purchase of material. dividend.65238119 Bahadurgarh Office : 01276-324593. taxes etc. Motives of holding Cash/ Need:1) Transactive Motive:.8 40000 11.6 10000 4. receivables are classified on basis of their age. As such. it is the responsibility of finance function to see that FARIDABAD PH 5002194-95 various functional areas of business have sufficient cash whenever they require the same. current assets. because it will effect interest cost & opportunity cost.00 Period (No of No Days) Accounts 0-20 100 21-40 200 41-60 40 61-80 50 81-100 20 Over 100 10 420 Management Of Cash ITS areas of overall Management of cash is one of most important STUDY CENTRE working SCF-54 is the most liquid type of capital management. As such. I Disha Institute of IT & Management Delhi Office: +91-11-65238118.232800 E-mail : info@dishainstitute.8 16. With the help of this schedule management can find out such debtors & can adopt appropriate collection method for them whose average credit period is higher and which are older. But there is no coordination between inflow and outflow of cash. A specimen of this schedule is given as under:Aging schedule of Accounts Receivables of Amt (Rs) No as % Total Amt as % of no. When expected cash receipt is short of required payment. it has also to be ensured that funds are not blocked in form of idle cash. It is prepared in form of a statement. wages. cash is needed by firm so that liabilities could be paid.5 10. Similary business gets cash from its selling activities & other investment. management of cash has to find a mean between these 2 extremes of shortage of cash as well as idle cash. This is due to the fact that cash (B’MNT) SECTOR 15 MARKET. At the same time.8 185000 100.

credit information about other customers. for certain services banks charge commission but same of services are provided by them free of cost for which they require indirect compensation. floods. (2) The relation of firm with bank does not deteriorate. (3) Contingencies can be met easily. failure of important customers. firm wants to make use of such profitable opportunities which are outside operation of business. (2) Slow rate of cash collection from debtors. (4) It helps firm to maintain good relation’s with suppliers. firm retains some cash.Disha Institute of IT & Management 2) Precautionary Motive:. Following are main advantages of adequate cash(1) To prevent firm from being insolvent.Bank provide number of services to its customers like clearance by cheque. taxes etc. Sometimes. (1) Strikes. (2) Opportunity to purchase securities at falling prices. 3) Speculative Motive:. Some of these opportunities are:(1) Opportunity to purchase raw material at low price by payment of cash immediately. For example. (4) Compensation Motive:.Firms need cash to meet some contingencies. (3) Purchasing raw material at a time when its prices are lowest. (3) Rejection of orders by customers due to their dissatisfaction. transfer of funds etc.232700.It means to make use of profitable opportunities by firm. (2) To minimise Cash Balance:- I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Objective of Cash Management:1) To make Payment According to Payment Schedule:Firm needs cash to meet its routine expenses including wages.65238119 Bahadurgarh Office : 01276-324593.232800 E-mail : info@dishainstitute. For this purpose. (4) Rise in cost of raw material etc.org . For this purpose they wish their customer to maintain minimum cash balance. salary.

Firm opens its account in local banks of these collection centre.232700. Excessive amount of cash balance helps in quicker payments. Contrarily. (2) Lock box System:Under concentration banking. firm is unable to pay its liabilities in time. Under the lock box system.Disha Institute of IT & Management The second objective of cash management is to minimise cash balance. Accelerating Cash Collections:The customers should be encouraged to make early payment by giving cash discount to fill time gap between sale of goods and its payment by cheque.232800 E-mail : info@dishainstitute. this method is profitable technique of realising debts at the earliest because it reduces time gap between sending of cheque by customer and their receipts by firm. sometime is wasted before cheques or drafts are sent for collection. After preparing cash budget. firm takes on rent a lock box from post office at important collection centres. centre sends them to local branch of bank and then they are transferred to Head office daily for disbursements. Under this system. Therefore optimum level of cash should be maintain. management should try that there should not be any significant difference in actual & budgeted cash flows. Some of these branches are selected for collection of cash from debtors which are called collection centres. cheques or drafts received by collection centres are deposited in local banks & therefore. There are 2 methods of reducing these time gaps:(1) Concentration Banking:It is a system of collecting cash from customers of large sized firms which have large number of branches. when cash available with firm is less.65238119 Bahadurgarh Office : 01276-324593. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Thus. this time gap can be reduced. On receiving cheque. but excessive cash may remain unused & reduces profitability of business.org . Managing Cash Flows:The main objective of managing cash flows is to accelerate collection of cash and delay disbursement of cash without damaging credit worthiness.

This system is considered better to concentration banking because in this system. This system will help in delaying payments and it will increase time gap in payment before they reach creditors. Firm authorises local banks to withdraw these cheques/drafts from lock box and credit the same to firm’s account. Slowing Disbursements:The main objective of disbursement management is to slow down the payments without farming goodwill & credit worthiness of firm.232800 E-mail : info@dishainstitute.232700. If payment is made by local branch. Bank operates this lock-box several times a day. firm should make payment on due date only.:1) Avoidance of Early Payments:Under this management. firm will have to maintain lesser total cash as against deentralised disbursement. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. In this method.Disha Institute of IT & Management Customers are instructed to send their cheques/drafts in lock-box. 2) Centralised Disbursements:Under this system. In this system. greater time will be involved in the presentation & collection of cheques.org . time involving in receiving cheque. FloatFloat is the amount which is trapped in cheques but which are yet to be collected. their accounting & deposit of these cheque in banks is saved. Where each branch will have to maintain some cash. But under this system. 3). it will not take much time to reach to creditors by post. Local banks are also instructed to transfer funds exceeding a particular level to Head office. neither early nor afterwards. all payments should be made from the central account by Head Office. It means that although cheque has been issued but actual cash will be required later when it will be actually presented for payment. Control over payments will also become easier. Following methods can be used for slowing disbursements.65238119 Bahadurgarh Office : 01276-324593. But firm should not bear loss of cash discount. Firm is allowed some time to make payment. firm has to bear additional expenses of post office & bank.

c) Marketability:. some on 2nd & some on 3rd.of securities means easiness in converting them into cash. Investing Surplus Cash:If nature of surplus cash is permanent. Unit-II Risk analysis Risk exists because of inability of decision maker to make perfect forecasts. Optimum cash balance is that level of cash at which transaction cost & opportunity cost are minimum. An investment is not risky if. While investing cash in securities.Disha Institute of IT & Management For Example:.org .Cash should be invested in those securities.65238119 Bahadurgarh Office : 01276-324593. 4) Accruals:Wages & other expenses can be paid after the date of actual services rendered to them. the prices of which do not change substantially and there is no risk in repayment of its principal & interest. It is not necessary that all cheques would be presented on Ist day. a) Safety:.if the payment of wages and salaries is made by cheque on Ist of every month. some cheques will be presented on Ist day. Therefore. maturity and marketability should be considered.more changes take place in long term securities. In actual practice. it can be invested in long term assets. If firm maintains more cash than optimum level.232700. opportunity cost increases and transaction decreases and vice versa. the surplus cash should be invested in such securities which can be converted into cash with out much loss. b) Maturity:. additional cash should be invested in short-terms securities. Forecasts cannot be made with perfection or certainity since the future events on which they depend are uncertain.232800 E-mail : info@dishainstitute. their safety. we can I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Thus firm need not deposit extra amount in bank on very Ist day. Determining Optimum cash Balance:If available cash is more than operating requirements of firm.

Accordingly. to allow for riskiness of those future cash flows a risk premium rate may be added to risk free discount rate. Techniques to handle Risk 1) Pay back 2) Risk-adjusted discount rate.232700. more uncertain the returns in future. risk arises in investment evaluation because we cannot anticipate occurrence of possible future events with certainity & consequently. But the whole trouble is that cash flows cannot be forecast accurately. Based on this reasoning. 3) Certainty equivalent. & alternative sequence of cash flows can occur depending on future events.232800 E-mail : info@dishainstitute. Thus. than. if time preference for money is to be recognised by discounting estimated future cash flows.65238119 Bahadurgarh Office : 01276-324593.Disha Institute of IT & Management specify a unique sequence of cash flows for it. Risk-adjusted discount rate= Risk free Rate+ Risk Premium K= kf+kr I Disha Institute of IT & Management Delhi Office: +91-11-65238118. businessman required a premium over and above an alternative which was risk free. will allow for both time preference & risk preference & will be a sum of risk-free rate & risk-premium rate reflecting the investors attitude towards risk. to their present value. the greater the risk & greater premium required. Such a composite discount rate. That is. cannot make any connect prediction about cash flow sequence. at same risk-free rate. That is. called risk-adjusted discount rate. 2) Risk-adjusted Discount Rate:To allow a risk.org . The risk adjusted discount rate method can be expressed as follows: n NPV = ∑ t=0 NCFt (1+k)t Where K= Risk-adjusted rate. it is proposed that risk premium be incorporated into capital budgeting analysis through discount rate.

2) It does not make any risk adjustment is numerator for cash flows that are for cast over future years. as the level of risk increases. Accordingly. For example. Accordingly. otherwise it should be rejected. • It is based on the assumption that investors are risk averse. 3) It is based on assumption that investors are risk-averse. If IRR is higher than this adjusted rate. 2) Has a great deal of intuitive appeal for risk averse businessman.232800 E-mail : info@dishainstitute. not increased. In contrast to net present value method.org . not increased.1 Certainty Equivalent Yet another common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash flows to some conservative levels. The net present value will decrease with increasing k. the IRR for project should be compared with risk-adjusted minimum required rate of return. the composite discount rate would be reduced. the less likely it will be accepted.65238119 Bahadurgarh Office : 01276-324593.232700. as the level of risk increases. there exists a category of risk seekers who do not demand premium for assuming risks. the project would be accepted. Though it is generally true. composite discount rate would be reduced.premium is difference between market rate of return & risk free rate multiplied by beta of the project. Disadvantages:1) There is no easy way of deriving a risk-adjusted discount rate.Disha Institute of IT & Management Under CAPM risk. there exists a category or risk seekers who do not demand premium for assuming risks. 3) It incorporates an attitude towards uncertainity. if firm uses IRR method. they are willing to pay a premium to take risks. The risk adjusted discount rate accounts for risk by varying discount rate depending on degree of risk of investment projects. then to allow for risk of an investment project. indicating that riskier a project is perceived. if I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Evaluation:Advantages:1) Simple to understood. A higher rate will be used for riskier projects & a lower rate for less risky projects. they are willing to pay a premium to take risk. Though it is generally true.

80.232700. t assumes a value between 0 and 1.000. There is a certainty-equivalent cash flow. the certainty equivalent approach may be expressed as: n NPV = ∑ t=0 Where. That is: t = NCFt* = NCFt Certain net cash flow Risky net cash flow For example. The certainty.000 and Rs 1. A lower t will be used if greater risk is perceived and a higher t will be used if lower risk is anticipated. we will multiply estimated cash flows by the certainty-equivalent coefficients.232800 E-mail : info@dishainstitute.000. Thus. 3=0. a cash flow of Rs 20.000. tNCFt (1+kf)t NCFt= the forecasts of net cash flow without risk-adjustment t = the risk-adjustment factor or the certainty equivalent coefficient kf = risk-free rate assumed to be constant for all periods.000 and it has cash flows of Rs 4. 1=0.Disha Institute of IT & Management an investor. and varies inversely with risk.75=60. ILLUSTRATION 15. Rs 3. he considers only Rs 16000 as the certain cash flow. according to his ‘best estimate. Assume that the associated t factors are estimated to be: o = 1.’ expects a cash flow of Rs 60.000/80.000 equally desirable.000 in period t and considers a certain cash flow of Rs 60.equivalent coefficient.000 to be on safe side.90. then t will be 0.00.50 I Disha Institute of IT & Management Delhi Office: +91-11-65238118. 2=0. to obtain certain cash flows.70. The coefficients are subjectively or objectively established by the decision maker. Rs 2.org . he will apply an intuitive correction factor and may work with Rs 40. That is.000 may be estimated in the next year. The certainty-equivalent coefficient can be determined as a relationship between the certain cash flows and the risky cash flows.000 next year. if one expected a risky cash flow of Rs 80. then the certainty-equivalent coefficient will be 0. For example.65238119 Bahadurgarh Office : 01276-324593. These coefficients reflect the decision-maker’s confidence in obtaining a particular cash flow in period t.000 in year 1 through 4.2 A project costs Rs 6. In formal way. but if the investor feels that only 80 per cent of it is a certain amount.

the forecaster.30. if forecasts have to pass through several layers of management. Evaluation of Certainty Equivalent The certainty-equivalent approach explicitly recognizes risk. Thus.000) 0. Project will be accepted if the internal rate is higher than.232800 E-mail : info@dishainstitute. If the internal rate of return method is used. The net present value will be: 0.000) 0. the minimum rate. we will calculate that rate of discount which equates the present value of certainty-equivalent cash inflows with the present value of certainty-equivalent cash outflows. the effect may be to greatly exaggerate the original forecasts or to make it ultra conservative. expecting the reduction that will be made in his forecasts.30(1. may inflate them in anticipation. chances are increased for passing by some good investments. Certainty-Equivalent The certainty-equivalent approach recognizes risk in capital budgeting analysis by adjusting estimated cash flows and employs risk-free rate to discount the adjusted cash flows. the risk-adjusted discount rate adjusts for risk by adjusting the discount rate.000) + + + = Rs 37 (1+0. by focusing explicit attention only on the gloomy outcomes.org . this method suffers from many dangers in a large enterprise.10)3 (1+010)4 NPV = 1. and the risk free discount rate is 10 per cent. On the other hand.10) (1+0.50(2.232700.90(4. The ratio so found will be compared with the minimum required risk-free rate. It has been suggested that the certainty equivalent approach is theoretically a superior technique over the risk-adjusted discount approach because it can measure risk more accurately.’ Second.1 The risk-adjusted discount rate approach will yield the same result as the certainty-equivalent approach if the risk-free rate is constant and the riskadjusted discount rate is the same for all future periods. Further. First.000) 0.70(3. otherwise it will be unacceptable.Disha Institute of IT & Management and 4=0. Risk-adjusted Discount Rate VS. This will no longer give forecasts according to ‘best estimate. I Disha Institute of IT & Management Delhi Office: +91-11-65238118.10)2 (1+0. Third.000) + The project would be rejected as it has a negative net present value. but the procedure for reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one investment to another.0(-6.65238119 Bahadurgarh Office : 01276-324593.

65238119 Bahadurgarh Office : 01276-324593. bank I Disha Institute of IT & Management Delhi Office: +91-11-65238118. we have stated that the values of 1 will vary between 0 and 1. then K must be larger than Kf to satisfy the condition that t varies. are used for day to day operation of business. op. Current Assets.. 1. on the other hand. pp. cit.org . Thus.232700. Unit IV 16 Management Of Working Capital Working capital management is an important component of overall financial management. building. (1) Fixed Assets (2) Current Assets Fixed Assets include land. if Kf and k are constant for all future periods. plant and machinery. Current assets include cash. For the efficient and effective use of fixed assets.232800 E-mail : info@dishainstitute. Equation (6) will becomes t+1 = (1+kf)t+1 (1+k)t+1 Earlier.Disha Institute of IT & Management t NCFt = To solve for l t NCF(1+k)t = NCFt (1+kf)t t = NCFt(1+kf)t NCFt(1+k)t = (1+kf)t (1+k)t (1+kf)t (1+k)t NCFt For period t+1. Management of working capital like long-term financial decisions affects the risk and profitability of business. fixed assets are used in the business for a long period and they are not purchased for the purpose of selling them to earn profit. 82-86. furniture and fittings etc. there should be adequate working capital in the business. Robichek and Myers. In business two types of assets are used.

232800 E-mail : info@dishainstitute. it will increases the liquidity but profitability will reduce.According to the net concept of working capital. The problem relating to management of working capital is different from that of management of fixed assets.Disha Institute of IT & Management stock debtors.According to the gross concept. Fixed assets are purchased for long term use in business and the return on them is received during their lifetime. if the amount of current assets is more in a business. On the other hand. It is also called gross working capital. Considering the objectives and scope of working capital. there should be proper balance between fixed capital and working capital. Definition of Working Capital There is difference of opinion among different authors about the definition of working capital. the capital employed in these assets is called working capital. Gross Working Capital= Total Current Assets (ii) Net Concept:. In any business.232700. current assets get converted into cash in short term. Therefore.org . the working capital will be called negative working capital. Net Working Capital= Current Assets-Current Liabilities I Disha Institute of IT & Management Delhi Office: +91-11-65238118. marketable securities etc. it can be defined in two ways: (i) Gross Concept (ii) Net Concept (i) Gross Concept:. On the other hand.65238119 Bahadurgarh Office : 01276-324593. working capital means total of all the current assets of a business. profitability will improve but liquidity will be adversely affected. net working capital means the excess of current assets over current liabilities. if current assets are relatively lesser. One more significant characteristic of the current assets is that. bills receivable. the main objective of working capital management is to determine optimum amount of investment in current assets so that balance in profitability and liquidity of the business could be ascertained. If current assets are equal to current liabilities then according to this concept working capital will be zero and in case current liabilities are more than current assets.

The difference between gross working capital and net working capital can be understood with the help of following illustration.232700.000 2. Net working capital is the part of current assets which has been financed from long term funds.232800 E-mail : info@dishainstitute. for example. Under this concept the relationship between current assets and current liabilities is established or their liquidity is determined.000 90.000 = Rs.000 1.000+Rs90. debtors.00. stock.000 10. Similarly. From the following balance sheet. Net working capital can also be defined in another manner.000 4.000+Rs40. bills receivables.000 1. 3.Disha Institute of IT & Management Current assets are those assets which are converted into cash within one accounting period. current liabilities are those liabilities which have to be paid within an accounting year. prepaid expenses. you are required to calculate the amount of Gross Working Capital and Net Working Capital:Balance Sheet Share Capital Reserves Debentures Short-term Loan Trade Creditors Bills Payable Rs 10.00.00. gross concept of working capital is used.65238119 Bahadurgarh Office : 01276-324593.org . 10.000 I Land and Building Plant and Machinery Cash and Bank Balance Marketable Securities Trade Debtors Bills Receivable Inventory Rs 10. Gross concept and net concept of working capital have their own significance.000 50.000 16.000 40. creditors bills payables.00. short term loans etc. cash and bank balance.000 Disha Institute of IT & Management Delhi Office: +91-11-65238118. Net concept of working capital emphasizes on how much current assets have been financed out of long term funds. ILLUSTRATION I.90.000 70.000+Rs70.000 40. It is. When individual current assets are to be managed.00. therefore also called circulating capital.10.00.000 10.000 Solution : Gross Working capital= Cash and Bank Balance+ Marketable Securities+ Trade Debtors+ Bills Receivable+ Inventory = Rs.000 16. for example.00.000+Rs1.00.

Thus.232700. The need for working capital canFARIDABAD PH with the help of be explained 5002194-95 operating cycle or cash cycle. The need for working capital is different businesses.10.org Cash Raw Materials Work-in- .00. working capital is MARKET. both receivable through sales and lastly cash is received from debtors and bills receivable. Working capital is needed for the purchase of raw material and for the payment of various day to day expenses.000.000 Need For Working Capital For the efficient operation of the business. the collection of which takes place after time terms.000 – Rs 10. Debtors and Bills Receivable I Disha Institute of IT & Management Finished Goods Delhi Office: +91-11-65238118.rs 1. there exists a gap between ITS STUDY CENTRE the sale of goods and realisation of cash.000 = Rs 3.000 + Rs 40. it is necessary to earn adequate profits. To achieve this objective. required. working capital is required along with the fixed capital. (4) Conversation of finished goods into Debtors and Bills Receivable.65238119 Bahadurgarh Office : 01276-324593.Disha Institute of IT & Management Net Working Capital= Current Assets.Rs50.232800 E-mail : info@dishainstitute. (2) Conversation of raw material into work-in-progress. which in turn gets converted into finished goods.000 + Rs70.000 + Rs 90. In the operating cycle. The profit depends largely on sales but sales do not result in cash immediately.10. (5) Conversation of Debtors and Bills receivable through sales into cash.000 – Rs 40. For this purpose. There will be hardly any business which does not require working capital. following events are included: (1) Conversation of cash into raw material.000 + 1.000.00.Current Liabilities = Rs10. Financial management aims at maximising the wealth of shareholders.000 = Rs 2. (3) Conversation of work in progress into finished goods. then raw material is converted into work-in progress. In a manufacturing enterprise raw material is purchased with cash. During this (B’MNT) SECTORare to be SCF-54 period expenses 15 incurred to continue business operations. To increase sales goods are to be sold on credit. Operating cycle means that time period which is required to convert raw material into cash.

But the need for working capital does not end with the completion of operating cycle. business needs adequate working capital.232700. (a) Permanent Working Capital:.The requirements for current assets do not remain stable throughout the year and it fluctuates from time to time. Similarly. the business needs to maintain some cash to pay its current liabilities in time. Thus.65238119 Bahadurgarh Office : 01276-324593.org . to maintain supply of goods to meet the demand in the market. the stock of finished goods has to be kept. work in progress and finished goods and cash must be maintained regularly in the business so that day to day operation of the business could continue without any obstacles. This minimum I Disha Institute of IT & Management Delhi Office: +91-11-65238118.232800 E-mail : info@dishainstitute. Business enterprises engaged in manufacturing work have larger duration of operating cycle as compared to those engaged in trading business because in such enterprises cash is directly converted into finished goods. therefore. Permanent And Variable Working Capital In business current assets are required because of the operating cycle. more will be the requirement of working capital.Disha Institute of IT & Management Operating Cycle The greater the period of operating cycle. For the smooth running of manufacturing work stock of raw material has to be maintained. Firm has to sell on credit due to competition. it becomes essential to distinguish between permanent or regular and variable or seasonal or temporary working capital. Because no business is able to match its cash inflows and cash outflows. A certain minimum amount of raw material. in order to understand the need for working capital. Operating cycle goes on continuously and therefore.

debentures. in boom period.Disha Institute of IT & Management requirement of current assets is called permanent or regular working capital. extra working capital required due to changes in demand and production is called variable working capital.org X . in depression. for example. Amount of working capital (RS. 1. the amount of stock and debtors declines. additional working capital may be required along with the permanent working capital.1 it is clear that the need for regular working capital remains the same for whole the year.232700. Permanent and Temporary Working Capital From Fig. Thus. This part of the working capital is required due to changes in demand and supply of goods on account of change in seasons etc.65238119 PERMANENT TEMPARARY CAPITAL Bahadurgarh Office : 01276-324593. In a growing concern the need for working capital goes on rising because in the level of business activities. Similarly. In order to run the business smoothly both types of working capital is required.) Y TEMPARARY WORKING CAPITAL I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Therefore. for example share capital.232800 E-mail : info@dishainstitute. whereas variable working capital needs are sometimes high and sometimes low. It is presented in Fig.) Y TEMPARARY WORKING CAPITAL PERMANENT WORKING CAPITAL X TIME Fig. It is known as variable or temporary working capital. stock is to be kept to fulfill demand and the amount of debtors increases due to more sales. Variable working capital is required for a short time.In certain months of the year the level of business activities is higher than normal and therefore. long term loans etc. 2) UNT OF WORKING CAPITAL (RS. it should be financed from the short term sources only so that later on it can be refunded when it is not required. (b) Variable Working Capital:. The arrangement of permanent working capital should be made from long term sources only.

(3) Production Cycle:. Thus. (2) Growth and Expansion:.the large sized businesses require more permanent and variable working capital in comparison to small business. Railways. On the other hand. the need for working capital is more than permanent capital. The needs for every business are different but generally the following factors must be considered while determining the requirement of working capital.Production cycle means the time period between the purchase of raw material and converting it into finished product. They also get immediate payment. electricity.232800 E-mail : info@dishainstitute. transport. Permanent and Temporary Working Capital Factors Affecting Working Capital Business should prepare its financial plan in such a way that it has neither surplus nor inadequate working capital. It the period of production cycle is longer. 2. the requirements of working capital will also be small.org . the growing concerns require more working capital as compared to the stable industries.Disha Institute of IT & Management Fig. business should choose such an alternate method of I Disha Institute of IT & Management Delhi Office: +91-11-65238118. In financial institutions and banks.Nature of business affects the working capital requirements of the business. more working capital will be required. cash and debtors. If a company is growing. (1) Nature of Business:. water and other public utilities require relatively lower working capital because the demand for their services is regular and fixed. the trading institutions require more working capital because they have to keep adequate stock. Therefore. its working capital requirements will also go on increasing.232700. The requirements of working capital in a business depends upon the production cycle. They need not keep much stock. If the production cycle is small.65238119 Bahadurgarh Office : 01276-324593.

In such a situation firm requires greater working capital to meet the requirements of production. it would require more working capital. (4) Business Fluctuations:. There are certain types of raw materials which are not available regularly. lesser working capital would be required.65238119 Bahadurgarh Office : 01276-324593. If the firm sells goods on credit to its customers. (8) Availability of Bank Credit:. This requires additional working capital. (ii) Terms of credit available to the firm. the requirement for working capital will decrease. Similarly. If the second alternative is followed. If the firm follows tight credit policy. During the boom period the business grows rapidly. (7) Availability of Raw Material:. Some raw materials are available in particular season only for example wool.e.org . For such industries two type of production policy can be followed. Firstly they can produce the goods in the months of demand or secondly. it would mean that till the time of demand finishes. Thus.Disha Institute of IT & Management production which takes lowest time. such product are purchased in certain months of a year. As a result the quantum of stock and debtors also reduces.Business has to pass through the stages of boom and depression. it should be seen that it is completed in pre-determined time. etc. a liberal credit policy towards purchase will reduce the amount of working capital requirement against a tight credit policy. These fluctuations affect the requirement of working capital. product will have to be kept in stock. Management has to invest more in stock and debtors. It decreases the need for working capital. cotton oil seeds. They have to be kept in stock for the whole year for which additional working capital is needed. they produce for the whole year.The determination of working capital needs depends upon the production policy of the business.If the firm is in a position to get financial help easily from the bank at the time of its need. sale of business decreases.232700. it keep a low level of working I Disha Institute of IT & Management Delhi Office: +91-11-65238118. (5) Production Policy:.232800 E-mail : info@dishainstitute. Before selecting specific production process. on the other hand.Availability of raw material on the continuous basis affects the requirement of working capital. (6) Credit Policy:. It would require additional working capital. if the firm purchases raw material on credit. The demand for certain products is seasonal i. during depression.Credit policy affects the working capital requirements in two ways:(i) Terms of credit allowed by customers to the firm.

Work-in-progress. When dividend is paid in cash it has unfavourable effect on working capital. (9) Turnover of Inventories:. there will be lesser outflow of cash. finished product. more working capital is needed. firm will have to keep greater working capital. more working capital will be needed.232800 of Liquidity Cost E-mail : info@dishainstitute. control on the market and ability of managers etc.e. it will help to arrange funds internally which will also increases the working capital. Nature of product. If the prices of different goods increase.It also affects the working capital. I Minimum Cost Total Cost Disha Institute of IT & Management Delhi Office: +91-11-65238118. it affects working capital directly. (12) Dividend Policy:. If the profit margin is high.Dividend policy also affects working capital needs. need of capital for business. (13) Depreciation Policy:. more working capital is needed. Taxes and dividends are to be paid out of profits. How much dividend is to be paid in cash and how much profits to be retained in business.65238119 Bahadurgarh Office : 01276-324593.Disha Institute of IT & Management capital but if such facility is not available. (14) Price Level Changes:. Depreciation does not result in outflow of cash. Dividend as bonus shares does not affect the working capital. (11) Level of Taxes:.Magnitude of profit is different for different businesses.The greater the turnover of inventories i. Amount of dividend will also be lower. Therefore . to maintain same level of production. which would impair sales further. High depreciation means lesser profit and accordingly lesser taxes. raw material. past dividend policy. If turnover is lower.Whole of the cash profit is not available for working capital. Taxes are a statutory liability but it can be planned. (10) Magnitude of Profit:. It affects tax liability and dividend.org Cost Cost of Illiquidity . If the management does not pay dividend and the profits are retained.232700. it increases working capital. Taxes are to be paid within a reasonable time. In all. lesser will be the requirement of working capital. If tax liability is high. it all depends upon number of factors including liquidity position of business.Price level changes also affect working capital needs.. determine the quantum of profit. Debtors may be due to tight credit policy.

However. This is illustrated in Figure 22. In determining the optimum level of current assets.5 Figure 22.Disha Institute of IT & Management Thus.232800 E-mail : info@dishainstitute.org . Ratio of sales To estimate working capital requirements as a ratio of sales on the assumption that current assets change with sales.232700. Ratio of fixed investment To estimate working capital requirements as a percentage of fixed investment.65238119 Bahadurgarh Office : 01276-324593. The minimum cost point indicates the optimum level of current assets in Figure 22. the low level of current assets involves costs which increases as this level falls.5 Cost trade-off ESTIMATING WORKING CAPITAL NEEDS The most appropriate method of calculating the working capital needs of a firm is the concept of operating cycle.5.6). a number of other methods may be used to determine working capital needs in practice. It is indicated in the figure that with the level of current assets the cost of liquidity increases while the cost of illiquidity decreases and vice versa. To illustrate the above methods of estimating working capital requirement and their impact on of return we shall take two hypothetical firms (as given in Table 22. The firm should maintain its current assets at that level where the sum of these two costs is minimized. We shall illustrate here three approaches which have been successfully applied in practice: Current assets holding period To estimate working capital requirements on the basis of average holding period of current assets and relating them to costs based on the company’s experience in the previous year. the firm should balance the profitability solvency tangle by minimizing total cost-cost of liquidity and cost of illiquidity. This method is essentially based on the operating cycle concept. The calculations are based on the following assumptions regarding each of the three methods: I Disha Institute of IT & Management Delhi Office: +91-11-65238118.

000 1 year 10 year 6. Inventory: one Month’s supply of each of raw material.667 Semi-finished material: one month’s supply (based on raw material plus one half of normal conversion cost): Rs 20.48.000 32.88.48.232700.000 57.200 1.200 1.20.40.000+ Rs 57.40.48.48.48.000 4. The following calculations based on data of firm A are made to show how three methods work: Method 1: Let us first compute inventory requirements.000 3.800 1.800 11.60.71.000 57.200 1. Debtors: one month’s sales.200= Rs 36. Labour Maintenance Power and fuel Factory overheads Depreciation (DEP) Total product cost Total product cost Annual sales PBIT Investment (INVST) Period Plant life PBDIT 2.60. semi finished goods and finished material.80.6 DATA FOR TWO FIRMS Firm A (Rs) Material Cost.600 2.000 Disha Institute of IT & Management Delhi Office: +91-11-65238118.000 68.00.60. Operating cash: one month’s total cost.800 9.800 1.600 2.000+12= Rs 20.40. Raw Material consumed Less: By product Net material cost Manufacturing cost.60.000 I Firm B (Rs) 2.org .000 14.20.667+16.000 9. Method 3: 10-20% of fixed capital investment.28.48.40.Disha Institute of IT & Management Method 1.79.600) ½ ÷12 = Rs 20.200 + Rs 1. Raw material: one month’s supply: Rs 2.71.000 1 year 10 year 6.65238119 Bahadurgarh Office : 01276-324593. Method 2: 25-35% of annual sales.79.00.68.667+ (Rs 1.000 3.867 Table 22.71.000 7.000 1.000 16.232800 E-mail : info@dishainstitute.000 14.000 68.200 1.

Method 3.3% to 27%.666= Rs 138. Debtors: one month’s sales: Rs14.200. As per the first method the working capital requirement is Rs 3.48.20.Disha Institute of IT & Management ROI [{PBIT/INVST-DEP)] 33.org .667 Operating Cash: one month’s total Cost: Rs 9.666 The total inventory needs are: Rs 20.667+ Rs 36.533 Method 2: The average ratio is 30 per cent.40.68.533.232800 E-mail : info@dishainstitute. the return of firm B drops from 11.34.000.38. if this figure is in calculating the rate of return.1% to 9.000÷12= Rs 1.667+ Td 80.667 Thus the total working capital required is: Rs 1.000 is 4.68.00. This approach is subject to markets are seasonal.200+ Rs 1.200 After determining the inventory requirements.39.39.3% 11.9%.20.000÷ 12= Rs 80.1% Finished material: one month’s supply: Rs 9.65238119 Bahadurgarh Office : 01276-324593.000 ÷ 12= Rs 80.48.66. it is lowered from 33.400. Rates of return are calculated as follows: I Disha Institute of IT & Management Delhi Office: +91-11-65238118.232700.666= Rs 3. projection for debtors and operating cash should be made. Therefore. The first method gives details of the working capital items.867 + Rs 80.000) is Rs 2. 30% of annual sales (Rs 14. 15% (the average rate) of fixed investment (Rs 16. the estimated working capital for firm B as per the method is Rs 3. On the other hand.

(EPS) and dividend per share (DIV) may be changed in the model to determine results. Walter who argues that the choice of dividend policies almost always affect the value of the firm.Disha Institute of IT & Management Unit –III Dividend Models A WALTER’S MODEL This model was propounded by Prof.org .65238119 Bahadurgarh Office : 01276-324593. James E.232700. 3) 100% payout or retention:All earning are either distributed as dividends or reinvested internally immediately. but any given values of EPS or DIV are assumed to remain constant forever in determining a given value. He shows the importance of relationship between the firm’s rate of return ® and its cost of capital (K) in determining the dividend policy that will maximise the wealth of shareholders. 5) Infinite time:The firm has a very long or infinite life. that is debt or new equity is not issued.232800 E-mail : info@dishainstitute. The value of the earnings per share. 4) Constant EPS and DIV:Beginning earnings and dividends never change. Walter’s formula to determine the market price per share is as follows:DIV P = K + K r (EPS-DIV)/k I Disha Institute of IT & Management Delhi Office: +91-11-65238118. 2) Constant return and cost of capital:The firm’s rate of return (r ) and its cost of capital (k) are constant. Assumptions:1) Internal financing:The firm finances all investment through retained earnings.

I Disha Institute of IT & Management Delhi Office: +91-11-65238118. r (EPS-DIV)/k will be equal to : [r(EPS-DIV)] /k. the present value of an infinite number of capital gains.its present value will be: R (EPS-DIV)/R This quantity can be known as a capital gain which occurs when earnings are retained within the firm. we shall use Eq (2) E. Equation (1) reveals that the market price per share is the sum of present value of 2 sources of income (i) Present value of infinite stream of constant dividends. Thus. normal firm and declining firm is constructed through given table.232700. DIV = Dividend price per share. If this retained earnings occur every year. K= firm’s cost of capital or capitalisation rate.org . (DIV/k) and (ii) Present value of infinite stream of capital gain r (EPS-DIV)/k k When the firm retains a perpetual sum of (EPS-DIV) at rate of return ®.g The effect of different dividend policies on the value of shares respectively for the growth firm.65238119 Bahadurgarh Office : 01276-324593.232800 E-mail : info@dishainstitute.Disha Institute of IT & Management Where P= market price per share. EPS = Earning price per share. the value of a share is the present value of all dividends plus the present value of all capital gain as show in eg (1) which can be rewritten as follows: P= DIV+(r/K) (EPS-DIV) ____________________ K To show the effect of dividend or retention policy on the market value of share. R= firm’s rate of return (average).

15/0.10 =Rs 130 Payout Ratio 80% DIV = Rs 8 P = 110 Payout Ratio 100% DIV = Rs 10 P = Rs 100 Normal Firm (r=k) T= 0. I Disha Institute of IT & Management Delhi Office: +91-11-65238118.10 EPS = Rs 10 Declining Firm (r<k) r= 0.10 K= 0.10)(10-4) 0.Disha Institute of IT & Management Dividend Policy and the value of share (Walter’s Model) Growth Firm (r>k) Basic Data r= 0.15/0.10 EPS = Rs 10 Payout Ratio 10% DIV R 50 P= [0+(0.65238119 Bahadurgarh Office : 01276-324593.org .10 EPS = Rs 10 DIV = Rs 0 P = 100 DIV =Rs 50 P= 80 DIV=Rs54 P= Rs 88 DIV=Rs 4 P= Rs= 100 DIV = Rs 8 P = 100 DIV= Rs 10 P = Rs 100 DIV = Rs 8 P = 96 DIV = Rs 10 P = Rs 100 The above table shows that dividend policy depends on the relationship between the firm’s rate of return ® and its cost of capital (k).232800 E-mail : info@dishainstitute. Walter’s view on the optimum dividend pay out ratio can be summarised as follows.15 k=0.232700.08 k = 0.10)(10-0)] 0.10 = Rs = 150 Payout Ratio 40% DIV = Rs 4 P=[4+0.

One dividend policy is as good as the other.Disha Institute of IT & Management Growth firm: Internal Rate More than Opportunity Cost of Capital (r>k) Growth firms are those firms which expand rapidly because of ample investment opportunities yielding returns higher than the opportunity cost of capital. • • • Retain all earnings when r>k. these firms earns on their investments rate of return equal to cost of capital (r=K). the optimum payout ratio for a growth firm is zero. Criticism:I Disha Institute of IT & Management Delhi Office: +91-11-65238118. The market value per share. The market value per share as not affected by payout ratio when r=k. Rs 100) for different dividend-payout ratio. They will maximise value per share if they follow a policy of retaining all earnings for internal investment.org .65238119 Bahadurgarh Office : 01276-324593. yielding returns higher than opportunity cost of capital. optimum payout ratio for declining firm is 100%. Thus.e. Some firms do not have any profitable investment opportunities to invest earnings. From above table it is shown that market value per share for normal firm is same (i. The market value per share P. P. increases as payout ratio decline when r>k. o retained earnings) the market value per share is Rs 100 & it is Rs 80 when payout ratio is zero. Thus. Declining firms: Internal Rate less than Opportunity Cost of Capital (r<k). the dividend policy has not effect on market value per share in Walter’s Model. Normal firms: Internal Rate equal opportunity cost of Capital (r=k) Most of the firms do not have unlimited surplus-generating investment opportunities. Thus. Dividend (or retention) policy has no effect when r=k. increases as payout ratio increases when r<k. These firms are able to reinvest earning at a rate ® which is higher than the rate expected by shareholders (k).e. Rs150) when it retain 100% earnings & minimum (Rs100) if distributes all earnings. The market value per share of declining firm with R<k will be maximum when it does not retain earnings at all from above table it is observed that declinings firm’s payout ratio is 100% (i. for normal firms with r=K. It can be seen from table above that the market value per share for growth firm is maximum (i. there is no unique optimum pay out ratio for normal firm.232800 E-mail : info@dishainstitute. Distribute all earnings when r<k. After exhausting super profitable opportunities.232700.e. Thus.

Disha Institute of IT & Management (1) No External Financing:Walter’s model of share valuation mixes dividend policy with investment policy of firm. it changes directly with the firm’s risk. Thus the present value of the firm’s income moves inversely with the cost of capital. k A firm’s cost of capital or discount rate. When such a situation exists. Constant Opportunity Cost of Capital. This reflects the assumption that the most profitable investment are made first & then poorer investment is made. r. o No external financing No external financing is available. does not remain constant. The model assumes that the investment opportunities of the firm are financed by retained earnings only & no external financing debt or equity is used for the purpose. By assuming that the discount rate. r decreases as more and more investment is made. The firm should stop at a point where r=k. Thus. k. In fact.232700. it changes directly with the firm’s risk. k.65238119 Bahadurgarh Office : 01276-324593. of the firm is constant. Walter’s model abstracts from the effect of risk on the value of the firm. just as Walter’s model Gordon’s model too confounds dividend and investment policies.1 I Disha Institute of IT & Management Delhi Office: +91-11-65238118. k. (3) Constant opportunity Cost of Capital. is constant. o Constant return The internal rate to return. Walter’s model abstracts from the effect of risk on the value of firm.org . is constant. k. (2) Constant rate of Return. This model is based on the assumption that r is constant. Consequently retained earnings would be used to finance any expansion. • DIVIDEND RELEVANCE: GORDON’S MODEL One very popular model explicitly relating the market value of the firm to dividend policy is developed by Myron Gordon.232800 E-mail : info@dishainstitute. By assuming that the discount rate. either the firm’s investment or its dividend policy or both will be sub-optimum. This ignores the diminishing marginal efficiency of investment as represented in Figure 20.1 Gordon’s model is based on the following assumptions:2 o All-equity firm The firm is an all-equity firm. does not remain constant. Thus the present value of firm’s income moves inversely with cost of capital. and it has no debt. k A firm’s cost of capital or discount rate.

If this condition is not fulfilled. we cannot get a meaningful value for the share. cit. the present value of a share is determined by the following formula: DIV(1+g)2 + (1+k) (1+k)2 + (1+k)3 DIV(1+g)3 +…. DIV (1+g)t = ∑ t=1 (1+k)t I Disha Institute of IT & Management Delhi Office: +91-11-65238118.+ (1+k)t DIV(1+g) Po = DIV(1+g) 1.e. Richard D. Financing and Valuation of Corporation. Gordon.Disha Institute of IT & Management o Constant cost of capital The appropriate discount rate K for the firm remains constant. p. The retained earnings are assumed to be reinvested within the all-equity firm at a rate of return of r. Thus. the market value of a share is equal to the present value of an infinite stream of dividends to be received by the shareholders as explained earlier in Chapter 8. K>br=g. o Constant retention The retention ratio. The dividend per share is equal to the payout ratio. is constant forever. b. DIVt = (1-b) EPS. The Investment. Gordon’s model also ignores the effect of a change in the firm’s risk-class and its effect on K. 1962. is constant.org ..232700. Irwin. in the dividend-capitalisation model. o No taxes Corporate taxes do not exist. the dividend per share is expected to grow when earnings are retained. When we incorporate growth in earnings and dividend. 2. the growth rate. Francis. once decided upon. Thus: DIV1 Po = (1+k) + DIV2 DIV DIVt =∑ t=1 (1+k)t +… (1+k)2 (1+k) However. o Perpetual earnings The firm and its stream of earnings are perpetual. g=br. Myron J. 352. op. resulting from the retained earnings. times earnings. Thud. (1-b). i.. According to Gordon’s dividend-capitalisation model.65238119 Bahadurgarh Office : 01276-324593.232800 E-mail : info@dishainstitute.. o Cost of capital greater than growth rate The discount rate is greater than growth rate. where b is the fraction of retained earnings. This allows earnings to grow at the rate of g= br per period.

which represents the firm’s dividend policy.e. k.. k. in the determination of the value of the share. dividend policy is irrelevant since b. EPS1. EPS1. r=k. this finding implies that. internal profitability.Disha Institute of IT & Management When Equation (4) is solved it becomes: DIV1 Po = K-g Substituting EPS1 (1-b) for DIV.. and br for g. Consequently. Equation (6) is particularly useful for studying the effects of dividend policy (as represented by b) on the value of the share.A total assets per share) Equation (8) shows that regardless of the firm’s earnings. i.232800 E-mail : info@dishainstitute. completely cancels out of equation (8). That is. the firm’s value is not affected by dividend policy and is equal to the book value of assets per share. Under such a situation. dividend policy. Interpreted in economic sense.232700. Let us consider the case of a normal firm where the internal rate of return of the firm equals its cost of capital. under competitive conditions. b. the opportunity cost of capital. then EPSl(1-b) = Po = K(1-b) rA(1-b) = k(1-b) k EPS1 = r rA =A = k-br rA(1-B) (since EPS =rA. and the all-equity firm’s cost of capital. or riskiness (which determines K). shareholders can neither I Disha Institute of IT & Management Delhi Office: +91-11-65238118.65238119 Bahadurgarh Office : 01276-324593. when r=k. Equation (6) maybe expressed as follows: EPSl (1-b) Po = K-br If r=k. This means that any funds distributed as dividends may be invested in the market at the rate equal to the firm’s internal rate of return. Equation (5) can be rewritten as EPS1 (1-b) Po = k-br Equation(6) explicitly shows the relationship of expected earnings. must be equal to the rate of return generally available to investors in comparable shares.org . r.

the company should adopt a policy of contraction and disinvestment. p. Equation (6) reveals that denominator.org . P0. p. according to Equation (6). Dobrovolsky. profit retention clearly becomes undersirable from the shareholders’ standpoint. Gordon’s model is illustrated in Illustration 20.1 Finally. to get the meaningful value of the share. kbr=0. and the market value of their shares must remain unchanged. however. b. A. let us consider the case of a growth firm where r>k. if the retention ratio. is zero or payout ratio. more remunerative enterprise.1 Considering the case of the declining firm where r<k.55.2. 1971. the value of b should be less than k/r. The Economics of Corporation Finance. thus making P0 negative. if b=k/r. which would allow the owner to transfer not only the net profit but also paid in capital (or a part of it) to some other. is 100 per cent the value of the share is equal to: rA Po = k If r<k then r/k<1 and from Equation (9) it follows that Po is smaller than the firm’s investment per share in assets. which is equal to the rate available in the market.k. For example. ibid. Under such conditions. Each additional rupee (sic) retained reduces the amount of funds that shareholders could invest at a higher rate elsewhere and thus further depress the value of the company’s share. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. It can be shown that if the value of b increases.. 56. thus making P0 infinitely large. Thus.br becomes negative.232800 E-mail : info@dishainstitute. These absurd result are obtained because of the assumption that r and k are constant.65238119 Bahadurgarh Office : 01276-324593.232700. which underlie the model. McGraw Hill. b increases under the condition of r>k. Sergie P. Equation (8) indicates that. the value of the share continuously falls.Disha Institute of IT & Management lose nor gain by any change in the company’s dividend policy. and if b=1. (1-b). 2.. (if b=0) It the internal rate of return is smaller than k. 2 These result may be interpreted as follows: 1. The value of a share will increase as the retention ratio. it is not clear as to what the value of b should be to maximise the value of the share.

04 6 = Rs 100 = 0. The implications of dividend policy.08 k = 0. B = 60% g=br=0.032 6 Rs 88 0.04 P= 0.048 4 = Rs 77 0.010-0.052 Declining Firm (r<k) r= 0.4) P= 0. (1-b) =.048 10(1-0.10-0.232800 E-mail : info@dishainstitute.15=0.10 EPS1 = Rs 10 g=br=0.01 10(1-0.10 EPS1 = Rs 10 g=br=0.085 Rs 106 0. b = 40% g=br=0.2 Let us consider the data in Table 20.06 10(1-0.09 4 = Rs 400 0.6X0.015 10(1-0.10-0.10X0.008 It is revealed that under Gordon’s model: I Disha Institute of IT & Management Delhi Office: +91-11-65238118.6) g=br=0.10X0.06 6 = Rs 150 0.4X0.08=0.2.015 = 9 = 0. according to Gordon’s model.09 9 Rs 100 = 0.10 EPS1 = Rs 10 Payout Ratio.10=0.4X0.10-0.06 4 = Rs 100 0.6X0.08=0.15= 0. Retention Ratio.15 k=0. Table 20.04 Payout Ratio = (1=b) = 90% .10-0.10-0.6) P= 0.10 K= 0.6X0.org .Disha Institute of IT & Management ILLUSTRATION 20.09 10(1-0.032 10(1-0.4X0.232700.65238119 Bahadurgarh Office : 01276-324593.06 g=br= 0.10=0.1) P= 0. Retention Ratio.068 g=br=0.10= 0.10-0.092 9 Rs 98 Normal Firm (r=k) T= 0.08=0. b =10% g=br=0.1) P = 0.10-0.008 10(1-0.06 10(1-0.4) P= 0. are shown respectively for the growth.6) P= 0.10-0.3 DIVIDEND POLICY AND THE VALUE OF THE FIRM (GORDON’S MODEL) Growth Firm (r>k) Basic Data r= 0. the normal and the declining firms.01 Payout Ratio = (1-b) = 60% Retention Ratio.15=0.4) p= 0.10X0.01 g=br=0.04 10(1-0.1) P = 0.

Johan. the former will undoubtedly command a higher price merely because stockholders prefer present to future values. Gordon concludes that dividend policy does affect the value of a share even when r=k. are risk-averse and.org . The market value of the share is not affected by dividend policy when r=k. Gordon’s model’s conclusions about dividend policy are similar to that of Walter’s model. Thus the Gordon model suffers from the same limitations as the Walter model. Investors. Krishman. McGraw Hill.e. P0.+ I DIV0((1+g)t Disha Institute of IT & Management Delhi Office: +91-11-65238118. (1-b).65238119 Bahadurgarh Office : 01276-324593. Iz the weighted average of Kt:1 DIV0(1+g) Po = + DIV0(1+g)2 +……. The logic underlying the dividend effect on the share value can be described as the bird-in-the-hand argument. Myopic vision plays a part in the price-making process.Disha Institute of IT & Management • • • The market value of the share. Stockholders often act upon the principle that a bird in the hand is worth two in the bush and for this reason are willing to pay a premium for the stock with the higher dividend rate. b. p. 1969. The bird-in-the hand argument was put forward. Principles of Investment. therefore. i. The market value of the share. increases with the payout ratio.. Where Pb is the price of the share when the retention rate b is positive i. P0. investors tend to discount distant dividends (capital gains) at a higher rate than they discount near dividends. E. in Mao J. 737. when r>k.. • DIVIDENDS AND UNCERTAINTY: THE BIRD-IN-THE HAND ARGUMENT According to Gordon’s model.. b>0. cf. first of all by Kirshman in the following words: Of two stocks with identical earnings record. This similarity is due to the similarities of assumptions which underlie both the models. just as they discount the one with the lower rate.e. increases with the retention ratio. dividend policy is irrelevant where r=k.C.232800 E-mail : info@dishainstitute. k. This view is based on the assumption that under conditions of uncertainty. Quantitative Analysis of Financial Decision. behaving rationally.232700. But when the simplifying assumptions are modified to conform more closely with reality.T. The value of Pb calculated in this way can be determined by discounting this dividend stream at the uniform rate. 1933. Macmillan.1 1. for declining firms with r<k. have a preference for near dividends to future dividends.. and prospects but the one paying a larger dividend that the other. when all other assumptions are held valid. for firms with growth opportunities.

Gordon concludes that the rate at which an investor discounts his dividend stream from a given firm increases with the futurity of this dividend stream.org .br (1+kl)t Assuming that the firm’s rate of return equals the discount rate.Disha Institute of IT & Management (1+kt) DIVl = = kl – g (1+kl)2 (1-b) EPSl kl .2 However all do not agree with this view. K. The firm does not pay dividends. These investors prefer dividend above capital gains because dividends are easier to predict. he reached this conclusion through two assumptions regarding investor’s behaviour: (i) investors are risk averters and (ii) they consider distant dividends as less certain than near dividends. increasing the retention ratio has the effect of raising the average discount rate. dividend decision the split of earnings between dividends and retained earnings is of no significance in determining the value of the firm. the dividend policy of a firm is irrelevant as it does not affect the value of the firm. when investment decision of the firm is given. or equivalently lowering share prices. Gordon concludes that dividend policy affects the value of the share. will Pb be higher or lower than P0? Gordon’s View. The firm does not have sufficient cash to pay dividends. To emphasise.232800 E-mail : info@dishainstitute. Thus. incorporating uncertainty into his model. and therefore. Thus. but a shareholder needs cash. are less uncertain and less risky. If investors discount distant dividend at a higher rate than near dividends. operating in perfect capital market conditions.232700. • DIVIDEND IRRELEVANCE: MODIGLIANI AND MILLER’S HYPOTHESIS According to Modigliani and Miller (M-M) under a perfect market situation. and are therefore. as explained above. On the basis of these assumptions. His reformulation of the model justifies the behaviour of investors who value a rupee of dividend income more than a rupee of capital gains income. A firm. 3 They argue that the value of the firm depends on the firm’s earnings which result from its investment policy. discounted with a lower discount rate. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. may face one of the following three situations regarding the payment of dividends: • • • The firm has sufficient cash to pay dividends.65238119 Bahadurgarh Office : 01276-324593. it that the increase in earnings retention will result in a lower value of share. it issues new shares to finance the payment of dividends.

Merton H. consider the example in illustration 20. shareholders get cash in their hand.T. 411-433. 482. and thus. Journal of business XXIV (October 1961). Mao. First. they lose in the form of their claims on the (reduced) assets.354. 2. before or after these transactions.65238119 Bahadurgarh Office : 01276-324593. The shareholder will have less number of shares. pp.232700.3.3 The Himgir Manufacturing Company Limited currently has 2 crore outstanding shares selling at a market price of Rs 100 per share. the firm will have to I Disha Institute of IT & Management Delhi Office: +91-11-65238118. There is no net gain or loss. He or she has exchanged a part of his claim on the firm to a new shareholder for cash. Macmillan. the value of the firm will remain unaffected. but the firm’s assets reduce (its cash balance declines). if the firm does not pay any dividend a shareholder can create a “home-made dividend” by selling a part of his/her shares at the market (fair) price in the capital market for obtaining cash. The fair price per share is share price before the payment of dividends less dividend per share to the existing shareholders. ILLUSTRATION 20. Miller and France Modigliani. Quantitative Analysis of Financial Decision.org . when the firm issues new shares to finance the payment of dividends. Given the firm’s capex plan and its policy of zero borrowing. 1969. and no one loses or gains. when the firm pays dividends. Dividend Policy. two transactions take place. the value of the firm will remain unaltered after these transactions. p. It has internal funds available to make a capital expenditure (capex) of Rs 30 crores. there is a transfer of wealth from shareholder’s one pocket to their another pocket. Since it is a fair transaction under perfect capital market conditions. In the third situation.232800 E-mail : info@dishainstitute. The existing shareholders transfer a part of their claim(in the form of new shares) to the new shareholders in exchange for cash. the existing shareholders get cash in the form of dividends. Thus. The capex is expected to yield a positive net present value of Rs 20 crore. The transaction is a fair transaction is a fair transaction. the wealth of shareholders does not change. James C. but they suffer an equal amount of capital loss since the value of their claim on assets reduces. What shareholders gain in the form of cash dividends. Thus. cit. The firm has no borrowing. the value of the firm remains the same. 3.. The firm also wants to pay a dividend per share of Rs 15. Francis. second. In the first situation. the new shareholders part with their cash to the company in exchange for new shares at a fair price per share. There is no net gain or loss.. Both transactions are fair. In the second situation.Disha Institute of IT & Management 1. The net effect is the same as in the case of the second situation. p. op. Growth and Valuation of the Shares.

65238119 Bahadurgarh Office : 01276-324593. investors are able to forecast future prices and dividends with certainty.57. No risk Risk of uncertainty foes not exist.e. The value of a share after paying dividend will be: 110-15= Rs 95. which is composed of the rate of dividends and capital gains. high-payout firms) need not command higher prices for their shares. • • • Under the M-M assumptions. it will entirely utilize its internal funds (15X2=Rs 30 crores).232700. and it will have to raise Rs 30 crore by issuing new shares to undertake capex.316 crore shares at Rs 95 each share.org . In the absence of taxes. but incur a capital loss of Rs 15 in the form of reduce share value.232800 E-mail : info@dishainstitute.6 lakh) share to raise Rs 30 crore. A formal explanation of the M-M hypothesis is given in the following pages. information is freely available to all and transactions and flotation costs do not exist. they can bet cash by devising “home-made dividend” without any dilution in their wealth. Thus. k and identical for all shares.Disha Institute of IT & Management issue new shares to finance payment of dividends to its shareholders. the value per share will be: 220/2 = Rs 110. the value will increases to:200+20= Rs220 crore. The firm now has 2. That is. Therefore. (ii) if it pays dividend per share Rs 15? The firm’s current value is: 2X100= Rs200 crore. is that shareholders do not necessarily depend on dividends for obtaining cash. As a result. r=k=kt for all t.316X95 = Rs 220 Crore. the price of each share must adjust so that the rate of return. r will be equal to the discount rate.895 (about 31. I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Thus. How will the firm’s value be affected (i) if it does not pay any dividend. Perfect capital markets also imply that no investor is large enough to affect the market price of a share. The crux of the M-M dividend hypothesis. No taxes Taxes do not exist. flotation costs and difficulties in selling shares. M-M’s hypothesis of irrelevance is based on the following assumptions:1 • Perfect capital markets The firm operates in perfect capital markets where investors behave rationally. Thus. This means that investors value a rupee of dividend as much as a rupee of capital gains. If the firm pays a dividend of Rs 15 per share. They neither gain nor lose. firms paying high dividends (i. If the firm does not pay dividends. and one discount rate is appropriate for all securities and all time periods. Investment policy given The firm has a fixed investment policy. the existing shareholders get cash of Rs 15 per share in the form of dividends. as explained above. After the capex. the value of the firm remains as: 2.: or there are no differences in the tax rates applicable to capital gains and dividends. The firm will have to issue: 30 crores/95= 31.

232800 E-mail : info@dishainstitute. P1 is the market price per share at time 1 and DIV1 is dividend per share at time 1. n. This switching or arbitrage will continue until the differentials in rates of return are eliminated.org . The discount rate will also be equal for all firms under the M-M assumptions since there are no risk differences. This process will tend to reduce the price of the low-return shares and increase the prices of the high-return shares.65238119 Bahadurgarh Office : 01276-324593. r should be equal for all shares.Disha Institute of IT & Management on every share will be equal to the discount rate and be identical for all shares. As hypothesized by M-M. Multiplying both sides of equation (14) by the number of shares outstanding. we obtain the total value of the firm if no new financing exists: nDIV1+P1) V = nPo = (1+k) (15) I Disha Institute of IT & Management Delhi Office: +91-11-65238118. Thus.232700. the rate of return for a share held for one year may be calculated as follows: Dividends + Capital gains (or loss) r= Share price (13) DIV1 + (P1 –Po) r= Po Where P0 is the market or purchase price per share at time 0. we can derive their valuation model model as follows: DIV1 + (P1 –Po) r= Po DIV1+P1 Po = (1+r) = (1+k) DIV1+P1 (14) Since r=K in the assumed world of certainty and perfect markets. From M-M’s fundamental principle of valuation described by Equation (13). If it is not so. the lowreturn yielding shares will be sold by investors who will purchase the high return yielding share.

nDIV1 + Pl) + mPl .65238119 Bahadurgarh Office : 01276-324593.mPl nPo = (1+k) (16) M-M’ s valuation Equation (16) allows for the issue of new shares.org . can be financed either by retained earnings or the issue of new shares or both thus.1). M-M’s argument. implies that when the firm pays dividends. Thus. This means that the terminal value of I Disha Institute of IT & Management Delhi Office: +91-11-65238118. the amount of new shares issued will be: mP1=I1-(X1-nDIV1)=I1-X1+nDIV1 (17) where I1 represents the total amount of investment during first period and X1 is the total net profit of the firm during first period. unlike Walter’s and Gordon’s models. in a given period of time.232700. M-M’s model yields more general conclusions.mPl nPo = (1+k) nDIVl + (n+m) Pl – (Il – Xl + nDIVl) = (1+k) (n+m) Pl – Il + Xl = (1+k) (18) A firm which pays dividends will have to raise funds externally to finance it investment plans. a firm can pay dividends and raise funds to undertake the optimum investment policy (as explained in figure 20. The investment programmes of a firm. like Walter’s and Gordon’s models. that dividend policy does not affect the wealth of the shareholders. Consequently.Disha Institute of IT & Management If the firm sells m number of new share at time 1 at a price of P1.232800 E-mail : info@dishainstitute. By substituting Equation (17) into Equation (16). the value of the firm at time 0 will be: n(DIV1+ P1) + mPl . M-M showed that the value of the firm is unaffected by its dividend policy. thus. its advantage is offset by external financing. dividend and investment policies are not confounded in the M-M model. As such.

the shareholders are indifferent between payment of dividends and retention of earnings. the wealth of the shareholders dividends plus terminal price-remains unchanged. Thus.000 outstanding shares selling at Rs 100 each. (ii) a dividend is declared.org . ILLUSTRATION 20. Co.00. price of the share at first period if the holding period is one year) declines when dividends are paid.10)-Rs 5 = Rs 105 In can be observed that whether dividend is paid or not the wealth of shareholders remains the same.000 – (10.Disha Institute of IT & Management the share (say. currently has 1.00.4 The Vikas Engineering Ltd. The number of new shares to be issued by the company to finance its investments is determined as follows: mPl = I – (X-nDIVl) 105m = 20. The firm’s opportunity cost of capital is 10 per cent. Thus. On the other hand.00. What will be the price of the share at the end of the year if (i) a dividend is not declared. when dividend is paid.000/ 105= 14.000-5.. the shareholder will realise Rs 105 by way of the price per share at the end of the current fiscal year plus Rs as dividend. (iii) How many new shares must be issued? The price of the share at the end of the current fiscal year is determined as follows: DIVl + Pl Po = (1+k) The value of P when dividend is not paid is: Pl = Rs100(1.000 during the period the firm is also thinking of declaring a dividend of Rs 5 per share at the end of the current fiscal year.00.232700.285 shares I Disha Institute of IT & Management Delhi Office: +91-11-65238118.00.65238119 Bahadurgarh Office : 01276-324593.000 and wants to make new investments of Rs 20.000) 105m = 15.00. When the dividend is not paid the shareholder will get Rs 110 by way of the price per share at the end of the current fiscal year. the present value per share after dividends and external financing is equal to the present value per share before the payment of dividends.000 m = 15.00.232800 E-mail : info@dishainstitute. As a result.10)-0=Rs110 When dividend is paid it is: Pl = Rs 100(1. The firm has net profits of Rs 10.00.

Dividend policy of the firm may affect the perception of shareholders and. while capital gains are specially treated for tax I Disha Institute of IT & Management Delhi Office: +91-11-65238118. But the assumptions underlying M-M’s hypothesis may not always be found valid in practice.Disha Institute of IT & Management RELEVANCE.65238119 Bahadurgarh Office : 01276-324593. For example. We may not find capital markets to be perfect in reality. The following are the situations where the M-M hypothesis may go wrong. But different tax rates are applicable to dividends and capital gains. Tax Differential: Low Payout Clientele M-M’s assumption that taxes do not exist is far from reality. M-M’s hypothesis is alleged to lack practical relevance. Because of the unrealistic nature of the assumptions. there may exist issue costs.232700. OF DIVIDEND POLICY:MARKET IMPERFECTIONS M-M hypothesis of dividend irrelevance is based on simplifying assumptions as discussed in the preceding section. dividends may be taxed differently than capital gains.org . the conclusion derived by them is logically consistent and intuitively appealing. therefore. Under these assumptions. This suggests that internal financing and external financing are not equivalent. Investors have to pay taxes on dividends and capital gains. Dividends are generally treated as the ordinary income. they may not remain indifferent between dividends and capital gains.232800 E-mail : info@dishainstitute. investors may encounter difficulties in selling their shares.

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