Lesson : 1

NATURE AND FUNCTIONS OF FINANCIAL MANAGEMENT

Objectives :
• Explain the nature of fiance and its interaction with other management
functions.
• Review the changing role of the finance manager and his/her position in
the management hierarchy.
• Focus on the shareholders' wealth maximisation principle as an
operationally desirable finance decision criterion.
Structure :
1.1 Introduction
1.2 Scope of Finance
1.3 Relation of Finance and other Relation Disciplines
1.4 Approaches to the Finance Functions
1.5 Financial Decisions in a Firm
1.6 Goals of Financial Management
1.7 Risk and Return Trade off
1.8 Organisation of the Finance Function
1.9 Summary
1.10 Self Test Questions
1.11 References
1.12 Suggested Readings
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1.1 INTRODUCTION

Financial management is that managerial area which is concerned with the

planning and controlling of the firm's financial resources. Though it was a branch
of economics till 1890, as a separate managerial area or discipline it is of
recent origin. Still, it has no unique body of knowledge of its own, and draws
heavily on economics for its theoretical concepts even today. In the early years
of its evaluation it was treated synonymously with the raising of funds. In the
current literature pertaining to financial management, in addition to
procurement of funds, efficient use of resources is universally recognised.
The subject of financial management is of great interest to academicians
because the subject is still developing, and there are still certain areas where
controversies exit for which no unanimous solutions have been reached as yet.
Practising managers are interested in this subject because among the most
crucial decisions of the firm are those which relate to finance, and an
understanding of the theory of financial management provides them with
conceptual and analytical in sights to make those decisions skilfully.

1.2 SCOPE OF FINANCE

What are a firm's financial activities? How are they related to the firm's other
activities. The three most important activities of a business firm are :
production, marketing and 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).

A firm needs real assets to carry on its business. Real assets can be tangible or
intangible. Plant, machinery, office, factory, furniture and building are examples
of tangible real assets, while technical know-how, technological collaborations,
patents and copyrights are intangible real assets. The firm sells financial assets
or securities, such as shares and bonds or debentures, to investors in capital
markets to raise necessary funds. Financial assets also include lease obligations

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and borrowing from banks, financial institutions and other sources. Funds
applied to assets by the firm are called capital expenditures or investment.
The firm expects to receive return on investment and distribute return as
dividends to inventors.
The raising of capital funds and using them for generating returns and paying
returns to the suppliers of funds are called the finance functions of the firm.
There are two types of funds that a firm raises : equity funds and borrowed
funds. A firm has to sell shares to acquire equity funds. Shares represent
ownership rights of their holders. The buyers of shares are called shareholders
and are the legal owners of the firm whose shares they hold. Shareholders
invest their money in the shares of a company in the expectation of returns on
their invested capital. The return on the shareholders' capital is called dividend.
Shareholders can be of two types : common and preference. Preference
shareholders receive dividends at a fixed rate and have a priority over common
shareholders in receiving dividends. The dividends rate for common
shareholders is not fixed and can vary from year to year depending on the
decision of the board of directors. The payment of dividends to shareholders
is not a legal obligation; it is an absolute discretion of the board of directors.
Since common shareholders receive dividends (or re-payment of invested
capital, if the company is wound up) in the end, they are generally called owners
of residue. Dividends paid by a company are not deductible charges for
calculating corporate income taxes.
Another important source of securing capital is creditors or lenders. Lenders
are not owners of the company. They make money available to the firm on
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. A
firm may borrow funds from banks, financial institutions, debenture holders

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and others.
A company can also secure funds by retaining a portion of the returns
available for shareholders. This method of acquiring funds is called retained
earnings. The retained earnings are undistributed returns on equity capital; they
are, therefore, rightfully a part of equity capital. The retention of earnings can
be considered as a form of raising new capital. If a company distributes all
earnings to shareholders, then, it can require new capital from the same sources
by issuing new shares.

The funds raised by a company will be invested in the available investment

opportunities. Each investment opportunity available to a company is called
investment project or simply a project. A project involves use of funds presently
in the expectation of future benefits. The company may also have on-going
projects. They (on-going projects) may also involve outlays of cash to maintain
or to increase their profitabilities. It would be realised that generation of
revenue – a production activity – is possible only when funds are invested in
projects.
1.3 RELATION OF FINANCE AND RELATED DISCIPLINES

1. Finance and Other Management Functions : Financial management,

as an integral part of management, is not a totally independent area. It draws
heavily on related disciplines and fields of study such as economics, marketing,
production, accounting and quantitative models. Despite key differences among
these fields, they are inter-related. Almost all kinds of business activities,
directly or indirectly, involve the acquisition and use of funds. For example,
recruitment and promotion of employees in production is clearly a
responsibility of the production department' but it requires payment of wages
and salaries and other benefits, and thus, involves finance. Similarly, buying a
new machine or replacing an old machine for the purpose of increasing
productive capacity affects the flow of funds.
Sales promotion policies come within the purview of marketing, but
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advertising and other sales promotion activities require outlays of cash and
therefore, affect financial resources. Where, then, is the separation between
production and marketing functions and the finance function of making money
available to meet the costs of production and marketing operations? Where do
the production and marketing functions end and the finance functions begin?
There are no clear-cut answers to these questions. The finance function of
raising and using money although has a significant effect on other functions,
yet it need not necessarily limit or constraint the general running of the
business. A company in a tight financial position will, of course, give more
weight to financial considerations, and devise its marketing and production
strategies in the light of the financial constraint. On the 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 and marketing decisions of a firm in practice.
Relationship to Economics

There are two important linkages between economics and finance. The macro-
economics environment defines the setting within which a firm operates and
the micro-economic theory provides the conceptual foundation for the tools
of financial decision making.
Key macro-economic factors such as growth rate of the economy, domestic
savings rate, role of the government in economic affairs, tax environment,
nature of external economic relationships, availability of funds to the corporate
sector, rate of inflation, real rate of interest, and terms on which the firm can
raise finances define the environment in which the firm operates. No finance
manager can afford to ignore the key developments in the macro-economic
sphere and the impact of the same on the firm. Similarly, a firm grounding in
micro-economic principles sharpens his analysis of decision alternatives.
Finance, in essence, is applied micro-economics. For example, the principle
of marginal analysis – a key principle of micro-economics according to which
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a decision should be guided by a comparison of incremental benefits and costs–
is applicable to a number of managerial decisions in finance.
Relationship to Accounting
Finance and accounting functions are closely related. Finance and accounting
are often considered indistinguishable or at least substantially overlapping.
However, as a student of finance you should know how the two differ and how
the two relate. The primary objective of accounting is to measure the
performance of the firm, assess its financial condition, and determine the base
for tax payment. The principal goal of financial management is to create
shareholder value by investing in positive net present value projects and
minimising the cost of financing. Of course, financial decision-making requires
considerable inputs from accounting.
Further, the accountant prepares the accounting reports based on the accrual
method which recognises revenues when the sale occurs and matches expenses
to sales. The focus of the finance manager, however, is on cash flows. He is
concerned about the magnitude, timing, and risk of cash flows as these are the
fundamental determinants of values.
Accounting deals primarily with the past. It records what has happened. Finance
is concerned mainly with the future. It involves decision making under
imperfect information and uncertainty. Hence it is characterised by a high
degree of subjectivity.
1.4 APPROACHES TO THE FINANCE FUNCTIONS
The approach to the functions of financial management is divided into two
broad categories : (a) Traditional Approach, and (b) The Modern Approach.
Traditional Approach
The traditional approach to the functions of financial management refers to
its subject-matter, in academic literature in the initial stages of its evolution,
as a separate branch of academic study. The term 'corporation finance' was
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used to describe what is now known in the academic would as 'financial
management'. The traditional phase of financial management lasted for about
four decades (upto 1950).

Traditionally the concern of financial management was with the financing of

corporate enterprises. In other words, the scope of the finance function was
treated by the traditional approach in the narrow sense of procurement of funds
by corporate enterprise to meet their financing needs. The term 'procurement'
was used in a broad sense so as to include the whole gamut of raising funds
externally. Thus defined, the field of study dealing with finance was treated as
encompassing the following aspects of raising and administering resources
from outside :
• The focus of financial management was mainly on certain episodic events
like formation, issuance of capital, major expansion, merger,
reorganisation, and liquidation in the life cycle of the firm.

• The approach was mainly descriptive and institutional. The instruments

of financing, the institutions and procedures used in capital markets,
and the legal aspects of financial events formed the core of financial
management.
• The outsider's point of view was dominant. Financial management was
viewed mainly from the point of view the investment bankers, lenders,
and other outside interests.

The coverage of corporation finance was, this, conceived to describe the rapidly
evolving complex of capital market institutions, instruments and practices. A
related aspect was that firms require funds at certain episodic events such as
merger, liquidation, reorganisation and so on. A detailed description of these
major events contributed the second element of the scope of this field of
academic study. Thus, the issues to which literature on finance addressed itself
was how resources could best be raised from the combination of the available
sources.
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The traditional approach has now been discarded as it suffers from serious
limitations. The first argument against the traditional approach was based on
its emphasis on issues relating to the procurement of funds by corporate
enterprises. Further, the traditional treatment of finance was criticised because
the finance function was equated with the issues involved in raising and
administering funds, the theme was woven around the viewpoint of the suppliers
of funds such as investors, investment bankers and so on, that is, the outsiders.
It implies that no consideration was given to the viewpoint of those who had to
take internal financial decisions. The traditional treatment was, in other words,
the outsider-looking-in approach. The limitation was that internal decision
making (i.e. insider-looking-out) was completely ignored.
The second criticism of the traditional treatment was that the focus was on
financing problems of corporate enterprises. To that extent the scope of
financial management was confined only to a segment of the industrial
enterprises, as non-corporate organisations lay outside its scope.

The third ground of criticism of the traditional approach was that the treatment
was built too closely around episodic events, such as promotion, incorporation,
merger, consolidation, reorganisation and so on. Financial management was
confined to a description of these infrequent happenings in the life of an
enterprise, but the day-to-day financial problems of normal company did not
receive much attention.
Lastly, the traditional approach was challenged because its focus was on a long-
term financing. Its natural implication was that the issues involved in working
capital management were not in the purview of the finance function.

The limitations of the traditional approach were more fundamental. The

conceptual and analytical shortcoming of this approach arose from the fact
that it confined financial management to issues involved in procurement of
external funds, it did not consider the important dimension of allocation of
capital. These issues are reflected in the following fundamental questions which
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a finance manager should address. Should an enterprise commit capital funds
to certain purposes? Do the expected returns meet financial standards of
performance? How should these standards be set and what is the cost of capital
funds to the enterprise? How does the cost vary with the mixture of financing
methods used? In the absence of the coverage of these crucial aspects, the
traditional approach implied a very narrow scope for financial management.
The modern approach provides a solution to these shortocomings.
Modern Approach : The traditional approach, with its emphasis on the episodic
financing and lacking in sound theoretical background, lost its utility in the
changed business situation since the mid 1950's A number of economic and
environment factors, such as the increasing pace of industrialisation,
technological innovations and inventions, intense competition, increasing
intervention of government on account of management efficiency and failure,
population growth and widened markets etc., during and after mid-1950's
necessitated efficient and effective utilisation of the firm's resources,
including financial resources. Fortunately, the development of a number of
management skills and decision-making techniques facilitated to implement a
system of optimum allocation of the firm's resources. As a result, the approach
to, and the scope of, financial management also changed. The emphasis shifted
from episodic financing to the managerial financial problems, from raising of
funds to efficient and effective use of funds. The new approach is embedded
with sound conceptual and analytical theories.
The new or modern approach is an analytical way of looking into the financial
problems of the firm. Financial management is considered a vital and an integral
part of overall management. In this broader view the central issue of financial
policy is the wise use of funds, and the central process involved is a rational
matching of advantages of potential uses against the cost of alternative potential
sources so as to achieve the broad financial goals which an enterprise sets for
itself. Thus, in a modern enterprise, the basic finance function is to decide

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about the expenditure decisions and to determine the demand for capital for
these expenditures. In other words, the financial manager, in his new role, is
concerned with the efficient allocation of funds. The allocation of funds is
not a new problem, however. It did exist in the past, but it was not considered
important in achieving the firm's long run objectives.
In his new role of using funds wisely, the financial manager must find a rational
basis for answering the following three questions :

1. How large should an enterprise be, and how fast should it grow?
2. In what form should it hold its assets?

3. What should be the composition of its liabilities?

The questions stated above relate to three broad decision areas of financial
management : investment ; financing and dividend decisions. The "modern"
financial manager has to help making these decisions in the most rational way.
These decisions have to be made in such a way that the funds of the firm are
used optimally. We have referred to these decisions as managerial finance
functions since they require special care and extraordinary administrative
ability.

The financial decisions have a great impact on all other business activities.
The concern of the financial manger, besides his traditional function of raising
money, will be in determining the size and technology, in setting the pace and
direction of growth and in shaping the profitability and risk complexion of the
firm by selecting the best asset mix and by obtaining the optimum financing
mix. The new approach to financial management may be broadened to include
profit-planning function also. The term profit-planning refers to the operating
decisions in the areas of pricing, volume of output and the firm's selection of
product lines. Profit-planning is therefore, a prerequisite for optimising
investment and financing decisions.

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1.5 FINANCIAL DECISIONS IN A FIRM
Finance functions or decisions include :
• Investment or long-term asset-mix decision
• Financing or capital-mix decision

• Dividend or profit allocation decision

• Liquidity or short-term asset-mix decision

A firm performs finance functions simultaneously and continuously in the

normal course of the business. They do not necessarily occur in a sequence.
Finance functions call for skilful planning, control and execution of a firm's
activities.
Let us note at the outset that shareholders are made better off by a financial
decision that increases the value of their shares. Thus while performing the
finance functions, the financial manager should strive to maximise the value
of shares. Following is brief description of the financial decisions :

Investment Decision : The first and perhaps the most important decision that
any firm has to make is to define the business or businesses that it wants to be
in. This decision has a significant bearing on how capital is allocated in the
firm.
Once the managers of a firm choose the business or businesses they want to
be in, they have to develop a plan to invest in buildings, machineries, equipment,
research and development, godowns, showrooms, distribution network,
information infrastructure, brands, and other long-lived assets. This is the
capital budgeting process.

The unit of analysis in capital budgeting is a investment project. Considerable

managerial time, attention, and energy is devoted to identify, evaluate, and
implement investment projects. When you look at an investment project from
the financial point of view, you should focus on the magnitude, timing, and
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riskiness of cash flows associated with it. In addition, consider the options
embedded in the investment projects.
Financing Decision : Financing decision is the second important function to
be performed by the financial manager. Once a firm has decided the investment
projects it wants to undertake, it has to figure out ways and means of financing
them. The key issues in capital structure decisions are : What is the optimal
debt-equity ratio for the firm? Which specific instruments of equity and debt
finance should the firm employ? Which capital markets should the firm access?
When should the firm raise finances? At what price should the firm offer its
securities?
Financing decisions should be guided by considerations of cost and flexibility,
in the main. The objective should be to minimise the cost of financing without
impairing the ability of the firm to raise finances required for value creating
investment projects. The firm must decide whether it should buy back its own
shares.
Dividend Decision : Dividend decision is the third major financial decision.
The financial manager must decide whether the firm should distribute all profits,
or retain them, or distribute a portion and retain the balance. Like the debt
policy, the dividend policy should be determined in terms of its impact on the
shareholders' value. The optimum dividend policy is one that maximises the
market value of the firm's shares. Thus, if shareholders are not indifferent to
the firm's dividend policy, the financial manager must determine the optimum
dividend-payout ratio. The financial manager should also consider the questions
of dividend stability, bonus shares and cash dividends in practice. Most
profitable companies pay cash dividends regularly. Periodically, additional
shares, called bonus shares (or stock dividend), are also issued to the existing
shareholders in addition to the cash dividend.

Working Capital Management : Working capital management also referred

to as short-term financial management, refers to the day-to-day financial
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activities that deal with current assets (inventories, debtors, short-term holdings
of marketable securities, and cash) and current liabilities (short-term debt,
trade creditors, accruals, and provisions). Current assets should be managed
efficiently for safeguarding the firm against the dangers of illiquidity and
insolvency. Investment in current assets affects the firm's profitability, liquidity
and risk.
A conflict exists between profitability and liquidity while managing current
assets. If the firm does not invest sufficient funds in current assets, it may
become illiquid. But it would lose profitability as idle current assets would
not earn anything. Thus, a proper trade-off must be achieved between profitability
and liquidity. In order to ensure that neither insufficient nor unnecessary funds
are invested in current assets, the financial manager should develop sound
techniques of managing current assets.

The key issues in working capital management are : What is the optimal level
of inventory for the operations of the firm? Should the firm grant credit to its
customers and, if so, on what terms? How much cash should the firm carry on
hand? Where should the firm invest its temporary cash surpluses? What sources
of short-term finance are appropriate for the firm?
It would thus be clear that financial decisions directly concern the firm's
decision to acquire or dispose off assets and require commitment or
recommitment of funds on a continuous basis. It is in this context that finance
functions are said to influence production, marketing and Other functions of
the firm. This, in consequence, finance functions may affect the size, growth,
profitability and risk of the firm, and ultimately, the value of the firm. To quote
Ezra Solomon 1 :

The function of financial management is to review and control decisions to

commit or recommit funds to new or ongoing uses. Thus, in addition to
raising funds, financial management is directly concerned with production,
marketing and other functions, within an enterprise whenever decisions are
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made about the acquisition or distribution of assets.
1.6 GOALS OF FINANCIAL MANAGEMENT

In order to make the firm's financial decisions rationally, the firm must have a
goal. It is generally agreed in theory that the financial goals of the firm should
be the maximisation of owners' economic welfare There are two widely-
discussed alternative approaches which can be used a as decision criterion for
the maximisation of owners' economic welfare : (i) Profit maximisation
approach, and (ii) Wealth maximisation approach. In this section, we discuss
that the shareholders. Wealth maximisation approach is theoretically logical
and operationally small feasible normative goal of financial management for
guiding the financial decision-making
Profit Maximisation :
According to this approach, actions that increase profits should be undertaken
and those that decrease profits are to be avoided. In specific operational terms,
as applicable to financial management, the profit maximisation criterion
implies that the investment, financing and dividend policy decisions of a firm
should be oriented to the maximisation of profits.
Profit maximisation means maximising the rupee (or any other currency such
as dollar, pound or euro) income of firms. Firms produce goods and services.
They may function in a market economy, or in a government-controlled
economy. Price system is the most important organ of a market economy
indicating what goods and services society wants. Goods and services in great
demand command higher prices. This results in higher profit for firms; more
of such goods and services are produced. Higher profit opportunities attract
other firms to produce such goods and services. Ultimately, with intensifying
competition an equilibrium price is reached at which demand and supply match.
In the case of goods and services which are not required by society, their prices
and profits fall. Such goods and services are dropped out by producers in favour

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of more profitable opportunities2. Price system directs managerial efforts
towards more profitable goods or services. Prices are determined by the
demand and supply conditions as well as the competitive forces, and they guide
the allocation of resources for various productive activities.
However, regarding price system a question is generally raised : Would the
price system in a free market economy serve in interests of the society? The
answer has been given by Adam Smith many years ago. According to him 3 :

(the businessman), by directing... industry in such a manner as its produce

may be of greater value.. intends only his own gain, and he is in this, as in
many other cases, led by an invisible hand to promote an end which was not
part of his intention..... pursuing his own interest he frequently promotes
that of society more effectually than he really intends to promote it.
Thus the economists following Smith's logic held that under the conditions of
free competition, businessmen pursuing their own self-interests also serve
the interest of society. It is also assumed that when individual firms pursue the
interest of maximising profits, society's resources are efficiently utilised.

The economic behaviour of a firm is analysed in terms of profit maximisation.

While maximising profit, a firm either produces maximum output for a given
amount of output, or uses minimum input for producing a given output. Thus,
the underlying logic of profit maximisation is efficiency. It is assumed to cause
the efficient allocation of resources under the competitive market conditions,
and profit is considered as the most appropriate measure of a firm's
performance.
Objections to Profit Maximisation : The profit maximisation criterion has,
however, been questioned and criticised on several grounds. It is argued that
profit maximisation assumes perfect competition, and in the face of imperfect
modern markets, it cannot be a legitimate objective of the firm. It is also argued
that profit maximisation, as a business objective, developed in the early 19th

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century when the characteristic features of the business structure were self-
financing, private property and single entrepreneurship. The only aim of the
single owner then was to enhance his or her individual wealth and personal
power, which could easily be satisfied by the profit maximisation objective.
The modern business environment is characterised by limited liability and a
divorce between management and ownership. The business firm today is
financed by shareholders and lenders but it is controlled and directed by
professional management. The other interested parties are customers,
employees, government and society. In practice, the objectives of these
constituents (or stakeholders) of a firm differ and may conflict with each other.
The manager of the firm has the difficult task of reconciling and balancing
these conflicting objectives. In the new business environment, profit
maximisation is regarded as unrealistic, difficult, inappropriate and immoral4 .
There is also a suspension that profit maximisation behaviour in a market
economy may tend to produce goods and services that are wasteful and
unnecessary from the society's point of view. Also, it might lead to inequality
of income and wealth. It is for this reason that governments tend to intervene
in business. The price system and therefore, the profit maximisation principle
may not work due to imperfections in practice. Oligopolies and monopolies
are quite common phenomena of modern economies. Firms producing same
goods and services differ substantially in terms of technology, costs and capital.
In view of such conditions, it is difficult to have a truly competitive price
system, and thus, it is doubtful if the profit maximising behaviour will lead to
the optimum social welfare.

Is profit maximisation an operationally feasible criterion? Because of the

aforesaid criticisms, profit maximisation fails to serve as an operational
criterion for maximising the owners' economic welfare. The main technical
flaws of this criterion are ambiguity, timing of benefits, and quality of benefits.
Ambiguity : The first operational difficulty with profit maximisation criterion
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for financial decision making is that the term profit is a vague and ambiguous
concept. It has no precise connotation. It is amenable to different
interpretations by different people. To illustrate, profit may be short term or
long term; it may be total profit or rate of profit; it may be before-tax or after-
tax; it may be return on total capital employed or total assets or shareholders'
equity and so on. If profit maximisation is taken to be the objective, the question
arises, which of these variants of profit should a firm try to maximise?
Obviously, a loose expression like profit cannot form the basis of operational
criterion for financial management.
Timing of Benefits : A more important technical objection to profit
maximisation, as guide to financial decision making, is that it ignores the
differences in the time pattern of the benefits received from investment
proposals or courses of action. While working out profitability, 'the bigger
the better' principle is adopted, as the decision is based on the total benefits
received over the working life of the asset, irrespective of when they were
received. Consider Table 1.1

Table 1.1 Time-Pattern of Benefits (Profits)

Alternative A (Rs. lakhs) Alternative B (Rs. lakhs)

Period I 100 (–)

Period II 200 200

Period III 100 200

Total 400 400

Table 1.1 shows that the total profits associated with the alternatives, A and B,
are identical. If the profit maximisation is the decision criterion, both the
alternatives would be ranked equally. But the returns from both the alternatives
differ in one important respect, while alternative A provides higher returns in
earlier years, the returns from alternative B are larger in later years. As a result,

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the two alternative courses of action are not strictly identical. This is primarily
because a basic dictum of financial planning is the earlier the better as
benefits received sooner are more valuable than benefits received later. The
reason for the superiority of benefits now over benefits later lies in the fact
that the former can be reinvested to earn a return. This is referred to as time
value of money. The profit maximisation criterion does not consider the
distinction between returns received in different time periods and treats all
benefits irrespective of the timing, as equally valuable. This is not true in
actual practice as benefits in early years should be valued more highly than
equivalent benefits in later years. The assumption of equal value is inconsistent
with the real world situation.
Uncertainty of returns : Third important technical limitation of profit
maximisation is that it ignores the quality aspect of benefits associated with
a financial course of action. The term quality here refers to the degree of
certainty with which benefits can be expected. As a rule, the more certain the
expected return, the higher is the quality of the benefits. Against it, an
uncertain and fluctuating return implies risk to the investors. It can be assumed
that the investors want to avoid or at least minimise risk. They can therefore,
be reasonably expected to have a preference for a return which is more certain
in the sense that it has smaller variance over the years.

Thus, the uncertainty of process renders profit maximisation unsuitable as an

operational criterion for financial management as it considers only the size
of benefits and gives no weight to the degree of uncertainty of the future
benefits.
Maximising Profit After Taxes : One can easily prove that maximising profit
after taxes will not maximise the economic welfare of the owners. It is
possible for a firm to increase profit after taxes by selling additional equity
shares and investing the proceeds in low-yielding assets, such as the
governments bonds. Profit after taxes would go up but earnings per share
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would go down. To illustrate, let us assume that a company has 5,000 shares
outstanding, profit after taxes of Rs. 50,000 and earnings per share of Rs. 10.
If the company sells 5,000 additional shares at Rs. 100 per share and invests
the proceeds (Rs. 5,00,000) at 5 per cent after taxes. The total profits after
taxes will increase to Rs. 75,000. However, the earnings per share will fall to
Rs. 7.5. This example clearly indicates that maximising profits after taxes does
not necessarily serve the best interests of owners.
Maximising Earnings Per Share: The financial objective of maximising
earnings per share will also not ensure the maximisation of owners' economic
welfare. It also suffers from the flaws already mentioned, i.e. it ignores timing
and risk of the expected benefits. Apart from these problems, maximisation of
earnings per share has certain deficiencies as a financial objective. For example,
if the market value is not a function of earnings per share, then maximisation
of the latter will not necessarily result in the highest possible price for the
company's shares. Maximisation of earnings per share further implies that the
firm should make no dividend payments so long as funds can be invested
internally at any positive rate of return, however small.

To conclude, maximising profits after taxes or earnings per share as the

financial objective fails to maximise the economic welfare of owners. Both
methods do not take account of the timing and objective of wealth-
maximisation. This objective is also considered consistent with the survival
goal and with the personal objectives of managers such as recognition, power,
status and personal wealth.
Shareholders' Wealth Maximisation

It is also termed as value maximisation or net present worth maximisation. In

current academic literature value maximisation is almost universally accepted
as an appropriate operational decision criterion for financial management
decisions. Its operational features satisfy all the three requirements of a
suitable operational objective of financial courses of action, namely, exactness,
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quality of benefits and the time value of money. This goal has been defended by
distinguished finance scholars, economists, and practitioners. The following
are some evidences of their views :

In a market-based economy which recognises the rights of private property ,

the only social responsibility of business is to create value and do so legally
and with integrity. It is a profound error to view increases in a company's value
as a concern just for its shareholders. Enlightened managers and public officials
recognise that increases in stock prices reflect improvement in competitiveness
– an issue which affects everyone who has a stake in the company or economy 5.
Should a firm maximise the welfare of employees or customers, or creditors?
These are bogus questions. The real question is : What should a firm do to
maximise its contribution to the society? The contribution to the society is
maximised by maximising the value of the firm 6.

Those who regard shareholder wealth maximisation as irrelevant or immoral

are forgetting that shareholders are not merely the beneficiary of a corporation's
financial successes, but also the referee who determine management's financial
power 7.
What is meant by Shareholders' Wealth Maximisation (SWM)? SWM means
maximising the pet present value (or wealth) of a course of action to
shareholders. The net present value (NPV) of a course of action is the difference
between the present value of its benefits and the present value of its costs. The
net present value of wealth can be defined more explicitly in the following way
:

n
Σt=1
A1 A2 An At
W = (1+k) + (1+k) 2 + ........ + (1+k) n – C 0 = (1+k) t – C 0

where A 1, A 2 .. represent the stream of benefits expected to occur if a course of

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action is adopted, C 0 is the cost of that action and k is the appropriate discount
rate to measure the quality of A's; k reflects both timing and risk of benefits,
and W is the Net present value or wealth which is the difference between the
present value of the stream of benefits and the initial cost. The firm should
adopt a course of action only when W is positive, i.e. when there is net increase
in the wealth of the firm. This is a very simple model of expressing wealth
maximisation principle. A complicated model can assume capital investments
to occur over a period of time and k to change with time. A financial action
that has a positive NPV creates wealth for shareholders and, therefore is
desirable. A financial action resulting in negative NPV should be rejected since
it would destroy shareholders' wealth. Between a number of mutually exclusive
projects the one with the highest NPV should be adopted. Therefore, the wealth
will be maximised if this criterion is followed in making financial decisions.
The objective of shareholders' wealth maximisation takes care of the questions
of the timing and risk of the expected benefits. These problems are handled by
selecting an appropriate rate (the shareholders' opportunity cost of capital)
for discounting the expected flow of future benefits. It is important to
emphasise that benefits are measured in terms of cash flows. In investment
and financing decisions, it is the flow of cash which is important, not the
accounting profits.

Maximising the shareholders' economic welfare is equivalent to maximising

the utility of their consumption over time. With their wealth maximised,
shareholders can adjust their cash flows in such way as to optimise their
consumption. From the shareholders' point of view, the wealth created by a
company through its actions is reflected in the market value of the company's
shares. Therefore, the wealth maximisation principle implies that the
fundamental objective of a firm is to maximise the market value of its shares.
The value of the company's shares is represented by their market price which,
in turn, is a reflection of the firm's financial decisions. The market price serves

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as the firm's performance indicator. How is the market price of a firm's share
determined?
Need for a Valuation Approach

Wealth maximisation approach requires a valuation model. The

financial manager must know or at least assume the factors that influence the
market price of shares, otherwise he or she would find himself or herself
unable to maximise the market value of the company's shares. What is the
appropriate share valuation model? In practice, innumerable factors influence
the price of a share, and also, these factors change very frequently. Moreover,
these factors vary across shares of different companies. For the purpose of
the financial management problem, we can phrase the crucial questions
normatively : How much should a particular share be worth? Upon what factor
or factors should its value depend? Although there is no simple answer to
these questions, it is generally agreed that the value of an asset depends on its
risk and return.
Criticism of Wealth Maximisation Objectives :

Despite the forceful arguments in favour of the goal of maximising

shareholders value, its supremacy has been challenged by many. The critics
fall into four main categories : the capital market sceptics, the strategic
visionaries, the balancers, and the social responsibility advocates. The
arguments of these critics and the rebuttal by the defendants of shareholder
value maximisation principal are summarised as follows :
1. The capital market critics argue that the stock market displays myopic
tendencies, often wrongly priced securities, and fails to reflect long-term
values. Managers, on the other hand, are well-informed and make decisions
based on more reliable and robust measures of value creation.

2. The strategists are of the opinion that the firm should pursue a product
market goal like maximising the market share, or enhancing customer
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satisfaction, or minimising costs in relation to competitors, or achieving a
zero defect level. If the firm succeeds in implementing its product market
strategy, investors would be amply rewarded.
3. It is also argued that a firm should seek to balance the interest of
various stakeholders, viz. customers, employees, shareholders, creditors,
suppliers, community, and others.

Justification for Wealth Maximisation Objective :

1. Financial economists argue that there are extensive empirical evidence
of the fact that in developed capital markets, at least, share prices are the
least biased estimates of intrinsic values and managers are not generally better
than investors at assessing values.

2. Some financial experts advocates that shareholders wealth is created

only through successful product market strategies. For example, satisfied
and loyal customers are essential for value creation. However beyond a certain
point customer satisfaction comes at the cost of shareholders value. When
that happens, the conflict should be resolved in favour of shareholders to
enhance the long-term viability and competitiveness of the firm.
3. Practically, there is no such mantra that can ensure balancing of the
interest of various stakeholders. There is no formula for balancing the
interests. When managers confront complex problems involving numerous
trade-offs, they will have no clear guidelines on how to resolve the differences.

1.7 RISK RETURN TRADE OFF

Financial decisions often involve alternative courses of action. Should the
firm set up a plant which has a capacity of one million tonnes or two million
tonnes? Should the debt-equity ratio of the firm be 2:1 or 1:1? Should the
firm pursue a generous credit policy or a conservative one? Should the firm
carry a large inventory or a small one?

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The alternative courses of action typically have different risk-return
implications. A large plant may have a higher expected return and a higher
risk exposure, whereas a small plant may have a lower expected return and a
lower risk exposure. A higher debt-equity ratio compared to a lower debt-
equity ratio, may reduce the cost of capital but expose the firm to greater
risk. A 'hot' stock compared to a defensive stock, may offer a higher expected
return but also a greater possibility of loss.
In general, when you make a financial decision, you have to answer the
following questions : What is the expected return? What is the risk exposure?
Given the risk-return characteristics of the decision, how would it influence
value? Exhibit 1.1 shows schematically the relationship between the key
financial decisions, return, risk, and market value.

Exhibit 1.1 : Risk-Return Trade-Off

Investment
decisions Return

Financing
decisions
Market value of
the firm
Dividend
decisions
Risk
Working Capital
decisions

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1.8 ORGANISATION OF THE FINANCE FUNCTION
Financial management is in many ways an integral part of the jobs of managers
who are involved in planning, allocation of resources, and control. The
responsibilities for financial management are dispersed throughout the
organisation. For example :
• The technocrat who proposes a new plant shapes the investment policy
of the firm.
• The marketing analyst provides inputs in the process of forecasting and
planning.
• The purchase manager influences the level of investment in inventories.
• The sales manager has a say in the determination of the receivables
policy.
• Departmental managers, in general, are important links in the financial
control system of the firm.
There are many tasks of financial management and allied areas (like accounting)
which are specialised in nature and which are attended to by specialists. These
tasks and their typical distribution between the two key financial officers of
the firm, the treasurer and the controller, are shown in Exhibit 1.2. Note that
the treasurer is responsible mainly for financing and investment activities and
the controller is concerned primarily with accounting and control.
Exhibit 1.2 : Functions of the Treasurer and the controller
Treasurer Controller
Obtaining finance Financial accounting
Banking relationship Internal auditing
Cash management Taxation
Credit administration Management accounting
Capital budgeting and control

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The finance function in a large organisation may be organised as shown in Exhibit
1.3. Generally, the chief finance officer is overall inchrage/head of the firm.
The chief finance officer may be designated as Director (Finance) or vice
President (Finance) and he supervises the work of the treasurer and the
controller. In turn, these officers are assisted by several specialist managers
working under them.
Exhibit 1.3 : Organisation of Finance function

Chief finance
officer
Treasurer Controller

Cash Credit Financial Cost

manager manger accounting accounting
manager manager
Capital Fund raising Tax Data
budgeting manager manager processing
manager manager
Portfolio Internal
manager auditor

The finance officers, in addition to their specialised responsibility, have

significant involvement in injecting financial discipline in corporate
management processes. They are responsible for emphasising the need for
rationality in the use of funds and the need for monitoring the operations of
the firm to achieve desired financial results. In this respect the tasks of financial
officers have assumed new dimensions. Instead of just looking after routine
financing and accounting activities they guide and participate in the tasks of
planning, funds allocation, and control so that the financial point of view is
sufficiently emphasised in the process of corporate management.

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Functions of Controller and Treasurer in the Indian Context
The two terms 'controller' and 'the treasurer' are not Indian terms. In fact these
are American terms. Generally speaking, the American pattern of dividing the
financial executive's functions into controllership and treasurership functions
is not being widely followed in India. We do have a number of companies in
India having officers with the designation of the controller, or the financial
controller. The controller or the financial controller in India, by and large,
performs the functions of a chief accountant or management accountant. The
officer with the title of treasurer can also be found in a few companies in
India.
Presently some of the controllership functions are performed by the company
secretary in India. His or her duties, for example, include asset control and
protection, maintaining records and preparing reports and government reporting.
The economic appraisal function is generally performed at the top level in
India. Some companies do have separate economics and statistical departments
for this purpose. Some other functions, such as internal audit, can be brought
within the fold of the controllership functions, if this concept is developed in
the Indian context.
It has been noted the financial controller does not control finances : he or she
develops, uses and interprets information – some of which will be financial –
for management control and planning. For this reason, the financial controller
may simply be called as the controller. Management of finance or money is a
separate and important activity. Traditionally, the accountants have been
involved in managing money in India. But the difference in managing money
resources and information resources should be appreciated.
As per as the American business is concerned, the management of fiance is
treated as a separate activity and is being performed by the treasurer. The title
of the treasurer has not found favour in India to the extent the controller has.
Some of the functions performed by the treasurer in the American context are

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again discharged by the company secretary in India. Insurance coverage is an
example in this regard. The function of maintaining relations with investors
(particularly shareholders) may now assume significance in India because of
the development in the India capital markets and the increasing awareness among
investors.
The designation, financial manager, seems to be more popular in India. This
title is also better than the title of treasurer since it conveys the functions
involved. The main function of the financial manager in India should be the
management of the company's funds. He or she should ensure the optimum use
of money under various constraints. He or she should therefore, be allowed to
devote his or her full energy and time in managing the money resources only.
1.9 SUMMARY
Financial management, also referred to as corporate finance or managerial
finance, emerged as a distinct field of study at the turn of the 20th century.
Financial management is closely related to macro-economic, financial
accounting, marketing, production and other related fields of management. The
financial management function in the modern sense of the term covers decision
making in three interrelated areas, namely, investment including working capital
management, financing and dividend policy. The financial manager has to take
these decisions with reference to the objectives of the firm. Wealth
maximisation as measured by the market price of shares emerges as a superior
normative objective of financial management as compared to profit
maximisation mainly because the latter is inapplicable in real situations due
to two technical limitations; it ignores timing of benefits and does not consider
the quality (uncertainty) of benefits.
Though managers are the agents of shareholders, they are likely to act in a way
incompatible with the interest of the shareholders. To harmonise the conflict
between them arising out of agency problems, shareholders have to bear agency
costs.

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Although, the importance of finance functions depends largely on the size of
the firm, financial management is an integral part of the overall management
of the firm. In small firms the finance functions are generally performed by
the accounting departments. In large firms, there is a separate department of
finance headed by a specialist known by different designations such as vice-
president, director of finance and so on.
1.10 SELF ASSESSMENT QUESTIONS
1. Define the scope of financial management. What role should the financial
manager play in a modern enterprise?
2. ".... the function of financial management is to review and control
decisions to commit or recommit funds to new or ongoing uses. Thus,
in addition to raising funds, financial management is directly concerned
with production, marketing, and other functions within an enterprise
whenever decisions are made about the acquisition or destruction of
assets" (Ezra Solomon). Elucidate.
3. What are the basic financial decisions? How do they involve risk-return
trade-off?
4. "The profit maximisation is not an operationally feasible criterion". Do
you agree? Illustrate your views.
5. What is the justification for the goal of maximising the wealth of
shareholders?
6. What do the critics of the goal of maximising shareholder wealth say?
What is the rebuttal provided by the advocates of maximising shareholder
wealth?
7. Critically evaluate the goals of maximisation of profit and maximisation
of return on equity.
8. Discuss the risk-return tradeoff in financial decisions.
9. How is the finance function typically organised in a large company?

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10. Discuss the relationship of financial management to economics and
accounting.
11. Comment on the emerging role of the finance manger in India.
1.11 REFERENCES
1. Solomon, Ezra, The Theory of Financial Management, Columbia
University Press, 1969, p.3.
2. Solomon, Ezra and Pringle John J., An Introduction to Financial
Management, Prentice-Hall of India. 1987, pp 6-7.
3. Adam Smith, The Wealth of Nations, Modern Library, 1937, p. 423,
quoted in Solomon and Pringle, op. cit.
4. Anthony, Robert B., The Trouble with Profit Maximization, Harvard
Business Review, 38, (Nov.-Dec., 1960), pp. 126-34.
5. Alfred Rappaport, "Let's Let Business Be Business" New York Times,
February 4,1990.
6. Michael Jenson, The Economist, 1997.
7. Jack L. Treynor, "The Financial Objective in the widely Held
Corporation", Financial Analysts Journal, March-April, 1981.
1.12 SUGGESTED READINGS
1. Prasanna Chandra : Financial Management, Tata McGraw Hill
2. I.M. Pandey : Financial Management, Vikas Publishing House
3. John J. Hampton : Financial Decision Making, PHI
4. Khan and Jain : Financial Management, Tata McGraw Hill

✪✪✪

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 Lesson : 2

FINANCIAL ANLAYSIS : RATIO ANALYSIS

Objective : After reading this lesson you should be able to

(i) understand the meaning, uses and limitations of ratio analysis;

(ii) workout all the important ratios that are required to analyse liquidity
position, operational efficiency, capital structure, profitability and solvency
position of manufacturing, trading, and service concerns.

Structure
2.1 Meaning of Analysis of Financial Statements

2.2 Meaning of Ratio Analysis

2.3 Interpretation of Financial Ratios

2.4 Managerial Uses of Ratio Analysis

2.5 Drawback of Ratio Analysis
2.6 Classification of Ratios
2.6.1 Liquidity Ratios

2.6.2 Activity Ratios

2.6.3 Leverage/Capital Structure

2.6.4 Coverage Ratios

2.6.5 Profitability Ratios

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2.7 Summary

2.8 Important Questions

2.9 Suggested Readings

2.1 MEANING OF ANALYSIS OF FINANCIAL STATEMENTS

An analysis of financial statements is the process of critically examining in detail

accounting information given in the financial statements. For the purpose of analy-
sis, individual items are studied, their interrelationships with other related figures
are established, the data is sometimes rearranged to have better understanding of
the information with the help of different techniques or tools for the purpose.
Analysing financial statements is a process of evaluating relationship between com-
ponent parts of financial statements to obtain a better understanding of firm’s po-
sition and performance. The analysis of financial statements thus refers to the treat-
ment of the information contained in the financial statements in a way so as to
afford a full diagnosis of the profitability and financial position of the firm con-
cerned. For this purpose financial statements are classified methodically, analysed
and compared with the figures of previous years or other similar firms.

The term ‘Analysis’ and ‘interpretation’ though are closely related, but distinction
can be made between the two. Analysis means evalauting relationship between com-
ponents of financial statements to understand firm’s performance in a better way.
Various account balances appear in the financial statements. These account bal-
ances do not represent homogeneous data so it is difficult to interpret them and
draw some conclusions. This requires an analysis of the data in the financial state-
ments so as to bring some homogeneity to the figures shown in the financial state-
ments. Interpretation is thus drawing of inference and stating what the figures in
the financial statements really mean. Interpretation is dependent on interpreter him-
self. Interpreter must have experience, understanding and intelligence to draw cor-
rect conclusions from the analysed data.

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2.2 MEANING OF RATIO ANALYSIS

A ratio is a simple arithmetical expression of the relationship of one number to

another. According to Accountant's Handbook by Wixon, Kelland bedbord, "a ratio"
is an expression of the quantitative relationship between two numbers". In simple
language ratio is one number expressed in terms of the other and can be worked out
by dividing one number into the other.This relationship can be expressed as (i)
percentages, say, net profits are 20 per cent of sales (assuming net profits of Rs.
20,000 and sales of Rs. 1,00,000), (ii) fraction (net profit is one-fourth of sales)
and (iii) proportion of numbers (the relationship between net profits and sales is
1:4).

The rational of ratio analysis lies in the fact that it makes related information
comparable. A single figure by itself has no meaning but when expressed in terms
of a related figure, it yields significant inferences. Ratio analysis helps in financial
forecasting, making comparisons, evaluating solvency position of a firm, etc. For
instance, the fact that the net profits of a firm amount to, say, Rs. 20 lakhs throws
no light on its adequacy or otherwise. The figure of net profit has to be considered
in relation to other variables. How does it stand in relation to sales? What does it
represent by way of return on total assets used or total capital employed? In case
net profits are shown in terms of their relationship with items such as sales, assets,
capital employed, equity capital and so on, meaningful conclusions can be drawn
regarding their adequacy. Ratio analysis, thus, as a quantitative tool, enables analysts
to draw quantitative answers to questions such as : Are the net profits adequate ?
Are the assets being used efficiently? Can the firm meet its current obligations and
so on ? However, ratio analysis is not an end in itself. Calculation of mere ratios
does not serve any purpose, unless several appropriate ratios are analysed and
interpreted. The following are the four steps involved in the ratio analysis :

(i) Selection of relevant data from the financial statements depending upon the
objective of the analysis.

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(ii) Calculation of appropriate ratios from the above data.

(iii) Comparison of the calculated ratios with the ratios of the same firm in the
past, or the ratios developed from projected financial statements or the ra-
tios of some other firms or the comparison with ratios of industry to which
the firm belongs.

(iv) Interpretation of the ratio.

2.3 INTERPRETATION OF RATIOS :

The interpretation of ratios is an important factor. Though calculation is also im-

portant but it is only a clerical task whereas interpretation needs skills, intelli-
gence and foresightedness. The interpretation of the ratios can be done in the fol-
lowing ways :

1. Single Absolute Ratio: Generally speaking one cannot draw meaningful

conclusions when a single ratio is considered in isolation. But single ratios may be
studied in relation to certain rules of thumb which are based upon well proven
contentions as for example 2:1 is considered to be a good ratio for current assets
to current liabilities.

2. Groups of Ratio : Ratios may be interpreted by calculating a group of re-

lated ratios. A single ratio supported by related additional ratios becomes more
understandable and meaningful.

3. Historical Comparisons : One of the easiest and most popular ways of

evaluating the performance of the firm is to compare its present ratios with the
past ratios called comparison over time.

4. Projected Ratios : Ratios can also be calculated for future standard based
upon the projected financial statements. Ratio calculation on actual financial state-
ments can be used for comparison with the standard ratios to find out variance, if
any. Such variance helps in interpreting and taking corrective action for improve-
ment in future.
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5. Inter-firm Comparison : Ratios of one firm can also be compared with
the ratios of some other selected firms in the same industry at the same point of
time.

2.4 MANAGERIAL USES OF RATIO ANALYSIS

The following are the important managerial uses of ratio analysis –

1. Helps in Financial Forecasting : Ratio analysis is very helfpful in financial

forecasting. Ratios relating to past sales, profits and financial position form the
basis for setting future trends.

2. Helps in Comparison : With the help of ratio analysis, ideal ratios can be
composed and they can be used for comparing a firm's progress and performance.
Inter-firm comparison or comparison with industry averages is made possible by
the ratio analysis.

3. Financial Solvency of the Firm : Ratio analysis indicates the trends in

financial solvency of the firm. Solvency has two dimensions-long-term solvency
and short-term solvency. Long-term solvency refers to the financial viability of a
firm and it is closely related with the existing financial structure. On the other
hand, short-term solvency is the liquidity position of the firm. With the help of
ratio analysis conclusions can be drawn regarding the firm's liquidity and long-
term solvency position.

4. Evaluation of Operating Efficiency : Ratio analysis throws light on the

degree of efficiency in the management and utilisation of its assets and resources.
Various activity ratios measure this kind of operational efficiency and indicate the
guidelines for economy in costs, operations and time.

5. Communication Value : Different financial ratios communicate the strength

and financial standing of the firm to the internal and external parties. They indicate
the over-all profitability of the firm.

6. Others Uses : Financial ratios are very helpful in the diagnosis of financial
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health of a firm. They highlight the liquidity, solvency, profitability and capital
gearing etc. of the firm.

2.5 DRAW BACKS OF RATIO ANALYSIS

1. Limited use of a single ratio : Ratio can be useful only when they are
computed in a sufficient large number. A single ratio would not be able to convey
anything. A the same time, if too many ratios are calculated, they are likely to
confuse instead of revealing any meaningful conclusion.

2. Effect of inherent limitations of accounting : Because ratios are computed

from historical accounting records, so they also possess those limitations and
weaknesses as accounting records possess.

4. Lack of proper standards : While making comparisons, it is always a

challenging job to find out an adequate standard. It is not possible to calculate exact
and well accepted absolute standard, so a quality range is used for this purpose. If
actual performance is within this range, it may be regarded as satisfactory.

5. Past is not indicator of future : It is not always possible to make future

estimates on the basis of the past as it always does not come true.

6. No allowance for change in price level : While making comparisons of

ratios, no allowance for changes in general price level is made. A change in price
level can seriously affect the validity of comparisons of ratios computed for
different time periods.

7. Difference in definitions : Comparisons are also made difficult due to

differences in definitions of various financial terms. The terms like gross profit,
net profit, operating profit etc. have not precise definitions and an established
procedure for their computation.

8. Window Dressing : Financial statements can easily be window dressed to

present a better picture of its financial and profitability position to outsiders. Hence
one has to be careful while making decision on the basis of ratios calculated from
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such window dressing made by a firm.

9. Personal Bias : Ratios are only means of financial analysis and is not an
end in itself. Ratios have to be Interpreted carefully because the same ratio can be
looked at, in different ways.

2.6 CLASSIFICATION OF RATIOS

Ratios can be classified into five broad groups : (i) Liquidity ratios (ii) Activity
ratios (iii) Leverage/Capital structure ratios (iv) Coverage ratios (v) Profitability
ratios.

2.6.1 Liquidity Ratios : Liquidity refers to the ability of a firm to meet its crrenct
obligations as and when they become due. The importance of adequate liquidity in
the sense of the ability of a firm to meet current/short-term obligations when they
become due for payment can hardly be overstressed. In fact, liquidity is a prerequisite
for the very survival of a firm.

The ratios which indicate the liquidity of a firm are (i) net working capital, (ii)
current ratio, (iii) acid test/quick ratio, (iv) super quick ratio, (v) basic defensive
interval.

1. Net Working Capital : The first measurement of liquidity of a firm is to

compute its Net Working capital (NWC). NWC is really not a ratio, it is frequently
employed as a measure of a company's liquidity position. NWC represents the excess
of current assets over current liabilities. A firm should have sufficient NWC in
order to be able to meet the claims of the creditors and the day-to-day needs of
business. The greater the amount of NWC, the greater the liquidity of the firm.
Inadequate working capital is the first sign of financial problems for a firm. It is
useful for purposes of internal control also.

NWC = Total Current Assets – Total Current Liabilities

Illustration 1. : The following data has been given in respect of two general
insurance firms. Calculate their NWC and comment upon the liquidity position.
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 Company X Company Y

Total Current Assets Rs. 2,80,000 Rs. 1,30,000

Total Current Liabilities Rs. 2,20,000 Rs. 1,10,000

Solution :

NWC = TCA–TCL

Company X : Rs. 2,80,000–Rs. 2,20,000 = Rs. 60,000.

Company Y : Rs. 1,30,000–Rs. 1,10,000 = Rs. 20,000.

X company has three times NWC in comparison to Y company, hence it is

more liquid. However, the size of NWC alone is not an appropriate measure of the
liquidity position of a firm. The composition of current assets is also important in
this respect.

2. Current Ratio : Current ratio is the most common ratio for measuring
liquidity. Being related to working capital analysis, it is also called the working
capital ratio. The current ratio is the ratio of total current assets to total current
liabilities.
Current Assets
Current Ratio =
Current Liabilities
As a measure of short-term financial liquidity, it indicates the rupees of current
assets available for each rupee of current liability. The higher the current ratio, the
larger the amount of rupees available per rupee of current liability, the more the
firm's ability to meet current obligations and the greater the safety of funds of
short-term creditors. If the result is greater than 1, the firm presumably has sufficient
current assets to meet its current liabilities. A ratio of 2:1 (two times current assets
of current liabilities) is considered satisfactory as a rule of thumb. Thus, a good
current ratio, in a way, provides a margin of safety to the creditors.

3. Acid-Test/Quick Ratio : One defect of the current ratio is that it fails to

convey any information on the composition of the current assets of a firm. A rupee
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of cash is considered equivalent to a rupee of inventory or receivables. But it is not
so. A rupee of cash is more readily available to meet current obligations than a
rupee of, say, inventory. This impairs the usefulness of the current ratio. The acid-
test ratio is a measure of liquidity designed to overcome this defect of the current
ratio. It is often referred to as quick ratio because it is a measurement of a firm's
ability to convert its current assets quickly into cash in order to meet its current
liabilities. Thus, it is a measure of quick or acid liquidity.
Quick assets
Acid-test ratio =
Current liabilities
The term quick assets refers to current assets which can be converted into cash
immediately or at a short notice without diminution of value. Included in this
category of current assets are (i) cash and bank balances; (ii) short-term marketable
securities and (iii) debtors/receivables. Thus, the current assets which are excluded
are : prepaid expenses and inventory. The exclusion of inventory is based on the
reasoning that it is not easily and readily convertible into cash. Prepaid expenses
by their very nature are not available to pay off current debts. An acid-test ratio of
1:1 or greater is recommended.

4. Cash-Position Ratio or Super-Quick Ratio : It is a variant of Quick ratio.

When liquidity is highly restricted in terms of cash and cash equivalents, this ratio
should be calculated. It is calculated by dividing the super-quick current assets by
the current liabilities of a firm. The super-quick current assets are cash and
marketable securities. It can be calculated as below :

Cash-Position Ratio = Cash + Marketable Securities

Current Liabilities
Illustration 2 : From the following information regarding current assets and current
liabilities of a firm, comment upon the liquidity of the concern :
Current Assets : Rs.
Cash 50,000
Debtors 20,000
Bills Receivables 15,000
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 Stock 35,000
Investment in Govt. Securities 25,000
Prepaid Expenses 10,000
1,55,000
Current Liabilities :
Trade Creditors 27,000
Bills Payable 12,000
Outstanding Expenses 5,000
Provision for Taxation 18,000
Bank Overdraft 10,000
72,000
Solution :
(1) Current Ratio = Current Assets = 155000 = 2.15:1
Current Liabilities 72,000

(2) Quick Ratio = Liquid Assets = 110,000 = 1.53:1

Current Liabilities 72,000

(3) Cash Position Ratio = Cash + Marketable Securities

Current Liabilities

= 75,000 = 1.04 : 1
72,000
2.6.2 Activity Ratios

Activity ratios which are also called efficiency ratio or asset utilisation ratios are
concerned with measuring the efficiency in asset management. The efficiency with
which the assets are used would be reflected in the speed and rapidity with which
assets are converted into sales. The greater is the rate of turnover or conversion,
the more efficient is the utilisation/management, other things being equal. For this
reason, such ratios are also designated as turnover ratios.

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1. Inventory Turnover Ratio : It is computed as follows :
Cost of goods sold
Inventory turnover ratio =
Average inventory
The cost of goods sold means sales minus gross profit. The average inventory refers
to the simple average of the opening and closing inventory. The ratio indicates how
fast inventory is sold. A high ratio is good from the viewpoint of liquidity and vice
versa. A low ratio would signify that inventory does not sell fast and stays on the
shelf or in the warehouse for a loan time.

2. Debtors Turnover Ratio : This ratio is determined by dividing the net credit
sales by average debtors outstanding during the year. Thus,

Debtors turnover ratio = Net credit sales

Average debtors
Net credit sales consist of gross credit sales minus sales returns, if any, from
customers. Average debtors is the simple average of debtors at the beginning and at
the end of year. The ratio measures how rapidly debts are collected. A high ratio is
indicative of shorter time-lag between credit sales and cash collection. A low ratio
shows that debts are not being collected rapidly.

3. Creditors Turnover Ratio : It is a ratio between net credit purchases and

the average amount of creditors outstanding during the year. It is calculated as
follows:
Net credit purchases
Creditors turnover ratio =
Average creditors
Net credit purchases = Gross credit purchases less returns to suppliers

Average creditors = Average of creditors outstanding at the beginning and at

the end of the year.

A low turnover ratio reflects liberal credit terms granted by suppliers, while a high
ratio shows that accounts are to be settled rapidly.

4. Average Age of Sundry Debtors : The average age of sundry debtors (or
accounts receivable), or average collection period is more meaningful figure to
(41)
use in evaluating the firm's credit and collection policies. The main objective of
calculating average collection period is to find out cash inflow rate from realisation
from debtros. It is found by a simple transformation of the firm's accounts receivable
turnover :
365
Average Age of Debtors =
Debtors Trunover
It can be calculated as follows also :
Trade Debtors
Average Collection Period = Net Credit Sales × No. of working days

The average of collection period should not exceed the standard or stated credit
period in sales terms plus 1/3 of such days. If it happens, it will indicate either
liberal credit policy or slackness of management in realising debts or accounts
receivable.

Illustration 3 : A manufacturer of stoves sells to retailers on terms 2½% discount

in 30 days, 60 days net. The debtors and receivables at the end of December of past
two years and net sales for all these two years are as under :

2000 2001
Rs. Rs.
Debtors 33,932 85,582
Bills Receivables 3,686 9,242
Net Sales 3,37,392 4,43,126

Determine the average collection period for both years and comment.

Solution :
Trade Receivables
Average Collection Period = × No. of Working Days
Net Credit Sales

37,618
2000 : × 365 = 41 days
3,37,392
94,824
2001 : × 365 = 78 days
4,43,126
(42)
Comment : The average collection period in both years has been within standard
period, i.e. 80 days (60+1/3 of 60 days), Hence it is good.

Illustration 4 : The comparative statement of income and financial position of a

company are given below :
1999 2000
Rs. Rs.
Net Sales 75,000 92,000
Less Cost of Sales 50,000 69,000
Gross Profit 25,000 23,000
Less Operating Expenses (including
Rs. 3,000p.a. for Depreciation) 22,000 21,000
Net Profit 3,000 2,000
Cash in hand 6,000 7,000
Debtors 30,000 18,000
Stock at cost 12,000 9,000
Fixed Assets (Net) 51,000 53,000
99,000 87,000
Creditors and Bills Payable 19,000 10,000
Debentures 20,000 15,000
Share Capital 50,000 58,000
Surplus (earned) 10,000 4,000
99,000 87,000

During the year 1979, 10% Stock Dividend was declared and paid. The factors for
the change in earned surplus during 2000 are, inter-alia, profit and cash dividends.

Compare the following :

(i) Debentors turnover for two years

(ii) Liquidity Ratio for two years.

(iii) Current Ratio for two years.

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(iv) Average collection period assuming all sales as credit sales.

(v) If desirable current ratio is 3:1 what should be the amount of current
liabilities at the end of 2000 ?

Solution :

(i) Debtors Trnover

( Trade Receivables
Net Credit Sales
×100 ) 30,000
75,000 ×100 = 40%
18,000
92,000 ×100= 19.56%

(ii) Liquidity Ratio = Liquid Assets/Current Liabilities

1999 : 36,000/19,000 = 1.9 :1

2000 : 25,000/10,000 = 2.5:1

(iii) Current Ratio = Current Assets/Current Liabilities

1999 : 48,000/19,000 = 2.5:1

2000 : 34,000/10,000 = 3.4:1

Trade Receivables
(iv) Average Collectioon Period = × No. of Working Days
Net Credit Sales
30,000
1999 : × 365 = 146 days
75,000

18,000
2000 : × 365 = 71 days
92,000
(v) As the current assets for 2000 are Rs. 34,000 and the desirable Current
Ratio is 3:1, the current liability must be one-third of the current assets, i.e., Current
Liabilities = 34,000 ×1/3 = Rs. 11,333.

5. Assets Turnover Ratio : This ratio is also known as the investment turnover
ratio. It is based on the relationship between the cost of goods sold and assets/
investments of a firm. A reference to this was made while working out the overall
profitability of a firm as reflected in its earning power. Depending upon the different

(44)
concepts of assets employed, there are many variants of this ratio.

Thus,
Cost of goods sold
1. Total assets turnover =
Average total assets

Cost of goods sold

2. Fixed assets turnover = Average fixed assets

Cost of goods sold

3. Capital turnover =
Average capital employed

4. Current assets turnover = Cost of goods sold

Average current assets

5. Working capital turnover ratio = Cost of goods sold

Net working capital
Here, the total assets and fixed assets are net of depreciation and the assets are
exclusive of fictitious assets like debit balance of profit and loss account and
deferred expenditures and so on.

The assets turnover ratio, howsoever defined, measures the efficiency of a firm in
managing and utilising its asses. The higher the turnover ratio, the more efficient is
the management and utilisation of the assets while low turnover ratios are indicative
of underutilisation of available resources and presence of idle capacity.

2.6.3 Leverage/Capital Structure Ratios : The second category of financial

ratios is leverage ratios. The long-term creditors would judge the soundeness of a
firm on the basis of the long-term financial strength measured in terms of its ability
to pay the interest regularly as well as repay the instalment of the principal on due
dates or in lump sum at the time of maturity. The long-term solvency of a firm can
be examined by using leverage or capital structure ratios. The leverage ratios may
be defined as financial ratios which throw light on the long-term solvency of a firm
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as reflected in its ability to assure the long-term creditors with regard to (i) periodic
payment of interest during the period of the loan and (ii) repayment of principal on
maturity or in predetermined instalments at due dates.

1. The Debt-equity Ratio – This ratio establishes the relationship between

the long-term funds provided by creditors and those provided by the firm's owners.
It is commonly used to measure the degree of financial leverage of the firm. It is
calcualted as follows :
Long-term Debts
Debt-equity Ratio =
Sahreholder’s Equity
Some experts use the following formula to calculate this ratio :
External Equities
Debt-equity Ratio =
Internal Equities
Generally, a ratio of 2:1 is considered satisfactory.

2. Proprietary Ratio : This ratio is also known as Shareholders' Equity to

Total Equities Ratio or Net Worth to Total Assets Ratio. It indicates the relationship
of Shareholders' equity to total assets or total equities. As per formula :
Shareholders’ Funds
Proprietary Ratio =
Total Assets or Total Equities
Higher the ratio, better the financial position of the firm.

3. The Solvency Ratio – It is also known as Debt Ratio. It is a difference of

100 and proprietary ratio. It measures the proportion of total assets provided by
the firm's creditors. This ratio is calculated as follows :
Total Liabilities
Solvency Ratio (or Debt Ratio) =
Total Assets
Interpretation :

Generally, lower the rate of total liabilities to total assets; more satisfactory or
stable is the long-term solvency position of a firm.

4. Fixed Assets to Net Worth Ratio – One of the important aspects of sound

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financial position of a firm is that its fixed assets are totally financed out of
shareholders' funds. If aggregate of fixed assets exceeds the net worth (or
proprietors' funds), it proves that fixed assets have been financed with outsiders'
funds (or creditors' funds). It may create difficulty in the long-run. This ratio is
calcualted as follows :
Fixed Assets (after depreciation)
Fixed Assets-Net Worth Ratio =
Proprietors' Funds
This ratio should not exceed 1:1. On the contrary, lower the ratio, better the position.
Usually, a ratio of 0.67 : 1 is considered satisfactory.

5. Proprietors' Liabilities Ratio : This ratio indicates the relationship of

proprietors' funds to total liabilities. It is calculated as follows :
Proprietros' Funds
Proprietors' Liabilities Ratio =
Total Liabilities
Higher the ratio, better is the position of creditors.

6. Fixed Assets Ratio

A variant to the ratio of fixed assets to net worth is the ratio of fixed assets to all
long-term funds which is calculated as :
Fixed Assets Ratio = Fixed Assets (After depreciation)
Total long-term funds
Interpretation :

This ratio indicates the extent to which the total of fixed assets are financed by log-
term funds of the firm. Generally, the total of the fixed assets should be equal to
total of the long-term funds or say the ratio should be 100%. And if total long-term
funds are more than total fixed assets, it means that part of working capital require-
ment is met out.

7. Ratio of Current Assets to Proprietary's Funds

The ratio is calculated by dividing the total of current assets by the amount of share-
holder's funds. For example, if current assets are Rs. 2,00,000 and shareholder's
(47)
Funds are Rs. 4,00,000 the ratio of current assets to proprietors funds in terms of
percentage would be
Current Assets
= × 100
Shareholders Funds

2,00,000
= × 100
4,00,000
Interpretation :

This ratio indicates the extent to which proprietors funds are invested in current
assets. There is no rule of thumb for this ratio and depending upon the nature of the
business there may be different ratios of different firms.

8. Debt-Service Ratio

Net income to debt service ratio or simply debt service ratio is used to test the
debt-servicing capacity of a firm. The ratio is also known as interest coverage ratio
or fixed charges cover or times interest earned. This ratio is calculated by dividing
the net profit before interest and taxes by fixed interest charges.
Net Profit (before interest and tax)
Debt Service or Interest Coverage Ratio =
Fixed Interest Charges
Interpretation

Interest coverage ratio indicates the number of times interest is covered by the
profits available to pay the interest charges. Longterm creditors of a firm are inter-
ested in knowing the firm's ability to pay interest on their long-term borrowings.
Generally, higher the ratio, more safe are long term creditors because even if earn-
ings of the firm fall, the firm shall be able to meet its commitment of fixed interest
changes. But a too high interest coverage ratio may not be good for the firm be-
cause it may imply that firm is not using debt as a source of finance so as to in-
crease the earnings per share.

Illustration 5 : Extracts from financial account of X, Y, Z Ltd. are given below :

(48)
 Year I Year II
Assets Liabilities Assets Liabilities
Rs. Rs. Rs. Rs.
Stock 10,000 20,000
Debtors 30,000 30,000
Payment in advance 2,000 –
Cash in hand 20,000 10,000
Sundry Creditors 25,000 30,000
Acceptances 15,000 12,000
Bank Overdraft – 5,000
62,000 40,000 65,000 47,000

Sales amounted to Rs. 3,50,000 in the first year and Rs. 3,00,000 in the second
year.

You are required to comment on the solvency position of the concern with the help
of accounting ratios.

Solution :

Short-term Solvency Analysis :

Current Assets
(1) Current Ratio =
Current Liabilities

10,000 + 30,000 + 2,000 + 20,000

Year I = = 1.55 :1
25,000 + 15,000

20,000 + 30,000 + 15,000

Year II = = 1.38 :1
30,000 + 12,000 + 5,000

Current Assets
(2) Liquid or Quick Ratio =
Current Liabilities

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 10,000 + 30,000 + 2,000
Year I = = 1.30 :1
25,000 + 15,000

30,000 + 15,000
Year II = 30,000 + 12,000 = 1.07 :1

Note : Bank overdraft is not included in liquid liabilities, as it tends to become

some sort of a permanent mode of financing.

Net Sales
(3) Inventory Turnover Ratio = Average Invntory

3,50,000
Year I = = 35:1
10,000

3,00,000
Year II = = 20:1
15,000

Inventory
(4) Inventory Current Assets Ratio = Total Current Assets × 100

10,000
Year I = × 100 = 16%
62,000

20,000
Year II = × 100 = 31%
65,000

Trade Receivables
(5) Average Collection Period = × No. of Working Days
Net Credit Sales

30,000
Year I = × 365 = 31.3 days
3,50,000
(50)
 30,000
Year II = × 365 = 36.5 days
3,00,000
The liquidity position (or shot-term solvency) of the company is not sound. The
current ratio in the first year, 1.55:1 does not appear to be good enough as it is
below the norm of 2:1. In the second year, the position has further deteriorated to
1.38:1. The latter ratio shows a definite weakening in the solvency position of the
company. As regards Acid Test Ratio, it is satisfactory in the first year and not
alarming in the second year, as it is above the generally accepted standard of 1:1.
However, the fall in the cash balance and appearance of bank overdraft in the second
year show a definite deterioration in the financial position. Moreover, because of
factors concerning sales, stock and debtors, the quick ratio is likely to soon
deteriorate.

The inventory turnover ratio, indicates a deterioration in the second year. The
disproportionate rise in the percentage of stock of total current assets from 16%
in the first year to 31% in the second year is also a matter of concern. This shows
over-purchase of materials which needs a thorough investigation.

A comparison of debtors' turnover ratios of the two years indicates worsening of

the company's liquid position. There will be much cause of worry, if the sales is
only to a few customers.

Long-term Solvency Analysis

External Equities
(1) Debt to Equity Ratio =
Internal Equities

Year I : 25,000 + 15,000 = 40,000 = 1.82 :1

62,000 – 40,000 22,000

Year II : 30,000 + 12,000, 5,000 = 47,000 = 2.61 :1

65,000 – 47,000 18,000
Sharehodlers' Equities
(2) Proprietary Ratio =
Total Equities
(51)
 22,000
Year I = 62,000 = 35 :1

18,000
Year II = 65,000 = 28.1

To sum up, the financial position of the company is very unsatisfactory as the debt
to equity ratio and proprietary ratio are far off the norm in both the years. The
situation has worsened in the second year resulting in a serious decline in the
shareholders' equity. The company seems to be heavily banking upon creditors' funds.

The overall conclusion of the above analysis is that the solvency position of the
company is not satisfactory and has deteriorated in the second year.

2.6.4 Coverage Ratios : The another category of leverage ratios are coverage
ratios. These ratios are computed from information available in the profit and loss
account. The coverage ratios measure the relationship between what is normally
available from operations of the firms and the claims of the outsiders. The important
coverage ratios are as folows :

1. Interest Coverage Ratio : This ratio measures the debt servicing capacity
of a firm insofar as fixed interest on long-term loan is concerned. It is determined
by dividing the operating profits or earnings before interest and taxes (EBIT) by
the fixed interest charges on loans. Thus,
EBIT
Interest coverage =
Interest
From the point of view of the creditors, the larger the coverage, the greater is the
ability of the firm to handle fixed-charge capabilities and the more assured is the
payment of interest to the creditors. However, too high a ratio may imply unused
debt capacity.

2. Dividend Coverage Ratio : It measures the ability of a firm to pay dividend

on preference shares which carry a stated rate of return. This ratio is computed as

(52)
under :
EAT
Dividend coverage = Preference dividend
The ratio, like the interest coverage ratio, reveals the safety margin available to the
preference shareholders. As a rule, the higher the coverage, the better it is from
their point of view.

3. Total Coverage Ratio : The total coverage ratio has a wider scope and takes
into account all the fixed obligations of a firm, that is, (i) interest on loan, (ii)
preference dividend, (iii) Lease payments, and (iv) repayment of principal.
Symbolically,
EBIT + Lease payment
Total coverage =
Interest + Lease payments + (Preference
dividend + Instalment of principal)/(1-t)

4. Debt-Services Coverage Ratio (DSCR) : This ratio is considered more

comprehensive and apt measure to compute debt service capacity of a business
firm. It provides the value in terms of the number of times the total debt service
obligations consisting of interest and repayment of principal in instalments are
covered by the total operating funds, available after the payment of taxes.
Symbolically,
n
∑
n=1 EATt + Interestt + Depreciationt + OAt
DSCR =
n
∑ Instalment t
n=1
The higher the ratio, the better it is. In general, lending financial institutions consider
2:1 as satisfactory ratio.

2.6.5 Profitability Ratios : Apart from the creditors, also interested in the
financial soundness of a firm are the owners and management or the company itself.
The management of the firm is naturally eager to measure its operating efficiency.
Similarly, the owners invest their funds in the expectation of reasonable returns.

(53)
Profitability ratios can be determined on the basis of either sales or investments.

1. Profitability Ratios Related to Sales : These ratios are based on the

premise that a firm should earn sufficient profit on each rupee of sales. These
ratios consist of (1) profit margin, and (2) expenses ratio.

(i) Gross Profit Margin :

Illustration 6 : Calculate the Gross Profit Ratio from the following figures :
Sales Rs. 1,00,000 Purchses Rs. 60,000
Sales Returns 10,000 Purchases Returns 15,000
Opening Stock 20,000 Closing Stock 5,000

Solution :
Gross Profit Ratio = Gross Profit × 100
Net Sales

= Net Sales – Cost of Goods sold × 100

Net Sales
= Rs. 90,000 – Rs. 60,000 × 100
Rs. 90,000

= Rs. 30,000 × 100 = 33.33%

Rs. 90,00
A high ratio of gross profit to sales is a sign of good management as it implies that
the cost of production of the firm is relatively low. It may also be indicative of a
higher sales price without a corresponding increase in the cost of goods sold.

A relatively low gross margin is definitely a danger signal, warranting a careful and
detailed analysis of the factors responsible for it.

(ii) Net profit margin is also known as net margin. This measures the relationship
between net profits and sales of a firm. Depending on the concept of net profit
employed, this ratio can be computed in two ways :

1. Operating profit ratio = Earnings before interest and taxes (EBIT)

Sales

(54)
 Earnings after interest and taxes (EAT)
2. Net profit ratio =
Sales

This ratio is indicative of management's ability to operate the business with sufficient
success not only to recover from revenues of the period, the cost of merchandise
or services, the expenses of operating the business (including depreciation) and
the cost of the borrowed funds, but also to leave a margin of reasonable compensation
to the owners for providing their capital at risk. The ratio of net profit (after interest
and taxes) to sales essentially expresses the cost price effectiveness of the operation.

A high net profit margin would ensure adequate return to the owners.

2. Expenses Ratio : Another profitability ratio related to sales is the expenses

ratio. It is computed by dividing expenses by sales.
Cost of goods sold
1. Cost of goods sold ratio = × 100
Net sales

Administrative expenses
2. Administrative expenses ratio = × 100
Net sales

Selling expenses
3. Selling expenses ratio = × 100
Net sales

Cost of goods sold + Operating expenses

4. Operating ratio = × 100
Net sales

The expenses ratio should be compared over a period of time with the industry
average as well as firms of similar type. As a working proposition, a low ratio is
favourable, while a high one is unfavourable.

3. Rate of Return on Equity Share Capital : This ratio is calcualted by

dividing the net profits (after deducing income-tax and dividend on preference share
capital) by the paid up amount of equity share capital. It is usually expressed in
(55)
percentage as below :
Net Profit (after tax and Pref. Div.)
Rate of Return of Equity Share Capital =
Paid-up Equity Share Capital × 100
This ratio examines the earning capacity of equity share capital.

4. Return on Proprietors Funds on Return on Net Worth : Some experts

suggest to calculate return on net worth instead of calculating return on equity
share capital. The proprietors funds or net worth represents the total interest of
shareholders which include share capital (whether equity or preference) and all
accumulated profits. Alternatively, proprietors' funds may be taken equal to fixed
assets plus current assets minus all outside liabilities both long-term and current.
This ratio may be calcualted as under :
Net Profits (less taxes)
Return on Proprietors' Funds = Proprietors' Funds
This ratio helps the proprietors and potential investors to judge the earning of the
company in relation to others and the adequacy of the return on proprietors' funds.

5. Return on Investment (ROI) Ratio : This is one of the key profibaility

ratios. It examines the overall operating efficiency or earning power of the com-
pany in relation to total investment in business. It indicates the percentage of re-
turn on the capital employed in the business. It is calculated on the basis of the
following formula :

Operating Profit
Capital Employed × 100

The term capital employed has been given different meanings by different
accountants. Some of the popular meanings are as follows :

(i) Sum-total of all assets whether fixed or current.

(ii) Sum-total of fixed assets

(iii) Sum-total of long-term funds employed in the business, i.e.,

(56)
 Share Capital + Reserves and Surplus + Long term Loans + Non-business
Assets + Fictitious Assets

In management accounting the term capital employed is generally used in the meaning
given in the point third above.

The term Operating Profit means Profit before Interest and Tax. The term Interest
means Interest on long-term Borrowings. Interest on short-term borrowings will
be deducted for computing operating profit. Non-trading incomes such as interest
on Government securities or non-trading losses or expenses such as loss on account
of fire, etc. will also be excluded.

The computation of ROI can be understood with the help of the following
illustration:

Illustration 7 : From the following figures extracted from the Income Statement
and Balance Sheet of Anu Sales Pvt. Ltd., calculate the Return on Total Capital
employed (ROI) :

Particulars Amount Particulars Amount

Rs. Rs.
Fixed Assets 4,50,000 Reserves 1,00,000
Current Assets 1,50,000 Debentures 1,00,000
Investment in Govt. Securities1,00,000 Income from Investments 10,000
Sales 5,00,000 Interest on Debentures at 10%
Cost of goods sold 3,00,000 Provision for tax at 50% of
Share Capital : Net Profits
10% Preference 1,00,000
Equity 2,00,000

Solution : It will be appropriate to prepare the Profit and Loss Account and the
Balance Sheet of the company before computation of the returns on capital
employed.
(57)
 Anu Sales Pvt. Limited
Profit and Loss Account

Particulars Amount Particulars Amount

Rs. Rs.

To Cost of goods sold 3,00,000 By Sales 5,00,000

To Interest on Debentures 10,000 By Income form Investments 10,000
To Provision for Taxation 1,00,000
To Net profit after tax 1,00,000
5,10,000 5,10,000

Balance Sheet as on ..........

Liabilities Rs. Assets Rs.

Share Capital Fixed Assets 1,50,000

10% Preference 1,00,000 Current Assets 1,50,000
Equity 2,00,000 Investment in govt. Securities 1,00,000
Reserves 1,00,000
10% Debentures 1,00,000
Profit and Loss Account 1,00,000
Provision for Taxation 1,00,000
7,00,000 7,00,000

Net operating profit before interest and tax

Return on total capital employed =
Total capital employed

2,00,000
= × 100
5,00,000

= 40%
Net Operating Profit = Net Profit + Provision for Tax – Income from
Investments + Interest on Debentures
= Rs.1,00,000 + Rs.1,00,000–Rs.10,000 + Rs. 10,000
(58)
 = Rs. 2,00,000
Capital employed = Fixed Assets + Current Assets – Provision for Tax
= Rs. 4,50,000 + Rs. 1,50,000–Rs. 1,00,000
= Rs. 5,00,000
Or = Share Capital+Reserves+Debentures+Profit &Loss
Account Balance – Investment in Govt. Securities
= Rs. 3,00,000 + Rs. 1,00,000 + Rs. 1,00,000 +
Rs. 1,00,000 – Rs. 1,00,000
= Rs. 5,00,000

Significance of ROI : The Return on Capital invested is a concept that measures

the profit which a firm earns on investing a unit of capital. Yield on capital is an-
other term employed to express the idea. It is desirable to ascertain this periodi-
cally. The profit being the net result of all operations, the return on capital ex-
presses all efficiences or inefficiencies of a business collectively and thus is a
dependable basis for judging its overall efficiency or inefficiency. On this basis,
there can be comparison of the efficiency of one department with that of another
or one plant with that another, one company with that of another and one industry
with that of another. For this purpose, the amount of profits considered is that
before making deductions on account of interest, income-tax and dividends and
capital is the aggregate of all the capital at the disposal of the company, viz., equity
capital, preference capital, reserve, debentures, etc.

The Return on Capital when calculated in this manner would also show whether the
company's borrowing policy was wise economically and whether the capital had
been employed fruitfully. Suppose, funds have been borrowed at 8% and the Return
on Capital is 7½% it would have been better not to borrow (unless borrowing was
vital for survival). It would also show that the firm had not been employing the
funds efficiently.

Limitations of ROI : ROI is one of the very important measures for judging the
overall financial performance of a firm. However, it suffers from certain important
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limitations. These limitations are :

(i) Manipulation is possible : ROI is based on earnings and investments. Both

these figures can be manipulated by management by adopting varying accounting
policies regarding depreciation, inventory valuation, treatment of provisions, etc.
The decision in respect of most of these matters is arbitrary and subject to whims
of the management.

(ii) Different bases for computation of Profit and Investments : There are
different bases for calculating both profit and investment as explained in the
preceeding pages. For example, fixed assets may be taken at gross or net values,
earnings may be taken before or after tax, etc.

(iii) Emphasis on short-term profit : ROI emphasises the generation of short-

term profits. The firm may achieve this objective by cutting down cost such as
those on research and development or sales promotion. Cutting down of such costs
without any justification may adversely affect the profitability of the firm in the
long run, though ROI may indicate better performance in the shortrun.

(iv) Poor Measure : ROI is a poor measure of a firm's performance since it is

also affected by many extraneous and non-controllable factors.

6. Return on Capital Employed (ROCE) : The ROCE is the second type of

ROI. It is similar to the ROA except in one respect. Here the profits are related to
the total capital employed. The term capital employed refers to long-tern funds
supplied by the creditors and owners of the firm. The higher the ratio, the more
efficient is the use of capital employed.

The ROCE can be computed in different ways as shown below :

Net profit after taxes/EBIT
1. ROCE = Average total capital employed × 100

Net profit after taxes + Interest + Tax advantage on interest

2. ROCE = × 100
Average total capital employed

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(7) Earning Per Share (EPS) measures the profit available to the equity
shareholders on a per share basis, that is, the amount that they can get on every
share held. It is calculated by dividing the profits available to the shareholders by
the number of the outstanding shares. The profits available to be the ordinary
shareholders are represented by net profits after taxes and preference dividend.
Thus,
Net profit available to equity holders
EPS =
Number of ordinary shares outstanding

8. Divided Per Share (DPS) is the dividends paid to shareholders on a per

share basis. In other words, DPS is the net distributed profit belonging to the
shareholders divided by the number of ordinary shares outstanding. That is,

Dividend paid to ordinary shareholders

DPS =
Number of ordinary shares outstanding
The DPS would be a better indicator than EPS as the former shows what exactly is
received by the owners.

9. Divided-Pay Out (D/P) Ratio : This is also known as pay-out ratio. It

measures the relationship between the earnings belonging to the ordinary
shareholders and the dividend paid to them. In other words, the D/P ratio shows
what percentage share of the net profits after taxes and preference dividend is paid
out as dividend to the equity holders.

Dividend per ordinary share (DPS)

D/P = × 100
Earnings per share (EPS)

If the D/P ratio is subtracted from 100, it will give that percentage share of the net
profits which are retained in the business.

10. Earnings and Dividend Yield : This ratio is closely related to the EPS and
DPS. While the EPS and DPS are based on the book value per share, the yield is
expressed in terms of the market value per share.

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This ratio is calculated as follows :
EPS
1. Earning yield = × 100
Market value per share

DPS
2. Dividend yield = × 100
Market value per share

The earning yield is also called the earning-price ratio

Price Earnings (P/E) Ratio is closely related to the earnings yield/earnings price
ratio. It is actually the reciprocal of the latter. This ratio is computed by dividing
the market price of the shares by the EPS. Thus,
Market price of share
P/E ratio =
EPS
The P/E ratio reflects the price currently being paid by the market for each rupee
of currently reported EPS. In other words, the P/E ratio measures investors'
expectations and the market appraisal of the performance of a firm.

2.7 SUMMARY

Ratio analysis is a widely- used tool of financial analysis. The rational of ratio
analysis lies in the fact that it makes related information comparable. A single
figure by itself has no meaning but when expressed in terms of a related figure, it
yields significant inferences. Ratio analysis helps in financial forecasting, in making
comparisons, in evaluating solvency position of a firm, etc.

Ratios can be classified into five broad groups : (i) Liquidity ratios (ii) Activity
ratios (iii) Longterm solvency/capital structure/leverage ratios (iv) coverage ratios
(v) Profitability ratios. In life insurance area, the ratios are calculated for each
operating unit i.e. each branch office, each divisional office (consolidated for
division as a whole), each zonal office (consolidated for zone as a whole) and for
the corporation as a whole. Ratios are calculated for two or more than two years
and compared; then they are compared with other units, and even with the corporate
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ratios , and interpreted and based on the indications received, corrective action is
taken. Sometimes some of the ratios are calculated monthly for observing the trend
of movement in various indices, and for taking remedial action promptly.

2.8 IMPORTANT QUESTIONS

1. Discuss the significance of any three of the following ratios to financial

analyst :

(a) Current Ratio

(b) Liquidly Ratio

(c) Net Profit to Capital Employed Ratio

(d) Debt Equity Ratio

2. State the meaning of expression "Return on Capital Employed" and point out
the advantages the business would derive from its use.

3. Ratios like statistics have a set of principles and finality about them which
at times may be misleading." discuss with illustrations.

4. Discuss the importance of ratio analysis for inter-firm and intra-firm

comparison including circumstances responsible for its limitations, if any.

5. "The study of financial analysis is simply memorising a bunch of ratios and

gives the students very little opportunity for creative problem solving." Do
you agree with it ? Explain.

6. Discuss in detail and with illustrations the limitations of ratio analysis.

7. What do you understand by 'Ratio Analysis'? What are its objects? Discuss
the role of three important ratios to the management.

8. Discuss some of the important ratios usually worked from financial

statements showing how they would be useful to higher management.

9. What is Profitability and how is it measured? Which of the accounting ratios

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 serve as indication of profitability and how are they computed ?

10 From the following information of a textile company complete the proforma

balance sheet if its sales are Rs. 32,00,000.

Sales to Net worth 2.3 times

Current Debt to Net Worth 42%
Total Debt to Net Worth 75%
Current Ratio 2.9 times
Net Sales to Inventory 4.7 times
Average Collection Period 64 days
Fixed Assets to Net Worth 53.2%

Proforoma Balance Sheet

Net Worth ? Fixed Assets ?
Long-term Debt ? Cash ?
Current Debt ? Stock ?
Sundry Debtors ?

11. From the following informations given below find out Debtors Turnover for
each year :

2000 2001
Rs. Rs.

Net Credit Sales 26,809 29,836

Total Debtors 5,644 6,089

If the Company increases its debtors turnover for the year 2001 to 6 times,
what would be the impact on profitability.

(Ans. 2000 – 4.75 times; 2001 – 4.90 times. If debtors turnover for 2001
increases to 6 times, working capital needs of the Company will be reduced
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 by Rs. 1,116. Assuming the cost of funds employed in debtors at 10%, the
company will save Rs. 111.60. Besides loss from bad debts will also be
reduced due to decrease in debtors).

12. From the following information, calculate average collection period :

Rs. Rs.
Total sales 1,05,000 Stock at the end 3,000
Sales Returns 5,000 Debtors at the end 3,000
Credit sales 60,000 B/R at the end 3,650
B/P at the end 3,000 Creditors at the end 7,000
Credit purchases 75,000 Provision for doubtful debt 15%

Also calculate number of days purchases in payables. Assume 360 days in a

year.

(Ans. 43.5 days, 48 day)

13. From the following Balance Sheet of Company A, you are required to
calculate : (a) Solvency Ratio (b) Liquidity Ratio

Balance Sheet of Company A

Liabilities Rs. Assets Rs.

Share Capital 5,00,000 Fixed Assets 6,00,000
Fixed Liabilities 2,50,000 Current Assets 4,00,000
Current Liabilities 2,50,000
10,00,000 10,00,000

[(Ans. (a) 5:1; (b) 1.6:1]

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14. The Capital of Everest Co. Ltd. is as follows :

Rs.
9% Preference Shares of Rs. 10 each 3,00,000
Equity Shares of Rs. 10 each 8,00,000
11,00,000
The accountant has ascertained the following information :
Rs.
Profit after tax at 60 per cent 2,70,000
Depreciation 60,000
Equity Dividend Paid 20 per cent
Market Price of Equity Shares Rs. 40
(You are required to state the following, showing the necessary workings :
(a) The dividend yield on the Equity Shares.
(b) The cover for the Preference and Equity dividends.
(c) The earnings per share.
(d) The price-earnings ratio.
(e) The net cash flow
2.9 SUGGESTED READINGS
1. Nigam, B.M. Lall and Jain, I.C.; Cost Accounting, PHI, New Delhi.
2. Pau,, S.Kr.; Management Accounting, Central Book Agency, Calcutta.
3. Khan, M.Y. and Jain, P.K.; Financial Management, Tata McGraw, New Delhi.
4. Maheshwari, S.N.; Management Accounting and Financial Control.

✪✪✪

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 Lesson : 3

MARGINAL COSTING AND COST-VOLUME-PROFIT ANALYSIS

Chapter Overview

I. Introduction

II. Assumptions of Marginal Costing

III. Absorption Costing and Marginal Costing

IV. Segregation of Semi-Variable Cost into Fixed and Variable Elements.

V. Contribution

VI. Break-even Point

VII. Profit Volume Ratio (P/V Ratio)

VIII. Margin of Safety (MOS)

IX. Application of Marginal Costing

X. Advantages of Marginal Costing

XI. Disadvantages or limitations of Marginal Costing

XII. Exercises

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 MARGINAL COSTING AND COST – VOLUME – PROFIT ANALYSIS

INTRODUCTION

Marginal costing is a comparatively new area in the field of accounting. Quite in tune
with the economic connotation of the term, it may be described in simple words as the
cost which arises from the production of additional increments or additional unit(s) of
output and it does not arise in case the additional increments or additional unit(s) are
not produced. Marginal Costing is also known as Direct Costing or Variable Costing.
It is very useful in decision making and is gradually gaining more and more importance
in management theory. It refers to the method of costing that is concerned with changes
in cost resulting from changes in the volume of production or sale of any product. The
essence of Marginal Costing technique lines in considering fixed costs on the whole
as separate, quite distinct from variable costs those are only relevant to current opera-
tions. Variable costs only are matched with revenues under different conditions of
production and sales to compute what is known as ‘contribution’ towards recovery of
fixed costs and yielding of profits.

It deals primarily with changes in future cost. Projected cost provides very helpful
guidelines for managerial decisions on pricing, sales, budgeting, production planning
and marketing etc. Hence, it is very important concept as it provides vital information
for making business decisions both in private and public sectors of the economy.

DEFINITION OF MARGINAL COSTING

Marginal Costing in simple words is the process of determining and analysing the
marginal costs. According to the Institute of Cost and Works Accounts London, Mar-
ginal Costing is the ascertainment, by differentiating between fixed costs and variable
costs, of marginal cost and of the effect on profit of changes in volume or type of
output. This definition suggests that marginal costing is the process of determining
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marginal cost (will be defined latter) and secondly how profit changes if the volume of
sales or composition of sales (sales mix) is changed. The term ‘marginal costs’ has
been defined by the same institute as, the amount of any given volume of output by
which aggregate costs are changed, if the volume of output is increased or decreased
by one unit. Thus, the marginal cost represents the incremental cost increased due to
increased unit of production. This unit may be a single article, a batch of articles, an
order, a stage of production capacity or a department. It relates to the change in output
in the particular circumstances under consideration. It includes the prime cost and
variable component of indirect overheads. Analysing the definitions given above, we
find that with the increase in one unit of output, the total cost from the existing to the
new level is known as Marginal Cost.

Thus, we see that Marginal Costing is not a system of costing such as process or job
costing rather it is a technique which enables the management to measure the profit-
ability of an undertaking by considering the underlying cost behavior. It makes neces-
sary to distinguish between fixed costs and variables costs. The behavior of variable
cost (that varies directly in proportion to change in the volume of production) is an
important aspect of marginal cost analysis. The relationship between different types
of costs will be clear from the following figures:

Example: If variable costs per unit are Rs.5/- and fixed expenses are Rs.50, 000 per
annum, an output of 30,000 units per annum results in the following expenditure——

Rs.
Variable Costs 30,000 x 5 1,50,000
Fixed Costs 50,000
Total costs 2,00,000

Cost per unit 2,00,000 / 5 = Rs.6.67

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Now, if output is increased by one unit, only Rs.5/- p.a. will be the incremental costs,
i.e. variable costs. Assume production is increased to 40,000 units, the total cost per
unit will be Rs.2,50,000/40,000 = Rs.6.25 per unit while at 30,000 units it was
Rs.6.67 per unit.

Such classification of production costs into fixed and variable expenses is very mean-
ingful. It helps to the management in understanding the cost behavior. The recovery of
fixed costs after break-even point (point of activity at which there in no profit or loss)
becomes meaningless, hence only the variable costs are meaningful for managerial
decision-making.

BASIC CHARACTERISTICS OF MARGINAL COSTING

The concept of marginal costing is based on the important distinction between product
costs and period costs, the former being related to the volume of output and the latter
to the period of time rather than the volume of production.

Marginal Costing, regards product costs as only those manufacturing cost, which have
a tendency to vary directly with the volume of output. Variability with volume is the
criterion for the classification of costs into product and period categories.

Prices are determined on the basis of marginal cost by adding ‘contribution’ which is
the excess of sales or selling price over marginal costs of sales (will be explained in
detail shortly). It is a technique of analysis and presentation of costs that help manage-
ment in taking many managerial decisions and as stated earlier, is not an independent
system of costing such as process costing or job costing.

The essential characteristic and mechanism of marginal costing technique may now be
stated as follows:

1. Segregation of costs into fixed and variable elements. In marginal costing

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 all costs are classified into fixed and variable. Semi variable costs are also
segregated into fixed and variable elements.

2. Marginal costs as products costs. In managerial costing only marginal

(variable) costs are charged to products.

3. Fixed costs as period. Fixed costs are treated as period costs and are
charged to costing Profit and Loss Account of the period in which they are
incurred.

4. Valuation of inventory. The work in progress and finished stocks are valued
at marginal cost only

5. Contribution. Contribution is the difference between sales value and

marginal cost of sales. The relative profitability of products or departments
is based on a study of contribution made by each of the products or
department.

6. Pricing. In marginal costing, prices are based on marginal cost plus

contribution.

7. Marginal costing and profit. In marginal costing, profit is calculated by a

two-stage approach. First of all contribution is determined for each product
or department. The contributions of various products or departments are
pooled together and such a total of contributions from all products is called
fund. Then from this fund is deducted the total fixed cost of the organization.

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ASSUMPTIONS OF MARGINAL COSTING

Marginal Costing is based on a number of underlying assumptions, as follows:

a. The behavior of total revenue is linear within the relevant range.

b. The behavior of total expenses is linear within the relevant range. This
assumption dictates that (a) expenses can be categorized as fixed, vari-
able, or semi variable and (b) efficiency and productivity remain as pre-
dicted.

c. The sales mix remains constant over the relevant range.

d. Inventory levels remain constant throughout the period (i.e., sales equals
production).

Absorption Costing and Marginal Costing

Absorption costing is the practice of charging all costs, both fixed and variable to
operations, process or products. In marginal costing, only variable costs are charged
to production.

The Institute of Cost and Management Accountants (U.K.) defines absorption costing
as, the practices of charging all costs, both variable and fixed to operations, processes
or products. This explains why this technique is also called full costing. Administra-
tive, selling and distributions overheads as much form part of total cost as prime cost
and factory burden.

The following example that illustrates the difference between the two techniques shall
help to understand both the concepts better.

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Example: The monthly cost figures for production in a manufacturing company are:

Variable Cost Rs 1,20,000

Fixed costs Rs. 35,000

Total Rs.1,55,000

Normally monthly sales figure is Rs.2,00,000

Actual sales figures for three separate months are :

1 Month II nd Month III Month

Rs. Rs. Rs.

2,00,000 1,65,000 2,35,000

Under a system of marginal costing stock are valued as:

1 Month II nd Month III Month

Rs. Rs. Rs

Opening Stock 84,000 84,000 1,05,000

Closing Stock 84,000 1,05,000 84,000

If the marginal costing techniques were not used stocks would be valued as follows

1 Month II nd Month III Month

Rs Rs. Rs

Opening Stock 1,08,500 1,08,500 1,35,625

Closing Stock 1,08,500 1,35,625 1,08,500

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Prepare two tabulations, to summarise these results for each of the three months, basing
one tabulation on marginal cost theory and the other tabulation on absorption cost
theory.

Solution:

Marginal Costing

1 Month 2 nd Month 3 Month

Rs. Rs. Rs.

Opening Stock 84,000 84,0000 1,05,000

Variable Cost 1,20,000 1,20,000 1,20,000

Fixed Cost —— —— ——

Total 2,04,000 2,04,000 2,25,000

Less: Closing stock 84,000 1,05,000 84,000

Cost of sales 1,20,000 99,000 1,41,000

Sales 2,00,000 1,65,000 2,35,000

Contribution 80,000 66,000 94,000

Less: fixed cost 35,000 35,000 35,000

Profit 45,000 31,000 59,000

Margin % on sales 40% 40% 40%

Profit on Sales 22.5% 18.8% 25%

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 ABSORPTION COSTING

1 Month 2 nd Month 3 Month

Rs. Rs. Rs.

Opening Stock 1,08,500 1,08,500 1,35,625

Variable Cost 1,20,000 1,20,000 1,20,000

Fixed Cost 35,000 35,000 35,000

Total 2,63,500 2,63,500 2,90,625

Less : Closing stock 1,08,500 1,35,625 1,08,500

Cost of sales 1,55,000 1,27,875 1,82,125

Sales 2,00,000 1,65,000 2,35,000

Contribution 45,000 37,125 52,875

Less: fixed cost Shown above Shown above Shown above

Profit 45,000 37,125 52,875

Margin % on sales 22.5% 22.5% 22.5%

Profit on Sales 22.5% 22.5% 22.5%

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Difference between absorption costing and marginal costing: Above stated ex-
ample clearly shows the difference between absorption costing and marginal costing.
The same is also discussed below:

Absorption Costing Marginal Costing

All cost-fixed and variable are Only variable costs are charged to products,
charged to product. fixed costs are transferred to profit & loss
account.

Profit = Sales – Cost of Goods Sold Contribution Margin = Sale–Variable Cost

Profit = Contribution – Fixed Cost

It does not reveal the cost volume Cost volume profit relationship is an
profit relationship. important part of marginal costing.

Closing inventories are valued at full Closing inventories are valued at variable
cost. Absorption costing reveals cost. Marginal costing reveals less profit,
more profit since the inclusion of when compared to absorption costing as all
fixed costs in inventories the fixed costs are charged to the same year.

Costs are included in the products, Fixed costs are not included in the product;
this leads to over or under absorption so it will not lead to the problem of over or
under absorption.
Segregation of Semi-variable Costs into Fixed and Variable Elements

A semi-variable cost is the cost that is fixed to a certain level of activity and then it
goes up. If plotted on graph paper would like stairs. It is a cost with both a fixed and a
variable component. Example of semi variable cost would be travel of officers by car
to a certain specific place, say from Hissar to New Delhi. Cost of one, two or even
four officers will be same but if seven need to go then cost goes up.

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In marginal costing all costs are classified into fixed and variable. This is because the
technique is based on this classification only. Semi variable costs also have to be
segregated into fixed and variable elements.

In other words, the extent to which an item of semi fixed or semi-variable cost is fixed
or variable has to be determined. The following methods are used for this purpose:

1. High and Lows Points Method.

2. Comparison of Output and Costs Method

3. Scatter Diagram Method

4. Simultaneous Equations Method

All these methods have been explained with the help of the following illustration.

Illustration:

Production Semi-variable
Units Cost Rs.

Jan. 40 1100
Feb. 20 800
March 60 1400
April 80 1700
May 100 2000
June 70 1550

In July, the production is 50 units, Calculate fixed, variable and semi variable costs
for this month.

1. High and low points method. In this method, the difference between the highest
and the lowest volume of output and the difference of the corresponding costs
are worked out. Then variable element per unit is computed by applying the

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 following formula:
Variable Element per unit = Difference in Semi-variable cost
Difference in production quantity

Solution : The highest production is 100 units in May and the lowest is 20
units in Feb.

Month Production units Semi variable cost

Rs.
May 100 2,000
Feb. 20 800
—— ————
80 1,200
—— ————
Variable element = Rs.1,200 = Rs.15 per unit
80 units
Variable element in Feb. = 20 x Rs.15 = Rs.300
Fixed element in Feb. = Semi variable cost – variable element
= Rs.800 -- 300 = Rs.500
Similar calculations for May.
Variable cost for May = 100 x Rs.15 = Rs.1500

Fixed cost (Rs.2000-1500) Rs. 500

————
Semi-variable cost 2,000
————
In July, when production is 50 units variable and fixed costs are calculated as follows:
Rs.
Variable Cost (50 units @ Rs.15) 750
Fixed Cost 500
————
Semi variable cost (Total) 1,250
————
2. Comparison of Output And Cost Method: This method is similar to High

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 and Low points method except that in this method a comparison is made be-
tween levels of output and corresponding costs at any two levels. Variable and
fixed elements are computed in the same manner as explained in the first method.
Solution : Let us take the figures of March and April in the above illustration

Month Production Semi-variable cost

Units Rs.

March 60 1,400
April 80 1700
——— ———
Difference 20 300
——— ———
Variable element = Rs.300 = Rs.15 per unit
20 units
Variable element in March = 60 x Rs.15 = Rs.900
Fixed element in March = Rs.1400 – Rs.900
= Rs.500
FOR THE MONTH OF APRIL
Variable cost (80 units @ Rs.15 ) = Rs.1200
Fixed Cost Rs. 500
————
Semi-variable cost Rs.1700
————
It may be noted that both the methods discussed above may give different value of
fixed cost.

3. Scatter diagram method. This is a graphic method and is explained in the

following step

(i) On X-axis represent units of production and on Y – axis represent

semi-variable costs.

(ii) Costs at various levels of production are plotted on the graph thereby
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 showing various points.

(iii) A straight line, ‘ the line of best fit is then drawn averaging the points
plotted. This line represents the trend shown by the majority of these
plotted points

(iv) The point where this line of best fit intersects the y-axis marks the
fixed cost. A line parallel to the X-axis is then drawn from the point
where the line of best fit had intersected Y-axis. This is fixed cost
line (shown as dotted line in the following diagram)

(v) The difference between the semi-variable cost and the fixed element
is the variable cost.

Using the data in the above question the scatter diagram follows.

Scatter Diagram

25

20
semi-variable costs (Rs '00)

15

Variable Elements
10

Fixed elements

0
0 10 20 30 40 50 60 70 80 90 100 110

production (Unit)

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1. Simultaneous Equations Method. In this method, two simultaneous equa-
tions are used to segregate fixed and variable elements in semi variable costs.
Two equations are used in respect of two periods or levels of production.

The equation is:

Y = a + bx
Where Y = Total semi-variable cost
a = Fixed cost
b = Variable cost per unit
x = Units of production

Solution- This equation has to be used with two periods. Here it is applied for
January and February. Thus we get:

Y = a + bx

Jan.1100 = a + 40b

Feb. 800 = a+ 20b

Substracting equation (ii) from (i) , we get

300 = 20b
b= 300
20
b = Rs.15

Thus variable cost per unit is Rs.15

Putting the value of b in equation (i)1100 = a +40 x 15

a=Rs.500

The result will be the same when value of b is put in equation (ii)

Thus in January
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 Fixed Cost = Rs.500

Variable cost = Rs.600 (i.e. 400 x15)

———
Semi-variable cost = 1,100
———
It is interesting to note that results obtained under the various methods are identi-
cal. This is because there is a linear relationship between output and variable over-
head cost i.e., for each unit of output, the same amount of variable overhead cost is
incurred, In practice, it may not always be so and final separated figures for fixed
and variable elements may differ widely under different methods.

The methods discussed above are used not only for determining the fixed and vari-
able elements in semi-variable costs but also for segregating the fixed and variable
costs when total cost is given.

Contribution:

In marginal costing as mentioned earlier costs are classified into fixed and variable
costs. The concept of marginal costing is based on the behaviour of costs with volume
of output. From this approach, it is not possible to identify an amount of net profit per
product, but it is possible to identify the amount of contribution per product toward
fixed overheads and profits.
Contribution is the difference between the sale price per unit and the marginal cost per
unit. In other words contribution margin is sales revenue minus variable expenses. The
amount of sales revenue, which is left to cover fixed expenses and profit after paying
variable expenses. It contributes towards fixed expenses and profit. Suppose in one
case, the selling price per unit is Rs.10 and variable cost per unit is Rs.7 per unit. Now,
in this example, contribution is Rs.3 per unit. If fixed cost is Rs.30,000. The break-
even sale will be 10,000 units (30,000/3). Thus, contribution first goes to meet fixed
costs be point and the to earn profits.
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In marginal costing it is not possible to determine the profit per unit of product because
fixed overheads are charged in total to the Profit and Loss Account rather than recovered
in product costing. Contribution is a pool of amount from which total fixed costs will
be deducted to arrive at the profit or loss. The distinction between contribution and
profit is given in Table

Contribution Profit

It includes fixed cost and profit. It does not include Fixed cost.

Marginal costing technique uses the Profit is the accounting concept to

concept of contribution. determine profit or loss of a business
concern.

At break-even point, contribution Only the sales in excess of break-even

equals to Fixed cost. points results in profit.

Contribution concept is used in Profit is computed to determine the

managerial decision making. profitability of product and the concern.

BREAK EVEN-POINT

In business profits should not be left to chances. They should be planned in a

systematic way. The breakeven analysis is a useful technique in this connection.
The break-even point and break-even charts are two by products of this analysis
that are excellent tool of managerial control over business profits. The break-even
analysis is principally concerned with the cost volume profit analysis. It studies
the inter-relationship that exist among fixed costs, the level of activity and sales

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mix. Essentially, it is a tool of financial analysis where by the impact on profit
position of the changes in volume, prices, costs and mix can be estimated with
reasonable definiteness and accuracy. This analysis as a matter of fact is an
improvement over the ratio technique of financial analysis. While the ratio analysis
is concerned with the forecasting of data and as such provides invaluable
information on many types of managerial decisions.

In the words of Matz and Curry, Break-even analysis indicates at what level costs
and revenue are in equilibrium. In this way break-even analysis is associated with
the calculation of break-even point. This Break Even-Point may be described as a
specific level of activity or volume of sales that breaks the revenues and costs
evenly. It is also known as ‘no profit, no loss point’. This point can be computed
mathematically and charted on a graph paper also. If the Break-Even Point, is
shown on the graph paper it will assume the name of break-even chart. A break-
even chart can be defined as a analysis in graphic form of relationship of production
and sales to profit.

The break-even point can be expressed in terms of units produced, in percent of

plant capacity or in amount of sales. This can be calculated in two ways.

BREAK-EVEN CHART
The technique of break-even analysis can be made easy with the help of graph or
mathematical formula. Graphical representation of break-even point (or cost
volume-profit) is known as the break-even chart. It is a graph showing the amounts
of fixed cost, variable costs and the sales revenue at different volumes of
operations. It shows at what volume the firm first covers all costs. Break Even
Chart shows the profitability of an undertaking at various levels of activity, and indicates
the point at which neither profit nor loss is made. So the chart is also known as break-
even chart. At this point, the total costs are recovered and profit begins.
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Significance of Break Even Chart. at various levels of activity:

1. It will show the variable cost, fixed costs and total costs.

2. Sales unit or value can be known.

3. Profit or loss can be known

4. Margin of safety can be known

5. Angle of incidence or the intersection of sales line with costs line can
also be known.

Thus, it is very useful for managerial decision.

ASSUMPTIONS OF BREAK EVEN CHART

1. Fixed costs remain the same and do not change with level of activity.

2. Costs are divided into fixed and variable costs. Variable costs change
according to the volume of production.

3. Variable cost vary with the volume of output but price of variable costs
such as wage rate, price of materials, supplies, will be unchanged.

4. Selling price remains the same at different levels of activity.

5. There is no change in the product mix

6. There is no change in the level of efficiency

7. Policies of management do not change

8. No change in the manufacturing process is due to non-static operating

efficiency.

9. As the numbers of units produced and sold are the same, there is no
closing or opening stock.

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Construction of Break-even Chart

1. On the graph the ‘X’ axis (horizontal axis) shows the volume of
production and the “Y” axis (Vertical axis) shows the cost and sales. A
graph has two sides that are known as “axes”. The horizontal side at the
bottom of the graph is the X-axis. The left hand vertical side is the Y-
axis. On the Y-axis, costs and revenues are exhibited. On the X-axis
one or more of production quantity, capacity in percentage form, sales
volume etc. are shown.

2. Draw both axes on the suitable graph paper on the basis of appropriate
scale. This is very important.

3. Insert production quantity on X-axis and costs and sales revenue on Y-

axis.

4. Draw the fixed cost line on the graph. Even at zero production, the
fixed costs remain the same. At zero production, the fixed costs will
be the loss

5. The total cost line is drawn above the fixed cost line because at zero
production fixed costs will be there. For this purpose, the variable cost
is added to the fixed cost to arrive at the total cost and drawn at each
and every scale of production.

6. Sales revenue line is drawn commencing at zero and finishing at the last
point.

7. Then the sales line cuts and total cost line i.e., sales equals the total
cost. This is known as Break-even point. If dotted line is drawn from
Break Even-Point to X-axis, it indicates Break Even-Point (units) and
if it is drawn towards. Y-axis, it indicates Break Even-Point (Value).

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 8. The difference between the sales line and total cost line is marked as
profit and it is to the right of Break Even-Point. The angle at which
sales line cuts the total cost line is the angle of incidence.

9. The position to the left of the Break Even-Point on the graph indicates
the loss which goes up to the total amount of fixed costs which is the
maximum loss at the zero production.

10. Then the graph will indicate the Break Even-Point, profit or loss at
different level of output, margin of safety, contribution and the
relationship between the marginal cost, fixed cost and total cost.

Let us now consider an example and draw Break Even Chart of the same.

Example

Assume fixed costs of a Stadium to be Rs. 1,80,000, Selling Price Rs. 10 per
ticket and Variable Cost Rs. Rs. 1 per ticket. Draw a Break-even chart.

Break-even chart has been drawn on next page.

ADVANTAGE OF BREAK-EVEN ANALYSIS AND CHART

1. Total cost, variable cost and fixed cost can be determined.

2. Break Even output or sales value can be determined.

3. Cost, volume and profit relationship can be studied, and they are very
useful to the managerial decision-making.

4. Inter-firm comparison is possible.

5. It is useful for forecasting plans and profits.

6. The best product mix can be selected.

7. Total profits can be calculated.

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 8. Profitability of different levels of activity, various products or profit,
i.e. plans can be known.

9. It is helpful for cost control.

BREAK EVEN CHART

Rs. per year
Total revenue
300,000

Break-even point: Total expenses

250,000 20,000 tickets Profit
area
Variable
200,000 expense
(at 30,000
tickets)

150,000

Loss area

100,000 Annual
fixed
expenses

50,000

Tickets
sold per
5,000 10,000 15,000 20,000 25,000 30,000 year

Limitation of Break Even Chart

Break Even Chart is constructed under some unrealistic assumptions. The

roots of the limitations are in these assumptions only. Some of them are dis-

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 cussed as under:

1. Exact and accurate classification of cost into fixed and variable is not pos-
sible Fixed cost vary beyond a certain level or output. Variable cost per
unit is constant and it varies in proportion to the volume.

2. Constant selling price is not true.

3. Detailed information cannot be known from the chart. To know all the in-
formation about fixed cost, variable const and selling price, a number of
charts must be drawn.

4. No importance is given to opening and closing stocks

5. Various product mix on profits cannot be studied as the study is concerned

with only one sales mix or product mix.

6. Cost, volume and profit relation can be known only but capital amount,
market aspects, effect of government policy etc., which are important for
decision-making cannot be considered from Break Even Chart.

7. If the business conditions change during a period, the Break Even Chart
becomes out of date, as it assume no change in business condition.

Example

ABC Limited, Minor-league baseball team, play their weekly games in a small sta-
dium just outside Houston. The stadium holds 10,000 people and tickets sell for
Rs.10 each. The franchise owner estimates that the team’s annual fixed expenses are
Rs.180,000, and the variable expense per ticket sold is Rs.1. (In the following re-
quirements, ignore income taxes).

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Required:

1. Prepare a fully labeled profit-volume graph for the Houston Armadillos.

2. What is the safety margin for the baseball franchise if the team plays a 12-
game season and the team owner expects the stadium to be 30 percent full
for each game?

3. If the stadium is half full for each game, what ticket price would the team
have to charge in order to break even?

Solution

1. Profit volume graph appears on the next page.

2. Safety margin:

Budgeted sales revenue

(12 games ´ 10,000 seats ´ .30 full ´ Rs10) Rs360,000

Break-even sales revenue

(20,000 tickets ´ Rs10) 200,000

Safety margin Rs160,000

3. Let P denote the break-even ticket price, assuming a 12-game season and 50
percent attendance:

(12)(10,000)(.50)P – (12)(10,000)(.50)(Rs1) –

Rs180,000 = 0

60,000P = Rs. 240,000

P = Rs 4 per ticket

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1. Profit-volume graph :
Rupees per year

150,000

100,000

50,000
Break-even point: Profit
20,000 tickets area
0
5,000 10,000 15,000
• 25,000
Tickets sold
per year

Loss
area
(50,000)

(100,000)

Annual fixed
expenses
(150,000)

(180,000)

PROFIT VOLUME RATIO (P/V RATIO)

The profit volume ratio, better known as P/V Ratio or Contribution/Sales Ratio (C/
S ratio), expresses the relation of contribution to sales. This ratio expressed as a
percentage indicates the relative profitability of different products. This ratio is
very helpful in pricing policy, product analysis, breakeven point and so on.

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Symbolically:
C
P/V ratio = S
S-V
Or =
S
Where : C = Contribution

S = Sales

V = Variable cost

By transposition, we have

(i) C = S x P/V ratio

C
(ii) S= P/V ratio
Example

Sales = Rs. 10,000

Variable cost = Rs. 8,000

C S-V 10,000 - 8000

Then P/V Ratio x = =
S S 10000
2000 2
= 10,000 = 10

When expressed in percentage, then

2000 x 100
P/V ratio = = 20%
10000

When P/V ratio is given, the contribution can be quickly calculated from any given
level of sales. In the above example, if only sales and P/V ratio were given, contribu-
tion can be calculated as under: -

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 C = S x P/V ratio
C = 10,000 x 20%
= Rs.2,000

There is another method of computing this ratio and this method is used when we are
given sales and profit figure for two years only and nothing has been given about the
variable cost element. Under such circumstances P/V ratio may be computed by com-
paring the change in contribution to change in sales or change in profit to change in
sales. Any increase in profit will mean increase in contribution because fixed costs
are assumed to remain constant at all levels of production. Thus:

P/V/ratio = Change in contribution = Change in profit

Change in sales Change in sales

EXAMPLE
Year Sales Net Profit
Rs. Rs.
1990 20,000 1,000
1991 22,000 1,600

Ascertain P/V ratio.

P/V ratio = Change in profit = 1600 – 1,000

Change in sales 22,000 – 20,000

P/V ratio = 600 x 100 = 30%

2000

USES OF P/V RATIO

P/V ratio is one of the most important ratios to watch in business. It is an indicator of
the rate at which profit is being earned. A high P/V ratio indicates high profitability
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and a low P/V ratio indicates low profitability in the business. The profitability of
different sections of the business, such as sales areas, classes of customers, product
lines, methods of production,, etc. may also be compared with the help of profit-
volume ratio. The P/V ratio is also used in making the following type of calculations:

(a) Calculation of break-even point

(b) Calculation of profit at a given level of sales

(c) Calculation of the volume of sales required to earn a given profit

(d) Calculation of profit when margin of safety is given

(e) Calculation of the volume of sales required to maintain the present level of
profit if selling price is reduced.

IMPROVEMENT OF P/V RATIO

As P/V ratio indicates the rate of profitability, any improvement in this ratio without
increase in fixed cost, would result in higher profits. As a note of caution, erroneous
conclusions may be dawn by mere reference to P/V ratio and, therefore, this ratio
should not be used in isolations.

P/V ratio is the function of sales and variable cost. Thus it can be improved by widen-
ing the gap between sales and variable cost. This can be achieved by:

(a) Increasing the selling price

(b) Reducing the variable cost

(c) Changing the sales mix i.e selling more of those products that have larger P/V
ratio, thereby improving the overall P/V ratio.

Application of P/V Ratio

P/V ratio plays a very important part in the solution of problems sought to be dealt
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with by the break-even analysis. It is very helpful in pricing policy, product analysis
and profit planning. Here are some important applications of P/V ratio:

(1) Determination of B.E.P.

B.E.P = FC
P/V Ratio

(2) Determination of Contribution

Contribution = Sales x P/V ratio

(3) Determination of Margin of Safety:

M.S. = Profit
P/V Ratio

(4) Determination of Variable costs for any volume of sales:

V.C. = Sales (I – P/V ratio)

(5) Determination of Profit or Loss:

Profit = (Sales x P/V ratio) – F.C.

Or

Profit = Margin of Safety x P/V ratio

Or

% or profit = P/V ratio x M.S. % x 100

(6) Determination of Increase in sales to meet increased expenditure:

Additional sales required = Increased Expenses

P/V Ratio
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 (7) Calculation of change in the break-even point when non-variable costs are
increased or decreased:

Change in B.E.P. = Change in Non-variable costs

P/V ratio

(8) Determination of sales volume required to offset price reduction:

Net sales volume = F.C. + Pt

New P/V ratio

(9) Determination of sales volume to produce desired profit:

Required sales volume = F.C. + desired profit

P/V ratio

Margin of Safety:

It is the difference (excess) between the current actual sales and break-even point
output. As per formula:-

Margin of Safety = Total Sales – Break Even Price Sales

On the break-even chart, this is represented as the distance between the break-even
point and the present production or sales. It can be expressed as percentage of total
sales also. For examples, if the current sales of a firm are Rs.5,00,000. Its Break Even
Price. Sales are Rs. 3,00,000. Hence its margin of safety will be Rs.2,00,000
(Rs.5,00,000 – Rs.3,00,000). It can be expressed as 40% also. It can also be calcu-
lated with the help of the following formula also:

Margin of Safety = Profit

P/V Ratio

If the margin of safety is large. It is an indicator of the strength of a business because

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with a substantial reduction in sales or production, profit shall be made. On the other
hand if the margin is small, a small reduction in sales or production will be a serious
mater and because actual sales volume is just equal to the break-even sales.

The following steps may be taken to improve an unsatisfactory margin of safety.

1. Increase the level of production

2. Increase the selling price

3. Reduce the fixed or the variable costs or both

4. Substitute the existing product by more profitable products.

Application of Marginal Costing

Marginal costing is a very useful tool for management. It adds to the understanding of
various managerial issues in an objective and analytical manner. The following are the
applications of marginal costing:

(1) Cost Control

Marginal costing as we have seen divides the total cost into fixed and variable
cost. Fixed cost can be controller by the top management and that to a limited
extent. The lower level of management focuses more on variable costs. Marginal
costing by concentrating all efforts on the variable costs can control and thus
provides a tool to the management for control of total cost.

There may be situations where the profits of the concern are decreasing in
spite of increase in sales. If the data is presented on the basis of absorption
costing basis, the management may not be able to comprehend the results.
Marginal costing analysis as a technique of cost control will correctly bring
out the reasons as to why the profits are decreasing in spite of increase in sales.

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 Moreover, it should be noted that in marginal costing fixed costs are not
eliminated at all. These are shown separately as a deduction from the contribution
instead of merging with cost of sales and inventories. This helps the management
to have control on fixed costs also in the long period as these costs are
programmed in advance. Thus it would be unwise on the part of the critics of
marginal costing advocating that the technique ignores fixed costs.

(2) Profit Planning

Needless to say that business organizations exist for profit. Marginal costing
helps in profit planning, i.e., planning for future operations in such a way as to
maximize the profits or to maintain a specified level of profit. In other words
we can say that if we intend to ascertain as to how many units of a product
should be sold to have a desired level of profit, marginal costing has an answer
to it. Absorption costing on the other hand fails to bring out the correct effect
of change in sale price, variable cost or product mix on the profits of the concern
but that is possible with the help of marginal costing. Profits are increased or
decreased as a consequence of fluctuations in selling prices, variable costs and
sales quantities in case there is fixed capacity to produce and sell. Thus marginal
costing is a very helpful tool in profit planning. Marginal Costing also helps in
determining which sales-mix would give maximum profit.

(3) Evaluation of Performance

As all individuals do not have same performance level so is also true with other
performers or items. The different products, departments, markets and sales
divisions have different profit earning potentialities. Marginal cost analysis is
very useful for evaluating the performance of each sector or product of a concern.
Performance evaluation is better done if distinction is made between fixed and

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 variable expenses. Product, department, market or sale divisions giving higher
contribution should be preferred if fixed expenses remain the same.

(4) Decision Making

Marginal costing as a technique is highly helpful in decision-making. Decision-

making may be defined as the process of selecting one alternative among many
available. The information provided by the total cost method is not sufficient in
solving the management’s decision-making problems. Marginal costing
technique is used in providing assistance to the management in decision making,
especially in dealing with the problems requiring short-term decisions where
fixed costs are excluded. The following are important areas where problems
are simplified and better decisions can be taken by management by the use of
the marginal costing:

I. Fixation of selling price

II. Key or limiting factor
III. Make or buy decision
IV. Selection of a suitable product mix
V. Effect of change in price
VI. Maintaining a desired level of profit
VII. Alternative methods of production
VIII. Diversification of products
IX. Closing down or suspending activities
X. Alternative course of action

XI. Level of activity planning

XII. Purchasing or leasing
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I ). Fixation of Selling Prices: No doubt that the prices are more controlled by
market conditions and other economic factors than by decisions of management. This
is because competition is so high that the price is determined by the forces of demand
and supply and only those business units will see the light of the day which can produce
at a price less than the one fixed by the market. Yet fixation of selling prices is one of
the most important decision that management has to take. In the long run, the selling
price must be sufficient to cover the total cost or otherwise profit cannot be earned.
The technique of marginal costing is of great help in fixing selling prices under special
conditions as stated below:

a. Under normal circumstances

b. In times of competition

c. In times of trade depression

d. In accepting additional orders for utilizing idle capacity

e. In exporting and exploring new markets (may be in out side the country)

In normal circumstances the price fixed must cover total cost, as otherwise profits
cannot be earned. It can also be fixed on the basis of marginal cost by adding a high
margin to marginal cost that may be sufficient to contribute towards fixed expenses
and the organization may earn profits. But under circumstances other than this, products
may have to be sold at a price below total cost, if such a step is necessary to meet the
situation arising due to competition, trade depression, additional orders for utilising
spare capacity exploring new markets etc. Thus, in special circumstances, price may
be below the total cost and it should be equal to marginal cost plus a certain amount (if
possible) so as to cover fixed cost to possible extent.

Prices fall during depression and the management may be forced to sell the product

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below the total cost. In case there is a serious but temporary fall in the demand on
account of depression leading to the need for a drastic reduction in prices temporarily,
the minimum selling price should be equal to the marginal cost. If the selling price at
which the goods can be sold is equal to marginal cost or more than marginal cost the
product should be continued. Fixed expenses as because of their nature will be incurred
even if the product is discontinued during depression for a short period. If the product
can be sold at a price that is a little more than marginal cost, loss on account of fixed
expenses will get reduced because price will recover fixed expenses to the extent it
is higher than marginal cost.

At this stage it may be worthwhile to mention that under certain conditions the
management may also consider it wise to sell even below the marginal cost. Stated
below are some of such conditions:

a. When a new product is introduced in the market. The new product is sold
at a very low price to make it popular. This is done with the hope that sales will
increase with the passage of time and cost of production will come down as a
result of increase in sales. Ultimately cost of production will be in line with
the selling price and the concern will start earning profit from the new line of
production.

b. When foreign market is to be explored to earn foreign exchange. If the

Government allows import quotas against foreign exchange earned and profit
from import quotas may be much more than the loss on exporting the product
at a price below the marginal cost.

c. When the concern has already purchased large quantities of materials.

Under such circumstance it is better to convert the material into finished goods
and sell these at a price below the marginal cost if the sale of materials will

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 give rise to loss which is more than the loss incurred if the production is done.

d. When closure of business may mean breaking of business connections

and connections may be re-established by a heavy expenditure on
advertisements and sales promotion. In such a case, it is better to continue
the production and sell the product at a price below the marginal cost.

e. When the sales of one product at a price below the marginal cost will
push up the sales of other profitable products. The loss in one product will
be made up by profits in other products.

f. When employees cannot be retrenched. In such a case, it is better to maintain

the production even if the price is below the marginal cost.

g. When competitors are to be eliminated from the market. If it is desired

that competitors should be eliminated from the market the organization may
sell the product at a price less than marginal cost.

h. When the goods are of perishable nature. It is better to sell the perishable
goods at a price that they can realize; otherwise these goods will perish and
nothing will be realized.

Accepting Additional Orders, Exploring Additional Markets and Exporting.

When additional orders are accepted or additional markets explored at a price below
normal price to utilize idle capacity, it should be very carefully seen that they would
not affect the normal present market and goodwill of the company. The order from a
local merchant should not be accepted at a price below normal price because it will
affect relationship of the concern with the other customers purchasing the goods at
normal price and we may loose our present customers. In case of foreign markets,
goods may be sold at a price below normal price keeping in view the direct and indirect

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benefits associated. It is important to note that the following factors should be
considered before launching a product in the new market

a. Whether the firm has surplus capacity to meet the new demand or in other
words the fixed costs after accepting additional orders will not change.

b. What price the new market is offering? In any case, it should be higher than the
variable cost of the product plus any additional expenditure to be incurred to
meet the specific requirements of the new market. If this is not there then it
will result in loss.

c. Whether the sale of goods in the new market will affect the present market for
the goods. In case it does, better do not venture in.

It is particularly true in case of sale of goods in a foreign market at a price

lower than the domestic market price. Before accepting such an order from a foreign
buyer, it must be seen that the goods sold are not dumped in the domestic market
itself.

II) Key Or Limiting Factor: Limiting factor is a factor of production that is less or
is fixed in supply. In the short term demand may exceed the capacity to produce. The
firm’s output may be restricted by a shortage of firm’s materials, labor, equipment or
factory space. If demand does exceed production capacity, the reason must be identified.
The scarce resource is known as the limiting factor. If, in the short term, it is impossible
to acquire additional resources, the firm’s output and profit will be restricted by the
limiting factor. In that case it is important to maximize profit by concentrating
production on those products, which offer the largest contribution each time one unit
of the scarce resource is used.

III) Make or Buy Decisions: Managers are often faced with the decision of whether
to make the product our self or buy components used in manufacturing from the market.
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A concern can utilize its idle capacity by making component parts instead of buying
them from market. In arriving at such a make or buy decision, the price asked by the
outside suppliers should be compared with the marginal cost of producing the
component parts. If the marginal cost is lower than the price demanded by the outside
suppliers, the component parts should be manufactured in the factory itself to utilise
unused capacity. Fixed expenses are not taken in the cost of manufacturing component
parts on the assumption that they have been already incurred, the additional cost involved
is only variable cost. For example, the total cost of making a component part comes
to Rs.9 consisting of Rs.6 as variable cost and Rs.3 as fixed cost. Suppose further an
outside supplier is ready to supply the same component part at Rs.8. On the basis of
total cost method, it appears that it is cheaper to buy the component. But on the basis
of marginal cost, the offer of the outside supplier should be rejected because the
acceptance will mean that the total cost of the purchased part from the outside supplier
will come to Rs.11, i.e., Rs.8 (supplier’s price) plus Rs.3 (fixed cost which cannot be
saved even if the component is purchased from outside source)

In addition to the quantitative factors discussed above, the management has to consider
the following qualitative factors into consideration to influence the make or buy
decision:

a. Quality of goods supplied by the supplier

b. Uninterrupted supply by the supplier meeting the delivery cost

c. If secrecy is to be maintained and manufacturing know-how is not to be passed

on to the supplier of the component part, the decision will be to manufacture
part even though the manufacturing cost may be more than the price to be charged
by the supplier.

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d. Any adverse effect on labour relations of the organization if it is decided to buy
from outside instead of making

e. The faculty of wider selection in case of buy-decision.

iv) Selection of a Suitable Product Mix: Product mix refers to the proportion of
each type of product in sales. When a factory manufactures more than one product, a
problem is faced by management as to which product mix will give the maximum
profits faces a problem. The best product mix is that which yields the maximum
contribution. The products that give the maximum contribution are only to be retained
but their production should be increased. The products that give comparatively less
contribution should be reduced or closed down altogether. Comparing the P/V ratio
and break-even point can also examine the effect of sales mix. The new sales mix will
be favorable if it increase the P/V ratio and reduces the break-even point.

v) Effect of Change in Sales Price: Management is confronted with the problem of

cut in prices of products from time to time on account of competition, expansion
programme or government regulations. It is therefore necessary to know the effect of
a cut in prices of the products on total sales and profit. The effect of a such cut in
selling price per unit can be better analysed with the help of marginal costing.

vi) Maintaining a Desired Level of Profits: As stated earlier organizations exist

for profit and management may be interested in maintaining a desired level of profits.
The volume of sales needed to have a desired level of profits can be ascertained by the
marginal costing technique.

vii) Alternative Methods of Production: Marginal Costing is helpful is comparing

the alternative methods of production i.e., machine work or handwork. The method
that gives the greatest contribution (assuming fixed expenses remaining same) is to be
adopted keeping, of course, the limiting factor in mind. Where, however, fixed expenses
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change, the decision will be taken on the basis of profit contributed by each.

viii) Diversification of products: Sometimes it becomes necessary for a concern

to introduce a new product to the existing product mix in order to utilize the idle
capacity or to capture a new market or for any other purposes. The new product,
should be profitable. In order to decide about the profitability of the new product, it
is assumed that the manufacture of the new product will not increase fixed costs of
the concern and if the price realized from the sale of such product is more than its
variable cost of production it is worth trying. If this data is presented under adsorption
costing method, the management may take a wrong decision. But if with the
introduction of new product there is an increase in the fixed costs, then such specific
increase in fixed cost must be deducted from the contribution. General fixed costs
will however be charged to the old product/products.

ix) Closing Down or Suspending Activities: Sometimes it becomes necessary

for a firm to temporarily suspend or close the activities of a particular product,
department or factory as a whole due to trade recession or any other reason. The
decision to close down or suspend its activities will depend on whether products are
making a contribution towards fixed costs or not. If the products are making a
contribution towards fixed costs, it is advised under marginal costing not to close
business or suspend its activities to minimize the losses. If the business or that
particular product is closed down there may be certain fixed costs which could be
avoided but there will be certain expenses which will have to be incurred at the time
of closing the operation like redundancy payment, necessary maintenance of plant or
overhauling of plant on reopening, training of personnel etc. Such costs are associated
with closing down of the business and must be taken into consideration before taking
any decision. Fixed costs may be general or specific. General fixed costs may or
may not remain constant while specific costs will be directly affected by the closing
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down of the operation. To sum up, if general fixed costs are likely to come down in the
event of closure or suspension of activities, the excess of contribution over specific
fixed costs will have to be compared with reduction in general fixed cost. If the former
exceeds the latter it is profitable to continue the activities and close down or suspend
activities if the latter exceeds the former.

In addition to cost consideration, there may be some non-cost consideration that may
have to be considered in taking the decision to close down or suspend its activities or
not. The following non-cost considerations are relevant in this respect:

a. Once the business is closed down, competitions may establish their product
and our business may be lost. It may be difficult to recapture the lost market
again; heavy advertisement charges may have to be incurred to recapture the
business again. This has to be considered.

b. Fear of retrenchment of workers. If worker are discharged it may be difficult

to get experienced and skilled workers again at the restart of the business

c. Plant may become obsolete with the closure of the business and heavy capital
expenditure may have to be incurred on restart of the business,

d. Reputation of the firm may suffer if some activities are closed down or
suspended.

e. Temporary closing down or suspending activities may not be desirable if the

relationship with the suppliers is adversely affected.

f. Fear of non collection of dues from customers in case of close of business

may not go in favour of closure of business.

ix) Alternative Course of Action: When deciding between alternative courses of

action, it shall be kept in mind that whatever course of action is adopted, certain fixed
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expenses will remain unaffected. The criterion, therefore, which weighs is the effect
of alternative course of action upon the marginal (i.e. variable) costs in relation to the
revenue obtained. The course of action which yields the greatest contribution is the
most profitable to be followed by the management.

Advantages of Marginal Costing:

The following are the important advantage of marginal costing system.

(1) Easiness: The system of marginal costing is very simple and easy to
understand. Marginal costs remain the same per unit of production
irrespective of the volume of production. Hence, it helps the
management in future production planning.

(2) Simplification of Overhead Treatment: Marginal costing system

simplifies the overhead recovery system. It does away with the need for
allocation, apportionment and absorption of fixed overheads thereby
removing an important source of accounting complication by way of
under-absorbed or over-absorbed over heads.

(3) Relationship of Net Income with Sales: Marginal costing system

establishes direct relationship of net income with the sale. The marginal
contribution techniques provide a better and more logical basis for the
fixation of sales prices with intending profits.

(4) Helpful in Profit Planning: With the rising costs of production and
shrinkage in profit margin, attention is now directed more and more by
managements towards a better and fuller understanding of the relationship
between profit and the major factor affecting it like sales volume,
production level, selling price and sales-mix etc. The technique of
marginal costing helps a lot in this direction. It enables the management
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 to plan for future profits by providing data in a manner showing cost-
volume-profit relationship. In addition to it, this analysis helps in break-
even analysis, the determination of optimum level of activities etc. that
are the main problems attached to profit planning.

(5) Profitability Appraisal: Marginal costing helps the management in

evaluating the profitability of alternative operations. Manufactures have
sometime to decide whether any item should be purchased from the
market or produced in the factory. The marginal cost of producing the
parts compared with the market price gives an accurate basis for taking
the decision to make or buy.

(6) Assistance in Decision-Making: The technique of marginal costing is

a valuable aid to management for decision-making under changing
conditions. Some of the important areas of managerial decision making,
where marginal costing becomes very useful include, fixation of selling
prices, make or buy decisions, key or limiting factor, effect of change
in sales price, maintaining a desired level of profits, selection of a
suitable product mix, and choosing among alternative methods of
production etc.

(7) Compatibility with Budgeting and Standard Costing: The use of

marginal costing in the organization brings cohesiveness between
budgetary control and standard costing. It is a complementary system
to the both techniques stated above.

(8) Helpful in Pricing: Marginal costing is very helpful in fixation of

selling price of the products under various conditions. It gives a better
and more logical basis for the fixation of sale price as well as in tendering
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 for contracts when business is at a low level.

(9) Help in Cost Control: The clear-cut division of costs into fixed and
variable costs paves the way for better and efficient cost control. It is
necessary for effective cost control that the responsibility of control
must lie with those who make the cost incurring decisions. It is possible
only when the techniques of marginal costing is applied and expenses are
divided into controllable and non-controllable. Under Marginal Costing
it is possible to accumulate costs by cost centers, the smallest area of
responsibility for example, a department or a division.

(10) Helpful in Management Reporting: Marginal costing is very useful in

management reporting also. As reports sent to management are based on
figures of sales rather than of production, marginal costing helps the
management in evaluating the marginal contribution of sales. Marginal
costing also make ‘management by exception’ possible. By management
by exception we mean that the top management should focus more
attention towards those result that are significantly moving out of line
and need prompt action.

DISADVANTAGES OR LIMITATIONS OF MARGINAL COSTING:

Along with foregoing advantages of marginal costing, a few limitations of this technique
are as follows:-

(1) Practical Difficulty in Dividing the Costs: It is difficult to classify

all expenses into fixed and variable practically, while marginal costing
assumes that all costs can be analysed in this manner. There may be
various semi-variable expenses also and they are dividend into fixed into
variable costs arbitrarily, which is not a sound decision.
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 (2) More Emphasis on Sales: This system has a tendency to attach more
importance to the selling function while production function that is also
equally important is ignored.

(3) Not Suitable to all Concerns: The technique of marginal costing

cannot be adequately applied in the case of industries in which according
to the nature of business, large stock have to be carried by way of work
in progress. It is not suitable to industries working on contract basis
also.

(4) Difficulties in Valuation of Inventories: It is possible that a concern

using marginal costing may value work in progress and inventory at
marginal costs. It will not be a sound decision from balance sheet point
of view as it will not show true and fair view of the financial condition.

(5) Other Disadvantages: Cost control can better achieved with the help
of other techniques such as budgetary control and standard costing rather
than marginal costing. Moreover, selling price cannot always be
reasonably fixed on the basis of contribution only. This is because then
it may incur loss to the business or in adequate profits.

To sum up, though marginal costing is an important tool of management accounting, it

must be applied with a full awareness of its limitation too.

EXERCISES

Basic CVP Relationships

1 Bruno’s Pizza delivers pizzas to dormitories and apartments near a

major state university. The company’s annual fixed expenses are
Rs.30,000. The sales price averages Rs.10, and it costs the company

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 Rs.4 to make and deliver each pizza.

REQUIRED:

A. How many pizzas must Bruno’s sell to break even?

B. How many pizzas must the company sell to earn a target net profit
of Rs.36,000?

C. If current sales total 7,400 pizzas, how much is the company’s

safety margin?

D. Bruno’s assistant manager, an accounting major, has suggested

that the firm should try to raise the contribution margin per pizza.
Explain the meaning of the term “contribution margin” in layman’s
terms.

Basic CVP Relationships

2. Seascape takes tourists on helicopter tours of Hawaii. Each tourist buys

an Rs.80 ticket; the variable costs average Rs.20 per person. Seascape
has annual fixed costs of Rs.720,000.

REQUIRED:

A. How many tours must the company conduct in a month to break-

even?

B. Compute the sales revenue needed to produce a target net profit

of Rs.30,000 per month.

C. Calculate the contribution margin ratio.

D. Determine whether the actions that follow will increase, decrease,

or not affect the company’s break-even point.

(1) An increase in tour prices.

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 (2) An increase in the number of tours sold.

(3) The termination of a salaried clerk (no replacement is

planned).

CVP: Analysis of Operations

3 Thompson Company is considering the development of two products:

no. 65 or no. 66. Manufacturing cost information follows.

No. 65 No. 66
Annual fixed costs Rs.220,000 Rs.340,000

Variable cost per unit 33 25

Regardless of which product is introduced, the anticipated selling price will be

Rs.50 and the company will pay a 10% sales commission on gross dollar sales.
Thompson will not carry an inventory of these items.

REQUIRED:

A. What is the break-even sales volume (in dollars) on product no.

66?

B. Which of the two products will be more profitable at a sales

level of 25,000 units?

C. At what unit-volume level will the profit/loss on product no. 65

equal the profit/loss on product no. 66?

Break-even Analysis, Decision Making

4. The Bruggs & Strutton Company manufactures an engine for carpet

cleaners called the “Snooper.” Cost and revenue data for the “Snooper”
are given below, based on sales of 40,000 units.
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 Total
Sales Rs.1,600,000
Less: Cost of goods sold 1,120,000
Gross margin Rs. 480,000
Less: Operating expenses 100,000
Operating income before taxes Rs. 380,000

Cost of goods sold consists of Rs.800,000 of variable costs and Rs.320,000 of

fixed costs. Operating expenses consist of Rs.40,000 of variable costs and
Rs.60,000 of fixed costs.

REQUIRED:

A. Calculate the break-even point in units and sales dollars.

B. Calculate the safety margin.

C. Bruggs & Strutton received an order for 6,000 units at a price of Rs.25.00.
There will be no increase in fixed costs, but variable costs will be reduced
by Rs.0.54 per unit because of cheaper packaging. Determine the
projected increase or decrease in profit from the order.

D. Bruggs also received an order for 2,500 units at Rs.29 per unit. If
packaging costs will not be reduced on this order and only one order
(“c” or “d”) can be accepted, which order is more attractive?

Cost-volume-profit Analysis, Multiple Products

5. Alfay Company manufactures and sells three products: Algo, Bego, and
Cego. Annual fixed costs are Rs.1,210,000 and data about the three
products follow.

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 Algo Bego Cego

Sales mix in units 50% 30% 20%

Selling price Rs.200 Rs.600 Rs.800

Variable cost 100 280 320

REQUIRED:

A. Determine the weighted-average unit contribution margin.

B. Determine the break-even volume in units for each product.

C. Determine the number of units of each product that must be sold

to obtain a total profit for the company of Rs.484,000.

D. Assume that the sales mix for Algo, Bego, and Cego is changed
to 40%, 30%, and 30%, respectively. Will the number of units
required to break-even increase or decrease? Explain. Hint:
Detailed calculations are not needed to obtain the proper solution.

Contribution Income Statement, Operating Leverage

6. Worldwide Publications Inc., produces and sells scientific reference

books. The results of the company’s operations for the year ended
December 31, 199x are given below.

Sales revenue Rs.400,000

Manufacturing costs:
Fixed 100,000
Variable 200,000
Selling costs:
Fixed 10,000
Variable 20,000
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 Administrative costs:
Fixed 24,000
Variable 6,000

REQUIRED:

A. Prepare a traditional income statement for the company.

B. Prepare a contribution income statement for the company.

C. What is the firm’s operating leverage factor for the sales volume
generated during 199x?

D. Assume that sales revenue increased by 20% because of an increase in

the volume of books sold. What will be the percentage increase in
operating income?

E. Which income statement (traditional or contribution) would an operating

manager most likely use to answer question “d” above? Why?

DISCUSSION QUESTIONS

Cost-volume-profit Analysis

7. The BoSan Corporation makes major household appliances such as

refrigerators, stoves, and dishwashers. Sales are heavily dependent on
the number of housing starts and the level of disposable income. Next
year, the number of housing starts in the Central region is expected to be
the same as this year; however, about two-thirds of these starts will be
for rental apartments as compared to an historical average of one-third.
The remaining housing starts will be for single-family homes and upscale
condominiums.

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 BoSan generally makes two models of each product: economy (fully functional,
but with few special features) and prestige (with the most popular special
features). BoSan assumes a product mix of 40% economy and 60% prestige.

REQUIRED:

A. Explain how a cost-volume-profit (CVP) analysis may be used by

management.

B. One of the assumptions that underlies CVP analysis is a constant sales

mix over the relevant range of activity. What are three other assumptions
of CVP analysis?

C. Describe how the percentage change in rental units could create a

problem with BoSan’s CVP analysis.

SOLUTIONS TO EXERCISES

1. A. Selling price per pizza Rs.10

Less: Variable cost per pizza 4
Unit contribution margin Rs. 6

Break-even pizzas: Rs.30,000 ÷ Rs.6 = 5,000

B. Pizzas to earn Rs.36,000: (Rs.30,000 + Rs.36,000) ÷ Rs.6 = 11,000

C. Safety margin: (7,400 x Rs.10) - (5,000 x Rs.10) = Rs.24,000

D. The contribution margin is the amount that each unit (pizza) contributes
toward covering fixed cost and producing a profit. Once a company’s
fixed costs are covered, operating income will increase by the amount
of the contribution margin. Mathematically, it is computed as the
difference between selling price and the variable cost per unit.

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2. A. Selling price per tour Rs.80
Less: Variable cost per tour 20
Unit contribution margin 60

Break-even tours: (Rs.720,000 ÷ 12 months) ÷ Rs.60 = 1,000

B. Tours to earn Rs.30,000: [(Rs.720,000 ÷ 12 months) + Rs.30,000] ÷

Rs.60 = 1,500

C. Contribution margin ratio: Rs.60 ÷ Rs.80 = 0.75

D. (1) Decrease
(2) No effect
(3) Decrease

3 A. Selling price Rs.50

Less:Variable cost (Rs.25 + Rs.5) 30
Unit contribution margin 20

Break-even units: Rs.340,000 ÷ Rs.20 = 17,000

Break-even sales: 17,000 x Rs.50 = Rs.8,50,000

B. No. 65 No. 66
Sales 1,250,000 1,250,000
Less: Variable costs* 950,000 750,000
Contribution margin 300,000 500,000
Less: Fixed costs 220,000 340,000
Operating income 80,000 160,000

* No. 65: Rs.33 + Rs.5 = Rs.38; no. 66: Rs.25 + Rs.5 = Rs.30

Product no. 66 is more profitable: Rs.160,000 vs. Rs.80,000

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 C. X = Number of units

(Rs.50 - Rs.38)X - Rs.220,000 = (Rs.50 - Rs.30)X - Rs.340,000

Rs.12X - Rs.220,000 = Rs.20X - Rs.340,000
Rs.8X = Rs.120,000
X = 15,000 units
4. A. Sales 16,00,000
Less: Variable costs (Rs.800,000 + Rs.40,000) 8,40,000
Contribution margin 7,60,000

Unit contribution margin: Rs.7,60,000 ÷ 40,000 units = Rs.19

Break-even point in units: (Rs.320,000 + Rs.60,000) ÷ Rs.19 = 20,000

units

Unit selling price: Rs.1,600,000 ÷ 40,000 units = Rs.40

Break-even point in rupees: 20,000 units x Rs.40 = Rs.8,00,000

B. Safety margin: Rs.16,00,000 - Rs.800,000 = Rs.8,00,000

C. Sales (6,000 x Rs.25) Rs.150,000

Less: Variable costs at Rs.20.46* 122,760
Increase in profit Rs. 27,240

* (Rs.800,000 + Rs.40,000) ÷ 40,000 units = Rs.21.00; Rs.21.00 -

Rs.0.54 = Rs.20.46

D. Sales (2,500 x Rs.29) Rs. 72,500

Less: Variable costs at Rs.21* 52,500
Increase in profit Rs. 20,000

* (Rs.800,000 + Rs.40,000) ÷ 40,000 units = Rs.21

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 The first order (“c”) is more attractive: Rs.27,240 vs. Rs.20,000

5. A. Algo Bego Cego

Selling price Rs.200 Rs.600 Rs.800
Less: Variable cost 100 280 320
Contribution margin Rs.100 Rs.320 Rs.480

Algo: Rs.100 x 50% Rs. 50

Bego: Rs.320 x 30% 96
Cego: Rs.480 x 20% 96
Weighted-average CM Rs.242

B. Break-even volume: Rs.12,10,000 ÷ Rs.242 = 5,000 units

Algo: 5,000 x 50% = 2,500 units

Bego: 5,000 x 30% = 1,500 units
Cego: 5,000 x 20% = 1,000 units

C. Volume to earn Rs.484,000: (Rs.1,210,000 + Rs.484,000) ÷ Rs.242

= 7,000 units
Algo: 7,000 x 50% = 3,500 units
Bego: 7,000 x 30% = 2,100 units
Cego: 7,000 x 20% = 1,400 units

D. The number of units required would decrease since a greater proportion

of higher-contribution-margin units (specifically, Cego) would be sold.

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6. A. Traditional Income Statement

Sales Rs.400,000
Less: Cost of goods sold 300,000
Gross margin Rs.100,000
Less operating expenses:
Selling Rs.
30,000
Administrative 30,000 60,000
Net income Rs. 40,000

B. Contribution Income Statement

Sales Rs.400,000
Less variable expenses:
Manufacturing Rs.200,000
Selling 20,000
Administrative 6,000 226,000
Contribution margin Rs.174,000
Less fixed expenses:
Manufacturing Rs.100,000
Selling 10,000
Administrative 24,000 134,000
Net income Rs. 40,000

C. Operating leverage factor: Rs.174,000 ÷ Rs.40,000 = 4.35

D. Percentage increase in net income: 20% x 4.35 = 87%

E. The contribution statement would be used because the fixed and variable
costs must be separated in order to measure the effect of a volume
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 change on total costs. Unfortunately, a traditional income statement
does not provide the necessary information.

7. A. CVP analysis may be used to perform “what if” analyses that allow
management to study the effects of various operating changes on firm
profitability. For example, the effects of changes in selling price,
variable costs, fixed costs, and volume may be explored by manipulating
the CVP model with different values for these items.

B. Three additional assumptions for the CVP model are:

• The per-unit selling price is constant.

• Cost behavior is linear over the relevant range—that is, variable

cost per unit is constant and fixed costs in total are constant.

• The number of units manufactured and sold are the same.

C. The shift toward more apartments and fewer single-family homes and
upscale condominiums is very likely to mean that demand for the
economy models will increase relative to the demand for prestige
models. The rental apartment generally will be used for households
with lower income.

The shift in buying habits could create a problem since the CVP model
assumes a constant sales mix. The mix change could invalidate previous
CVP studies.

✪✪✪

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 Lesson : 4

THE TIME VALUE OF MONEY

Objectives : After reading this lesson the learners will be able :

• to understand what gives money, its time value;

• to calculate present and compound values;

• to understand the use of present value technique (discounting) in

financial decisions; and

• to explain the basic concept of internal rate of return.

Structure :

4.1 Introduction

4.2 Meaning of Time Value of Money

4.3 Time Preference Rate and Required Rate of Return

4.4 Compound Value

4.5 Present Value

4.6 Net Present Value

4.7 Solved Problems

4.8 Summary

4.9 Self Test Questions

4.10 Suggested Readings

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4.1 INTRODUCTION

Most financial decisions involve cash flows occurring at different time periods.
For example, if a firm borrows funds from a bank or from any other source, it
receives cash now and commits an obligation to pay interest and repay principal
in future periods. The firm may also raise funds by issuing equity shares. The
firm's cash balance will increase at the time shares are issued, but, as the firm
pays dividends in future, the outflow of cash will occur. Sound decision-making
requires that the cash flows which a firm is expected to give up over period
should be logically comparable. The absolute cash flows which differ in timing
and risk are not directly comparable. Cash flows become logically comparable
when they are appropriately adjusted for their differences in timing and risk.
The understanding and recognising the time value of money and risk is
extremely vital in financial decision-making to attain its objective of
maximising the owners' welfare. The welfare of owners would be maximised
when net wealth or net present value is created from making a financial
decision. The net present value is a time value concept. Let us now understand
the concept of time value of money.

4.2 MEANING OF TIME VALUE OF MONEY

Money has time value. A rupee today is more valuable than a rupee a year hence.
In fact, if an individual behaves rationally, he would not value the opportunity
to receive a specific amount of money now equally with the opportunity to
have the same amount at some future date. Most individuals value the opportunity
to receive money now higher than waiting for one or more years to receive the
same amount. This phenomenon is referred to as an individual's time preference
for money. Thus, an individual's preference for possession of a given amount

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of cash now, rather than the same amount at some future time, is called time
value of money.

There are several reasons for time value of money :

• G e n e r a l l y, i n d i v i d u a l s p r e f e r c u r r e n t c o n s u m p t i o n t o f u t u r e
consumption.

• Capital can be employed productively to generate positive returns. An

investment of one rupee today would grow to (1+r) a year hence (r is
the rate of return earned on the investment).

• In an inflationary period a rupee today represents a greater real

purchasing power than a rupee a year hence.

As an individual is not certain about future cash receipts. He prefers receiving

cash now. Most people have subjective preference for present consumption
over future consumption of goods and services either because of the urgency
of their present wants or because of the risk of not being in a position to enjoy
future consumption that may be caused by illness or death, or because of
inflation. As money is the means by which individuals acquire most goods and
services, they may prefer to have money now. Further, most individuals prefer
present cash to future cash because of the available investment opportunities
to which they can put present cash to earn additional cash. For example, an
individual who is offered Rs. 200 now or Rs. 200 one year from now would
prefer Rs. 200 now if he could earn on it an interest of, say Rs. 10 by putting it
in the savings account in a bank for one year. His total cash in one year from
now will be Rs. 210. Thus, if he wishes to increase his cash resources, the
opportunity to earn interest would lead him to prefer Rs. 200 now, not Rs. 200
after one year.
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4.3 TIME PREFERENCE RATE AND REQUIRED RATE OF RETURN

The time value for money is generally expressed by an interest rate. This rate
will be positive even in the absence of any risk. It may be therefore called the
risk-free rate. For instance, if time preference rate is 4 per cent, it implies
that an investor can forego the opportunity of receiving Rs. 100 if he is offered
Rs. 104 after one year (i.e. Rs. 100 which he would have received now plus the
interest which he could earn in a year by investing Rs. 100 at 4 per cent). Thus,
the individual is indifferent between Rs. 100 and Rs. 104 a year from now as
he considers these two amounts equivalent in value. In reality, an investor will
be exposed to some degree of risk. Therefore, he would require a rate of return
from the investment which compensates him for both time and risk. His required
rate of return will be.

Required rate of return = Risk-free rate + risk premium

The risk-free rate compensates for time while risk premium compensates for
risk. The required rate of return may also be called the opportunity cost of
capital of comparable risk. It is called so because the investor could invest
his money in assets or securities of equivalent risk. Like individuals, firms
also have required rates of return and use them in evaluating the desirability of
alternative financial decisions. The interest rates account for the time value of
money, irrespective of an individual's preferences and attitudes.

Let us understand the answer to the question : How does knowledge of the
required rate of return or simply the interest rate help an individual or a firm
in making investment decision? It helps the individual or the firm to convert
different amounts offered at different times to amounts of equivalent value in
the present, a common point of reference. For example, let us assume an
individual with an interest rate of 10 per cent. If he is offered Rs. 115.50 one
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year from now in exchange for Rs. 100 which he should give up today, should
he accept the offer? The answer in this particular case is that he should accept
the offer. When his interest rate is 10 per cent, this implies that he is indifferent
between any amount today and 100 per cent of that amount one year hence. He
would obviously favour more than 110 per cent of the amount (i.e. more than
Rs. 110 in the example) one year from now.

4.4 COMPOUND VALUE

Interest is compounded when the amount earned on an initial deposit (the initial
principal) becomes part of the principal at the end of the first compounding
period. The term principal refers to the amount of money on which interest is
received. Consider Example 1

Example 1 : Suppose you invest Rs. 1,000 for three years in a savings account
that pays 10 per cent interest per year. If you let your interest income be
reinvested, your investment will grow as follows :

First year : Principal at the beginning 1,000

Interest for the year 100
(Rs. 1,000 × 0.10)
Principal at the end 1,100
Second year : Principal at the beginning 1,100
Interest for the year 110
(Rs. 1,100×0.10)
Principal at the end 1,210
Third year : Principal at the beginning 1,210
Interest for the year 121
(Rs. 1,210×0.10)
Principal at the end 1,331
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Formula

The process of investing money as well as reinvesting the interest earned thereon
is called compounding. The future value or compounded value of an investment
after n years when the interest rate is r per cent is :

FV n = PV (1+r)n ------------ (1)

in which FV = The future or compound value

PV = Present value

r = rate of interest

n = number of years

(1+r) n = the future value interest factor

To solve future value problems you have to find the future value factors. You
can do it in different ways. In the example given above, you can multiply 1.10
by itself three times or more generally (1+r) by itself n times. This becomes
tedious when the period of investment is long.

Fortunately, you have an easy way to get the future value factors. Most
calculators have a key labelled "y x". So all that you have to do is to enter 1.10,
press the key labelled y x , enter 3, and press the "=" key to obtain the answer.

Alternatively, you can consult a future value interest factor (FVIF) table. One
such table showing the future value factor for certain combinations of periods
and interest rates is given in Appendix A at the end of this book.

Example 2 : Suppose Mr. Ram deposits Rs. 1,000 today in a bank which pays
10 per cent interest compounded annually, how much will the deposit grow to
after 8 years and 12 years?

The future value, 8 years hence, will be :

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 Rs. 1,000 (1.10) 8 = Rs. 1,000 (2.144)
= Rs. 2,144
The future value, 12 years hence, will be :
Rs. 1,000 (1.10) 12 = Rs. 1,000 (3.138)
= Rs. 3,138

Graphic View of Compounding

Exhibit 4.1 shows graphically how one rupee would grow over time for different
interest rates. Naturally the higher the interest rates, the faster the growth
rate. We have plotted the growth curves for three interest rates : 0 per cent, 6
per cent, and 12 per cent. Growth curves can be readily plotted for other interest
rates.

Compound and Simple Interest

So far we assumed that money is invested at compound interest which means

that each interest payment is reinvested to earn further interest in future periods.
By contrast, if no interest is earned on interest the investment earns only simple
interest. In such a case the investment grows as follows :

Future value = Present value [1+Number of years × Interest rate]

FVI r, n

5
4 12%
3
2 6%

1 0%
Periods
2 4 6 8 10 12 14 16
Exhibit 4.1 : Graphic View of Compounding
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Example 3 : An investment of Rs. 2,000, if invested at 12 per cent simple
interest rate will in 5 years time become :

2,000 [1 + 5 × 0.12] = Rs. 3,200

Semi-annual and Other Compounding Periods : In the foregoing discussion

we have assumed annual compounding of interest at the end of the year. Very
often the interest rates are compounded more than once in a year. Savings
institutions, particularly, compound interests semi annually, quarterly and even
monthly.

In case of Semi-annual Compounding there would be two compounding periods

within the year. Interest is actually paid after every six months at a rate of one-
half of the annual (stated) rate of interest.

Example 4 :

Assume Mr. Investor places his savings of Rs. 1,000 in a two-year time deposit
scheme of a bank which yields 6 per cent interest compounded semi-annually.
He will be paid 3 per cent interest compounded over four periods – each of six
months' duration. Table presents the calculations of the amount Mr Investor
will have from the time deposit after two year.

Table 4.1 : Semi-annual Compounding

Year 6 months 1 Year 18 months 2 years

Beginning amount Rs. 1,000.00 Rs. 1,030.00 Rs. 1,060.90 Rs. 1,092.73
Interest rate 0.03 0.03 0.03 0.03
Amount of interest 30.0 30.90 31.83 32.78
Beginning principal 1,000.00 1,030.00 1,060.90 1,092.73
Ending principal 1,030.00 1,060.90 1,092.73 1,125.51

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Table 4.1 reveals that his savings will amount to Rs. 1,060.90 and Rs. 1,125.51
respectively at the end of the first and second years.

Quarterly Compounding means that there are four compounding periods within
the year. Instead of paying the interest once a year, it is paid in four equal
instalments after every three months. Using the above illustration, there will
be eight compounding periods and the rate of interest for each compounding
period will be 1.5 per cent, that is (1/4 of 6 per cent).

The effect of compounding more than once a year can also be expressed in the
form of a formula, Equation 1 can be modified as Eq. 2.

r mn
{
P 1+
m }=A (2)

Here, m is the number of times per year compounding is made. For semi-annual
compounding, m would be 2, while for quarterly compounding it would equal 4
and if interest is compounded monthly, weekly and daily, it would equal 12, 52
and 365 respectively.

The general applicability of the formula can be shown as follows, assuming

the same figures of Mr Investor's savings of Rs. 1,000 :

1. For semi-annual compounding,

2×2
Rs. 1,000 { 1 + 0.06
2
} = Rs.1,000(1+0.03) 4 = Rs. 1,125.51

2. For quarterly compounding,

4×2
Rs. 1,000 { 1 + 0.06
4
}= Rs.1,000(1+0.015)8 = Rs. 1,126.49

The table of the sum of Re 1 (Table A) can also be used to simplify calculations
when compounding occurs more than once a year. We are required simply to
divide the interest rate by the number of times compounding occurs, that is (1

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»m) and multiply the years by the number of compounding periods per year,
that is, (m×n). In our example, we have to look at Table A for the sum of rupee
one under the 3 per cent column and in the row for the fourth year when
compounding is done semi-annually, the respective rate and year figures would
be 1.5 per cent and the eighth year in quarterly compounding.

The compounding factor for 3 per cent and 4 years is 1.126 while the factor
for 1.5 per cent and 8 year is 1.127. Multiplying each of the factors by the
initial savings deposit for Rs. 1,000, we find Rs. 1.126 (Rs. 1,000×1.126) for
semi-annual compounding and Rs. 1,127 (Rs. 1,000×1.127) for quarterly
compounding. The corresponding values found by the long method are Rs.
1,125.51 and Rs. 1,126.49 respectively. The difference can be attributed to
the rounding off of values in Table A.

Compounded Value of a Series of payments : So far we have considered only

the future value of a single payment made at time zero. In many instances, we
may be interested in the future value of a series of payments made at different
time periods. For simplicity, we assume that the compounding time period is
one year and payment is made at the end of each year. Suppose, Mr X deposits
each year Rs. 1,000, Rs. 2,000, Rs. 3,000, Rs. 4,000 and Rs. 5,000 in his saving
bank account for 5 years. The interest rate is 5 per cent. He wishes to find the
future value of his deposits at the end of the 5th year. Since the deposits are
made at the end of the year, the first deposit will earn interest for four years,
the second for three years and so on. The last payment of Rs. 5,000 comes at
the end of the fifth year and, therefore, the future value remains Rs. 5,000.
The future value of the entire stream of payments is the sum of the individual
future values, that is Rs. 16,041. Table 4.2 presents the calculations required
to determine the sum of money he will have.

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Table 4.2 : Annual Compounding of a Series of Payments
End of Amount deposited Number of years Compounded interest Future value
year compounded factor from Table A (2) × (4)
1 2 3 4 5

1 1000 4 1.216 1216.00

2. 2000 3 1.158 2316.00
3. 3000 2 1.103 3309.00
4. 4000 1 1.050 4200.00
5. 5000 0 1.000 5000.00
16041.00

Compound Value of an Annuity

An annuity is a fixed payment (or receipt) each year for a specified number of years. If
you rent a flat and promise to make a series of payments over an agreed period, you
have created an annuity. The equal instalment loans from the house financing companies
or employers are common examples of annuities. The compound value of an annuity
cannot be computed directly from Equation (2). Let us illustrate the computation of
the compound value of an annuity.

Example 5 :
Assume a constant sum of Re1 is deposited in a savings account at the end of
each year for four years at 6 per cent interest. This implies that Re 1 deposited
at the end of the first year will grow for 3 years, Re 1 at the end of second year
for 2 years, Re 1 at the end of the third year for 1 year and Re 1 at the end of
the fourth year will not yield any interest. Using the concept of the compound
value of a lump sum, we can compute the value of annuity. The compound value
of Re 1 deposited in the first year will be : Re 1 (1+0.06) 3 = Rs. 1.191, that of
Re 1 deposited in the second year will be : Re 1 (1+0.06) 2 = Rs. 1.124 and Re
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1 deposited at the end of third year will grow to : Re 1 (1+0.06) 1 = Rs. 1.06
and Re 1 deposited at the end of fourth year will remain Re 1. The aggregate
compound value of Re 1 deposited at the end of each year for four years would
be : Rs. 1.191 + Rs. 1.124 + Rs. 1.060 + Re 1.00 = Rs. 4.375. This is the
compound value of an annuity of Re 1 for four years at 6 per cent rate of
interest.

The above computations can be expressed as follows :

FV 4 = A (1+r)3 + A(1+r) 2 + A (1+r) + A
FV 4 A[(1+r) 3 + (1+r) 2 + (1+r)+ 1] (3)

where A is the annuity. We can extend Equation (3) for n periods and rewrite it
as follows :

FV n = A [ (1+r)r
n
–1
] (4)

The term within brackets is the compound value factor for an annuity of Re 1,
which we shall refer as CVAF.

Suppose Rs. 1000 are deposited at the end of each of the next three years at 10
per cent interest rate. The compound value employing Equation (4) is :

FV = Rs. 1000 [ (1.10)

0.10
3
]
– 1 = Rs. 1000 × 3.31 = Rs. 3310

It would be quite difficult to solve Equation (4) manually if n is very large.

Our calculations can be facilitated by either using a calculator or precalculated
compound values of an annuity of Re.1 Table B at the end of the book gives
compound value factors for an annuity of Re 1 for various combinations of
time period (n) and rates of interest (r). This table is constructed under the
assumption that the funds are deposited at the end of a period. The compound
value factor of an annuity (CVAF) should be ascertained from the table to find
out the future value of the annuity. We can also write Equation (4) as follows :
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 FV = A (CVAF n.i) (5)

where CVAF n.i is the compound value factor of an annuity for n periods at i rate
of interest.

Example 6 : Suppose that a firm deposits Rs. 5,000 at the end of each year for
four years at 6 per cent rate of interest. How much would this annuity
accumulate at the end of the fourth year? From Table B, we find that fourth
row and 6 per cent column give us a CVAF of 4.375. If we multiply 4.375 by
Rs. 5,000, we obtain a compound value of Rs. 21,875.

FV = Rs. 5,000 (CVAF 4,0.06 ) = Rs. 5,000 × 4.375 = Rs. 21,875

Sinkin Fund

Suppose that we want Rs. 21,875 at the end of four years from now. How much
should we deposit each year at an interest rate of 6 per cent so that it grows to
Rs. 21,875 at the end of fourth year? We know from the computations above
that the answer is Rs. 5,000 each year. The problem posed is the reversal of
the situation above; we are given the future amount and we have to calculate
the annual payments. Sinking fund is a fund which is created out of fixed
payments each period to accumulate to a future sum after a specified period.
Companies generally create sinking funds to retire bonds on maturity.
The factor used to calculate the annuity for a given future sum is called the
sinking fund factor (SFF). SFF ranges between zero and 1.0. It is equal to the
reciprocal of the compound value annuity factor. In the example above, the
reciprocal of CFAV of 4.375 is 0.2286. If the future sum of Rs. 21,875 is
multiplied by SFF of 0.2286, we obtain an annuity of Rs. 5,000. The problem
can be written as follows :

FV = A(CVAF n,i)

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 1
A = FV [ CVAF n,i ]
or A = FV (SFF n,i)
i
or A = FV [ (1+i) n –1 ] (6)

Applying Equation (6) to the above example, we obtain :

1
A = Rs. 21,875 [ 4.375 ] = Rs. 21,875 × 0.2286 = Rs. 5,000
The sinking fund factor is useful in determining the annual amount to be put in
a fund to repay bonds or debentures at the end of a specified period.

Doubling Period

Generally, a question is raised by the savers : How long would it take to double
the amount at a given rate of interest? To answer this question we may look at
the future value interest factor table. Looking at Table 4 we find that when the
interest rate is 12 per cent it takes about 6 years to double the amount, when
the interest is 6 per cent it takes about 12 years to double the amount, so on
and so forth. Is there a rule of thumb which dispenses with the use of the future
value interest factor table? Yes, there is one and it is called the rule of 72.
According to this rule of thumb the doubling period is obtained by dividing 72
by the interest rate. For example if the interest rate is 8 per cent, the doubling
period is about 9 years (72/8). Likewise, if the interest rate is 4 per cent the
doubling period is about 18 years (72/4). Though somewhat crude, it is a handy
and useful rule of thumb.

If you are inclined to do a slightly more involved calculation, a more accurate

rule of thumb is the rule of 69. According to this rule of thumb, the doubling
period is equal to :
69
0.35 +
Interest Rate

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As an illustration of this rule of thumb, the doubling period is calculated for
two interest rates, 10 per cent and 15 per cent.

Interest Rate Doubling Period

69
10% 0.35 + = 7.25 years
10
69
15% 0.35 + = 4.95 years
10
Finding the Growth Rate

The formula used to calculate future value can be applied to answer other type
of questions related to growth. Suppose your company currently has 5,000
employees and this number is expected to grow by 5 per cent per year. How
many employees will your company have in 10 years? The number of employees
10 years hence will be :

5,000 × (1.05) 10 = 5000 × 1.629 = 8,145

Example 7 : Sumit Limited had revenues of Rs. 100 million in 1990 which
increased to Rs. 1000 million in 2000. What was the compound growth rate in
revenues? The compound growth rate may be calculated as follows :

A = P (1+i) n (7)

1000 = 100 (1+i) 10

1000
= (1+i) 10
100
10 = (1+r) 10
1
10 = 1+r
10
1
10 –1 =r
10
r = 1.26-1 = 0.26 or 26%

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Applications of the Compound Value of Annuity

The future value annuity formula can be applied in a variety of context. Its
important applications are illustrated below.

Calculating the future value

Example 8 : Suppose you have decided to deposit Rs. 30,000 per year in your
Public Provident Fund Account for 30 years. What will be the accumulated
amount in your Public Provident Fund Account at the end of 30 years if the
interest rate is 11 per cent?

The accumulated sum will be

Rs. 30,000 (FVIFA 11%, 30 yrs)

30
= Rs. 30,000 [ (1.11).11 – 1]
= Rs. 30,000 [199.02]

= Rs. 5,970,600

Decoding the amount of Annual savings

Example 9 : You want to buy a house after 5 years when it is expected to cost
Rs. 4 million. How much should your save annually if your savings earn a
compound return of 12 per cent?
The future value interest factor for a 5 year annuity, given an interest rate of
12 per cent, is :
(1+0.12) 5–1
FVIFA n=5, r = 12%) = = 6.353
0.12
The annual savings should be :
Rs. 4000,000 = Rs. 6,29,624
6.353

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Annual Deposit in a Sinking Fund : Example 10 : Modern Limited has an
obligation to redeem Rs. 100 million bonds 6 years hence. How much should
the company deposit annually in a sinking fund account wherein it earns 14 per
cent interest to cumulate Rs. 100 million in 6 years time?

The future value interest factor for a 5 year annuity, given an interest rate of
14 per cent is :
(1+0.14) 6 –1
FVIFAn=6, r = 14% = 0.14 = 8.536

The annual sinking fund deposit should be :

Rs. 100 million
= Rs. 11.715 million
8.536

Finding the Interest Rate : Example 11 : A finance company advertises that it will
pay a lump sum of Rs. 16,000 at the end of 6 years to investors who deposit annually
Rs. 2,000 for 6 years. What interest rate is implicit in this offer?

The interest rate may be calculated in two steps :

1. Find the FVIFA r,6 for this contract as follows :

Rs. 16,000 = Rs. 2,000 × FVIFAr,6

Rs. 16,000
FVIFA r,6 = Rs. 20,000 = 8,000

2. Look at the FVIFAr,n table and read the row corresponding to 6 years
until you find a value close to 8,000. Doing so, we find that

FVIFA 12%,6 is 8.115

Hence, the interest rate is slightly below 12 per cent.

Deciding waiting period : Example 12 : You want to take up a trip to the

moon which costs Rs. 1,000,000 – the cost is expected to remain unchanged
in nominal terms. You can save annually Rs. 50,000 to fulfil your desire. How

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long will you have to wait if your savings earn an interest of 12 per cent?

The future value of an annuity of Rs. 50,000 that earns 12 per cent is equated
to Rs. 1,000,000.

50,000 × FVIFA n=?,12% = 1,000,000

1.12 n - 1
50,000 × [ 0.12 ] = 1,000,000
1,000,000
1.12 n–1 = × 0.12 = 2.4
Rs. 50,000

1.12 n = 2.4 + 1 = 3.4

n log 1.12 = log 3.4

n × 0.0492 = 0.5315
0.5315
n = 0.0492 = 10.8 years

You will have to wait for 10.8 years.

4.5 PRESENT VALUE

The concept of the present value is the exact opposite of that of compound
value. While in the latter approach money invested now appreciates in value
because compound interest is added, in the former approach (present value
approach) money is received at some future date and will be worth less because
the corresponding interest is lost during the period. In other words, the present
value of a rupee that will be received in the future will be less than the value of
a rupee in hand today. Thus, in contrast to the compounding approach where we
convert present sums into future sums, in present value approach future sums
are converted into present sums. Given a positive rate of interest, the present
value of future rupees will always be lower. It is for this reason, therefore,
that the procedure of finding present values is commonly called discounting.
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It is concerned with determining the present value of a future amount, assuming
that the decision maker has an opportunity to earn a certain return on his money.
This return is designated in financial literature as the discount rate, the cost of
capital or an opportunity cost.

Mathematical Formula : The process of discounting, used for calculating

the present value, is simply the inverse of compounding. The present value
formula can be readily obtained by manipulating the compounding formula :

FV n = PV (1+r) n (8)

Dividing both the sides of Eq. (8) by (1+r) n , we get :

PV = FV n [1/ (1+r) n] (9)

The factor 1/(1+r) n in Eq. (9) is called the discounting factor or the present
value interest factor (PVIF r,n ). Table C which is available in the end of this
book gives the value of PVIF r,n for several combinations of r and n.
Example 13 : What is the present value of Rs. 2,000 receivable 6 years hence
if the rate of discount is 10 per cent?

The present value is :

Rs 2,000 × PVIF 10%,6= Rs. 2,000 (0.5645) = Rs. 1129.0

Present Value of an Uneven Series

In financial analysis we often come across uneven cash flow streams. For
example, the cash flow stream associated with a capital investment project is
typically uneven. Likewise, the dividend stream associated with an equity share
is usually uneven and perhaps growing.

The present value of a cash flow stream – uneven or even – may be calculated
with the help of the following formula :

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 n
A1 A2 An
PV n = (1+r) + (1+r) 2 +......+ (1+r) n = Σ At
t=1 (1+r)
t (10)

where PVz n = present value of a cash flow stream

A t = cash flow occurring at the end of year t

k = discount rate

n = duration of the cash flow stream

Show the calculation of the present value of an uneven cash flow stream given
in the following table, using a discount rate of 12 per cent.

Year Cash Flows

1 Rs. 500

2 1,000

3 1,500
4 2,000

5 2,500

In order to solve this problem, the present value of each individual cash flow
discounted at 10 per cent for the appropriate number of years is to be
determined. The sum of all these individual values is then calculated to get the
present value of the total stream. The present value factors required for the
purpose are obtained from Table C (see appendix). The results are summarised
in Table.......

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Table 4.3 : Present Value of a Mixed Stream of Cash Flows

Year end Cash flows Present value factor (2)×(3) Present value
1 2 3 4

1 Rs. 500 0.909 Rs. 454.50

2 1,000 0.826 826.00

3 1,500 0.751 1,126.50

4 2,000 0.683 1,366.00

5 2,500 0.621 1,552.50

5,325.50

Present Value of an Annuity

An investor may have an opportunity to receive a constant periodic amount (an annuity)
for a certain number of years. The present value of an annuity cannot be found out by
using Equation (8). We will have to find out the present value of the amount every year
and will have to aggregate all the present values to get the total present value of the
annuity. For example, An investor, who has a required interest rate as 10 per cent, may
have an opportunity to receive an annuity of Re 1 for four years. The present value of
Re 1 received after one year is, P=1/(1.10) = Re0.909, after two years, P=1/(1.10)2 =
Re 0.826, after three years, P=1/(1.10)3 = Re 0.751 and after four years, P=1/(1.10)4
= Re 0.683. Thus the total present value of annuity of Re 1 is Rs. 3.169 :
1 1 1 1
PV = + 2 + 3 +
(1.10) (1.10) (1.10) (1.10) 4
= 0.909 + 0.826 + 0.751 + 0.683 = Rs. 3.169

If Re 1 would have been received as a lump sum at the end of the fourth year,
the present value would be only Re 0.683. Notice that the present value factors
of Re 1 after one, two, three and four years and so on can be ascertained from
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Table D (at the end of the book), and when they are aggregated we obtain the
present value of the annuity of Re 1. The present value of an annuity of Re 1
for four years at 10 per cent interest rate is shown in Figure 4.2. It can be
noticed that the present value declines over period for a given discount rate.

The computation of the present value of an annuity can be written in the

following general form :
A A A A
P = + + + ......
(1+r) (1+r) 2 (1+r) 3 (1+r) n
1 1 1 1
= [ (1+r) +
(1+r) 2
+
(1+r) 3
+......+
(1+r) n ] (11)

where A is a constant payment (or receipt) each year. Equation (10) can be
solved and expressed as follows :
1
PV = A
[ 1– (1+r) n
i
]
(i+r) n–1
or PV = A [ i (1+r) n
]
or P=A [ 1r –
1
i(1+r)n
] (12)

End of Year
0 1 2 3 4
Re1 Re1 Re1 Re1 Receipt at the end of year
Rs. 0.909
Rs. 0.826
Rs. 0.751
Rs. 0.683
Rs. 3.169 Present value
Figure 4.2 : Graphic representation of present value of an annuity of Re 1 at 10%
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The term within parentheses of Equation (12) is the present value factor of an
annuity of Re 1, which we will call PVAF, and it is a sum of single-payment
present value factors.

To illustrate, let us suppose that a person receives an annuity of Rs. 5,000 for
four years. If the rate of interest is 10 per cent, the present value of Rs. 5,000
annuity is :
1
PV = Rs. 5,000 [ 1– (1+10)4
i
]
= Rs. 5,000 × 3.170 = Rs. 15,850

It can be realised that the present value calculations of an annuity for a long
period would be extremely cumbersome. Our calculations are, however,
simplified when we use calculator or the precalculated present values of an
annuity of Re 1 as given in Table D at the end of the book. Table D is constructed
using Equation (12). To compute the present value of an annuity, we should
simply find out the appropriate factor from Table D and multiply it by the annuity
value. In our example, the value 3.170 solved using Equation (11) could be
ascertained directly from Table D. Reading fourth row and 10 per cent column,
the value is 3.170. Equation (12) can also be written as follows :

PV = A (PVAFn,r )
where PVAF n,r is present value factor of an annuity of Re 1 for n periods at r
rate of interest. Applying the formula and using Table D, we get :
PV = Rs. 5,000 (PVAF 4,0.10 ) = Rs. 5,000×3.170 = Rs. 15,850
7. Applications of the Present Value of Annuity
The present value annuity formula can be applied in the following contexts :
How Much Can You Borrow for a Car : After reviewing your budget, you
have determined that you can afford to pay Rs. 12,000 per month for 3 years
towards a new car. You call a finance company and learn that the going rate of
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interest on car finance is 1.5 per cent per month for 36 months. How much can
you borrow?

To determine how much you can borrow, we have to calculate the present value
of Rs. 12,000 per month for 36 months at 1.5 per cent per month.

Since the loan payments are an ordinary annuity, the present value interest factor
of annuity is :

(1+r) n–1 (1+.015) 36 – 1 1.7091–1

PVIFAr,n = = = =27.70
r(1+r) n .015(1+.015)36 0.0256

Hence the present value of 36 payments of Rs. 12,000 each is :

Present Value = Rs. 12,000 × 27.70 = Rs. 332,400

You can, therefore, borrow Rs. 332,400 to buy the car.

Period of Loan Amortisation : Suppose you want to borrow Rs. 1,080,000

to buy a flat. You approach a housing finance company which charges 12.5 per
cent interest. You can pay Rs. 180,000 per year toward loan amortisation. What
should be the maturity period of the loan?

The present value of annuity of Rs. 180,000 is set equal to Rs. 1,080,000.

180,000 × PVIFAn,r = 1,080,000

180,000 × PVIFA n=?, r = 12.5% = 1,080,000

1.125 n -1
180,000 [ ]
0.125 × 1.125 n = 1,080,000

Given this equality the value of n is calculated as follows :

1.125 n-1 1,080,000
= = 6
0.125 × 1.125 n 180,000

1.125 n-1 = 6(0.125×1.125 n) = 0.75×1.125 n

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 0.25×1.125 n = 1

1.125 n = 4

n log 1.125 = log 4

n × 0.0512 = 0.6021
0.6021
n = = 11.76 years
0.0512
You can perhaps request for a maturity of 12 years.

Determining the Loan Amortisation Schedule : Most loans are repaid in

equal periodic instalments (monthly, quarterly, or annually), which cover
interest as well as principal repayment. Such loans are referred to as amortised
loans.

For an amortised loan we would like to know (a) the periodic instalment payment
and (b) the loan amortisation schedule showing the break up of the periodic
instalment payments between the interest component and the principal
repayment component. To illustrate how these are calculated, let us look an
example.
Suppose a firm borrows Rs. 1,000,000 at an interest rate of 15 per cent and
the loan is to be repaid in 5 equal instalments payable at the end of each of the
next 5 years. The annual instalment payment A is obtained by solving the
following equation.
Loan amount = A + PVIFa n=5, r=15%
1,000,000 = A × 3.3532
Hence A = 298,223
The amortisation schedule is shown in Table 4.4. The interest component is
the largest for year 1 and progressively declines as the outstanding loan amount
decreases.
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 Table 4.4 : Loan Amortisation Schedule

Year Beginning Annual Interest Principal Remaining

Amount Instalment Repayment Balance
(1) (2) (3) (2)-(3) = (4) (1)-(4)=(5)
1 1,000,000 298,329 150,000 148,329 851,671
2 851,671 298,329 127,751 170,578 681,093
3 681,093 298,329 102,164 196,165 484,928
4 484,928 298,329 72,739 225,590 259,338
5 259,338 298,329 38,901 259,428 – 90 *
a. Interest is calculated by multiplying the beginning loan balance by the interest
rate.
b. Principal repayment is equal to annual instalment minus interest
* Due to rounding off error a small amount is shown.

Present Value of a Perpetuity

Perpetuity is an annuity that occurs indefinitely. Perpetuities are not very

common in financial decision making. But one can find a few examples. For
instance, in the case of irredeemable preference shares (i.e. preference shares
without a maturity), the company is expected to pay preference dividend
perpetually. By definition, in a perpetuity, time period, n, is so large
(mathematically n approaches infinity) that the expression (1+r)n in Equation
(12) tends to become zero, and the formula for a perpetuity simply becomes:
A
P = r (13)

Let us assume that an investor expects a perpetual sum of Rs. 500 annually
from his investment. What is the present value of this perpetuity if his interest
rate is 10 per cent? Applying Equation (13), we get :
Rs. 500
P= = Rs. 5,000
0.10
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Present Value of a Growing Annuity

In financial decision-making there are number of situations where cash flows

may grow at a compound rate. For example, in the case of companies dividends
are expected to grow at a compound rate. Assume that to finance your studies
in an evening college, you undertake a part-time job for 5 years. Your employer
fixes an annual salary of Rs. 2000 with the provision that you will get annual
increment at the rate of 10 per cent. It means that you shall get the following
amounts from year 1 through year 5.
Year End Amount of Salary (Rs.)

1 2,000 = 1,000
2 2,000(1.10) = 1,200 = 2,200
3 2,200(1.10) = 2,000(1.10) 2 = 2,420
4 2,420(1.10) = 1,000(1.10) 3 = 2,662
5 2,662(1.10) = 1,000(1.10) 4 = 2,928

If your required rate of return is 12 per cent, the present value of your salary
is calculated as follows :

Year End Amount of Salary (Rs.) PVF @ 12% PV of Salary (Rs.)

1 2,000 0.893 1786

2 2,200 0.797 1754
3 2,410 0.712 1724
4 2,662 0.636 1694
5 2,928 0.567 1660
12,210 8618

We can write the formula for calculating the present value as follows :

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 A1 A2 A3 An
PV = + + + ......
(1+i) (1+i) 2 (1+i) 3 (1+i) n

A1(1+g)0 A1(1+g)1 A1(1+g)2 A1(1+g)n-1

= [(1+i)
+
(1+i) 2
+
(1+i) 3
+......+
(1+i) n ] (14)

where g is the rate of growth of cash flows. We know that for calculating the present
value of a non-growing annuity, we can use Equation (12) or Equation (13). With an
adjustment in the discount rate for growth, we can use the same procedure for
calculating the present value of cash flows growing at constant rate.

If Equation (12) is modified to incorporate growth in cash flows, it can be

rewritten as follows :
A 1-(1+i *)-n
PV =
1+g [ i* ] (15)

Note that i * is the required rate of interest adjusted for growth. It can be found
as follows :
i-g
i* =
1+g
If we use the data of the example above, the growth-adjusted rate of return
would be :
0.12 - 0.10
i* = = 0.018
1.10
The present value factor for an annuity for 5 years at a rate 1.8 per cent is
4.740. Thus, thus the present value of your salaries would be :
Rs. 2,000
P = × 4.740 = Rs. 8618
1.10
This amount is the same as we calculated earlier.

Example 14 : A dividend stream commencing one year hence at Rs. 66 is

expected to grow at 10 per cent per annum for 15 years and then ceases. If the
discount rate is 21 per cent, what is the present value of the expected series?

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 A 1-(1+i*)-n 1-g
P=
1+g [ i* ] where i * =
i+g

hence
0.21 – 0.10 0.11
i* = = = 0.10
1.10 1.10
A Rs. 66
and = = Rs. 60
1+g Rs. 1.10
Referring to Table D at the end of the book, we find the present value of an
annuity of Re 1 and 10 per cent for 15 years is 7.606, therefore :

P = Rs. 60 × 7.606 = Rs. 456.36

In showing the calculation of the present value of constantly growing series of

cash flows, we have assumed a finite time period. Cash flows may grow
indefinitely. In mathematical term, we may say that n may extend to infinity ( n
→ ∞) in Equation (14). Then the calculation of the present value of a constantly
growing perpetuity becomes very simple ; it is given by the following equation:
A
P = (16)
i-g
Thus, in the example above if the dividend is expected to grow perpetually, the
present value would be :
66 Rs. 66
P = = = Rs. 600
0.21 – 0.10 0.11
Value of an Annuity Due

The concepts of compound value and present value of an annuity discussed

earlier are based on the assumption that series of payments are made at the
end of the year. In practice, payments could be made at the beginning of the
year. When you buy a scooter on instalment sale, the dealer requires you to
make the first payment immediately (viz. in the beginning of the first period)

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and subsequent instalments in the beginning of each period. Similarly it is
common in lease or hire purchase contracts to require payments to be made in
the beginning of each period. Lease is a contract to pay lease rentals (payments)
for the use of an asset. Hire purchase contract involves regular payments
(instalments) for acquiring (owning) an asset. A series of fixed payments
starting at the beginning of each period for a specified number of periods is
called an annuity due.

Present Value of an Annuity Due

Now a question arises : What is the present value of the annuity if each payment is
made at the beginning of the year? Let us consider a 4-year annuity of Re 1 each
year paid in the beginning of the year, the interest rate being 10 per cent. Note that
the first payment is made immediately, therefore its present value is equal to its
absolute value. Other payments have been discounted at 10 per cent to compute
their present values. Thus, the present value of the series of payments is :
Re 1 Re 1 Re 1 Re 1
PV = (1.10) 0+ (1.10)1 + (1.10)2 + (1.10) 3

= Re 1 + Re 0.909 + Re 0.826 + Re 0.751 = Rs. 3.487

The formula for the present value of an annuity due is :

-n
1 1 1
P=A [ ]
1 + (1+r) + (1+r) 2 + ... + (1+r) n-1 = A [ 1-(1+r)
r
] (1+r) (17)

P= A (PVAFn,r ) (1+r) (18)

Applying Equation (18), the present value of Re 1 paid at the beginning of each
year for 4 years is :
Re 1(3.170) (1.10) = Rs. 3.487
The present value annuity factors in Table D should be multiplied by (1+r) to
obtain relevant factors for an annuity due.
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Effective versus Stated Rate

If the stated rate of interest is 12 per cent, a sum of Rs. 1000, will grow to
Rs. 1,123.6 at the end of a year if compounding is done semi-annually. This
means that Rs. 1,000 grows at the rate of 12.36 per cent per annum. The figure
of 12.36 per cent is called the effective interest rate –the rate of interest
under annual compounding which produces the same result as that produced by
an interest rate of 12 per cent under semi-annual compounding.

The general relationship between the effective interest rate and the stated annual
interest rate is as follows :
Stated annual interest rate m
Effective interest rate = [ 1+ m ] –1

where m is the frequency of compounding per year.

Suppose a bank offer 12 per cent stated annual interest rate. What will be the
effective interest rate when compounding is done annually, semiannually, and
quarterly?
1
0.12
Effective interest rate with annual compounding = 1 +
1[ ]
– 1 = 0.12
2
Effective interest rate with semi-annual compounding = [ 1 +
0.12
2
] – 1 = 0.1236
4
0.12
Effective interst rate with quarterly compounding = 1+
4
[ ]
–1 = 0.1255

When compounding becomes continuous, the effective interest rate is

expressed as follows :

Effective interest rate = e r – 1

Where e = base of natural logarithm (19)

r = stated interest rate

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4.6 NET PRESENT VALUE

We have stated in lesson 1 that the firm's financial objective should be to

maximise the shareholder's wealth. Wealth is defined as net present value
(NPV). NPV of a financial decision is the difference between the present value
of cash inflows and the present value of cash outflows. Suppose you have Rs.
2,00,000. You want to invest this money in land which can fetch you Rs.
2,45,000 after one year when you sell it. You should undertake this investment
if the present value of the expected Rs. 2,45,000 after a year is greater than
the investment outlay of Rs. 2,00,000 today. You can put your money to
alternate uses. For example, you can invest Rs. 2,00,000 in units (Unit Trust
of India sells 'units' and invest money in securities of companies on behalf of
investors) and earn, say, 15 per cent divided a year. How much should you
invest in units to obtain Rs. 2,45,000 after a year? In other words, if your
opportunity cost of capital is 15 per cent, what is the present value of Rs.
2,45,000 if you invest in land? The present value is :

PV = Rs. 2,45,000 (PVF 1.0,15 ) = Rs. 2,45,000×0.870 = Rs. 2,13,150

The land is worth Rs. 2,13,150 today, but that does not mean that your wealth
will increase by Rs. 2,13,150. You will have to commit Rs. 2,00,000, and
therefore, the net increase in your wealth or net present value is : Rs. 2,13,150-
Rs. 2,00,000 = Rs. 13,150. It is worth investing in land. The general formula
for calculating NPV can be written as follows :
A1 A2 An
NPV = + 2 +....+ – C0
(1+r) (1+r) (1+r) n
n
NPV = Σ At
(1+r)t
– C0 (20)
t=1
where A t is cash inflow in period t, C 0 cash outflow today, r the opportunity

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cost of capital and t the time period. Note that the opportunity cost of capital
is 15 per cent because it is the return foregone by investing in land rather than
investing in securities (units). The opportunity cost of capital is used as a
discount rate.

4.7 SOLVED PROBLEMS

1. If the interest rate is 12 per cent, what are the doubling periods as per
the rule of 72 and the rule of 69 respectively?

Solution : As per the rule of 72 the doubling period will be

72/12 = 6 years

As per the rule of 69, the doubling period will be

69
0.35 + = 6.1 years
12
2. A borrower offers 16 per cent nominal rate of interest with quarterly
compounding. What is the effective rate of interest?

Solution : The effective rate of interest is

4
0.16
[ 1+
4 ] –1 = (1.04) 4 – 1

= 1.17 – 1

= 0.17 = 17 per cent

3. A finance company advertises that it will pay a lumpsum of Rs. 44,650

at the end of five years to investors who deposit annually Rs. 6,000 for
5 years. What is the interest rate implicit in this offer?

Solution : The interest rate may be calculated in two steps

(a) Find the FVIFA for this contract as follows :

Rs. 6,000 (FVIFA) = Rs. 44,650

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 Rs. 44,650
FVIFA = = 7.442
Rs. 6,000
(b) Look at the FVIFA table and read the row corresponding to 5 years
until 7.442 or a value close to it is reached. Doing so we find that

FVIFA 20%, 5yrs. is 7.442

So, we conclude that the interest rate is 20 per cent

4. What is the present value of the following cash stream if the discount
rate is 14 per cent ?
Year 0 1 2 3 4

Cash flow 5,000 6,000 8,000 9,000 8,000

Solution : The present value of the above cash flow stream is :

Year Cash Flow (PVIFA14%,n ) Present Value

0 Rs. 5,000 1.000 Rs. 5,000

1 6,000 0.877 5,262
2 8,000 0.769 6,152
3 9,000 0.675 6,075
4 8,000 0.592 4,736
Rs. 27,225

5. Shyam borrows Rs. 80,000 for a musical system at a monthly interst of

1.25 per cent. The loan is to be repaid in 12 equal monthly instalments,
payable at the end of each month. Prepare the loan amortisation schedule.

Solution : The monthly instalment A is obtained by solving the equation:

80,000 = A × PVIFAn=12, r = 1.25%

(1+r) 12 – 1
80,000 = A × r (1+r) 12

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 (1.0125)12 – 1
80,000 = A×
(0.0125) (1.0125)12
1.16075 – 1
= A×
0.0125 × 1.16075
= A × 11.0786

Hence A = 80,000/11.0786 = Rs. 7221

The loan amortisation schedule is shown below :

Loan Amortisation Schedule
Month Beginning Monthly Interest Principal Remaining
Amount Instalment Repayment Balance
(1) (2) (3) (2)-(3)=(4) (1)-(4)=(5)
1 80,000 7221 1000 6221 73779

2 73,779 7221 922.2 6298.8 67480.2

3 67,480.2 7221 843.5 6377.5 61102.7

4 61102.7 7221 763.8 6457.2 54645.5

5 54645.5 7221 683.1 6537.9 48107.6

6 48107.6 7221 601.3 6619.7 41487.9

7 41487.9 7221 518.6 6702.4 34785.5

8 34785.5 7221 434.8 6786.2 27999.3

9 27999.3 7221 350.0 6871.0 21128.3

10 21128.3 7221 264.1 6956.9 14171.4

11 14171.4 7221 177.1 7043.9 7127.1

12 7127.1 7221 89.1 7131.9 - 4.8@

@ Rounding off error

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4.8 SUMMARY

Money has time value. A rupee today is more valuable than a rupee a year hence.
The time value of money are future value and present value.

Future value depends on compounding of interest to measure the value of future

amounts. When interest is compounded, the initial principal/deposit in one
period, along with the interest earned on it, becomes the principal of the
following period and so on. Interest can be compounded annually, six monthly,
quarterly, monthly, weekly, daily or even continuously. The more frequently
interest is compounded, the larger is the future amount that will be accumulated.
Table A in the appendix presents the future value interest factors used in the
annual compounding of interest at various rates for a number of years. This
table can also be used to evaluate the benefits of compounding interest more
frequently than annually. Table B provides a short cut for finding the future
value if the amount is annuity.

Present value represents the opposite (inverse) of compound value. In finding

the present value of a future sum, we determine what amount of money today
would be equivalent to the given future amount, considering the fact that we
can earn certain return on this money. The sum is discounted using a discount
rate. Table C and D in the Appendix contain present value interest factor for
various discount rates and periods for mixed streams of cash flows and annuity
cash flows respectively.

The future values and present values can be used to determine (i) the deposit
needed to accumulate a future sum, (ii) loan amortisation payments (iii)
interest and growth rates and so on. The present value of perpetuity can also be
calculated.

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4.9 SELF TEST QUESTIONS

1. 'Cash flows of two years in absolute terms are incomparable'. Give

reasons in support of your answer.

2. Define the following terms and phrases :

(a) Compound sum of an annuity

(b) Present value of a future sum

(c) Present value of an annuity

(d) Perpetuity
(e) Annuity

(f) Discount rate

3. 'Generally individuals show a time preference for money'. Give reasons

for such a preference.

4. Is the adjustment of time relatively more important for financial

decisions with short-range implications or for decisions with long-range
implications? Explain.

5. Explain the mechanics of calculating the present value of cash flows.

6. What happens to the present value of an annuity when the interest rate rises ?

7. What is multi-period compounding? How does it affect the annual rate of

interest? Give an example.

8. How does discounting and compounding help in determining the sinking fund
and capital recovery?

9. Calculate the present value of Rs. 600 (a) received one year from now; (b)
received at the end of five years; (c) received at the end of fifteen years. Assume
a 5 per cent time preference rate.
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10. Determine the present value of Rs. 700 each paid at the end of each of the next
six years. Assume a 8 per cent rate of interest.

11. Assume a 10 per cent discount rate. Compute the present value of Rs. 1,100; Rs.
900; Rs. 1,500 and Rs. 700 received at the end of one through four years. For
calculations, use the tables given at the end of the book.

12. Exactly ten years from now Shri Chand will start receiving a pension of Rs.
3,000 a year. The payment will continue for sixteen years. How much is the
pension worth now, if Sri Chand's interest rate is 10 per cent?

13. How long will it take to double your money if it grows at 12 per cent annually?
14. Mohan bought a share 15 years ago for Rs. 10. It is now selling for Rs. 27.60.
What is the compound growth rate in the price of the share?

15. Sadhulal Bhai is borrowing Rs. 50,000 to buy a low-income group house. If he
pays equal instalments for 25 years and 4 per cent interest on outstanding balance,
what is the amount of instalment? What shall be amount of instalment if quarterly
payments are required to be made?

4.10 SUTTESTED READINGS

1. Prasanna Chandra : Financial Management, Tata McGraw Hill

2. I.M. Pandey : Financial Management, Vikas Publishing House

3. John J. Hampton : Financial Decision Making, PHI

4. Ravi M. Kishore : Financial Management

5. Khan and Jain : Financial Management, Tata McGraw Hill

✪✪✪

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 Lesson : 5

VALUATION AND RATES OF RETURN

Objective : After reading this lesson, you must be able to discuss

various conceptual approaches to valuation of firm; and valuation of
securities.

Structure

5.1 Introduction to Valuation

5.2 Approaches to Value Determination

5.3 Valuation of Different Kinds of Financial Securities

5.4 Summary

5.5 Self-Test Questions

5.6 Suggested Readings

5.1 INTRODUCTION TO VALUATION

The issue of valuation is so important in real business world that it

is accepted as the principal criterion for gauging the effectiveness of
all the financial decisions. Investment decisions affect value of the
enterprise and it is through its investment decisions that the
enterprise creates value and thus benefits both its shareholders and
society. Financial decisions also affect the value primarily because
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of the tax deductibility of interest payment on debt. Dividend decisions
too influence value of the enterprise. By formulating suitable dividend
policy the finance manager can maximise value of the firm.

More specifically, the question of valuation arises in a number of

situations. Thus, principle of valuation is closer to determining the
economic value of the enterprise. Where the management is
contemplating to acquire an enterprise or merger issue is under
consideration, it must use the techniques of valuation to appraise
new investment opportunities and to determine the value of an entire
firm involved in a merger. Similarly, feasibility of reorganisation plan
can be studied by determining value of the enterprise. The finance
manager faced with the problems of recapitalisation makes extensive
use of principles of valuation. Likewise, principles of valuation are
useful to the management who is interested to know the reliable value
of the enterprise being terminated either in bankruptcy or voluntary
liquidation. In analysing utility of lease the finance manager uses very
frequently the principles of valuation. Aside from this, any enterprise
which is considering a public offering of its own stock to raise equity
capital is faced with the need to establish a price for the issue. Thus,
the principles of valuation constitute vital cornerstones in the financial
management.

5.2 APPROACHES TO VALUE DETERMINATION

Broadly speaking, there are three methods of valuation, viz., Asset

approach to valuation, Market value approach and capitalised earnings
approach.

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1. Asset Approach to Valuation

A number of methods, prominently book value, reproduction value,

going concern value and liquidation value can be included under asset
approach to valuation for the fact that they centre attention more on
the assets to which the shareholders have claim.

Book Value : Book Value is defined as the value of company’s assets

that is carried on the company’s position statement. Thus, asset values
are accumulation of historical costs and may or may not reflect current
market value. This is determined by the use of standardised accounting
techniques and is calculated from the financial reports prepared by
the company. The excess of assets over debts represents the
accounting networth of the business and hence the book value of the
owner’ investment. Where preferred stock is outstanding, a value for
the preferred stock must also be subtracted to determine the networth.
The networth divided by the number of equity shares outstanding
gives book value per share.

Book value is relatively easily and simply determined. However, it has

little relevance to the owners and others interested in the enterprise.
Failure of the book value approach to give consideration to the earning
power of the assets is another serious drawback of this approach as a
measure of appraisal of the enterprise. The approach is rendered
unscientific because of the absence of standardisation of accounting
practice particularly in respect of the valuation of fixed assets and in
the treatment of intangibles such as patents and goodwill. Thus, a
company following a rigorous depreciation policy would show lower
net fixed assets and hence lower book values than would a similar
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company that had charged less depreciation. Even if a company follows
conventional accounting practice in all respects, it will arrive at its
balance sheet values by reference to conventions rather than sheer
logics of value. Hence, inventories are generally carried at cost or
market value, whichever is lower. Fixed assets are typically reported
at historical cost less depreciation rather than at current value.

Book values are most useful in evaluating these concerns whose assets
are largely liquid and subject to fairly accurate accounting valuation.
These are mostly financial institutions such as banks and insurance
companies. However, even in these instances, book values used alone
are seldom reliable standards of value.

Liquidation Value : Liquidation value is another method based on

asset approach employed to judge what the enterprise (or asset) could
be sold by selling of its component parts. Thus, liquidating value seeks
to determine the amount that could be realised if an asset or a group
of assets (the entire assets of the company) are sold separately from
the organisation that has been using them. The sum of the proceeds
from each category of assets would be the liquidating value of the
assets. If owner’s debts are subtracted from this amount, the difference
would represent the liquidating value of ownership in the enterprise.
It might be noted here that in the liquidation approach the value of
the assets is based indirectly on their potential earning capacity. Unless
they are to be sold for scrap value, the assets will ultimately find a
market in someone who feels that the assets could be used effectively
to make earnings. This method might be gainfully used only when it is
apparent that greatest value of the company is determined by breaking
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down its components and evaluating each at its ‘liquidation’ price.
Such a valuation method is seldom used particularly in times of
bankruptcy because the sum of the values of the various assets when
sold individually and independently is often less than the value of the
company as a going concern.

Going concern Value : Going concern value refers to the value of the
enterprise which is determined on the basis of the presumption that
the whole business is being disposed off. Going concern value is very
likely to be higher than liquidation value because in the former the
assets are integrated in a successful way to create an income stream.
The difference between the going concern value and liquidation value
sometimes called “good will” which may include such thing as good
location, a quality reputation and monopoly power. The going concern
concept also suggests that it is the earning power of assets which
generate their ultimate value.

Replacement Value : Replacement value method attempts to

determine the current cost of reconstructing the assets of a concern.
This value must be reduced by an amount equal to that proportion of
the remaining life of the asset to its original life. If, for example, half of
the asset’s life has expired, the replacement cost should be cut in half
(assuming straight-line depreciation). A major objection lies in the
inescapable fact that the typical business is much more than the sum
of its physical assets. While cost of replacing physical properties can
be calculated with same exactness by painstaking appraisal, cost of
duplicating the business organisation, its experience, know-how and
reputation, apart from the physical assets, is most difficult in
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determination.

2. Market Value Approach

According to market value approach, value of a company is determined

on the basis of actual value of securities of the company traded in the
market. If we are examining a company whose stock or debt is traded
in a securities market, we can determine the market value of the
security. This is the value of the debt or equity securities as reflected
in the bond or stock market’s perception of the company.

Market value is sometimes advanced as the true measure of value on

the ground that it represents the current valuation in the market place
which is set by buyers and sellers acting in basic self-interest. Thus,
they are appraisals of supposed experts who are willing to support
their opinions with cash. It is, therefore, maintaining that the prices at
which sales take place are practical expression of value. Another
advantage of market value approach put forth by the advocates of this
approach is that the price of security in a free market serves as an
effective common denominator of all current ideas of the worth of
security as compared to other investment opportunities. Also, market
price is a definite measure that can readily be applied to a particular
situation. The subjectivity of other approaches is avoided in favour of
a known yardstick of value.

However, there are many problems in applying market price as a

standard of valuation of an enterprise. The first such problem arises
because of volatility of market value even in a normal year which may
not have been warranted by earnings factor due to the fact that earnings

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prospects of the company would not change so sharply in such a short
period. It is more likely that the capitalisation rate changes during the
year, and small absolute changes in the capitalisation rate can produce
large changes in the market value of a security. Furthermore,
speculative activities in the market tend to exaggerate major upward
and downward movements in stock prices which do not represent the
actual changes in financial conditions of the company. Another problem
often arises in regard to the valuation of large blocks of securities.
Recorded sales prices for the date in question may be based on the
sale of one or two hundred shares. It may not be always fair and
appropriate to apply the price set on a small scale to a large block of
shares. Market value of shares may not always represent value set by
free forces as buyers and sellers operating in the market. Sometimes
listed stocks are traded on a very desultory and infrequent basis.

To meet some of the objectives noted above theory of the market value
or intrinsic value approach has been developed. Under this approach
fair market value is the value at which transaction would take place
between willing buyers and willing sellers who are well equipped with
complete information on the security and who are prepared to act in a
rational manner. Undoubtedly this approach does meet most of the
objections stated; yet it raises a need for other methods of valuation
than market quotations and accordingly suggests capitalised earnings
approach as more valid measure of appraisal of intrinsic worth of the
enterprise.

3. Capitalised Earnings Approach

Capitalised earnings approach attempts to measure real value of

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company. A business enterprise is a profit seeking entity and therefore
its real value should be determined according to what it earns. It
should, however, not mean that if a company’s annual earnings is
about 50,000, it is worth that amount, for the company will continue to
earn for a number of years. Since the company is a going concern, it is
customary to assume that the stream of net earnings will continue for
an indefinite period. Accordingly, value obtained by multiplying annual
net income of the company by appropriate multiplier would be the
real value of the company. The multiplier here would mean
capitalisation rate. Capitalisation of earnings indicates the maximum
amount which investors in the market would be willing to pay for the
given stream of earnings.

Thus, for determining real value of the enterprise the finance manager
is required first to estimate annual net income after taxes (or earnings
per share) of the enterprise. As a second step capitalisation rate to be
applied to these earnings will have to be determined. Thereafter, with
the help of the following formula real value of the company can be
obtained :

P0 = CF/K

Where, P0 = Capitalised value of earnings

CF = Value of cash income stream into perpetuity,

K = Capitalisation rate or required rate of return.

Assume, for example, that a company has earnings after taxes of Rs.
20,000 per year and an investor requires an 8 per cent return on his
money, the maximum amount that the investor would be required for
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the company will be Rs. 2,50,000 (Rs. 20,000/.08).

The basic validity of the concept that value rates on earning power or
potential earning power is seldom challenged. It is, however, in the
application of the concept to actual situations that major problems
arise. These problems can be identified as the problem of estimating
earnings and problem of determining capitalisation rate.

Estimating Earnings : A business entity should be considered as

having an unlimited future. Accordingly, its income stream must be
treated as if it will flow to infinity. It is, therefore, obvious to think of
earnings figures in terms of earnings per unit of time—the amount per
year.

The task of estimating future earnings is a difficult one. In the case of

an established enterprise, future earnings can be based on the past
income, since past earnings give a partial evidence of what future
earnings will be. Thus, the first step in the process would be to choose
a period of time that will represent a normal picture of both the good
and bad years in the company’s recent history. In computing these
historical figures, care is taken to remove non-recurring gains such as
gain realised on the sale of building. Usually only earnings attributable
to operations of the enterprise are included in the figure that is to be
capitalised. Income tax is deducted from the earnings figure.

The net income figure is further adjusted for any other factors that
would make the adjusted income more representative of the expected
future earnings. The long run prospects of the company should also
be taken into consideration. If the company’s profits have recorded

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upward tendency, recent years figures are given more weight and
historical period need not be used. Usually average of the recent five-
year span is taken as a typical of what the future will be. Appropriate
adjustments should also be made for any unusual items of income or
expenses. Losses resulting from floods or other disasters should
ordinarily not be deducted from income.

In the case of a new concern such an estimate is a difficult one. An

estimate of cost and earnings of the proposed venture has to be made.
Cost will be determined on the basis of the manager’s knowledge of
material costs, labour costs and other operating expense-factors.

Earnings of the company should be projected on the basis of the volume

of sales. The sales estimate is arrived at on the basis of forecasts of
business conditions in the country as a whole, in industries that will
buy from the company and in fields which the company is entering.
These estimates are then compared with the actual figures of
companies engaged in the same business. Allowance, of course, must
be made for differences in size, age, location, managerial experience,
rate of growth and similar other factors in such comparison. The
earnings estimate, thus, arrived at is employed for determining value
of the company.

Rate of Capitalisation : Once we determine an annual earnings for

the company as a whole or possibly a range of earnings, the next step
is to apply a capitalisation rate to arrive at the prospective investment
value. This is the sum which, if invested at the assumed capitalisation
rate, will yield the expected annual earnings in perpetuity.

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The capitalisation rate or discount rate is defined as the rate of return
required to induce investors to invest in the company. More specifically,
capitalisation rate tantamount to cost of capital. The rate of
capitalisation can at best be determined by studying earnings rate of
the similarly situated enterprises in the same industry and the rate at
which market is capitalising earnings.

The determination of the appropriate rate of return is the most difficult

and subjective since it is primarily related to the degree of risk inherent
in the business and to the amount of managerial skill needed to cope
with that risk. Also it is affected by degree of variability of income.
Even intangible factors such as prestige or stigma associated with the
time of business affect the capitalisation rate. Alongside this, there is
an element of uncertainty in capitalisation rate as it fluctuates with
stages in business cycle.

For practical purposes capitalisation rate for security valuation is taken

as the riskless rate of interest (RF) plus a risk premium P.

K = RF + P

Where,

K stands for capitalisation rate

RF stands for riskless rate of interest

P stands for risk premium

The current yield on Indian government Treasury Securities is generally

used to measure RF.

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5.3 VALUATION OF DIFFERENT KINDS OF FINANCIAL
SECURITIES

Following capitalised-earnings approach we shall now discuss the

process of valuation of bonds, preferred stock and common stock.
The sum of the values of these securities represents total value of the
company. The finance manager is interested in security valuation
because he is a designer of financial securities and sometimes the
buyer of other companies’ securities. Furthermore, security valuation
is a basic to the goal of share-price maximisation and hence a complete
understanding of valuation of financial securities is called for. Finally
risks and returns available on financial securities define a minimum
acceptable level of performance to corporate investment.

1. Valuation of Bonds

The value of bonds is commonly determined through the use of a

capitalisation technique. In the case of a bond with no maturity period,
its worth can be measured with the help of the following formula :
Int. Int. Int.
V = ————— + ————— +… ——————
(1 + kd)1 (1 + Kd)2 (1 + Kd)∞

Where, Int. = Constant annual interest payments,

Kd = Appropriate interest rate or required rate of return.

The above equation is an infinite series of interest payment and the

value of the bond is the discounted sum of the infinite series.
Capitalisation rate in the case of a bond is taken as the going interest
rate or yield on bonds of similar risk. To illustrate the process of

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determining value of perpetual bond, suppose a company issues a
perpetual bond paying Rs. 60 interest annually into perpetuity and
such bonds carry yield rate of 5 per cent under current market
conditions. Then the value of the bond will be as follows :
Int. Rs. 60
V = —— = ———— = Rs. 1250
Kd 0.05

If the going rate of interest rises to 6 per cent the value of the bond
drops to Rs. 1,000 (Rs. 60/.06 = Rs. 1,000).

As regards valuation of redeemable bonds bearing certain maturity

period, the stream of future interest payments and the principal
repayment are discounted to the present value with a selected
capitalisation rate. The following formula is used to find value of a
bond bearing 4-year maturity period :
CO1 CO2 CO3 CO4 + M
V = ————— + ————— + ————— + —————
(1 + kd)1 (1 + kd)2 (1 + k d)3 (1 + kd)4

Here CO = Annual interest payments

M = Maturity value of the bond.

Assume, for example, a bond of Rs. 1,000 is due to mature in 5 years,

has a 7 per cent interest rate and the appropriate capitalisation rate is
5 per cent. The present value of the bond is calculated below :

(173)
Table 1 : Going Concern Value of a 7 per cent Bond with 5 years
to Maturity Discounted at 5 per cent

Year Interest and Principal 5 per cent Present

to be Paid Discount Factor* Value

1 70 0.952 66.44

2 70 0.907 63.49

3 70 0.864 60.48

4 70 0.823 57.61

5 70+1000 0.784 54.88 + 700

Going concern value of bond 1003.10

*See table C given in appendices.

The value of the bond changes in correspondence with changes in the

market rate of interest. This change takes place in the opposite
direction. When interest rates rise, the value of outstanding bonds
drops and vice versa. Given 3-year maturity period of the bond, current
value of the bond at different interest rates is given below :

Table 2

Current Market Present Value

Interest Rate (%)

0.02 1,086.15

0.03 1,056.45

0.04 1,027.80

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 0.05 1,000.00

0.06 973.65

0.07 947.20

0.08 922.85

A glance at the above table will make it evident that with a rise in
capitalisation rate present value of the bond falls.

2. Valuation of Preferred Stock

Preferred stocks ensure their owners regular dividend payment at

stipulated rate similar to bond interest and most preferred issues carry
call feature allowing the issuing company to retire or convert it to
Common Stock at the firm’s option. However, most of the issue are of
perpetual character which do not retire during the life time of the
company. The value of such issues is the stream of future dividends
discounted to the present value. The formula is :
D
V = ——
Kp

Where, D = Dividend on preferred stock

Kp = Capitalisation rate or yield on preferred stock of

companies offering similar degree of safety and record of declaration
of dividends.

The yield on a preferred stock is similar to that on a perpetual bond.

To illustrate, a company has an 8 per cent Rs. 100 per preferred stock
at a time when similar stocks yield 5.70 per cent. The value of the
(175)
stock will be :
Rs. 8
Value = ———— = Rs. 140.35
0.057

In the case of a redeemable preferred stock having a specified maturity

date, its value will be determined in the same manner as for bonds.
The stream of expected future dividends is discounted to the present
value using yield rate as the discount factor.

3. Valuation of Common Stock

While capitalised earnings approach can be gainfully employed to

determine current value of the common stock, the process of valuation
followed in the case of bonds and preferred stocks will be different in
the case of valuation of common stocks because of certain features of
common stock as distinct from bond and preferred stock. In sum,
unlike bond, a share of common stock has no maturity. It is a claim
into perpetuity on the stream of income and assets of the issuing
company. Furthermore, there is no promised rate of return. While for
bonds and preferred stocks future interest and dividend payments
can be known with certainty, in the case of common stocks forecasting
future earnings dividends and stock price is none-too an easy job.
Another characteristic feature of common stocks is that unlike interest
and preferred stock dividends, earnings and dividends of common
stock usually tend to grow. Hence, current dividend rate on common
stocks cannot be expected to remain constant. In view of this, standard
annuity formulae cannot be applied and some other techniques will
have to be used.
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Normally, current value of common stock is determined by making
use of the following formula :
D1
P0 = ———
k-g

Where, P0 = Current value of the stock

D1 = Cash dividends at the end of the current income

period.

k = Expected rate of return by stockholders

g = Expected growth rate in the Company’s earnings.

The presumption in the above formula is that the stock is held for one
year, one dividend is received and the stock is disposed off at the end
of one year.

Estimating Value of Common Stock—Multiperiod case

Where common stock is held for perpetuity, its value will be calculated
in the manner value of perpetual bonds was calculated. This value of
a share of common stock will be the present value of its stream of
dividends. For an individual investor, cash flows consist of dividends
plus capital gains but for total investors expected cash flows consist
only of future dividends. Unless a firm is liquidated or is sold to another
concern, the cash flows received by the stockholders as a whole consist
of a stream of dividends. Thus :

Value of Stock P0 = PV of expected future dividends

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 D1 D2 D∞
P0 = ————— + ————— +… —————
(1 + ke)1 (1 + ke)2 (1 + ke)∞

∞ Dt
= ∑ ————
t=1 (1 + ke)t

The above formula represents a general stock valuation model because

Dt can be anything; it may be rising, falling, constant or it can even
fluctuate randomly. However, for practical purpose, it will be more
useful to estimate a particular pattern of change in dividends over a
period of time, and develop a simplified version of the stock valuation
model. Accordingly, stock valuation model may be developed
separately for valuation with zero growth, normal growth and abnormal
growth situations.

Value of Common Stock with Zero Growth Rate

If future growth rate in dividends is expected to be zero, the value of

the stock will be determined with the help of the following formula :
Dividend
Price = ——————————
Capitalisation Rate
D1
Symbolically, P 0 = ———
ke

Valuation of Common Stocks with Normal Growth Rate

Where earnings and dividends of common stocks are expected to grow

annually at the normal rate (normal rate being the average annual
growth rate of national income) the current value of a common stock

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is found by using the following formula :
D1
P0 = ————
ke - g

The above constant growth model is identical to the single period model
discussed earlier. Simply speaking, the present value of a common
stock is equal to the beginning dividend divided by the capitalisation
rate less the growth rate.

Illustration

The equity stock of Rax. Ltd. is currently selling for Rs. 30 per share.
The dividend expected next year is Rs. 2.00. The investor’s required
rate of return on this stock is 15 per cent. If the constant growth model
applies to Rax. Ltd., what is the expected growth rate ?

Solution

According to the constant growth model

D1
P0 = ————
ke - g
D1
This means g = ke -——
P0

Hence, the expected growth rate (g) for Rax Limited is :

2.00
g = 0.15 - ——— = 0.083 or 8.3 per cent
30.00

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Valuation of Stock with Varying Growth Rate

The simplest extention of the constant growth model assumes that

extraordinary growth (good or bad) will continue for a finite number of
years and thereafter normal growth rate will prevail indefinitely.

Assuming that the dividends move in line with the growth rate, the
price of the equity share will be :
 D1 D1(1 + g1) D1(1+g1)2 D1(1+g1)n-1  Pn
P0 = ——— + ———— + ————— +…+ ————— + ————
 (1+r) (1+r)2 (1+r)3 (1+r)n  (1+r)n

Where, P0 = current price of the equity share

D1 = dividend expected a year hence.

g1 = extraordinary growth rate applicable for n years

Pn = price of the equity share at the end of year n.

The first term on the right hand side of above equation is the present
value of growing annuity. Its value is equal to :

  1+g1  n 
 1 -  ———  
D1   1+r  
 ————————
 r - g1 

Hence
  1+g1  n 
 1 -  ———   Pn
D1   1+r   + ———
 ———————— (1+r)n
 r - g1 
Since the two-stage growth model assumes that the growth rate after
n years remains constant, Pn will be equal to :
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 Dn + 1
Pn = ————
r - g2

Where, Dn+1 = Dividend for year n+1

g2 = growth rate in the second period.

Dn+1, the dividend for year n+1, may be expressed in terms of the
dividend in the first stage.

Dn+1 = D 1 (1 + g1)n-1 (1 + g2)

Substituting the values, we finally get :

1-[(1+g1)/(1+r)]n   D1(1+g1)n-1 (1+g2)   1 
P0 = D1———————  +  ————————   ——— 
 r - g1   r - g2   (1+r)n 

Illustration

The current dividend on an equity share of Vertigo Ltd. is Rs. 2.00.

Vertigo is expected to enjoy an above - normal growth rate of 20 per
cent for a period of 6 years. Thereafter the growth will fall and stabilise
at 10 per cent. Equity investors require a return of 15 per cent. What
is the intrinsic value of the equity share of Vertigo?

Solution

The inputs required for applying the two-stage growth model are :

g1 = 20%
g2 = 10%

n = 6 years

r = 15%

D1 = D0 (1 + g1) = Rs. 2 (1.20) = 2.40

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Plugging these inputs in the two-stage model, we get the intrinsic value
estimate as follows :
1-[(1.20)/(1.15)]6  2.40 (1.20)5 (1.10)   1 
P0 = 2.40 ————————  +  —————————  ——— 
 0.15 - 0.20   0.15 - 0.10   (1.15)6 

 1 - 1.291  2.40 (2.488) (1.10)

P0 = 2.40 —————  + ————————— (0.497)
 - 0.05   0.05 

= 13.968 + 65.289 = Rs. 79.597

Rate of Return

The rate of return on an asset for a given period (usually a period of

one year) is defined as follows :
Annual income + Ending Price - Beginning Price
Rate of Return = ——————————————————————— ——
Beginning Price

To illustrate, consider the following information about a certain equity

stock :

• Price at the beginning of the year Rs. 60.00

• Dividend paid at the end of the year Rs. 2.40

• Price at the end of the year Rs. 69.00

The rate of return on this stock is calculated as follows :

2.40 + (69.00 - 60.00)

——————————— = 0.19 or 19 per cent
60.00

It is sometimes helpful to split the rate of return into two components,

viz. current yield and capital gains/loss yield as follows :

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Rate of Return = Current Yield + Capital gains/loss yield
Annual income Ending Price - Beginning Price
———————— + ———————————————
Beginning Price Beginning Price

The rate of return of 19 per cent in our example may be broken down
as follows :-

Rate of Return = Current yield + Capital gains yields

2.40 (69.00 - 60.00)
——— + ———————— = 4 per cent + 15 per cent
60.00 60.00

Expected Rate of Return

The expected rate of return is the weighted average of all possible

returns multiplied by their respective probabilities.

In symbols,
n
—
R = ∑ piRi
i=1
—
Where, R = expected return

Ri = return for the ith possible outcome

pi = probability associated with Ri

n = number of possible outcomes.

—
It is clear that R is the weighted average of possible outcomes—each
outcome is weighted by the probability associated with it.

Standard Deviation of Return

Risk refers to the dispersion of a variable. It is commonly measured

by the variance or the standard deviation. The variance of a probability

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distribution is the sum of the squares of the deviations of actual returns
from the expected return, weighted by the associated probabilities. In
symbols,
—
σ2 = ∑pi (R i - R )2

Where, σ2 = variance

Ri = return for the ith possible outcome.

pi = probability associated with the ith possible outcome.

—
R = expected return.

Since variance is expressed as squared returns, it is somewhat difficult

to grasp. So its square root, the standard deviation, is employed as an
equivalent measure.

σ = (σ2)½

Where, σ = Standard Deviation.

Expected Return of a Portfolio

Most investors invest in a portfolio of assets, as they do not want to

put all their eggs in one basket. Hence, what really matters to them is
not the risk and return of stocks in isolation, but the risk and return of
the portfolio as a whole.

The expected return on a portfolio is simply the weighted average of

the expected returns on the assets comprising the portfolio. Fro
example, when a portfolio consists of two securities, its expected return
is :-
— — —
R p = x 1 R 1 + (1 - x1) R 2

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 —
Where, R p = expected return on a portfolio.

X1 = proportion of portfolio invested in security 1.

—
R 1 = expected return on security 1.

(1 - x1) = proportion of portfolio invested in security 2.

—
R 2 = expected return on security 2.

To illustrate, consider a portfolio consisting of two securities, A and B.

The expected return on these two securities are 10 per cent and 18
per cent respectively. The expected return on the portfolio, when the
proportions invested in A and B are 0.4 and 0.6, is simply 0.4 x 10 +
0.6 x 18 = 14.8 per cent.

In general, when a portfolio consists of ‘n’ securities, the expected

return on the portfolio is :
— —
R p = ∑xi R i
—
Where, R p = expected return on portfolio.

xi = proportion of portfolio invested in security i.

—
R i = expected return on security i.

To illustrate, consider a portfolio consisting of five securities with the

— — —
following expected returns : R1 = 10 per cent, R2 = 12 per cent, R3 =
— —
15 per cent, R 4 = 18 per cent and R 5 = 20 per cent. The portfolio
proportions invested in these securities are : x1 = 0.1, X2 = 0.2, X3 =
0.3, x4 = 0.2, and x5 = 0.2. The expected portfolio return is
— — — — — —
R p = x1 R1 + x2 R 2 + x3 R 3 + x4 R 4 + x5 R 5

= 0.1 x 10 + 0.2 x 12 + 0.3 x 15 + 0.2 x 18 + 0.2 x 20

= 15.5 per cent.

(185)
5.4 SUMMARY

The value of any asset, real or financial, is equal to the present value
of the cash flows expected from it. Hence, determining the value of an
asset requires an estimate of expected cash flows and an estimate of
the required return. There are three methods of valuation viz. asset
approach to valuation, market value approach and capitalised earnings
approach. According to dividend discount model, the value of an equity
share is equal to the present value of dividends expected from its
ownership. If the dividend per share remains constant the value of
share is given by P0=D/kp. If the dividend per share grows at constant
rate, the value of the share is P0 = D1/(k-g). Risk is presented in virtually
every decision. Assessing risk and incorporating the same in the final
decision is an integral part of financial analysis.

5.5 SELF TEST QUESTIONS

1. What are the different approaches to valuation of the company?

Which one of these approaches is the most suitable method of
valuing the company and why?

2. How is value of bond determined? In what respect is valuation

of preferred stock similar to bond valuation?

3. How is value of a share of a common stock of a company found?

What role does growth factor play in valuation of the common
stock?

4. Explain why a share of no-growth common stock is similar to a

share of preferred stock?

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5. How is the rate of return on an asset defined?

6. Define the standard deviation of the return on a two-security

portfolio.

5.6 SUGGESTED READINGS

1. Financial Management by Prasanna Chandra.

2. Financial Management by I.M. Pandey.

3. Financial Management by Khan & Jain.

4. Organisation & Management by R.D. Aggarwal.

5. Financial Management and Policy by R.M. Srivastava.

✪✪✪

(187)
 LESSON – 6

INVESTMENT DECISION (CAPITAL BUDGETING)

Objective : After reading this lesson, you should be able

(a) to understand meaning and significance of capital budgeting

decisions;

(b) to explain the process of evaluation of capital budgeting

decisions; and

(c) to apply various methods of evaluating and ranking capital

expenditure projects.

Structure

6.1 Introduction to Capital Budgeting.

6.2 Investment Decision Criteria.

6.3 Risk Analysis in Investment Decision.

6.4 Solved Questions.

6.5 Summary

6.6 Self Test Questions.

6.7 Suggested Readings.

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6.1 INTRODUCTION TO CAPITAL BUDGETING

Capital budgeting is one of the most important areas of financial

decision making. It involves the selection of that assortment of
investment opportunities which will make the optimum contribution
to corporate objectives, and, of course, one of the most important
corporate objectives is long-term profitability of the enterprises. Capital
budgeting or investment decisions commit the company’s resources
far into the future, and thus vitally affect its future growth and
profitability. Strictly speaking, investment decisions refer to those
financial decisions which have relatively long-term financial
consequences for the company. Capital budgeting is a broader term.
It includes not only investment decisions but also the exploration of
profitable investment opportunities, marketing and engineering
investigation of these opportunities and financial analysis as to their
future profitability. However, the terms investment decisions and
capital budgeting are generally used interchangeably.

Investment decisions may involve capital expenditure on : (i) cost

reduction through modernization, rationalization, automation, etc., (ii)
increasing production through expansion of capacity, creation of
balancing facilities, replacement of semiautomatic plants with
automatic ones etc., (iii) product improvement, addition to the existing
product line, diversification, etc., and (iv) larger market share through
establishment of new distribution outlets, creation of additional
warehousing and transportation facilities, etc. Decisions involving
capital outlays which fructify within a year are of a revenue nature
and constitute part of short-range planning. Investment or capital
budgeting decisions have long-term consequences. They usually have
a gestation period and bring cash inflows to the company over a period
of time. As such investment decisions constitute a part of long-range
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corporate planning.

6.1.0 Significance of Capital Budgeting

Capital expenditure decision is a single most important financial

decision in as much as it affects the financial health of the enterprise
for a long period of time. The very fact that this kind of decision deals
with capital expenditure projects involving considerably large volume
of capital, return on which will be flowing in the enterprise over a
number of years bears testimony to its significance.

It should be noted at this juncture that capital expenditure decision

involving the acquisition of major assets is not a routine process and
whatever decision is taken can be reversed only at considerable cost
to the company. This necessitates a careful job of planning and
evaluation. This fact becomes more important particularly when the
management is faced with problem of allocation of scarce resources
among competing alternatives. A finance manager is required to choose
the best alternative in order to maximise the wealth of the owners.

Another factor contributing to the significance of the capital expenditure

decision is the risk exposure of burgeoning funds committed in capital
expenditure projects, effect of which will be felt by the company over
extended period of time. Once a multimillion investment is made in
acquiring a sophisticated machine, the company cannot easily withdraw
from continuing the construction. The long-term commitment of funds
reduces the flexibility of the manager. The decision-maker is bound
by the decision whether it is good or bad. Once he has committed the
funds, he is at the mercy of future development.

Capital expenditure decision is also important because of its effects

on operating expenditures and the patterns of cash flows for a longer
period. For example, capital expenditure decision determines where
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and how the company’s products will be manufactured which in turn
shapes the basic character of the organisation, operations, cash flows,
and the financial structure of the company.
Where a company is contemplating to diversify its operations or expand
its activity the management is required to make a series of investment
decisions. A company to grow and prosper has to make investment
decision, otherwise the company’s growth will be accompanied by
financial strains.
Finally, sentient investment decision based on sophisticated
techniques and managerial skill and experience will usually improve
the timing and quality of asset acquisition. If done poorly, it will cost
the company large sums of money because of over capacity or under
capacity — sometimes at the same time. The company may have idle
assets to produce a product that is not in demand while it has a
shortage of the machinery and facilities to produce a much demanded
high-profit product.
6.1.1 Planning Capital Expenditure
Since capital investment decisions involve long-term commitment of
the company’s financial resources and vitally affect its future growth
and profitability, they are top management decisions. Such investment
projects may, of course, originate from the shop-floor level, or the
middle management level in the production division, or initiated by
marketing or quality control division, head of the research and
development division, or the personnel division. All the investment
proposals, irrespective of their source of origin, are investigated for
their technological feasibility, marketing implications, compatibility with
overall corporate objectives, strategy and policies, and financial
soundness. The most important criterion before the top management
is the relative impact of various investment proposals on the future
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growth and profit making capability of the company.

6.1.2 Criterion for Investment

The investment projects are evaluated at various stages—the

departmental and divisional level, the financial controller level, the
project committee level, the chief executive level and finally the board
level. As the capital projects are evaluated at multiple levels, it is
imperative that an uniform evaluation criterion is used consistently
and objectively at each level. The most widely accepted criterion of
evaluating capital budgeting or investment decisions is estimated
networth of the capital project. Every capital project involves one or a
series of cash outflows and cash inflows. If the present value of
estimated cash inflows of a project exceeds the present value of cash
outlays it has net cash benefits or net worth. If, on the other hand,
present value of cash outflows on the project exceeds the present
value of its cash inflows over its estimated life, it has net expenditure
or net cash losses. Obviously, projects having net cash benefits are
candidates for further consideration, while those involving net cash
expenditure are out of the race. Among projects which have net cash
benefits, the one having the maximum net cash benefit is selected for
investment.

6.1.3 Net Investment and Net Cash Inflows

In matching cash outlays with cash inflows, we take into account net
investment and net cash inflows.

Net Investment : Net investment is the incremental or marginal

investment involved in an investment project at a point of time or over
a period of time. It represents the net amount which is to be expended
in executing the project. The net investment outlay of a capital project
includes not only the expenditure on the new physical equipment
(192)
and facilities, installation cost, etc., but also the value of the existing
physical facilities that are to be used as part of the new project. The
value of the existing facilities is not their book value but the amount
of money that would have to be spent in acquiring facilities in
comparative condition had they not been available, their opportunity
cost or the amount of money that could be realised on their sale,
whichever may happen to be the realistic alternative in the existing
situation.
When a capital project replaces any existing physical facilities (for
example, a new lathe machine replaces an old one), its book value
shown in the books of accounts is of no relevance in estimating the
outlay of the capital project. It is to be regarded as sunk cost resulting
from a past decision. Perhaps its operational life had been
overestimated and it had not been depreciated fully over its real
operational life. The loss on the old facility is a book loss and involves
no cash outflows. As such it is not to be included in estimating the
cash outflows associated with the investment project under
consideration.

However, if the existing physical facility is disposed of and fetches

some price, that is to say, it has a salvage value, it should be deducted
from the capital outlay of the new project in order to arrive at the net
investment outlay.
Cash Inflows : Net cash inflows of a project are based on an estimate
of future streams of cash generated as a result of the fructification of
the investment project. These estimates are based on a number of
forecasts. These forecasts relate to production, plant performance,
market share, sales revenues, profit margin , tax laws, state of the
economy, etc. Cash inflows at various points of time have to be
estimated on the basis of these and other forecasts. These estimates
(193)
are more than mere guesses as they are based on systematic forecasts
and past experience of the company and industry. Nevertheless,
projections of future cash inflows are not more than estimates and
must contain an element of variance.
Net Cash Benefits : Net cash benefits are net cash inflows over a
period of time resulting from the capital project. Net cash inflows are
incremental cash inflows, and are estimates of cash revenues minus
all cash outflows including maintenance costs, corporate taxes, etc.
Depreciation, being noncash expense, is excluded but tax benefit
resulting from depreciation appropriation is included in cash inflows.
Another component of cash inflow is the salvage value, if any, of the
physical facility at the end of its operational life. Removal expenses
and capital gains taxes, if any, are to be deducted from it. Lastly,
working capital representing the value of current assets released at
the end of the operational period of the physical facility, are to be
taken into account. Thus net cash inflows are equal to cash revenues
minus cash expenses plus tax benefit from depreciation appropriation
plus salvage value of physical facility net of removal charges and capital
gains tax value of current assets released.

Illustration
Novex Manufacturing company bought a machine 5 years ago at a
cost of Rs. 15,000. The machine had an expected life of 15 years at
the time of purchase and a zero estimated salvage value at the end of
15 years. It is being depreciated on a straight line basis and has a
book value of Rs. 10,000 at present. The purchase manager reports
that he can buy a new machine for Rs. 20,000 which over its 10 years
life will expand sales annually from Rs. 20,000 to Rs. 22,000. Further,
it will reduce operating cost from Rs. 14,000 to Rs. 10,000. The old
machine’s current market value is Rs. 2,000. Taxes are at present 50
(194)
per cent and the company’s cost of capital is 10 per cent. Calculate
cash outflow of the project and net cash inflows.

Solution

(i) Estimating Net Investment Outlay Rs.

Invoice Price of New Machine 20,000
Less : Tax Savings 4,000
Less : Salvage value of old machine 2,000
Net Cash Outlay 14,000

(ii) Estimating Net Cash Benefits

Without New With New

Investment Investment

Sales 20,000 22,000

Operating Cost 14,000 10,000
Depreciation (D) 1,000 2,000
Taxable Profit 5,000 10,000
Less: Income Tax 2,500 5,000
Profit after Tax (P) 2,500 5,000
Cash Benefits (P+D) 3,500 7,000

Incremental cash benefits Rs. 3,500 (7,000 - 3,500)

Present Value of Future Cash Flows : Before we start discussing

investment evaluation methods, it will be useful to understand the
concept of Present Value of Money or Discounted Cash Flows. It is
generally agreed that a rupee received tomorrow does not have the
same value to us as a rupee received today. This is so for several
reasons.

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1. Tomorrow is hidden in the mysteries of the unknown and is
attendant with risks and uncertainties. One may fairly accurately
peep into the tomorrow yet never be sure about it. There is often
a slip between the cup and the lips. One is sceptical even about
the money in the bank payable tomorrow because he may have
left this mortal world before tomorrow comes.

2. Money invested in securities, deposited in bank, lent to a private

party or invested in business generally grows in value. A rupee
invested today is likely to be more than a rupee tomorrow.
Therefore, a rupee to be received tomorrow is worth less than a
rupee today.

3. Often people have subjective time preference for money. Many

of us will like to consume their rupee worth of comforts today
rather than wait for tomorrow which may never come.

It is because of one or more of these factors that if a businessman

expects that he will receive a certain sum of money after a year, or a
series of future payments, he wants to know suitable rate of interest.
This rate of interest is usually the cost of capital or the required rate of
return, and sometimes even an arbitrary cut-off point. The present
value or PV of future cash flow of Re. 1 to be received in n years is
computed by the following formula :
1
PV = ————
(1 + K)n
where PV = present value

K = the discount rate.

If rate of interest is 10 per cent and money is to be received after one

year, Re. 1 one year later will be worth :

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 ✪✪✪

1
PV = ———— = Re. 0.90909
(1 + 10)1
If rate of interest or discount rate is 10 per cent and Re. 1 is to be
received after 5 years, its present value will be as follows :
1
PV = ———— = Re. 0.6209
(1 + 10)5

6.2 INVESTMENT DECISION CRITERIA

The most important basis of making an investment or capital budgeting

decision is to determine whether the particular capital project will
earn the desired rate of return. In case a management has a number
of alternative capital projects for consideration, it will be necessary to
determine which of them is the most profitable, and also whether the
most profitable one earns to determine which of them is the most
profitable, and also whether the most profitable one earns at least the
desired rate of return. A number of methods for evaluating capital
investment projects are available. Before discussing the various
investment methods and their relative merits and demerits, it is
necessary to make it clear that most of these methods evaluate
investment projects on one criterion only and that is profitability. The
management may have a number of other criteria besides profitability
such as its public image, market share, future growth, excellence in
quality, price leadership, etc. In making the final investment decision
a management may find that some or all of these latter criteria are not
wholly compatible with the profitability criterion and it may try to strike
a balance between them. In doing this, it exercises judgement. In fact,
there is no investment decision, or for that matter any decision in
which management does not have to exercise its judgement. Project
evaluation on profitability criterion helps this judgement.

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The commonly used methods of decision making for selecting capital
projects are :

1. Ranking by inspection

2. The payback period

3. Accounting rate of return

4. Average rate of return

5. Net present value method

6. Profitability index

7. Internal rate of return or the yield of investment method

6.2.1 Ranking by Inspection

In some cases, it is possible to evaluate investment projects on

profitability criterion by merely looking at them and without using any
other complicated technique.

This is possible in two situations :

1. When competing investment projects have : (i) identical cash

outlays, and (ii) identical cash inflows over a period of time, but
in one case inflows continue for a longer time than in others. On
this basis, capital project B in Table 1 is obviously more profitable
than project A.

(198)
 Table 1 : Ranking by Inspection Method

Capital Net Investment Net Cash inflows (Rs.)

project outlay (Rs.) Year 1 Year 2

A 25,000 25,000 -
B 25,000 25,000 5,000
C 25,000 15,000 20,000
D 25,000 20,000 15,000
E 25,000 20,000 10,000
F 25,000 15,000 20,000
2. When two investment projects have equal aggregate inflows but
in one case inflows are larger in the earlier years than those in
the later years. In Table 1, C and D are projects of this type, and
project D is distinctly and obviously superior than project C.
But the simple ranking method of capital project evaluation cannot
be used when the alternate projects have unequal aggregate cash
inflows, and at the same time, inflows at various time periods are also
unequal. In case of capital projects E and F, it is not possible to make
investment decision only on the basis of inspection. This method is all
the more unsuitable in cases where the above conditions are combined
with unequal investment outlays. Moreover, this method also does
not take into account the time value of money. All the outflows and
inflows are considered on their nominal value even though various
installments of cash flows may occur at different time periods. The
advantage of this method is that it is simple and does not require an
expert to evaluate the capital projects.

6.2.2 Payback Period Criterion

Payback period is the time period during which net cash outlays on
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capital project are equal to the net cash inflows. Simply put, it is the
time period during which capital investment pays off its full value. It is
relatively a simple method of evaluation, and it is widely used. Its
computation is simple and can be done by the following formula in
cases where inflows are in the nature of a series of uniform amounts.
total cash outlay
Payback period =——————————
annual cash inflows
For example, an investment project involves a net cash outlay of Rs.
20,000 and annual cash inflows are in the amount of Rs. 10,000 for
five years. Payback period in this case is :
Rs. 20,000
—————— = 2 years
Rs. 10,000
In case of projects A and B, shown in Table 1, payback period is one
year.
If net cash inflows are of an uneven nature, as in the following example,
payback will be computed as shown in Table 2.

Table 2 : Computation of Payback Period

Year Net cash Annual net Cumulative

outlays cash inflows net cash inflows
(Rs.) (Rs.) (Rs.)

1 10,000 5,000 5,000

2. — 4,000 9,000

3 — 3,000 12,000

Payback period in this case is more than two years but less than three
years. In the whole of the third year, net cash inflow is Rs. 3,000.
Assuming that cash inflows are in an even amount from month to month
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 1
it will take (Rs. 1,000)/(Rs. 3,000) = — year to get cash inflow of Rs.
3
1,000.
1
Payback period = 2 + — years. Companies using payback criterion for
3
accepting or rejecting the proposed investment projects predetermine
a maximum or required payback period which acts as a decision rule
for investment decisions. Projects which have a payback period equal
to or less than this predetermined payback period are accepted, and
projects with playbacks greater than this period are rejected.

Payback period method of capital project evaluation recommends itself

in companies which are subject to rapid technological changes such
as pharmaceutical, electronics and space industries, or to rapid
consumer taste changes such as clothing industry. Such companies
have to make huge investments in research and development,
production facilities and marketing, and they are keen to recover it
before their products become obsolete. It is also used by companies
when money market is tight, or when they have surplus cash resources
available for a short period of time. It is simple to calculate and
management can know in relatively definite terms how long it will take
to get its money back. It, of course, tells nothing about relative merits
of alternate investment projects in terms of surplus generation.

Its most obvious limitation, as in case of ranking by inspection method,

is that it does not take into account time value of money. All streams
of cash inflows whether received now or a year or ten years after have
the same value in the computation of payback period.

The payback method of investment evaluation does not take into

account the post-payback surplus generating capacity of alternate
investment projects. In case of projects illustrated in Table 1, payback
1
period for both projects E and F is the same 1— years—and it is a
2
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matter of indifference to management as to which project is accepted.
But a glance at net cash inflows shows that project F is to be preferred
over project E as net cash inflow of the former after one year is larger
than of the latter. Thus the payback period method of investment
analysis has the same weakness as the ranking by inspection method
: it does not take into account the time value of money. These
weaknesses of the payback period criterion make it unsuitable as a
tool of investment decisions.
6.2.3. Average Rate of Return
The average rate of return method of investment decisions is very
similar to the accounting rate of return method except that in place of
aggregate of additional net income, we use its average as numerator.
Thus, average rate of return for the investment project in the preceding
example, will be as follows :
Average income
Average Rate of Return = —————————
Average investment
Illustration
Management of Raj Electricals is contemplating to buy a machine for
manufacturing purpose. There are presently two machines available
in the market which could serve the purpose. Details about these two
machines are set out below :

Machine A (Rs.) Machine B (Rs.)

Cost 30,000 30,000

Annual income estimated

after depreciation and tax
Ist year 5,500 6,700

IInd year 8,000 7,200

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IIIrd year 8,400 8,500
IVth year 8,800 7,000
Vth year 9,000 8,800
Estimated life in years 5 5
Average income Tax Rate 55% 55%

Depreciation on straight-line basis

Which machine should the management buy? Assume that the

management uses accounting rate of return for the project.

Solution
Total Income during the life of the project
Average Income = —————————————————————
Life of the Project

Rs. 39,700
Average Income of Machine A =———————= Rs. 7,940
5 years

Rs. 38,200
Average Income of Machine B =———————= Rs. 7,640
5 years
Average investment = Original Investment ÷ 2

Rs. 30,000
Average Investment of Machine A = —————— = Rs. 15,000
2

Rs. 30,000
Average Investment of Machine B = —————— = Rs. 15,000
2
Rs. 7,940
ARR of Machine A =—————— x 100 = 52.93%
Rs. 15,000
Rs. 7,640
ARR of Machine B =—————— x 100 = 50.93%
Rs. 15,000
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Since rate of return on machine A is higher as compared to machine
B, the management should acquire machine A.

It should be noted at this juncture that income figure is not based on

cash flows but upon the reported accounting profits.

The average rate of return also ignores time value of money and it is
based on book income instead of cash flows. This shortcoming can,
however, be removed by using the data of cash inflows instead of
accounting data.
We have seen that one of the serious limitations of all the methods of
investment decisions discussed above is that none of them takes into
account the present value of the future streams of cash inflows and
capital outlays. The next three methods, viz., the net present value
method, the internal rate of return or the yield of investment method,
and the profitability index method take account of the timings of cash
flows. As a group these methods are called discounted cash flow
methods. These methods overcome the shortcomings of all other
methods of project evaluation by taking into account (i) cash flows
over the entire operational life of the capital project, as well as (ii)
present values of future streams of cash flows.

6.2.4 Net Present Value (NPV) Method

The net present value (NPV) method, also called the discounted
benefit-cost ratio method, of capital budgeting is based on a
comparison of the present values of the investment outlays and that
of cash inflows.

1. The first step in computing the present values of investment

outlays and cash inflows is to determine the rate of discount. This
discount rate is the cost of capital of the firm or the rate of return
desired by the firm on its investments.
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 Table 3 : Computation of Present Value of Investment Outlays

Time Investment Present Present Salvage Present Present Present

period outlay value value of value at value value of value of
factor investment the end factor salvage net
of 5 yrs. (Rs.) investment
(Rs.) (Rs.) (Rs.) (Rs.)
Present 1 50,000 - 50,000
end of 2 10,000 0.909 9,090
year 3 8,000 0.826 6,608
4 5,000 0.751 3,755
5 10,000 0.621 6,210
Total Rs. 73,000 Rs. 69,453 Rs. 6,210 Rs. 63,243

2. Once this discount rate is determined, the financial manager

has to compute the present values of cash outlays of the capital project
by discounting future cash outlays at the predetermined discount rate.
If the capital assets acquired for the capital project have any salvage
value, its present value has to be set off against the present value of
the cash outlays. To illustrate, a capital project involves a cash outlay
of Rs. 50,000 in the present and future outlays of Rs. 10,000 in the
first year, Rs. 8,000 in the second year and Rs. 5,000 in the third year.
The salvage value of the plant after 5 years is Rs. 10,000. Rate of
discount is 10 per cent. The computation of present value of investment
in this capital project is given in Table 3.

As mentioned in an earlier section, these present values can be

computed by the formula :
1
PV = ————
(1 + K)n
where PV is present value and K is the discount rate. Let us remember
that these present value computations are based on the assumptions
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that each outlay has been made in one instalment, and also that it
has been made at the year end.

As shown in Table 3 the present value of investment outlays discounted

at 10 per cent compound rate is Rs. 63,243. This is the minimum
amount which the firm must get back in the form of cash inflows from
the capital project in order to leave its present value unaffected.

3. The third step in analysis for investment decisions is to determine

the present value of the cash inflows expected to be generated by the
investment outlays. In estimating the cash inflows, depreciation is
disregarded as it represents only a book entry and does not involve
any cash outflow. All other direct and indirect expenses including
operational and maintenance costs are deducted from the total cash
receipts in order to arrive at the cash inflows. Thus cash inflows are
total revenue receipts minus all cash expenses.

Cash inflows are to be discounted at a predetermined discount rate

which is equal to the cost of capital or the required rate of return. The
discount rate for determining the present values of cash inflows is the
same as that for discounting investment outlays, and is computed by
the same formula :
CF1 CF2 CFn
PV = ———— + ———— + … + ————
(1 + k) (1 + k)2 (1 + k)n
Let us assume that the investment project illustrated earlier will
generate Rs. 30,000, 40,000, 50,000, 30,000 and 20,000 at the end of
the first, second, third, fourth and fifth year. What is the present value
of these streams of cash inflows at 10 per cent discount rate.

(206)
Time Cash Present Present value
period inflows value factor of cash inflows
(Rs.) (Rs.)

1 30,000 0.909 27,270

2 40,000 0.862 34,480
3 50,000 0.751 37,550
4 30,000 0.683 20.490
5 20,000 0.621 12,420

Total present value of cash inflows = Rs. 1,32,210

4. The fourth and the final step in capital project evaluation is to

compare the present value of cash outlays with the present values of
cash inflows. The difference is the net present value (NPV). If the net
present value is negative, the project results into a financial loss to
the company; if it is positive, it results into a financial gain, and if it is
zero, it is no profit no loss situation. In case of the above investment
project, present value of investment outlays is Rs. 63,243 and present
value of cash inflows is Rs. 1,32,210. It has positive net cash flows, or
what may be called net present value to the extent of Rs. 68,967.
Hence the capital project is acceptable from the financial criterion.

6.2.5 Profitability Index

A firm can also use the net present value method to select the best
out of a number of investment projects. This can be done by computing
profitability index of each project on the basis of the present value of
its investment outlays and cash inflows.
Present value of cash inflows
Profitability index =——————————————————
Present value of investment outlays
The hypothetical present values of investment outlays and cash inflows

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of three capital projects are given in Table 4, and they have been
ranked on the criterion of profitability. The most profitable and
therefore the most acceptable project from profitability criterion is
project C. Profitability index is thus an effective tool of ranking the
alternate investment projects and provides a sound basis for the
selection of the most profitable one.

Table 4 : Selection of investment Project by Profitability Index

Investment Present value Present value Profitability Ranking
project of investment of cash index
outlays inflows (3 ÷ 2)
(Rs.) (Rs.)

1 2 3 4 5

A 50,000 70,000 1.400 2

B 90,000 100,000 1.111 3
C 40,000 60,000 1.500 1

The shortcoming of NPV method is that it does not tell us the rate of
return on a single or alternate investment projects. It merely tells
whether net present value generated by a capital project is equal to,
more or less than the required rate of return. It does not tell us how
much. Profitability index provides a basis of comparability and serves
as a tool for selecting the most profitable project; it does not tell us
how much better one project is as compared to others.

6.2.6 Internal Rate of Return Method

The internal rate of return (IRR) method of project evaluation is also

called, ‘yield of investment’, ‘marginal efficiency of capital’ and
‘discounted cash flow rate of return’. It removes the shortcomings of
the present value method as it tells us the rate of return expected to
be yielded by various investment projects.
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The yield of investment or the internal rate of return is the discount
rate at which present values of investment outlays and of future
streams of cash inflows are equal. This discount rate is the true rate of
return or yield on investment. In the present value method, the
discounting rate is determined in advance and it is either the cost of
capital or the desired rate of return. In case of the yield method, the
discount rate at which present values of investment outlays and inflows
are equal is found by trial and error. It can be computed by using the
following formula :
n At
∑ ———— =0
t=0 (1 + r)t
where r = rate of discount = internal rate of return

A = net cash flow for period t

n = total period during which cash flow is expected.

If investment outlay occurs only once and that too at time 0, then the
above equation can be expressed as follows :
A1 A2 A3 An
A0 = ———— + ———— + ———— + … + ————
(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)n

n At
A0 = ∑ ———
t=1 (1 + r)t
Here r is that rate of discount at which present value of A1 through An
(future stream of cash inflows) is equal to A0 (investment outlay at time
0).

As mentioned earlier, the discount rate can be ascertained only through

a process of trial and error. First, we arbitrarily select a discount rate
(r) and compute present values of future streams of investment outlays,

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i.e., costs (C), and also present values of future streams of cash inflows,
i.e., benefits (B). If B = C, r is the correct rate of discount as also the
yield rate or the internal rate of return (IRR). If B > C, it means that a
higher rate should be tried to equate B and C; in case C > B it means
that a lower discount rate should be tried. This process of trial and
error goes on until we hit at a discount rate at which B = C.
Problem
Let us suppose that investment on a capital project is Rs. 45,000.
Cash inflows for five years are Rs. 15,000, Rs. 20,000, Rs. 20,000, Rs
10,000. What is the yield of investment?
Let us now compute PV of cash inflows at 20 per cent discount rate.
This is done in Table 5.

Table 5 : Computation of Yield of Investment

Time Cash PV factor PV of cash PV factor PV of cash

period inflows at 20 per cent inflows at at 22 per cent inflows at
(Rs.) 20 per cent 22 per cent
(Rs.) (Rs.)

1 15,000 0.833 12,495 0.820 12,300

2 20,000 0.694 13,880 0.672 13,440
3 20,000 0.579 11,580 0.551 11,020
4 10,000 0.482 4,820 0.451 4,510
5 10,000 0.402 4,020 0.370 3,700
46,795 44,970

Present value of investment (it is the same as investment outlay

because the investment is to be made at the beginning of the time
period) is Rs. 45,000. PV of cash inflows at 20 per cent discount rate is
Rs. 46,795. Since in this case B > C, the actual yield of investment

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should be more than 20 per cent. Therefore, we calculated PV of cash
inflows at 22 per cent discount rate and found that it is Rs. 44,970.
Now C > B. Therefore, the yield of investment is less than 22 per cent.

We come to the conclusion that the actual yield of investment lies

between 22 per cent and 20 per cent. Let us find the actual yield of
investment by using the formula :
PV of inflows at lower D - PV of Investment Outlays
Actual IRR = D+ —————————————————————————— x ∆D
PV of investment at lower D - PV of inflows at higher D
where, IRR = Internal Rate of Return or yield on investment

D = lower discount rate

∆D = Difference between the two discount rates

Rs. 46,795 - 45,000
20 + —————————— x 2 = 21.97 per cent
Rs. 46,795 - 44,970
Actual yield of investment or IRR = 21.97 per cent.

In case yield of investment or IRR is equal to or more than the desired

rate of return, the project is accepted; otherwise it is rejected. IRR is
also used to rank the projects in order of their profitability.

The yield of investment method is more complicated than the present

value method as it is to be computed by the trial and error method. It
becomes even more complex if investment outlays are made over a
period of time rather than in one block at the beginning of the time
period, and the capital assets have a salvage value. However, in such
cases the yield of investment method can be used with the help of
computer.

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Net Present Value Method Vs. Internal Rate of Return— Which is
Better ?

These two methods sometimes give contradictory results when used

for the selection of the most profitable investment project from among
mutually exclusive projects, i.e. if one is selected, the others have to
be rejected. This can be seen from the following example.

Problem

Two alternative capital projects X and Y involve an investment outlay

of Rs. 36,000 each. The streams of cash inflows are as follows :
Year Cash inflows (Rs.)
Project X Project Y
1 25,000 5,000
2 20,000 10,000
3 5,000 10,000
4 5,000 10,000
5 5,000 45,000

The required rate of earnings is 10 per cent. Which of the two projects
should be accepted?
Solution :
Table 6

Year PV factor Cash inflows PV of cash Cash inflows PV of cash

at 10 per cent of Project X inflows of of Project Y inflows of
(Rs.) Project X (Rs.) Project Y
(Rs.) (Rs.)

1 0.909 25,000 22,725 5,000 4,545

2 0.826 20,000 16,520 10,000 8,260
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3 0.751 5,000 3,755 10,000 7,510
4 0.683 5,000 3,415 10,000 6,830
5 0.621 5,000 3,105 45,000 27,945

PV of total cash inflows 49,520 55,090

NPV of Project X = Rs. 49,520 - Rs. 36,000 = Rs. 13,520

NPV of Project Y = Rs. 55,090 - Rs. 36,000 = Rs. 19,090

Since Project Y has larger NPV than Project X, it is to be accepted and

Project X rejected.

Project Net Present Value Decision

Y Rs. 19,090 Accept

X Rs. 13,520 Reject

Selection of Project by Yield of Investment Method

Table 7 : Selection of Capital Projects by the Yield of

Investment Method
Project X

Year Cash PV factor PV of cash PV factor PV of cash

inflows at 20 per cent inflows at at 32 per inflows at
20 per cent cent 32 per cent
(Rs.) (Rs.) (Rs.)
1 25,000 0.833 20,825 0.758 18,950
2 20,000 0.694 13,880 0.574 11,480
3 5,000 0.579 2,895 0.435 2,175
4 5,000 0.482 2,410 0.329 1,645
5 5,000 0.402 2,010 0.249 1,245
Rs. 42,020 Rs. 35,495

(213)
Project Y

Year Cash PV factor PV of cash PV factor PV of cash

inflows at 34 per cent inflows at at 20 per inflows at
34 per cent cent 20 per cent
(Rs.) (Rs.) (Rs.)
1. 5,000 0.746 3,730 0.833 4,165

2. 10,000 0.557 5,570 0.694 6,940

3 10,000 0.416 4,160 0.579 5,790

4 10,000 0.310 3,100 0.482 4,820

5 45,000 0.231 10,395 0.402 18,090

Rs. 26,955 Rs. 39,805

In case of Project X, PV of cash inflows at 20 per cent rate of discount

is higher than the PV of investment outlay. Therefore, the actual yield
of investment must be higher than 20 per cent. We next tried 32 per
cent rate of discount. At this rate PV of cash inflows is lower than the
PV of investment outlay. Therefore, actual yield of investment must lie
between 20 per cent and 32 per cent.

In case of Project Y, PV of cash inflows at 34 per cent rate of discount

is lower than the PV of investment outlay. Therefore, the actual yield
of investment must be lower than 34 per cent. We next tried 20 per
cent discount rate and found that at this rate PV of cash inflows is
higher than the PV of investment outlay. Therefore, actual investment
yield of Project Y must lie between 34 per cent and 20 per cent.

Let us now compute the actual investment yields of Projects X and Y

by using the formula given earlier.

Actual yield of investment of Project X

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 Rs. 42,020 - Rs. 36,000
= 20 + ———————————— x 12 = 31.07 per cent
Rs. 42,020 - Rs. 35,495

Actual yield of Investment of Project Y

39,805 - 36,000
= 20 +——————————x 14 = 24.14 per cent
39,805 - 26,955
Since yield of investment of Project X is higher than that of Project Y, it
should be accepted against Project Y.

Project X Yield = 31.07 per cent Accept

Project Y Yield = 24.14 per cent Reject

In this illustration, according to the NPV method, Project Y is to be

accepted in preference to Project X as it has larger net present value;
and according to yield of investment method, Project X has higher
yield than Project Y. Hence Project X is to be selected and Y is to be
rejected. These contradictory results are obtained because of the
different assumptions underlying the two methods. The yield of
investment method assumes that all future streams of cash inflows
are reinvested at the yield rate over the life of the project. The net
present value method assumes that the cash inflows generated during
the operational life of the project are reinvested at the discount rate.

Since the management’s objective is to maximize the shareholder’s

wealth, and, therefore, the value of the firm, the net present value
method provides the correct criterion of investment decisions. A
company should select the project which has the maximum NPV out
of the mutually exclusive projects under its consideration. The project
with the maximum NPV makes maximum contribution to the present
value of the firm.

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6.3 RISK IN INVESTMENT DECISIONS

Risk involves situations in which the probabilities of an event occurring

are known and these probabilities are objectively or subjectively
determinable. The main attribute of risk situation is that the event is
repetitive in nature and possesses a frequency distribution. It is the
inability to predict with perfect knowledge the course of future events
that introduces risk. As events become more predictable, risk is
reduced. Conversely, as events become less predictable, risk is
increased. Thus, if Rs. 10 lakhs is invested in stock of a company
organised to extract coal from a mine, then the probable return cannot
be predicted with 100 per cent certainty. The rate of return on the
above investment could vary from minus 100 per cent to some
extremely high figure and because of this high variability, the project
is regarded as relatively risky. Risk is then associated with project
variability — the more variable the expected future returns from the
project, the riskier the investment.

Sources of Risk

The first step in risk analysis is to uncover the major factors that
contribute to the risk of the investment. Four main factors that
contribute to the variability of results of a particular investment are
size of the investment in the project, reinvestment of cash flows,
variability of cash flows and life of the project.

1. Size of the Investment : A large project involving greater

investments entails more risk than the small project because in case
of failure of the large project, the company will have to suffer
considerably greater loss and it may be forced to liquidation.
Furthermore, cost of a project in many cases is known in advance.
There is always the chance that the actual cost will vary from the

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original estimate. One can never foresee exactly what the construction,
debugging, design and developmental costs will be. Rather than being
satisfied with a single estimate, it seems more realistic to specify a
range of costs and the probability of occurrence of each value within
the range. The less confidence the decision-maker has in his estimate,
the wider will be the range.

2. Reinvestment of Cash Flows : Whether a company should

accept a project that offers a 20 per cent return for two years or one
that offers a 16 per cent return for three years would depend upon
the rate of return available for reinvesting the proceeds from the 20
per cent, two-year period. The danger that the company will not be
able to reinvest funds as they become available is a continuing risk in
managing fixed assets and cash flows.

3. Variability of Cash Flows : It may not be an easy job to forecast

the likely returns from a project. Instead of basing investment decision
on a single estimate of cash flow it would be desirable to have range of
estimates.

4. Life of the Project : Life of a project can never be determined

precisely. The production manager should base the investment
decision on the range of life of the project.

Measurement of Risk

1. Probability Distribution : As stated above, a risky proposition

in a business enterprise is presumed to be one with a wide range of
possible outcomes. If a range of possible outcomes for cash flow in
each year is arranged in the form of a frequency distribution, it is
known as a probability distribution. The probability that a particular
event will occur is a measure of its likelihood of occurrence.
Probabilities normally are stated as decimal fractions to 1.0.
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In capital budgeting usually the forecast of annual cash flow in one
single figure is made. This is the most likely or most probable outcome
perceived by the forecaster for the proposal. The question that arises
in this connection is how much the forecaster is confident about this
outcome. Is he very certain, very uncertain or somewhere in between?
This degree of uncertainty can be defined and measured in terms of
the forecaster’s probability distribution. Thus, a probability distribution
consists of just a few potential outcomes, viz., on optimistic estimate,
a pessimistic estimate and a most likely estimate or alternatively one
could make high, low and best guess estimates. An analysis is not
limited to these three alternatives. Any number may be used to express
the future conditions applicable to the project.

Normally, the most likely estimate represents the expected value of

the variable. This is in the middle of the other possibilities and has
the highest probability of occurrence. Weighted arithmetic mean
provides expected value. This value is constructed by multiplying each
possible outcome by its associated probability and summing the
products. The following formula is used to compute the expected value
of the distribution:
n
Expected Value = R = ∑ (Ri Pi)
i=1
Where, Ri = the return associated with each outcome
Pi = the probability of occurrence of each outcome
R=the expected value
2. Standard Deviation as a Measure of Risk : Probability
distribution provides the basis for measuring the risk of a project. The
rule set down in this connection is “the higher the probability
distribution of expected future return, the smaller the risk of a given
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project and the vice versa”. To measure the rightness or dispersion of
the probability distribution the most widely used statistical technique
of standard deviation is employed. The following steps are used to
calculate the standard deviation:
1. Calculate the mean of expected value of the distribution.
2. Calculate the deviation from each possible outcome.
—
Deviation = Ri - R
3. Square each deviation.
4. Multiply the squared deviations by the probability of occurrence
for its related outcome.
5. Sum all the products. This is called variance.
n
—
Variance = σ2 = ∑ (Ri - R )2 Pi
i=1
6. The standard deviation is determined by taking the square root
of the variance
n
—
σ = ∑ (Ri - R )2 Pi
i=1
The smaller the standard deviation, accordingly the lower the riskiness
of the project.
3. Coefficient of Variation as a Relative Measure of Risk
The size difficulty can be eliminated by developing a third measure,
the coefficient of variation. It measures the relative variability of returns.
It calls for nothing more difficult than dividing the standard deviation
from an investment by the expected value :
σ
Coefficient of variation (v) = —
R
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Utility Theory and Risk Analysis in Investment Decisions

Even after the determination of the various outcomes and their

respective probabilities objectively, it may be difficult to know whether
or not the company would accept the risk. It is because of the fact that
the decision is ultimately based on the management’s subjective
evaluation of risk. Utility theory has been developed by Milton Friedman
to measure an individual’s attitude toward varying amounts of gains
and losses. The utility function spelt out in this theory is different
from the ordinary concept of utility discussed in the principles of
economics.

The core of the utility theory is the concept of diminishing marginal

utility for money. According to this concept, marginal utility of a unit of
money goes on declining successively in correspondence with
increasing money income. Thus, increase in income will mean lower
utility from additional income. As one proceeds from necessities to
comforts and then luxuries the intensity of desire will go on decreasing
and therefore, the successive increments of income necessary to satisfy
these categories of wants will necessarily give less and less utility.

The investors with a diminishing marginal utility of money will get

more pain from a rupee lost than pleasure from a rupee gained. They
cannot, therefore, be apathetic to risk and will require a higher return
as a compensation for bearing risk.

The above discussion leads us to an unmistakable conclusion that

business managers are predominantly risk averters who cannot remain
indifferent between risk free and riskier projects. This is why a prudent
finance manager considers both risk factor and utility function together
while choosing worth-while capital investment projects.

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Risk Analysis Approaches
There are two major approaches which may be adopted for handling
the risk dimension within the investment decisions process. These
are simulation approach and sensitivity analysis. We shall now discuss
each of these approaches.

1. Simulation Approach : Simulation approach has, of late, come

to be used by the business executives who are interested to gauge
the effects of the uncertainty surrounding of the significant factors
that enter into the valuation of a specific decision on the expected
returns. This approach combines the variabilities in all the relevant
factors so as to provide a clear picture of the relative risk and the
probable odds of coming out ahead or behind it in the light of uncertain
foreknowledge.

This model considers the following variables which are subject to

random variation.

Market Related Factors

1. Market Size
2. Market growth rate
3. Selling price of product
4. Market share captured by the firm

Investment Related Factors

5. Investment outlay
6. Useful life of investment
7. Residual value of the investment

Cost Related Factors

8. Variable operating unit cost

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9. Fixed costs

Risk analysis based on simulation approach involves the following

steps:

1. List all the basic economic variables that will affect the outcome
of the decision.

2. Estimate the range of variables for each of these variables that

are subject to uncertainty.

3. State in equation form the economic or accounting relationships

that connect the basic variables to the final outcome on which
the decision will be based.

4. With the aid of a computer randomly select a specific value for

each basic variable according to the chances this value has of
actually turning up in the future. Given these specific values,
use the equation in step III to calculate the resulting outcome.

5. Repeat this process to define and evaluate the probability of the

occurrence of each possible rate of return. Since there are literally
millions of possible combinations of values, we need to test the
likelihood that various specific returns on the investment will
occur.

The simulation approach has several advantages. In the first instance,

the simulation enables the analyst to handle more complicated
problems. Secondly, compared with the single valued estimate
approach, simulation allows the experts providing input data to
indicate the probable accuracy of their estimates as well as expected
values. Thirdly, this approach enables the analyst to make a sensitivity
analysis of any stochastic variable merely by holding all other variables
constant (presumably at their expected values). Finally, since the

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output is probability of NPV or IRR, decision-maker have substantial
information about the reward-risk profile of the project.

The main limiting factor of this approach is scarcity of appropriate

inputs data, incorporating interdependence among the variables,
correct modelling of the project variables and correct specification of
independence or correlation of cost flows over this time.

2. Sensitivity Analysis : Sensitivity analysis is a meaningful

technique used to locate and assess the potential impact of risk on a
project’s profitability. It does not attempt to quantify risk, but rather
provides insight into how the final outcome of an investment decision
is likely to be affected by possible variations in the underlying factors.
For instance, it attempts to answer what is the NPV if selling price falls
by 10 per cent, what is the IRR if the project’s life is only three years,
not five years as expected, what is the level of sales revenue required
to break-even in the net present value terms.

Sensitivity analysis helps the management to improve decision-making

in a number of ways. In the first instance, it identifies the critical factors
which have greatest impact on a project’s profitability. Secondly, it
encourages consideration of uncertainties and risks by managers at
different levels. Finally, it isolates areas on which the management is
required to concentrate during implementation of the project. However,
it does not actually evaluate risk; the decision maker must still assess
the probability of occurrence for these deviations from expected values.

Methods of Adjusting Risk

A finance manager being risk averter when given choice between two
projects promising the same rate of return but different in risk would
prefer the one with the least perceived risk. He will require
compensation for bearing risk so that overall value of the company
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remains unaffected by assumption of the risky project. There are
several methods of adjusting risk in investment decisions which can
be classified broadly in two groups, viz., informal and formal methods.
1. Informal Method : This is the most common method of adjusting
risk. The finance manager recognizes that some projects are more
riskier than others. He also finds that riskier projects would yield more
than what risk free or less risky projects promise. To choose a project
carrying greater risk as against the less risky one, the finance manager
decides on subjective basis (by using his discretion), the margin of
difference in rate of return of both types of projects. The manner of
fixing the standard is strictly internal known to the finance manager
himself and is not specified.
2. Formal Methods : Among the formal methods of adjusting risk
in capital budgeting decisions, the most popular one is Risk adjusted
discount rate method.
Risk Adjusted Discount Rate : A popular approach to adjusting for risk
is the use of different discount rates for proposals with different risk
levels. A project that carries a normal amount of risk and does not
change the overall risk complexion of the company should be
discounted at the cost of capital. Projects involving more than normal
risks will be discounted at a higher rate and so on.
Illustration : Modern Steel Company is considering two mutually
exclusive projects. The expected investment outlay of these projects
is Rs. 1,500 : net cash flow information for both projects are as under :

Year Project A (Rs.) Project B (Rs.)

1 575 450
2 510 450
3 430 450
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4 278 450
5 278 450

Which project should modern Steel Company select and why?

Solution : The cash flow information shows that Project A is more

risky than Project B because the distribution of the cash flows of the
latter is normal while the distribution of cash flows of the former is
negatively skewed. In view of the risk differential the management
decides to evaluate Project A with 14 per cent discount rate and Project
B with 10 per cent discount rate as follows :

The risk adjusted NPVA = - 1500 + (.877 x 575 + .769 x 510 + .675 x
430 + .592 x 278 + .519 x 278)

= - 1,500 + 1,495

NPV = - Rs. 5

The risk adjusted NPVB = -1500 + (.909 x 450 + .826 x 450 + .751 x
450 + .683 x 450 + .621 x 450)

= -1,500 + 1750.5

NPV = Rs. 250.50

Since Project B has higher NPV in comparison to Project A the

management should choose the former.

Adjusting discount rate in consonance with variation in risk yields

useful results. However, the problem that arises in the approach is in
respect of variation in discount rate exactly in relation to the variation
the degree of risk. No generally accepted scale has thus far been
evolved that could guide in allowing additional percentage amount for
a project carrying a specified amount of risk in comparison to a perfectly
riskless project.
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6.4 SOLVED PROBLEMS

Illustration 1

Consider the following investment opportunity :

A machine is available for purchase at a cost of Rs. 80,000. We expect

it to have a life of five years and to have a scrap value of Rs. 10,000 at
the end of the five year period. We have estimated that it will generate
additional profits over its life as follows :

Year Amount (Rs.)

1 20,000
2 40,000
3 30,000
4 15,000
5 5,000

These estimates are of profits before depreciation. You are required

to calculate the return on capital employed.

Solution :

Total profit before depreciation over the life of the machine = Rs.
1,10,000
Rs. 1,10,000
Average profit p.a. = —————— = Rs. 22,000
5 years
Total depreciation over the life of the machine = Rs. 80,000 - Rs. 10,000

= Rs. 70,000

Rs. 70,000
Average depreciation p.a. =———————= Rs. 14,000
5 years

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Average annual profit after depreciation = Rs. 22,000 - Rs. 14,000

= Rs. 8,000
Return on original Investment :
Original investment required = Rs. 80,000
Rs. 8,000
Accounting rate of return = —————— x 100 = 10%
Rs. 80,000
Return on average investment :

80,000 + 10,000
Average investment = ————————— = Rs. 45,000
2
8,000
Therefore accounting rate of return =——— x 100 = 17.78%
45,000
Illustration 2.

XYZ Ltd. has decided to diversify its production and wants to invest its
surplus funds on the most profitable project. It has under consideration
only two projects - “A” and “B”. The cost of project “A” is Rs. 100 lakhs
and that of “B” is Rs. 150 lakhs. Both projects are expected to have a
life of 8 years only and at the end of this period. “A” will have a salvage
value of Rs. 4 lakhs and “B” Rs. 14 lakhs. The running expenses of
“A” will be Rs. 35 lakhs per year and that of “B” Rs. 20 lakhs per year.
In either case the company expects a rate of return of 10%. The
company’s tax rate is 50%. Depreciation is charged on straight line
basis. Which project should the company take up?

Note : Present value of annuity of Rs. 1 for eight years at 10% is 5.335
and present value of Rs. 1 received at the end of the eighth year is
0.467.

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Solution :
Statement showing NPV of Projects (Rs. lakhs)

Particulars Project A Project B

Profit after tax (10% on cost of project) 10.00 15.00

Depreciation 12.00 17.00
Net cash inflow every year 22.00 32.00
P.V. of cash flow in eight year period @ 5.335 117.370 170.720
P.V. of salvage at the end of 8th year 1.868 6.538
Total inflow 119.238 177.258
Less : Initial investment 100.000 150.000
Net present value (NPV) 19.238 27.258

Project B is more profitable than Project A, the increase in profit being

Rs. 8.020 lakhs. Hence, Project B should be taken up.

Illustration 3.

The project cash flows from two mutually exclusive projects A and B
are as under :

Period Project A Project B

0 (outflow) Rs. 22,000 Rs. 27,000

1 to 7 (inflow) Rs. 6,000 each year Rs. 7,000 each year
Project life 7 years 7 years

(i) Advise on project selection with reference to internal rate of

return.

(ii) Will it make any difference in project selection, if the cash flow
from Project B is for 8 years instead of 7 years @ Rs. 7,000 each
year?
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Relevant P.V. For 7 years factor at For 8 years

15% 4.16 4.49

16% 4.04 4.34

17% 3.92 4.21

18% 3.81 4.08

19% 3.71 3.95

20% 3.60 3.84

Solution

(i) Project selection based on internal rate of return.

The present values of Project A and Project B is calculated as follows :

Discount P.V. Factor Project A Project B
Rate for 7 yrs Cash inflow P.V. Cash inflow P.V.
p.a. (Rs.) (Rs.) p.a. (Rs.) (Rs.)

15% 4.16 6,000 24,960 7,000 29,120

16% 4.04 6,000 24,240 7,000 28,280

17% 3.92 6,000 23,520 7,000 27,440

18% 3.81 6,000 22,860 7,000 26,670

19% 3.71 6,000 22,260 7,000 25,970

20% 3.60 6,000 21,600 7,000 25,200

(a) Project A

Since the original investment in Project A is Rs. 22,000, its IRR will fall
between 19% and 20%.

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 (Rs.)

P.V. of cash inflows at 19% 22,260

P.V. of cash inflows at 20% 21,600
Difference 660

Now, IRR of Project A is calculated as follows, by applying formula for

interpretation :
22,260 - 22,000
IRR = 19 +———————— x 1 = 19.4% (approx.)
660
(b) Project B

Since the original investment in Project B is Rs. 27,000, its IRR will fall
between 17% and 18%.
(Rs.)
P.V. of cash inflows at 17% 27,440
P.V. of cash inflows at 18% 26,670
Difference 770

Now, IRR of Project B is ascertained as below :

27,440 - 27,000
IRR = 17 +————————x 1 = 17.6% (approximately)
770
Selection of project :

The IRR of Project A and Project B are 19.4% and 17.6% respectively.
A project can be selected based on its higher IRR over the other
Projects. Hence Project A is preferred to which is having a higher IRR
of 19.4%.

(i) Calculation of IRR of Project B whose cash flow from the project
is for 8 years instead of 7 years.

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Discount P.V. factor Cash inflow P.V. of cash
factor for 8 years each year (Rs.) inflows (Rs.)
15% 4.49 7,000 31,430
16% 4.34 7,000 30.380
17% 4.21 7,000 29,470
18% 4.08 7,000 28,560
19% 3.95 7,000 27,650
20% 3.84 7,000 26,880

Since the original investment in Project B is Rs. 27,000, its IRR will fall
between 19% to 20%.

(Rs.)
P.V. of cash inflows at 19% 27,650
P.V. of cash inflows at 20% 26,880
Difference 770

Now, IRR of Project B is ascertained as below :

27,650 - 27,000
IRR = 19 +————————x 1 = 19.8% (approximately)
770
Selection of project : With the change in cash inflow of Project B from
7 years to 8 years its IRR is also improved from 17.6% to 19.8 and it is
also higher than the IRR of Project A (i.e. 19.4%). Hence, Project B can
be selected (based on its 8 years of cash inflows).

6.5 SUMMARY

Capital budgeting involves the selection of projects which will make

the optimum contribution to corporate objectives, and one of the most
important corporate objective is to maximize the profitability of the
enterprise. Capital budgeting is broader in scope than investment
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decisions. It includes not only investment decisions but also the
exploration of profitable investment opportunities, and investigation
of potential opportunities. Capital budgeting decision are top
management decisions. Capital investment projects may be initiated
at any level of management, but they are processed through various
levels including the head of the operating division concerned, financial
controller, investment or finance committee, general manager and the
board. The most widely accepted criterion of investment decision is
the estimated net worth or present value of the project. Major
investment decision methods are : (i) ranking by inspection method
(ii) payback period (iii) average rate of return method (iv) net present
value (v) profitability index, and (vi) internal rate of return.
6.6 SELF TEST QUESTIONS

1. What is capital budgeting? What is the most acceptable criterion

for making capital budgeting decisions?
2. Discuss the payback criterion of investment decisions. What are
its strengths and weaknesses?
3. Discuss and distinguish between net present value and yield of
investment methods of making investment decisions. Illustrate
your answer with the help of an example. Which of the two is
better? Why?
4. Your bank pays you Rs. 12,000 at the end of seven years of your
deposit of Rs. 1200 a year for seven years in a recurring deposit
account. What is the net present value of your investment if
your required rate of return is 10 per cent? What is the internal
rate of return?

5. XYZ Ltd. has a target accounting rate of return of 20% and is

now considering the following project.
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 Capital cost of asset Rs. 80,000
Estimated Life 4 years
Estimated profit before depreciation Rs.
Year 1 20,000
Year 2 25,000

Year 3 35,000
Year 4 25,000

The capital asset would be depreciated by 25% of its cost each

year, and would have no residual value. Should the project be
undertaken?

6. A company proposes to undertake one of the two mutually

exclusive projects namely, AXE and BXE. The initial capital outlay
and annual cash inflows are as under :

AXE BXE
Initial capital outlay (Rs.) 22,50,000 30,00,000
Salvage value at the end of the life 0 0
Economic life (years) 4 7

Year Rs. lakhs After tax annual cash inflows Rs. lakhs
1 6.00 5.00
2 12.50 7.50
3 10.00 7.50
4 7.50 12.50
5 - 12.50
6 - 10.00
7 - 8.00

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The company’s cost of capital is 16%.
Required :
(i) Calculate for each project
(a) Net present value of cash flows
(b) Internal rate of return
7. Precision Instruments is considering two mutually exclusive
Projects X and Y : following details are made available to you :

(Rs. lakhs)

Project X Project Y
Project Cost 700 700
- -
Cash inflows : Year 1 100 500
Year 2 200 400
Year 3 300 200
Year 4 450 100
Year 5 600 100
Total 1,650 1,300
Assume no residual values at the end of the fifth year. The firm’s
cost of capital is 10%. Required, in respect of each of the two
Project :
(i) Net Present Value, using 10% discounting;
(ii) Internal rate of return;
(iii) Profitability Index.
8. A company is considering taking up of one of two Projects, ‘X’
and ‘Y’. Both projects have the same life, require equal investment
of Rs. 80 lakhs each and both are estimated to have almost the
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 same yield. As the company is new to this type of busienss, the
cash flows arising from the projects cannot be estimated with
certainty. An attempt was therefore, made to use probability to
analyse the pattern of cash flow from either project during the
first year of operation. This pattern is likely to continue during
the life of these projects. The results of the analysis are as follows :
Project X Project Y
Cash flow Probability Cash flow Probability
(Rs. lakhs) (Rs. lakhs)
12 0.1 8 0.10
14 0.2 12 0.25
16 0.4 16 0.30
18 0.2 20 0.25
20 0.1 24 0.10

Which project should the Company take up ?

6.7 SUGGESTED READINGS

1. Financial Management by Prasanna Chandra.

2. Financial Management by I.M. Pandey.

3. Financial Management by Khan & Jain.

4. Organisation & Management by R.D. Aggarwal.

5. Financial Management and Policy by R.M. Srivastava.

✪✪✪

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 LESSON – 7

THE COST OF CAPITAL

Objectives : The objectives of this lesson are :

• to explain the concept of cost of capital;
• to learn about the methods of calculating component cost of capital and
the weighted average cost of capital; and
• to understand the concept and calculation of the marginal cost of capital.
Structure :
7.1 Introduction
7.2 Significance of the Cost of Capital
7.3 The Concept of the Cost of Capital
7.4 Determining Component Cost of Capital
7.4.1 Cost of Debt
7.4.2 Cost of Preference Capital
7.4.3 Cost of Equity Capital
7.5 Weighted Average Cost of Capital
7.6 Weighted Marginal Cost of Capital Schedule (WACC)
7.7 Floatation Costs and NPV
7.8 Summary
7.9 Solved Problems
7.10 Self Assessment Questions
7.11 Suggested Readings
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7.1 INTRODUCTION
The use of capital budgeting techniques for evaluating an investment project
require two basic inputs : (1) the estimates of the project's cash flow and (2)
the discount rate. In our discussions of the investment decisions so far we
have assumed that the cost of capital is known. Here we focus on the discount
rate. The discount rate is the project's opportunity cost of capital (or simply
the cost of capital) for discounting its cash flows. The project's cost of capital
is the minimum acceptable rate of return on funds committed to the project.
The minimum acceptable rate, or the required rate of return is a compensation
for time and risk in the use of capital by the project. Since the investment
projects may differ in risk, each one of them will have its own unique cost of
capital. The firm's cost of capital is not the same thing as the project's cost of
capital. The firm's cost of capital will be the overall, or average, required rate
of return on the aggregate of the investment projects.
7.2 SIGNIFICANCE OF THE COST OF CAPITAL
The concept of cost of capital is of vital importance in financial decision-
making. Its usefulness to the finance manager is as follows :
Firstly, the cost of capital is an important element, as a basic input information,
in capital budgeting decisions. In the present value method of discounted cash
flow technique, the cost of capital is used as the discount rate to calculate the
NPV. The profitability index or benefit-cost ratio method similarly employs it
to determine the present value of future cash inflows. When the internal rate
of return method is used, the computed IRR is compared with the cost of capital.
The cost of capital, thus, constitutes an internal part of investment decisions.
It provides a yardstick to measure the worth of investment proposal and, thus,
performs the role of accept-reject criterion. This underlines the crucial
significance of cost of capital. It is also referred to as cut-off rate, target rate,
hurdle rate, minimum required rate of return, standard return and so on.
The cost of capital is related to the firms' objective of wealth maximisation.
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The accept-reject rules require that a firm should avail of only such investment
opportunities as promise a rate of return higher than the cost of capital.
Conversely, the firm would be well advised to reject proposals whose rates of
return are less than the cost of capital. If the firm accepts a proposal having a
rate of return higher than the cost of capital, it implies that the proposal yields
returns higher than the minimum required by the investors and the prices of
shares will increase and, thus, the shareholders' wealth. By virtue of the same
logic, the shareholders' wealth will decline on the acceptance of a proposal in
which the actual return is less than the cost of capital. The cost of capital,
thus, provides a rational mechanism for making optimum investment decisions.
In brief, the cost of capital is important because of its practical utility as an
acceptance-rejection decision criterion.
Secondly, the debt policy of a firm is significantly influenced by the cost
consideration. In designing the financing policy, that is, the proportion of debt
and equity in the capital structure, the firm aims at minimising the overall
cost of capital. The relationship between the cost of capital and the capital
structure decision is discussed somewhere else in this book.
Finally, the cost of capital framework can be used to evaluate the financial
performance of top management. Such an evaluation will involve a comparison
of actual profitabilities of the investment projects undertaken by the firm with
the projected overall cost of capital, and the appraisal of the actual costs
incurred by management in raising the required funds.
The cost of capital also plays a useful role in dividend decision and investment
in current assets. The chapters dealing with these decisions show their linkages
with the cost of capital.
7.3 THE CONCEPT OF THE COST OF CAPITAL
The term 'cost of capital' refers to the discount rate that is used in determining
the present value of the estimated future cash proceeds and eventually deciding
whether the project is worth undertaking or not. In this sense, it is defined as
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the minimum rate of return that a firm must earn on its investment for the
market value of the firm to remain unchanged.
The cost of capital is visualised as being composed of several elements. These
elements are the cost of each component of capital. The term 'component'
means the different sources from which funds are raised by a firm. Obviously,
each source of funds or each component of capital has its cost. For example,
equity capital has a cost, so also preference share capital and so on. The cost
of each source or component is called specific cost of capital. When these
specific costs are combined to arrive at overall cost of capital, it is referred
to as the weighted cost of capital. The terms, cost of capital, weighted cost of
capital, composite cost of capital and combined cost of capital are used
interchangeably. In other words, the term, cost of capital, as the acceptance
criterion for investment proposals, is used in the sense of the combined cost
of all sources of financing.
Opportunity Cost
The opportunity cost is the rate of return foregone on the next best alternative
investment opportunity of comparable risk. The required rate of return on an
investment project is an opportunity cost.
For example, you may invest your savings of Rs. 1,000 either in 10 per cent 3-
year postal certificates or in 11 per cent 3-year fixed deposit in a bank. In both
the cases, the payment is assured by the government; so the investment
opportunities reflect equivalent risk. You decide to deposit your savings in the
bank. By this action, you have foregone the opportunity of investing in the
postal certificates. You have, thus, incurred an opportunity cost equal to the
return on the foregone investment opportunity. It is 10 per cent in this case of
your investment.
In the case of companies as there is a divorce between management and
ownership the investment decisions are made by management, but the capital
is supplied by shareholders. He also has the responsibility for the investment
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decision. Here a question arise : Whose opportunity cost should the manager
use? Since shareholders are the supplier of funds to the firm and the manager
is acting on their behalf, shareholders will require him to use their required
rate of return in making investment decisions. If he is unable to earn returns
equal to shareholders required rate of return, they can ask him to return the
money to them which they can invest outside and earn the required rate of
return.
Thus the manager should consider the owner's (shareholders') required rate of
return in evaluating the investment decisions. If the manager is unable to earn
the rates on the investment projects which the shareholders could themselves
earn on alternative investment opportunities, they will be within their rights to
ask for returning their funds.
Investors will require different rates of return on various securities since they
have risk differences. Higher the risk of a security, the higher the rate of return
demanded by investors. Since ordinary share is most risky, investors will require
highest rate of return on their investment in ordinary shares.
The firm sells various securities to investors to raise capital for financing
investment projects. Viewed from all investors point of view, the firm's cost
of capital is the rate of return required by them for supplying capital for
financing the firm's investment projects by purchasing various securities. It
may be emphasised that the rate of return required by all investors will be an
overall rate. Thus, the firm's cost of capital is the 'average' of the opportunity
cost (or required rates of return) of various securities which have claims on
the firm's assets. Recall that the cost of capital of an all equity financed firm
is simply equal to the ordinary shareholders' required rate of return.
Opportunity Cost of Capital Formula
The opportunity cost of a source of capital is given by the following formula:
CF1 CF2 CFn
I0 = + 2 + ....... + (7.1)
(1+k) 1 (1+k) (1+k) n
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where I 0 is the capital supplied by investors in period 0 (it represents a net
cash inflow to the firm), CF 1, CF 2 ....., CF n are returns expected by investors
(they represent cash outlfows to the firm) and k is the required rate of return
or the cost of capital.
In terms of Equation (7.1), the cost of capital is the internal rate of return
which equates the present values of inflows and outflows of a financial
opportunity. The outflows in this equation represent the returns which investors
could earn on the alternative investment opportunities of equivalent risk. The
opportunity cost of retained earnings is the rate of return which the ordinary
shareholders would have earned to these funds if they would have been
distributed as dividends to them.
Concept of Average Cost of Capital
A firm's cost of capital is the weighted average cost of various sources of
finance used by it, viz., equity, preference, long-term debt, and short-term debt.
Note that many companies leave out the cost of short-term debt while
calculating the weighted average cost of capital (WACC). In principle, this is
not correct. Investors who provide short-term debt also have a claim on the
operating earnings of the firm. If a company ignores this claim, it will misstate
the rate of return required on capital investments.
Suppose that a firm uses equity costing 16 per cent and debt costing 9 per
cent. If the proportions in which equity and debt are used are respectively 40
per cent and 60 per cent, its WACC will be :
WACC = Proportion of equity × cost of equity + Proportion of debt × Cost of debt
= 0.40 × 16% + 0.6 × 9%
= 6.4% + 5.4%
= 11.8%
In general, if the firm uses n different sources of finance, its WACC is :
WACC = Σ pi ri (7.2)
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where P i is the proportion of the ith source of finance and r i is the cost of the
ith source of finance.
The rationale for using the WACC as the hurdle rate in capital budgeting is
fairly straight-forward. If a firm's rate of return on its investments exceeds its
cost of capital, the wealth of equity stockholders is enhanced. Why? When the
firm's rate of return on its investments is greater than its cost of capital, the
rate of return earned on equity capital will exceed the rate of return required
by equity stockholders. Hence, the wealth of equity stockholders will increase.
Two basic conditions should be satisfied for using WACC for evaluating new
investments.
• The risk of new investments is the same as the average risk of existing
investments. In other words, the adoption of new investments will not
change the risk complexion of the firm.
• The capital structure of the firm will not be affected by the new
investments. Put differently the firm will continue to pursue the same
financing policy.
Thus, strictly speaking, WACC is the right discount rate for a project that is a
carbon copy of the firm's existing business. However, in practice WACC is
used as a benchmark hurdle rate that is adjusted for variations in risk and
financing patterns. More details regarding WACC are available in section 7.6
of present lesson.
7.4 DETERMINING COMPONENT COST OF CAPITAL
The term 'cost of capital' is the combined cost of the specific costs associated
with specific sources of financing. The cost of the different sources of
financing represents the components of the combined cost. The computation
of the cost of capital, therefore, involves two steps : (i) the computation of
the different elements of the cost in terms of the cost of the different sources
of finance (specific costs), and (ii) the calculation of the overall cost by

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combining the specific costs into a composite cost.

The first step in the measurement of the cost of capital of the firm is the
calculation of the cost of individual sources of raising funds. In the following
pages we will discuss the same.

7.4.1 Cost of Debt

A company may raise debt from financial institutions or public either in the
form of public deposits or debentures for a specified period of time at certain
rate of interest. The cost of funds raised through debt in the form of debentures
or loan from financial institutions can be determined from Eq. 7.3. To apply
the formulation of explicit cost of debt, we need data regarding : (i) the net
cash proceeds/inflows (the issue price of debentures/amount of loan minus
all floatation costs) from specific source of debt, and (ii) the net cash outflows
in terms of the amount of periodic interest payment and repayment of principal
in instalments or in lump sum on maturity. The interest payments made by the
firm on debt issues qualify for tax deduction in determining net taxable income.
Therefore, the effective cash outflows is less than the actual payment of interest
made by the firm to the debt holders by the amount of tax shield on interest
payment. The debt can be either perpetual/irredeemable or redeemable. A
debenture or bond may be issued at par or at discount or premium.

Cost of Perpetual Debt : The measurement of the cost of perpetual debt is

relatively easy. It is the rate of return which the lenders expect. The coupon
interest rate or the market yield on debt can be said to represent an
approximation of the cost of debt. The nominal/coupon rate of interest on
debt is the before-tax cost of debt. Since the effective cost of debt is the tax-
adjusted rate of interest, the before-tax cost of debt should be adjusted for the
tax effect. Thus:
I
ki = (7.3)
SV

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 kd = I (1-t) (7.4)
SV
k i = Before tax cost of debt
k d = Tax-adjusted cost of debt
I = Annual interest payment
SV = Sale proceeds of the bond/debenture
t = Tax rate
Example 7.1 : Assume acompany has 12 per cent perpetual debt of Rs.
1,00,000. The tax rate is 35 per cent. Determine the cost of capital (before tax
as well as after tax) assuming the debt is issued at (i) par, (ii) 10 per cent
discount, and (iii) 10 per cent premium.
Solution :
(i) Debt issued at par
12,000
Before-tax cost, k i = Rs. = 12 per cent
1,00,000
After-tax cost, k d = k i ( 1 - t) = 12% (1-0.35) = 7.80 per cent
(ii) Issued at discount
12,000
Before-tax cost, ki = Rs. = 13.33 percent
90,000
After-tax cost, k d = 13.33 (1-0.35) = 8.67 per cent
( i i i ) Issued at premium
12,000
Before-tax cost, k i = Rs. = 10.91 per cent
1,10,000
After-tax cost, k d = 10.91 (1-0.35) = 7.09 per cent

Cost of Redeemable Debt : While computing the cost of redeemable debt,

account has to be taken in addition to interest payments, of the repayment of
the principal. When the amount of principal is repaid in one lump sum at the
time of maturity, the before tax cost of debt would be given by solving Eq. 7.5.
If, however, the repayments are in a number of instalments, the cost of debt

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can be calculated on the basis of Eq. 7.6.
t =1 It Pn
I0 = Σ + (7.5)
n (I + k d) t (I + k d )n
where I 0 = Net cash proceeds from issue of debentures or from raising debt
I1 + I 2 +...+ In = Interest payments in time period 1,2 and so on up to the year of
maturity after adjusting tax savings on interest payment.
Pn = Principal repayment in the year of maturity
k d = Before tax cost of debt
If the repayment of debt is in a number of instalments instead of one lump sum
payment, the equation would be :
t =1 It + P n
I0 = Σ (I + k d) t
(7.6)
n
Example 7.2 : A company decides to sell a new issue of 7 year 15 per cent
debenture of Rs. 100 each. The debenture is expected to be sold at 5 per cent
discount. It will also involve floatation costs of 2.5 per cent. The company's
tax rate is 40 per cent. What would the cost of debt be?
Solution :
(i) Trial and Error/Long Approach
Cash flow pattern of the debenture would be as follows :
Years Cash flow
0 + Rs. 92.5 (Rs. 100 - Rs. 7.5, that is, par value
less flotation cost less discount)
1-7 - Rs. 15 (interest outgo)
7 - Rs 100 (repayment of principal at maturity)
We are to determine the value k d in the following equation :
7 Rs. 9.0 Rs. 100
Rs. 92.5 = Σ (1 + k ) t + (1 + k ) 7
t =1 d d

The value kd for this equation would be the cost of debt. The value of kd can be
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obtained, as in the case of IRR, by trial and error.
Determination of PV at 10% and 11% rates of interest
Year(s) Cash PV factor at Total PV at
outflows 10% 11% 10% 11%
1-7 Rs. 9.0 4.868 4.712 43.81 42.41
7 100 0.513 0.482 51.30 48.20
(Table A-3)
94.11 90.61
The value of k d would be 10.5 approximately (i.e. between 10 % and 11%).
(ii) Shortcut Method : The formula for approximating the effective cost
of debt can, as a shortcut, be shown in the Equation (7.7) :
I (1- t) + (f+d+pr-pi) / N m
kd = (7.7)
(RV + SV) / 2
where
I= Annual interest payment
RV = Redeemable value of debentures/debt
SV = Net sales proceeds from the issue of debenture/debt (face value of debt
minus issue expenses)
N m = Term of debt
f = Flotation cost
d = Discount of issue of debentures
pi= Premium on issue of debentures
pr= Premium on redemption of debentures
t= Tax rate
Rs 15 (1-.40) + (5+2.5)/7
kd = = 10.46 per cent
(Rs. 92.5 + Rs. 100)/2

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Illustration 7.3 : A 7-year Rs. 100 debenture of a firm can be sold for a net
price of Rs. 97.75. The coupon rate of interest is 15 per cent per year, and
bond will be redeemed at 5 per cent premium on maturity. The firm's tax rate
is 35 per cent. Compute the after-tax cost of debenture.
Solution : The annual interest will be Rs. 100 × 0.15 =Rs. 15, and maturity
price will be : Rs. 100 (1.05) = Rs. 105. We can use Equation (7.5) to compute
the after-tax cost of debenture :
7 15 105
97.75 = Σ t +
t =1 (1+k d) (I + k d )7
By trial and error, we find k d = 16% :
15(4.038) + 105 (0.354) = 97.75
The after-tax cost of debenture will be :
k d (1-t) = 0.16 (1-0.35) = 0.104 or 10.4%
Thus the calculation of the cost of debt is relatively easy. Also, debt is the cheapest
source of long-term funds from the point of view of the company. In the first place, it
is the safest form of investment from the point of view of the creditors because they
are the first claimants on the company's assets at the time of its liquidation. Likewise,
they are the first to be paid their interest before any dividend is paid to preference and
equity shareholders. Therefore, the supplier's required rate of return on debt instruments
is lower vis-a-vis other financial instruments, and, hence, lower cost of debt to the
firm. Another, reasons for debt having the lowest cost is the tax-deductibility of interest
payments.
7.4.2 Cost of Preference Capital
Preference capital carries a fixed rate of dividend and is redeemable in nature.
Even though the obligation of a company towards its preference shareholders
is not as firm as that towards its debenture holders, we will assume that
preference dividend will be paid regularly and preference capital will be
redeemed as per the original intent.

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Thus, preference stock will be considered much like a bond with fixed
commitments. However, preference dividend, unlike debt interest, is not a tax-
deductible expense and hence does not produce any tax saving.
The failure to pay dividends, although does not cause bankrupety, yet it can be
a serious matter from the ordinary shareholders' point of view. The nonpayment
of dividends on preference capital may result in voting rights and control to
the preference shareholders. More than this, the firm's credit standing may be
damaged. The accumulation of preference dividend arrears may adversely affect
the prospects of ordinary shareholders for receiving any dividends, because
dividends on preference capital represent a prior claim on profits. As a
consequence, the market value of the equity shares can be adversely affected
if dividends are not paid to the preference shareholders and, therefore, to the
equity shareholders. For these reasons, dividends on preference capital should
be paid regularly except when the firm does not make profits, or it is in a very
tight cash position.
Perpetual preference share: The preference share may be treated as a perpetual
security if it is irredeemable. Thus, its cost is given by the following equation:
PD
kp = (7.8)
P0
where k p is the cost of preference share, PD is the expected preference dividend,
and P 0 is the issue price of preference share.
Example 7.4 : A company issues 10 per cent irredeemable preference shares.
The face value per share is Rs. 100, but the issue price is Rs. 95. What is the
cost of preference share? What is the cost if the issue price is Rs. 105?
Solution : We can compute cost of a preference share as follows :
Issue price Rs. 95 :
PD 10
kp = = = 0.1053 or 10.53%
P0 95
Issue price Rs. 105 :
PD 10
Kp = = = 0.0952 or 9.52%
P0 105
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Cost of Redeemable Preference capital :
The explicit cost of preference share in such a situation is the discount rate
that equates the net proceeds of the sale of preference shares with the present
value of the future dividends and principal repayments. The appropriate formula
to calculate cost is given by Eq. (7.9).
PD 1 PD2 Pn PDn
P0 (1-f) = + +....+ +
(1 + k p )1 (1 + k p )2 (1 + k p) n (1 + k p) n
n PDt Pn
P 0(1-f) = Σ (1 + k p) t
+
(1 + k p) n
(7.9)
t =1
where P 0 = Expected sale price of preference shares
f = Floatation cost as percentage of P0
PD = Dividends paid on preference shares
Pn = Repayment of preference capital amount
Example 7.5 : Krishan Kant Ltd. has issued 14 per cent preference shares of
the face value of Rs. 100 each to be redeemed after 10 years. Flotation cost is
expected to be 5 per cent. Determine the cost of preference shares (k p).
Solution : 10 Rs. 14 Rs. 100
Rs. 95 = Σ +
t =1 (1 + kp )t (1 + k p) 10
The value of kp is likely to be between 14 and 15 per cent as the rate of dividend
is 14 per cent.
Determination of the PV at 14 per cent and 15 per cent
Year Cash PV factor at Total PV at
outflows 14% 15% 14% 15%
1-10 Rs. 14 5.216 5.019 Rs. 73 Rs. 70.30
10 100 0.270 0.247 27 24.70
100 95.00
k p = 15 per cent
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7.4.3 Cost of Equity Capital :
Equity finance may be obtained in two ways : (i) retention of earnings and (ii)
issue of additional equity. The cost of equity or the return required by equity
shareholders is the same in both the cases. Remember that when a firm decides
to retain earnings, an opportunity cost is involved. Shareholders could receive
the earnings as dividends and invest the same in alternative investments of
comparable risk to earn a return. So, irrespective of whether a firm raises equity
finance by retaining earnings or issuing additional equity shares, the cost of
equity is the same. The only difference is in floatation costs. There is no
floatation cost for retained earnings whereas there is a floatation cost of 2 to
10 per cent or even more for additional equity. In our present discussion we
will discuss cost of external equity as well as cost of retained earnings.
It may, therefore, prima facie, appear that equity capital does not carry any
cost. But this is not true. Equity capital, like other sources of funds, does
certainly involve a cost to the firm. It may be recalled that the objective of
financial management is to maximise shareholders' wealth and the maximisation
of market price of shares is the operational substitute for wealth maximisation.
When equity holders invest their funds they also expect returns in the form of
dividends. The market value of shares is a function of the return that the
shareholders expect and get. If the company does not meet the requirements
of its shareholders and pay dividends, it will have an adverse effect on the
market price of shares.
The equity shares involve the highest degree of financial risk since they are
entitled to receive dividend and return of principal after all other obligations
of the firm are met. As a compensation to the higher risk exposure, holders of
such securities expect a higher return and, therefore, higher cost is associated
with them.
Cost of External Equity :
There are two important approaches that can be employed to calculate the cost
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of external equity capital : (i) dividend approach, and (ii) capital asset pricing
model.
Dividend Approach : The dividend approach is based on the following assumptions :
• The market price of the ordinary share (P0) is a function of expected
dividends.
• The initial dividend, D 1, is positive (i.e. D 1 > 0).
• The dividends grow at a constant rate g, and the growth rate (g) is equal
to the return on equity (ROE) times the retention ratio (b) (i.e. g =
ROE×b).
• The dividend payout ratio [i.e. (1-b)] is constant.
Mathematically :
D1 D2
P0 = + + ......... (7.10)
(1 + ke ) 1 (1 + ke ) 2
α Dt
= Σ (1 + k e) t
t =1
where P0 = current price of the stock
D t = dividend expected to be paid at the end of year t
ke = equity shareholders' required rate of return/cost of equity capital.
If dividends are expected to grow at a constant rate of g per cent per year, then
Eq. (7.10) becomes :
D1 D 1(1+g) D 1(1+g) 2
P0 = + + + ....... α
(1 + ke )1 (1 + k e )2 (1 + k e )3
This simplifies to :
D1
P0 =
ke - g
Solving the above equation for k e, we get :
D1 D 0 (1+g)
ke = +g = +g (7.11)
P0 P0
So, the expected return of shareholders, which in equilibrium is also the

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required return, is equal to the dividend yield plus the expected growth rate.
Example 7.6 : The share of a company is currently selling for Rs. 100. It
wants to finance its capital expenditures of Rs. 1,00,000 either by retaining
earnings or selling new shares. If the company sells new shares, the issue price
will be Rs. 95. The dividend per share next year is Rs. 4.75 and it is expected
to grow at 6 per cent. Calculate (i) the cost of internal equity (retained
earnings) and (ii) the cost of external equity (new issue of shares).
Equation (7.11) can be used to calculate also the cost of internal equity :
Rs. 4.75
ke = + 0.06 = 0.0475 + 0.06 = 0.1075 or 10.75%
Rs 100
The cost of external equity can be calculated as follows :
Rs. 4.75
ke = + 0.06 = 0.05 + 0.06 = 0.11 or 11%
Rs 95
It is obvious that the cost of external equity is greater than the cost of internal
equity because of the underpricing (cost of external equity = 11% > cost of
internal equity = 10.75%).
For publicly traded company, it is fairly easy to determine the dividend yield.
However, estimating the expected growth rate, g, is difficult. You can estimate
g by using the following methods :
1. You can get g by relying on analysts' forecasts for the future growth
rates. Analysts' forecasts may be available from a variety of sources.
Since different sources are likely to give different estimates, a simple
approach may be to obtain multiple estimates and then average them.
2. You can look at dividends for the preceding 5-10 years, calculate the
annual growth rates, and average them. Suppose you observe the following
dividends for some stock :

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 Year Dividend Rupee change Growth (%)
1996 Rs. 3.00 – –
1997 Rs. 3.50 Rs. 0.50 16.7
1998 Rs. 4.00 Rs. 0.50 14.3
1999 Rs. 4.25 Rs. 0.25 6.3
2000 Rs. 4.75 Rs. 0.50 11.8

If you average the four growth rates, the result is 12.3 per cent, so you
can use this as an estimate of the expected growth rate, g.
3. You can use the retention growth rate method. Here, you first forecast
the firm's average retention rate (this is simply 1 minus the dividend
payout rate) and then multiply it by the firm's expected future return on
equity (ROE).
g = (Retention rate) (Return on equity)
For example, if the forecasted retention rate and return on equity are 0.60 and
15 per cent the expected growth rate is : g = (0.6) (15%) = 9 per cent.
The dividend growth model is simple. It is easy to understand and easy to apply.
However, there are some problems associated with it.
• First, it cannot be applied to companies that do not pay dividends or to
companies that are not listed on the stock market. Even for companies
that pay dividends, the assumption that dividends will grow at a constant
rate may not be valid.
• Second, it does not explicitly consider risk. There is not direct
adjustment for the risk associated with the estimated growth. Of course,
there is an implicit adjustment for risk as the current stock price is used.
Example 7.7 : From the undermentioned facts determine the cost of equity
shares of company X :
(i) Current market price of a share = Rs. 150.
(ii) Cost of floatation per share on new shares, Rs. 3
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(iii) Dividend paid on the outstanding shares over the past six years :
Year Dividend per share
1 Rs. 10.50
2 11.02
3 11.58
4 12.16
5 12.76
6 13.40
(iv) Assume a fixed dividend pay out ratio.
(v) Expected dividend on the new shares at the end of the current year is Rs.
14.10 per share.
Solution :
To begin with, we have to estimate the growth rate in dividends. Using the
compound interest table (Table A), the annual growth rate of dividends would
be approximately 5 per cent. (During the five years the dividends have increased
from Rs. 10.50 to Rs. 13.40, giving a compound factor of 1.276, that is, Rs.
13.40/Rs. 10.50. The sum of Re 1 would accumulate to Rs 1.276 in five years
@ 5 per cent interest).
Rs. 14.10
Ke = + 5% = 14.6 per cent
Rs 147 (Rs 150 - Rs 3)
Supernormal growth : Dividends may grow at different rates in future. The
growth rate may be very high for a few years, and afterwards, it may become
normal indefinitely in the future. The dividend valuation model can also be
used to calculate the cost of equity under different growth assumptions. For
example, if the dividends are expected to grow at a super-normal growth rate
g s for n years and thereafter, at a normal, perpetual growth rate of gn beginning
in year n+1, then the cost of equity can be determined by the following formula:
n D 0 (1+g s )t Pn
P0 = Σ + (7.12)
t =1 (1+k e) t (1 + k e) n
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Pn is the discounted value of the dividend stream, beginning in year n+1 and
growing at a constant, perpetual rate gn, at the end of year n, and therefore it is
equal to :
D n+1
Pn = (7.13)
k e - gn
When we multiply P n by 1/(1+k e )n we obtain the present value of Pn in year 0.
Substituting Equation (7.13) in Equation (7.12), we get :
n D 0 (1+g s ) t D n+1 1
P0 = Σ + × (7.14)
t =1 (1+ke )t k e + gn (1 + k e) n
The cost of equity, k e, can be computed by solving equation (12) by trial and
error.
Illustration 7.8 : Assume that a company's share is currently selling for Rs.
134. Current dividend, D 0 are Rs. 3.50 per share and are expected to grow at
15 per cent over the next 6 years and then at a rate of 8 per cent for ever. The
company's cost of equity can be found out as follows :
6 3.50(1.15)t D7 1
134 = Σ + ×
t =1 (1+k e) t (k e - 0.08) (1+k e) 6

4.03 4.63 5.33

= + +
(1+k e) (1+k e) 2 (1+k e )3

6.13 7.05 8.11 8.11(1.08) 1

+ 4
+ 5
+ 6
+ ×
(1+k e ) (1+k e) (1+k e) (ke -0.08) (1+k e) 6

= 4.03 (PVF 1,ke) + 4.63(PVF 2,ke) + 5.33(PVF 3,ke) + 6.13(PVF 4,ke)

8.76
+ 7.05(PVF5,ke ) + 8.11 (PVF 6,ke ) + (PVF 6,ke)
k e –0.08
By trial and error, we find that k e = 0.12 or 12 per cent :
134 = 4.03(0.893) + 4.63(0.797) + 5.33 (0.712) + 6.13 (0.636)
8.76
+ 7.05 (0.567) + 8.11 (0.507) + (0.507)
0.12–0.08

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Zero Growth : In addition to its use in constant and variable growth situations,
the dividend valuation model can also be used to estimate the cost of equity of
no-growth companies. The cost of equity of a share on which a constant amount
of dividend is expected perpetually is given as follows :
D1
ke = (7.15)
P0
The growth rate g will be zero if the firm does not retain any of its earnings;
that is, the firm follows a policy of 100 per cent payout. Under such case,
dividends will be equal to earnings, and therefore Equation (7.15) can also be
written as :
EPS1
ke = (7.16)
P0
which implies that in a no-growth situation, the expected earnings-price (E/P)
ratio may be used as the measure of the firm's cost of equity.
Cost of Retained Earnings
The opportunity cost of the retained earnings (internal equity) is the rate of
return on dividends foregone by equity shareholders. The shareholders generally
expect dividend and capital gain from their investment. The required rate of
return of shareholders can be determined from the dividend valuation model.
Normal growth : The dividend-valuation model for a firm whose dividends
are expected to grow at a constant rate of g is as follows:
D1
P0 =
k e– g
where D 1 = D 0 (1+g)
Above equation can be solved for calculating the cost of equity k e as follows :
D1
ke = +g
P0
The cost of retained earnings determined by the dividend-valuation model
implies that if the firm would have distributed earnings to shareholders, they
could have invested it in the shares of the firm or in the shares of other firms
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of similar risk at the market price (P 0) to earn a rate of return equal to k e. Thus,
the firm should earn a return on retained funds equal to k e to ensure growth of
dividends and share price. If a return less than ke is earned on retained earnings,
the market price of the firm's share will fall. It may be re-emphasised that the
cost of retained earnings will be equal to the share-holders' required rate of
return.
Example 7.9 : Suppose that the current market price of a company's share is
Rs. 90 and the expected dividend per share next year is Rs. 4.50. If the dividends
are expected to grow at a constant rate of 8 per cent, the shareholders' required
rate of return is :
D1
ke = +g
P0
Rs 4.50
ke = + 0.08 = 0.05 + 0.08 = 0.13 or 13%
Rs 90
if the company intends to retain earnings, it should atleast earn a return of 13
per cent on retained earnings to keep the current market price unchanged.
Capital Asset Pricing Model Approach : Another approach that can be used
to estimate the cost of equity is the capital asset pricing model (CAPM)
approach.
The CAPM explains the behaviour of security prices and provides a mechanism
whereby investors could assess the impact of proposed security investment on
their overall portfolio risk and return. In other words, it formally describes
the risk return trade-off for securities. It is based on the following assumptions.
(i) All investors have common (homogenous) expectations regarding the
expected returns, variances and correlation of returns among all securities;
(ii) All investors have the same information about securities; (iii) There are
no restrictions on investments; (iv) There are no taxes; (v) There are no
transaction costs; and (vi) No single investor can affect market price
significantly. (vii) All investors prefer the security that provides the highest
return for a given level of risk or the lowest amount of risk for a given level of
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return, that is, the investors are risk averse.
Thus, the basic assumption of CAPM is that the capital market is efficient and
the investors are risk averse.
The risk to which security investment is exposed falls into two groups : (i)
diversifiable/unsystematic, and (ii) non-diversifiable/systematic. The first
represents that portion of the total risk of an investment that can be eliminated/
minimised through diversification. The events/factors that cause such risks
vary from firm to firm. The sources of such risks include management
capabilities and decisions, strikes, unique government regulations, availability
or non-availability of raw materials, competition, level of operating and
financial leverage of the firm, and so on.
The systematic/non-diversifiable risk is attributable to factors that affect all
firms. Illustrative sources of such risks are interest rate changes, inflation or
purchasing power change, changes in investor expectations about the overall
performance of the economy and political changes, and so on. As unsympathetic
risk can be eliminated by an investor through diversification, the systematic
risk is the only relevant risk. Therefore, an investor (firm) should be concerned,
according to CAPM, solely with the non-diversifiable (systematic) risk.
According to CAPM, the non-diversifiable risk of an investment/security is
assumed in terms of the beta coefficient. Beta is a measure of the volatility of
a security's return relative to the returns of a broad-based market portfolio.
The beta for the market portfolio as measured by the broad-based market index
equals one. Beta coefficient of 1 would imply that the risk of the specified
security is equal to the market; the interpretation of zero coefficient is that
there is no market-related risk to the investment. A negative coefficient would
indicate a relationship in the opposite direction. The 'going' required rate of
return in the market for a given amount of systematic risk is called the Security
Market Line (SML). Beta can be calculated as follows :
COVim
βi = (7.17)
σ2m
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where βi is the beta of security i, COV im is the covaraince between the returns
of security and market portfolio m and σ 2m is the variance of returns on the
market portfolio m. In practice the following equation can be used to calculate
k e under CAPM :
K e = R f + B (R m - R f) (7.18)
where Ke = cost of equity capital
Rf = the rate of return required on a risk-free asset/security/
investment
Rm = the required rate of return on the market portfolio of assets
that can be viewed as the average rate of return on all assets.
B = the beta coefficient
Example 7.10 : To illustrate the SML approach, let us assume that Rf = 10 per
cent and R M =18 per cent. The required return on equity stocks of companies
with different betas is given below.
Beta Required return = R f + βE (R M - R f )
0.5 10 + 0.5 (18-10) = 14%
1.0 10 + 1.0 (18-10) = 18%
1.5 10 + 1.5 (18.10) = 22%
To use the SML, the following inputs are required : R f , the risk-free rate; (R M
- R f ) the market risk premium, and βE the beta of the stock.
The CAPM has wider applications and it is determined in an objective manner
by using sound statistical methods. One practical problem with the use of beta,
however, is that it does not probably remain stable over time.
7.5 WEIGHTED AVERAGE COST OF CAPITAL(WACC)
After calculating the component costs they are multipled by the weights of the
various sources of capital to obtain a weighted average cost of capital (WACC).
The composite, or overall cost of capital is the weighted average of the costs of
various sources of funds, weights being the proportion of each source of funds in
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the capital structure. It should be remembered that it is the weighted average concept,
not the simple average, which is relevant in calculating the overall cost of capital.
The simple average cost of capital is not appropriate to use because firms hardly
use various sources of fund equally in the capital structure.
The following steps are involved to calculate the weighted average cost of
capital:
• Calculate the cost of the specific sources of funds (i.e. cost of debt,
cost of equity, cost of preference capital etc.)
• Multiply the cost of each source by its proportion in the capital structure.
• Add the weighted component costs to get the firm's weighted average
cost of capital
Example 7.11 : The market value proportions and cost of capital of equity,
preference, and debt are :
E/V = 0.60 ke = 16.0%
P/V = 0.05 kP = 14.0%
D/V = 0.35 kd = 12.0%
The corporate tax rate, T c is 30 per cent.
The WACC for Bharat Nigam Limited is calculated in Table 7.1.
Table 7.1 : Calculation of the WACC for Bharat Nigam Limited
Source of Capital Proportion Cost Weighted Cost
(1) (2) [(1)×(2)]
Equity 0.60 16.0% 9.60%
Preference 0.05 14.0% 0.70%
Debt 0.35 8.4% 2.94%

Thus, given the cost of specific sources of financing and the scheme of
weighting, the weighted average cost of capital (WACC) can be readily
calculated by multiplying the specific cost of each source of financing by its
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proportion in the capital structure and adding the weighted values. In symbols,
the weighted average cost of capital may be expressed as follows :
E P D
WACC = ke + kp + k (1-T c)
V V V d
where WACC = weighted average cost of capital
E = market value of equity
V = market value of the firm
ke = cost of equity
P = market value of preference
kp = cost of preference
D = market value of debt
kd = cost of debt
Tc = corporate tax rate
Example 7.12 : (Book Value Weights)
A firm's after-tax cost of capital of the specific sources is as follows :
Cost of debt 8 per cent
Cost of preference shares 14 per cent
Cost of equity funds 17 per cent
The following is the capital structure :
Source Amount
Debt Rs. 3,00,000
Preference capital 2,00,000
Equity capital 5,00,000
10,00,000
Calculate the weighted average cost of capital, k 0 , using book value
weights.

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Solution :
Table : Computation of Weighted Average Cost of Capital (Book value weights)
Sources of funds Amount Proportion Cost Weighted cost
(%) (3×4)
(1) (2) (3) (4) (5)
Debt Rs. 3,00,000 0.3 (30) 0.08 0.024
Preference capital 2,00,000 0.2 (20) 0.14 0.028
Equity Capital 5,00,000 0.5 (50) 0.17 0.085
10,00,000 1.00 (100) 0.137
Weighted average cost of capital = 13.7 per cent
Book-Value VS, Market-Value Weights
The weighted cost of capital can be computed by using the book-value or the
market-value weights. If there is a difference between the book-value and
market-value weights, the weighted average cost of capital would differ
according to the weights used. The weighted average cost of capital calculated
by using the book-value weights will be understated if the market-value of the
share is higher than the book-value and vice-versa.
Illustration : Suppose in example 7.12 the firm has 40,000 equity shares
outstanding and that the current market price per share is Rs. 20. Assume that
the market-values and the book-values of the debt and the preference capital
are same. If the component costs are the same as before, the market-value
weighted average cost of capital would be :

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Table : Computation of Weighted Average Cost of Capital (Market-Value
Weights)
Source Amount (Rs.) Proportion After-tax Cost Weighted Cost
(1) (2) (3) (4) (5)=(3)×(4)
Equity capital (Rs.40,000)
share @ Rs. 20) 8,00,000 0.615 0.18 0.1107
Preference capital 2,00,000 0.154 0.11 0.0169
Debt 3,00,000 0.231 0.08 0.0180
13,00,000 1,000 k0 = 0.1456
It should be noted that the equity capital of the firm is the total market-value
of the ordinary shares outstanding which includes retained earnings (reserves).
It is obvious that the market value weighted cost of capital (14.56%) is higher
than the book-value weighted cost of capital (13.7%), because the market-
value of equity share capital (Rs. 8,00,000) is higher than its book-value (Rs.
5,00,000).
Besides the simplicity of their use, the book-value weights are said to have the
following advantages :
• Firms in practice set their capital structure targets in terms of book-
values.
• The book-value information can be easily derived from the published
sources.
• The book-value debt-equity ratios are analysed by investors to evaluate
the riskiness of the firms in practice.
The use of the book-value weights can be seriously questioned on theoretical grounds.
First, the component costs are opportunity rate and are determined in the capital markets.
The weights should also be market-determined. Second, the book-value weights are
based on arbitrary accounting policies that are used to calculate retained
earnings and value of assets. Thus, they do not reflect economic values. It is
very difficult to justify the use of the book-value weights in theory.
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Market-value weights are not influenced by accounting policies. They are also
consistent with the market-determined component costs. The difficulty in using
market-value weights is that the market prices of securities fluctuate widely
and frequently.
7.6 WEIGHTED MARGINAL COST OF CAPITAL SCHEDULE
At the outset we assumed, inter alia, that the adoption of new investment
proposals will not change either the risk complexion or the capital structure
of the firm. Does it mean that the weighted average cost of capital will remain
the same irrespective of the magnitude of financing? Apparently not. Generally,
the weighted average cost of capital tends to rise as the firm seeks more and
more capital. This happens because the supply schedule of capital is typically
upward sloping - as suppliers provide more capital, the rate of return required
by them tends to increase. A schedule or graph showing the relationship between
additional financing and the weighted average cost of capital is called the
weighted marginal cost of capital schedule.
Determining the Weighted Marginal Cost of Capital Schedule
The procedure for determining the weighted marginal cost of capital involves
the following steps :
1. Estimate the cost of each source of financing for various levels of its
use through an analysis of current market conditions and an assessment
of the expectations of investors and lenders.
2. Identify the levels of total new financing at which the cost of the new
components would change, given the capital structure policy of the firm.
These levels, called breaking points, can be established using the
following relationship.
TF j
BP j =
Wj
where BPj = breaking point on account of financing source j
TFj = total new financing from source j at the breaking point
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 Wj = proportion of financing source j in the capital structure
3. Calculate the WACC for various ranges of total financing between the
breaking points.
4. Prepare the weighted marginal cost of capital schedule which reflects
the WACC for each level of total new financing.
Illustration :
To illustrate the preparation of the weighted marginal cost of capital schedule,
let us consider an example. Shiva chemicals Limited wishes to use equity,
preference, and debt capital in the following proportions :
Equity : 0.45
Preference : 0.05
Debt : 0.50
Cost of Each Source of Financing for Various Levels of its Use : Based on
its discussions with its merchant bankers and lenders Shiva Chemicals Limited
estimates that the cost of each of its three sources of financing for various
levels of usage as given in Table 7.2.
Breaking Points : Given the target capital structure proportions and the
financing ranges for each source of finance, the breaking points for each source
of finance and the corresponding ranges of total new financing are given in
columns 3 and 4 of Table 7.2 :
Table 7.2 : Data for Calculating the Weighted Marginal Cost of Capital
(MWCC) Schedule for Shiva Chemicals
Source of capital Target Proportion Range of New Financing Cost
Equity 45% 0-10 15%
10-30 16.50
30 and above 18.00
Preference 5% 0-1 14.50

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 1 and above 15.00
Debt 50% 0-15 7.50
15-40 8.0
40 and above 8.40
* These ranges are for the respective sources of financing and not for total
new financing
Table : Determination of Breaking Points and the Resulting Ranges of Total New
Financing for Shiva Chemicals Limited
Source of Cost Range of New Financing Breaking Point Range of Total New
Capital (%) (Rs. in million) (Rs. in million) Financing
(Rs. in million)
(1) (2) (3) (4)
Equity 15.00 0-10 10/0.45=22.22 0-22.22
16.50 10-30 30/0.45=66.67 22.22-66.67
18.00 30 and above – 66.67 and above
Preference 14.50 0-1 1/0.05 = 20.00 0 - 20.00
15.00 1 and above – 20.00 and above
Debt 7.50 0-15 15/0.50=30.00 0 - 30.00
8.00 15-40 40/0.50=80.00 30.00-80.00
8.40 40 and above – 80.00 and above
WACC for Various Ranges of total New Financing : An examination of column 4 of
above table shows that the firm's weighted average cost of capital will change at Rs.
20.00, Rs. 22.22, Rs. 30.00, Rs. 66.67, and Rs. 80.00 million of total new financing.
Exhibit 12.4 shows the calculation of the weighted average cost of capital over three
ranges.
Weighted Marginal Cost of Capital Schedule : The weighted marginal cost of capital
schedule is shown in the following table. It is represented graphically in Exhibit 7.1.

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WACC for Various Ranges of Total New Financing for Shiva Chemicals Limited
Range of Total Source of Capital Proportion Cost Weighted Cost(%)
New Financing (%) [(2) × (3)]
(Rs in million) (1) (2) (3) (4)
0-20.00 Equity 0.45 15.00 6.750
Preference 0.05 14.50 0.725
Debt 0.50 7.50 3.750
Weighted average cost of capital 11.225
20.00-22.22 Equity 0.45 15.00 6.750
Preference 0.05 14.50 0.750
Debt 0.50 7.50 3.750
Weighted average cost of capital 11.250
22.22-30.00 Equity 0.45 16.50 7.425
Preference 0.05 15.00 0.750
Debt 0.50 7.50 3.750
Weighted average cost of capital 11.925
30.00-66.67 Equity 0.45 16.50 7.425
Preference 0.05 15.00 0.750
Debt 0.50 8.00 4.000
Weighted average cost of capital 12.175
66.67-80.00 Equity 0.45 18.00 8.100
Preference 0.05 15.00 0.750
Debt 0.50 8.00 4.000
Weighted average cost of capital 12.850
80.00 and above Equity 0.45 18.00 8.100
Preference 0.05 15.00 0.750
Debt 0.50 8.40 4.200
Weighted average cost of capital 13.050

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 Exhibit 7.1 : Weighted Marginal cost of Capital Schedule
Range of Total Financing Weighted Marginal Cost of
(Rs. in million) capital (%)
0-20.00 11.225
22.00-22.22 11.250
22.22-30.00 11.925
30.00-66.67 12.175
66.67-80.00 12.850
80.00 and above 13.050

Exhibit Weighted Marginal Cost of Capital Schedule

13
weighted
marginal cost 12
of capital (%)

11

0 20 40 60 80 Financing (Rs. in million)

7.8 SUMMARY
The cost of capital is an important element in capital expenditure management. In
operational terms, the cost of capital is a discount rate that is used in determining the
present value of future cash flows. Conceptually, it is the minimum rate of return that a
firm must earn on its investments to keep its market value unchanged. It consists of
three elements : (i) the riskless cost of a particular form of financing (rf); (ii) the business
risk premium (b) and (iii) the financial risk premium (f).
The cost of capital means the weighted average cost of capital (k0) of all long-term
sources of finance. It comprises of several components in terms of specific cost of
each source of finance. When these specific costs are combined, it is known as the
overall/composite/combined cost of capital.
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There are four types of specific costs, namely, cost of debt (kd ), cost of
preference shares (k p), cost of equity capital (k e) and cost of retained earnings
(k r).
The cost of debt is on after-tax basis and its measurement depends on whether
it is perpetual or redeemable. While, in the former situation the cost is
determined in terms of the only interest out go, the repayment of the loan
either in instalments or in lump sum on maturity is also taken into account in
the later situation. The cost of debt is generally the lowest among all sources
partly because the risk involved is low but mainly because interest paid on
debt is tax liability.
There are two approaches to measure cost of equity ke : (i) the dividend valuation
model approach and (ii) capital asset pricing model (CAPM) approach. Both
the approaches faces problems in its application since the required data may
not be available in readily usable form.
The cost of retrained earning (k r ) is equally difficult to calculate in theoretical
terms. Since retained earnings essentially involves use of funds, it is associated
with an opportunity/implicit cost. The alternative to retained earnings is the
investment of the funds by the firm itself in a homogenous outside investment.
Therefore, k r , is equal to k e. However, it might be slightly lower than k e in the
case of new equity issue due to floatation costs.
Firms obtain their supply of capital for financing their investments in the form
of equity or debt or both. Also, in practice, they maintain a target debt-equity
mix. Therefore, the firm's cost of capital means the weighted average cost of
debt and equity. Three steps are involved in calculating the firm's weighted
average cost of capital (WACC). First, the component costs of debt and equity
are calculated. Second, weights to the each component of capital assigned in
proportion of its amount in the capital structure. Third, the product of
component costs and weights is summed up to determine WACC. The weighted
average cost of new capital is called the marginal cost of capital (MCC).
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7.9 SOLVED PROBLEMS
1. Assuming that a firm pays tax at a 50 per cent rate, compute the after-
tax cost of capital in the following cases :
(i) A ten-year, 8 per cent, Rs. 1000 per bond sold at Rs. 950 less 4 per cent
underwriting commission.
(ii) A preference share sold at Rs. 100 with a 9 per cent dividend and a
redemption price of Rs. 110 if the company redeems it in five years.
(iii) An ordinary share selling at a current market price of Rs. 120, and paying
a current dividend of Rs. 9 per share which is expected to grow at a rate
of 8 per cent.
(iv) An ordinary share of a company which engages no external financing is
selling for Rs. 50. The earnings per share are Rs. 7.50 of which sixty
per cent is paid in dividends. The company reinvests retained earnings
at a rate of 10 per cent.
Solution :
(i) The after-tax cost of bond is (using approximate method) :
1
(1-T)[INT+n (F-B0)] (1-0.5) [Rs. 80 +1/10 (Rs. 1000- Rs. 950)]
=
1/2 (F + B0) 1/2 (Rs 1000 + Rs 950)

(1-0.5) [Rs. 80 +1/10 (Rs. 50)] (1-0.5)(Rs.85)

= = Rs. 975
1/2 (Rs. 1950)
Rs. 4250
= = 0.0436 or 4.36%
Rs. 975
Note :Flotation costs such as underwriting commission should be adjusted to
the project's cash flows.
n 9 110
(ii) 100 = Σ +
t =1 (1+k p ) t (1+k p )5
By trial and error, we find k p = 0.105 or 10.5%
D1 Rs 9(1.08) Rs 9.72
(iii) ke +g = + 0.08 = + 0.08
P0 Rs 120 Rs 120
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 = 0.081 + 0.08 = 0.161 or 16.1%
EPS (1-b)
(iv) P0 =
k e - br

EPS (1-b) Rs 7.50(1-0.4)

ke = + br = + 0.10 ×0.4
P0 Rs 50
Rs 4.50
= + 0.04 = 0.09 + 0.04 = 0.13 or 13 per cent
Rs 50.00
2. Suppose that dividend of firm is expected to be Re. 1 per share next
year and is expected to grow at 6 per cent per year perpetually. Determine the
cost of equity capital, assuming the market price per share is Rs. 25.
Solution : This is a case of constant growth of expected dividends. The k e can
be calculated by using the following equation :
D1 Re. 1
ke = +g = + 0.06 = 10 per cent
P0 Rs. 25
The dividend approach can be used to determine the expected market value of
a share in different years. The expected value of share at the end of years 1 and
2 would be as follows, applying Eq. 7.13
D2 Rs 1.06
(i) Price at the end of the first year (P 1) = =
ke - g 0.10-0.06
= Rs. 26.50
D3 Rs 1.124
(ii) P2 = = = Rs. 28
ke - g 0.10-0.06
3. The following information is available in respect of company X :
(i) Current dividend per share, Rs. 2.
(ii) Current market price per share, Rs. 75.
(iii) Compound growth rates of dividends :
1-5 years 15 per cent
6-10 years 10 per cent
11 years and beyond 5 per cent

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What would the cost of its equity capital be, assuming a fixed dividend pay out
ratio?
Solution :
The cost of equity capital would be obtained by solving for k e in the following
equation, as it is a case of different growth rates in expected dividends :
5 D 0(1.15) t 10 D 5(1.10) t-5 ∞ D 10 (1.05) t-10
P0 = Σ + Σ + Σ = k e = 9.5 per cent.
t =1 (1+k e) t t =6 (1+ke )t t=11 (1+k e) t
4. Shiva Chemicals plans to use equity and debt in the following proportions:
Equity : 40
Debt : 60
Based on its discussion with its merchant bankers and lenders, Shiva
Chemicals estimates the cost of its sources of finance for various levels of
usage as follows :
Source of Finance Range of New Financing Cost
(Rs. in million) (%)
Equity 0-30 18
More than 30 20
Debt 0-50 10
More than 50 11
Determine the weightage marginal cost of capital schedule for Shiva Chemicals.
Solution : The breaking points and the resulting range of total new financing
for Shiva Chemicals are as follows :

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Source of Cost Range of new Breaking point Range of total
capital financing (Rs. in million) new financing
(Rs in million) (Rs in million)
(1) (2) (3) (4)
Equity 18% 0-30 30/0.4=75 0-75
20% Above 30 – Above 75
Debt 10% 0-50 50/0.6=83.3 0-83.3
11% Above 50 – Above 83.3
The weightage average cost of capital for various range of total financing for
Shiva Chemicals is as follows :
Range of total Source of capital Proportion Cost % Weighted cost %
new financing [(2) × (3)]
(Rs in million)
(1) (2) (3) (4)
0-75 Equity 0.4 0.18 .072
Debt 0.6 0.10 .060
Weighted average .132
cost of capital
75-83.3 Equity 0.4 0.20 .080
Debt 0.6 0.10 .060
Weighted average .140
cost of capital
83.3 and above Equity 0.4 0.20 .080
Debt 0.6 0.11 .066
Weighted average .146
cost of capital

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 The weighted marginal cost of capital schedule is as shown below :
Range of total financing Weighted marginal cost of capital
(Rs. in million) (%)
0-75 13.2
75-83.3 14.0
83.3 and above 14.6

5. Consider the following figures pertaining to risk free rate, market rate
and return rate of a security of A Ltd. during the last 6 years.
Year risk-free rate (R f) Market rate (R m) Security return (R j)
1 0.06 0.14 0.08
2 0.05 0.03 0.11
3 0.07 0.21 0.29
4 0.08 0.26 0.25
5 0.09 0.03 007
6. 0.07 0.11 0.04

On the basis of the above information, you are required to determine the cost
of equity capital in the context of CAPM. Past data may be taken as proxy for
the future.
Solution :
Year risk-free Market Excess in Security Excess in Cross
rate(Rf) return market (M)2 return security product
returns return
(Km) (M) (Rj) (J) (MJ)
[col.3-col.2] [col.6-col.2] [col.4×col.7]
1 2 3 4 5 6 7 8
1 0.06 0.14 0.08 0.0064 0.08 0.02 0.0016
2 0.05 0.03 (0.02) 0.0004 0.11 0.06 (0.0012)
3 0.07 0.21 0.14 0.0196 0.29 0.22 0.0308
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4. 0.08 0.26 0.18 0.0324 0.25 0.17 0.0306
5. 0.09 0.03 (0.06) 0.0036 0.07 (0.02) 0.0012
6. 0.07 0.11 0.04 0.0016 0.04 (0.03) (0.0012)
Total 0.42 0.78 0.36 0.0640 0.42 0.0618
Average
return 0.07 0.13 0.06 – 0.07 –
Figures in brackets represent negative returns
ΣMJ - NMJ 0.0618 - 6(0.06 ×0.07) 0.0366
b = = = = 0.863
ΣM - NM
2 2
0.0640 - 6×(0.06)2 0.0424
ke = R f + b (k m - R f) = 0.07 + 0.863 (0.13 - 0.07) = 12.18 per cent

7.10 SELF ASSESSMENT QUESTIONS

1. Define cost of capital? Explain its significance in financial decision
making.
2. How is the cost of debt computed? How does it differ from the cost of
preference capital?
3. "The equity capital is cost free". Do you agree? Give reasons
4. Explain why :
(a) The cost of preference shares is less than the cost of equity.
(b) The cost of retained earnings is less than the cost of new equity.
(c) The cost of equity and retained earnings is not zero.
(d) The cost of capital is most appropriately measured on an after-
tax basis.
5. Explain the problems faced in determining the cost of capital. How is
the cost of capital relevant in capital budgeting decisions?
6. Examine critically the different approaches to the calculation of cost
of equity capital.
7. What is the CAPM approach for calculating the cost of equity? What is
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 the difference between this approach and the constant growth approach?
Which one is better and why?
8. How is the weighted average cost of capital calculated? What weights
should be used in its calculation?
9. Distinguish between the weighted average cost of capital and the marginal
cost of capital. Which one should be used in capital budgeting and
valuation of the firm? Why?
10. Discuss the approach to determine the cost of retained earnings. Also
explain the rationale behind treating retained earnings as a fully
subscribed issue of equity shares.
11. Calculate the explicit cost of debt for each of the following situations:
(a) Debentures are sold at part and flotation costs are 5 per cent
(b) debentures are sold at premium of 10 per cent and flotation costs
are 5 per cent of issue price.
(c) Debentures are sold at discount of 5 per cent and flotation costs
are 5 per cent of issue price.
Assume: (i) coupon rate of interest on debentures is 15 per cent; (ii)
face value of debentures is Rs. 100; (iii) maturity period is 10
years; and (iv) tax rate is 35 per cent.
12. A company issues new debentures of Rs. 20 lakh, at par, the net proceeds
being Rs. 18 lakh. It has a 13.5 per cent rate of interest and 7 year
maturity. The company's tax rate is 52 per cent. What is the cost of
debenture issue? What will be the cost in 4 years if the market value at
that time is Rs. 22 lakh?
13. A company has 1,00,000 shares of Rs. 100 at par of preference shares
outstanding at 9.75 per cent dividend rate. The current market price of
the preference share is Rs. 80. What is its cost?
14. A firm has 80,00,000 ordinary shares outstanding. The current market
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 price is Rs. 25 and book value is Rs. 18 per share. The firm's earnings
per share are Rs. 3.50 and dividend per share is Rs. 1.44. What is the
growth rate assuming that the past performance will continue? Calculate
the cost of equity capital.
15. An investor is contemplating the purchase of equity shares of a company
which had paid a dividend of Rs. 5 per share last year. The dividends are
expected to grow at 6 per cent for ever. The required rate of return on
the shares of this company in the capital market is 12 per cent. What
will be the maximum price you will recommend the investor to pay for
an equity share of the company? Will your answer be different if he
wants to hold the equity share for 3 years and 6 years?
16. A mining company's iron ore reserves are being depleted, and its cost
of recovering a declining quantity of iron ore are rising each year. As a
consequence, the company's earnings and dividends are declining, at a
rate of 8 per cent per year. If the previous year's dividend was Rs. 10 and
the required rate of return is 15 per cent, what would be the current
price of the equity share of the company?
17. A company is contemplating an issue of new equity shares. The firm's
equity shares are currently selling at Rs. 125 a share. The historical pattern
of dividend payments per share, for the last 5 years is given below :
Year Dividend
1 Rs. 10.70
2 Rs. 11.45
3 Rs. 12.25
4 Rs. 13.11
5 Rs. 14.03
The flotation costs are expected to be 3 per cent of the current selling
price of the shares. You are required to determine the following :
(a) growth rate in dividends;
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(b) cost of equity, assuming growth rate determined under situation (i)
continues for ever ;
(c) cost of new equity shares.
18 The Sewing Company has the following capital structure on 30 June
1998 :
Ordinary shares (200,000 shares) Rs. 40,00,000
10% Preference shares 10,00,000
14% Debentures 30,00,000
80,00,000
The share of the company sells for Rs. 20. It is expected that company will pay
next year a dividend of Rs. 2 per share which will grow at 7 per cent forever.
Assume a 50 per cent tax rate.
(a) Compute a weighted average cost of capital based on the existing capital
structure.
(b) Compute the new weighted average cost of capital if the company raises
an additional Rs. 20 lakh debt by issuing 15 per cent debenture. This
would result in increasing the expected dividend to Rs. 3 and leave the
growth rate unchanged, but the price of share will fall to Rs. 15 per
share.
(c) Compute the cost of capital if in (b) above growth rate increases to 10
per cent.
7.11 SUGGESTED READINGS
1. Prasanna Chandra : Financial Management, Tata McGraw Hill
2. I.M. Pandey : Financial Management, Vikas Publishing House
3. John J. Hampton : Financial Decision Making, PHI
4. Khan and Jain : Financial Management, Tata McGraw Hill
5. Bhattacharya, S.K., A Cost-of-Capital Framework for Management
Control, Economic and Political Weekly, Vol. 35, 29 August, 1970.
✪✪✪
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 LESSON – 8

LEVERAGES

Objective: The main objective of this lesson is to make the students learn about the
basic concepts of leverages with reference to operating, financial and composite
leverages.
STRUCTURE
8.1 Backdrop
8.2 Meaning of Leverage
8.3 Types of Leverage
8.3.1 Operating Leverage
8.3.2 Financial Leverage
8.3.3 Composite Leverage
8.4 Significance of Financial and Operative Leverages
8.5 Comprehensive Illustrations
8.6 Summary
8.7 Self- Assessment Exercise
8.8 Suggested Readings
8.1 Backdrop
It is pretty apparent fundamental that an organization may raise funds required for
investment either by increasing the owner’s claims or the creditors claims or a mix of
the both. The claim of the owners increase when the company raises funds by issuing
equity shares or ploughs back its earnings. The claims of the creditors increase when
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the funds are raised by borrowing. The various means used to raise the funds represent
the financial or the capital structure of the company.
The financing or capital structure decision is of fabulous significance for the manage-
ment, as it influences the debt-equity blend of the company, which ultimately affects
shareholders return and risk. In case, the borrowed funds are more as compared to the
owner’s funds, it results in increase in shareholders earnings together with increase in
their risk. This is because the cost of borrowed funds is less than that of the sharehold-
ers funds on account of cost of borrowed funds being permissible as a deduction for
income-tax purposes. But at the same time, the borrowed funds carry a preset interest,
which has to be paid whether the company is earning profits or not. Thus, the risk of
the shareholders increases in case there are a high proportion of borrowed funds in the
total capital structure of the company. In a situation where the percentage of the share-
holders funds is more than the fraction of the borrowed funds, the return as well as the
risk of the shareholders will be much less.
In the present lesson, we are discussing the special effects of financing or debt, equity
mix on the shareholders earnings and risk. The theory of leverages helps in probing
this facet.
8.2 Meaning of Leverage
The dictionary sense of the term leverage refers to “an increased means of accom-
plishing some purpose.” For example, leverage helps us in lifting heavy objects, which
may not be otherwise feasible. Nevertheless, in the area of finance, the term leverage
has a special connotation. It is used to describe the firm’s ability to use fixed cost
assets or funds to blow up the return to its owners.
James Van Horne has defined leverage as “the employment of an asset or funds for
which the firm pays a fixed cost or fixed return.” Thus, according to him, leverage
results as an outcome of the firm employing an asset or source of funds, which has a
fixed charge (or return). The former may be termed as “fixed operating cost”, while
the latter may be termed as “fixed financial cost”. It should be noted that fixed cost or
return is the pivot of leverage. If it is not obligatory for a firm to pay fixed cost or
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fixed return, there will be no leverage. Since fixed cost or return has to be paid or
incurred irrespective of the level of output or sales, the size of such cost or return has
substantial influence over the amount of profits available for the shareholders. When
the level of sales changes, leverage helps in quantifying such influence. It may there-
fore be defined as relative change in profits due to a change in sales. A high degree of
leverage implies that there will be a stout change in profits due to a relatively minute
change in sales and vice versa. Thus, higher is the leverage, higher is the risk and higher
is the expected return.
8.3 Types of Leverages
Leverages are of three types: (i) Operating leverage, (ii) Financial leverage and (iii)
Composite leverage. Let us discuss these leverages taking one by one.
8.3.1 Operating Leverage
The operating leverage may be defined as the tendency of the operating profit to vary
disproportionately with sales. It is assumed to exist when a firm has to pay fixed cost
regardless of level of output or sales. The firm is said to have a high degree of operat-
ing leverage if its employs a greater amount of fixed costs and a small amount of
variable costs. On the other hand, a firm will have a low operating leverage when it
employs a greater amount of variable costs and a smaller amount of fixed costs. Thus,
the degree of operating leverage depends upon the amount of fixed elements in the
cost structure. Operating leverage in a firm is a function of three factors:
1. The amount of fixed costs.
2. The contribution margin.
3. The volume of sales.
Of course, there will be no operating leverage, if there are no fixed operating costs.
Computation of Operating Leverage: The operating leverage can be calculated by
the following formula:
Contribution [C]
Operating Leverage = ————————— or C/OP
Operating Profit [OP]
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Operating profit here means “Earning Before Interest and Tax” (EBIT).
Operating leverage may be favourable or unfavourable. In case the contribution (i.e.,
sales less variable cost) exceeds the fixed cost, there is favourable operating leverage.
In a reverse case, the operating leverage will be termed as unfavourable.
Degree of operating leverage. The degree of operating leverage may be defined as
percentage change in the profits resulting from a percentage change in the sales. It
may be put in the form of following formula:

Percentage change in operating profits

Degree of operating leverage = —————————————————
Percentage change in sales

Usefulness: The operating leverage indicates the impact of change in sales on operat-
ing income. If a firm has a high degree of operating leverage, small changes in sales
will have large effects on operating income. In other words, the operating profits [EBIT]
of such a firm will increase at a quicker rate than the increase in sales. Similarly, the
operating profits of such a firm will suffer a greater loss as compared to reduction in
its sales. Generally, the firms do not like to operate under conditions of a high degree
of operating leverage. This is a very risky situation where a small jump down in sales
can be excessively damaging to the firms efforts to achieve profitability.
The concept of operating leverage will be apparent with the help of the following
illustration:
Illustration 8.1
The installed capacity of a factory is 600 units. Actual capacity used is 400 units.
Selling price per unit is Rs.10 and Variable cost is Rs. 6 per unit. Calculate the operating
leverage in each of the following three situations:
1. When fixed costs are Rs.400.
2. When fixed costs are Rs.1, 000.
3. When fixed costs are Rs.1, 200.

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Solution:
STATEMENT SHOWING OPERATING LEVERAGE

Situation Situation Situation

1 2 3
(i) Sales Rs.4000 4000 4000
(ii) Variable cost 2400 2400 2400
(iii) Contribution (i-ii) 1600 1600 1600
(iv) Fixed cost 400 1000 1200
(v) Operating profit 1200 600 400
(iii-iv)
(vi) Operating 1600/1200 1600/600 1600/400
Leverage[C/OP]
= 1.33 2.67 4

The above illustration shows that the degree of operating leverage increases with every
increase in share of fixed cost in the total cost structure of the firm. It shows, for
example, in situation ‘3’ that if sales increase by rupee one, the profit would increase
by Rs.4. This can be verified by taking situation ‘3’ when sales increase to Rs.8000,
the profit in such an event will be as follows:
Sales 8000
Variable cost 4800
Contribution 3200
Fixed cost 1200
Profit 2000
Thus, the sales have increased from Rs.4000 to Rs.8000, i.e. a hundred percent in-
crease. The operating profits have increased from 400 to Rs.2000, i.e. by Rs.1600
(giving an increase of 400 percent). The operating leverage is 4 in case of situation
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‘3’, which indicates that with every increase of one rupee in sales the profit will in-
crease four times. This has been verified by the above illustration where a hundred
percent increase in sales has resulted in 400 percent increase in profits. The degree of
operating leverage may, therefore, be put as follows:
Degree of operating leverage = %age change in operating income/%age change in
sales
= 400/100
= 4
As a matter of fact, operating leverage exists only when the quotient in the above
equation exceeds one.
8.3.2 Financial Leverage
The financial leverage may be defined as the propensity of the residual net income to
vary disproportionately with operating profit. It indicates the change that takes place
in the taxable income as a result of change in the operating income. It signifies the
survival of fixed interest/fixed dividend bearing securities in the total capital structure
of the company. Thus, the use of fixed interest/dividend bearing securities such as
debt and preference capital along with the owners’ equity in the total capital structure
of the company is described as financial leverage. Where in the capital structure of the
company, the fixed interest, the leverage is said to be larger. In a reverse case the
leverage will be said to be smaller.
Favourable and unfavourable financial leverage: Financial leverage may be
favourable or unfavourable depending upon whether the earnings made by the use of
fixed interest or dividend bearing securities exceeds the explicit fixed cost, the firm
has to pay for the employment of such funds, or not. The leverage will be considered
to be favourable if the firm earns more on assets purchased with the funds than the
fixed costs of their use. Unfavourable or negative leverage occurs when the firm does
not earn as much as the funds cost.
Trading on equity and financial leverage: Financial leverage is also sometimes

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termed as “trading on equity”. However, most of the scholars on financial management
are of the opinion that the term trading on equity should be used for the term financial
leverage only when the financial leverage is favourable. The company resorts to trad-
ing on equity with the objective of giving the equity shareholders a high rate of return
than the general rate of earning on capital employed in the company, to compensate
them for the risk that they have to swallow. For example, if a company borrows Rs.1000
at 9% interest per annum, and earns a return of 14% the balance of Rs.5 per annum
after payment of interest will belong to the shareholders and thus they can be paid a
higher rate of return that than general rate of earning of the company. But in case the
company could earn a return of only 7% on Rs. 1000 employed by it, the equity share-
holders loss would be Rs.2 per annum. Thus, the financial leverage is a double-edged
blade. It has the potentiality of increasing the return to equity shareholders, but at the
same time creates additional risk for them. Mr. Waterman in his Essays on Business
Finance has magnificently described the role of financial leverage in the following
words: “This role of financial leverage suggests a lesson in Physics, and there might be
some point to considering the rate of interest paid as the fulcrum used in applying
forces through leverage. At least it suggests consideration of pertinent variables; the
lower the interest rate, the greater will be the profit and take away the chances of loss.
The less the amount borrowed, the lower will be the profit or loss; also a greater the
borrowing the greater the risk of unprofitable leverage and greater the chances of gain.”
Computation of Financial Leverage: The computation of financial leverage can be
done according to the following methods:
(i) Where capital structure consists of equity shares and debt:
In such a case, financial leverage can be calculated according to the following
formula:
Financial leverage = OP / PBT
Where, OP = Operating profit or earning before interest and tax. (EBIT)
PBT = Profit before tax but after interest.

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Illustration 8.2
A company has any choice of the following three financial plans. You are required to
calculate the financial leverage in each case and interpret it.
X Y Z
Equity Capital 2000 1000 3000
Debt 2000 3000 1000
Operating Profit (EBIT) 400 400 400
Interest @ 10% on debt in all cases and tax rate 50% only.

Solution:
The financial leverage will be computed as follows in case of each of these financial
plans:

X Y Z
Operating Profit (OP) 400 400 400
Interest (10% on debt) 200 300 100
Profit before tax PBT 200 100 300
Financial leverage 400/200 400/100 400/300
= 2 4 1.33

Financial leverage, as explained earlier, indicates the change that will take place in the
taxable income as a result of change in the operating income. For example, taking
Financial Plan X as the basis, if the operating profit decreases to Rs.200, its impact on
taxable income will be as follows:
Operating Profit (OP or EBIT) Rs. 200
Less: Interest Rs. 200
Profit before tax PBT NIL
Financial leverage in case of plan X is 2. It means every 1% change in operating profit
will result in 2% change in the taxable profit. In the above case operating profit has
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decreased from Rs.400 to Rs.200 (i.e. 5% decrease), as a result the taxable profit has
decreased from Rs.200 to zero 100% decrease.
Degree of Financial leverage. Degree of financial leverage may be defined as the
percentage change in taxable profit as a result of percentage change in “operating profit”.
This may be put in the form of following equation:
Percentage change in taxable income
Degree of financial leverage (DFL) =
Percentage change in operating income

For example, in the above case the degree of financial leverage will be “2” calculated
as follows:
100/50 = 2
It should be noted that financial leverage exists only when the quotient as per the above
equation is more than one.
(ii) Where the capital structure consists of preference shares and equity
shares. The formula for computation of financial leverage can also be applied
to a financial plan having preference shares. Of course, the amount of prefer-
ence dividends will have to be grossed up (as per the tax rate applicable to the
company) and then deducted from the earnings before interest and tax.

Illustration 8.3
The capital structure of a company consists of the following securities:
10% Preference share capital Rs.100000
Equity share capital (Rs. 10/- shares) Rs.100000
The amount of operating profit is Rs. 60,000. The company is in 50% tax bracket.
You are required to calculate the financial leverage of the company. What would be
new financial leverage if the operating profit increase to Rs.90000 and read between
the lines your results.

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Solution:
COMPUTATION OF THE PRESENT FINANCIAL LEVERAGE
Operating profit (OP or EBIT) Rs.60, 000
Less: Preference dividend (after grossing up) Rs.20, 000
PBT Rs.40, 000
Present Financial Leverage = OP/PBT = 60000/40000 = 1.5

COMPUTATION OF NEW FINANCIAL LEVERAGE

New operating Profit Rs.90000
Less: Preference Dividend (after grossing up) Rs.20000
PBT Rs.70000
Financial Leverage = OP/ PBT = 90000/70000 = 1.286
The existing financial leverage is 1.5. It means 1% change in operating profit (OP or
EBIT) will cause in taxable profit (PBT) in the same direction. For example, in the
present case operating profit has increased by 50% (i.e. from Rs. 60000 to Rs. 90000).
This has resulted in 75% increase in the taxable profit (i.e. from Rs. 40000 to Rs.
70000).
(iii) Where the capital structure consists of equity shares, preferences, shares
and debt.
In such a case the financial leverage is calculated for deducting from operating
profit both interest and preference dividend on a before tax basis.

Illustration 8.4
A company has the following capital structure:
Equity share capital Rs. 1,00,000
10% Preference share capital Rs. 1,00,000
8% Debentures Rs. 1,25,000
The present EBIT is Rs. 50,000. Calculate the financial leverage assuming that
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company is in 50% tax bracket.

Solution:
Operating Profit Rs. 50,000
Less: Interest on debenture Rs. 10,000
Pref. dividend (pre-tax basis) Rs. 20,000
Profit before tax Rs. 20,000
Financial leverage = OP/ PBT = 50,000/ 20,000 = 2.5
Alternative definition of financial leverage: One of the objectives of planning an
appropriate capital structure is to maximize the return on equity shareholder’s funds or
maximize the earning per share (EPS). Some scholars have used the terms “financial
leverage” in the context that it defines the relationship between EBIT and EPS.
According to Gitman, financial leverage is “the ability of a firm to use fixed financial
charges to blow up the effects of changes in EBIT on the firm’s earning per share”. The
financial leverage therefore indicates the percentage change in earning per share in
relation to a percentage change in EBIT.
The degree of financial leverage as per the above definition can be calculated according
to the following equation:
Percentage change in EPS
Degree of Financial Leverage = ———————————
Percentage change in EBIT
Of course, there will be no financial leverage according to the above equation if the
quotient does not exceed one.

Illustration 8.5
A company has the following capital structure;
10,000 Equity shares of Rs. 10 each Rs. 1,00,000
2,000 10% Prof. shares of Rs. 100 each Rs. 2,00,000
2,000 10% Debentures of Rs. 100 each Rs. 2,00,000

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Calculate the EPS for each of the following levels of EBIT:
(i) Rs. 1,00,000
(ii) (ii) Rs. 60,000
(iii) (iii) Rs. 1,40,000.
The company is in 50% tab bracket. Calculate also the financial leverage EBIT level
under (i) as base

Solution:
COMPUTATION OF EARNING PER SHARE
(i) (ii) (iii)
EBIT Rs. 1,00,000 60,000 1,40,000
Less: Interest on debenture 20,000 20,000 20,000
PBT 80,000 40,000 1,20,000
Less : Income Tax 40,000 20,000 60,000
PAT 40,000 20,000 60,000
Less: Preference dividend 20,000 20,000 20,000
Earning available for equity
Shareholders (EAS) 20,000 ——— 40,000
Earning per share (EPS) 2 Nil 4

The above table shows that (a) In case (ii) the EBIT has decreased by 40% (i.e. from Rs.
1,00,000 to Rs. 60,000 while the earning per share has decreased by 100% (from Rs.
2 per share to nil); (b) In case (iii) the EBIT has increased by 40% (from Rs. 1,00,000
to Rs. 1,40,000 as compared to case (i), while the earning per share has increased by
100% (from Rs. 2 to Rs. 4).
The degree of financial leverage can therefore be computed as follows:
DFL= Percentage change in EPS/Percentage change in EBIT
Financial Leverage in between (i) and (ii) =100/40=2.5
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 Financial Leverage in between (i) and (iii) =100/40=2.5
The same result can be obtained by using the equation OP/PBT as shown below.

COMPUTATION OF FINANCIAL LEVERAGE

(i) (ii) (iii)
OP Rs. 1,00,000 60,000 1,40,000
Less: Interest 20,000
Preference
Dividend 40,000 60,000 60,000 60,000
(Grossed up)
PBT 40,000 X 80,000

Financial leverage = OP/PBT= 2.5

This means that with every 1% change in operating profit (OP), profit before tax (PBT)
will change (in the same direction) by 2.5%. For example, in situation (ii) OP has
decreased by 40%. This has resulted in decrease of PBT by 100% (i.e., 40 x 2.5). In
situation (iii) OP has increased by 40%. This has resulted of PBT by 100% (i.e., 40 x
2.5).
Usefulness: Financial leverage helps considerably the financial manager while devising
the capital structure of the company. A high financial leverage means high fixed financial
costs and high financial risk. A financial manager must plan the capital composition in
a way that the firm is in a position to meet its fixed financial costs. Increase in fixed
financial costs requires indispensable increase in EBIT level. In the event of collapse
to do so, the company may be in principle forced into insolvency.
8.3.3 Composite Leverage
As discussed in the foregoing sections, operating leverage measures percentage change
in operating profit due to percentage change in sales. It explains the degree of operating
risk. Financial leverage measures percentage change in taxable profit (or EPS) on
account of percentage change in operating profit (i.e., EBIT). Thus, it explains the

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degree of financial risk. Both these leverages are closely fretful with the firm’s capacity
to meet its fixed costs (both operating and financial). In case both the leverage are
combined, the result obtained will unveil the effect of change in sales over change in
taxable profit (or EPS).
Composite leverage thus expresses the relationship between revenue on account of
sales (i.e. contribution or sales less variable cost) and the taxable income. It helps in
finding out the resulting percentage change in taxable income on account of percentage
change in sales. This can be computed as follows:
Composite leverage = Operating leverage x Financial leverage
= C/OP x OP/PBI = C/PBT
Where C = Contribution (i.e. sales - variable cost)
OP = Operation Profit or Earning before Interest and Tax
PBT = Profit before Tax but after Interest.
The computation of the composite leverage can be explained with the help of the fol-
lowing illustration:
Illustration 8.6
A company has sales of Rs. 1,00,000. The variable costs are 40% of the sales while
the fixed operating costs amounts to Rs. 30,000. The amount of interest on long-term
debt is Rs. 10,000. You are required to calculate the composite leverage and illustrate
its impact if sales increase by 5%.
Solution:
STATEMENT SHOWING COMPUTATION OF COMPOSITE LEVERAGE
Sales 1,00,000
Less : Variable costs (40% of sales) 40,000
Contribution © 60,000
Less : Fixed operating costs 30,000
Earning before interest and tax (EBIT) or 30,000
Operating profit (OP)
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Less : Interest 10,000
Taxable Income (PBT) 20,000
Composite leverage = C/PBT = 60000/20000 = 3.
The composite leverage of ‘3’ indicates that with each increase of Re. 1 in sales, the
taxable income will increase by Rs. 3 (i.e. 1 x 3).
This can be verified by the following computations when the sales increase by 5%.
Sales Rs. 1,05,000
Less: Variable costs 42,000
Contribution ( C ) 63,000
Less: Fixed operating costs 30,000
Earning before interest and tax (EBIT) or 33,000
Operating profit (OP)
Less: Interest 10,000
Taxable Income (PBT) 23,000
It is clear from the above computation that on account of increase in sales by 5% the
profit before tax has increased by 15%. This can be verified as follows:
Increase in percentage profits = [Increase in profit/Base Profit] X 100
= [3,000/20,000] X 100 = 15%
8.4 Significance of Financial and Operating Leverages
The operating leverage and the financial leverage are the two quantitative tools used by
the financial experts to measure the return to the owners (viz., earning per share) and
the market price of the equity shares. The financial leverage is considered to be supe-
rior of these two tools, since it focuses the attention on the market price of the shares,
which the management always tries to increase by increasing the net worth of the firm.
The management for this purpose resorts to trading on equity because when there is
increase in EBIT then there is corresponding increase in the price of the equity shares.
However, a firm cannot go indefinitely in raising the debt content in the total capital
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structure of the company. If a firm goes on employing greater proportion of debt
capital, the marginal cost of debt will also go on increasing because the subsequent
lenders will demand higher rate of interest. The company’s inability to offer sufficient
assets and security will also stand in the way of further employment of debt capital.
Moreover, a firm with widely fluctuating income cannot afford to employ a high de-
gree of financial leverage.
A company should try to have a balance of the two leverages because they have got
remarkable acceleration or deceleration effect on EBIT and EPS. It may be noted that
a right combination of these leverages is a very big challenge for the management. A
proper combination of both operating and financial leverages is a blessing for the firm’s
growth while an improper combination may prove to be a curse.
A high degree of operating leverage together with a high degree of financial leverage
makes the position of the firm very risky. This is because on the one hand it is employ-
ing excessively assets for which it has to pay fixed costs and at the same time it is also
using a large amount of debt capital. The fixed costs towards using assets and fixed
interest charges bring a greater risk to the firm. In case, the earnings fall, the firm may
not be in a position to meet its fixed costs. Moreover, greater fluctuations in earnings
are likely to occur on account of the existence of a high degree of operating leverage.
Earnings to the equity shareholders will also fluctuate widely on account of existence
of a high degree of financial leverage. The existence of a high degree of operating
leverage will result in a more than proportionate change in operating profits even on
account of a small change is sales. The presence of a high degree of financial leverage
causes a more than proportionate change in EPS even on account of a small change in
EBIT. Thus, a firm having a high degree of financial leverage and a high degree of
operating leverage has to face the problems of inadequate liquidity or insolvency in
one or the other year. It does not, however, mean that a firm should opt for low degree
of operating and financial leverages. Of course, such lower leverages indicate the
cautious policy of the management, but the firm will be losing many profit earning
opportunities. A firm should, therefore, make all possible efforts to combine the

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operating and financial leverage in a way that suits the risk bearing capacity of the firm.
It may be observed that a firm with high operating leverage should not have a high
financial leverage. In fact, it should have a low financial leverage. Similarly, a firm
having a low operating leverage will stand to gain by having a high financial leverage
provided it has enough profitable opportunities for the employment of borrowed funds.
However, low operating leverage and a high financial leverage is well thought-out to be
an ideal situation for the maximization of the profits with bare minimum of risk.

8.5 Comprehensive Illustrations

The comprehensive illustrations given in the following pages will endow with the stu-
dents a more conceptual lucidity about the gist and implications of leverage.

Illustration. 8.7
The capital structure of the Shimla Progressive Corporation consists of an ordinary
share capital of Rs. 10,00,000 (shares of Rs. 100 per value) and Rs. 10,00,000 of 10%
debentures. Sales increased by 20% from 1,00,000 units to 1,20,000 units, the selling
price is Rs. 10 per unit: variable cost amounts to Rs. 6 per unit and fixed expenses
amount to Rs. 2,00,000. The income tax rate is assumed to be 50 per cent. You are
required to calculate the following:
(i) the percentage increase in earnings per share:
(ii) the degree of financial leverage at 1,00,000 units and 1,20,000 units.
Comment on the behaviour of operating and financial leverages in relation to increase
in production from 1,00,000 units to 1,20,000.

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Solution:
SHIMLA PROGRESSIVE CORPORATION STATEMENT SHOWING EPS
AND OPERATION AND FINANCIAL LEVERAGES AT
TWO LEVEL OF OPERATION
1,00,000 1,20,000
Units Units
Sales (@ Rs. 10. per unit) Rs. 10,00,00 Rs. 12,00,000
Less : Variable costs 6,00,000 7,20,000
Contribution ( C ) 4,00,000 4,80,000
Less : Fixed expenses 2,00,000 2,00,000
Operating Profit (EBIT or OP) 2,00,000 2,80,000
Less : Interest 1,00,000 1,00,000
Profit before tax (PBT) 1,00,000 1,80,000
Less : Tax 50% 50,000 90,000
Profit after Tax or Net Profit 50,000 90,000
(i) EPS : Profit after tax/Number of ordinary shares
= Rs. 50,000/10,000 Rs. 90,000/10,000
= Rs. 5. Rs. 9.
Percentage increase in EPS 80%
(ii) Operating leverage
C /OP 4,00,000/2,00,000 = 2 4,80,000/2,80,000 = 1.71
(iii) Financial Leverage
OP/PBT 2,00,000/1,00,000 = 2 2,80,000/1,80,000 = 1.55
On account of increase in sales from 1 lac units to 1,20,000 units at the rate of Rs. 10.
per unit EPS rises by 80% while the operating leverage comes down from 2 to 1.71
and financial leverage declines from 2 to 1.55. There is, therefore, a significant de-
crease in both the business risk and the financial risk of the company on account of
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reduction in both the leverages. This is generally the result when there is increase in
sales without any increase in fixed operating or financial costs.

Illustration 8.8
A firm has sales of Rs. 10,00,000 variable cost or Rs. 7,00,000 and fixed costs of Rs.
2,00,000 and debt of Rs. 5,00,000 at 10% rate of interest. What are the operating,
financial and combined leverages? If the firm wants to double it Earnings Before In-
terest and Tax (EBIT), how much of a rise in sales would be needed on a percentage
basis?

Solution:
COMPUTATION OF OPERATING, FINANCIAL AND COMBINED LEVERAGES
Operating leverage = Contribution / Operating Profit
Rs. 3,00,000/1,00,000 = 3
Financial leverage = Operating Profit / Profit before tax
Rs. 1,00,000/50,000 = 2
Combined leverage = Operating leverage x Financial leverage = 3 x 2 = 6
Profit at Present
Sales Rs. 10,00,000
Variable cost 7,00,000
Contribution 3,00,000
Fixed costs 2,00,000
Operating profit (EBIT) 1,00,000
Interest (10% on Rs. 5,00,000) 50,000
Profit before tax 50,000
Comments: Operating leverage is 3 times. This means that if sales increase by 100
per cent, operating profit will rise by 300 per cent (i.e., times the rise in sales). There-
fore, in case the firm wants to double its earnings before interest and tax (i.e., a 100%
rise), then a 33.33 per cent rise in sales will be required. This is confirmed by the
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flowing computation:
Sales after 33.33% rise Rs. 13,33,333
Variable cost 9,33,333
Contribution 4,00,000
Fixed cost 2,00,000
Operating Profit 2,00,000

Illustration 8.9
Mc Grow Corporation has estimated that for a new product its break-even point is
2,000 units, if the item is sold for Rs. 14 per unit; the cost accounting department has
currently identified variable cost of Rs. 9 per unit. Calculate the degree of operating
leverage for sales volume of 2,500 units and 3,000 units. What do you infer from the
degree of operating leverage at the sales volumes of 2,500 units and 3,000 units and
their difference, if any?

Solution:
OPERATING LEVERAGE IN Mc Grow CORPORATION
Per unit 2,500 units 3,000 units
Sales Rs. 14 35,000 42,000
Variables costs 9 22,500 27,000
Contribution 5 12,500 15,000
Fixed costs 10,000 10,000
(2,000 x Rs. 5 per unit)
2,500 5,000
Operating leverage: Contribution / Operating Profit
=12,500 /2,500 = 5 15,000/5,000 =3
Inference: The degree of operating leverage is much higher at the sales volume of
2,500 units than at the sales volume of 3,000 units, i.e., 5 times and 3 times respec-
tively. It means that at the sales volume of 2,500 units, the variation in operating profit
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will be 5 times the variation in sales volume. This is apparent from the profit statement
for 3,000 units a 20% increase in sales volume has resulted in a 100% increase in
operating profits. However, at the sales volume of 3,000 units, the degree of operating
leverage is only 3 times. This means that at this level, the rise in operating profits will
be 3 times the rise in sales volume. A very high degree of operating leverage is not
considered desirable, as a small fall in sales volume will result in a substantial fall in
operating profit.

Illustration 8.10
The following data relate to Company XYZ Ltd.
Sales Rs. 2,00,000
Less: Variable expenses (30%) 60,000
Contribution 1,40,000
Fixed operating expenses 1,00,000
EBIT 40,000
Less Interest 5,000
Taxable income 35,000
You are required to compute the following:
1. Using the concept of leverage, by what percentage will taxable incomes
increase if sales increase by 6 per cent?
2. Using the concept of operating leverage, by what percentage will EBIT
increase if there is a 10 per cent increases in sale?
3. Using the concept of financial leverage, by what percentage will taxable
income increase if EBIT increases by 6 per cent?

Solution:
1. Degree of composite leverage on sales level of Rs. 2,00,000.
Contribution / Taxable income = 1,40,000/35,000 = 4
If sales increase by 6 per cent, taxable income will
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 increase by 4 x 6 = 24 per cent:
[8400 x 100] / 35000 = 24%
Workings Note :
Sales Rs. 2,12,000
Less : Variable expenses (30%) 63,000
Contribution 1,48,000
Less : Fixed expenses 1,00,000
EBIT 48,400
Less : Interest 5,000
Taxable income 43,400
Increase in Taxable Income = Rs. 8400, i.e. 24% over Rs. 35000.
2. Degree of operating leverage on sales level of Rs. 2,00,000:
Contribution/Operating Income = 140000/40000 = 3.5
If sales increase by 10% EBIT will increase by 3.5 x 10 = 35 per cent

Workings Note:
Sales Rs. 2,20,000
Less : Variable expenses 66,000
Contribution 1,54,000
Less : Fixed expenses 1,00,000
EBIT 54,000
Increase is Rs. 54,000 — Rs. 40,000 or [14000 x 100] / 40,000 = 35%
3. Degree of financial leverage if EBIT increases by 6%.
EBIT / Taxable Income = 40000 / 35000 = 1.15
If EBIT increases by 6 per cent, taxable income will increase by 1.15 x 6 = 6.9
per cent.

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Working Note:
EBIT Rs. 40,000
Add : 6% 2,400
42,400
Less : Interest 5,000
Taxable Income 37,400
Increase is Rs. 37,400 - 35,000 or [2400 x 100] /35000 = 6.9%

Illustration 8.11
The following data relate to two companies KPS Ltd. and BSB Ltd.
KPS Ltd. BSB Ltd.
Capital employed : 9% Debentures 2,50,000
Equity share capital 5,00,000 2,50,000
(in Rs. 10/- shares)
Earnings before interest and tax 1,00,000 1,00,000
Return on capital employed 20% 20%

The equity shareholders of KPS Ltd. find to their dismay that instead of same return
earned by their company on the total capital employed, their earning per share is much
less as compared to BSB Limited.
You are required to state for the satisfaction of the shareholders of A Ltd., the reasons
for such lower earning per share on their capital. Assume the tax at 50%.

Solution:
In order to find out the reasons of a lower rate of earning for the shareholders of KPS
Limited, the earning per share for both the companies will have to be calculated :

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 COMPUTATION OF EARNING PER SHARE
KPS Ltd. BSB Ltd.
Rs. Rs.
Earning before Interest and Tax 1,00,000 1,00,000
(EBIT)
Less : Debenture interest ——— 22,500
Profit before tax (PBT) 1,00,000 77,500
Less : Taxes at 50% 50,000 38,750
Earning after interest and tax (EAIT)
Number of shares 50,000 38,750
Earning per share 1 1.55
Financial leverage: EBIT/PBT 1,00,000/1,00,000 1,00,000/77,500
=1 =1.29
The above working explains that there are two causes for a lower earning per share in
case of the company KPS as compared to company BSB. These causes are as follows:
1. The company BSB has a favourable financial leverage or, in other words, it is
taking the advantage of trading on equity. It has been in a position to borrow half
of its capital employed at a much lower cost as compared to the total return on
its capital employed. It is paying an interest of 9% on its debentures of Rs.
2,50,000 but is earning a return of 20%. This saving of 11% has accrued to the
shareholders as owners of the firm. This has been shown below:
Earning on assets financed by debentures 50,000
(Rs. 2,50,000 at the rate of 20%)
Less : Interest charges 22,500
Favourable leverage effect 27,500
(11% on Rs. 2,50,000)
Less : Tax at 50% 13,750
After tax favourable leverage effect 13,750

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 Thus, Rs. 13,750 is additionally available to the shareholders of BSB Co. as
compared to the shareholders of KPS Co.
2. The total number of equity shares issued by BSB Co. are only 25,00 as compared
to 50,000 shares issued by KPS Co. Consequently the after tax favourable
leverage effect of Rs. 13,750 has accrued to shareholders of 25,000 shares.
This has resulted in increase in earning per share in case of company BSB as
compared to company KPS by Re. 0.55 (i.e., Rs. 13,750/25,000) per share.

Illustration 8.12
Calculate operating leverage and financial leverage under situations A. B and C and
Financial Plans. I, II and III respectively from the following information relating to the
operation and capital structure of MCG & HPU Co. Also find out the combinations of
operating and financial leverages, which give the highest value and the least value. How
are these calculations useful to financial manager in a company?
Installed capacity 1200 units
Actual Production and Sales 800 units
Selling price per unit Rs. 15
Variable cost per unit Rs. 10
Fixed cost: Situation A Rs. 1000
Situation B Rs. 2000
Situation C Rs. 3000

Capital Structure : Financial Plan

I II II
Equity Rs. 5000 Rs. 7500 Rs. 2500
Debt Rs. 5000 Rs. 2500 Rs. 7500
Cost of debt 12%

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Solution:
COMPUTATION OF OPERATING LEVERAGE
Situation Situation Situation
A B C
Sales (S) 12000 12000 12000
Variable cost (VC) 8000 8000 8000
Contribution ( C) 4000 4000 4000
Fixed cost (FC) 1000 2000 3000
Operating Profit (OP) 3000 2000 1000
Operating/Leverage C/OP 1.33 2 4

COMPUTATION OF FINANCIAL LEVERAGE

Fin. Fin. Fin.
Plan.I Plan II Plan.III
Situation A :
Operating Profit 3000 3000 3000
Interest 600 300 900
PBT 2400 2700 2100
Financial Leverage
= OP/PBT = 1.25 1.11 1.43
Situation B:
Operating Profit 2000 2000 2000
Interest 600 300 900
PBT 1400 1700 1100
Financial Leverage 1.43 1.18 1.82
Situation C :
Operating Profit 1000 1000 1000
Interest 600 300 900
PBT 400 700 100
Financial Leverage 2.5 1.43 10

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 Combination of Operating Leverage and Financial leverage
Highest value Situation C and Financial Plan III 4x10 =40
Least value Situation A and Financial Plan II 1.33x1.11= 1.476

8.6 Summary
The operating leverage and the financial leverage computed as above has a great utility
for the financial manager. Since they disclose the extent of both operating and financial
risk assumed by a company under a particular situation, both the leverages should neither
be too high nor too low. A high degree of this leverage will indicate that the company
is working under a very high risky situation while a too low leverage will indicate that
the company is observing extra conservatism at the cost of equity shareholders. A
financial manager would try to keep the financial leverage high and the operating leverage
low to maximize the earnings per share. In case, the financial leverage is high, he
should try to bring down the financial leverage gradually. Analysis of leverages is thus
very crucial in financial decision-making.

8.7 Self- Assessment Exercise

1) What is meant by “Operating leverage” and “Financial leverage.”.
2) Explain the following with illustrations: (a) Operating leverage is determined
by the firm’s cost structure and, therefore, by nature of business. The mix of
debt and equity, funds used to finance the firm’s assets, on the other hand,
determines financial leverage. Operating and financial leverages combined
provide a risky profile of the firm, the variability of returns to the equity
shareholders arise from the business and financial risk. Explain. (b) Which
combination of operating and financial leverage constitutes (i) risky situation
and (ii) ideal situation.
3) The capital structure of HB Limited consists of equity share capital of Rs.
1,00,000 (10,000 shares of Rs. 10 each) and 8% debentures of Rs. 50,000.
You are required to calculate and verity the degree of financial leverage on
earning before interest and tax (EBIT) level of Rs. 20,000.
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 4) An analytical statement of MRP Company is shown below :
It is based on an output (sales) level of 80,000 units.
Sales Rs. 9,60,000
Variable cost 5,60,000
Revenue before fixed costs 4,00,000
Fixed costs 2,40,000
1,60,000
Interest 60,000
Earning before tax 1,00,000
Tax 50,000
Net Income 50,000
Calculate the degree of (i) operating leverage (ii) financial leverage, and (iii)
the combined leverage from the above data.
5) Calculate degree of (i) operating leverage, (ii) financial leverage and
(iii) combined leverage from the following data:
Sales 1,00,000 units @ Rs. 2 per unit = Rs. 2,00,000
Variable cost per unit @ Rs. 0.70.
Fixed costs : Rs. 1,00,000
Interest charges : Rs. 3,668.
6) Calculate the Degree of Operating Leverage, Degree of Financial Leverage and
the Degree of Combined Leverage for the following firms and interpret the
results :

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 P Q R
Output (Units) 3,00,000 75,000 5,00,000
Fixed Costs (Rs.) 3,50,000 7,00,000 75,000
Unit Variable Cost (Rs.) 1.00 7.50 0.10
Interest Expenses (Rs.) 25.00 40,000 Nil
Unit Selling Price (Rs.) 3.00 25.00 0.50
7) The following is the balance sheet of PKG company.
BALANCE SHEET
Liabilities Amount Assets Amount
Equity capital Rs. Net fixed assets Rs. 1,50,000
(Rs. 10 per share 60,000 50,000
10% Long-term debt 80,000
Retained earnings 20,000
Current liabilities 40,000
2,00,000 2,00,000
The company’s total assets turnover ratio is 3.0 its fixed operating costs are Rs.
1,00,000 and its variable operating costs ratio is 40%. The income tax rate is
50%.
(i) Calculate for the company all the three types of leverages.
(ii) Determine the likely level of EBIT if EPS is (a) Re. 1 (b) Rs. 3 (c) Zero.

8.8 Suggested Readings

1) Khan and Jain, Financial Management, (7th Edition).
2) Pandey, I M, Financial Management (6th Edition).
3) Hampton, John J., Financial Management and Policy (3rd edition).
4) Solo man, Ezra & Pringle, John J., An Introduction to Financial Management,
(1978)
5) Weston J., Fred, & Drigham, Managerial Finance, (5th edition).
✪✪✪
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 Lesson : 9

CAPITAL STRUCTURE DECISIONS

Objective: The key objective of this lesson is to make the students familiar about the
basic notion of capital structure and decisions relating to capital structure of a company.

STRUCTURE
9.1 Backdrop
9.2 Assumptions and Definitions
9.3 Net Income Approach
9.4 Net Operating Income Approach
9.5 Traditional Approach
9.6 Modigliani and Miller Approach
9.7 Taxation and Capital Structure
9.8 Other Imperfections of Capital Structure
9.9 Guidelines for Capital Structure Planning
9.10 Summary
9.11 Self- Assessment Exercise
9.12 Suggested Readings
9.1 Backdrop
The two primary sources of finance for a business firm are equity and debt. What
should be the magnitude of equity and debt in the capital structure of a firm? Put in a
different way, how much financial leverage (kind of capital structure) should a firm
employ? The choice of a firm’s capital structure is a marketing problem. It is essentially
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concerned with how the firm decides to segregate its cash flows into two broad
components, a fixed component that is earmarked to meet the obligations towards debt
capital and a residual component that belongs to equity shareholders.
Since the objective of financial management is to maximise shareholders’ wealth, the
key issue in the capital structure decision is: What is the relationship between capital
structure and firm value? Alternatively, what is the relationship between capital structure
and cost of capital? Remember that valuation and cost of capital are inversely related.
Given a certain level of earnings, the value of the firm is maximised when the cost of
capital is minimised and vice versa. There are different views on how capital structure
influences value. Some argue that there is no relationship whatsoever between capital
structure and firm value; others believe that financial leverage (i.e. the use of debt
capital) has a positive effect on firm value up to a point and negative effect thereafter;
still others argue that, other things being equal, greater the leverage, greater the value
of the firm.
This lesson explores the various positions taken on the relationship between financial
leverage and cost of capital, one of the most contentious issues in finance.

9.2 Assumptions and Definitions

To examine the liaison between capital structure and cost of capital (or valuation) the
following simplifying assumptions are commonly made:
• There is no income tax, corporate or personal. (We shall, however, later in the
lesson consider the implications of taxes.)
• The firm pursues a policy of paying all of its earnings as dividends. Put differently
a 100 per cent dividend payout ratio is assumed.
• Investors have identical subjective probability distributions of net operating income
(earnings before income and taxes) for each company.
• The net operating income is not expected to grow or decline over time.
• A firm can change as capital structure almost instantaneously without incurring
transaction costs.
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The justification for the above assumptions is to abstract away the influence of taxation,
dividend policy, varying perceptions about risk, growth, and market imperfections so
that the influence of financial leverage on cost of capital can be discussed with greater
clarity.
Given the above assumptions, the analysis focuses on the subsequent discussion:
Kd =F/B = Annual interest charges/Market value of debt
Assuming that the debt capital is perpetual, kd represents the cost of debt.
ke = E/S = Equity earnings/Market value of equity
When the dividend pay out ratio is 100 per cent, and earnings constant; ke as defined
here, represents the cost of equity capital.
ko = O/V = Net operating income/Market value of the firm
where V=B + S ko is the over all capitalisation rate for the firm. Since it is the weighted
average cost of capital, it may be expressed as :
ko = kd (B/B+S) + k s (S/B + S)
In terms of the above definitions, the question of interest to us is:
What happens to kd ke and ko when financial leverage, measured by the ratio B/S,
changes? This would be answered through various approaches of capital structure.

9.3 Net Income Approach

According to this approach, the cost of debt capital, kd and the cost of equity capital, ke
remain unchanged when B/S the degree of leverage, varies. The constancy of kd and ke
with respect to B/S means that ko the average cost of capital, measured as:
Ko = kd (B/B + S) + ke (S/B +S)
declines as B/S increases. This happens because when B/S increases, kd, which is
lower than ke receivers a higher weight in the calculation of ko.

Illustration 9.1
The net income approach may be illustrated with numerical example. There are two
firms A and B similar in all respects except in the degree of leverage employed by
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them. Financial data for these firms are shown below:
Firm A Firm B
O Net operating income Rs. 10,000. Rs. 10,000
F Interest on debt Rs. 0 Rs. 3000
E Equity earnings Rs. 10,000 Rs. 7,000
ke cost of equity capital 10% 10%
kd cost of debt capital 6% 6%
S Market value of equity Rs. 100,000 Rs. 70,000
B Market value of debt Rs. 0 Rs. 50,000
V Total value of the firm Rs. 100,000 Rs.120,000
The average cost of capital for firm A is
6% x 0/10000+10% x 100,000/100,000=10%
The average cost of capital for firm B is
6% x 50,000/120,000 + 10% x 70,000/100,000 =8.33%

9.4 Net Operating Income Approach

According to the net operating income approach, the overall capitalisation rate and the
cost of debt remain constant for all degrees of leverage. In the equation
ko= kd ( B/B+S) + ke (S/B+S)
ko and kd are constant for all degrees of leverage. Given this the cost of equity can be
expressed as:
ke =k0 + (k 0 - k d ) (B/S)
The critical premise of this approach is that the market capitalizes the firm as a whole
at a discount rate, which is independent of the firm’s degree of leverage. As a
consequence, the division between debt and equity is irrelevant. An increase in the use
of debt funds, which are apparently cheaper, is offset by an increase in the equity
capitalisation rate. This happens because equity investors seek higher return as they
are exposed to greater risk arising from increase in the degree of leverage. They raise
the capitalisation rate ke (lower the price-earnings ratio, P/E), as the degree of leverage
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increases.
The net operating income position has been advocated eloquently by David Durand.
He argued that the market value of a firm depends on its net operating income and
business risk. The change in the degree of leverage employed by a firm cannot change
these underlying factors. It merely changes the distribution of income and risk between
debt and equity without affecting the total income and risk, which influence the market
value of the firm. Hence the degree of leverage per se cannot influence the market
value (or equivalently the average cost of capital) of the firm. Arguing in a similar
vein, Modigliani and Miller, in a seminal contribution made in 1958, forcefully advanced
the proposition that the cost of capital of a firm is independent of its capital structure.

Illustration 9.2
Two firms, A and B, are similar in all respects except the degree of leverage employed
by them. Relevant financial data for these firms are given below:
Firm A Firm B
O Net operating income 10000 10000
Ko Overall capitalisation rate 0.15 0.15
V Total market value 66667 66667
F Interest on debt 1000 3000
Kd Debt capitalisation rate 0.10 0.10
B Market value of debt 10000 30000
S Market value of equity 56667 36667
B/S Degree of leverage 0.176 0.818
The equity capitalisation rates of firms A and B are as follows:
Firm A Equity earnings/Market value of equity = 9000/56667 = 0.159=15.9%
Firm B Equity earnings/Market value of equity = 7000/36667=0.191=19.1%

9.5 Traditional Approach

The main propositions of the traditional approach are:

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1. The cost of debt capital kd remains more or less constant up to a certain degree
of leverage but rises thereafter at an increasing rate.
2. The cost of equity capital, ke remain more or less constant or rises only gradually
up to a certain degree of leverage and rises sharply thereafter.
3. The average cost of capital, ko as a consequence of the above behaviour of ke and
kd (i) decrease up to a certain point; (ii) remains more or less unchanged for
moderate increases in leverage thereafter; and (iii) rises beyond a certain point.
The traditional approach is not as sharply defined as the net income approach. Several
shapes of kd, ke and ko are consistent with this approach.
The principal implication of the traditional position is that the cost of capital is dependent
on the capital structure and there is an optimal capital structure, which minimizes the
cost of capital. At the optimal capital structure the real marginal cost of debt and
equity is the same. Before the optimal point the real marginal cost of debt is less than
the real marginal cost of equity and beyond the optimal point the real marginal cost of
debt it more than the real marginal cost of equity.

Illustration 9.3
A numerical illustration of the traditional approach is given in Table 9.1. This table
shows the average cost of capital for a firm which has a net operating income of Rs.
100000 that is split variously between interest and equity earnings depending on the
degree of leverage employed by the firm.
Table 9.1 Numerical illustration of the Traditional Approach
F E kd ke B S V ko
Rs. Rs. (%) (%) Rs. Rs. Rs. (%)
0 100000 6.0 10.0 0 1000000 1000000 10.00
10000 90000 6.0 10.0 10.0 166667 900000 1066667 9.37
20000 80000 6.5 10.5 10.0 307692 761905 1069597 9.36
30000 70000 6.5 11.0 11.0 461538 636363 1097901 9.10
40000 60000 7.0 11.0 11.0 571429 545455 1116884 8.95
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50000 50000 7.5 11.5 11.5 666667 434783 1101450 9.08
60000 40000 9.0 12.0 12.0 666667 333333 1000000 10.00
70000 30000 11.0 14.0 14.0 636364 214286 850650 11.75
80000 20000 15.0 16.0 16.0 533333 125000 658333 15.20
90000 10000 18.0 20.0 20.0 500000 100000 600000 16.67

9.6 Modigliani and Miller Approach

In their celebrated 1958 paper, Modigliani and Miller (MM, hereafter) have restated
and amplified the net operating income position terms of three basic propositions.
Before discussing their propositions, let us look at the assumptions underlying their
analysis.
• Capital markets are perfect. Information is freely available and transactions are
costless securities are infinitely divisible.
• Investors are rational. Investors are well-Informed and choose a combination of
risk and return that is most advantageous to them.
• Investors have homogenous expectations. Investors hold identical subjective
probability distributions about future operating earnings.
• Firms can be grouped into equivalent risk classes on the basis of their business
risk.
• There is no corporate income tax.

Basic Propositions
Based on the above assumptions, MM derived the following three propositions.
Proposition 1 The total market value of a firm is equal to its expected operating income
divided by the discount rate appropriate to its risk class. It is independent of the degree
of leverage.
In symbols
Vj = Sj + Bj = Oj/ko
Where Vj = total market value of firm j
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 Sj = market value of the equity of firm j
Bj = market value of the debt of firm j
Oj = expected operating income of firm j
Ko = discount rate applicable to the risk class to which the firm j belongs.
Proposition II The expected yield on equity, ke is equal to ko plus a premium. This
premium is equal to the debt-equity ratio times the difference between ko and the yield
on debt, kd. In symbols
Ke = ko + (ko - kd) B/S
Proposition III The cutoff rate for investment decision making for a firm in a given risk
class is not affected by the manner in which the investment is financed. (This proposition
states the implication of the earlier propositions for investment decision-making. It
emphasizes the point that investment and financing decisions are independent because
the average cost of capital is not affected by the financing decision).

Proof of MM Argument - The Arbitrage Mechanism

MM has recommended an arbitrage mechanism to prove their argument. To thrash out
their proof, consider two firms P and Q in the identical risk class with the equivalent
expected operating income but different capital structures.
P Q

Expected operating income O O

Market value of equity Sp Sq
Market value of debt — Bq
Market value of the firm Vp Vq
Interest rate of debt — r
Interest burden — rBq
Suppose the market value of the unlevered firm, firm P, is less than the market value of
the levered firm, firm Q, (Vp < Vq). Now consider the case of an investor who holds Sq
rupees worth of equity shares of firm Q, representing a fraction of the total outstanding
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market value of equity shares of firm Q (Sq = aSq). The return he gets is:
Yq = a (O - rBq)
If this investor sells aSq worth of shares of firm Q and borrows aBq on his personal
account at an interest rate of r percent, he can purchase a (Sq + Bq)/Sp of the equity
shares of firm P. (Remember for firm P, Vp = Sp since it is an all-equity firm). The
return obtained by the investor after these transactions would be:
Yp = a (Sq + Bq) / Sp, O-raBq = aVq/Vp, O - RaBq
Comparing EPS, we find that as long as Vq > Vp we have Yp > Yq. This means that equity
shareholders of firm Q will sell their shareholders, resort to personal leverage, and
acquire shares of firm P since it is profitable to do so. In this process Sq (and hence
Vq) will get depressed and Sp (and hence Vp) will rise till the equality between Vp and Vq
is established. Thus we find that a levered firm cannot enjoy a premium over an
unlevered firm because investors by their personal leverage will abolish the difference.
We next consider the possibility Vp> Vq. Let us here put V p/Vq = B > 1. Suppose an
investor holds equity shares of firm P worth sp representing a fraction a of the total
market value of outstanding shares, Sp.
His return is
Yp = sp/Sp O = aO
If he sells his shareholdings worth aVp (V p = Sp) he can buy a fraction aB of the equity
shares and bonds of firm Q because the market value of firm P is B times the market
value of firm Q. Such an action will make his return equal to
Yq = aB(O - rB q) = aBO
Without changing the level of risk borne by him.
Comparing EPS, we find that as long as Vp > Vq (B > 1), we have Yq > Yp. This means
that equity shareholders of firm P will sell shares of firm P and buy a portfolio consisting
of shares and bonds of firm Q since it is profitable to do so. In this process Vp will get
depressed and Vq will rise till the equality between Vp and Vq is established.

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Illustration 9.4
A numerical illustration may be given to show how the arbitrage mechanism works.
Take two firms, X and Y, similar in all respects except in their capital structure. Firm
X is financed by equity only; a mixture of equity and debt finances firm Y. Relevant
financial particulars of the two firms are as shown in Table 9.2.
According to Table 9.2 the value of the levered firm Y is higher than that of the unlevered
firm. Such a situation, argues MM, cannot persist because equity investors would do
well to sell their equity investment in firm Y and invest in the equity of firm X with
personal leverage. For example, an equity investor who owns 1 per cent equity in firm
Y would do well to:
1. Sell his equity in firm Y for Rs. 6667;
2. Borrow Rs. 4000 at 5 per cent interest on personal account; and
3. Buy 1.0667 per cent of the equity of rim X with the amount of Rs.
10667 that he has.
Such an action will result in the following income:
Rs.
Income on investment in firm X 1066.7
Less interest (4000 x 0.5) 200.0
Net income 866.7
Table 9.2 Financial Particulars of Firms X and Y

X Y
Total Capital Employed Rs.1000000 1000000
Equity Capital Rs.1000000 600000
Debt Rs. 0 400000
Net Operating income Rs. 100000 100000
Debt Interest Rs. 0 20000
Market Value of Debt Rs. 0 400000
(Debt capitalisation rate is 5%)
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Equity Earnings Rs. 100000 80000
Equity Capitalisation Rate 10% 12%
Market Value of Equity Rs.1000000 666667
Total Market Value of the Firm Rs.1000000 1066667
Average Cost of Capital 10% 9.37%
Debt Equity Ratio (in terms of market
Value) 0 0.6
This net income of Rs. 866.7 is higher than a net income of Rs. 800.0 foregone by
selling 1 per cent equity of firm Y and the leverage ratio is the same in both the cases.
(In the case of investment in firm X with personal borrowing we have personal leverage;
in the case of investment in firm Y we have corporate leverage).
When investors sell their equity in firm Y and buy the equity in firm X with personal
leverage, the market value of equity of firm Y tends to decline and the market value of
equity of firm X tends to increase. This process continues until the net market values
of both the firms become equal because only then the possibility of earning a higher
income for a given level of investment and leverage by arbitraging is eliminated. As a
result of this the cost of capital for both the firms is the same.
In the preceding discussion we explained that due to the arbitrage mechanism the value
of a levered firm couldn’t be higher than of an unlevered firm, other things being equal.
A similar explanation, with arbitrage in the opposite direction, may be offered to prove
that the value of an unlevered firm cannot be higher than that of a levered firm, other
things being equal.
Assume that the valuation of the two firms X and Y is as follows:
X Y
Debt Interest Rs. 0 20000
Market Value of Debt Rs. 0 400000
(Debt capitalisation rate is 5%)
Equity Earnings Rs. 100000 80000
Equity Capitalisation Rate 8% 12%
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Market Value of Equity Rs.1250000 666667
Total Market Value Rs.1200000 1066667
If a situation like this obtains, equity investors in firm X would do well to sell the
equity in firm X and use the proceeds partly for investment in the equity of rim Y and
partly for investment in the debt of firm Y. For example, an equity investor who owns
1 per cent equity in firm X would do well to:
1. Sell his 1 percent equity in firm X for Rs. 12,500, and
2. Buy 111/64 percent of equity and debt in firm Y involving an outlay of Rs 12500
(The total market value of Y is Rs 1,066,66711 /64 percent of this is Rs 12,500).
Such an action will result in an increase of income by Rs 172 without changing the risk
shouldered by the investor. When investors resort to such a change, the market value of
the equity of firm X tends to decline and the market value of the equity of firm Y tends
to increase. This process continues until the total market value of both the firms
becomes equal.

9.7 Taxation and Capital Structure

The leverage irrelevance of MM is valid if the perfect market assumptions underlying
their analysis are satisfied. However in the face of imperfections characterising the
real world capital markets the capital structure of a firm may affect its valuation. Presence
of taxes is a major imperfection in the real world. This section examines the implications
of corporate and personal taxes for the capital structure. Other imperfections and their
effect on the optimal capital structure are examined in a later section.
Corporate Taxes
When taxes are applicable to corporate income, debt financing is advantageous. Why?
While dividends and retained earnings are not deductible for tax purposes, interest on
debt is a tax-deductible expense. As a result, the total income available for both
stockholders and debtholders is greater when debt capital is used.
To illustrate consider two firms which have an expected net operating income of Rs. 1
million and which are similar in all respects, except in the degree of leverage employed
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by them. Firm A employs no debt capital whereas firm B has Rs. 4 million in debt
capital on which it pays 12 per cent interest. The corporate tax rate applicable to both
the firms is 50 per cent. The income to stockholders and debtholders of these two
firms is shown in Table 9.3. From this table it is clear that the combined income of
debtholders and stockholders of the levered firm (firm B) is higher than that of the
unlevered firm (firm A).
Table 9.3 Corporate Taxes and Income of Debtholders and Stockholders
A B
Net operating income 1000000 1000000
Interest on debt 0 480000
Profit before taxes 1000000 520000
Taxes 500000 260000
Profit after tax (income
Available to stockholders) 500000 260000
Combined income of debt-
Holders and stockholders 500000 740000
The explanation for this is fairly simple: the interest payment of Rs. 480000 made by
the levered from brings a tax shield of Rs. 240000 (Rs. 480000 x tax rate). Hence the
combined income of debtholders and stockholders of firm B is higher by this amount.
If the debt employed by a levered firm is perpetual in nature, the present value of the
tax shield associated with interest can be obtained by applying the formula for perpetuity.
Present value of tax shield = tcrB/r = tcB
Where tc = corporate tax rate
B = market value of debt
r = interest rate on debt.
For firm B the present value of tax shield works out to : 0.5 (Rs. 4000000 = Rs.
2000000. This represents the increase in its market value arising from financial leverage.
In general the value of a firm may be represented as :
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 V = O(1 - tc)/k + tcB
Where V = value of the firm
O = net operating income
tc = corporate tax rate
k = capitalisation rate applicable to the unlevered firm.
B = market value of debt.
The first term in the above equation, O(1 - tc)/k, represents the value of the unlevered
firm and the second term, tcB, denotes the value of tax shield arising out of financial
leverage. Hence it implies that:
Value of levered firm = Value of unlevered firm + Gain from leverage
Vt = Vu+ tcB
From the above equation, it is evident that greater the leverage, greater the value of the
firm, other things being equal. This implies that the optimal strategy of a firm should
be to maximize the degree of leverage in its capital structure.
Corporate Taxes and Personal Taxes

What happens when personal taxes are considered along with corporate taxes? If
investors pay the same rate of personal taxes on debt returns as well as stock returns,
the advantage corporate tax in favour of debt capital remains in tact. This point cab be
proved by applying a 30 per cent personal tax rate to debt as well stock returns in the
previous example. The income to debtholders and stockholders after taxes, both
corporate and personal, is calculated in Table 9.4. From this table it is clear that although
the combined post-tax income to stockholders and debtholders decreases in both the
firms, the proportional advantage of debt remains unaffected because the combined
income of stockholders and debtholders still is higher by 48 per cent in the levered
firm.

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 Table 9.4 Personal Taxes and Income of Debtholders and Stockholders
Firm A Firm B
Income available to stockholders 500000 260000
Less personal taxes at 30% 150000 78000
Income available to stockholders after
Personal taxes 350000 182000
Income to debtholders 0 480000
Less personal taxes at 30% —— 144000
Income to debtholders after personal taxes 0 336000
Combined income of stockholders and
Debtholders after personal taxes 350000 518000
If the personal tax rate is tpthe tax advantage of debt becomes:
tcB (1-tp)
This formula is valid when the personal tax rate applicable to stock as well as debt
income is the same as was assumed in the preceding example. In many countries,
including India this is not true. Stock income, which comprises of dividend income and
capital gains is taxed at a rate which is effectively lover than that of debt income. When
the tax rate on stock income (tps) differs from the tax rate on debt income (tpd), the tax
advantage of a rupee of debt may be expressed as:
(1- (1-tc)(1-tps) / (1-tpd) )
This expression is derived as follows:
X = earning before interest and taxes
B = face value of risk-free debt
r = coupon rate (as well the bondholders’ required rate)
tc = corporate tax rate
tpd = personal tax rate on debt income
tps = personal tax rate on equity income

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The total post -tax cash flow to all investors is:
=rB(1-tpd ) +(X-rB)(1-tc)(1-tps)
=X(1-tc)(1-tps) +rB(1-tpd)(1- (1-t c)(1-tps)/(1-tpd)
First term Second term
The first term represents the post-tax cash flow to the shareholders of the unlevered
firm. If it is capitalized using the discount rate applicable to the unlevered firm its
capitalized value is
Vu(value of the unlevered firm)
The second term is the product of rB(1-tpd)the post-tax interest income of bond holders,
and a constant term
1- (1-tc)(1-t ps)/1-tpd)
Hence its capitalized value, using the discount rate applicable to debt capital is:
B [1- (1-tc)(1-tps)/(1-t pd)]
The value additivity principle implies that:
V1 = Vu +B[1- (1-tc)1-tps)/(1-t pd)]
From the second term in the above equation it is clear that the gain from using one
rupee of debt is:
[1-(1-tc)(1-tps)/(1-t pd) ]
To illustrate, if tc is 50 per cent, t ps 5 per cent, and t pd 30 per cent , the tax advantage of
every rupee of debt is:
1 - (0.5) (0.95)/(.070) = 0.32 rupee
From above equation, it is clear that:
• If (1 - tc) (1 - tps) < (1 -tpd)
• the tax advantage of debt is positive
• If (1 - tc) (1- t ps) = (1-tpd)
the tax advantage of debt is nil

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 • If (1 - tc) (1 - tps) > ( (1 - tpd)
the tax advantage of debt is negative

MERTON MILLER ARGUMENT

Merton Miller in his 1976 Presidential Address to the American answered the issue of
optimal debt policy in a novel, though controversial, manner. He argued that the original
MM proposition, which says that financial leverage does not matter in a tax free world,
is valid in a world where both corporate and personal taxes exist.
To understand Miller’s argument, let us begin with the model of firm valuation when
corporate and personal taxes exist:
Vl = Vu + B [1 - (1-tc) 1-tps/1-tpd)]
If (1-tpd) = (1-tc) (1-tps), Eqn becomes:
Vl = Vu
This is the Modigliani and Miller Proposition in a tax-free world. If tpd = tps Eqn.
becomes:
VL = VU + t cB
This is the Modigliani and Miller proposition taking into account only the corporate
taxes.
Miller posits that the former case is the correct case. Broadly, the key premises and
links in his argument are as follows:
• The personal tax rate on equity income, tps, is nil; the personal tax rate on debt
income, tpd, varies across investors; the corporate tax rate, tc, is constant across
companies.
• Companies will change their capital structure in such a manner that, at the margin,
the after tax value of a rupee of debt income is the same as the after tax value of
a rupee of equity income.
• If the starting point is an all-equity capital structure, as long as some investors
are tax exempt (tpd = 0), companies can by borrowing a rupee of debt enhance
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 their value by tc - this is clear from the above equations.
• Once companies exhaust their tax-exempt clientele, they have to sell debt to
investors who pay taxes. To induce investors to switch from equity (whose
income is tax-exempt) to debt (whose income is taxed), companies have to
raise the interest rate. If the risk adjusted expected rate of return on equity is ke
the risk adjusted expected rate of return on debt should be at least ke/(1 - tpd) in
order to compensate investors for personal taxes on debt.
• In the aggregate, companies will issue debt till the tax rate for the marginal
bondholder, t pd, is the same as the corporate tax rate, tc. Beyond this point, there
is no tax advantage to companies from issuing debt. Thus, the equilibrium supply
of corporate debt is that aggregate amount at which the tax bracket of the
marginal debtholders just equals the corporate tax rate.
• If the corporate tax rate exceeds the marginal personal tax rate on debt income,
companies will use only debt capital; if it is the other way companies will not
use any debt capital. Hence, the supply curve for debt capital remains horizontal
at a given risk adjusted interest rate [ke/(1-tc)]. Figure 12.4 shows two such supply
curves.
• The demand curve for debt capital slopes upwards because investors would buy
more debt as companies offer a higher pre-tax expected rate of return. The
slope of this curve will depend on funds available to investors in various tax
brackets.
• The point at which the supply and demand curves of debt interest represents the
optimal economy-wide debt-equity ratio. If the tax burden on debt income rises,
the optimal debt-equity ratio will decline; on the other hand, if the corporate tax
rate rises in relation to personal tax rate, the optimal debt equity ratio will
increase. The important point is that no single firm can derive any benefit from
varying its financial leverage — only the optimal debt-equity ratio for the
economy changes.

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9.8 Other Imperfections of Capital Structure
In addition to taxation, which is the most important imperfection, there are several
other imperfections, which have a bearing on the optimal capital structure. Among
them the following need to be discussed:
• Bankruptcy costs
• Difference between home-made leverage and corporate leverage
• Agency costs

Bankruptcy Costs
An important imperfection affecting the capital structure decision is the existence of
bankruptcy costs. In a perfect capital market, there are no costs associated with
bankruptcy. If a firm becomes bankrupt its assets cab be sold at their economic values
and there are no legal and administrative expenses. In the real world, however, there
are considerable costs associated with bankruptcy. Assets, when disposed under distress
conditions, generally sell at a significant discount below their economic values. Further,
the legal and administrative cost associated with bankruptcy proceedings is quite high.
Finally, an impending bankruptcy entails significant costs in the form of sharply impaired
operational efficiency.
Other things being equal, the probability of bankruptcy is higher for a levered firm than
for an unlevered firm. It seems that the probability of bankruptcy increases at an
increasing rate as the debt-equity ratio increases beyond a certain threshold level. This
means the expected cost of bankruptcy increases when the debt-equity ratio increases.
Since bankruptcy costs represent a loss that cannot be diversified away, investors expect
a higher rate of return from a firm, which is faced, with the prospect of bankruptcy.

Difference Between Corporate and Home-made Leverage

MM assumes that personal leverage and corporate leverage are perfect substitutes.
However, there are some differences.
• An individual may not be able to borrow on his personal account at the same
rate of interest as a company can do. In India, the average rate of interest n
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 personal borrowings is higher than the average rate of interest on corporate
borrowings.
• An individual usually cannot adopt as high a leverage ratio as a company can do,
Why? The creditors simply may refuse to lend to individuals who want to employ
a high leverage ratio.
• When an individual borrows on his personal account, his liability towards that
borrowing is unlimited. The equity shareholders of a company, however, have
limited liability; irrespective of the company’s level of borrowing.
Due to the above differences, the substitutability of personal and corporate leverages
is suspect. Hence the efficiency of the arbitraging mechanism is questionable.
Agency costs
When a firm obtain debt capital, the creditors generally impose restrictions on the
firm in the form of protective covenants incorporated in the debt/loan contract. These
restrictions may release to several things; approval of the creditors before key
managerial appointments are made, maintenance of current ratio above a certain level,
limitation on the rate of dividend during the currency of the loan, constraints on
additional issue of capital, limitation on further investments, and so on.
The restrictions imposed by the creditors entail considerable legal and enforcement
costs and also impair the operating efficiency of the firm. All these costs, broadly
referred to as monitoring costs or agency costs, detract from the value of the firm.
Michael C Jensen and William H. Heckling, who have put forward a sophisticated and
elegant theory of agency costs, argue that these costs are eventually borne by equity
shareholders in the form of wealth reduction. (When the creditors incur the monitoring
costs in the first instance they are likely to enhance the interest rate and other charges
to cover these costs.)
Monitoring costs are a function of the level of debt in the capital structure. When
there is little debt lenders may limit their monitoring activity. However, when the level
of debt is high lenders may insist on extensive monitoring which entail substantial
costs.
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9.9 Guidelines for Capital Structure Planning
The capital structure decision is a difficult decision that involves a complex tradeoff
among several considerations like income, risk, flexibility, control, timing, and so on.
Given the overriding objective of maximizing the market value of a firm, bear in mind
the following guidelines while hammering out the capital structure of the firm.
Avail of the Tax Advantage of Debt
Interest on debt finance is a tax-deductible expense. Hence finance scholars and
practitioners agree that debt financing gives rise to tax shelter, which enhances the
value of the firm. What is the impact of this tax shelter on the value of the firm? In
their 1963 paper Modigliani and Miller argued that the present value of interest tax
shield is:
Where tc = corporate tax rate on a unit of marginal earnings
D = debt financing
The above formula assumes that the investor pays the same tax on equity income as
well as debt income. In most countries (including India), however, the tax rate on
equity income (tps) is different from that on debt income (tpd). Typically, the former is
lesser than the latter. In view of this, the contribution of debt to value id expressed as
follows:
1 - (1 - tc )(1 - t ps)/(1 - tpd)
The contribution of a rupee of debt to the value of the firm for various combinations of
corporate tax rate, personal tax on stock income, and personal tax rate on debt income
can be calculated.
What is the empirical evidence on this issue? Empirical evidence suggests that a
dollar of debt financing enhances company value by 10 to 17 cents.
Preserve Flexibility
The tax advantage of debt should not persuade one to believe that a company should
exploit its debt capacity fully. By doing so, it loses flexibility. And loss of flexibility
can erode shareholder value. As Modigliani and Miller say: “the existence of a tax
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advantage of debt financing …. Does not necessarily mean that corporations should at
all times seek to use the maximum possible amount of debt in their capital structure.
There are, as we pointed out, limitations imposed by lenders as well as many other
dimensions in real world problems of financial strategy, which are not fully
comprehended within the framework of static equilibrium models. …. These additional
considerations, which are typically grouped under the rubric of the need for preserving
flexibility, will normally imply the maintenance by the corporation of a substantial
reserve of untapped borrowing power.”

Flexibility implies that the firm maintains reserve borrowing power to enable it to
raise debt capital to fund unforeseen changes in government policies, necessary
conditions in the market place, disruption in supplies, decline in production caused by
power shortage or labour unrest, intensification in competition, and, perhaps most
importantly, emergence of profitable investment opportunities. The timing and
magnitude of such development cannot often be forecast easily. Hence the firm must
maintain some unused debt capacity as an insurance against adverse future developments.

Flexibility is a powerful defense against financial distress and its consequences, which
may include bankruptcy. Of course, in most cases, bankruptcy costs are fairly small.
What is likely to be more important, however, is that the loss of flexibility and the
accompanying liquidity crisis may adversely affect product market strategies and
operating policies and impair the value of the firm. As Thomas R. Piper and Wold A.
Weinhold say: “Mangers fearful of incurring liquidity constraints or of violating debt
covenants will usually trim strategic expenditures, be un-aggressive in exploiting market
and investment opportunities, and base operating policies on the low end of a range of
sales forecasts.”

Note that flexibility or financial slack is more valuable to a firm with abundant growth
opportunities. Likewise, it is more important to firms, which have more intangible
assets. Hence such firms would do well to have more conservative capital structures.

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Ensure That the Total Risk Exposure Is Reasonable
While examining risk from the point of view of the investor, a distinction is made
between systematic risk (also referred to as the market risk or non-diversifiable risk)
and unsystematic risk (also referred to as the non market risk or diversifiable risk).
We now dwell on the distinction between business risk and financial risk.
Business risk refers to the variability of earnings before interest and taxes. It is
influenced, inter alias, by the following factors:
• Demand Variability Other things being equal, the higher the variability
of demand for the products manufactured by the firm, the higher is its
business risk.
• Price Variability A firm which is exposed to a higher degree of volatility
in the prices of its products is, in general, characterized by a higher degree
of business risk in comparison with similar firms which are exposed to
a lesser degree of volatility in the prices of their products.
• Variability in Input Prices When input prices are highly variable, business
risk tends to be high.
• Proportion of Fixed Costs If fixed costs represent a substantial proportion
of total costs, other things being equal, business risk is likely to be high.
This is because when fixed costs are high, EBIT is more sensitive to
variations in demand.
Financial risk represents the risk emanating from financial leverage. When a firm
employs a high proportion of debt in its capital structure, i.e., when it has a high degree
of financial leverage, it carries a high burden of fixed financial commitment. Equity
stockholders, who have a residual interest in the income and wealth of the firm, are
naturally exposed to the risk arising from such fixed commitments. Equity stockholders
face this risk, also referred to as financial risk, in addition to business risk.
Generally, the affairs of the firm are, or should be, managed in such a way that the total
risk borne by equity stockholders, which consists of business risk plus financial risk,

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is not unduly high. This implies that if the firm is exposed to a high degree of business
risk, its financial risk should be kept low. On the other hand, if the firm has a low
business risk profile, it can assume a high degree of financial risk.
Examine the Control Implications of Alternative Financing Plans
Consider the case of a firm, which presently has an equity capital of 1000, owned
entirely by the original promoters. If the firm wants to raise additional capital, say
another 1000 it may go for debt finance, or a rights issue of equity stock, or a public
issue of equity stock or a combination of two or more of these. The pros and cons of
the three basic ways of raising additional finance are shown as follows:
Pros Cons
1. Rights issue of equity stock No dilution of Severe limits on
control the financing ability
of the firm
No financial risk Financial risk
2. Debt finance No dilution of Dilution of
control control
Lower cost
3. Public issue of equity stock No financial risk Higher cost

Since the rights issue option severely limits the financing ability of rim the present
owners may lack resources or inclination or both the options, which may merit serious
consideration, are debt finance and public issue of equity stock. In evaluating these
options, among other things, the issue of control is important.
Generally, the control issue is critical at three points: when the equity holding of the
promoters is reduced below 100 per cent, below 50 per cent, and below 26 per cent.
The introduction of outside owners for the first time represents more of a psychological
problem and less of a managerial one. As long as the original promoters are able to
hold more than 50 per cent of the equity stock of the company, their control over the
management of the firm cannot be challenged. However, they become answerable for
their actions and performance to the new shareholders. While offering equity capital
to outsiders may not be psychologically appealing to the promoters, it becomes
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unavoidable if the company wants to raise substantial funds through the capital market.
Once outsiders participate in equity ownership, the original promoters would be
concerned when their share in ownership is likely to fall below 50 per cent. It may be
difficult for some owners to cross this hurdle. However, the original promoters will
have to accept a reduction of their equity holding below 50 per cent to support growth.
Further dilution may also be required to ensure that the firm has resources needed to
support its growing financing needs.
The last major hurdle in India seems to be 26 per cent. This stems largely from a
provision of company law according to which 75 per cent of the votes are required to
pass a special resolution. It implies that a shareholding of 26 per cent is adequate to
block any special resolution. In practice, of course, effective control can be exercised
with a smaller holding also. This is the reason why many business houses have brooked
dilution of their holdings, in companies controlled by them, to much lower levels.
Essentially, they seem to have reconciled themselves to dilution because it appeared
to be the only way to facilitate expansion and growth. However, the episodes of Delhi
Cloth and General Mills Limited and Escorts India Limited, which sharply highlighted
the risk associated with dilution, have introduced conservatism, in business circles.
Subordinate Financial Policy to Corporate Strategy
Financial policy and corporate strategy are often integrated well. This may be because
financial policy originates in the capital market and corporate strategy in the product
market. As Richard R. Ellsworth says: “Caught between the disparate demands of the
operating divisions for capital to fuel strategies and of the capital markets for near
term increases in earnings per share and adherence to long accepted financial standards,
many CEOs take positions that seem more suspicious than supportive of investment
ideas”. In a similar vein he adds: “When apparently objective financial policies become
arbitrarily imposed corporate goals, they lose their flexibility, become sacrosanct, and
can even restrict a company’s potential value.
To facilitate an integration of financial policies with corporate strategy, Ellsworth argues
that the chief executive of the company should:
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• Critically examine the assumptions underlying the firm’s financial policies.
• Persuade finance officers to ensure that financial policies.
• Involve operating managers in financial policy discussions.
• Prevent financial policies from becoming corporate goals.

Mitigate Potential Agency Costs

Due to separation of ownership and control in modern corporations, agency problems
arise. Shareholders, scattered and dispersed as they are, are not able to organise
themselves effectively. More important, given their limited stake and the ‘free rider’
problem they often lack the required incentive to supervise management behaviour.
Hence, very little monitoring take place in the securities markets.
Since agency costs are borne by shareholders and the management, the financing strategy
of a firm should seek to minimise these costs. One way to minimise agency costs is to
employ an external agent who specialises in low cost monitoring. Such an agent may
be a lending organisation like a commercial (or a term- lending institution). It appears
that commercial banks(and term lending institutions) have a comparative advantage in
low cost monitoring. This stems from a continuing relationship between the bank and
borrower and the repetitive lending that the does. Hence when a bank give a loan it
conveys two positive signals to other investers:
(1) The bank considers the firm to be sound and creditworthy.
(2) The bank will monitor the firm on a regular basis to ensure that the management
behaves well. This will induce other investors to look at the securities of the
firm favourably.
As Alan Shapiro says: If this line of reasoning to look at the securities of the firm takes
out a bank loan, it is renting more than money; it is hiring the bank to certify that the
firm is behaving efficiently and to act as a watchdog.
Resort to Timing judiciously
Suppose a firm has determined that it should have debt and equity in equal proportions
in its capital structure. Does it mean that every time it raises finance, it will tap debt
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and equity in equal proportions? This does not happen. One reason is that financing is
often a ‘lumpy’ process-so it is difficult for the firm to maintain strict proportions
each time it raises finance.
There is yet another, and perhaps a more potent, reason. The management of a firm may
perceive that the capital market may not always be favourable for raising finances from
both the sources, viz. debt and equity. On some occasions it may like to raise debt
capital because it believes that the company’s equity stock is depressed; on other
occasions it may want to raise equity capital; because it thinks that the company’s
equity stock is buoyant. Put differently the management may want to resort to timing
based on its assessment of the conditions in the capital market.
Is timing a profitable proposition? The proponents of efficient market theory believe
that it is not. They argue that the market had no memory and an attempt to catch the
market when it is high or avoid it when it is low is a futile exercise.
Practitioners however are often not convinced about the efficient market theory. Warren
Buffet, for example, questions the wisdom of those who advocate the efficient market
theory. He says: “Observing correctly that the market was frequently efficient, they
went on to conclude incorrectly that it was always efficient. The difference between
these propositions is night and day.” Practitioners believe that market aberrations occur
and timing matters.
While it is very difficult-almost impossible- to achieve perfect timing, thanks to market
uncertainties, the following guidelines may be helpful in improving the performance
of a firm with respect to timing.
• Never be Greedy If present conditions are favourable for a certain type of
financing, take advantage of it. Driven by greed, do not wait for an even better
possible tomorrow. The advice of Bernard Baruch formulated for the stock
market investor applies equally well to the participant in a financial market:”
Leave the first 10 percent and the last 10 percent for someone else.”
• Avoid Being Dominated by Other’s Advice. While it nay be helpful to consult
others, avoid being dominated by their opinions. It is difficult to fully fathom
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 and assess the biases and attitudes on which such opinion based.
• Rely on Long term Market Relationships Financial markets seem to follow
certain pattern of behaviour which tend to recur. Even though these patterns
may not be perfectly regular, they have sufficient persistence. They can profitably
be used as general signals, If not as precise markers, of turning points.
• Emphasize Timing when Inside Information Suggests that the Stock is Mispriced
Suppose the financial manager is aware of some good news, which is not known
to the market and hence not reflected, in the stock price. In such a case he
should wait till the good news is captured in the stock price and issue equity
shares only after that.

Finance Proactively not Reactively

Opportunities for smart moves on investment and financing sides of the business often
do not synchronize. Hence financing decision should be decoupled from investment
decisions. warren Buffet, arguably one of the most outstanding managers of our times,
says:
“Unlike many in the business world, we prefer to finance in anticipation of need
rather than in reaction to it. A business to obtain the best financial results possibly
by managing both sides of its balance sheet well”.
This means obtaining the highest-possible returns on assets and the lowest-
possible cost on liabilities. It would be convenient if opportunities for intelligent
actions on both fronts coincided. However, reason tells us that just the opposite
is likely to be the case: Tight money conditions, which translate into high costs
for liabilities, will create the best opportunities for acquisitions, and cheap money
will cause assets to be bid to the sky. Our conclusion: Action on the liability
side sometimes to be taken independent of any action on the asset side.
Alas, what is “tight” and “cheap” money is far from clear at any particular time.
We have no ability to forecast interest rates and maintaining our usual open-
minded spirit-believe that no one else can. Therefore, we simply borrow when

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 conditions seem non-oppressive and hope that we will later find intelligent
expansion or acquisition opportunities, which as we have said - are more likely
to pop up when conditions in the debt market are clearly oppressive. Our basic
principle is that if you want to shoot rare, fast moving elephants, you should
always carry a loaded gun.”

9.10 Summary
What is the relationship between financial leverage and cost of capital? This question
has been answered by the discussion made so far. Is has been established that the effect
of taxation is to reduce the cost of capital as financial leverage increases. Alternatively,
it implies that the value of the firm increases with financial leverage. Imperfections
like bankruptcy costs and agency costs, however, tend to increase the cost of capital as
financial leverage increases. Put differently these imperfections detract from the value
of the firm as financial leverage increases.
Several positions have been taken on the relationship between financial leverage and
cost of capital: net income approach; net operating income approach; traditional
position; and Modigliani and Miller position. According to the net income approach
the cost of debt capital and the cost of equity capital remain unchanged when the leverage
ratio varies. As a result, the average cost of capital declines as the leverage ratio
increases. This happens because when the leverage ratio increases, the cost of debt,
which is lower than the cost of equity, receives a higher weightage in the average cost
of lower than the cost equity receives a higher weightage in the average cost of capital
calculation.
According to the net operating income approach (i) the overall capitalisation rate
remains constant for all levels of financial leverage, (ii) the cost of debt remains constant
for all levels of financial leverage, and (iii) the cost of equity increases linearly with
financial leverage. The main propositions of the traditional approach are (i) The cost
of debt remains more or less constant up to a certain degree of leverage but rises
thereafter at an increasing rete. (ii) The cost of equity capital remains more or less
constant or rises only gradually up to a certain degree of leverage and rises sharply
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thereafter. (iii) The average cost of equity of capital, as a consequence of the above
behaviour of the cost of debt and the cost of equity (a) decreases up to a certain point
(b) remains more or less uncharged for moderate increases in leverage thereafter, and
(c) rises beyond that at an increasing rate.
Modigliani and Miller (MM) have rested and amplified the net operating income
position in three basic propositions: (i) The total market value of a firm is equal to its
expected operating income divided by the discount rate appropriate to its risk class.
(ii) The expected yield on equity is equal to the risk-free rate plus a premium. The
premium is equal to the debt-equity ratio times the difference between the discount
rate applicable to the risk class to which the firm belongs and the risk free rate. (iii)
The cut-off rate for investment decision making for a firm in risk class k is Pk and it is
not affected by the manner in which the investment is financed. Modigliani and Miller
suggested an arbitrage mechanism to prove their point. In the presence of taxes, the
MM valuation model changes. When corporate taxes alone are considered, financial
leverage changes the value of the firm by tcB. When personal taxes are also considered,
the advantage of debt capital is equal to:
1 - [(1 - tc) (1 -tps)/(1 -tpd)] B
Merton Miller in his 1976 Presidential Address to the American Finance Association
answered the issue of optimal debt policy in a novel, though controversial, manner. He
argued that the original MM proposition, which says that financial leverage does not
matter in a tax free world, is valid in a world where both corporate and personal taxes
exists. In addition to taxation, which is the most important imperfection, there are
several other imperfections, which have a bearing on the optimal capital structure. In
particular, the following are very relevant: bankruptcy costs, difference between
homemade leverage and corporate leverage, and agency costs.

9.11 Self- Assessment Exercise

1. What is the relationship between leverage and cost of capital as per the net
income approach?

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2. What is the relationship between leverage and cost of capital as per the net
operating income approach?
3. What are the main propositions of the traditional approach?
4. State the principal propositions of the Modigliani and Miller (MM) position.
5. Prove the MM hypothesis with the help of the arbitrage mechanism.
6. Illustrate the arbitrage mechanism suggested by MM with the help of a suitable
numerical example.
7. What are the implications of corporate taxes for firm valuation?
8. What is the bearing of taxes, bankruptcy costs, and agency costs on the optimal
structure?
9. Mahatma Limited has a net operating income of Rs. 30 million. Mahatma
employs Rs. 100 million of debt capital carrying 10 per cent interest charge.
The equity capitalisation rate applicable to Mahatma is 15 per cent. What is the
market value of Mahatma under the net income method?
Assume there is no tax.
10. The following information is available for two firms, Sachet Corporation and
Zox Corporation.
Sachet Zox
Net Operating Income Rs. 2000000 Rs. 2000000
Interest on Debt Nil 500000
Cost of Equity 15% 15%
Cost of Debt 10% 10%

(a) Calculate the market value of equity, market value of debt, and market
value of the firms.
(b) What is the average cost of capital for each of the firms?
(c ) What happens to the average cost of capital of Box Corporation if it
employs Rs. 30 million of debt to finance a project that yields an operating

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 income or Rs. 4 millions?
(d) What happens to the average cost of capital of Zox Corporation if it
sells Rs. 10 millions of additional equity (at par) to retire Rs. 10 million
of outstanding debt?
In answering the above questions assume that the net income approach and MM
approach apply and there are no taxes.

9.12 Suggested Readings

1) Khan and Jain, Financial Management, (7th Edition).
2) Pandey, I M, Financial Management (6th Edition).
3) Hampton, John J., Financial Management and Policy (3rd edition).
4) Solo man, Ezra & Pringle, John J., An Introduction to Financial Management,
(1978)
5) Weston J., Fred, & Drigham, Managerial Finance, (5th edition).

✪✪✪

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 Lesson : 10

OPTIMUM CAPITAL STRUCTURE

Objective: The major objective of this lesson is to make the students familiar about
the basic idea of optimum capital structure and factors flattering it.
STRUCTURE
10.1 Backdrop
10.2 Features of An Appropriate Capital Structure
10.3 The Optimum Capital Structure Models
10.4 Operating and Financial Leverage Model: EBIT-EPS Analysis
10.5 Cost of Capital and Valuation Model
10.6 Cash Flow Model
10.7 Additional Practical Considerations
10.8 Manager’s Attitude toward Debt
10.9 Optimum Capital Structure: Indian Scene
10.10  Summary
10.11  Self- Assessment Exercise
10.12  Suggested Readings

10.1 Backdrop
Capital structure refers to the mix of long-term sources of funds, such as debentures,
long-term debt, preference share capital and equity share capital including reserves
and surpluses (i.e., retained earnings). Some companies do not graph their capital
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structure, and the financial manager takes the financial decisions without any prescribed
planning. These companies may do well in the short-run, but in due course they may
face considerable difficulties in raising funds to finance their activities. With sponta-
neous capital structure, these companies may also fail to economize the use of their
funds. As a result, it is being all the time more realized that a company should graph its
capital structure to maximise the use of the funds and to be able to adapt more easily to
the changing market state of affairs.
Theoretically, the financial manager should plan an optimum capital structure for his
company. The optimum capital structure is obtained with the market value per share is
most favourable. The value will be maximised when the marginal real cost of each
source of funds is the identical. In practice, the determination of an optimum capital
structure is a terrifying task, and one has to go beyond the theory. There are significant
variations among industries and among individual companies within an industry in terms
of capital structure. Since a number of factors influence the capital structure decision
of a company, the judgment of the person making the capital structure decision, plays
a decisive role. Two similar companies can have different capital structures if the
decision makers differ in their judgment of the implication of various factors. A totally
theoretical model possibly cannot effectively handle all those factors, which have an
effect on the capital structure decision. These factors are highly psychological, complex
and qualitative and do not always follow acknowledged theory, since capital markets
are not perfect and the decision has to be taken under flawed acquaintance and risk.
The purpose of this lesson is to discuss some of the most important factors, which
influence the planning of the optimum capital structure in theory and practice.
10.2 Features of An Appropriate Capital Structure
The board of directors or the chief financial executive of a company ought to develop
an appropriate capital structure, which is most gainful to the company. This can be
done only when all those factors, which are pertinent to the company’s capital structure
decision, are properly analyzed and even handed. The capital structure should be planned
generally keeping in view the interests of the equity shareholders and the financial

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requirements of a company. The equity shareholders, being the owners of the company
and the providers of risk capital (equity) would be fretful about the ways of financing a
company’s operations. However, the interests of other groups, such as employees,
customers, creditors, society and government, should also be given sensible
consideration. When the company lays down its objective in terms of the shareholders’
well being, it is generally attuned with the welfare of other groups.
Thus, while developing an suitable capital structure for its company, the financial man-
ager should inter alia aim at maximizing the long-term market price per share. Theo-
retically, there may be a precise point or range within which the market value per share
is maximum. In practice, for most companies within an industry there may be a range
of an appropriate capital structure within which there would not be great differences in
the market value per share. One way to get an idea of this range is to observe the capital
structure patterns of companies’ vis-à-vis their market prices of shares. I may be found
pragmatic that there are not significant differences in the share values within a agreed
range. The management of a company may fix its capital structure near the top of this
range in order to make maximum use of favourable leverage, subject to other necessi-
ties such as flexibility, solvency, control and norms set by the financial institutions,
the Security Exchange Board of India (SEBI) and stock exchanges. A sound or appro-
priate capital structure should have the following facial appearances.
• Profitability: The capital structure of the company should be most advanta-
geous. Within the constraints, maximum use of leverage at a minimum cost
should be made.
• Solvency: The use of excessive debt threatens the solvency of the company.
To the point debt does not add significant risk it should be used, otherwise its
use should be avoided.
• Flexibility: The capital structure should be flexible to meet the changing
conditions. It should be possible for a company to adapt its capital structure
with a minimum cost and delay if warranted by a changed situation. It should
also be possible for the company to provide funds whenever needed to finance
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 its profitable activities.
• Capacity: The capital structure should be determined within the debt capacity
of the company, and this capacity should not be exceeded. The debt capacity of
a company depends on its ability to generate future cash flows. It should have
enough cash to pay creditors fixed changes and principal sum.
• Control: The capital structure should involve minimum risk of loss of control
of the company. The owners of closely-held companies are particularly
concerned about dilution of control.
The above-mentioned are the universal features of a suitable capital structure. The
particular characteristics of a company may reflect some additional particular fea-
tures. Further, the emphasis given to each of these features will be at variance from
company to company. For example, a company may give more importance to flexibil-
ity than control, while another company may be more apprehensive about solvency
than any other requirement. Furthermore, the relative weight of these requirements
may change with changing state of affairs. The company’s capital structure should,
therefore, be easily adjustable.

10.3    The Optimum Capital Structure Models

The capital structure will be planned at the outset when company is incorporated. The
initial capital structure ought to be designed very cautiously. The management of the
company ought to set a target capital structure and the subsequent financing decisions
ought to be made with a view to achieve the target capital structure. The financial
manager has also to deal with an existing capital structure. The company needs funds
to finance its activities constantly. Every time when funds have to be procured, the
financial manager weighs pros and cons of various sources of finance and selects most
gainful sources keeping in view the target capital structure. Thus the capital structure
decision is a continuous one and has to be taken whenever a firm needs further finances.

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The following are the three most common models to decide about a firm’s optimum
capital structure:
I. Operating and financial leverage model for analyzing the impact of
debt on EPS
II. Cost of capital and valuation model for determining the impact of
debt on the shareholders value.
III. Cash flow models governing the capital structure decisions, many
other factors such as control, flexibility, or marketability are also con-
sidered in practice.
10.4    Operating and Financial Leverage Model: EBIT-EPS            Analysis
We shall emphasize some of the main conclusions here. The use of fixed cost sources
of finance, such as debt and preference share capital to finance the assets of the company
is known as financial leverage or trading on equity. If the assets financed with the use
of debt yield a return greater than the cost of debt the earning per share increases
without an increase in the owners’ investment. The earning per share also increases
when the preference share capital is used to acquire assets. But the leverage impact is
more pronounced in case of debt because (i) the cost of debt is usually lower than the
cost of preference share capital and (ii) the interest paid on debt is tax deductible.
Because of its effect on the earnings per share, financial leverage is an important
consideration in planning the capital structure of a company. The companies with high
level of the earnings before interest and taxed (EBIT) can make profitable use of the
high degree of leverage to increase return on the shareholders equity. One common
method of examining the impact of leverage is to analyze the relationship between
EPS and various possible levels of EBIT under alternative methods of financing.
Illustration
Suppose that a firm has an all-equity capital structure consisting of 1,00,000 ordinary
shares of Rs. 10 per share. The firm wants to raise Rs. 2,50,000 to finance its
investments and is considering three alternative methods of financing: (i) to issue 25,000
common shares at Rs. 10 each, (ii) to borrow Rs. 2,50,000 at a 8 per cent rate of
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interest, (iii) to issue 2,500 preference shares of Rs. 100 each at a 8 per cent rate of
dividend. If the firm’s earnings before interest and taxes after additional investment
are Rs. 3,12,500 and the tax rate is 50 per cent, the effect on the earnings per share
under the three financing alternatives will be as follows:
Table 1. EPS UNDER ALTERNATIVE FINANCING FAVOURABLE EBIT
Equity Debt Preference
Financing financing financing
Rs. Rs. Rs.
EBIT 312500 312500 312500
Less : Interest 0 20000 0
312500 292500 312500
Less Tax 156250 146250 156250
PAT 156250 146250 156250
Less Preference dividend 0 0 20000
Earning available to common 156500 146250 136250
Shareholders
Shares outstanding 125000 100000 100000
EPS 1.25 1.46 1.36

The firm is able to maximise the earnings per share when it used debt financing. Though
the rate of preference dividend is equal to the rate of interest, EPS is high in case of
debt financing because interest charges are tax deductible while preference dividends
are not. With increasing levels of EBIT, EPS will increase at a faster rate with a high
degree of leverage. However, if a company is not able to earn a rate of return on its
assets higher than the interest rate (or the preference dividend rate), debt (or preference
financing) will have adverse impact on EPS. Suppose the firm in the above example
has an EBIT of Rs. 75000, EPS under different methods will be as follows:

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Table 2. EPS UNDER ALTERNATIVE FINANCING METHODS: UNFAVOURABLE EBIT
Equity Debt Preference
Financing financing financing
Rs. Rs. Rs.
EBIT 75000 75000 75000
Less : Interest 0 20000 0
PBT 75000 55000 75000
Less Taxes 37500 27500 37500
PAT 37500 27500 37500
Less Preference dividend 0 0 20000
Earning available to common 37500 27500 17500
Shareholders
Shares outstanding 125000 100000 100000
EPS 0.30 0.27 0.17
It is obvious that, under unfavourable conditions, i.e., when the rate of return on total
assets is less than the cost of debt, the earning per share will fall with the degree of
leverage.
The EBIT-EPS analysis is one important tool in the hands of the financial manager to
get an insight into firm’s capital structure management. He can consider the possible
fluctuations in EBIT and examine their impact on EPS under different financial plans.
If the probability of earning a rate of return on the firm’s assets less than the cost of
debt is insignificant, the firm in its capital structure to increase the earnings per share
can use a large amount of debt. This may have a favourable effect on the market value
per share. On the other hand, if the probability of earning a rate of return on the firm’s
assets less than the cost of debt is very high, the firm should refrain from employing
debt capital. It may, thus, be concluded that the greater the level of EBIT and lower the
probability of downward fluctuation, the more beneficial it is to employ debt in the
capital structure. However, it should be realised that the EBIT-EPS is a first step in
deciding about a firm’s provide unambiguous guide in determining the capital structure
of a firm in practice.
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Limitations of EPS as a financing-decision criterion. EPS is one of the most
widely used measures of the company’s performance. As a result of this, in choosing
between debt and equity in practice, sometimes too much attention is paid on EPS.
EPS, however, has some serious limitations as a financing-decision criterion. The major
shortcoming of the EPS criterion is that is does not consider risk; it ignores the
variability about the expected value of EPS. The belief that investors would be just
concerned with the expected EPS is not well founded. Investors in valuing the shares
of the company consider both expected value and variability.
EPS variability. The EPS variability resulting from the use of leverage is called
financial risk. As discussed, financial risk is added with the use of debt because of (a)
the increased variability in the shareholders earnings and (b) the threat of insolvency.
A firm can avoid financial risk altogether if it does not employ any debt in its capital
structure. But then the shareholders will be deprived of the benefit of the expected
increases in EPS. As we have seen, if a company increased its debt beyond a point, the
expected EPS will continue to increase, but the value of the company will fall because
of the greater exposure of shareholders to financial risk in the form of financial distress.
The EPS criterion does not consider the long-term perspectives of financing decisions.
It fails to deal with the risk-return trade-off. A long-term view of the effects of financing
decisions will lead one to a criterion of wealth maximization rather than EPS
maximization. The EPS criterion is an important performance measure but not a decision
criterion.
Given its limitations should EPS criterion be ignored in making financing decision?
Remember that it is an important index of the firm’s performance and that investors
rely heavily on it for their investment decisions. Investors also do not have information
on the projected earnings and cash flows and base their evaluation on historical data. In
choosing between alternative financial plans, management should start with the evaluation
of the impact of each alternative on near-term EPS. But the best interests of shareholders
should guide management’s ultimate decision making. Therefore, a long-term view of
the effect of the alternative financial plans on the value of the shares should be taken.

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If management opts for a financial plan that will maximize value in the long run but has
an adverse impact on near-term EPS, the reasons must be communicated to investors.
A careful communication to market will be helpful in reducing the misunderstanding
between management and investors.
Operating conditions. One very important factor on which the variability of EPS
depends is the growth and stability of sales. The magnitude of the EPS variability with
sales will depend on the degrees of operating and financial leverages employed by the
company. The firms with stable sales and favourable cost price structure and successful
operating strategy will have stable earnings and cash flows and thus, can employ a high
degree of leverage, as they will not face difficulty in meeting their fixed commitments.
The likely fluctuations in sales increase the business risk. A small change in sales can
lead to a dramatic change in the earnings of a company when its fixed costs and debt are
high. As a result, the shareholders perceive a high degree of financial risk if such
companies employ debt. A company will get into a debt trap if operating conditions
become unfavourable and it lacks focussed strategy. (See Exhibit 1 for an example of
a company in a debt trap.)
EXHIBIT 1. DEBT TRAP: CASE OF HINDUSTAN SHIPYARD
1. The fluctuating raw material and components price ups and downs in the
revenues and profits of a ship-building company. With right operating
strategy and appropriate and prudent financing a company can manage to
sail safely. Hindustan Shipyard Limited (HSL), however, is finding it quite
difficult to come out of the troubled waters due to huge borrowings. It has
total out standings of Rs. 554 crore: working capital loan Rs. 138 crore,
development loan for modernization Rs. 69 crore, outstanding interest on
these loans Rs. 160 crore; cash credit Rs. 62 crore; outstanding interest on
cash credit Rs. 65 crore, and penal interest Rs. 60 crore. How did this
happen?
2. HSL’s trouble began when, between 1981 and 1982, Japanese and South
Korean shipbuilders started offering “heavily subsidized rates” against
the rates fixed by the Indian government, based on international parity
price. In effect, building ships turned out to be unviable for the yard.
Further, HSL’s overline bill soared up, being a highly overstaffed company.

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 It has 11000 workers in 1990. A lack of strategy paved way for unchecked
downfall. Orders continued declining, and became almost nil by 1988 and
1989. To not improve, the company fell deeper and deeper into debt trap.
3. HSL is technically insolvent. The capital restructuring plans are on to put
company back on its feet.
Sales of the consumer goods industries show wide fluctuations; therefore, they do not
employ a large amount of debt. On the other hand, the sales of public utilities are quite
stable and predictable. Public utilities, therefore, employ a large amount of debt to
finance their assets. The expected growth in sales also affects the degree of leverage.
The greater the expectation of growth, the greater the amount of external financing
needed since it may not be possible for the firm to cope up with growth through internally
generated funds. A number of managers consider debt to be cheaper and easy to raise.
The growth firms, therefore, may usually employ a high degree of leverage. Companies
with declining sales should not employ debt in their capital structures, as they would
find difficulty in meeting their fixed obligations. Non-payment of fixed charges can
force a company into liquidation. It may be noted that sales growth and stability is just
one factor in the leverage decision; many other factors would dictate the decision.
There are instances of a large number of high growth firms employing no or small
amount of debt.
10.5 Cost of Capital and Valuation Model
We are familiar with the problem of measuring the cost of various sources of finance.
Here we shall compare the costs of various sources of finance to show the desirability
of one source over the other. Let us reiterate the main conclusions of our discussion
of the cost of capital and valuation discussed earlier.
The cost of a source of finance is the minimum return expected by its suppliers. The
expected return depends on the degree of risk assumed by investors. Shareholders
than debt-holders assume a high degree of risk. In the case of debt-holders, the rate of
interest is fixed and the company is legally bound to pay interest whether it makes
profits or not. For shareholders the rate of dividends is not fixed and the board of
directors has no legal obligation to pay dividends even if the company makes the profits.
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The loan of debt-holders is returned within a prescribed period; while shareholders
will have to share the residue only when the company is would up. This leads one to
conclude that debt is a cheaper source of funds than equity. This is generally the case
even when taxes are not considered. The tax deductibility of interest charges further
reduces the cost of debt. The preference share capital is also cheaper than equity capital,
but is not as cheap as debt is. Thus, using the component, or specific, cost of capital as
a criterion for financing decisions, a firm would always like to employ debt since it is
the cheapest source of funds.
Pecking Order Hypothesis: The cost of equity includes the cost of new issue of
shares and the cost of retained earnings. The cost of debt is cheaper than the costs of
both these sources of equity funds. Between the cost of new issue and retained earnings,
the latter is cheaper. The cost of retained earnings is less than the cost of new issues
because the personal taxes have to be paid by shareholders on distributed earnings
while no taxes are paid on retained earnings and because no floatation costs are incurred
when the earnings are retained. As a result, between the two sources of equity funds,
retained earnings are preferred. It has been found in practice that firms prefer internal
finance. If the internal funds are not sufficient to meet the investment outlays, firms
go for external finance, issuing the safest security first. They start with debt, then
possibly hybrid securities such as convertible debentures, then perhaps equity as a last
resort. Myers has called it the pecking order theory since there is not well-defined
debt-equity target and there are two kinds of equity, internal and external, one at the top
of the pecking order and one at the bottom.
Trade-off Theory: The specific cost of capital criterion does not consider the entire
issue. It ignores risk and the impact on equity value and cost. The impact of financing
decision on the overall cost of capital should be evaluated and the criterion should be
to minimize the overall cost of capital, or to maximise the value of the firm. If we
consider the tax shield advantage of debt (on account of interest tax deductibility),
then debt would have a favourable impact on value and would help to reduce the overall
cost of capital. It should, however, be realised that a company cannot continuously
minimize its overall cost of capital by employing debt. A point or range is reached
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beyond which debt becomes more expensive because of the increased risk of excessive
debt to creditors as well to shareholders (financial distress). When the degree of
leverage increases, the risk of creditors increased and they demand a higher interest
rate and to not grant loan to the company at all once its debt has reached a particular
level. Further, the excessive amount of debt makes the shareholder’s position very
risky. This has the effect of increasing the cost of equity. Thus, up to a point the
overall cost of capital decreases with debt, but beyond that point the cost of capital
would start increasing and, therefore, it would not be advantageous to employ debt
further. So there is a combination of debt and equity, which minimizes the firm’s
average cost of capital and maximizes the market value per share. In practice, there is
generally a range of debt-equity ration within which the cost of capital is minimum or
the value is maximum. As stated earlier in this chapter for individual companies this
range can be found out empirically and the can operate safely within that rang.
The valuation framework makes it clear that excessive debt will reduce the share price
(or increase the cost of equity) and thereby lower the overall return to shareholders,
despite the increase in EPS. The return of shareholders is made of dividends and
appreciation in share prices, not of EPS. Thus, the impact of debt-equity ratio should
be evaluated in terms of value, rather than EPS. The difficulty with the valuation
framework is that managers find it difficult to put into practice. It is not possible for
them to quantify all variables. Also, the operations of the financial markets are so
complicated that it is not easy to understand them. But this kind of analysis does
provide insights and qualitative guidance to the decision maker.
The trade-off between cost of capital and EPS set the maximum limit to the use of
debt. However, other factors should be evaluated to determine the appropriate capital
structure for a company.
10.6 Cash Flow Model
One of the features of a sound capital structure is conservation. Conservatism does
not mean employing no debt or small amount of debt. Conservatism is related to the
fixed changes created by the use of debt or preference capital in the capital structure
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and the firm’s ability to generate cash to meet these fixed charges. In practice, the
question of the optimum (rather appropriate) debt-equity mix boils down to the firm’s
ability to service debt without any threat and operating inflexibility. A firm is considered
prudently financed if it is able to service its fixed charged under any reasonably
predictable adverse conditions.
The fixed charges of a company include payment of interest, preference dividends and
principal, and they depend on both the amount of senior securities and the terms of
payment. The amount of fixed charges will be high if the company employs a large
amount of debt or preference capital with short-term maturity. Whenever a company
thinks of raising additional debt, it should analyze its expected future cash flows to
meet the fixed charges. It is mandatory to pay interest and return the principal amount
of debt. If a company is not able to generate enough cash to meet its fixed obligation,
it may have to face financial insolvency. The companies expecting larger and stable
cash inflows in the future can employ a large amount of debt in their capital structure.
It is quite risky to employ fixed charges sources of finance by those companies whose
cash inflows are unstable and unpredictable. It is possible for a high growth, profitable
company to suffer from cash shortage if its liquidity (working capital) management is
poor. We have examples of companies like BHEL, NTPC etc., whose debtors are very
sticky and they continuously face liquidity problem in spite of being profitable. Servicing
debt is very burdensome for them.
One important ratio, which should be examined at the time of planning the capital
structure, is the ratio of net cash inflows to fixed charges (debt-servicing ratio). It
indicates the number of times the fixed financial obligations are covered by the net
cash inflows generated by the company. The greater the coverage, the greater the amount
of debt a company can use. However, a company with a small coverage can also employ
a large amount of debt if there are not significant yearly variance in its cash inflows and
a small probability of the cash inflows being considerably less to meet fixed charges in
a given period. Thus, it is not the average cash inflows but the yearly cash inflows,
which are important to determine the debt capacity of a company. Fixed financial
obligations must be met when due, not on an average and not in most years but always.
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This requires a full cash flow analysis.
Debt capacity. The technique of cash flow analysis is helpful in determining the firm’s
debt capacity. Debt capacity is the amount, which a firm can service easily, even under
adverse conditions; it is the amount that the firm should employ. There may be lenders
who are prepared to lend to you. But you should borrow only if you can service debt
without any problem. A firm can avoid the risk of financial distress if it can maintain
its ability to meet contractual obligation of interest and principal payments. Debt
capacity therefore should be thought in terms of cash flows rather than debt ratios. A
high debt ratio is not necessarily bad. If you can service high debt without any risk, it
will increase shareholders wealth. On the other hand, a low debt ratio can prove to be
burdensome for a firm, which has liquidity problem. A firm faces financial distress
(or even insolvency) when it has cash flow problem. It sis dangerous to finance a
capital-intensive project out of borrowings which has built in uncertainty about the
earnings and cash flows. National Aluminium Company is an example of a wrong
initial choice of capital structure, without analyzing the company’s debt servicing ability
(See Exhibit 2).
EXHIBIT 2. DEBT BURDEN UNDER CASH CRUNCH: A CASE OF NALCO
1. National Aluminium Company (NALCO). Started in 1981, is the largest
integrated aluminium complex in Asia of total investment of Rs. 2,408 crore,
borrowings from a consortium of European banks financed to the extent of
$830 million or Rs. 1119 crore (46.5 per cent). The loan was repayable by
1995. Aluminium is an electricity intensive business; each tonne of
aluminium needs over 15000 kWh of electricity. Since it’s commissioning
in 1988. Nalco has exported substantial portion of its production since the
domestic demand has been very low than what the company had projected
at its inception. The falling international prices in last few years have
eroded the company’s profitability. The net profit of Rs. 172 crore in 1989
dropped to Rs. 14 crore in 1991-92. The Rs. 1119 crore Eurodollar loan
has appreciated to Rs. 2667 crore in spite of having repaid Rs. 644 crore.
Due to profitability and liquidity problem and hit by the depreciating rupee
and the liberalized exchange mechanism, the company is forced to
reschedule repayments of its debt by the year 2003 instead of 1995. Nalco’s
debt-equity ratio has increased from 1: 1 to 2.7: 1.
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 2. The reasons for Nalco’s plight are its decision to go for the production of
aluminium, which consumes heavy electricity in addition to alumina. The
problem of power shortage led to the setting up of power plant, which is
proving very costly to the company. The overcapacity of aluminium
production world wide and highly competitive prices has added to Nalco’s
woes. Nalco is trying to get out of its problems by attempting to diversity
into value-added products.
3. Nalco’s fate can change if the domestic demand for aluminium picks up and
international fate can change if the domestic debt of the company poses a
question: Should you use heavy dose of debt (since it is available from
certain sources) to finance investments in a business like aluminium which
has worldwide overcapacity, fluctuating international prices and expensive
and short supply of electricity in the country in which it is set up? Debt
would accentuate the financial crises when a company has built in operating
uncertainties.
Components of cash flows. The cash flows should be analyzed over a long period of
time, which can cover the various adverse phases, for determining the firm’s debt policy.
Preparing proforma cash flow statements to show the firm’s financial conditions under
adverse conditions such as a recession can carry out the cash flow analysis. The expected
cash flows can be categorized into three groups:
1. Operating cash flows
2. Non-operating cash flows
3. Financial flows.
Operating cash flows relate to the operations of the firm and can be determined from
the projected profit and loss statements. The behaviour of sales volume, output price
and input price over the period of analysis should be examined and predicted.
Non-operating cash flows generally include capital expenditures and working capital
changes. During a necessary period, the firm may have to specially spend for the
promotion of the product. Such expenditures should be included in the non-operating
cash flows. Certain types of capital expenditure cannot be avoided even during most
adverse conditions. They are necessary to maintain the minimum operating efficiency.
Such irreducible, minimum capital expenditure should be clearly identified.
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Financial flows include interest, dividends, lease rentals, repayment of debt etc. they
are further divided into: contractual obligations and policy obligations. Contractual
obligations include those financial obligations, like interest, lease rentals and principal
payments that are matters of contract, and should not be defaulted. Policy obligations
consist of those financial obligations, like dividends, that are at the discretion of the
board of directors. Policy obligations, like dividends, that are at the discretion of the
board of directors. Policy obligations are also called discretionary obligations.
The cash flow analysis may indicate that decline in sales resulting into profit decline
or losses may not necessarily cause cash inadequacy. This may be so because cash
may be released from permanent inventory and receivables. Also, some of the permanent
current liabilities may decline with fall in sales and profits. On the other hand, when
sales and profits are growing the firm may face cash inadequacy as large amount of
cash is needed to finance growing inventories and receivables. If the profits decline
due to increase in expenses or falling output prices instead of the decline in the number
of units sold, the firm may face cash inadequacy because its funds in inventories and
receivables will not be released. The point to be emphasized is that a firm should carry
out cash flow analysis to get a clear picture of its ability to service debt obligations
even under the adverse conditions, and thus, decide about the proper amount of dent in
the capital structure. Examining the impact of alternative debt policies on the firm’s
cash flow ability can do this. The firm should then choose the debt policy, which it can
service.
Cash flow analysis versus EBIT-EPS analysis. Is cash flow analysis superior to
EBIT-EPS analysis? How does it incorporate the insights of the finance theory? The
cash flow analysis has the following advantages over EBIT-EPS analysis.
• It focuses on the liquidity and solvency of the firm over a long -period of time,
even encompassing adverse circumstances. Thus, it evaluates the firm’s ability
to meet fixed obligations.
• It goes beyond the analysis of profit and loss statement and also considers
changes in the balance sheet items.
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 • It identifies discretionary cash flows. The firm can thus prepare an action plan
to face adverse situations.
• It provides a list of potential financial flows, which can be utilized under
emergency.
• It is long-term, dynamic analysis, and does not remain confined to a single period
analysis.
The most significant advantage of the cash flow analysis is that it provides a practical
way of incorporating the insights of the finance theory. As per the theory, debt financing
has tax advantage. But is also involves risk of financial distress. Therefore, the optimum
amount of debt depends on the trade-off between tax advantage of debt and risk of
financial distress. Financial distress occurs when the firm is not in a position to meet
its contractual obligations. The cash flow analysis indicates when the firm will find it
difficult to service its debt. Therefore, it is useful in providing good insights to
determine the debt capacity, which helps to maximise the market value of the firm.
Cash flow analysis versus debt-equity ratio. The cash flow analysis discussed above
clearly reveals that a higher debt equity ratio is not risky if the company has the ability
of generating substantial cash inflows in the future to meet its fixed financial obligations.
Financial risk in this sense is indicated by the company’s cash flow ability, not by the
debt equity ratio.
To quote Van Horne.……the analysis of debt-to-equity ratios alone can be
deceiving, and analysis of the magnitude and stability of cash-flows relative to
fixed charges is extremely important in determining the appropriate capital
structure for the firm. To the extent that creditors and investors analyze a firm’s
cash flow ability to service debt, and management’s risk preferences correspond
to those of investors, capital structure decisions made in this basis should tend
to maximise share price.
The cash flow analysis does have its limitations. It is difficult to predict all possible
factors that may influence the firm’s cash flows. Therefore, it is not a perfect technique
to determine the firm’s debt policy.
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10.7 Additional Practical Considerations
The determination of capital structure in practice involves additional considerations in
addition to the concerns about EPS, value and cash flow. Attitudes of managers with
regard to financing decisions are quite often influenced by their desire not to lose
control, to maintain operating flexibility, and to have convenient and cheaper means of
raising funds. The most important considerations are discussed hereunder:
1. Control. In designing the capital structure, sometimes the existing management
is governed by its desire to continue control over the company. This is
particularly so in the case of the firms promoted by entrepreneurs. The existing
management team not only wants control and ownership but also to manage the
company, without any outside interference.
2. Widely-held companies. The ordinary shareholders elect the directors of the
company. If company issues new shares, there is risk of dilution of control.
This is not a very important consideration in the case of a widely held company.
The shares of such company are widely scattered. Most of the shareholders are
not interested in taking active part in the company’s management. Nor do they
have time and money to attend the meetings. They are interested in dividends
and capital gains. If they are not satisfied, they will sell their shares. Thus, the
best way to ensure control and to have the confidence of the shareholders is to
mange company most efficiently and compensate shareholders in the form of
dividends and capital gains. The risk of loss of control can be reduced by
distribution of shares widely and in small lots.
3. Closely-held companies. The consideration of maintaining control may be
significant in case of a closely held, small company. A shareholder or a group
of shareholders can purchase all or most of the new shares and control the
company. Even if the owner managers hold the majority shares, their freedom
to manage the company will be curtailed when they go public for the first time.
Fear of sharing control and being interfered by others often delays the decision
of the closely held companies to go public. To avoid the risk of loss of control,
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 small companies may slow their rate of growth or issue preference shares or
raise debt capital. If the closely held companies can ensure a wide distribution
of shares, they need not worry about the loss of control so much.
The holders of debt do not generally have voting rights. Therefore, it is suggested
that a company should use debt to avoid the loss of control. However, when a
company uses large amount of debt, a lot of restrictions are put by the debt
holders, specifically the financial institutions in India since they are the major
providers of loan capital to the companies, on company to protect their interest.
These restrictions curtail the freedom of the management to run the business.
A very excessive amount of debt can also cause serious liquidity problem and
ultimately render the company sick, which means a complete loss of control.
4. Flexibility. Flexibility is one of the most serious considerations in setting up
the capital structure. Flexibility means the firm’s ability to adapt its capital
structure to the needs of the changing conditions. The company should be able
to raise funds, without undue delay and cons, whenever needed to finance the
profitable investments. It should also be in a position to redeem its preference
capital or debt whenever warranted by the future conditions. The financial plan
of the company should be flexible enough to change the composition of the
capital structure as warranted by the company’s operating strategy and needs. It
should also be able to substitute one form of financing for another to economise
the use of funds.
5. Loan covenants. Restrictive covenants are commonly included in long-term
loan agreements and debentures. These restrictions curtail the company’s
freedom in dealing with the financial matters and put it in an inflexible position.
Covenants in loan agreements may include restrictions to distribute cash
dividends, to incur capital expenditure, to raise additional external finances or
to maintain working capital at a particular level. These restrictions may be
quite reasonable from the lenders point of view as they are meant to protect
their interest, but they reduce the flexibility of company to operate freely and

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 may become burdensome if conditions change. Therefore, a company while
issuing debentures or accepting other forms of long term debt, should ensure
that a minimum of restrictive clauses, that circumscribe its financial action in
future are included in debt agreements.
6. Early repayability. A considerable degree of flexibility will be introduced in
a company has the discretion of early repaying its debt and preference share
capital. This will enable management to retire or replace cheaper source of
finance for the expensive one whenever warranted by the circumstances. When
a company has excess cash inflows and does not have profitable investment
opportunities, it becomes desirable to retire debt. Similarly, a company can
take advantage of a declining rate of interest if it has a right to repay debt at its
option. Suppose that funds are available at 15 per cent rate of interest presently.
The company has outstanding debt at an 18 per cent rate of interest. It can save
in terms of interest cost if in can retire the ‘old’ debt and replace it by the ‘new’ debt.
7. Reserve capacity. The flexibility of the capital structure also depends on the
company’s debt capacity. The greater the debt capacity and the greater the
availability of unused debt capacity, the greater the degree of flexibility. If a
company borrows to the limit of its capacity, it will not be in a position to
borrow additional funds to finance unforeseen and unpredictable demands except
at restrictive and unfavourable terms. Therefore, a company should not borrow
to the limit of its capacity, but keep available some unused capacity to raise
funds in future to meet some sudden demand for finances.
Although flexibility is most desirable, it is achieved at a cost. A company trying
to obtain loans on easy terms will have to pay interest at a higher rate. Also, to
obtain the right of refunding, it may have to compensate lenders by paying a
higher interest. Therefore, the company should compare the benefits and costs
of attaining the desired degree of flexibility and balance them properly.
8. Marketability. Marketability means the readiness of investors to purchase a
security in a given period of time and to demand reasonable return. Marketability
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 does not influence the initial capital structure, but it is an important consideration
to decide about the appropriate timing of security issues. The capital markets
are changing continuously. At one time, the market favours debenture issues,
and, at another time, it may readily accept common share issues. Due to the
changing market sentiments, the company has to decide whether to raise funds
with a common shares issue or with a debt issue. The alternative methods of
financing should, therefore, be evaluated in the light of general market conditions
and the internal conditions of the company.
9. Market conditions. If the share market is depressed, the company should not
issue common shares, but issue debt and wait to issue common shares till the
share market revives. During boom period in the share market, it may be
advantageous for the company to issue shares at high premium. These will help
to keep its debt capacity unutilized. The internal conditions of a company may
also dictate the marketability of securities. For example, a highly levered
company may find it difficult to raise additional debt. Similarly, when restrictive
covenants in existing debt agreements preclude payment of dividends on
common shares, convertible debt may be the only source to raise additional
funds. A company may find difficulty to issue any kind of security in the market
merely because of its small size. The heavy indebtedness, low rating of the
company, which would make it difficult for the company to raise external finance
at favourable terms.
10. Flotation costs. Flotation cost is not a very important factor influencing the
capital structure of a company. Flotation costs are incurred only when the funds
are externally raised. Generally, the cost of floating a debt is less than the cost
of floating an equity issue. This may encourage a company to use debt than
issue common shares. If retaining the earning no flotation cost increases the
owners capital are incurred. To repeat, except sometimes in the case of small
companies, flotation cost are not a significant consideration to decide about
the alternative forms of financing.

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 Flotation costs, as a percentage of funds raised will decline with larger amount
of funds. Therefore, it can be an important consideration in deciding the size of
a security issue. The company will save in terms of flotation costs if it raises
funds through large issues of securities. But a large issue can curtail company’s
financial flexibility. Also, the company should raise only that much of funds,
which can be employed profitably. Many other more important factors, as
discussed above, have to be considered when deciding about the methods of
financing and the size of a security issue.
11. Availability: size of the company. The size of a company may influence the
availability of funds from different sources. A small company finds great
difficulties in raising long-term loans. If it is able to obtain some long-term
loan, it will be available at a higher rate of interest and inconvenient terms. The
highly restrictive covenants in loan agreements in case of small companies make
their capital and retained earnings for their long-term funds. It is quite difficult
for small companies to raise share capital in the capital markets. Also, the
capital base of most small companies is so small that they are not allowed to be
registered in the stock exchanges. Those small companies, which are able to
approach the capital markets, the cost of issuing shares is generally more for
them than the large ones. Further, resorting frequently to ordinary share issues
to raise long-term funds carries a greater danger of the possible loss of control
to a small company than to a large company. The shares of a small company are
not widely scattered and the dissident group of shareholders can be easily
organized to get control of the company. The small companies, therefore,
sometimes limit the growth of their business to what can easily be financed by
retaining the earnings.
A large company has relative flexibility in designing its capital structure. It can obtain
loans on easy terms and sell common shares, preference shares and debentures to the
public. Because of the large size of issues, its cost of distributing a security is less
than that for a small company. A large issue of ordinary shares can be widely distributed

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and thus, making the loss of control difficult. The size of the firm has an influence on
the amount and the cost of funds, but it does not necessarily determine the pattern of
financing. In practice, the debt-equity ratios of the firms do not have a definite
relationship with their size.
10.8 Manager’s Attitude Towards Debt
We know now the factors, which are theoretically important in determining the capital
structure policy of a company. They are interest tax shield (adjusted for personal
taxed) and financial risk. We also know the additional factors in practice such as sales
growth and stability, cash flow, market conditions, transaction costs etc. which may
have influence on the choice of capital structure. How do managers view the question
of borrowing? There seems to be a mixed feeling. Some would prefer borrowing
while others would like to decide after considering variety of factors. They also feel
that they can borrow only when lenders are prepared to lend. They think that lenders
evaluate a number of before deciding to lend, and these factors go beyond the theoretical
considerations or risk and returns. Exhibit 3 summarizes the perceptions of manager’s
vis-à-vis borrowing.
Analysis of Capital Structure in Practice: Case of Larsen and Toubro
In this section, we analyze the capital structure of Larsen and Toubro ( L & T). L & T is
a well-known engineering company in India. It was founded in 1938. It is a well-
diversified company, having sales of Rs. 1,092 crore and total assets of Rs. 1,651
crore in 1990. L&T covers a wide range of manufacturing activities. Main activities
include dairy equipment, cement and cement equipment, steel, paper, nuclear power
and space exploration, hydraulic excavators, switchgears, electronic controls, valves
welding alloys, computer peripherals, excavators, switchgears, electronic controls,
valves welding alloys, computer peripherals, test and measuring equipments etc.

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 EXHIBIT 3. DO MANAGERS PREFER BORROWING?
• A number of companies in practice would always prefer to borrow for the
following reasons:
1. Tax deductibility of interest
2. Higher return to shareholders due to gearing
3. Complicated procedure for raising equity capital
4. No dilution of ownership and control
5. Equity results in a permanent commitment than debt.
There are, however, managers whose choice of financing depends on internal and external
factors. The internal factors include: purpose of financing, company’s earning capacity,
existing capital structure, cash flow ability, investment plans etc. The external factors
are: capital and money market conditions, debt-equity stipulations followed by
financiers, restrictions imposed etc. A company, for example, feels:
“There can be no specific preference towards borrowings as a source of finance.
The company’s financial requirement will vary from time to time depending on
factors such as its existing capital structure, investment plans vis-à-vis expansion,
modernization and replacement as also its margin money requirement for
incremental working capital. In addition, the cost of share issue, existing money
market and banking conditions and the impact of statutory regulations would
influence the mix of finance required by a company.”
In practice, it may not be possible for a company to borrow whenever it wants. Lenders
may analyze a number of characteristics of the borrower before they decide to lend.
What factors do borrowers think are considered by lenders? Borrowing-firms managers
perceive the following factors in order of importance being considered by lenders: (i)
profitability, (ii) quality of management, (iii) security, (iv) liquidity, (v) existing debt-
equity ratio, (vi) sales growth, (vii) net worth, (viii) reserve position, and (ix) fluctuations
in profits.
Table 3 provides data about L&T’s debt-equity ratio, interest coverage, interest as a
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percentage of sales, and average market price ( AMP). We may observe three phases in
L & T’s borrowing policy. Prior to 1982, the company followed a conservative debt-
equity ratio; its equity always exceeded its debt.
Table 3 LARSEN & TOUBRO’S DEBT RATIOS AND OTHER DATA
Year Debt equity ratio Interest coverage Interest as AMP (Rs.)
%of sales
1976 0.57 5.50 2.80 25.33
1977 0.47 10.30 1.50 56.80
1978 0.43 6.90 2.10 54.20
1979 0.71 6.10 2.40 57.80
1980 0.58 5.60 2.60 57.00
1981 0.55 7.70 1.90 80.60
1982 1.45 2.90 5.50 163.84
1983 1.54 2.30 7.80 143.04
1984 1.75 2.20 9.20 187.52
1985 1.14 2.10 9.60 312.32
1986 1.27 2.00 9.40 587.52
1987 1.43 1.80 10.10 366.72
1989 1.22 1.50 8.70 416.64
1990 1.85 1.60 7.50 335.20
1991 1.25 2.56 7.04 465.60
1992 0.63 3.50 4.08 940.80
1993 0.10 4.73 2.06 no
Note: L & T changes its accounting period in 1981 and 1989. Data for these years
has been annualized. The company paid bonus share in 1976, 1982, and 1986.
AMP data has been adjusted accordingly.
This is also reflected in the interest coverage ratio (viz., earnings before interest and
taxed divided by interest), which has generally remained around 5-6 times. The company
resorted to heavy reliance on debt after 1981; as a consequence, debt-equity ratio
significantly increased — it was highest at 1.85 in 1990. Once again 1991 onwards the
use of debt has reduced considerably. In fact, total debt to equity ratio has declined to
0.19 in 1993. It is reported that it has further reduced to 0.10 in 1994 (see figure 1)
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Because of heavy borrowing, interest coverage ratio has deteriorated after 1981; it
hovered around 2-3 times until 1986 and became less than 2 thereafter. Coverage ratio
has again improved in the last three years because of low debt. (See Figure 2). Interest
charges constitute around 8-10 per cent of sales since 1984 until recently. As a
percentage to sales, it has come down to 2.6 per cent in 1993.
L&T capital structure has changes after 1981 on account of its large diversification
activities. The company has grown more than what could be financed from internal
funds. After 1981, company’s capital expenditures (CAPEX) have increased
substantially, and a large part of them has been financed out of borrowing. Thus, its
borrowing has been moving up with its capital expenditures. The company continues
retaining 70 per cent of its earnings. It has also made three rights issues of about Rs.
300 crore during last 17 years. The company also augmented its equity base to borrow
more by converting loans and debentures into equity.
The company’s financing policy has undergone a change recently. During last three
years it has financed its expansion mainly from retained earnings and to some extent
issue of shares. It has been able to “retire” its long-term debt partly through conversion
into equity. The change in the company’s financial position during last three year is
shown in Table 4.
Table 4. L & T’s FINANCIAL POSITION : 1991-93.
1990-91 1991-92 1992-93
CAPEX 106.84 128.23 365.84
Investments (54.11) 65.13 (89.53) Net
current assets (2.15) 123.60 59.20
Total use 50.58 316.96 335.51
Internal funds 155.64 363.52 544.12
Share capital 7.34 54.19 80.33
Net worth 162.98 417.71 624.45
Long-term borrowing (47.91) (125.56) (373.07)
Bank borrowing (63.74) 23.81 84.90
Net borrowing (111.65) (101.75) (288.17)
Total Source 51.33 315.96 336.28
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 * The discrepancy in total use and total source is due to rounding off error.
The company’s capital structure until 1980’s had a history of heavy reliance on the
shareholder’s equity. This pattern charged during the next decade when L & T borrowed
heavily for financing its growth. A large part of the borrowing during this period was
raised through convertible debentures. The company has again consolidated its financial
position and capability by improving internal generation of funds and reducing debt. At
the end of 1993 the company’s total debt-equity ratio was 0.19 : 1 and merely 0.10 in
1994. Thus the company has a large reserve debt capacity providing it with financial
capability to easily fund its diversification and expansion programmes in future. L & T
has plans to diversify into related areas, which have a synergy with its current operations.
It is estimated that company may require additional Rs. 800 crore to carry out its
investments. L &T has already planned to make $ 100 million Euro issue. The company
can also make a rights issue to finance its expansion.
10.9 Optimum Capital Structure: Indian Scene
Raising of funds to finance the firm’s investments is an important function of the
financial manager. In practice, it is observed that financial managers use different
combinations of debt and equity. A practical question therefore is : What motivates
them to do so ? More fundamental questions to be answered are : (1) Does use of debt
create value? (2) If so, do firms gravitate towards an optimum mix of debt and equity?
In theory, it is argued that the financing decision is irrelevant under perfect capital
markets. When within the framework of perfect capital markets, taxes and bankruptcy
costs are assumed, the financial economists argue that an optimum capital structure,
which maximized the market value of the firm ( or minimizes cost of capital), can
exist. In the finance literature, two alternate theories are also found justifying the
optimum capital structure in the absence of bankruptcy costs and taxes. One theory
justifies optimum capital structure in items of the agency costs while another justifies
it in terms of the information signaling. Agency costs are costs of monitoring the
performance of managers. To protect their interests, debt holders will provide for
various covenants in the loan agreement. Similarly, the new shareholders will have to
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incur monitoring costs for safeguarding their interests. Thus, agency costs are involved
both in raising debt and equity. At the optimum mix of debt and equity total agency
costs will be minimised. Alternatively, it is also plausible that managers may use the
decision of debt-equity mix to convey information to investors, as market prices of
shares do not reflect entire information.
The empirical evidence on the capital structure and the cost of capital is as conflicting
or inconclusive as the theory is. The empirical evidence, however, seems to be somewhat
titled in favour of the view that debt has net tax advantage. What is also clear is that
zero debt is not optimum. In practice, firms in developed countries like USA or in
developing countries like India are found following different financing policies - some
aggressive and some conservative. One needs to investigate in to the causes of this
behaviour.
Capital structure and the cost of capital: We would refer to two Indian’s studies on
the relationship between the cost of capital and the capital structure. Sarma and Rao
(1968)2 following Modigliani and Miller’s ( M-M’s) 1966 article, 3 employed a two-
stage least square method on the data of 30 Indian engineering firms for three years. In
their estimates, the leverage variable had a coefficient greater than the tax rate. Thus,
agreeing with the traditional view, they concluded that the cost of capital is affected by
debt apart from its tax advantages.
Another study was conducted by Pandey (1981). He attempted to determine the
empirical relationship between cost of capital and the capital structure using data of 4
industries viz., cotton (47), chemicals (32) engineering (32), and electricity generation
(20). To account for the heterogeneous characteristics of the sample firms, be
introduced a proxy for risk variable measured by the coefficient of variation of the net
operating income. Other explanatory variables, expected to influence the cost of capital
and/or leverage, were also incorporated in the regression equations. These variables
were: size, growth, payout, and liquidity. Two measures of leverage were used. The
first measure included preference capital in debt, while the second measure treated it
as a part of equity. Because of the substitutability of short-term loans for long-term

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loans in India, debt included both short-term and long-term debt. When the average
cost of capital was regressed with leverage, holding other variables constant, the results
were found consistent with the traditional position. In view of the M-M’s (1963) tax
corrected article, for supporting the traditional view, it should be shown that the cost
of capital would decline with leverage even in the absence of tax deductibility of interest
charges. Therefore, a modified model was used in Pandey’s study. The regressions
were run for the pooled data of 3 industries; electricity generation industry was excluded
for the lack of sufficient number of observations. The coefficients of leverage variable
were significant and negative in sign. The third regression model was used to determine
the empirical relation with leverage and the cost of equity. If the M-M view is correct,
the cost of equity must increase linearly with leverage. On the other hand, if the
traditional view approximates the reality, the cost of equity function would be either
horizontal or rise slightly up to some level of leverage. Contrary to these views, Pandey’s
study explored the possibility of the cost of equity declining with leverage up to a
certain level. The basis for this possibility is that leverage could accelerate growth in
earnings and if growth in earnings is higher than the risk, then cost of equity could
decline with leverage. This hypothesis could be established only in the case of
electricity industry. The results of other industries, however, showed that cost of equity
remains constant up to a level of leverage change. Thus, the results of these models
also generally supported the traditional view. It is observed that the lack of consistency
in the behaviour of equity with leverage is not entirely unexpected. Firms within the
same industry differ widely with respect to their economic characteristics. Moreover,
risk preferences of investors differ. As a result, leverage may affect the cost of equity
differently.
Determinants of capital structure: Some studies have been conducted to ascertain
the determinants of financial leverage under the Indian context. Bhat’s (1980) paper
concerned the impact of size, growth, business risk, dividend policy, profitability, debts
service capacity and the degree of operating leverage on the leverage ratio of the firm.
They study used the multiple regression model to find out the contribution of each

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characteristic. Business risk (defined as earnings instability), profitability, dividend
payout and debt service capacity were found to be significant determinants of the
leverage ratio. The study used a sample of 62 companies from engineering industry.
Pandey’s (1984) study about the corporate managers’ attitude towards use of borrowings
in India revealed that the practicing managers generally preferred to borrow instead of
using other sources of funds because of low cost of debt due to the interest tax
deductibility and the complicated procedures for raising the equity capital. In the light
of this finding, Pandey (1985) conducted another empirical study examining the
industrial patterns, trend, and volatilities of leverage and the impact of size, profitability,
and growth on leverage. For this purpose, data of 743 companies in 18 industrial
groups for the period 1973-74 to 1980-81 were analyzed. It was found that about 72 to
80 per cent of the assets of sample companies were financed by external debt, including
current liabilities. Companies employed trade credit as much as bank borrowings. The
level of leverage for all industries showed a noticeable increase after 1973-74. The
study also indicated that classifying leverage percentages by the type of industry does
not produce any patients, which may be regarded as systematic and significant. The
trends and volatilities associated with the leverage percentages also did not give any
support to the belief that the type of industry had an impact on the degree of leverage.
It also revealed that there was some evidence of the tendency of large size companies
to concentrate in the high levels of leverage. But it is difficult to say conclusively that
size has an impact on the degree of leverage since a large number of small firms were
also found employing high levels of debt. The study also did not show a definite
structural relationship between the degrees of leverage, on the one hand and profitability
and growth, on the other hand; although over time profitability and growth have improved
and so has the degree of leverage. The majority of the profitability and growth groups
of companies were concentrated within narrow bands of leverage.
Chakraborty (1977) has also conducted a study to investigate debt-equity ratio in the
private corporate sector in India. He tested the relation of debt-equity ratio with age,
total assets, retained earnings, profitability and capital intensity. He found that age;

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retained earnings and profitability were negatively correlated while total assets and
capital intensity were positively related to debt-equity ratio. He also provided a glimpse
of the regional patterns of debt-equity rations in different industrial centres in India.
He also attempted a prediction equation for debt-equity ratio for each industry.
Chakraborty also used a very simple methodology for calculating the cost of capital.
He showed calculation of cost of capital for 22firms. He found that cost of capital
increased from 7.36 per cent to 12.36 per cent over years. The average cost of capital
for all the consumer goods industry firms taken together was the highest while it was
lowest for the intermediate goods firms. One of the reasons for this was attributed to
the relatively low amount of debt used in the former industry than in the latter. An
indirect attempt was also made to test the M-M hypothesis by plotting debt-equity
ratios on the X-axis and the rest of capital on the Y-axis for 22 firms. The result
showed almost a horizontal line parallel to the X-axis. The study also discussed
environmental factors influencing corporate debt-equity ratios and cost of capital in
India.
10.10 Summary
The gain of debt is that is saves taxes since interest is a deductible expense. On the
other hand, its drawback is that it can reason financial sorrow. Therefore, the trade off
between tax gain and costs of financial pain should administer the optimum capital
structure decision of the firm in practice. Financial sorrow becomes costly when the
firm finds it hard to pay interest and principal. From this point of view, both debt ratio
and EBIT-EPS analysis have their precincts. They do not reveal the debt-servicing
ability of the firm. A full cash flow analysis over a long period, which covers the
adverse state of affairs also, helps to decide the firm’s debt capacity. Debt capacity
means the amount of debt, which a firm should use, given its cash flows. Cash flow
analysis indicates how much debt a firm can service without any intricacy A firm does
not wear out its debt capacity at one time. It keeps reserve debt capacity to meet
financial emergencies. The actual amount of debt also depends on flexibility, control
and size of the firm in terms of its assets. Other factors, which are important when

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capital is actually raised, include timing (marketability) and flotation costs.
10.11 Self Assessment Exercise
1. Define the capital structure. What do you mean by an appropriate capital
structure? What should generally be the features of an appropriate capital
structure?
2. Briefly explain the factors, which influence the planning of the capital structure
in practice.
3. Explain the features and limitations of three approaches to the determination of
a firm’s capital structure: (a) EBIT-EPS approach, (b) valuation approach and
(c) cash flow approach.
4. ‘’…….the analysis of debt to equity ratios along can be deceiving, and a analysis
of the magnitude and stability of cash flows relatives to fixed changes is
extremely important in determining the appropriate capital structure ——’’ Give
your opinion.
5. What is meant by a flexible capital structure? Is a flexible capital structure
more costly?
6. If debt is cheaper than equity why do companies not finance their assets with
say 80 or 90 percent debt ratio?
7. What is the importance of marketability and floatation costs in the capital
structure decision of a company?
8. How do considerations of control size affect the capital structure decision of
the firm?
9. GSFC Consider the following financial data of the Gujrat State Fertilizers
Company Ltd. (Rs. Lakh)

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 Year Sales PAT Inter-. Net Worth Long Gross
est Term block
Debt
1986 35331 2298 817 17023 4563 26036
1987 35827 3623 2082 19732 6649 31479
1989 67631 4666 4116 23583 20959 39277
1990 68251 5134 2110 38045 19143 50153
1991 73989 6467 3395 44125 37177 67050
Note: Data for 1989 is for 15 months.
You are required to analyze GSFC’s debt policy.
10. Philips, India Limited. Philips has the following financial data for last five
years. Comment on the company’s investment and financial policy.
Year Sales PAT Net current Invest- Net Debe- Loans
Assets net fixed ment worth ntures
1989-90 4169.4 32.4 714.6 1036.3 20.8 606.1 566.6 599.0
1990-91 5642.2 287.3 767.2 991.7 75.9 808.6 482.7 543.5
1991-92 7445.9 183.1 959.2 1004.1 122.3 935.1 411.8 738.7
1992-93 7970.3 134.9 1233.9 1183.3 130.5 1082.1 394.7 1071.1
1993-94 7074.6 124.1 790.9 1219.8 138.0 1456.0 228.1 464.6
Note: Data are for a twelve-month period from April to March except for 1993-
94 for which data are for a nine-month period form April to December.
10.12 Suggested Readings
1) Khan and Jain, Financial Management, (7th Edition).
2) Pandey, I M, Financial Management (6th Edition).
3) Hampton, John J., Financial Management and Policy (3rd edition).
4) Soloman, Ezra & Pringle, John J., An Introduction to Financial
Management, (1978)
5) Weston J., Fred, & Drigham, Managerial Finance, (5th edition).

✪✪✪
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 LESSON – 11

INSTRUMENTS OF LONG-TERM SOURCES OF FINANCE

Objectives : After going through this lesson, you should be able to :

• Explain the features of ordinary shares, debentures/bonds, term loan,
preference capital and retained earning.
• Understand the benefits and valuation of rights shares.
• Explain the features of innovative instruments like convertible
debentures, warrants, and deep-discount bonds.
Structure :
11.1 Introduction
11.2 Equity/Ordinary Shares
11.3 Public Issue of Equity Shares
11.4 Right Issue of Equity Shares
11.5 Retained Earnings
11.6 Preference Capital
11.7 Debenture Capital
11.8 Term Loans
11.9 Convertible Debentures/Bonds
11.10 Warrants
11.11 Zero Interest Bond/Debentures
11.12 Summary
11.13 Self Test Questions
11.14 Suggested Readings
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11.1 INTRODUCTION
To support its long-term investments, a firm must find the means to finance
them. Equity and debt represent the two broad sources of long-term finance
for a business firm. Equity consists of equity capital, retained earnings, and
preference capital. Debt consists of term loan, debentures, and short-term
borrowings.
The key differences between equity and debt are as : (i) Debt investors are
entitled to a contractual set of cash flows (interest and principal) whereas equity
investors have a claim on the residual cash flows of the firm after it has satisfied
all other claims and liabilities; (ii) Interest paid to debt investors represents a
tax-deductible expense whereas dividend paid to equity investors has to come
out of the profit after tax; (iii) Debt has a fixed maturity whereas equity
ordinarily has an infinite life; (iv) Equity investors enjoy the prerogative to
control the affairs of the firm whereas debt investors play a passive role.
11.2 EQUITY/ORDINARY SHARES
Equity shares represent the ownership position in a company and its owners-
ordinary shareholders share the risk and rewards associated with the ownership
of companies. Ordinary shares are the source of permanent capital since they
do not have a maturity date. On the capital contributed by shareholders they
are entitled for dividends. The amount or rate of dividend is not fixed; it is
decided by the company's board of directors. Being the owners of the company,
shareholders bear the risk of ownership; they are entitled to dividends after
the income claims of others have been satisfied.
Equity shares have typically a par/face value in terms of the price for each
share, the most popular denomination being Rs.10. The price at which the equity
shares are issued is the issue price. The issue price for new companies is
generally equal to the face value. It may be higher for existing companies, the
excess being share premium. The book value of ordinary shares refers to the
paid-up capital plus reserves and surplus (net worth) divided by the number of
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outstanding shares. The price at which equity shares are traded in the stock
market is their market value. However, the market value of unlisted shares is
not available.
Features :
The ordinary shares have some special features which are as follows :
Residual Claim to Income : The equity investors have a residual claim to the
income of the firm. The income left after satisfying the claims of all other
investors belongs to the equity shareholders. This income is simply equal to
profit after tax minus preferred dividend.
The income of equity shareholders may be retained by the firm or paid out as
dividends. Equity earnings which are ploughed back in the firm tend to increase
the market value of equity shares and equity earnings distributed as dividend
provide current income to equity shareholders. For example, if a firm earns
Rs. 16 million during the year and pays dividend of Rs. 7 million, the value of
equity shares may rise by about Rs. 9 million, the amount retained by the firm.
Equity shareholders thus receive benefits in two ways : dividend income of
Rs. 7 million and capital appreciation of Rs. 9 million.
The dividend decision is the prerogative of the board of directors and equity
shareholders cannot challenge this decision in a court of law. In this respect,
the position of equity shareholders differs markedly from that of suppliers of
debt capital. Debenture holders, for example, can take legal action against the
company for its failure to meet contractual interest payment and principal
repayment, irrespective of the financial circumstances of the company. Equity
shareholders, on the other hand, cannot challenge the dividend decision of the
board of directors in a court of law, however impressive the financial
performance of the company may be.
Claim on Assets : The ordinary shareholders' claim in the assets of the
company is also residual in that their claim would rank after the claims of the
creditors and preference shareholders in the event of liquidation. If the
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liquidation value of assets is insufficient, their claims may remain unpaid.
Right to control : As owners of the company, the equity holders have the
right to control the operations of the company. Their control is, however,
indirect. The major policies/decisions are approved by the board of directors
and the board-appointed management carries out the day-to-day operations.
The shareholders have the legal right/power to elect the board of directors as
well as vote on every resolutioon placed in various meetings of the company.
Though, in theory, they have indirect right to control in actual practice, it is
weak and ineffective partly because of the apathy and indifference of the
majority of the shareholders who rarely bother to cast their votes and partly
because scattered equity holders are unable to exercise their collective power
effectively.
Voting rights : Equity shareholders are required to vote on a number of
important matters. The most significant proposals include : election of
directors and change in the memorandum of association. For example, if the
company wants to change its authorised share capital or objectives of business,
it requires ordinary shareholders' approval. Directors are elected at the annual
general meeting (AGM) by the majority votes. Each ordinary share carries one
vote. Thus, an ordinary shareholder has votes equal to the number of shares
held by him. Shareholder may vote in person or by proxy. A proxy gives a
designated person right to vote on behalf of a shareholder at the company's
annual general meeting. When management takeovers are threatened, proxy
fights – battles between rival groups of proxy votes – occur. An earlier example
in this regard was that of Gamon India where both existing management and
the Chhabrias fought for the control of the company and put all efforts to collect
proxy votes. The existing management could continue its hold on the company
with the help of majority shareholders including the financial institutions.
Pre-emptive rights : The pre-emptive right entitles a shareholder to maintain
his proportionate share of ownership in the company. The law grants
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shareholders the right to purchase new shares in the same proportion as their
current ownership. Thus, if a shareholder owns 1 per cent of the company's
ordinary shares, he has pre-emptive right to buy 1 per cent of new shares issued.
A shareholder may decline to exercise this right. The shareholder's option to
purchase a stated number of new shares at a specified price during a given
period are called rights. These rights can be exercised at a subscription price
which is generally much below the share's current market price, or they can be
allowed to expire, or they can be sold in the stock market.
Limited liability : Ordinary shareholders are the true owners of the company,
but their liability is limited to the amount of their investment in shares. If a
shareholder has already fully paid the issue price of shares purchased, he has
nothing more to contribute in the event of a financial distress or liquidation.
This position of shareholders is different from the owners in the case of sole
proprietary businesses or partnership firms where they have unlimited liability.
The limited liability feature of ordinary share encourages otherwise unwilling
investors to invest their funds in the company. Thus, it helps companies to
raise funds.
Global Depository Receipts (GDRs) : A GDR is an instrument issued abroad
and is listed/traded on a foreign stock exchange. It represents one/more share(s)
of the issuing company. It does not carry any voting rights. A holder of GDRs
can at any time covert it into the number of shares that it represents. After
conversion, the underlying shares are listed/traded on the domestic stock
exchanges. The dividend on GDRs is paid in local currency (Rupees).
Advantages and Disadvantages of Equity Financing
As the single most important source of long term funds, equity capital has
merits as well demerits from the viewpoint of the company as well as the
shareholders.
Advantages : The advantages of equity capital to a company are : first, it is a
permanent source of funds without any repayment liability; second, it does not
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involve obligatory dividend payment and; thirdly, it forms the basis of further
long-term financing in the form of borrowing related to the creditworthiness
of the firm.
Disadvantages :
• Shares have a higher cost at least for two reasons : Dividends are not tax
deductible as are interest payments, and flotation costs on ordinary
shares are higher than those on debt.
• Ordinary shares are riskier from investors' point of view as there is
uncertainty regarding dividend and capital gains. Therefore, they require
a relatively higher rate of return. This makes equity capital as the highest
cost source of finance.
• The issue of new ordinary shares dilutes the existing shareholders'
earnings per share if the profits do not increase immediately in
proportion to the increase in the number of ordinary shares.
• The issuance of new ordinary shares may dilute the ownership and control
of the existing shareholders. While the shareholders have a pre-emptive
right to retain their proportionate ownership, they may not have funds
to invest in additional shares. Dilution of ownership assumes great
significance in the case of closely-held companies.
11.3 PUBLIC ISSUE OF EQUITY SHARES
Public issue of equity means, raising of share capital directly from the public.
For example, Megha Steel Limited (MSL), a subsidiary of Neha Steel Limited
made a public issue of equity shares of Rs. 10 crore on 15 July, 1995. The
issue price per share is Rs. 50 – representing a premium of Rs. 40 over its par
value. The issue price is also higher than its book value of Rs. 26.35 per share.
The company needs funds for expansion and modernisation of its plant as well
as for diversification into the manufacture of aluminium. The company expects
to pay a dividend of 20 per cent in 1994-95 and 1995-96 and 25 per cent in
1996-97.
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Consider another case : N.R. Goyal Industries Limited is approaching the public
for the first time to raise Rs. 3.20 crore on 10 July, 1995. Incorporated as a
public limited company in December 1994, the maiden issue of equity shares
is intended to finance its project for manufacturing industrial paper in Reva,
M.P. The share is issued at par at Rs. 10.
As per the existing norms, a company with a track record is free to determine
the issue price for its shares. Thus, it can issue shares at a premium. However,
a new company has to issue its shares at par.
Underwriting of issues : It is legally obligatory to underwrite a public and a
right issue. In an underwriting, the underwriters–generally banks, financial
institutions, brokers etc. – guarantee to buy the shares if the issue is not fully
subscribed by the public. The agreement may provide for a firm-buying by the
underwriters. The company has to pay an underwriting commission to the
underwriter for their services.
11.4 RIGHT ISSUE OF EQUITY SHARES
A right issue involves selling of ordinary shares to the existing shareholders
of the company. When a company issues additional equity capital, it has to be
offered in the first instance to the existing shareholders on a pro rata basis.
This is required under Section 81 of the Companies Act, 1956. The
shareholders, however, may by a special resolution forfeit this right, partially
or fully, to enable the company to issue additional capital to public.
Features of Rights
1. The number of rights that a shareholders gets is equal to the number of
shares held by him.
2. The number of rights required to subscribe to an additional share is
determined by the issuing company. In an issue of right shares of Modi
Xerox Ltd., for example, five rights were required to subscribe to two
additional shares. (Note that five 'rights' as defined by us are equal to
two 'rights' as defined in the market place).
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3. The price per share for additional equity, called the subscription price,
is left to the discretion of the company.
4. Rights are negotiable. The holder of rights can sell them.
5. Rights can be exercised only during a fixed period which is usually about
30 days.
Terms and Procedures
A company making a right issue sends a 'letter of offer', along with a composite
application form consisting of four forms (A,B,C, and D) to the shareholders.
Form A is meant for acceptance of the rights and application for additional
shares. This form shows the number of right shares the shareholder is entitled
to. It also has a column through which a request for additional shares may be
made. Form B is to be used for renouncing the rights in favour of someone.
Form C is meant for application by the renouncel in whose favour the rights
have been renounced, by the original allottee, through Form B. Form D is to be
used to make a request for split forms. The composite application form must
be mailed to the company within a stipulated period, which is usually about 30
days.
The conditions that have to be satisfied for obtaining the approval for right
issues are as follows :
1. Existing shareholders, who exercise their rights in full, are given an
opportunity to apply for additional shares.
2. Existing shareholders who renounce their rights, wholly or partially, are
not entitled to apply for additional shares.
3. Shares which become available due to non-exercise of rights by some
shareholders, are allotted to shareholders who have applied for additional
shares in proportion to their shareholding.
4. Any balance shares left after meeting requests for additional shares by
the existing shareholders are disposed of at the ruling market price or
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 the issue price, whichever is higher.
Consequences of a Rights Issue
To answer the question : What are the likely consequences of a rights issue on
the market value per share, value of a right, earnings per share, and the wealth
of shareholders?, let us look at the illustrative data of the Anita and Sunita
Company given in Table 11.1
Table 11.1 Illustrative Data of the Anita and Sunita Company
Paid-up equity capital (1,000 shares of Rs. 10 each) Rs. 10,000
Retained earnings 20,000
Earnings before interests and taxes 12,000
Interest 2,000
Profit before tax 10,000
Taxes (50 per cent) 5,000
Profit after taxes 5,000
Earnings per share Rs. 5
Market price per share Rs. 40
(Price-earnings ratio of 8 is assumed)
Number of additional equity shares proposed to be issued as
rights shares 200
Proposed subscription price Rs. 20
Number of existing shares required for a rights
share (1,000/200) 5
Value of Share
The value of share, after the rights issue, is expected to be :
NP 0 + S
Equation 11.1
N+1
where N = number of existing shares required for a rights share
P0 = cum-rights market price per share
S = subscription price at which the rights share are issued.
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The rationale behind this formula is as follows : For every N shares before the
rights issue, there would be N+1 shares after the rights issue. The market value
of these N+1 shares is expected to be the market value of N cum-rights shares
plus S, the subscription price.
Applying this formula to the data given in Table 11.1 we find that the value per
share after the rights issue is expected to be :
5×40×20
= Rs. 36.67
5+1
Value of Right
The theoretical value of a right is
P0 – S
Equation 11.2
N+1
The value is determined as follows. The difference between the market price
of a share after the rights issue and the subscription price is the benefit derived
from N rights, which are required along with the subscription price to obtain
one rights shares. This means that the value of N rights is :
NP 0 – S N(P 0 – S)
–S= Equation 11.3
N+1 N+1
Hence the value of one right is
N(P 0 – S) 1 P0 – S
× = Equation 11.4
N+1 N N–1
Apply the above formula to the data given in the Table 11.1 we find that the
value of a right of the Anita and Sunita Company is
40 – 20
= Rs. 3.33
5 +1
Affect on Wealth of Shareholders
The wealth of existing shareholders, is not affected by the rights offering,
provided the existing shareholders exercise their rights in full or sell their
rights. To illustrate this point, consider what happens to a shareholder who
owns 100 equity shares of the Anita and Sunita Company that has a market
value of Rs. 40 each before the rights issue. The impact on his wealth when he
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exercises his rights, when he sells his rights, and when he follows his rights to
expire is shown below :
He exercises his rights
Market value of original shareholding at the rate = Rs. 4,000
of Rs. 40 per share
Additional subscription price and for 20 rights shares at the
rate of Rs. 20 per share = Rs. 400
Total investment = Rs 4,400
Market value of 120 shares at the rate of Rs. 36.67
per share after the rights subscription = Rs. 4,440
Change in wealth (Rs. 4,400 - Rs. 4,400) = Rs. 0
He sells his rights
Market value of original shareholding at the rate of = Rs. 4,000
Rs. 40 per share
Value realised from the sale of 100 rights at Rs. 3.33 per right = Rs. 333
Market value of 100 shares held after the rights issue at the = Rs. 3,667
rate of Rs. 36.67 per share
Change in wealth (Rs. 3,667+Rs 333 - Rs. 4,000) = Rs. 0
He allows his rights to expire
Market value of original shareholding at the rate of = Rs. 4,000
Rs. 40 per share
Market value of 100 shares and after the rights issue at
the rate of Rs. 36.67 per share = Rs. 3,667
Change in wealth (Rs. 3,667 - Rs. 4,000) = Rs. (333)

Setting the Subscription Price

The subscription price, infact, is irrelevant because the wealth of a shareholder
who subscribes to the rights shares or sells the rights remains unchanged,
irrespective of what the subscription price is. To illustrate this point, consider
a shareholder who has N shares valued at P0 and who enjoys the right to subscribe
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to an additional share for S. His total investment would be:
NP 0 + S Equation 11.5
The value of his shareholding after subscription would be :
Number of shares × Market value per share after rights issue
This is equal to :
NP 0 + S
(N+1) × = NP 0 + S Equation 11.6
(N + 1)
Thus the value of his shareholding after subscription is equal to the value of
his investment, irrespective of the subscription price S.
Practically, the subscription price is important. Existing shareholders do not
like the idea of S being higher than P 0 because when S is higher than P 0, the
market value after issue would be lower than S. Non-shareholders, who have
an opportunity to subscribe to shares not taken by existing shareholders, will
have no interest in the shares if S is higher than P 0 because they would then
suffer a loss when the market value falls below S after the issue.
Due to the above consideration, S has to be set equal to or lower to P 0. A value
of S equal to P0 is not advisable because it has no appeal to existing shareholders
and other investors as they do not see any opportunity of gain in such a case.
So, S has to be set lower than P0. In determining S, the following considerations
should be borne in mind :
1. The lower the S in relation to P 0, the greater is the probability of the
success of offering.
2. When S is set low, a large number of rights shares have to be issued to
raise a given amount of additional capital. If the company wishes to
maintain a certain level of earnings per share and/or dividend per share,
it would find it difficult to do so when S is set low.
3. The expectations of investors, the fluctuation of the share, the size of
rights issue in relation to existing equity capital, and the pattern of
shareholding are important factors in determining what S is acceptable
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 to investors.
The subscription price for a right issue may be decided after taking into account
several things : state of the capital market, the trend of share prices in general
and of the company's shares in particular, the ruling cum-rights price, the ratio
or proportion of the rights issue to the existing equity capital of the firm, the
break-up value of the share, the profit-earning capacity of the firm, the dividend
record of the firm, and the resources position of the firm.
Comparison between Right Issue and Public Issue
1. A right issue, in comparison with a public issue, is likely to be more
successful because it is made to investors who are familiar with the
operations of the company.
2. Since the rights issue is not underwritten, the floatation costs of a rights
issue are significantly lower than those of a public issue.
3. A rights issue generally has to be made at a lower price than a public
issue because existing shareholders expect rights issue to be made at a
lower price. Due to this, a rights issue tends to result in a dilution of
earnings per share.
Advantages and Disadvantages of Rights Issue
The main advantages of the rights issue are (1) The existing shareholders'
control is maintained through the pro rata issue of shares. This is significant
in the case of closely-held company or when a company is going into financial
difficulties or is under a takeover threat; (2) Raising funds through the sale of
rights issue rather than the public issue involves less flotation costs as the
company can avoid underwriting commission; and (3) In the case of profitable
companies, the issue is more likely to be successful since the subscription
price is set below the current market price.
The main disadvantage to the shareholders who fail to exercise their rights is
they lose in terms of decline in their wealth. Yet another disadvantage is for
those companies whose shareholding is concentrated in the hands of financial
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institutions because of the conversion of loan into equity. They would prefer
public issue of shares rather than the rights issue.
11.5 RETAINED EARNINGS
The internal sources of long-term funds of an existing company consist of
depreciation charges and retained earnings. The depreciation charges are
normally used to replace the concerned asset (s). In a way, therefore, the only
internal source of financing expansion/growth/diversification for such
companies are retained earnings. In fact, they are an important source of long-
term finance for corporate enterprises.
As a source of long-term finance, retained earnings have some commendable
features. They are readily available to the firm. Flotation costs and losses on
account of underpricing associated with external equity are avoided/eliminated.
There is also no dilution of control of the firm. However, the magnitude of
financing through retained earnings may be limited and variable primarily as a
result of the quantum and variability of profits after tax. It has, moreover, high
opportunity costs in terms of dividends foregone by the shareholders.
For the shareholders, retention of profits by the firm is a convenient way of
reinvestment of their profit. But shareholders who want a current income would
find it convenient to the extent that they will be compelled to sell some shares
to convert them into income. Moreover, the easy availability of retained
earnings coupled with the notion of low cost may result in its investment in
submarginal/profitable projects which would have serious implications for, and
hurt the interest, of the shareholders.
Thus, retained earnings have both positive and negative attributes from the
viewpoint of the firm as well as shareholders and should be employed with
caution. They involve high cost and no risk, and put no restraint in management
freedom and do not dilute control.
11.6 PREFERENCE CAPITAL
Preference share capital represents a hybrid form of financing –it has some
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characteristics of equity and some attributes of debentures. It resembles equity
in the following ways : (i) preference dividend is payable only out of
distributable profits; (ii) preference dividend is not an obligatory payment (the
payment of preference dividend is entirely within the discretion of directors);
and (iii) preference dividend is not a tax-deductible payment.
Preference capital is similar to debentures in several ways : (i) the dividend
rate of preference capital is usually fixed; (ii) the claim of preference
shareholders is prior to the claim of equity shareholders; and (iii) preference
shareholders do not normally enjoy the right to vote.
Preference capital offers the following advantages :
1. There is no legal obligation to pay preference dividend. A company does
not face bankruptcy or legal action if it skips preference dividend.
2. There is no redemption liability in the case of perpetual preference
shares. Even in the case of redeemable preference shares, redemption
can be delayed without significant penalties.
3. Preference capital is generally regarded as part of net worth. Hence, it
enhances the creditworthiness of the firm.
4. Preference shares do not under normal circumstances, carry voting right.
Hence, there is no dilution of control.
Preference capital, however, suffers from some serious shortcomings :
1. Compared to debt capital, it is an expensive source of financing because
the dividend paid to preference shareholders is not, unlike debt interest,
a tax-deductible expense.
2. Though there is no legal obligation to pay preference dividends, skipping
them can adversely affect the image of the firm in the capital market.
3. Compared to equity shareholders, preference shareholders have a prior
claim on the assets and earnings of the firm.

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11.7 DEBENTURE CAPITAL
Akin to a promissory note, debentures/bonds represent creditorship security
and debenture holders are long-term creditors of the company. As a secured
instrument, it is a promise to pay interest and repay principal at stipulated
times. In contrast to equity capital which is a variable income security, the
debentures are fixed income (interest) security.
Features of Debentures
As a long-term source of borrowing, debentures have some contracting features
compared to equities which are as follows :
Trust Indenture : When a debenture is sold to investing public, a trustee is
appointed through an indenture trust deed. It is legal agreement between the
issuing company and the trustee who is usually a financial institution/bank/
insurance company/firm of attorneys. The trust deed provides the specific terms
of agreement such as description of debentures, rights of debenture holders,
rights of the issuing company and responsibilities of the trustee. The trustee
is responsible to ensure that the borrower/company fulfills all its contractual
obligations.
Interest : The debentures carry a fixed (coupon) rate of interest, the payment
of which is legally binding/enforceable. The debenture interest is tax-deductible
and is payable annually/semi-annually/quarterly. Some public sector
undertakings issue tax-free bonds the income from which is exempted from
tax in the hands of the investors. A company is free to choose the coupon rate
which may be fixed or floated, being determined in relation to some benchmark
rate. It is also related to the credit rating of the debenture as an instrument.
Maturity : It indicates the length of time for redemption of par value. A
company can choose the maturity period, though the redemption period for
non-convertible debenture is typically 7-10 years. The redemption of debentures
can be accompanied in either of two ways : (i) debentures redemption reserve
(sinking fund) and (ii) call and put (buy-back) provision.
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Debenture Redemption Reserve (DRR) : A DRR has to be created for the
redemption of all debentures with a maturity period exceeding 18 months
equivalent to at the least 50 per cent of the amount of issue/redemption before
commencement of redemption.
Call and Put Provision : The call/buy back provision provides an option to
the issuing company to redeem the debentures at a specified price before
maturity. The call price may be more than the part/face value by usually 5 per
cent, the difference being call premium. The put option is a right to the
debenture holder to seek redemption at specified time at predetermined prices.
Security : Debentures are generally secured by a charge on the present and
future immovable assets of the company by way of an equitable mortgage.
Convertibility : Apart from pure non-convertible debentures (NCDs),
debentures can also be converted into equity shares at the option of the
debenture holders. The conversion ratio and the period during which conversion
can be affected are specified at the time of the issue of the debenture itself.
The convertible debentures may be fully convertible (FCDs) or partly
convertible (PCDs). The FCDs carry interest rates lower than the normal rate
on NCDs; they may even have a zero rate of interest. The PCDs have two parts:
(a) convertible part, (b) non-convertible part. Typically, the convertible portion
is converted into equity share at a specified premium after a specified date
from the date of allotment, while the non-convertible portion is payable/
redeemable in specified equal instalments on the expiry of specified years
from the date of allotment.
Credit Rating : To ensure timely payment of interest and redemption of
principal by a borrower, all debentures must be compulsorily rated by one or
more of the four credit rating agencies, namely, Crisil, Icra, Care and DCR.
Claim on Income and Assets : The payment of interest and repayment of
principal is a contractual obligation enforceable by law. Default would lead to
bankruptcy of the company. The claim of debenture holders on income and
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assets ranks paris passu with other secured debt and higher than that of
shareholders-preference as well as equity.
Types of Debentures
Debentures may be straight debentures or convertible debentures. A convertible
debenture (CD) is one which can be converted, fully or partly, into shares after
a specified period of time. Thus on the basis of convertibility, debentures may
be classified into three categories.
• Non-convertible debentures (NCDs)
• Fully convertible debentures (FCDs)
• Partly convertible debentures (PCDs)
Non-convertible debentures (NCDs) : NCDs are pure debentures without a
feature of conversion. They are repayable on maturity. The investor is entitled
for interest and repayment of principal. Recently, the Industrial Credit and
Investment Corporation of India (ICICI) had issued debentures for Rs. 200
crores fully non-convertible bonds of Rs. 1,000 each at 16 per cent rate of
interest, payable half-yearly. The maturity period is five years. However, the
investors have the option to be repaid fully or partly the principal after 3 years
after giving due notice to ICICI.
Fully-convertible debentures (CFDs) : FCDs are converted into shares as
per the terms of the issue with regard to price and time of conversion. The
pure FCDs interest rates, generally less than the interest rates on NCDs since
they have the attraction feature of being converted into equity shares. Recently,
companies in India are issuing FCDs with zero rate of interest.
Partly-convertible Debentures (PCDs) : A number of debentures issued by
companies in India have two parts : a convertible part and a non-convertible
part. Such debentures are known as partly-convertible debentures (PCDs). The
investor has the advantages of both convertible and non-convertible debentures
blended into one debenture.

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Pros and Cons
Debenture has a number of advantages as long-term source of finance :
Less costly : It involves less cost to the firm than the equity financing because
(a) investors consider debentures as a relatively less risky investment alternative
and therefore, require a lower rate of return and (b) interest payments are tax
deductible.
Non ownership dilution: Debenture holders do not have voting rights;
therefore, debenture issue does not cause dilution of owernship.
Fixed payment of interest :Debenture do not participate in extraordinary
earnings of the company. Thus the payments are limited to interest.
Reduced real obligation : During periods of high inflation, debenture issue
benefits the company. Its obligation of paying interest and principal which are
fixed decline in real terms.
Debentures has some limitations also :
Obligatory payments : Debenture results in legal obligation of paying interest
and principal, which, if not paid, can force the company into liquidation.
Financial risk : It increases the firm's financial leverage, which may be
particularly disadvantageous to those firms which have fluctuating sales and
earnings.
Cash outflows : Debentures must be paid on maturity, and therefore, at some
points, it involves substantial cash outflows.
Restricted covenants : Debenture indenture may contain restrictive covenants
which may limit the company's operating flexibility in future.
11.8 TERM LOANS
So far we looked at the sources of finance which fall under the broad category
of equity finance (or shareholder's funds) and debentures. Now we turn our
attention to long-term debt. Firms obtain long-term debt mainly by raising term
loans or issuing debentures.
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Historically, term loans given by financial institutions and banks have been the
primary source of long-term debt for private firms and most public firms. Term
loans, also referred to as term finance, represent a source of debt finance which
is generally repayable in less than 10 years. They are employed to finance
acquisition of fixed assets and working capital margin. Term loans differ from
short-term bank loans which are employed to finance short-term working capital
need and tend to be self-liquidating over a period of time, usually less than
one year. The features of term loans are discussed as follows :
Currency : Financial institutions give rupee loans as well as foreign currency
term loans. The most significant form of assistance provided by financial
institutions, rupee term loans are given directly to industrial concerns for
setting up new project as well as for expansion, modernisation, and renovation
projects. These funds are provided for incurring expenditure for land, building,
plant and machinery, technical know-how, miscellaneous fixed assets,
preliminary expenses, and margin money for working capital.
Financial institutions provide foreign currency term loans for meeting the
foreign currency expenditure towards import of plant, machinery and equipment,
and payment of foreign technical know-how fees. The periodical liability for
interest and principal remains in the currency/currencies of the loan and is
translated into rupees at the prevailing rate of exchange for making payments
to the financial institutions.
Security : Term loans typically represent secured borrowing. Usually assets
which are financed with the proceeds of the term loan provide the prime security.
Other assets of the firm may serve as collateral security.
All loans provided by financing institutions, along with interest, liquidated
damages, commitment charges, expenses, etc. are secured by way of :
1. First equitable mortgage of all immovable properties of the borrower,
both present and future; and
2. Hypothecation of all movable properties of the borrower, both present
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 and future, subject to prior charges in favour of commercial banks for
obtaining working capital advance in the normal course of business.
Interest Payment and Principal Repayment
The interest and principal repayment on term loans are definite obligations
that are payable irrespective of the financial situation of the firm. To the general
category of borrowers, financial institutions charge an interest rate that is
related to the credit risk of the proposal, subject to usually a certain floor
rate. Financial institutions impose a penalty for defaults. In case of default of
payment of instalment of principal and/or interest, the borrower is liable to
pay by way of liquidated damages additional interest calculated at the rate of 2
per cent per annum for the period of default on the amount of principal and/or
interest in default. In addition to interest, lending institutions levy a
commitment fee on the unutilised loan amount.
The principal amount of a term loan is generally repayable over a period of 6
to 10 years after the initial grace period of 1 to 2 years. Typically, term loans
provided by financial institutions are repayable in equal semi-annual instalments
or equal quarterly instalments.
Note that the interest burden declines over time, whereas the principal
repayment remains constant. This means that the total debt servicing burden
(consisting of interest payment and principal repayment) decline over time.
This pattern of debt servicing burden, typical to India, differs from the pattern
obtaining in western economies where debt is typically amortised to equal
periodic instalments.
The latter pattern is relatively more acceptable to borrowers because it does
not result in a heavy debt servicing burden in earlier years. It has also been
recommended by the International Bank for Reconstruction and Development
(popularly called the World bank). However, presently financial institutions in
India do not follow the scheme of equal periodic amortisation. Yet they try to
ensure, by suitably modifying the debt repayment schedule, within limits, that
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the debt servicing burden is not very onerous.
Restrictive Covenants
In order to project their interest, financial institutions generally impose
restrictive conditions on the borrowers. While the specific set of restrictive
covenants depends on the nature of the project and the financial situation of
the borrower, loan contracts often require that the borrowing firm :
• Broad-base its board of directors and finalise its management set-up in
consultation with and to the satisfaction of the financial institutions.
• Make arrangements to bring additional funds in the form of unsecured
loans/deposits for meeting overruns/shortfalls.
• Refrain from undertaking any new project and/expansion or make any
investment without the prior approval of the financial institutions.
• Obtain clearances and licences from various government agencies.
• Repay existing loans with the concurrence of financial institutions.
• Refrain from additional borrowings or seek the consent of financial
institutions for additional borrowings.
• Reduce the proportion of debt in its capital structure by issuing
additional equity and preference capital.
• Limit its dividend payment to a certain rate or seek the consent of
financial institutions to declare dividend at a higher rate.
• Refrain from creating further charges on its assets.
• Provide periodic information about its operations.
• Limits the freedom of the promoters to dispose of their shareholding.
• Effect organisational changes and appoint suitable professional staff.
• Give financial institutions the right to appoint nominee directors.
Advantages and Disadvantages of Term Loans
Term loans and debentures are two important ways of raising long-term debt.
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The advantages of term loans are as follows :
1. Interest of term loan is a tax-deductible expense, whereas equity and
preference dividend are paid out of profit after tax.
2. Term loans do not result in dilution of control because debt-holders
(term lending institutions and debenture-holders) are not entitled to vote.
3. Lending institutions do not partake in the value created by the company
as payments to them are limited to interest and principle.
4. If there is a precipitous decline in the value of the firm, shareholders
have the option of defaulting on debt obligations and turning over the
firm to term-loan supplier.
Term loan financing is not an unmixed blessing. It has serious disadvantages
associated with it :
1. They entails fixed interest and principal repayment obligation. Failure
to meet these commitments can cause a great deal of financial
embarrassment and even lead to bankruptcy.
2. Loan increases financial leverage which, according to CAPM, raises the
cost of equity to the firm.
3. Loan contracts impose restrictions that limit the borrowing firm's
financial and operating flexibility. These restrictions may impair the
borrowing firm's ability to resort to value-maximising behaviour.
4. If the rate of inflation turns out to the unexpectedly low, the real cost of
borrowing will be greater than expected.
11.9 CONVERTIBLE DEBENTURES/BONDS
Features : Convertible debentures give the debenture holders the right (option)
to convert them into equity shares on certain terms. The holders are entitled
to a fixed income till the conversion option is exercised and would share the
benefits associated with equity shares after the conversion. The operational
features of convertible debentures in India at present are as follows :
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All the details about conversion terms, namely, conversion ratio, conversion
premium/price and conversion timing are specified in the offer/document/
prospectus. The companies can issue fully convertible debentures (FCDs) or
party convertible debentures (PCDs). The number of ordinary shares for each
convertible debenture is the conversion ratio. The 'conversion price' is the
price paid for the ordinary share at the time of conversion. Thus, 'conversion
ratio' equals par value of convertible debentures divided by the conversion price.
The 'conversion time' refers to the periods from the date of allotment of
convertible debentures after which the option to convert can be exercised. If
the conversion is to take place between 18-36 months, the holder will have the
option to exercise his rights in full or part. A conversion period exceeding 36
months is not permitted without put and call options. The call options give the
issuer the right to reedeem the debentures/bonds prematurely on stated terms.
The investor has the right to prematurely sell them back to the issuer on
specified terms. In addition, compulsory credit rating is necessary for fully
convertible debentures.
Valuation : The convertible debentures presently in India can be of three types:
(i) compulsorily convertible within 18 months, (ii) optionally convertible
within 36 months and (iii) convertible after 36 months with call and put features.
However, only the first two types are popular.
Compulsory Partly/Fully Convertible Debentures
Value : The holders of PCDs receive interest at a specified rate over the term
of the debenture plus equity share(s) on part conversion and repayment of
unconverted part of principal. Symbolically.
n It aPi n aPi
V0 = Σ t + i +Σ i Equation 11.7
t =1 (1+k d) (1+k e) j=m (1+k e)
where V 0 = Value of the convertible debenture at the time of issue
I t = Interest receivable at the end of period, t
n = Term of debentures
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 a = Equity shares on part conversion at the end of period, i
Pi = Expected per-equity share price at the end of period, i
Fj = Instalment of principal payment at the end of period, j
k d = Required rate of return on debt
k e = Required rate of return on equity
Example : 11.1
The Tata Iron and Steel Ltd. (TISCO) had offered in June 1989, Rs. 30 lakh
partly convertible debentures of Rs. 1,209 each at par. The conversion terms
were : (i) compulsory conversion of Rs. 600 par value into an equity share of
Rs. 100 at a premium of Rs. 500 within six months of the date of allotment,
that is, on February 1, 1990. (ii) 12 per cent per annum interest payable half-
yearly and (iii) redemption of non-convertible portion of the debentures at the
end of 8 years.
It had also simultaneously issued 32,54,167,12 per cent FCDs of Rs. 600 each
at par on rights basis to the existing share holders. Each debenture was fully
convertible into one share of Rs. 600, that is, Rs 100 par plus a premium of Rs
500 within six months from the date of allotment of debentures.
Assuming 8 and 10 per cent as the half-yearly required rate of return on debt
and equity respectively, find the value of a TISCO convertible debenture at the
time of issue.
Solution
16
Value of PCD = [ Rs1.0872 ] + Σ [ Rs 36
t =2 (1.08)
]t+[
1×Rs 1,200
(1.10)
] +[
1
Rs 600
(1.08)
] 16

= Rs. 352.03 + Rs. 1,090.91 + Rs 175.20 = Rs. 1,618.14

Cost : The cost of partly convertible debenture (k e) is given by Equation
n I t (1-T) aPib n Fj
S0 = Σ t
+ i
+ Σ j
Equation 11.8
t =1 (I+k c) (1 + k c) j=m (1 + k c)

S0 = net subscription price of debentures at the time of issue

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It = interest payable at the end of period, t
T= tax rate
a= number of equity shares offered on the occurrence of conversion at the
end of period, i
P1 = per equity share price at the end of period i
b= proportion of net realisable proportion of Pi on the equity share issues
to the public
Fj = principal repayment instalment at the end of period, j
ke = cost of capital/discount rate
For the TISCO convertible issue as detailed in Example 11.1, assuming future
issue expenses, Rs. 80, 35 per cent tax rate and 75 per cent as the net realisable
proportion of equity shares issued to public, the cost of capital (convertible
debenture) on a semi-annual basis is the discount rate by solving the following
equation :
72(1-0.35) 16 36(1-0.35) 1×1,200×0.75 600
1.120 = +Σ t + +
(1 + k c ) t =2 (1 + k c) (1 + k c ) (1 + k c )16
k c = 11.5 per cent
Optionally Convertible Debentures : The value of a debenture depends upon
the three factors : (i) straight debenture value, (ii) conversion value and (iii)
option value.
Straight Debenture Value (SDC) : It equals the discounted value of receivable
interest and principal repayment, if retained as a straight debt instrument. The
discount factor would depend upon the credit rating of the debenture.
n 1 P 8 12 100
Symbolically SDV = Σ + 16 = Σ t+
t =1 (1 + k d) (1 + kd ) t =1 (1.16) (1.16) 8
Equation 11.9
where,
Maturity period = 8 years, Discount factor = 0.16, Interest = 0.12 payable
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annually and Face value of debenture = Rs. 100.
Conversion Value (CV) : If the holders opt for conversion, is equal to the
share price multiplied by the conversion ratio, that is, the number of equity
share offered for each debenture.
If the price of share is, Rs. 50 and one debenture is convertible in to 5 shares
(conversion ratio =5), the CV=Rs 250 (Rs 50×5).
The value of a convertible debenture cannot be less than the SDV and CV which,
in a sense, represent its two floor values. In other words, the value of
convertible debenture would be the higher of the SDV and CV.
Optional Value (OV) : The investors have an option, that is, they may not
exercise the right/exercise the right at a time of the their choosing and select
the most profitable alternative. Thus, the option has value in the sense that the
value of debenture will be higher than the floor values. Therefore, the value of
the convertible debentures = Max [SDV, CV] + OV.
Evaluation : Convertible debentures/bonds have emerged as fairly popular
instruments of long-term finance in India in recent years. In the first place,
they improve cash flow matching of firms. With the invariably lower initial
interest burden, a growing firm would be in a better position to service the
debt. Subsequently, when it would do well, it can afford the servicing of the
financing instrument after conversion.
Secondly, they generate financial synerg y. The assessment of risk
characteristics of new firm is costly and difficult. Convertible debentures
provide a measure of protection against error of risk assessment. They have
two components : straight debentures and call option. In case the firm turns
out risky, the former will have a low value while the latter will have a high
value and vice versa if the firm turns out to be relatively risk free. As a result,
the required yield will not be very sensitive to default risk. In other words,
Thus, convertible debentures offer a financial synergy to companies to obtain

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capital on more favourable terms.
Finally, convertible debentures can mitigate agency problems associated with
financing arising out of conflicting demand of equity holders and debenture
holders/lenders. The focus of the latter is on minimising default risk whereas
the former would like the firm to undertake high risk projects. This conflict
can be resolved by the issue of convertible debentures/bonds. The debenture
holders would not impose highly restrictive covenants to protect the interest
and firms can undertake profitable investment opportunities.
Foreign Currency Convertible Bonds (FCCBs) : These are basically equity-
linked debt securities. Convertible into equity/depository receipts after a
specified period. The holder has the option either to convert the FCCBs into
equity, normally at a predetermined price and even at a predetermined exchange
rate, or retain them. The FCCBs are freely tradeable. Till conversion the interest
has to be paid in foreign currency (dollar). The FCCB are issued in a currency
different from the currency in which the shares of the company are
denominated. This feature enables the option of diversifying the currency risks.
Callabale/Puttable Bonds/Debentures/Bond Refunding
Beginning from 1992 when the Industrial Development Bank of India issued
bonds with call features, several callable/puttable bonds have emerged in the
country in recent years. The call provisions provide flexibility to the company
to redeem them prematurely. Generally, firms issue bonds presumably at lower
rate of interest when market conditions are favourable to redeem such bonds.
Evaluation : The bond refunding decision can be analysed as a capital
budgeting decision. If the present value of the stream of net cash savings
exceeds the initial cash outlay, the debt should be refunded.
Example : 11.2
The 22 per cent outstanding bonds of the Sugar Industries Ltd. (SIL) amount to
Rs. 50 crores, with a remaining maturity of 5 years. It can now issue fresh

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bonds of 5 year maturity at a coupon rate of 20 per cent. The existing bonds
can be refunded at a premium (call premium) of 5 per cent. The flotation costs
(issue expenses + discount) on new bonds are expected to be 5 per cent. The
unamortised portion of the issue expenses on existing bonds is 1.5 crore. They
would be written off as soon as the existing bonds are called/refunded.
If the SIL is in 35 per cent tax bracket, would you advise it to call the bond?
Solution (Amount in Rs. crore)
Annual net cash savings (Working note 2) 0.71
PVIFA (10,13) (Working note 3) 3.517
Present value of annual net cash savings 2.497
Less Initial outlay (Working note 1) 3.600
NPV (bond refunding) 1.103
It is not advisable to call the bond as the NPV is negative
Working notes
(1) (a) Cost of calling/refunding existing bonds
Face value 50.0
Plus call premium (5 per cent) 2.5
(b) Net proceeds of new bonds 52.5
Gross proceeds 50.0
Less flotation costs 2.5
(c) Tax savings on expenses 47.5
Call premium 2.5
Plus Unamortised issue costs 1.5
4.0×(0.35 tax) 1.40
Initial outlay [(1a)] -(1b) - (1c) 3.60

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(2) (a) Annual net cash outflow on existing bonds
Interest expenses 11.00
Less tax savings on interest on expenses
and amortisation of issue costs :
0.35[11.0+(1.5/5)] 3.96 7.04
(b) Annual net cash outflow on new bonds
Interest expenses 10.00
Less tax savings on interest expenses and
amortisation of issue costs:0.35[11.00+(2.5/5)] 3.67 6.33
Annual net cash savings[(2)(a) - (2) (b)] 0.71
(3) Present value interest factor of 5 year annuity, using a 13 per cent after
tax [0.20 (1-0.35)] cost of new bonds = 3.517
11.10 WARRANTS
A warrant entitles its holders to subscribe to the equity capital of a company
during a specified period at a particular price. The holder acquires only the
right (option) but he has no obligation to acquire the equity shares. Warrants
are generally issued in conjunction with other instruments, for example,
attached to (i) secured premium notes of TISCO in 1992, (ii) debentures of
Deepak Fertilisers and Petrochemical Corporation Ltd. in 1987, Ranbaxy and
Reliance in 1995. They can be issued independently also.
Difference with Convertible Debentures : Warrants are akin to convertible
debentures to the extent that both give the holder the option/right to buy
ordinary shares but there are differences between the two. While the debenture
and conversion option are inseparable, a warrant can be detached. Similarly,
conversion option is tied to the debenture but warrants can be offered
independently also. Warrant are typically exercisable for cash.

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Features : The important features of warrants are as follows :
Exercise Price : It is the price at which the holder of a warrant is entitled to
acquire the ordinary shares of the firm. Generally, it is set higher than the
market price of the shares at the time of the issue.
Exercise Ratio : It reflects the number of shares that can be acquired per
warrant. Typically, the ratio is 1:1which implies that one equity share can be
purchased for each warrant.
Expiry Date : It means the date after which the option to buy shares expires,
that is, the life of the warrant. Usually, the life of warrants is 5-10 years
although theoretically perpetual warrants can also be issued.
Types : Warrants can be (i) detachable, and (ii) non-detachable. A detachable
warrant can be sold separately in the sense that the holder can continue to
retain the instrument to which the warrant was tied and at the same time sell it
to take advantage of price increases. Separate sale independent of the
instrument is not possible in case of non-detaildetachable warrants. The
detachable warrants are listed independently for stock exchange trading but
non-detachable warrants are not.
Theoretical Value : A warrant is an option (call option) to buy a number of
ordinary share (exercise ratio) at the exercise price. Therefore, the theoretical
value of a warrant would depend upon market price of the shares of the company,
the exercise price and the exercise ratio. Thus,
Theoretical value = (Market share price – Exercise price) × Exercise ratio
Assuming an exercise price of Rs. 75, the expected market price of share of the
company at the time of exercise for the option (expiry date) of Rs. 100 and exercise
ratio of 2, theoretical value of a warrant = (Rs 100 - Rs. 75)×2=Rs. 50.
If the market value of shares is lower than the exercise price, the value of a
warrant would be zero.
The difference between the market value of shares and the theoretical value of
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the warrant is the premium. The premium divided by the theoretical value
expresses premium in percentage terms.
As an option, the value of a warrant can be computed using sophisticated option
pricing models. However, they are beyond the scope of this lesson.
11.11 ZERO INTEREST BONDS/DEBENTURES (ZIB/D)
Also known as zero coupon bonds, ZIBs do not carry any explicit rate of interest.
They are sold at a discount from their maturity value. The difference between
the face value of the bond and the acquisition cost is the return to the investors.
The implicit rate of return/interest on such bonds can be computed by Equation
11.10.
Acquisition price = Maturity (face) value/(1-i)n Equation 11.10
where i = rate of interest
n = maturity period (years)
Deep Discount Bond (DDB) : A deep discount bond is a form of ZIB. It is
issued at a deep/steep discount over its face value. It implies that the interest
(coupon) rate is far less than the yield to maturity. The DDB appreciates to its
face value over the maturity period.
The DDBs are being issued by the public financial institutions in India, namely,
IDBI, SIDBI and so on. For instance, IBDI sold in 1992 a DDB of face value of
Rs. 1 lakh at a deep discount price of Rs. 2,700 with a maturity period of 25
years. If the investor could hold the DDB for 25 years, the annualised rate of
return would work out to 15.54 per cent. The investor had the option to withdraw
(put option) at the end of every five years with a specified maturity/deemed
face value ranging between Rs. 5,700 (after 5 years) and Rs. 50000 (after 20
years), the implicit annual rate of interest being 16.12 and 15.71 per cent
respectively. The investors could also sell the DDBs in the market. The IDBI
had also the option to redeem them (call option) at the end of every 5 years
presumably to take advantage of prevailing interest rates. A second series of

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DDBs was issued by the IDBI in 1996 with a face value of Rs. 2 lakh and a
maturity period of 25 years, the deep discount issue price being Rs. 5,300.
The merit of DDBs/ZIDs is the that they enable the issuing companies to
conserve cash during their maturity. They protect the investors against the
reinvestment risk to the extent the implicit interest on such bonds is
automatically reinvested at a rate equal to its yield to maturity. However, they
are exposed to high repayment risk as they entail a balloon payment on maturity.
11.12 SUMMARY
Equity and debt represent the two broad sources of finance for a business firm.
The key differences between equity and debt are : (i) Debt investors are entitled
to a contractual set of cash flows (interest and principal) whereas equity
investors have a claim on the residual cash flows of the firm after it has satisfied
all other claims and liabilities. (ii) Interest paid to debt investors represents a
tax-deductible expense whereas dividend paid to equity investors has to come
out of the profit after tax. (iii) Debt has a fixed maturity whereas equity
ordinarily has an infinite life (iv) Equity investors enjoy the prerogative to
control the affairs of the firm whereas debt investors pay a passive role – of
course, they often impose restrictions on the way the firm is run to protect
their interests.
Ordinary shares provide ownership rights to ordinary shareholders. They are
the legal owners of the company. As a result, they have residual claims on
income and assets of the company. They have the right to elect the board of
directors and maintain their proportionate ownership in the company, called
the pre-emptive right. The pre-emptive right of the ordinary shareholders is
maintained by raising new equity funds through rights offerings. Rights issue
does not affect the wealth of a shareholder. The price of the share with rights-
one gets divided into ex-rights price and the value of a right. So what the
shareholder gains in terms of the value of right he loses in terms of the loan
ex-rights price. However, he will lose if he does not exercise his rights.
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Debenture or bond is a long-term promissory note. The debenture trust deed
or indenture defines the legal relationship between the issuing company and
the debenture trustee who represents the debenture holders. Debenture holders
have a prior claim on the company's income and assets. They will be paid before
shareholders are paid anything. Debentures could be secured and unsecured
and convertible and non-convertible. Debentures are issued with a maturity
date. In India, they are generally retired after 7 to 10 years by instalments.
Preference share is a hybrid security as it includes some features of both an
ordinary share and a debenture. In regard to claims on income and assets, it
stands before an ordinary share but after a debenture. Most preference shares
in India have a cumulative feature, requiring that all past outstanding preference
dividends be paid before any dividend to ordinary shareholders is announced.
Term loans are loans for more than a year maturity. Generally, in India, they
are available for a period of 6 to 10 years. In some cases, the maturity could
be as long as 25 years. Interest on term loans is tax deductible. Mostly, term
loans are secured through an equitable mortgage on immovable assets. To
protect their interest, lending institutions impose a number of restrictions on
the borrowing firm.
Convertible security is either a debenture or a preference share that can be
exchanged for a stated number of ordinary shares at the option of the investor.
Companies offer convertible securities to sweeten debt and thereby market it
attractive. It is a form of deferred equity financing, and provides low cost funds
during the early stage of investment project.
A warrant is an option to buy a specified number of ordinary shares at an
indicated price during a specified period. A detachable warrant is bought and
sold independent of the debenture to which it is associated. Warrants are
generally used to sweeten a debt to make it marketable and lower the interest
costs. When warrants are exercised, the firm obtains additional cash. The market
value of warrants depends primarily on the ordinary share price. Warrants
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generally sell above their minimum theoretical value. The difference between
the market price and theoretical value of warrants is the premium.
A company may also issue zero-interest or deep-discount bonds or debentures.
Such debentures are issued at a price much lower than their face value. Thus,
there is an implicit rate of interest. A company may also issue debentures
redeemable at premium and/or with warrants attached. These features are added
to make the issue of debentures attractive to the investors.
11.13 SELF TEST QUESTIONS
1. What is an ordinary share? How does it differ from a preference share
and a debenture? Explain its most important features.
2. What are the advantages and disadvantages of ordinary shares to the
company? What are the merits and demerits of the shareholders' residual
claim on income from the investors' point of view?
3. What is a rights issue? What are its advantages and disadvantages from
the company's and shareholders' points of view?
4. What is a debenture? Explain the features of a debenture.
5. What are the pros and cons of debentures from the company's and
investors' point of views?
6. Why is a preference share called a hybrid security? Do you agree that it
combines the worst features of ordinary shares and bonds?
7. What are term loans? What are their features?
8. What is common between term loans and debentures in India? Explain
the comparative merits and demerits of both.
9. How do various instruments of long-term financing compare?
10. What has been the pattern of corporate financing in India?
11. What are the important features of a convertible security? What reasons
are generally given for issuing convertible securities ? How is a

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 convertible security valued?
12. What is a warrant? What are its characteristics features? Why are
warrants issued?
13. Explain the difference between a convertible security and a warrant.
14. What is meant by zero-interest debentures and deep-discount debentures?
How is their cost determined? Illustrate your answer.
15. A firm is thinking of a rights issue to raise Rs. 5 crore. It has a 5 lakh
shares outstanding and the current market price of the share is Rs. 170.
The subscription price on the new share will be Rs. 125 per share. (i)
How many shares should be sold to raise the required funds? (ii) How
many rights are needed to purchase one new share? (iii) What is the
value of one right?
11.14 SUGGESTED READINGS
1. Prasanna Chandra : Financial Management, Tata McGraw Hill
2. I.M. Pandey : Financial Management, Vikas Publishing House
3. John J. Hampton : Financial Decision Making, PHI
4. Ravi M. Kishore : Financial Management
5. Khan and Jain : Financial Management, Tata McGraw Hill

✪✪✪

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 LESSON – 12

INTRODUCTION TO WORKING CAPITAL MANAGEMENT

Objective : After reading this lesson, your will be conversant with :

• The nature and types of working capital
• Estimation of a firm's working capital needs using the operating cycle
• Determinants of working capital
• Trade-off between liquidity and profitability
• Determination of financing mix
Structure
12.1 Introduction
12.2 Nature and Types of Working Capital
12.3 Operating Cycle Approach to Working Capital Management
12.4 Determinants of Working Capital
12.5 Classification of Working Capital
12.6 Importance of Working Capital
12.7 Liquidity Vs. Profitability : Risk-Return Trade-Off
12.8 Financing Current Assets
12.9 Summary
12.10 Self Assessment Questions
12.11 Further Readings

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12.1 INTRODUCTION
The working capital management is a delicate area in the field of
financial management. A firm's working capital consists of its investment in
current assets which include short term assets such as cash and bank balance,
inventories, receivables (including debtors and bills), and marketable
securities. So, the working capital management refers to the management of
the level of all these individual current assets. The need for working capital
management arises from two considerations. First, existence of working
capital is imperative in any firm. The fixed assets which usually partake a large
chunk of total funds, can be used at an optimum level only if supported by
sufficient working capital, and second, the working capital involves investment
of funds of the firm. If the working capital level is not properly maintained and
managed, then it may result in unnecessary blocking of scarce resources of
the firm. The insufficient working capital, on the other hand, put different
hindrances in smooth working of the firm. Therefore, the working capital
management needs attention of all the financial managers.
12.2 NATURE AND TYPES OF WORKING CAPITAL
The term working capital refers to current assets which may be
defined as (i) those which are convertible into cash or equivalents within a
period of one year, and (ii) those which are required to meet day to day
operations. The fixed assets as well as the current assets, both requires
investment of funds. So, the management of working capital and of fixed assets,
apparently, seem to involve same type of considerations but it is not so. The
management of working capital involves different concepts and methodology
than the techniques used in fixed assets management. The reason for this
difference is obvious. The very basics of fixed assets decision process (i.e.,
the capital budgeting) and the working capital decision process are different.
The fixed assets involve long period perspective and therefore, the concept of
time value of money is applied in order to discount the future cash flows;

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whereas in working capital the time horizon is limited, in general, to one year
only and the time value of money concept is not considered. The fixed assets
affect the long term profitability of the firm while the current asses affect the
short term liquidity position. The fixed assets decisions are irreversible and
affect the growth of the firm, whereas the working capital decisions can be
changed and modified without much implications.
Managing current assets may require more attention than managing
fixed assets. The financial manager cannot simply decide the level of the current
assets and stop there. The level of investment in each of the current assets
varies from day to day, and the financial manager must therefore, continuously
monitor these assets to ensure that the desired levels are being maintained.
Since, the amount of money invested in current assets can change rapidly, so
does the financing required. Mis-management of current assets can be costly.
Too large an investment in current assets means tying up capital that can be
productively used elsewhere (or it means added interest cost if the firm has
borrowed funds to finance the investment in current assets). Excess investment
may also expose the firm to undue risk e.g., in case, the inventory cannot be
sold or the receivables cannot be collected.
On the other hand, too little investment also can be expensive.
For example, insufficient inventory may mean that sales are lost as the goods
which a customer wants are not available. The result is that the financial
managers spend a large chunk of their time managing the current asses because
these assets vary quickly and a lack of attention paid to them may result in
appreciably lower profits for the firms. So, in the working capital management,
a financial manager is faced with a decisions involving some of the
considerations as follows :
1. What should be the total investment in working capital of the firm?
2. What should be the level of individual current assets?
3. What should be the relative proportion of different sources to finance
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 the working capital requirements?
Thus, the working capital management may be defined as the
management of firm's sources and uses of working capital in order to maximize
the wealth of the shareholders. The proper working capital management requires
both the medium term planning (say up to three years) and also the immediate
adoptions to changes arising due to fluctuations in operating levels of the firm.
The term working capital may be used in two different ways :
(i) Gross Working Capital
(ii) Net Working Capital
In the broad sense, the term working capital refers to the gross
working capital and represents the amount of funds invested in current assets.
Thus, the gross working capital is the capital invested in total current assets of
the enterprise. Current assets are those assets which in the ordinary course of
business can be converted into cash within a short period of normally one
accounting year. Examples of current assets are : cash in hand and bank balances
receivables, inventory, short-term loans and advances, temporary investments
of surplus funds and prepaid expenses.
In a narrow sense, the term working capital refers to the net
working capital. Net working capital is the excess of current assets over current
liabilities. Net working capital may be positive or negative . When the current
assets exceed the current liabilities the working capital is positive and the
negative working capital results when the current liabilities are more than
current assets. Current liabilities are those liabilities which are intended to be
paid in the ordinary course of business within a short period of normally one
accounting year out of the current assets or the income of the business.
Examples of the current liabilities are : bills payable, sundry creditors, short-
term loans, advances and deposits, bank overdraft.
Those authors who hold that working capital represents current
assets give various arguments to support their view. First, they say that gross
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concept of working capital takes into account the fact that with every increase
in the borrowings, the working capital will increase, while according to the
net concept there will be no increase. Secondly, profit is the result of
interaction of both fixed and current assets. Since the fixed assets constitute
the fixed capital of a firm, logic demands that current assets should be taken
to mean the working capital. Thirdly, the management is primarily concerned
with the total of current assets as they constitute the total funds available for
operating purposes.
The other school considers that working capital represents current
assets minus current liabilities. They argue that this concept helps the investors
and creditors to weigh the financial soundness and margin of protection and is
of special significance to suppliers of short-term loans and advances. It creates
confidence among the creditors about the security of their amounts. Secondly,
the surplus of current assets over current liabilities can always be relied upon
to meet contingencies since the enterprise is under no obligation to return the
amount invested in surplus current assets.
The gross working capital concept is useful for an analytical
insight into profitability with reference to the management of current assets.
The net working capital concept emphasises the aspect of liquidity, drawing
attention to the equity and long-term financing portion of current assets which
is supposed serve as a cushion of safety and security to current liabilities.
Also, the gross working capital concept emphasises the use and the 'net' concept
the source; the interaction of both these concepts is necessary in order to
understand the working capital management from the point of view of risk,
return and uncertainty.
Working capital viewed according to net concept is qualitative in
character. It is the amount of current assets that has been supplied by the
shareholders and/or long-term creditors. The gross concept of working capital
is quantitative in character because it represents the total amount of funds

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used for current operating purposes.
This distinction between gross working capital and net working
capital does not in any way undermine the relevance of the concepts of either
gross or net working capital. A financial manager must consider both of them
because they provide different interpretations. The gross working capital
denotes the total working capital or the total investment in current assets. A
firm should maintain an optimum level of gross working capital. This will help
avoiding (i) the unnecessarily stoppage of work or chance of liquidation due
to insufficient working capital, and (ii) effect on profitability (because over
flowing working capital implies cost). Therefore, a firm should have just
adequate level of total current assets. The gross working capital also gives an
idea of total funds required for maintaining current assets.
On the other hand, net working capital refers to the amount of
funds that must be invested by the firm, more or less, regularly in current assets.
The remaining portion of current assets being financed by the current liabilities.
The net working capital also denotes the net liquidity being maintained by the
firm. This also gives an idea of buffer available to the current liabilities. Thus,
both concepts of working capital i.e., the gross working capital and the net
working capital have their own relevance and a financial manager should give
due attention to both of these.
12.3 OPERATING CYCLE
The working capital requirements of a firm depends, to a great
extent upon the operating cycle of the firm. The operating cycle may be defined
as the time duration starting from the procurement of goods or raw materials
and ending with the sales realization. The length and nature of the operating
cycle may differ from one firm to another depending upon the size and nature
of the firm.
In a trading concern, there is a series of activities starting from
procurement of goods (saleable goods) and ending with the realization of sales
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revenue (at the time of sale itself in case of cash sales and at the time of
debtors realizations in case of credit sales). Similarly, in case of manufacturing
concern, this series starts from procurement of raw materials and ending with
the sales realization of finished goods (after going through the different stages
of production). In both the cases, however, there is a time gap between the
happening of the first event and the happening of the last event. This time gap
is called the operating cycle.
Thus, the operating cycle of a firm consists of the time required
for the completion of the chronological sequence of some or all of the
following:
i) Procurement of raw materials and services.
ii) Conversion of raw materials into work-in-progress.
iii) Conversion of work-in-progress into finished goods.
iv) Sale of finished goods (cash or credit).
v) Conversion of receivables into cash.
These activities create and necessitate cash flows which are
neither synchronized nor certain. The relevant cash flows are not synchronized
because the cash disbursements (i.e., payment for purchases) take place before
the cash inflows (from sales realizations). These cash flows are uncertain
because these depends upon the future costs and sales. Of course, the cash
outflows relating to payment for purchases and payment for wages and other
expenses are less uncertain with respect to time as well as quantum. What is
required on the part of a firm is to make adjustments and arrangements so that
the uncertainty and unsynchronization of these cash flows can be taken care
of. The firm is often required to extend credit facilities to customers. The
finished goods must be kept in store to take care of the orders and a minimum
cash balance must be maintained. It must also have a minimum of raw materials
to have smooth and uninterrupted production process. So, in order to have a
proper and smooth running of the business activities, the firm must make
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investments in all these current assets. This requirement of funds depends upon
the operating cycle period of the firm and is also denoted as the working capital
needs of the firm.
The duration of the operating cycle for the purpose of estimating
working capital requirements is equivalent to the sum of the durations of (a)
raw materials and stores storage stage (b) work-in-process stage (c) finished
goods stage and (d) receivables collection stage less the credit period allowed
by the suppliers of the firm.
Symbolically, the duration of the working capital cycle can be
put as follows :
O=R+W+F+D–C
O = Duration of operating cycle
R = Raw materials and stores storage period;
W = Working-in-process period;
F = Finished stock storage period;
D = Debtors' collection period;
C = Creditors' payment period.
Each of the component of the operating cycle can be calculated
as follows :
Average stock of raw materials and stores
R=
Average Raw Materials and stores consumption per day
Average work-in-process inventory
W=
Average cost of production per day

Average finished stock inventory

F=
Average cost of goods sold per day

Average books debts

D=
Average credit sales per day

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 Average trade creditors
C=
Average credit purchases per day

After computing the period of one operating cycle, the total

number of operating cycles that can be completed during a year can be computed
by dividing 365 days with the number of operating days in a cycle. The total
operating expenditure in the year when divided by the number of operating
cycles in a year will give the average amount of the working capital
requirements.
Illustration 1 : From the following information, extracted from the books of
a manufacturing company, compute the operating cycle in days and the amount
of working capital required :
Period covered 365 days
Average period of credit allowed by suppliers 16 days
(Rs. in '000)
Average Total of Debtors outstanding 480
Raw Material Consumption 4,440
Total Production Cost 10,000
Total Cost of Sales 10,500
Sales for the year 16,000
Value of Average Stock maintained :
Raw Material 320
Work-in-progress 350
Finished Goods 260

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Solution :
COMPUTATION OF OPERATIONAL CYCLE
(i) Raw materials held in stock
Average stocks of raw materials held 320
=
Average consumption per day 4,400/365
= 320×365 = 27 days
400
Less : Average credit period granted by suppliers 16 days
(ii) Work-in-progress : 11 days
Average WIP maintained 350
=
Average cost of production per day 10,000/365
350×365 = 13 days
=
10,000
(iii) Finished Goods held in stock :
Average finished goods maintained 260
=
Average cost of goods sold per day 10,500/365
260×365
=
10,500 = 9 days
(iv) Credit period allowed to debtors :
Average total of outstanding debtors 480
=
Average credit sales per day 16,000/365
365×480
=
16,000 = 11 days
Total Operating Cycle Period : (i) + (ii) + (iii) + (iv) = 44 days
Number of Operating cycles in a year = 365/44
= 8.30
Total Operating Cost
Amount of Working Capital required =
Number of Operating cycles in a year
= 10,500/8.3
= Rs. 1,265
12.4 DETERMINANTS OF WORKING CAPITAL
The working capital needs of a company are influenced by a large
number of factors and all the factors are of different importance. Again the
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importance of these factors also changes for the company over a period of
time. As such it is necessary that an analysis is made into these factors to
determine the total investment in the working capital of the company. Following
are the factors that determine the working capital needs of an enterprise :
1. Business size and its Nature : Nature of business greatly influences
the working capital requirements of an enterprise. Thus financial and trading
enterprises require less of fixed assets but require huge working capital
investments. For example a retailer has to carry large stocks of a variety of
goods to satisfy the varied and continuous needs and requirements of his
customers. Almost same is the case with some manufacturing enterprises like
bidi manufacturers who have to invest a nominal amount in fixed assets but a
substantial amount in their working capital. Contrary to this, public utility
undertakings like electricity and water works etc. have very little of working
capital requirements with huge investments in fixed assets. Such undertakings
supply services and not goods and resort to cash sales. With the result no funds
will be stuck as debtors and there will be no inventories. At the same time
most of the manufacturing enterprises fall in between the two extremes of
public utilities and trading enterprises. These manufacturing enterprises
maintain their working capital position as per their total assets structure and
other variables.
Along with the nature, the size of business also has a great bearing
upon the working capital requirements of an enterprise. The size of the
enterprise may be measured in terms of the scale of operations of the company.
Obviously an enterprise with greater scale of operations shall need greater
amount of investments in working capital. Similarly an enterprise with small
size of operations shall need small amount of investments in its working capital.
2. Manufacturing Cycle : Working capital requirements of an enterprise
are affected by its manufacturing cycle as well. The cycle starts with the
purchase and use of raw material and ends when finished goods are produced.

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Thus the longer the cycle the greater the company's working capital needs. To
avoid this an alternative manufacturing cycle should be adopted if it calls for
shortest time span. Also the company should always try to complete the
manufacturing process as per the schedule so that inventories do not
unnecessarily get accumulated. Some enterprises call for advances from their
customers and thereby minimise their investment in working capital.
3. Fluctuations of Business : Fluctuations in business are of several types,
namely, short-period fluctuations, seasonal fluctuations and cyclical
fluctuations etc. These fluctuations result in change in the demand of products
of the enterprise. This is turn results in change in working capital requirements
of the business.
In the event of upswing in the economy there will be increase in
demand and correspondingly increase in sales. With the result there will be
more investment in inventories and debtors will also increase. As against this
with a decline in the economy, sales will go down and with this investments in
inventories and debtors will also fall. Both these situations have a bearing on
the working capital requirements of the company.
Again the enterprises that are affected by seasonal fluctuations
face production problems also. When demand is at its peak, increased
production will be expensive. It will be again very expensive during slack period
when the company has to sustain its work force and the necessary infrastructure
when the production and sales are not adequate. Under these circumstances
the company may adopt a steady policy of production, unmindful of seasonal
variations, to enable it to utilize fully its available resources. This will mean
accumulation of inventories during off seasons and their quick disposal during
peak season. Thus during slack season the working capital will be more and
during peak period it may be less.
4. Policy of Production : An enterprise, as stated above, may adopt a
constant policy of production to suit its ends. But such a policy will expose
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the company to greater risks and inventory costs. Therefore the company may
prefer to follow the policy of varying its production schedules in accordance
with the changes in its demand. Some concerns may utilise their production
capacities for producing varies products and thus have the advantage of
diversified activities and with this solve their working capital problems. Thus
the original product will be produced during peak season and during slack season
the work force and other infrastructure will be used to produce other products.
As such the policy of production will vary from enterprise to enterprise with
its impact upon the working capital requirements of the business.
5. Credit Policy of the Company : The working capital of an enterprise
is also determined by its credit policy as it affects the company's level of
book debts. An enterprise formulates the terms of credit followed by it towards
its customers, which of course, is influenced by the norms set in the similar
business around. However, it is advisable if the enterprise follows the credit
policy on the merit of each individual case and thus it should have a
discretionary practice. As otherwise a liberal credit policy may land the
enterprise into trouble as it may face difficulty in collections if a credit policy
is formulated ignoring the credit worthiness of the parties. The collections
should be made promptly as a high collection period will mean tie-up of funds
in book debts and it may result in increase in bad debts.
Thus the enterprise should follow such a credit policy, whereby
funds do not unnecessarily get tied up. Such a policy should be based on the
credit standing of the customers besides other things. The credit worthiness
of the exiting customers should periodically be reviewed and that of the new
customers should be evaluated first. In the event of delayed payments the matter
should be thoroughly investigated to reshape the credit policy for future.
6. Credit Availability : Credit terms granted to an enterprise by its
customers also affect the requirements of working capital. If liberal credit
terms are available to the company it will require less investments in its

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working capital. The availability of bank creditors also affects the level of
working capital needs of an enterprise. It will operate on less working capital
if bank credits are available to its easily and on favourable conditions.
7. Activities of Growth and Expansion : With the growth of a firm by
way of increase in its sales and fixed assets the working capital needs of it
also increase. In fact the increased working capital needs precede the growth
in business activities. Thus the increased working capital need not follow the
growth of the firm rather the growth follows it. As such for a growing firm
there is every need to make advance planning on continuous basis for working
capital needs.
Again, in order to sustain its growing production and sales a
growing enterprise may need to invest funds in fixed assets. With this,
investment in current assets will increase in order to support enlarged scale
of operations.
A growing enterprise needs funds continuously and it obtains the
same both from internal as well as external sources. Under these circumstances
if the enterprise retains its profits it will result in more problems as it shall
not be paying dividends to its shareholders. Therefore, a growing enterprise
should formulate an appropriate planing and policy to fund its increased needs
of working capital.
8. Margin of Profit and Profit Appropriation : Profit earning capacity
of business enterprises vary from one another. This of course depends much
upon the quality of the product, pricing, marketing strategies and monopoly
power or otherwise enjoyed by the enterprise. Different organisations enjoy
these factors differently and thus their margin of profit differs, some earning
high and others low profit margin. The volume of net profit earned is a source
of working capital, of course to the extent it comprises of cash.
However, whole of the profit earned in cash is not available for
working capital purposes. Such a contribution towards the working capital would
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be affected by the way in which profits are appropriated in the business. As
such the availability of cash for working capital depends upon taxation, dividend,
retention policy and depreciation policy followed by the company.
9. Changes in Price Level : There is direct impact of changes in price
level on the working capital requirements of an enterprise. This makes the job
of the financial manager very important as he is required to anticipate correctly
this impact. Generally a company will have to maintain higher volume of
working capital as a result of rise in price line. This is because investments in
current assets will increase because of price rise. But such enterprises that
can immediately enhance the price of their product will not face severe working
capital problems. Also the impact of price level increase will affect the
business enterprises differently as individual prices may move differently.
Likewise some companies may be badly hit whereas others may not be affected
at all. As such the change in price level may affect the working capital of some
enterprises whereas others may not be affected at all.
10. Operating Efficiency : With optimum utilization of its resources a
company can improve its operational efficiency. This will result in
minimisation of costs and maximisation of returns. When the company is able
to control its operational costs, it can effectively contribute towards its working
capital. The operational efficiency of an enterprise improves the use of its
working capital and the pace of the cash cycle will be accelerated. Pressure on
working capital will get released when there is optimum utilization of resources
resulting in improved profitability.
12.5 CLASSIFICATION OR KINDS OF WORKING CAPITAL
Working capital may be classified in two ways :
(a) On the basis of concept.
(b) On the basis of time
On the basis of concept, working capital is classified as gross
working capital and net working capital as discussed earlier. This classification
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is important from the point of view of the financial manager. On the basis of
time, working capital may be classified as :
1. Permanent or fixed working capital.
2. Temporary or variable working capital

KINDS OF WORKING CAPITAL

On the basis of Concept On the Basis of Time

Gross Working Net Permanent or Temporary or

Capital Working Capital Fixed Working Variable
Capital Working Capital

Regular Reserve Seasonal Special

Working Capital Working Capital Working Capital Working Capital

1. Permanent or Fixed Working Capital : Permanent or fixed working

capital is the minimum amount which is required to ensure effective utilisation
of fixed facilities and for maintaining the circulation of current assets. There
is always a minimum level of current assets which is continuously required by
the enterprise to carry out its normal business operations. For example, every
firm has to maintain a minimum level raw materials, work-in-process, finished
goods and cash balance. This minimum level of current assets is called
permanent or fixed working capital as this part of capital is permanently blocked
in current assets. As the business grows the requirements of permanent working
capital also increase due to the increase in current assets. The permanent
working capital can further be classified as regular working capital and reserve
working capital required to ensure circulation of current assets from cash to
inventories, from inventories to receivables and from receivables to cash and
so on. Reserve working capital is the excess amount over the requirement for
regular working capital which may be provided for contingencies that may arise
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 at unstated periods such as strikes, rise in prices, depression, etc.
2. Temporary or Variable Working Capital : Temporary or variable
working capital is the amount of working capital which is require to meet the
seasonal demands and some special exigencies. Variable working capital can
be further classified as seasonal working capital and special working capital.
Most of the enterprises have to provide additional working capital to meet the
seasonal and special needs. The capital required to meet the seasonal needs of
the enterprise is called seasonal working capital. Special working capital is
that part of working capital which is required to meet special exigencies such
as launching of extensive marketing campaigns for conducting research, etc.
Temporary working capital differs from permanent working capital
in the sense that it is required for short periods and cannot be permanently
employed gainfully in the business. Figures given below illustrate the difference
between permanent and temporary working capital :

bl o r
Amount of Working Capital

Amount of Working Capital

ria r y
Temporary or Variable

Va ora
e
p
Working Capital

m
Te
Permanent or
fixed Working
Permanent or Fixed
Capital
Working Capital

Time Time
Fig. 1 Fig. 2
In Fig. 1, permanent working capital is stable or fixed over time
while the temporary or variable working capital fluctuates. In Fig. 2, permanent
working capital is also increasing with the passage of time due to expansion of
business but even then it does not fluctuate as variable working capital which
sometimes increases and sometimes decreases.

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12.6 NEED AND IMPORTANCE OF WORKING CAPITAL
Working capital is the lifeline of every concern, whether it is a
manufacturing or non-manufacturing one. Without adequate working capital
there can be no progress in the industry. Inadequate working capital means
shortage of raw materials, labour etc., resulting in partial utilisation of available
machinery. Moreover, research and development in the industry is at a low ebb
and essential innovations fail to appear. Inadequate working capital frustrates
the objectives of the enterprise through lack of funds and contributes towards
the failure of a business. On the other hand, more working capital may lead to
less control over workers' performances, inefficient store-keeping, excessive
stocks of raw materials and finished goods, delay in the flow of work-in-
progress and lack of co-ordination in the enterprise. So the amount of working
capital in every concern should be neither more nor less than what is required.
The management is to see that funds invested as working capital earn at least
as much as they would have earned if invested elsewhere.
In times of rising capital costs and scarce funds, the area of
working capital management assumes added importance. A firm's profitability
and liquidity are deeply influenced by the way its working capital is being
managed. The main objective of working capital management is to arrange the
needed funds adequately from the best sources and for the time period involved,
so that trade-off between liquidity and profitability may be realised.
The volume of working capital required is determined by the level
of production unlike fixed asset investment which is determined by the scale
of production. The precise level of working capital investment depends upon
the management's attitude towards risk and the factors that influence the levels
of cash, inventories and receivables required to support a given volume of
output. However, the working capital requirements vary from industry to
industry, from one undertaking to another in the same industry and even from
time to time in the same undertaking. Actually, the size of current assets in a

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concern depends upon the extent to which the three basic activities –
production, distribution (sales), and collection – are synchronised. The main
advantages of maintaining adequate amount of working capital are as follows :
1. Solvency of the business : Adequate working capital helps in
maintaining solvency of the business by providing uninterrupted flow of
production.
2. Goodwill : Sufficient working capital enables a business concern to
make prompt payments and hence helps in creating and maintaining goodwill.
3. Easy Loans : A concern having adequate working capital, high solvency
and good credit standing can arrange loans from banks and others on easy and
favourable terms.
4. Cash Discounts : Adequate working capital also enables a concern to
avail cash discounts on the purchases and hence it reduces costs.
5. Regular supply of raw materials : Sufficient working capital ensures
regular supply of raw materials and continuous production.
6. Regular payment of salaries, wages and other day-to-day
commitments: A company which has ample working capital can make regular
payment of salaries, wages and other day-to-day commitments which raises
the morale of its employees, increases their efficiency, reduces wastages and
costs and enhances production and profits.
7. Exploitation of favourable market conditions : Only concerns with
adequate working capital can exploit favourable market conditions such as
purchasing its requirements in bulk when the prices are lower and by holding
its inventories for higher prices.
8. Ability to face Crisis : Adequate working capital enables a concern to
face business crisis in emergencies such as depression because during such
periods, generally, there is much pressure on working capital.
9. Quick and Regular return on Investments : Every investor wants a
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quick and regular return on his investments. Sufficiency of working capital
enables a concern to pay quick and regular dividends to its investors as there
may not be much pressure to plough back profits. This gains the confidence of
its investors and creates a favourable market to raise additional funds in the
future.
10. High morale : Adequacy of working capital creates an environment of
security, confidence, high morale and creates overall efficiency in a business.
12.7 LIQUIDITY VS. PROFITABILITY : RISK-RETURN TRADE-OFF
The firm would make just enough investment in current assets if
it were possible to estimate working capital needs exactly. Under perfect
certainty, current assets holdings would be at the minimum level. A larger
investment in current assets under certainty would mean a low rate of return
on investment for the firm, as excess investment in current assets will not
earn enough return. A smaller investment in current assets, on the other hand,
would mean interrupted production and sales, because of frequent stock-outs
and inability to pay to creditors in time due to restrictive policy.
As it is not possible to estimate working capital needs accurately,
the firm must decide about levels of current assets to be carried. Given a firm's
technology and production policy, sales and demand conditions, operating
efficiency etc., its current assets holdings will depend upon its working capital
policy. It may follow a conservative or an aggressive policy. These policies
involve risk-return trade off. A conservative policy means lower return and
risk, while an aggressive policy produces higher return and risk.
The two important aims of the working capital management are :
profitability and solvency. Solvency, used in the technical sense, refers to the
firm's continuous ability to meet maturing obligations. Lenders and creditors
expect prompt settlements of their claims as and when due. To ensure solvency,
the firm should be very liquid, which means larger current assets holdings. If
the firm maintains a relatively large investment in current assets, it will have
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no difficulty in paying claims of creditors when they become due and will be
able to fill all sales orders and ensure smooth production. Thus, a liquid firm
has less risk of insolvency; that is, it will hardly experience a cash shortage or
a stock-out situation. However, there is a cost associated with maintaining a
sound liquidity position. A considerable amount of the firm's funds will be
tied up in current assets, and to extent this investment is idle, the firm's
profitability will suffer.
To have higher profitability, the firm may sacrifice solvency and
maintain a relatively low level of current assets. When the firm does so, its
profitability will improve as less funds are tied up in idle current assets, but
its solvency would be threatened and would be exposed to greater risk of cash
shortage and stockouts.
So, there exists a trade-off between profitability and liquidity or
a trade-off between risk (liquidity) and return (profitability) with reference to
working capital. The risk in this context is measured by the probability that the
firm will become technically insolvent by not paying current liabilities as they
occur; and profitability here means the reduction of cost of maintaiing of
current assets. The greater the amount of liqudi assets a firm has, the less
risky the firm is. In other words, ther more liquid is the firm, the less likely it
is to become insolvent. Conversely, lower levels of liquidity and risk of the
firm is that the liqudiity and risk move in opposite direction. So, every firm, in
order to reduce the risk will tend to increase the liquidity. But, increased
liquidity has a cost. If a firm wants to increase profits by reducing the cost of
maintaining liquidity, then it must also increase the risk. If it wants to decrease
risk, the profitability is also decreased. So, a trade-off between risk and return
is required. The risk-return trade-off of the working capital management is
illustrated in Illustration 2.

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Illustration 2 : Suppose, a firm has the following data for some future year :
Rs.
Sales (1,00,000 units) 15,00,000
Earnings before interest and taxes 1,50,000
Fixed assets 5,00,000
The three possible current assets holdings of the firm are : Rs.
5,00,000, Rs. 4,00,000 and Rs. 3,00,0000. It is assumed that fixed assets level
is constant and profits do not vary with current assets levels. The effect of the
three alternative current policies is as follows :
Effect of Alternative Working Capital policies :

Policies
A B C
Rs. Rs. Rs.
Sales 15,00,000 15,00,000 15,00,000
Earnings before interest & taxes(EBIT) 1,50,000 1,50,000 1,50,000
Current assets 5,00,000 4,00,000 3,00,000
Fixed assets 5,00,000 5,00,000 5,00,000
Total assets 10,00,000 9,00,000 8,00,000
Return on total assets (EBIT/Total assets) 15% 16.67% 18.75%
Current assets/Fixed assets 1.00 0.80 0.60

The calculations indicate that alternative A the most conservative

policy, provides greatest liquidity (solvency) to the firm, but also the lowest
return on total assets. On the other hand, alternative c, the most aggressive
policy, yields highest return but provides lowest liquidity and thus, is very
risky to the firm. Alternative B demonstrates a moderate policy and generates
a return higher than alternative A but lower than alternative C and is less risky
than alternative C but more risky than alternative A.

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12.8 FINANCING CURRENT ASSETS
A firm can adopt different financing policies vis-a-vis current
assets. Three types of financing may be distinguished :
(a) Long-term financing : The sources of long-term financing include
equity share capital, preference share capital, debentures, long-term
borrowings from financial institutions and reserves and surplus (retained
earnings).
(b) Short-term financing : The short-term financing is obtained for a period
less than one year. It is arranged in advance from banks and other suppliers of
short-term finance in the money market. Short-term finances include working
capital funds from banks, public deposits, commercial paper, factoring of
receivables etc.
(c) Spontaneous financing : Spontaneous financing refers to the automatic
source of short-term funds arising the normal course of a business. Trade
(suppliers') credit and outstanding expenses are examples of spontaneous
financing. There is no explicit cost of spontaneous financing. A firm is
expected to utilise these sources of finances to the fullest extent. The real
choice of financing current assets, once the spontaneous sources of financing
have been fully utilised, is between the long-term and short-term sources of
finances.
What should be the mix of short-and long-term sources in
financing current assets? Depending on the mix of short and long-term
financing, the approach followed by a company may be referred to as :
(i) matching approach
(ii) conservative approach
(iii) aggressive approach
(i) Hedging Approach
According to this approach, actual pattern of financing of the firm is
decided keeping in view life of assets and maturity of the sources of funds.
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Thus, each asset would be offset with a financing instrument of the same
approximate maturity. Short-term loans would be send to finance acquisition
of short-term assets and long-term assets or permanent part of current assets
would be purchased by long term debt or equity. In hedging approach (also
known as matching approach), finance manager has to endeavour to match the
life of assets with the term of sources of funds. For instance, if a firm has to
buy a machine having expected life of 10 years, according to hedging approach,
long-term loans for 10 years should be borrowed. Likewise, if inventory bought
is expected to be sold in 60 days, the firm would resort to short-term loans
for 60 days. However, it should be realised that exact matching is not possible
because of uncertainty about the expected lives of assets. Fig. 3 depicts pattern
of working capital financing as per the hedging approach
TEMPORARY
WORKING CAPITAL
Short-term financing
Working Capital (Rs.)

PERMANENT Long-term financing

WORKING CAPITAL

Time
Fig. 3 : Financing under hedging approach

This approach tends to reduce risk in as much as it saves the firm

from heavy cost of long-term funds lying idle during times when they were not
needed. The borrowing and payment schedule, under hedging approach, would
be arranged so as to correspond to the expected savings in current assets, less
payables and accruals. Fixed assets and permanent component of current assets
would be financed with long-term debt, equity and permanent component of
current liabilities.
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 Under the hedging approach, no short-term financing will be used
if the firm has a fixed current assets need only. During the seasonal upswings,
funds will be borrowed for short-term i.e., for the period of season. Short-
term borrowings would be liquidated with surplus cash in the off season.
(ii) Conservative Approach
According to this approach, long-term sources of funds are used
to finance current asset requirements. Only in times of emergency when current
asset needs surge suddenly, the firm should use short-term sources. This
implies that the predictable variable investment in current assets should also
be financed by long-term funds.
The financing plan based on the conservative approach minimizes
risk of technical insolvency because it gives the firm the greatest liquidity
cushion to meet unexpected needs for funds. However, cost of financing would
be relatively high with the result that the rate of return would be low.
So, under the conservation approach, the working capital is
primarily financed by long term sources. The larger the portion of long term
sources used for financing the working capital, the more conservative is said
to be the working capital policy of the firm. In case, the firm has no temporary
working capital need then the idle long term funds can be invested in marketable
securities. This will help the firm to earn some income.
( i i i ) Aggressive Approach
In this approach of working capital financing short-term funds
are used to finance a major part of the firm's permanent current assets and a
part of fixed assets. Thus, larger the ratio of short-term funds to total assets,
the more aggressive approach to financing. The following illustration will
explain this approach :

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Illustration 3
Aggressive Approach
Liabilities Policy Policy Policy
A B C
Current Liabilities 25,000 30,000 35,000
Long-term Liabilities 25,000 20,000 15,000
Total Liabilities 50,000 50,000 50,000
Current Assets 15,000 15,000 15,000
Long-term Assets 35,000 35,000 35,000
Total Assets 50,000 50,000 50,000

Ratio of Short-term funds to Total Investments

25,000
Policy A = = 0.5:1
50,000
30,000
Policy B = = 0.6:1
50,000
35,000
Policy C = = 0.7:1
50,000
The firm has aggressive approach when it adopts policy A, the
degree of aggressiveness increases when the firm moves from policy A to policy
B, and further to Policy C.
The financing plan based on aggressive approach increases the
risk exposure of the firm but reduces the cost of capital and increases the
profitability.
An analysis of the above approaches leads us to the following
conclusions :
(i) In conservative approach, cost is high, risk is low and return is low.
(ii) In aggressive approach, cost is low, risk is high and return is high.
(iii) In hedging approach, cost, risk and return are moderate. It aims at trade-

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 off between profitability and risk.
Choice of particular financing plan would depend on a host of
factors such as the approval of creditors, state of money and capital markets,
composition of current assets, recent use of a source and risk preferences of
the management.
12.9 SUMMARY
The concept of working capital is used in two ways. Gross working
capital refers to the firm's investment in current assets. Net working capital
means the difference between current assets and current liabilities, and
therefore, represents that position of current assets which the firm has to
finance either from long-term funds or bank borrowings.
A firm is required to invest in current assets for a smooth
uninterrupted production and sale. However much a firm will invest in current
assets will depend on its operating cycle. Operating cycle is defined as the
time duration which the firm requires to manufacture and sell the product and
collect cash. Thus operating cycle refers to the acquisition of resources,
conversion of raw materials into work-in-process into finished goods,
conversion of finished gods into sales and collection of sales. Larger the
operating cycle, larger the investment in current assets.
The firm's decision about the level of investment in current assets
involves a trade-off between risk and return. When the firm invested more in
current assets it reduces the work of illiquidity but losses in terms of
profitability since the opportunity of earning from the excess investment in
current assets is lost. The firm therefore is required to strike a right balance.
The determination of financing mix is the another ingredient of
the theory of working capital management. The financing-mix refers to the
proportion of current assets to be financed by current liabilities and long-
term sources. One approach to determine the financing mix is the hedging
approach, according to which the long-term funds should be used to finance
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the fixed/core portion of the current assets and the temporary/seasonal
requirements should be met out of short-term funds. This approach is a high-
profit, high-risk financing mix. According to second approach namely the
conservative approach, the estimated total requirements of the current assets
should be financed from long-term sources and short-term funds should be
used only in emergency situations. The conservative approach is a low-profit,
low-risk combination financing mix. If the firm uses more of short-term funds
for financing both current and fixed assets, its financing policy is considered
aggressive and risky. Theoretically, short-term debt is considered to be risky
and costly to finance permanent current assets.
12.10 SELF ASSESSMENT QUESTIONS
1. Define the term working capital. What factors would you take into
consideration in estimating the working capital needs of a concern ?
2. What do you understand by working capital ? Explain the concepts of
working capital ?
3. Discuss the importance of working capital for a manufacturing concern.
4. How are net working capital, liquidity, technical insolvency and risk related ?
5. Discuss the various approaches to determine an appropriate financing
mix of working capital.
12.11 FURTHER READINGS
1. Financial Management and Policy by James C. Van Horne
2. Financial Management by Prasana Chandra
3. Financial Management by Ravi M. Kishore
4. Financial Management by I.M. Pandey

✪✪✪

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 LESSON – 13

INVENTORY MANAGEMENT

Objective : This lesson will make you conversant with

• Meaning and types of inventory
• Purpose of having inventories
• Costs associated with inventory
• Inventory management techniques
Structure
13.1 Meaning and Types of Inventory
13.2 Need to hold Inventories
13.3 Objectives of Inventory Management
13.4 Cost of Holding Inventory
13.5 Techniques of Inventory Management
13.6 Inventory and the Finance Manager
13.7 Summary
13.8 Self Assessment Questions
13.9 Further Readings
Inventory constitutes a major component of working capital. To a
large extent, the success or failure of a business enterprise depends upon its
inventory management performances. The inventories need not be viewed as
an idle assets rather these are an integral part of firm's operations. But the
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question usually is as to how much inventories be maintained by a firm? If the
inventories are too big, they become a strain on the resources, however, if
they are too small, the firm may lose the sales. Therefore, the firm must have
an optimum level of inventories. Managing the level of inventories is like
maintaining the level of water in a bath tub with an open drain. The water is
flowing out continuously. If water is let in too slowly, the tub is soon empty. If
water is let in too fast, the tub over flows. Like the water in the tub, the particular
item in the inventory keeps changing, but the level may remain the same. The
basic financial problem is to determine the proper level of investment in the
inventories and to decide how much inventory must be acquired during each
period to maintain that level. The present lesson attempts to discuss different
aspects of inventory management.
13.1 MEANING AND TYPES OF INVENTORY
The term 'inventory' refers to the stockpile of the products a firm
is offering for sale and various components that make up these products. As
per accounting terminology, inventory means "the aggregate of these items of
tangible property which (i) are held for sale in the ordinary course of business,
(ii) are in the process of production for such sale, and (iii) are to be currently
consumed in the production of goods or services to be available for sale". Thus,
inventory includes the stock of raw materials, goods-in-process, finished goods
and stores and spares.
The various forms in which inventories exist in a manufacturing
company are : raw materials, work-in-process and finished goods.
Raw Materials are those basic inputs that are converted into finished product
through the manufacturing process. Raw materials inventories are those units
which have been purchased and stored for future productions.
Work-in-process inventories are semi-manufactured products. They represent
products that need more work before they become finished products for sale.
Finished goods inventories are those completely manufactured products which
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are ready for sale. Stocks of raw materials and work-in-process facilitate
production, while stock of finished goods is required for smooth marketing
operations. Thus, inventories serve as a link between the production and
consumption of goods.
The level of three kinds of inventories for a firm depend on the
nature of its business. A manufacturing firm will have substantially high level
of all three kinds of inventories, while a retail or wholesale firm will have a
very high level of finished goods inventories and no raw material and work-in-
process inventories. Within manufacturing firms, there will be differences.
Large heavy engineering companies produce long production cycle products,
therefore, they carry large inventories. On the other hand, inventories of a
consumer product company will not be large because of short production cycle
and fast turnover.
A fourth kind of inventory, supplies (or stores and spares), is also
maintained by firms. Supplies include office and plant cleaning materials like
soap, brooms, oil, fuel, light bulbs etc. These materials do not directly enter
production, but are necessary for production process. Usually, these supplies
are small part of the total inventory and do not involved significant investment.
Therefore, a sophisticated system of inventory control may not be maintained
for them.
13.2 NEED TO HOLD INVENTORIES
The question of managing inventories arises only when the
company holds inventories. Maintaining inventories involves tying up of the
company's funds and incurrence of storage and handling costs. If it is expensive
to maintain inventories, why do companies hold inventories? There are three
general motives for holding inventories.
(i) The transactions motive : It expresses the need to maintain inventories
to facilitate production and sales operation smoothly.
(ii) The precautionary motive : It necessitates holding of inventories to
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guard against the risk of unpredictable charges in demand and supply forces.
( i i i ) The speculative motive : It influences the decision to increase or
reduce inventory levels to take advantages of price fluctuations.
In order to maintain an uninterrupted production, it becomes
necessary to hold adequate stock of materials since there is a time lag between
the demand for materials and its supply due to some unavoidable circumstances.
Besides, there are two other motives for holding of inventories viz., to receive
the benefit of quantity discount on account of bulk purchases and to avoid the
anticipated rise in price of raw material.
The work-in-progress builds up since there is production cycle.
Actually, the stock of work-in-progress is to be maintained till the production
cycle completes. Similarly, stock of finished goods has also to be held since
there is a time lag between the production and sales. When goods are demanded
by the customers, it cannot immediately be produced and as such, for a
continuous and regular supply of goods, minimum stock of finished goods is
to be maintained. Stock of finished goods should also be maintained for sudden
demands from customers and for seasonal sales.
Therefore, the primary objective of holding raw materials are :
(i) to separate purchase and production activities and for holding finished goods
there should be a separate production and sales activities; (ii) to obtain quantity
discount against bulk purchases, and (iii) to avoid interruption in production.
At the same time, work in progress inventory is necessary since production is
not instantaneous and finished goods should also be maintained for : (i) serving
customer on a continuous basis; (ii) meeting the fluctuating demands.
13.3 OBJECTIVES OF INVENTORY MANAGEMENT
Efficient inventory management should result in the maximisation
of the owners's wealth. For this purpose, a firm should neither hold excessive
inventories nor hold inadequate inventories, i.e., it should hold the optimum
level of inventory. The optimum level of inventory investment lies between
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the point of excessive and inadequate levels. In other words, there must not be
an over investment or under investment in inventories. The danger of over
investment in inventories are : (i) funds of the firm are tied-up unnecessarily;
(ii) it creates loss of profit; (iii) excessive carrying cost and risk of liquidity
increases.
As such, the opportunity cost and carrying costs (viz., cost of
storage, handling, insurance etc.) increase proportionately. No doubt, these
costs will impair the profitability of the firm. Excessive investment in raw
materials, will prove the same result except at the time of inflation and scarcity.
Similar results may also be noticed for the over investment in work-in-progress
since it is very difficult to sell. Similarly, many difficulties will appear to
dispose of excessive finished goods since time lengthens (viz., the goods may
be sold at low price etc.) Moreover, for carrying excessive Inventory physical
deterioration of the same may occur while in storage. From the above, it
becomes clear that there must not be an over investment in inventories.
Similarly, inadequate level of inventories is not also free from
snags. The consequences are : (i) production may shut-down; (ii) commitment
for the delivery may not be possible; (iii) inadequate raw material and work-
in-progress will create frequent production interruption; (iv) customers may
shift to the competitor if their demands are not met up regularly, etc.,
Thus, the objective of inventory management is to maintain its
optimum level in the following manner :
(a) To ensure a continuous supply of materials to facilitate uninterrupted
production;
(b) To maintain sufficient stocks of raw materials during short-supply;
(c) To maintain sufficient finished goods for efficient customer service;
(d) To minimise the carrying cost; and
(e) To maintain the optimum level of investment in inventories.

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13.4 COST OF HOLDING INVENTORY
The effective management of inventory involves a trade-off
between having too little and too much inventory. In achieving this trade-off
the Finance Manager should realise that costs may be closely related. The cost
of holding inventories may include the following :
(i) Ordering/Acquisition/Set-up Costs, and
(ii) Carrying Costs.
(iii) Cost of Running out of goods/cost of stock-outs
(i) Ordering/Acquisition/Set-up Costs : These are the variable costs of
placing an order for the goods. Orders are placed by the firm with suppliers to
replenish inventory of raw materials. Ordering costs include the costs of :
requisiting, purchasing, ordering, transporting, receiving, inspecting and
storing. The ordinary costs vary in proportion to the number of orders placed.
They also include clerical costs and stationery costs. (That is why it is called
a set-up cost). Although, these costs are almost fixed in nature, the larger the
order placed, or the more frequent the acquisition of inventory made, the higher
are such costs. Similarly, the fewer the orders, the lower the order cost will be
for the firm. Thus, the ordering/acquisition costs are inversely related to the
level of inventory.
(ii) Carrying Cost : These are the expenses of storing goods, i.e., they are
involved in carrying inventory. The cost of holding inventory may be divided
into (a) Cost of Storing the Inventory and (b) Opportunity Cost of Funds.
(a) Cost of Storing the Inventory
This include :
(a) Storage Cost (i.e., tax, depreciation, insurance, maintenance of
building etc.)
(b) Insurance (for fire and theft);
(c) Obsolescence and Spoilage;
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 (d) Damage or Theft;
(e) Cost of running out of goods.
(b) Opportunity Cost of Funds
Whenever a firm commits its resources to inventory, it is using
funds that otherwise might be available for other purposes. The firm has lost
the use of funds for other profit making purposes. This is its opportunity cost.
Whatever the source of funds inventory has a cost in terms of financial
resources. Excess inventory represents an unnecessary cost.
(c) Cost of Running out of Goods/Cost of Stock-Outs
These are costs associated with the inability to provide materials
to be production department and/or inability to provide finished goods to the
marketing department as the requisite inventories are not available. In other
words, the requisite items have run out of stock for want of timely
replenishments. These costs have both quantitative dimensions. These are, in
the case of raw materials, the loss of production due to stoppage or work, the
uneconomical prices associated with 'cash' purchases and the set-up costs
which can be quantified in monetary terms with a reasonable degree of
precision. As a consequence of this, the production department may not be
able to reach its target in providing finished goods for sale.
When marketing personnel are unable to honour their commitment
to the customers in making finished goods available for sale, the sale may be
lost. This can be quantified to a certain extent. However, the erosion of the
goods customer relations and the consequent damage done to the image and
good-will of the company fall into the qualitative dimension and elude
quantification. Even if the stock-out cost cannot be fully quantified a reasonable
measure based on the loss of sales for want of finished goods inventory can be
used with the understanding that the amount so measured cannot capture the
qualitative aspects.

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 The level of inventory and the carrying costs are positively related
and move in the same direction, i.e., if inventory level decreases, the carrying
costs also decrease and vice-versa.
13.5 TECHNIQUES OF INVENTORY MANAGEMENT
As in the case of other current assets, the decision making in
investment in inventory involves a basic trade-off between risk and return. The
risk is that if the level of inventory is too low, the various functions of the
business do not operate independently. The return results because lower level
of inventory saves money. As the size of the inventory increases, the storage
and other costs also rise. Therefore, as the level of inventory increases, the
risk of running out of inventory decreases but the cost of carrying inventory
increases. Out of different current assets being maintained by the firm,
inventory is one which requires to be monitored and managed not only in terms
of monetary value but also in terms of number of physical units. The financial
manager must see that the inventory does not become unnecessarily large when
compared with the requirements; and for this, close control over the size and
composition of inventories must be maintained. Moreover, since the investment
in inventories is the least liquid of all the current assets, any error in its
management cannot be readily rectified and hence may be costly to the firm.
The goal of inventory management should therefore, be to established a level
of each item of the inventory.
There should be a systematic approach to inventory management
which must attempt to balance out the expected costs and benefits of
maintaining inventories. In order to ensure efficient management of inventories,
the finance manager may be required to answer the following questions :
1. Are all items of inventories equally important, or some of the items are
to be given more attention?
2. What should be the size of each order or each replenishment?
3. At what level should the order for replenishment be placed?
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 Various techniques has been suggested to deal with these
problems. Some of these has been discussed as follows :
1. Determination of Stock Levels : Carrying of too much and too little
of inventories is detrimental to the firm. If the inventory level is too little, the
firm will face frequent stock-outs involving heavy ordering cost and if the
inventory level is too high it will be unnecessary tie-up of Capital. Therefore,
an efficient inventory management requires that a firm should maintain an
optimum level of inventory where inventory costs are the minimum and at the
same time there is no stock-out which may result in loss of sale or stoppage
of production. Various stock levels are discussed as follows :
(a) Minimum Level : This represents the quantity which must be maintained
in hand at all times. If stocks are less than the minimum level then the work
will stop due to shortage of materials. Following factors are taken into account
while fixing minimum stock level :
(i) Lead Time : A purchasing firm requires some time to process the order
and time is also required by the supplying firm to execute the order. The time
taken in processing the order and then executing it is known as lead time. It is
essential to maintain some inventory during this period.
(ii) Rate of Consumption : It is the average consumption of materials in the
factory. The rate of consumption will be decided on the basis of past experience
and production plans.
(iii) Nature of Material : The nature of material also affects the minimum
level. If a material is required only against special orders of the customer then
minimum stock will not be required for such materials. Minimum stock level
can be calculated with the help of following formula :
Minimum stock level = Re-ordering level – (Normal consumption ×
Normal Re-order period).
(b) Re-ordering Level : When the quantity of materials reaches at a certain
figure then fresh order is sent to get materials again. The order is sent before
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the materials each minimum stock level. Re-ordering level or ordering level
is fixed between minimum level and maximum level. The rate of consumption,
number of days required to replenish the stocks, and maximum quantity of
materials required on any day are taken into account while fixing re-ordering
level. Re-ordering level is fixed with the following formula :
Re-ordering Level = Maximum Consumption × Maximum Re-order period.
(c) Maximum Level : It is the quantity of materials beyond which a firm
should not exceed its stocks. If the quantity exceeds maximum level limit then
it will be overstocking. A firm should avoid overstocking because it will result
in high material costs. Overstocking will mean blocking of more working
capital, more space for storing the materials, more wastage of materials and
more chances of losses from obsolescence. Maximum stock level will depend
upon the following factors :
(i) The availability of capital for the purchase of materials.
(ii) The maximum requirements of materials at any point of time.
(iii) The availability of space for storing the materials.
(iv) The rate of consumption of materials during lead time.
(v) The cost of maintaining the stores.
(vi) The possibility of fluctuations in prices.
(vii) The nature of materials. If the materials are perishable in nature, then
they cannot be stored for long.
(viii) Availability of materials. If the materials are available only during
seasons then they will have to be stored for the rest of the period.
(ix) Restrictions imposed by the Government. Sometimes, government fixes
the maximum quantity of materials which a concern can store. The limit
fixed by the government will become the limiting factor and maximum
level cannot be fixed more than this limit.
(x) The possibility of change in fashions will also affect the maximum level.
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 The following formula may be used for calculating maximum stock
level :
Maximum Stock Level = Re-ordering Level + Re-ordering Quantity –
(Minimum Consumption × Minimum Re-ordering
period).
(d) Danger Level : It is the level beyond which materials should not fall in
any case. If danger level arises then immediate steps should be taken to
replenish the stocks even if more cost is incurred in arranging the materials. If
materials are not arranged immediately there is a possibility of stoppage of
work. Danger level is determined with the following formula :
Danger Level = Average Consumption × Maximum re-order period for
emergency purchases.
(e) Average Stock Level
The average stock level is calculated as follows :
Average Stock Level = Minimum Stock Level + ½ of Re-order
quantity.
2. Determination of Economic Order Quantity (EOQ) : Determination
of the quantity for which the order should be placed is one of the important
problems concerned with efficient inventory management. Economic Order
Quantity (EOQ) refers to the size of the order which gives maximum economy
in purchasing any item of raw materials or finished product. It is fixed mainly
after taking into account the following costs :
(i) Ordering Cost : It is the cost of placing an order and securing the
supplies. It varies from time to time depending upon the number of orders
placed and the number of items ordered. The more frequently the orders are
placed, and fewer the quantities purchased on each order, the greater will be
the ordering cost and vice versa.
(ii) Inventory carrying cost : It is cost of keeping items in stock. It includes
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interest on investment, obsolescence losses, store-keeping cost, insurance
premium, etc. The larger the value of inventory, the higher will be the inventory
carrying cost and vice versa.
The former cost may be referred as the "cost of acquiring" while
the latter as "cost of holding" inventory. The cost of acquiring decreases while
the cost of holding increases with very increase in the quantity of purchase
lot. A balance is therefore struck between the two opposing factors and the
economic ordering quantity is determined at a level for which the aggregate of
two costs is the minimum.
Q= 2U ×P
S
where,
Q = Economic ordering quantity
U = Quantity (units) purchased in a year (month)
P = Cost of placing an order
S = Annual (Monthly) cost of storage of one unit
Illustration 1 : A, a T.V. manufacturer, purchases 1,600 units of a certain
component from B. His annual usage is 1,600 units. The order placing cost is
Rs. 100 and the cost of carrying one unit for a year is Rs. 8. Calculate the
economic Ordering Quantity and tabulate your results.
Solution :
Q = 2U ×P
S

= 2×1,600×100
8

= 40,000 = 200 units

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 Table Showing The Economic Ordering Quantity
Annual Orders Units per Order Average Carrying Total
requirements per year order placing inventory costs annual
costs in units costs
(50% of
order placed)
Rs. Rs.
1,600 1 1,600 100 800 6,400 6,500
2 800 200 400 3,200 3,400
3 533 300 267 2,136 2,436
4 400 400 200 1,600 2,000
5 320 500 160 1,280 1,780
6 267 600 134 1,072 1,672
7 229 700 115 920 1,620
8 200 800 100 800 1,600
9 178 900 89 712 1,612
10 160 1,000 80 640 1,640

The above table shows that total cost is the minimum when each order is
of 200 units. Therefore, economic ordering quantity is 200 units only.
Assumptions :EOQ model is based on the following assumptions :
(i) The firm knows with certainty the annual usage or demand of the particular
items of inventories.
(ii) The rate at which the firm uses the inventories or makes sales is constant
throughout the year.
(iii) The orders for replenishment of inventory are placed exactly when
inventories reach the zero level.
These assumptions have pointed out to illustrate the limitations
of the basic EOQ model.

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3. A B C Analysis :A B C analysis is the technique of exercising selective
control over inventory items. The technique is based on this assumption that a
firm should not exercise the same degree of control on items which are more
costly as compared to those items which are less costly. According to this
approach, the inventory items are dividend into three categories – A, B and C.
Category A may include more costly items, while category B may
consist of less costly items and category C of the least costly items. Though,
no definite procedure can be laid down for classifying the inventories in A, B,
C categories as this will depend upon a large number of factors, such as nature
and varieties of items, specific requirements of the business, etc., yet the
following method is generally adopted.
(i) The quantity of each material expected to be used in a period is estimated.
(ii) The value of each of the above items of materials is found out by
multiplying the quantity of each item with the price.
(iii) The items are then rearranged in the descending order of their value
irrespective of their quantities.
(iv) A running total of all the values will then be taken.
(v) It will be found that a small number of a first few items may amount to a
large percentage of the total value of the items. The management then
will have to take a decision as to the percentages of total value or the
total number of items which have to be covered by A, B and C categories.
Inventory surveys in general have shown the following trends
regarding the components of inventories manufacturing organisations :
Category % of total value % of total quantity
A 70 10
B 25 35
C 5 55
While exercising control over stores, items of category A should
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be given the utmost attention. Their levels of stock should be strictly
controlled. In case of items category B, ordinary stores routine should be
observed but the rules regarding levels of stock may not be so strictly adhered
to as those in category A. Items of category C may be considered as "free
issue" items and even normal accounting procedure may be dispersed with.
The advantages of this system are as follows :
(i) It ensures closer control on costly items in which a large amount of
capital has been invested.
(ii) It helps in developing a scientific method of controlling inventories.
Clerical costs are reduced and stock is maintained at optimum level.
(iii) It helps in achieving the main objective of inventory control at minimum
cost. The stock turnover rate can be maintained at comparatively higher
level through scientific control of inventories.
The system of A B C analysis suffers from a serious limitation.
The system analyses the items according to their value and not according to
their importance in the production process. It may, therefore, sometimes create
difficult problems. For example, an item of inventory may not be very costly
and hence it may have been put in category C. However, the item may be very
important to the production process because of its scarcity. Such an item as a
matter of fact requires the utmost attention of the management though it is no
advisable to do so as per the system of ABC analysis. Hence, the system of A
B C analysis should not be followed blindly.
Illustration 2 : The inventory of a company comprises of 7 different items.
The average number of each of these items along with their unit costs is given
below. The company wants to introduce ABC system of inventory management.
You are required to give a break-down of the items into the classification of
ABC. The details are :

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 Item Average No. of units Average Cost
in Inventory Per Unit (Rs.)
1 40,000 121.60
2 20,000 204.80
3 64,000 22.00
4 56,000 20.56
5 1,20,000 6.80
6 60,000 6.00
7 40,000 2.60
Solution :
ABC Analysis
Item Unit % of Total Unit Cost Total Cost % of
Units (Rs.) (Rs.) Total Cost
1 40,000 10 121.60 48,64,000.00 38.00
2 20,000 5 204.80 40,96,000.00 32.00
3 64,000 16 22.00 14,08,000.00 11.00
4. 56,000 14 20.56 11,52,000.00 9.00
5. 1,20,000 30 6.80 8,16,000.00 6.38
6. 60,000 15 6.00 3,60,000.00 2.80
7. 40,000 10 2.60 1,04,000.00 0.82
4,00,000 100 1,28,00,000.00 100.00

An analysis of the above table brings out that A items (1 and 2) are
less important in terms of number with only 15% of the total volume. But it accounts
for 70% of the total value of inventory. Therefore this group is very important.
Contrary to this C items (5,6 and 7) carry 55% of the total volume but have only
10% value of the total inventory value. The categorisation has been made on the
basis of cost involvement. However, this analysis does not mean that B and C items,
despite being less expensive, are of less importance. Instead their importance may
be tremendous in the production process of the company.
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4. VED Analysis
The VED analysis is used generally for spare parts. The
requirements and urgency of spare parts is different from that of materials.
ABC analysis may not be properly used for spare parts. The demand for spares
depends upon the performance of the plant and machinery. Spare parts are
classified as Vital (V), Essential (E) and Desirable (D). The vital spares are a
must for running the concern smoothly and these must be stored adequately.
The non-availability of vital spares will cause havoc in the concern. The E type
of spares are also necessary but their stocks may be kept at low figures. The
stocking of D type of spares may be avoided at times. If the lead time of these
spares is less, then stocking of these spares can be avoided.
The classification of spares under three categories is an important
decision. A wrong classification of any spare will create difficulties for
production department. The classification of spares should be left to the
technical staff because they know the need, urgency and use of these spares.
5. SDE Analysis : SDE Analysis evaluates the importance of the inventory
item on the basis of its availability. Accordingly SDE analysis groups inventory
items into the following categories :
(i) S (Scarce items) : The items which are in short-supply and mostly such
items constitute imported items.
(ii) D (Difficult Items) : This category refers to such items which cannot be
procured easily.
(iii) E (Easy Items) : The items which are easily available in the market.
6. Inventory Turnover Ratios : Inventory turnover ratios are also
calculated to minimise the investment in inventories. Turnover ratio can be
calculated regarding each item of inventory on the basis of the following
formula :
Cost of goods consumed/sold during the period
Inventory Turnover Ratio =
Average inventory held during the period
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 For example, if the cost of raw material consumed during January,
2002 is Rs. 10,000 and the average inventory held during the month is Rs.
2,000, the inventory turnover ratio comes to 5.
Inventory turnover ratios regarding different items of inventory
may be compared with the ratios of the earlier years as well as with each other
item. Such a comparison may reveal the following four types of inventories :
(i) Slow moving inventories. These are inventories which have a low
turnover ratio. An attempt should be made to keep these inventories at the
lowest level.
(ii) Dormant inventories : Inventories which have at present no demand are
classified as dormant inventories. A decision should be taken by the financial
manager in consultation with the storekeeper, the production controller and
the cost accountant whether to retain these inventories because of good chance
of future demand or to cut losses by scraping them while they have some market
value.
(iii) Obsolete inventories : These are inventories which are no longer in
demand because of their becoming out of date. They should be immediately
discarded or scrapped.
(iv) Fast moving inventories : These are inventories which are very much in
demand. Special care should be taken in respect of these items of inventories
so that the production of the sales do not suffer on account of their shortage.
7. Aging Schedule of Inventory : Classification of the inventories
according to age also helps in identifying inventories which are moving slowly
into production or sales. This requires identifying the date of purchase/
manufacture of each item of the inventory and classifying them as shown in
the table below :

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 Aging Schedule of Inventory as on 31 Dec., 2001
Age classification Date of purchase/ Amount Percentage to total
(days) manufacture Rs.
0-15 Dec. 16 8,000 20
16-30 Dec. 12 4,000 10
31-45 Nov. 26 2,000 5
46-60 Nov. 10 20,000 50
61 and above Oct. 25 6,000 15
Total 40,000 100

The above table shows that 50% of the inventory is of the age
group of 46-60 days, while 15% is older than 60 days. In case steps are not
taken to clear the inventories, it is possible that more than 50% inventories
may suffer deterioration in its value or may even become obsolete.
8. Just in time (JIT) Inventory System : As discussed, every
manufacturing company has to maintain three classes of inventories – raw
materials, work-in-process and finished goods. These inventories are designed
to act as buffers so that operations can proceed smoothly even if the suppliers
are late with deliveries or the department is unable to operate for a short period
because of breakdown or any other reason. However, carrying of inventories
results in costs in terms of storage, blocking of capital investment, insurance,
etc. Such costs can be reduced/minimised by keeping the inventories at the
lowest possible level. JIT system basically aims to achieve this objective.
JIT Inventory System, as its name suggests, means all inventories
whether of raw materials, work-in-process and finished goods are received in
time. In other words, raw material are received just in time to go into
production, manufactured parts are completed just in time to be assembled
into products, and products are completed 'just in time' to be shipped to
customers. In a JIT environment the flow of goods is controlled by what is
described as "pull approach" to the manufacture of products. The pull approach
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means at the final assembly stage, a signal is sent to the preceding work-station
as to the exact quantum of parts and materials that will be needed over the next
few hours' for the assembly of products, and only that quantum of parts and
materials is provided. The same signal is sent back through each preceding
work-station so that a smooth flow of parts and materials is maintained with
no inventory build-up at any point.
The "pull approach" described above is different from "push
approach" as used in case of conventional inventory system. In the latter case,
inventories of parts and materials are built up and 'pushed forward' to the next
work-station. This results in blocking of funds and stockpiling of parts which
may not be used for days or even weeks together.
Requirements of JIT System : The following are the key requirements for
the successful operation of JIT Inventory System :
(i) The company must have only a few suppliers.
(ii) Suppliers must be bound under long-term contracts and willing to make
frequent deliveries in small lots.
(iii) The company must develop a system of total quality control (TQC). TQC
means that no defects can be allowed over its parts and materials.
(iv) Poor quality of goods or parts cannot be accepted since JIT inventory
system operates with no work-in-process inventory.
(v) Workers must be multi-skilled in JIT environment. This is because in
case of JIT system machine and equipments are arranged in small cells
where several tasks can be performed in relation of a product. The
workers assigned to these cells are expected to operate all the
equipments which are there in the cells.
Benefits of JIT System : The following are the benefits of JIT System :
(i) Inventories of all types can be reduced significantly. This results in saving
of costs.
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(ii) Storage space used for inventories can be made available for other more
productive uses.
(iii) Total Quality Control results in production of quality products.
(iv) Productivity of workers is increased and machine set-up time is
decreased.
13.6 INVENTORY AND THE FINANCE MANAGER
The inventory control methods described in this lesson give us a
means for determining an optimal level of inventory, as well as how much
should be ordered and when. These tools are necessary for managing inventory
efficiently and balancing the advantages of additional inventory against the cost
of carrying it.
Although inventory management usually is not the direct operating
responsibility of the finance manager, the investment of funds in inventory is
an important aspect of financial management. Consequently, the finance
manager must be familiar with ways to control inventories effectively, so that
capital may be allocated efficiency. The greater the opportunity cost of funds
invested in inventory, the lower is the optimal level of average inventory and
the lower the optimal order quantity, all other things held constant. The EOQ
model also can be useful to the finance manger in planning for inventory
financing.
When demand or usage of inventory is uncertain, the finance
manager may try to effect policies that will reduce the average lead time
required to receive inventory, once an order is placed. The lower the average
lead time, the lower is the safety stock needed and the lower the total
investment in inventory, all other things held constant. The greater the
opportunity cost of funds invested in inventory, the greater is the incentive to
reduce this lead time. The purchasing department may try to find new vendors
that promise quicker delivery, or it may pressure existing vendors to deliver
faster. The production department may be able to deliver finished goods faster
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by producing a smaller run. In either case, there is trade off between the added
cost involved in reducing the lead time and the opportunity cost of funds tied
up in inventory.
The finance manager is concerned also with the risks involved in
carrying inventory. The main risk in inventory investment is that market value
of inventory may fall below what the firm paid for it, thereby causing inventory
losses. The sources of market value risk depend on the type of inventory.
Purchased inventory of manufactured goods is subject to losses due to changes
in technology. Such changes may sharply reduce final prices of the goods when
they are sold or may even make the goods unsaleable. This risk is, of course,
most acute in products embodying a high degree of technological
sophistication, for example, electronic parts.
There are also substantial risks in inventories of goods dependent
on current styles. The readymade industry in particularly susceptible to the
risk of changing consumer tastes. Agricultural commodities are a type of
inventory subject to risks due to unpredictable changes in production and
demand. A bumper crop of a commodity can send prices plummeting. Of course,
there is also the potential for shortage in these commodities, which cause rapid
price rises.
Moreover, all inventories are exposed to losses due to spoilage,
shrinkage, theft or other risks of this sort. Insurance is available to cover many
of these risks and, if purchased, is one of the costs of holding inventory. Also,
poor inventory control and storage systems can "lose" inventory. That is,
inventory may still exists in the store room, but if it cannot be found when
desired by a customer, the firm does not profit from its investment. The
financial manager must be aware of the degree of risk involved in the firm's
investment in inventories. The manager must take those risks into account in
evaluating the appropriate level of inventory investment. This can be done by
including the relatively predictable losses as part of the holding costs.

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13.7 SUMMARY
The term inventory refers to assets which will be sold in future in
the normal course of business operations. The assets which the firm stores as
inventory in anticipation of need are raw materials, work-in-process/semi-
finished goods and finished goods. The objectives of inventory management
consists of two counter-balancing parts, namely, to minimise investments in
inventory and to meet the demand for products by efficient production and
sales operations. In operational terms, the goal of inventory management is to
have a trade-off between costs and benefits at different levels of inventory.
The cost of holding inventory are ordering cost and carrying cost.
The major benefits of holding inventory are in the area of purchasing, production
and sales.
The inventory management techniques illustrated here are (i) the
determination of stock levels which shows the minimum, re-order, maximum
and danger levels of inventory (ii) EOQ model which reveals the size of order
for the acquisition of inventory by the firm; (iii) ABC system which is useful
in determining the type and degree of control on inventory; (iv) inventory
turnover ratios to minimise the investment in inventories; (v) classification of
inventory according to age and (vi) Just in time, which aims to minimise/
reduce the carrying cost of inventories.
13.8 SELF ASSESSMENT QUESTIONS
1. Explain the meaning and different types of inventory. Discuss the
objectives of inventory management.
2. Why should inventory be held? Why is inventory management important?
3. "There are two dangerous situations that management should usually avoid
in controlling inventories". Explain.
4. Define the economic order quantity. How is it computed?
5. What are ordering and carrying costs? What is their role in inventory
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 control?
6. What are the considerations governing the maximum and minimum level
of inventory?
7. Explain the ABC technique of inventory control. What are its
shortcomings?
8. Calculate the Economic Order Quantity from the following information.
Also state the number of orders to be placed in a year.
Consumption of materials per annum 10,000 kg.
Order placing costs per order Rs. 50
Cost per kg. of raw materials Rs. 2
Storage costs 8% on average inventory
9. A company predicts that 3,000 units of a certain material will be needed
next year. Each unit costs Rs. 6. Past experience indicates that the storage
costs are approximately equal to 10 per cent of the inventory investment.
The cost of place on order amounts to Rs. 9.
Determine the economic order quantity so as to enable the company to
balance its ordering and storage costs. How many orders will the
company place in a year based upon EOQ?
13.9 FURTHER READINGS
1. Financial Management and Policy by James C. Van Horne
2. Financial Management by Prasana Chandra
3. Financial Management by Ravi M. Kishore
4. Financial Management by I.M. Pandey
5. Working Capital Management by V.K. Bhalla

✪✪✪

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 LESSON – 14

RECEIVABLES AND CASH MANAGEMENT

Objective : After going through this lesson, you would be able to understand
the following :
• Concept of Receivables Management.
• Costs and benefits of maintaining receivables.
• Dimensions of receivables management.
• Motives for holding cash.
• Functions and objectives of cash management.
• Facets of cash management.
Structure
14.1 Introduction to Receivables Management
14.2 Costs and Benefits of Maintaining Receivables
14.3 Objectives of Receivables Management
14.4 Dimensions of Receivables Management
14.5 Background to Cash Management
14.6 Motives for Holding Cash
14.7 Functions of Cash Management
14.8 Objectives of Cash Management
14.9 Facets of Cash Management
14.10 Summary
14.11 Self Assessment Questions
14.12 Further Readings
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14.1 INTRODUCTION TO RECEIVABLES MANAGEMENT
Receivables are almost certain and inevitable to arise in the
ordinary course of business. They represent extension of credit and investment
of funds and need to be carefully managed. Every firm needs to develop a credit
policy that includes setting credit standard, defining credit terms and employing
methods for timely collection of receivables. The receivable (including the
debtors and the bills) constitute a significant portion of the working capital
and is an important element of it. The receivables are created when a firm
sells goods or services to its customers and accepts, instead of the spot cash
payment, the promise to pay within specified period. Thus, receivables is a
time of loan extended by the seller to the buyer to facilitate the purchase
process. As against the ordinary type of loan, the trade credit in the form of
receivables is not a profit making service but an inducement or facility to the
buyer-customer of the firm.
The receivable is an assets as it represents a claim of the firm
against its customers, expected to be realized in near future. Since credit sales
assumes a sizable proportion of total sales in any firm, the receivable
management becomes an area of attention. Every firm has a set of credit terms
and policies under which goods are sold on credit, and every policy has a cost
and benefit associated with it. This lesson attempts as to how to balance the
cost and benefit of a credit policy and the measures, which may be taken into
consideration in this reference.
The receivables represent credit allowed to customers and thereby
allowing them to defer the payment. In a competitive environment, sometimes
the firms are compelled and sometimes the firms desire to adopt liberal credit
policies for pushing up the sales. Higher credit sales at more liberal terms
will no doubt increase the profit of the firm, but simultaneously also increases
the risk of and debts as well as result in more and more funds blocking in the
receivables. So, a careful analysis of various aspects of the credit policy is
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required. This is what is known as receivables management. The term
'receivables management' may be defined as collection of steps and procedure
required to properly weigh the costs and benefits attached with the credit
policies. Receivable management consists of matching the cost of increasing
sales (particularly credit sales) with the benefits arising out of increased sales
with the objective of maximizing the return on investment of the firm.
14.2 COST AND BENEFITS OF MAINTAINING RECEIVABLES
There are various costs and benefits attached with a credit policy.
These are as follows :
COSTS OF RECEIVABLES
(a) Collection costs;
(b) Capital costs/Cost of financing;
(c) Delinquency costs; and
(d) Default cost
(a) Collection Costs : These costs are those which are to be incurred by a
firm in order to collect the amount on account of credit sales, i.e. these expenses
would not be incurred if the firm does not sell goods on credit, e.g., additional
expenses incurred for the maintenance of credit and collection department,
expenses incurred for obtaining information about credit-worthiness of
potential customers.
(b) Capital Costs/Cost of Financing : When a firm maintains receivables,
some of the firm's resources remain blocked in them because there is a time
lag between the credit sale to customer and receipt of cash from them as
payment. To the extent that the firm's resources are blocked in its receivables,
it has to arrange additional finance to meet its own obligations towards its
creditors and employees, like payments for purchases, salaries and other
production and administrative expenses. Whether this additional finance is met
from its own resources or from outside, it involves a cost to the firm in terms
of interest (if financed from outside) or opportunity costs (if internal resources
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which could have been put to some other use are taken).
(c) Delinquency Costs : When the period of payment becomes due (i.e.,
after the expiry of the credit period) but is not received from the customers,
the same is known as delinquency costs. It includes :
(i) blocking up of funds/cost of financing for an extended period; and
(ii) cost of extra steps to be taken to collect the overdues, e.g., reminders,
legal charges, etc.
(d) Default Costs : Sometimes the firms may not collect the overdues from
the customers since they are unable to pay. These debts are treated as bad debts
and are to be written off accordingly since the amounts will not be realised in
future. Such costs are termed as 'Default Costs'.
BENEFITS
Apart from the costs, another factor that has a bearing on accounts
receivable management is the benefit emanating from credit sales. The benefits
are the increased sales and anticipated profits because of a more liberal policy.
When firms extended trade credit, that is, invest in receivables, they intend to
increase the sales. The impact of a liberal trade credit policy is likely to take
two forms. First, it is oriented to sales expansion. In other words, a firm may
grant trade credit either to increase sales to existing customers or attract new
customers. This motive for investment in receivables is growth-oriented.
Secondly, the firm may extend credit to protect its current sales against
emerging competition. Here, the motive is sales-retention. As a result of
increased sales, the profits of the firm will increase.
From the above discussion, it becomes clear that investments in
receivables involve both benefits and costs. The extension of trade credit has
a major impact on sales, costs and profitability. Other things being equal, a
relatively liberal policy and, therefore, higher investments in receivables, will
produce larger sales. However, costs will be higher with liberal policies than
with more stringent measures. Therefore, accounts receivable management
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should aim at a trade-off between profit (benefit) and risk (cost). That is to
say, the decision to commit funds to receivables (or the decision to grant credit)
will be based on a comparison of the benefits and costs involved, while
determining the optimum level of receivables. The costs and benefits to be
compared are marginal costs and benefits. The firm should only consider the
incremental (additional) benefits and costs that result from a change in the
receivables or trade credit policy.
14.3 OBJECTIVES OF RECEIVABLES MANAGEMENT
Receivables management is the process of making decisions
relating to investment in trade debtors. It is clear that certain investment in
receivables is necessary to increase the sales and the profits of a firm. But at
the same time investment in this asset involves cost considerations also.
Further, there is always a risk of bad debts too. Thus, the objective of
receivables management is to promote sales and profits until that point is
reached where the returns that the company gets from funding of receivables
is less than the cost that the company has to incur in order to fund these
receivables. Hence, the purpose of receivables is directly connected with the
company's objectives of making credit sales which are:
• Increasing total sales as, if a company sells goods on credit, it will be in
a position to sell more goods than if it insists on immediate cash payment.
• Increasing profits as a result of increase in sales not only in volume, but
also because companies charge a higher margin of profit on credit sales
as compared to cash sales.
14.4 DIMENSIONS OF RECEIVABLES MANAGEMENT
The size of receivables or investment in receivables is determined
by the firm's credit policy and the level of its sales. Receivables management
involves the careful consideration of the following aspects :
1. Formulation of credit policy.
2. Executing the credit policy.
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 3. Formulating and executing collection policy.
1. Credit Policy
A firm makes significant investment by extending credit to its
customers and thus requires a suitable and effective credit policy to control
the level of total investment in the receivables. The basic decision to be made
regarding receivables is to decide how much credit be extended to a customer
and on what terms. This is what is known as the credit policy. The credit policy
may be defined as the set of parameters and principles that govern the extension
of credit to the customers. This requires the determination of (i) the credit
standard i.e., the conditions that the customer must meet before being granted
credit, and (ii) the credit terms i.e., the terms and conditions on which the
credit is extended to the customers. These are discussed as follows :
(i) The credit standards : When a firm sells on credit, it takes a risk about
the paying capacity of the customers. Therefore, to be on a safer side, it need
to set credit standard which may be applied in selecting customers for credit
sales. The initial tendency may be to set rigorous standards which may hamper
the sales growth. At the other extreme, if the standards are set loosely, it may
make the firm to bear losses as many customers may turn out to be bad debts.
Therefore, the problem is to balance the benefits of additional sales against
the cost of increasing bad debts. The following points are worth noting while
setting the credit standard for a firm :
(a) Effect of a particular standard on the sales volume.
(b) Effect of a particular standard on the total bad debts of the firm, and
(c) Effects of a particular standard on the total collection cost.
Further, the above considerations are also relevant if there is
proposal to change the credit standard from the present level. The credit
standard will help setting the level which must be satisfied by a customer before
being selected for making credit sales. However, even after selecting the
customers, all of them need not necessarily be offered same terms and
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conditions. The credit policy should also set out clearly the terms of credit
being offered to different types of customers.
(ii) Credit Terms
When sales on credit are made to customers there are certain basis
upon which sales are advanced. These basis are called terms of credit. There
are two important aspects of these credit terms. They are regarding (a) period
of credit and (b) the terms of cash discount. An explanation of these two terms
is given hereunder.
(a) Period of Credit. Period of credit is the time duration for which the
credit is extended to the customers. Credit period is generally given as a net
date. For instance when the terms of credit period allowed by an enterprise
indicate "net 40" it specifies that the payment is expected to be made 40 days
from the date of credit sale undertaken by the parties. Normally there are
industry norms which govern the credit period but individual undertakings can
extend credit for longer duration than provided in the industry norms so that
sales are extended. Similarly, if the bad debts build up such an enterprise may
tighten the credit period policy in relation with the provisions of the norms
provided by the industry.
(b) Cash Discount. The other aspect of credit terms in cash discount. Such
a discount is offered by business undertakings to motivate customers to make
early payment of their bills. The rate of discount and the period for which it is
granted is indicated in the terms of cash discount. In the event of a customer
not availing this opportunity of cash discount he is required to make the
payment by the net date specified as credit period.
The terms credit period and cash discount reflect a combination
of the credit terms. The terms of credit besides giving the credit period, also
indicate the rate of cash discount and the period of discount. When credit terms
are given as "3/15, net 45", it implies that if payment is made within 15 days
cash discount at the rate of 3 per cent will be granted, as otherwise the payment
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is to be made by 45th day if the offer of discount is not availed.
An enterprise can use credit terms as an instrument to expand
sales. The customers should in this case be offered most favourable terms of
credit, which at the same time increase the profitability of the company. Such
favourable terms can be determined by financial manager by referring to the
costs involved and the benefits resulting thereupon. At the same time before
taking into hand particular terms of credit the reaction of the business
competitors should be thoroughly studied. Thus if the competitors also relax
their credit terms at the same pace there will be no accrual of any benefits.
Rather credit relaxation may result in trade losses and the policy should
therefore not be relaxed.
The following illustration will explain the impact of credit
relaxation in case of manufacturing enterprise.
Illustration 1 : The credit terms provided currently by an enterprise are "net
35". The company is considering to resort to credit terms "3/21, net 63" so
that the sales are boosted. With this the enterprise expects to have the following
results :
Sales at present Rs. 10,00,000
Additional estimated sales Rs. 1,00,000
Total Sales Rs. 11,00,000
Estimated Total Sales that will
avail discount offers Rs. 3,00,000
Estimated increased Receivables Rs. 80,000
Increased Cost Estimated :
Losses by way of bad debts 1 per cent of increased sales
Production and selling costs 80 per cent of increased sales
Administrative expenses 2 per cent of increased sales
Opportunity cost 10 per cent of increased investment
in receivables
Cash discount 3 percent of total sales that avail
discount.
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 Do you think that the proposed change in the credit terms is desirable?
Solution :
If the changed terms of credit result in greater profits as compared
with the enhanced costs, it will be desirable to change the terms. We can find
out the same with the help of the following :
Costs and Benefits of Liberal Credit Terms
Increased sales Rs. 1,00,000
Increased costs :
Bad debt losses Rs. 1,000
Production and Selling Costs 80,000
Administrative expenses 2,000
Opportunity Cost (10% of
increased receivables times
the sum of production, selling and
administrative costs as a % age of
sales
i.e. (0.10) (Rs. 80,000) (0.80+0.02) 6,560
Cash discount 9,000 98560
Increased profits Rs. 1,440

Thus, in this case when the terms of credit sales are relaxed by
the company the profit generated thereupon will be higher than the additional
costs involved. As such the company can resort to the proposed relaxation.
2. Execution of Credit Policies
Once credit policies have been formulated, the finance manager
should execute these policies properly. Execution of credit policies calls for
evaluation of credit applicants and financing of investment in receivables.
(i) Evaluation of Credit Applicants : Mere determination of appropriate
credit policy for the firm will not help to accomplish the overall objective of
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minimizing investment in receivables and reducing bad debt losses unless
creditworthiness of applicants is evaluated to ensure that they conform to the
credit standards prescribed by the firm. Credit evaluation process involves three
steps, viz, gathering credit information about the credit applicants, determining
the credit worthiness of the applicants on the basis of information so collected
and finally, taking decision to grant credit facilities. The following paragraphs
will deal with these aspects :
(a) Gathering Credit Information : The finance manager gathers requisite
information from different sources on which customers evaluation must
necessarily be based. Two important factors that should be kept in mind while
searching for credit information are : cost and time. A firm can not afford to
spend a lot of money in investigation of some credit applicants particularly
smaller ones and in such case the finance manager should take decision on the
basis of limited information about the applicant. It is true that with larger
expenditure on gathering information, there is greater possibility for the firm
to reach better judgement on the credit worthiness of the applicant causing
reduction in bad debt losses. But beyond a certain point additional costs on
investigation outweigh the expected gains caused by reduction in bad debt
losses. This again is a matter of matching incremental costs and revenues.
Further, how much time credit department of the firm will spend
on analysis of credit applicant must also be considered by the finance manager.
Spending lot of time in investigation may be justified in case of new credit
customers. It must, however, be remembered that the customer may not wait
for long pending detailed credit investigation and turnover elsewhere for his
requirements.
There are number of sources of credit information that lend
insight into credit worthiness of the potential borrowers. Their use will depend
upon the nature of business of the applicant and the economical limit of credit
investigation costs. We may discuss these sources one by one as follows :

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(i) Financial Statement : The financial position of an individual
prospective customer can be scrutinised very easily by going through his Profit
and Loss Account and Balance Sheet. In case of joint stock companies these
financial statements can be very easily collected as these are statutorily
published. There is difficulty in obtaining the same from individual
proprietorship and partnership firms. The enterprise having seasonal business
and sales should be asked to supply additional information if they can provide
the same. It should be insisted that the financial statements supplied are duly
audited.
(ii) Bank References : This is the other source available to an enterprise through
which credit information can be collected from the bank in which the prospective
customer is maintaining his account. These banks do not generally provide such
information directly but it can be collected through the company's own bank. Sometimes
the customer is himself asked to direct his bank to provide the needed information and
in this case the information can be had directly from the said bank. It is true that such
information may not be a guarantee to believe that the customer will be able to settle
his account in due time, but it atleast gives some idea about his working behaviour.
Thus, some information is better than no information. This information can be
supplemented by more information from other sources.
(iii) Trade references : The prospective customer may be asked to give the
names of some of the businessmen with whom he is having dealings currently.
Thus credit information is collected without involving any cost. After obtaining
the names, these references can be immediately contacted for providing the
relevant credit information. It is not a mere formality and it should be taken
very seriously. If required the referees should be personally contacted for the
desired information.
The honesty and the seriousness of the referees should also be
examined as the customer can sometimes furnish misleading references. The
customers should be asked to provide as references persons or enterprises of
good reputation and standing.
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(iv) Credit Agency Report : There are certain credit rating agencies which
provide independent information on the credit worthiness of different parties.
These agencies gather information on the credit history of different
businessmen and sell it to the firms which want to extend credit. Obviously,
people who have failed to pay their bills in the past are viewed as greater credit
risk than those who have an un-blemished credit record. From these agencies,
a special report in respect of a particular customer may also be obtained. In
India, however, the credit agency system is not popular and there is a need to
develop such a network which can provide reliable information.
(v) Other sources : Other sources of credit information on business firms,
especially the large ones, might be trade journals, periodicals, newspapers,
trade directories, public records such as income tax statements, wealth tax
returns, sales tax returns, reports about actions and decrees in Government
gazettee, registration, revenue and municipal records.
(b) Credit Analysis
After collecting credit information about the potential customer,
the finance manager analysis these information to evaluate creditworthiness
of the customer and to determine whether he satisfies the standard of
acceptability or not. Such an analysis is known as credit analysis. Thus, credit
analysis involves the credit investigation of potential customer to determine
the degree of risk associated with the account. For that matter, capacity of the
applicant to borrow and his ability and willingness to repay the debt in
accordance with the terms of the agreement must be studied. Analysis of credit
worthiness of the applicant, therefore, calls for detailed study of five Cs, viz.,
character, capacity, capital, collateral and conditions.
'Credit' refers to the willingness of the customer to honour his
obligations. It reflects integrity, a moral attribute considered very important
by finance managers.
'Capacity' measures the ability of the potential customer to utilise
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the loan effectively and profitably. This is very important variable of credit
analysis as the customer's ability to repay is essentially dependent upon his
earning capacity.
'Capital' represents the general financial position of the
customer's firm with special emphasis on tangible net worth and profitability
(which indicates ability to generate funds for debt repayment). The net worth
figure in the business enterprise is the key factor that governs the amount of
credit that would be made available to the customer.
'Collateral' is represented by assets which may be offered as
pledge against credit extension. Collateral, thus, serves as a cushion or shock
absorber if one or several of the first three 'Cs' are insufficient to give
reasonable assurance of repayment of the loan on maturity. Collateral in the
form of a pledged asset serves to compensate for a deficiency in one or several
of the first three 'Cs'.
Finally, 'condition' includes the present status of the business
cycle and general credit and business conditions throughout the country and
also intensity of competition. These together effect a potential customer's
ability to earn income and repay the debt.
(c) Credit Decision
After determining credit worthiness of the applicant, the finance
manager has to decide whether or not credit facilities should be provided to
him. For that matter, the creditworthiness of the applicant should be matched
against established credit standards. If the applicant is above or upto the
standard, naturally credit facilities would be provided otherwise not. The
difficulty in taking credit decision arises where the applicant is marginally
credit worthy at best. In such cases, decision should be taken only after
matching potential profitability against cost of bad debt losses.
Customer not satisfying the standard of acceptability may, instead
of outright refusing to grant credit facilities, be offered cash on delivery
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(C.O.D.) terms. However, here also risk is involved when the customer refuses
to accept goods on some pretext or the other in order to compel the firm to
cut down price. If the finance manger feels that there is a great possibility of
the customer refusing goods on delivery, payment in advance must be insisted.
There is another possibility that the firm may insist on strong and reliable
third party guarantee against risky applicant. This will provide protection to
firm against risk of any loss caused by the customer's default to make payment.
3. Formulating and Executing collection Policy
The collection of amounts due to the customer is very important.
The business concern should devise procedures to be followed when accounts
become due after the expiry of credit period. The collection policy be termed
as strict and lenient. A strict policy of collection will involve more efforts on
collection. Such a policy has both plus and negative effects. This policy will
enable early collection of dues and will reduce bad debt losses. The money
collected will be used for other purposes and the profits of the concern will
go up. On the other hand a rigorous collection policy will involve increased
collection costs. It may also reduce the volume of sales. Some customers may
not appreciate the efforts of the concern and may shift to another concern
thus causing reduced sales and profits. A lenient policy may increase the debt
collection period and more bad debt losses. A customer not clearing the dues
for long may not repeat his order because he will have to pay earlier dues first,
thus causing loss of customers. The collection policy should weigh various
aspects associated with it, the benefits and losses of such policy and its effect
on the finances of the concern.
The collection policy should also devise the steps to the followed
in collecting over due amounts. The objective is to collect the dues and not to
annoy the customer. The steps should be like (i) Sending a reminder for
payments (ii) Personal request through telephone etc. (iii) Personal visits to
the customers (iv) Taking help of collecting agencies and lastly (v) Taking legal
action. The last step should be taken only after exhausting all other means
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because it will have a bad impact on relations with customers. The genuine
problems of customers should never be ignored while making collections. The
aim should be make collections and keep amiable relations with customers.
The collection of book debts can be monitored with the use of
average collection period and aging schedule. The actual average collection
period may compared with the stated collection period to evaluate the efficiency
of collection that necessary corrective action can be taken if the need be. The
aging schedule rather highlights the debtors according to the age or length of
time of the outstanding debtors.
Illustration 2 : A firm sells 40,000 units of its product per annum @ Rs. 35
per unit. The average cost per unit is Rs. 31 and the variable cost per unit is Rs.
28. The average collection period is 60 days. Bad debt losses are 3% of sales
and the collection charges amount to Rs. 15,000.
The firm is considering a proposal to follow a stricter collection
policy which would reduce bad debt losses to 1% of sales and the average
collection period to 45 days. It would, however, reduce sales volumes by 1000
units and increase the collections expenses to Rs. 25,000.
The firm's required rate of return is 20%. Would you recommend
the adoption of the new collection policy? Assume 360 days in a year for the
purpose of your calculation.
Solution :
(A) Calculation of Savings/Benefits of the New Policy
(i) Savings in Losses due to bad debts :
Present Sales (40,000 ×35) = Rs. 14,00,000
Proposed Sales (39,000×35) = Rs. 13,65,000
Present Bad Debts (3% of 14,00,000) = Rs. 42,000
Proposed Bad Debts (1% of 13,65,000) = Rs. 13,650
Savings in Losses due to bad debts (a) Rs. 28,350
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(ii) Savings in Cost of Receivables Investments

(
Present level of Receivables 14,00,000 ×
60
360 )
= Rs.2,33,333

(
Proposed level of Receivables 13,65,000 ×
45
360 )
= Rs.1,70,625
Reduction in the level of Receivables = Rs. 62,708
Total Savings in cost of Receivables Investment(b)
(20% of 62,708) = Rs. 12,547
Total Savings/Benefits of New Policy (a+b) Rs. 40,892
(B) Calculation of Increase in Cost and Reduction of Profit under New Policy
Rs.
(i) Increase in collection charges (25,000–15,000) = 10,000
(ii) Reduction in Profit due to decrease in Sales of 1000 units = 7,000
[1000 × (35-28)]
Total Increase in cost and Reduction of Profit (i+ii) = 17,000
Net Gain arising from adopting New Policy (A-B)
[40,892 – 17,000] = 23,892
Hence, the firm is advised to adopt the new collection policy.
14.5 BACKGROUND TO CASH MANAGEMENT
Cash is a vital component of working capital because it is the
cash which keeps a business going. It is the hub around which all other financial
matters centre. There is no denying the fact that cash is the very life-blood of
a business enterprise. Study and healthy circulation of cash in the entire
business operation is the basis of business solvency. Cash is the basic input
needed to keep the business running on a continuous basis; it is also the ultimate
output expected to be realised by selling the service or product manufactured
by the firm. Ultimately, every transaction in a business results in either in
inflow or an outflow of cash. Therefore, effective management of cash is the
key determinant of efficient working capital management. There should be
sufficient cash with a firm all the time to meet the needs of the business. Both
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excess and inadequate cash situations are undesirable from the pint of view of
profitability and liquidity. Inadequate cash may degenerate a firm into a state
of technical insolvency and even lead to its liquidation. It will eventually disrupt
the firm's Manufacturing operation. On the other hand, excessive cash remains
idle, without contributing anything towards the firm's profitability. Moreover,
holding of cash balance has an implicit cost in the form of its opportunity
cost. The larger the idle cash, the greater will be its opportunity cost in the
form of loss of interest which could have been earned either by investing it in
some interest-bearing securities or by reducing the burden of interest charges
by paying off the past loans. The carrying of cash and near cash reserves beyond
the irreducible operating needs costs asset turnover and rate of return. If the
cash balances with a firm at any time are surplus or deficit, it is obvious that
the finances are mismanaged. Today when cash, like any other asset of the
company, is a tool for profits the emphasis is on right amount of cash at the
right time, at the right place and at the right cost.
The term cash is used in two senses, i.e., narrow and broad. In the
narrow sense, it includes coins, currency and cheques in hand and balances in
bank accounts. However, in its borader sense, cash and near-cash items such as
marketable securities and bank time deposits are also included in cash. The
basic characteristic of near-cash assets is that they can readily be converted
into cash.
Second, in a broader sense, it also includes near cash assets such
as marketable securities and short term deposits with banks. For cash
management purposes, the term cash is used in this broader sense i.e., it covers
cash, cash equivalents and those assets which are immediately convertible into
cash.
A financial manager is required to manage the cash flows (both
inflows and outlfows) arising out of the operations of the firm. For this he
will have to forecast the cash inflows from sales and outflows for costs etc.
This will enable the financial manager to identify the timings as well as amount
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of future cash flows. Cash management does not end here and the financial
manager may also be required to identify the sources from where cash may be
procured on a short term basis or the outlets where excess cash may be invested
for a short term.
In most of the firms, the financial manager who is responsible
for cash management also controls the transactions that affect the firm's
investment in marketable securities. In case of excess cash, marketable
securities are purchased; and in case of shortage of cash, a part of the
marketable securities is liquidated to procure enough cash . All these issues
are important to the financial manager for several reasons. For example, a
judicious management of cash, near cash assets and marketable securities
allows the firm to hold the minimum amount of cash necessary to meet the
firm's obligations as and when they arise. As a result, the firm is not only able
to meet its obligations, but also is in a position to take advantage of the
opportunity of earning a return and thereby increasing the profitability of the
firm.
Motives for Holding Cash
Though cash is the most liquid asset, but it does not earn any
substantial return for the business. Nobody earns any income on the cash
balance or currency being maintained, however, some interest income may be
earned on short term deposits. But still everybody and every firm maintains
some cash balance. What is the reason? Why the firm still keep some cash
balance? It has been suggested that there are three primary motives for holding
cash. These are as follows :
(i) The transactions motive : This motive refers to the holding of cash in
order to meet the day-to-day transactions which a firm carries on in the ordinary
course of the business. Primarily, these transactions include purchase of raw
materials, wages, operating expenses, taxes, dividends etc. We all know that a
firm may enter into a variety of transactions to accomplish its objectives.
Similarly, there is a regular inflow of cash from revenues. Thus, the receipts
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and payments constitute a continuous two-way flow of cash. Since the inflows
and outflows of cash do not perfectly synchronize, an adequate or a minimum
cash balance is required to uphold the operations if outflows exceed the
inflows. Therefore, in order to meet the day-to-day transactions, the
requirement of cash in known as transaction motive. So, it refers to the holding
of cash to meet anticipated obligations when timing is not perfectly
synchronised with the inflows of cash. Although, a major part of transactions
balances is held in cash, a part may also be held in the form of marketable
securities whose maturity conforms to the timing of the anticipated payments,
such as, payment of taxes, dividends etc.
(ii) The Precautionary Motive : This motive for holding cash has to do
with maintaining a cushion or buffer to meet unexpected contingencies. The
unexpected cash needs at short notice may be the result of :
(a) uncontrollable circumstances, such as, floods, strikes, droughts etc.;
(b) bills which may be presented for settlement earlier than expected;
(c) unexpected delay in collection of trade dues;
(d) cancellation of some order for goods due to inferior quality; and
(e) increase in the cost of material, labour etc.
Precautionary balances are the cash balances which are held as
reserve for random and unforeseen fluctuations in cash flows, i.e., this motive
implies the need to hold cash to meet unpredictable obligations. The more
predictable the cash flows, the less precautionary balances that are needed and
vice-versa. Moreover, the need for this types of cash balance may be reduced
if there is a ready borrowing power in order to meet the emergency cash
outflows. Sometimes a portion of such cash balances may be held in marketable
securities, i.e., near-money assets.
( i i i ) The Speculative Motive : This motive refers to the holding of cash for
taking advantages of expected changes in security price. In other words, when
the rates of interest are expected to fall, cash may be invested in different
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securities so that the firm will benefit by any subsequent fall in interest rates
and rise in security prices. On the other hand, when the rate of interest are
expected to rise the firm should hold cash until the rise in interest rates ceases.
The precautionary motive is defensive in nature while speculative notice
represents a positive and aggressive approach. The speculative motive helps to
take advantages of :
(i) in opportunity to purchase raw material at a reduced price against
immediate payment, i.e., benefit of cash discounts;
(ii) a change to speculate of interest rate movements by purchasing securities
when rates of interest are expected to decline;
(iii) the purchase at favourable prices.
14.7 FUNCTIONS OF CASH MANAGEMENT
If during a year, the cash inflows of a firm balance its cash
outflows exactly, the job of the financial manger would be greatly simplified.
Unfortunately, this does not often happen. What is more, there are time during
the course of a year when the cash outflow may exceed the inflows by an amount
sufficient to prevent the financial manager form meeting his firm's regular
financial obligations, unless he takes steps to secure addition cash funds. These
imbalances may result from external causes over which the management has
little or no control; or they may be the result of changes made in the firm's
manufacturing, purchasing or selling policies. Since it is the responsibility of
the financial manager to provide sufficient cash funds to pay all liabilities as
and when they arise, he must correct such imbalances by pumping additional
cash into the firm. Alternatively, in situations where the imbalance lies in the
other direction i.e., when too much cash has become available, he must make
sure that the excess cash (but no more or no loss) is removed and put to some
income earning asset.
A firm may not face any problem in undertaking various activity
and entering into various transactions if it is having adequate and sufficient
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cash balance. For this purpose, the financial manager should ensure that the
firm is having right quantity and right quality of liquidity from right source at
right price and at right time. Cash management, thus deals with optimization
of cash as an asset and for this purpose the financial manager has to take various
decisions from time to time. Even if a firm is highly profitable, its cash inflows
may not exactly match the cash outflows. He has to manipulate and synchronize
the two for the advantage of the firm by investing excess cash, if any, as well
as arranging funds to cover the deficiency. Thus, an executive who manage
cash of an enterprise has to look after the functions like
(i) collection and upkeeping of cash and securities;
(ii) control of payments, i.e., providing requisite cash at the proper time
and place to meet financial obligations;
(iii) maintenance of adequate supply of cash to meet projected cash
requirements, cash budgets and day-to-day demands;
(iv) investment of surplus cash in suitable marketable securities to keep it
fully utilised and working towards greater profits; and
(v) maintenance of sound banking relations. Some of the important aspects
of cash management have been dealt with below.
14.8 OBJECTIVES OF CASH MANAGEMENT
The financial manager must know as to why the cash management
is a necessity. The cash management strategies are generally built around two
goals : (a) to provide cash needed to meet the obligations, and (b) to minimize
the idle cash held by the firm. The financial manager has to strike an acceptable
balance between holding too much cash and too little cash. This is the focal
point of the cash risk-return trade-off. A large cash investment minimizes the
chances of default but penalizes the profitability of the firm. A small cash
balance target may free the excess cash balance for investment in marketable
securities and thereby enhancing the profitability as well as value of the firm,
but increases simultaneously the chances of running out of cash. The risk-
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return trade-off of any firm can be reduced to two prime objectives for the
firm's cash management system, as follows :
(i) Meeting the cash outflows : The primary objective of cash management
is to ensure the cash outflows as and when required. Enough cash must be on
hand to meet the dispersal needs that arise in the normal course of business.
The firm should be able to make the payments at different point of time without
any liquidity problem. It means that the firm should have sufficient cash to
meet the payment schedules and disbursement needs. It will help the firm in
(a) avoiding the chance of default in meeting financial obligations, otherwise
the goodwill of the firm is adversely affected, (b) availing the opportunities of
getting cash discounts by making early or prompt payments, and (c) meeting
unexpected cash outflows without much problem.
(ii) Minimizing the Cash Balance : Investment in idle cash balance must
be reduced to a minimum. This objective of cash management is based on the
idea that unused asset earns no income for the firm. The funds locked up in
cash balance is a dead investment and has no earnings. Therefore, whatever
cash balance is maintained, the firm is foregoing interest income on that
balance. The objective of the cash management therefore, should be to keep a
minimum cash balance.
However, the objective of cash management i.e., maintaining the
minimum cash balance must be looked into together with the other objective
i.e., maintaining the payment schedule etc., which require that a firm must have
sufficient liquidity (even at the cost of reducing profitability). But the objective
of minimum cash balance affects the liquidity and thereby increasing the
profitability. Thus, these objectives seem to be contradictory in nature and
hence the financial manager has to achieve a trade-off between them. He has
to ensure that the minimum cash balance being maintained by the firm is not
affecting the payment schedule and meting all disbursement needs. The cash
management strategies are needed to reconcile these two goals wherever
possible. However, meeting payment commitments takes higher priority than
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minimizing the cash balance.
14.9 FACETS OF CASH MANAGEMENT
Cash management is concerned with the managing of : (i) cash
flows into and out of the firm, (ii) cash flows within the firm, and (iii) cash
balances held by the firm at a point of time by financing deficit or investing
surplus cash.
Unlike fixed assets or inventories, cash does not provide goods
for sale. The management of cash is important because it is difficult to predict
cash flows accurately, particularly the inflows, and there is no perfect
coincidence between the inflows and outflows of cash. During some periods,
cash outflows will exceed cash inflows, because payments for taxes, dividends,
or seasonal inventory build up. At other times, cash inflow will be more than
cash payments because there may be large cash sales and debtors may be
realised in large sums promptly. Cash management is also important because
cash constitutes the smallest portion of the total current assets, yet
management's considerable time is devoted in managing it. In recent past, a
number of innovations have been done in cash management techniques. An
obvious aim of the firm now-a-days is the manage its cash affairs in such a way
as to keep cash balance at a minimum level and to invest the surplus cash in
profitable investment opportunities.
In order to resolve the uncertainty about cash flow prediction and
lack of synchronisation between cash receipts and payments, the firm should
develop appropriate strategies for cash management. The firm should evolve
strategies regarding the following four facets of cash management :
1. Cash planning : Cash inflows and outflows should be planned to project
cash surplus or deficit for each period of the planning period. Cash budget
should be prepared for this purpose.
2. Managing the cash flows : The flow of cash should be properly
managed. The cash inflows should be accelerated while, as far as possible, the
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cash outflows should be decelerated.
3. Optimum cash level : The firm should decide about the appropriate
level of cash balances. The cost of excess cash and danger of cash deficiency
should be matched to determine the optimum level of cash balances.
4. Investing surplus cash : The surplus cash balances should be properly
invested to earn profits. The firm should decide about the division of such
cash balance between alternative short-term investment opportunities such as
bank deposits, marketable securities, or intercorporate lending.
1. Cash Planning : Cash flows are inseparable parts of the business
operations of firms. A firm needs cash to invest in inventory, receivable and
fixed assets and to make payment for operating expenses in order to maintain
growth in sales and earnings. It is possible that firm may be making adequate
profits, but may suffer from the shortage of cash as its growing needs may be
consuming cash very fast. The 'cash poor' position of the firm can be corrected
if its cash needs are planned in advance. At times, a firm can have excess cash
with it if its cash inflows exceed cash outflows. Such excess cash may remain
idle. Again, such excess cash flows can be anticipated and properly invested if
cash planning is resorted to. Thus, cash planning can help to anticipate the
future cash flows and needs of the firm and reduces the possibility of idle
cash balances (which lowers firm's profitability) and cash deficits (which can
cause the firm's failure).
Cash planning is a technique to plan and control the use of cash.
It protects the financial condition of the firm by developing a projected cash
statement from a forecast of expected cash inflows and outflows for a given
period. The forecasts may be based on the present operations or the anticipated
future operations. Cash plans are very crucial in developing the overall operating
plans of the firm.
Cash Forecasts and Budgeting : A cash budget is the most important device
for the control of receipts and payments of cash. A cash budget is an estimate
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of cash receipts and disbursements during a future period of time. It is an
analysis of flow of cash in a business over a future, short or long period of
time. It is a forecast of expected cash intake and outlay.
The short-term forecasts can be made with the help of cash flow
projections. The finance manager will make estimates of likely receipts in the
near future and the expected disbursements in that period. Though it is not
possible to make exact forecasts even then estimates of cash flows will enable
the planners to make arrangement for cash needs. It may so happen that expected
cash receipts may fall short or payments may exceed estimates. A financial
manager should keep in mind the sources from where he will meet short-term
needs. He should also plan for productive use of surplus cash for short periods.
The long-term cash forecasts are also essential for proper cash
planning. These estimates may be for three, four, five or more years. Long-
term forecasts indicate company's future financial needs for working capital,
capital projects, etc.
Both short-term and long-term cash forecasts may be made with
the help of following methods :
(i) Receipts and disbursements method
(ii) Adjusted net income method.
(i) Receipts and Disbursements Method : In this method the receipts
and payments of cash are estimated. The cash receipts may be from cash sales,
collections from debtors, sale of fixed assets, receipts of dividend or other
incomes of all the items. Cash sales will bring receipts at the time of sale
while credit sales will bring cash later on. The collections from debtors (Credit
Sales) will depend upon the credit policy of the firm. Any fluctuation in sales
will disturb the receipts of cash. Payments may be made for cash purchases, to
creditors for goods, purchase of fixed assets, for meeting operating expenses
such as wages rent, rates, taxes or other usual expenses, dividend to
shareholders etc.
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 The receipts and disbursements are to be equalled over a short
as well as long periods. Any shortfall in receipts will have to be met from
banks or other sources. Similarly, surplus cash may be invested in risk free
marketable securities. It may be easy to make estimates for payments but cash
receipts may not be accurately made.. The payments are to be made by outsiders,
so there may be some problem in finding out the exact receipts at a particular
period. Because of uncertainty, the reliability of this method may be reduced.
(ii) Adjusted Net Income Method : This method may also be known as
sources and uses approach. The adjusted net income method helps in projecting
the company's need for cash at some future date and to see whether the company
will be able to generate sufficient cash. If not, then it will have to decide about
borrowing or issuing shares, etc. In preparing its statement the items like net
income, depreciation, dividends, taxes, etc. can easily be determined from
company's annual operating budget. The estimation of working capital
movement becomes difficult because items like receivables and inventories
are influenced by factors such as fluctuations in raw material costs, changing
demand for company's products and likely delays in collections. This method
helps in keeping a control on working capital and anticipating financial
requirements.
II. Management of Cash Flows
In order to manage cash properly the finance manager has to
ensure that cash is flowing in and flowing out as per the plan. This requires
comparison of actual performance against predetermined plans and objectives,
finding out discrepancies, if any, analysing their variations in order to pinpoint
the underlying causes and finally, taking remedial steps to correct the anomaly.
All this is possible with the help of cash budget report.
Besides, efficient utilisation of cash involves accelerating cash
inflows and slowing disbursements. There are various methods of speeding
cash collections and delaying payments. We shall now discuss each of these
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methods in the following paragraphs :
Methods of Accelerating the cash inflows
(1) Quick deposit of customer's cheques : One way of shortening the
time lag between the date when a customer signs a cheque and the date when
the funds are available for use is to make an arrangement for quick deposit of
the cheques in the banks the moment they are received. Special attention should
be given to large remittances. For example, these may be deposited individually
or air mail services should be used for such remittances.
(2) Prompt Payment by Customers : In order to accelerate cash inflows,
the collections from customers should be prompt. This will be possible by
prompt billing. The customers should be promptly informed about the amount
payable and the time by which it should be paid. It will be better if self addressed
envelope is sent alongwith the bill and quick reply is requested. Another method
for prompting customers to pay earlier is to allow them a cash discount. The
availability of discount is a good saving for the customer and in an anxiety to
earn it they make quick payments.
(3) Decentralised collections : A b i g f i r m o p e r a t i n g o v e r w i d e
geographical area can accelerate collections by using the system of
decentralised collections. A number of collecting centres are opened in
different areas instead of collecting receipts at on place. The idea of opening
different collecting centres is to reduce the mailing time from customer's
despatch of cheque and its receipt in the firm and then reducing the time in
collecting these cheques. On the receipt of the cheque it is immediately sent
for collection. Since the party may have issued the cheque on a local bank it
will not take much time in collecting it. The amount so collected will be sent
in the central office at the earliest. Decentralised collection system saves
mailing and processing time and thus, reduces the financial requirements.
(4) Lock Box System : Lock box system is another technique of reducing
mailing, processing and collecting time. Under this system the firm selects
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some collecting centres at different places. The places are selected on the
basis of number of consumers and the remittances to be received from a
particular place. The firm hires a Post Box in a post office and the parties are
asked to send the cheques on that post box number. A local bank is authorised
to operate the post box. The bank will collect the post a number of times in a
day and start the collection process of cheques. The amount so collected is
credited to the firm's account. The bank will prepare a detailed account of
cheques received which will be used by the firm for processing purpose. This
system of collecting cheques expedites the collection process and avoids delays
due to mailing and processing time at the accounting department. By
transferring clerical function to the bank, the firm may reduce its costs,
improve internal control and reduce the possibility of fraud.
Methods of Slowing Cash Outflows
In order to optimize cash availability in the firm the finance
manager must employ some devices that could slow down the speed of
payments outward in addition to accelerating collections. Some of the important
methods that may delay disbursements are as follows :
1. Delaying outward payment : By delaying the payment on bills until
the last date of the no-cost period, the finance manager can economise cash
resources. If purchases are made on terms of 1/10, n/30, this method suggests
that payment should be made on 10th day. In this way the firm not only avails
of benefits of discount but also releases funds for eight days for investment in
short-term channels.
2. Making Payroll periods Less frequent : T h i s c a n a l s o h e l p a
company to economise cash. If the company is currently disbursing pay to its
employees weekly, it can effect substantial cash savings if pay is disbursed
only once in a month.
3. Where payroll is monthly, the finance manager should predict as to
when employees will present cheques to the company's bank for collection.
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Supposing if pay day falls on Saturday, not all cheques will be presented on
that day. The company need not deposit funds to cover its entire payroll. Even
on Monday, some employees may not present cheques for payment. This, on
the basis of the past experience, the finance manager could estimate on an
average, the cheques presented on the pay day on the subsequent days for
payment. Accordingly, the finance manager can assess fund requirements to
cover payroll cheques on different days.
4. Using float : Float is the difference between the company's cheque
book balance and the balance shown in the bank's books of account. When a
firm writes a cheque, it will reduce the balance in its books of account by the
amount of the cheque. But the bank will debit the account of its customers
only after a week or so when the cheque is collected. Thus, there is no strange
if the firm's books show a negative balance while the bank's books show positive
balance. The firm can make use of the float if the magnitude of the float can be
accurately estimated.
5. Inter-bank transfer : Another method of making efficient use of cash
resources is to transfer funds quickly from one bank to another bank where
disbursements are to be made. This would prevent building up of excess cash
balances in one bank. This procedure could be adopted by a company having
accounts with several banks.
6. Centralisation of Payments : The payments should be centralised and
would be made through cheques. When cheques are issued from the main office
then it will take time for the cheques to be cleared through post. The benefit
of cheque collection time is availed.
III. Determining Optimum Level of Cash Balance
A prudent finance manager desires to maintain only that much
amount of cash balance as is just sufficient to satisfy transaction requirements
as well as to meet precautionary and speculative motives. This task is so
important that carrying of excess cash balance entails loss of interest earnings
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to the firm and thus causes low profitability and maintaining a small cash
balance renders the firm's liquidity position weak, although a higher
profitability is ensured. Thus, determination of suitable level of cash holding
involves risk-return trade-off.
Determination of appropriate level of cash balance is not only
necessary to optimize cash utilisation but also to decide the level of investment
in marketable securities. A number of cash management models have been
developed to decide the optimal level of cash balance. There models are based
on various considerations such as the demand for cash, the interest rate on
marketable securities and the cost of transfers between marketable securities
and cash.
(1) Baumol Modal : This model was suggested by William J. Baumol. It
is similar to one use for determination of economic order quantity. According
to this model, optimum cash level is that level of cash where the carrying costs
and transactions costs are the minimum.
Carrying Costs : This refers to the cost of holding cash, namely, the interest
foregone on marketable securities. They may also be termed as opportunity
costs of keeping cash balance.
Transaction Costs : This refers to the cost involved in getting the marketable
securities converted into cash. This happens when the firm falls short of cash
and has to sell the securities resulting in clerical, brokerage, registration and
other costs.
There is an inverse relationship between the two costs. When
one increases, the other decreases. Hence, optimum cash level will be at that
point where these two costs are equal.
The formula for determining optimum cash balance can be put
as follows :
2U × P
C=
S
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where :
C = Optimum cash balance
U = Annual (or monthly) cash disbursements
P = Fixed costs per transaction
S = Opportunity cost of one rupee p.a. (or p.m.)
Illustration 3 :
Monthly cash requirements Rs 5,00,000
Fixed cost per transaction Rs. 25
Interest rate on marketable securities 15% p.a.
You are required to calculate optimum cash balance.
Solution :
2U × P
C=
S

= 2×5,00,000×25 = Rs. 12,910

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There are two limitations of the optimum Baumol's cash model :
(i) The model assumes a constant rate of use of cash. This is a hypothetical
assumption. Generally the cash outflows in any firm are not regular and
hence this model may not give correct results.
(ii) The transaction cost will also be difficult to be measured since these
depend upon the type of investment as well as the maturity period.
In spite of the limitations, the model has a theoretical value. It
gives an idea as to how the carrying cost and transaction cost should be
optimized by the firm. The cash balance being maintained by the firm should
be a level close to optimum level as given by the model so that the total cost is
minimized.
(2) Miller Orr-Model : Baumol model is not suitable in those
circumstances when the demand for cash is not steady and cannot be known in
advance. Miller-Orr Model helps in determining the optimum level of cash in
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such circumstances. It deals with cash management problem under the
assumption of stochastic or random cash flows by laying down control limits
for cash balances. These limits consists of an upper limit (h), Lower limit (o)
and return point (z). When cash balance reaches the upper limit, a transfer of
cash equal to "h -z" is effected to marketable securities. When it touches the
lower limit, a transfer equal to "z - o" from marketable securities to cash is
made. No transaction between cash and marketable securities to cash is made
during the period when the cash balance stays between these high and low limits.
The model is illustrated in the form of the following chart :

h
Upper control limit
Cash Balance

z
Return Point

O
Time Lower Control Limit
The above chart shows that when cash balance reaches the upper
limit, an amount equal to "h - z" is invested in the marketable securities and
cash balance comes down to 'z' level. When cash balance touches the lower
limit, marketable securities of the value of "z - o" are sold and the cash balance
again goes up to 'z' level. The upper and lower limits are set on the basis of
opportunity cost of holding cash, degree of likely fluctuation in cash balances
and the fixed costs associated with a securities transaction.
The optimal value of z, the return point for securities
transactions, can be determined by the following formula

z = 3 3b × σ 2
4i
where: b = fixed cost associated with a security transaction
σ 2 = Variance of daily net cash flows
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 i = interest rate per day on marketable securities.
If the firm take 'L' to be lower limit of cash balance, then the
return level may be defined as R=L+Z, and the upper limit H is defined as
H=3Z + L. For example, if a firm has a standard deviation of Rs. 1,200 (i.e.
V=s 2 = Rs. 14,40,000) in daily cash flows, the daily earnings on the short term
investment is expected at .01% and the transaction cost for each sale and
purchase of securities is Rs. 20. The variable Z may be calculated as follows :
Z = [3TV/4i] 1/3
= [(3×20×14,40,000)/(4.0001)] 1/3
= 6,000
Now, if the firm has a minimum level of Rs. 1,000, then its return
level, R would be Rs. 7,000 (i.e. Rs. 6,000+1,000), and the upper limit, H, is
3Z+L = Rs. (3×6,000)+1,000 = Rs. 19,000. The spread between the upper and
the lower limit is Rs. 18,000 (i.e. 19,000-1,000). So, long as the firm has
cash balance within the range of Rs. 1,000 and Rs. 19,000, it need not worry.
However, as soon as the cash balance touches the lower level of Rs. 1,000, the
firm should immediately sell off some securities to realize at least of Rs.
6,000 so that the cash level is returned to Rs. 7,000. Similarly, if the cash
balance touches the level of Rs. 19,000, the firm should buy enough marketable
securities to bring the cash level to Rs. 7,000.
In general, it may be said that the cash model gives the financial
manager a bench mark for judging the optimum cash balance. It does not have
to be used as a precise rule governing his behaviour. The model merely suggests
what would be the optimal balance under a set of assumptions. The actual balance
may be more or less if the assumptions do not hold good entirely.
IV. Investing Surplus Cash
There is a close relationship between cash and money market
securities or other short-term investment alternatives. Investment in these
alternatives should be properly managed. Excess cash should normally be
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invested in those alternatives which can be covenientaly and promptly converted
into cash. Cash in excess of the requirement of operating cash balance may be
held for two reasons. First, the working capital requirements of the firm
fluctuate because of the elements of seasonality and business cycles. The
excess cash may build up during slack seasons but it would be needed when the
demand picks up. Thus, excess cash during slack season is idle temporarily,
but has a predictable requirement later on. Second, excess cash may be held as
buffer to meet unpredictable financial needs. A firm holds extra cash because
cash flows cannot be predicted with certainty. Cash balance held to cover the
future exigencies is called the precautionary balance and is usually invested in
the short-term money market investments until needed.
Instead of holding excess cash for the above mentioned purpose,
the firm may meet its precautionary requirements as and when they arise by
making short-term borrowings. The choice between the short-term borrowings
and liquid assets holding will depend upon the firm's policy regarding the mix
of short-term financing.
The excess amount of cash held by the firm to meet its variable
cash requirements and future contingencies should be temporarily invested in
marketable securities, which can be regarded as near moneys. A number of
marketable securities may be available in the market. The financial manager
must decide about the portfolio of marketable securities in which the firm's
surplus cash should be invested.
Selecting Investment Opportunities
A firm can invest its excess cash in many types of securities or
short-term investment opportunities. As the firm invests its temporary cash
balance, its primary criterion in selecting a security or investment opportunities
will be its quickest convertibility into cash, when the need for cash arises.
Besides this, the firm would also be interested in the fact that when it sells the
security or liquidates investment, it at least gets the amount of cash equal to
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the investment outlay. Thus, in choosing among alternative investment, the firm
should examine three basic features of security : safety, maturity and
marketability.
(i) Safety : An investing firm would normally prefer to invest in high
yielding security. But high-yielding securities are relatively more risky.
Therefore, since the balances invested in securities are needed in the near
future, so the firm would invest in very safe securities. In other words the firm
would invest in high-yielding securities subject to the constraint that the
securities have acceptable level of risk. By risk here is meant the default risk,
i.e., the possibility of default in the payment of interest or interest on time
and in the amount promised. To minimise such a risk the firm should invest in
safe securities.
(ii) Maturity : The term maturity signifies the time period over which
interest and principal payments are to be made. It is a fact that there are wide
fluctuations in the price of long-term securities with the changes in interest
rates as against the short-term securities. This is so because the interest rates
have a tendency to change over time. Thus, the long-term securities are more
risky. Hence, for the purpose of investing excess cash, the firms prefer to
invest in short-term securities.
(iii) Marketability : Convenience and the speed with which a security can
be converted into cash is known as the marketability. When a security can easily
be sold without loss of time it is highly marketable. Government treasury bills
fall under this category of securities. Those securities with low marketability
are usually high-yielding to attract investment in them.
Types of Short-term Investment Opportunities
The following short-term investment opportunities are available
to companies in India to invest their temporary cash surplus :
(i) Treasury bills : Treasury bills (TBs) are short-term government
securities. The usual practice in India is to sell treasury bills at a discount and
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redeem them at par on maturity. The difference between the issue price and
the redemption price, adjusted for the time value of money, is return on treasury
bills. They can be bought and sold any time; thus, they have liquidity. Also,
they do not have the default risk.
(ii) Commercial papers : Commercial papers are short-term, unsecured
securities issued by highly creditworthy large (CPs) companies.. They are
issued with a maturity of three months to one year. CPs are marketable
securities, and therefore, liquidity is not a problem.
(iii) Certificates of deposits : Certificates of deposits (CDs) are papers
issued by banks acknowledging fixed deposits for a specified period of time.
CDs are negotiable instruments that make them marketable securities.
(iv) Bank deposits : A firm can deposit its temporary cash in a bank for a
fixed period of time. The interest rate depends on the maturity period. For
example, the current interest rate for a 30 to 45 days deposit is about 5 per
cent and for 180 days to one year is about 6.5 per cent. The default risk of the
bank deposits is quite low since most banks in India are owned by the
Government.
(v) Inter-corporate deposits : Inter-corporate lending/borrowing or
deposits is a popular short-term investment alternative for companies in India.
Generally a cash surplus company will deposit (lend) its funds in a sister or
associate companies or with outside companies with high credit standing. In
practice, companies can negotiate inter-corporate borrowing or lending for
very short periods. The risk of default is high, but returns are quite attractive.
(vi) Money market mutual funds : Money market mutual funds (MMMFs)
14.10 focus on short-term marketable securities such as TBs, CPs, CDs or
call money. They have a minimum lock-in period of 30 days, and after this
period, an investor can withdraw his or her money any time at a short notice or
even across the counter in some cases. They offer attractive yields; yields are
usually 2 per cent above than on bank deposits of same maturity. MMMFs are
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of recent origin in India, and they have become quite popular with institutional
investors and some companies.
14.10 SUMMARY
When a firm makes an ordinary sale of goods and services and
does not receive payment, the firm grants trade credit and creates accounts
receivable which would be collected in future. Thus, accounts receivable
represent an extension of credit to customers, allowing them a reasonable
period of time, in which to pay for the goods/services which they have received.
The objective of receivables management is to have a trade-off
between the benefits and costs associated with the extension of credit. The
benefits are increased sales and associated increased profits/marginal
contribution. The major categories of cost of accounts receivables are
collection costs, capital costs, delinquency costs and default costs.
The management of receivables involves crucial decision in three
areas : (i) formulation of credit policy (ii) executing the credit policy and
(iii) formulation in and execution of collection policy.
The formulation of credit policy of a firm provides the
framework to determine whether or not to extend credit to a customer and
terms and conditions off extending credit. The two broad dimensions of credit
policy decision are credit standards and credit terms. The term credit standards,
represents the basic criterion for the extension of credit to customers. The
credit terms specify the repayment terms comprising credit period, cash
discount, if any, and cash discount period. The execution of credit policies
includes obtaining credit information from different sources and its analysis.
The third area involved in formulation and execution of collection policies. It
refers to the procedure followed to collect receivables when they become due.
Cash management is one of the key areas of working capital
management. There are three motives of holding cash : (i) transaction motive,
(ii) precautionary motive, and (iii) speculative motive. The transaction motive
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refers to holding of cash to meet anticipated obligations whose time is not
perfectly synchronised with cash receipts. The cash balances held in reserve
for random and unforseen fluctuations in cash flows are called precautionary
balances. The speculative motive indicates the desire of a firm to take advantage
of opportunities which present themselves at unexpected moments and which
are typically outside the normal course of business. The compensating motive
means keeping the bank balance sufficient to earn a return equal to the cost of
free services provided by the banks.
The basic objectives of cash management are to reconcile two
mutually contradictory and conflicting takes : to meet the payment schedule
and to minimise funds committed to cash balances.
Management of cash involves three things : (a) managing cash
flows into and out of the firm, (b) managing cash follows within the firm, and
(c) financing deficit or investing surplus cash and thus, controlling cash balance
at a point of time. It is an important function in practice because it is difficult
to predict cash flows and there is hardly any synchronisation between inflows
and outflows.
The cash management strategies are intended to minimise the
operating cash balance requirement. The basic strategies that can be employed
are (i) stretching accounts payable without affecting the credit of the firm,
(ii) efficient inventory management and (iii) speedy collections of accounts
receivables. Some of the specific techniques and processes for speedy
collection of receivables from customers are ensuring prompt payment for
customers and early payment/ conversion into cash. Concentration banking and
lock-box system deserve specific mention as principal method of establishing
a decentralised collection network. The techniques to delay payments of
accounts payable include avoidance of early payment, centralised disbursements
and float.
Marketable securities are an outlet for surplus cash as liquid security/
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assets. To be liquid a security must have three basic characteristics, that is, a
ready market, maturity period and safety of principal.
14.11 SELF ASSESSMENT QUESTIONS
1. What do you mean by receivables management? Discuss the factors which
influence the size of receivables.
2. What are the costs and benefits associated with receivable?
3. What is credit policy? What are the elements of a credit policy?
4. What are credit terms? Explain the role of credit terms in a credit policy.
5 ABC Ltd. is examining the question of relaxing its credit policy. It sells
at present 20,000 units at a price of Rs. 100 per unit, the variable cost
per unit is Rs. 88 and average cost per unit at the current sales volume is
Rs. 92. All the sales are on credit, the average collection period being
36 days.
A relaxed credit policy is expected to increase sales by 10% and the
average age of receivables to 60 days. Assuming 15% return, should the
firm relax its credit policy?
6. What are the objectives of cash management? What are the factors
affecting the cash needs of a firm?
7. Explain the Baumol's model of cash management.
8. "Efficient cash management will aim at maximizing the availability of
cash inflows by decentralizing collections and decelerating cash
outlfows by centralizing the disbursements". Discuss and explain.
9. Discuss the Miller-Orr model for determining the cash balance for the
firm.
10. Explain and discus the role of marketable securities in cash management.
What are the factors affecting the choice of marketable securities?
11. "It has been observed in your organization that substantial cash surplus

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 is available for short period of time which is not being utilized properly
to generate maximum yield". How would you go about planning for short
term investment of funds?
14.12 FURTHER READINGS
1. Financial Management and Policy by James C. Van Horne
2. Financial Management by Prasana Chandra
3. Financial Management by Ravi M. Kishore
4. Financial Management by I.M. Pandey
5. Working Capital Management by V.K. Bhalla

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 LESSON – 15

INTERNAL FINANCING AND DIVIDEND POLICY

Objective : After reading this lesson, you would be conversant with factors
determining the magnitude of internal funds and dividend policy.
Structure
15.1 Introduction to Internal Financing
15.2 Mobilization of Internal Funds
15.3 Concept and Significance of Dividend Decisions
15.4 Determinants of Dividend Policy
15.5 Forms of Dividend
15.6 Legal and Procedural Aspects of Dividend
15.7 Summary
15.8 Self Assessment Questions
15.9 Further Readings
15.1 INTRODUCTION TO INTERNAL FINANCING
Financing an enterprise through its internal sources is known as
internal financing. Such internal resources comprise of earnings retained by
the company in the form of income left over after meeting all expenses. Such
funds are available to an enterprise which has been carrying on its business
successfully and thereby has been in a position to set aside a portion of its
earnings for future needs. This retaining of earnings is technically termed as

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ploughing back of profits.
Retained earnings constitute an important source of corporate
financing. The funds are relatively economic and without any obligation to
refund the same. These funds can be effectively utilized for modernisation and
expansion requirements and that too without creating any charge against any
asset. The earning position of the company improves tremendously when the
modernisation and expansion schemes are successfully undertaken.
Consequently the company is in a position to pay fair amount of dividend to its
shareholders regularly. It can also retain a portion of the enhanced earnings
for financing further growth requirements. This will carry forward further the
pace of development and progress of the company.
The excess of assets over capital and liabilities of company is the
surplus attained by it. This surplus is used for payment of dividends. If only a
part of this surplus is paid as dividends, the balance would be carried forward
from year to year as accumulated surplus. This in fact is the amount of retained
earnings of the company. With a fair amount of accumulated surplus or retained
earnings, a company can also absorb the shocks of business vicissitudes and
resist adverse conditions with confidence. Again, since the retained earnings
result in the company being strong and stable, it will be, in turn, in a better
position to attract investors and creditors. With this it can raise funds from
external sources conveniently at reasonable rates.
Similarly, any deficiency of depreciation, depletion and
obsolescence can be mitigated by the company when it has its own accumulated
resources. Thus, the company shall maintain its operating efficiency. In the
same way the drudgeries of debt burden can be avoided by a company when it
possesses its own retained accumulated funds for financing.
Internal financing through retained earnings results in benefits to
shareholders as well. It is a fact that in the short-run they have to forego a
portion of their dividends but their equity in the business tends to increase
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when the portion of retained earnings increases. The price of the shares
increases as there is considerable improvement in the credit standing of the
company. At this time shareholders can either wholly or partly sell their shares
and get benefited. If they want to hold shares, the proportion of their income
will increase as greater dividends will be declared with the improved prosperity
of the company. This is because the earnings of the company are expected to
improve considerably.
Furthermore, the retention of earnings offers tax saving advantages
as well to shareholders. This is because the tax liability of shareholders is
reduced to the extent income is retained by the company. The earnings are
more and more retained by closely-held companies for this purpose mainly as
the owners/shareholders are already in the very high bracket of tax payment
and with more dividend income the tax rate will shoot up still further.
15.2 MOBILIZATION OF INTERNAL FUNDS
There are a number of important factors that determine the
magnitude of internal funds raised in a company. These factors have been
identified as :
(i) Dividend Policy : This is the crucial policy of the company
management that determines the level of retained earnings vis-a-vis the
declaration of dividends. The level of retained earnings thereby will determine
the level of internal funds available to an enterprise through its ploughing back
of profits. Of course, a suitable dividend policy of a company shall be framed
by a capable financial executive, keeping in view a host of factors. These are
the investment opportunities available to the company, the preferences of
shareholders, access of the company to capital market, rate of growth of the
company, liquidity position and fund requirements of the company and control
and repayment scheme of debts of the company. All these factors help an
enterprise to declare a suitable rate of dividend payable to the shareholders.
The left over portion of the earning shall be the retained earnings available for
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internal financing.
(ii) Level of Earnings : This is the main factor that influences the magnitude
of retained earnings and the level of internal financing of an enterprise, after,
of course, all other expenditures of the business are met. The level of earnings
is in itself a function of several economic and commercial factors. The factors
may be cited as cost of production, general price level, cost of distribution,
product demand and supply, the size of business etc. Obviously, a company
either suffering losses or not earning good profits can not retain back a portion
of the same. Thus an enterprise that is run successfully and which shows
positive results shall be in a better position to plough back profits for use in
re-investment plans of the business.
( i i i ) Depreciation Policy : The level of internal financing is also greatly
affected by the allocation of funds for obsolescence and depreciation of the
company assets in pursuit of an appropriate depreciation policy. If the company
follows conservative policy there will be very little funds raised through internal
sources for replacement of assets, whereas a company following liberal
depreciation policy shall be in a comfortable position to effect replacements
and renewals necessitated by obsolescence and wear and tear.
(iv) Taxation Policy of Government : The taxation policy of the government
greatly affects the funds available for internal financing of a company. If the
corporate tax rate is high it will have adverse effects on the level of retained
earnings as the greatest chunk of the earnings will go to the exchequer. As
against this if there is a liberal tax policy followed by government whereby
rebate is provided on undistributed portion of business earnings and additional
tax is levied on dividends distributions beyond a limit, the business would be
more inclined to retain more of its earnings to meet its future expansion plans
and the programmes of modernisation.
Such a policy on the part of the government as stated above suits
a developing economy like India. The corporate sector would thereby be more
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inclined to save, retain and invest within. Therefore, the policy of the
government should be to encourage large savings and retentions. For this,
concessions should be provided to companies that retain larger portion of
earnings. Also dividend tax may be levied when dividend is distributed by a
company beyond a prescribed limit. Thus, when companies are encouraged to
retain more, there will be a boost to the industrial prosperity of the company
which is so vital for the progress and development of the country as whole.
15.3 CONCEPT AND SIGNIFICANCE OF DIVIDEND DECISIONS
The term dividend refers to that portion of profit (after tax) which
is distributed among the owners/shareholders of the company and the profit
which is not distributed is known as retained earnings. A company may have
preference share capital as well as equity share capital and dividends may be
paid on both types of capital. However, there is as such, no decision involved
as far as the dividend payable to preference shareholders is concerned. The
reason being that the preference dividend is more or less, a contractual liability
and is payable at a fixed rate. On the other hand, a firm has to consider a whole
lot of factors before deciding for the equity dividend. The expected level of
cash dividend, from the point of view of equity shareholders, is the key variable
from which the shareholders and equity investors determine the share value.
The establishment and determination of an effective dividend policy is
therefore, of significant importance to the firm's overall objective. However,
the development of such a policy is not an easy job. A whole gamut of
considerations affecting the dividend decision is thee. The dividend decision
may seem to be simple enough, but it evokes a surprising amount of controversy.
The dividend decision is one of the three basis decisions which a
financial manager is required to take, the other two being the investment
decisions and the financing decisions. In each period any earning that remains
after satisfying obligations to the creditors, the Government, and the preference
shareholders can either be retained, or paid out as dividends or bifurcated

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between retained earnings and dividends. The retained earnings can then be
invested in assets which will help the firm to increase or at least maintain its
present rate of growth. The dividend decision requires a financial manager to
decide about the distribution of profits as dividends. It may be noted that the
profits may be distributed either in the form of cash dividends to shareholders
or in the form of stock dividends (also known as bonus shares).
In dividend decision, a financial manger is concerned to decide
one or more of the followings :
(i) Should the profits be ploughed back to finance the investment decisions?
(ii) Whether any dividend be paid?
(iii) How much dividends be paid?
(iv) When these dividends be paid?
(v) In what form the dividends be paid?
All these decisions are inter-related and have bearing on the future
growth plans of the company. If a company pays dividends, it affects the cash
flow position of the firm but earns a goodwill among the investors who
therefore, may be willing to provide additional funds for the financing of
investment plans of the firm. On the other hand, the profits which are not
distributed as dividends become an easily available source of funds at no explicit
costs. However, in the case of ploughing back of profits, the firm may loose
the goodwill and confidence of the investors and may also defy the standards
set by other firms. Therefore, in taking the dividend decision, the financial
manage has to consider and analyze various factors. Every aspects of dividend
decision is to be critically evaluated. The most important of these
considerations is to decide as to what portion of profit should be distributed.
This is also known as the dividend payout ratio.
While deciding the dividend payout ratio the firm should consider
the effect of such policy on the objective of maximization of shareholder's
wealth. If payment of dividend is expected to increase the market value of the
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share (i.e. increase in the wealth of the shareholders) the dividend must be
paid, otherwise, the profits may be retained and used as an internal source of
finance. So, the firm must find out and establish a relationship between the
dividend policy and the market value of the share.
15.4 DETERMINANTS OF DIVIDEND POLICY
The payment of dividend involves financial as well as legal
considerations. It is difficult to determine a general dividend policy which can
be followed by different firms at different times because the dividend decision
has to be taken considering the special circumstances of an individual case.
The factors which determine the dividend policy are as follow :
1. Dividend Payout (D/P) Ratio
A major aspect of the dividend policy of a firm is its dividend
payout (D/P) ratio, that is, the percentage share of the net earnings distributed
to the shareholders as dividends.
Dividend policy involves the decision to pay out earnings or to
retain them for reinvestment in the firm. The retained earnings constitute a
source of financing. The payment of dividends results in the reduction of cash
and, therefore, is a depletion of total assets. In order to maintain the asset
level, as well as to finance investment opportunities, the firm must obtain funds
from the issue of additional equity or debt. If the firm is unable to raise external
funds, its growth would be affected. Thus, dividends imply outflow of cash and
lower future growth. In other words, the dividend policy of the firm affects
both the shareholders' wealth and the long-term growth of the firm. The
optimum dividend policy should strike the balance between current dividends
and future growth which maximises the price of the firm's shares. The D/P
ratio of a firm should be determined with reference to two basic objectives –
maximising the wealth of the firm's owners and providing sufficient funds to
finance growth. The objectives are not mutually exclusive, but interrelated.
Given the objective of wealth maximising, the firm's dividend
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policy (D/P ratio) should be one which can optimise the wealth of its owners
in the 'long run'. In theory, it can be expected that the shareholders take into
account the long-run effects of D/P ratio, that is, if the firm is paying low
dividends and having high retentions, they recognise the element of growth in
the level of future earnings of the firm. However, in practice, they have a clear
cut preference for dividends because of uncertainty and imperfect capital
markets. The payment of dividends can, therefore, be expected to affect the
price of shares : a low D/P ratio may cause a decline in share prices, while a
high ratio may lead to a rise in the market price of the shares.
Making a sufficient provision for financing growth can be
considered a secondary objective of dividend policy. Without adequate funds
to implement acceptable projects, the objective of wealth maximising cannot
be achieved. The firm must forecast its future needs for funds, and taking into
account the external availability of funds and certain market considerations,
determine both the amount of retained earnings needed and the amount of
retained earnings available after the minimum dividends have been paid. Thus,
dividend payments should not be viewed as a residual, but rather a required
outlay after which any remaining funds can be reinvested in the firm.
2. General State of Economy : As a whole, it affects the decision of the
management to a great extent whether the dividend should be retained or the
same should be distributed amongst the shareholders. In the following cases,
the business may prefer to retain the whole or part of the earnings in order to
build up reserves:
(a) where there is uncertain economic and business conditions;
(b) if there is a period of depression (management may withhold the payment
of dividends for maintaining the liquidity position of the firm.) ;
(c) if there is a period of prosperity (since there is large profitable
investment opportunities) ; and
(d) where there is a period of inflation.
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3. Capital Market Considerations : This also affects the dividend policy
to the extent to which the firm has access to the capital market. In other words,
if easy access to the capital market is possible whether due to financially strong
or, big in size, the firm in that case, may adopt a liberal dividend policy. In the
opposite case, i.e., if easy access to capital market is not possible, it must
have to adopt a low dividend pay out ratio, i.e., they have to follow a conservative
dividend policy. As such, they must have to rely more on their own funds, viz.,
retained earnings.
4. Legal, Contractual, Internal Constraints and Restrictions : The
dividend decision is also affected by certain legal, contractual, and internal
requirements and constraints. The legal factors stem from certain statutory
requirements, the contractual restrictions arise from certain loan covenants
and the internal constraints are the result of the firm's liquidity position.
(a) Legal Requirements
Legal stipulations do not require a dividend declaration but they
specify the condition under which dividends must be paid. Such conditions
pertain to (i) capital impairment, (ii) net profits and (iii) insolvency.
(i) Capital Impairment Rules
Legal enactment limit the amount of cash dividends that a firm
may pay. A firm cannot pay dividends out of its paid-up capital, otherwise there
would be a reduction in the capital adversely affecting the security of its lenders.
The rationale of this rule lies in protecting the claims of preference
shareholders and creditors on the firm's assets by providing a sufficient equity
base since the creditors have originally relied upon such an equity base while
extending credit. Any dividends that impair capital are illegal and the directors
are personally held liable for the amount of illegal dividend. Therefore, the
financial manager should keep in mind that payment of dividend is in order and
does not violate capital impairment rules.

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(ii) Net Profits
The net profits requirement is essentially a corollary of the capital
impairment requirement, in that it restricts the dividend to be paid out of the
firm's current profits plus past accumulated retained earnings. Alternatively, a
firm cannot pay cash dividends greater than the amount of current profits plus
the accumulated balance of retained earnings. For instance, section 205 of the
Indian Companies Act provides that dividends shall be paid only out of the
current profits or past profits after providing for depreciation. The point to be
recognised is that the company can count on the profits of previous years, if
the current years' profits fall short of the required funds for maintaining a
desired stable dividend policy. Likewise, if there are past accumulated losses,
they should be first set off against current earnings before the payment of
dividend.
( i i i ) Insolvency
A firm is said to be insolvent in two situations : First, when its
liabilities exceed the assets; and second, when it is unable to pay its bills. If
the firm is currently insolvent in either sense, it is prohibited from paying
dividends. Similarly, a firm would not pay dividends if such a payment leads to
insolvency of either type. The rationale of the rule is to protect the creditors
by prohibiting the liquidation of near bankrupt firms through cash dividend
payments to the equity owners.
(b) Contractual Requirements
Important restrictions on the payment of dividend may be accepted
by a company when obtaining external capital either by a loan agreement, a
debenture indenture, a preference share agreement, or a lease contract. Such
restrictions may cause the firm to restrict the payment of cash dividends until
a certain level of earnings has been achieved or limit the amount of dividends
paid to a certain amount or percentage of earnings. Since the payment of
dividend involves a cash outflow, firms are forced to reinvest the retained
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earnings within the firm. The restriction on dividends may take three forms. In
the first place, firms may be prohibited from paying dividends in excess of a
certain percentage, say, 12 per cent. Alternatively, a ceiling in terms of the
maximum amount of profits that may be used for dividend payment may be laid
down, say not more than 60 per cent of the net profits, or a given absolute
amount of such profits can be paid as dividends. Finally, dividends may be
restricted by insisting upon a minimum of earnings to be retained. Reinvestment
leads to a lower debt/equity ratio and, thus, enhances the margin of cushion
(safety) for the lenders.
Therefore, contractual constraints on dividend payments are quite
common. The payment of cash dividend in violation of a restriction would
amount to default in the case of a loan and the entire principal would become
due and payable. Keeping in view the severity of penalty, the financial manager
must ensure that the amount of dividend is within the covenants already
committed to lenders.
(c) Internal Constraints
Such factors are unique to a firm and include (i) liquid assets, (ii)
growth prospects, (iii) financial requirements, (iv) availability of funds, (v)
earnings stability and (vi) control.
(i) Liquid Assets
Once the payment of dividend is permissible on legal and
contractual grounds, the next step is to ascertain whether the firm has sufficient
cash funds to pay cash dividends. It may well be possible that the firm's earnings
are substantial, but the firm may be short of funds. This situation is common
for (a) growing companies; (b) companies which have to retire past loans as
their maturity year has come; and (c) companies whose preference shares are
to be redeemed. Such companies may not like to borrow at exorbitant rates
because of the increased financial risk especially if their existing leverage
ratio is already very high. Moreover, lenders may be reluctant to lend money
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for dividend payments since they produce no tangible or operating benefits
that will help the firm to repay the loan. Thus, the firm's ability to pay cash
dividends is largely restricted by the level of its liquid assets. On the other
hand, if excess cash is available, the firm can have a more liberal dividend
policy.
(ii) Growth Prospects
Another set of factors that can influence dividend policy relates
to the firm's growth prospects. The firm is required to make plans for financing
its expansion programmes. In this context, the availability of external funds
and its associated cost together with the need for investment funds would have
a significant bearing on the firm's dividend policy.
( i i i ) Financial Requirements : Financial requirements of a firm are directly
related to its investment needs. The firm should formulate its dividends policy
on the basis of its foreseeable investment needs. If a firm has abundant
investment opportunities, it should prefer a low payout ratio, as it can usually
reinvest earnings at a higher rate than the shareholders can. Such firms,
designated as 'growth' companies, are constantly in need of funds. Their
financial requirements may be characterized as large and immediate. That
retention of earnings is less costly than selling a new issue of equity needs no
reiteration. Moreover, retention of earnings provides the base upon which the
firm can borrow additional funds. Therefore, it provides flexibility in the
company's capital structure, that is, it make room for unused debt capacity.
The importance of creation of debt raising potential for a growing firm is
overwhelming.
On the other hand, if the firm has little or no growth opportunities,
it will probably prefer low retention and relatively high dividend payouts. This
is so for two vital reasons. First, the shareholders can reinvest earnings at a
higher rate than the firm can do, and, secondly, such firms may need funds
largely to replace or modernise assets. In many instances, these outlays may
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not be required immediately but after two or three years. Therefore, the need
for funds is small and periodic vis-a-vis large and fast growing companies. The
nature of the firm's needs, therefore, is an important factor in determining the
destination of the firm's fund-retention or distribution.
(iv) Availability of Funds
The dividend policy is also constrained by the availability of funds
and the need for additional investment. In evaluating its financial position, the
firm should consider not only its ability to raise funds but also the cost involved
in it and the promptness with which financing can be obtained. In general, large,
mature firms have greater access to new sources for raising funds than firms
which are growing rapidly. For this reason alone, the availability of external
funds to the growing firms may not be sufficient to finance a large number of
acceptable investment projects. Obviously, such firms have to depend on their
retained earnings so as to amount of maximum number of available profitable
projects. Therefore, large retentions are necessary for such firms.
(v) Earnings Stability
The stability of earnings also has a significant bearing on the
dividend decision of a firm. Generally, the more stable the income stream, the
higher is the dividend payout ratio. Public utility companies are classic
examples of firms that have relatively stable earnings pattern and high dividend
payout ratio. Growing firms, characterised by stable earnings, can muster debt
funds at a relatively lower cost because of a smaller total risk (business and
financial). This is unlike the experience of other firms which, though growing,
suffer form fluctuating earnings.
However, the financial manager should remember that dividends
have information value. Withholding the payment of dividends will raise the
required rate of return of the investors and, therefore, depress the market price
of the shares. The increase in earnings should be such that it can offset the
unfavourable effect of the increased cost of equity (k e).
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(vi) Control
Dividend policy may also be strongly influenced by the
shareholders' or the management's control objectives. That is to say, sometimes
management employs dividend policy as an effective instrument to maintain
its position of command and control. The management, in order to retain control
of the company in its own hands, may be reluctant to pay substantial dividends
and would prefer a smaller dividend payout ratio. This will particularly hold
good for companies which require funds to finance profitable investment
opportunities when an outside group is seeking to gain control of the firm.
Added to this, if a controlling group of shareholders either cannot or does not
wish to purchase new shares of equity, under such circumstances, by the issue
of additional shares to finance investment opportunities, management may lose
its existing control. Conversely, if management is securely in control, either
through substantial holdings or because the shares are widely held, and the
firm has a good image, it can afford to have a high dividend payout ratio. If it
requires funds later, the firm can easily raise additional funds owing to its
reputation.
5. Owner's Considerations
The dividend policy is also likely to be affected by the owner's
considerations of (a) the tax status of the shareholders, (b) their opportunities
of investment, and (c) the dilution of ownership. It is well-nigh impossible to
establish a policy that will maximise each owner's wealth. The firm must aim
at a dividend policy which has a beneficial effect on the wealth of the majority
of the shareholders.
(a) Taxes Status
The dividend policy of a firm may be dictated by the income tax
status of its shareholders. If a firm has a large percentage of owners who are in
high tax brackets, its dividend policy should seek to have higher retentions.
Such a policy will provide its owners with income in the form of capital gains
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as against dividends. Since capital gains are taxed at a lower rate than dividends,
they are worth more, after taxes, to the individuals in a high tax bracket. On the
other hand, if a firm has a majority of low income shareholders who are in a
lower tax bracket, they would probably favour a higher payout of earnings
because of the need for current income and the greater certainty associated
with receiving the dividend now, instead of the less certain prospects of capital
gains later.
(b) Opportunities of Investment
The firm should not retain funds if the rate of return earned by it
would be less than one which could have been earned by the investors themselves
from external investments of funds. Such a policy would obviously be
detrimental to the interests of shareholders. It is difficult to ascertain the
alternative investment opportunities of each of its shareholders and, therefore,
the alternative investment opportunity rate. However, the firm should evaluate
the rate of return obtainable from external investments in firms belonging to
the same risk class. If evaluation shows that the owners have better opportunities
out side, the firm should opt for a higher dividend payout ratio. On the other
hand, if the firm's investment opportunities yield a higher rate than that obtained
from similar external investment, a low dividend payout is suggested. Therefore,
in formulating dividend policy, the evaluation of the external investment
opportunities of owners is very significant.
(c) Dilution of Ownership
The financial manager should recognize that a high dividend payout
ratio may result in the dilution of both control and earnings for the existing
equity holders. Dilution in earnings results because low retentions may
necessitate the issue of new equity shares in the future, causing an increase in
the number of equity shares outstanding and ultimately lowering earnings per
share and their price in the market. By retaining a high percentage of its
earnings, the firm can minimize the possibility of dilution of earnings.
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6. Inflation
It may also affect the dividend policy of a firm. With rising prices,
funds which are generated by way of depreciation may fall short in order to
replace obsolete equipment. The shortfall may be made from retained earnings
(as a source of funds). This is very significant when the assets are to be replaced
in the near future. As such, the dividend payout ratio tends to be low during the
periods of inflation.
7. Stability of Dividends
Stability of dividends is another guiding principle in the
formulation of a dividend policy. Stability of dividend policy refers to the
payment of dividend regularly and shareholders, generally, prefer payment of
such regular dividends. The dividend policy, of course, should have a degree of
stability, i.e., earnings/profits may fluctuate from year to year but not the
dividend since the equity shareholders prefer to value stable dividends than
the fluctuating ones. In other words, the investors favour a stable dividend in
as much as they do the payment of dividend.
The stability of dividends can be in any of the following three
forms:
(a) Constant Dividend Per Share ;
(b) Constant Percentage of Net Earnings (constant dividend payout ratio); and
(c) Constant Dividend Per Share plus Extra Dividend.
(a) Constant Dividend Per Share : Under this form, a firm pays a certain
fixed amount per share by way of dividend. For example, a firm may pay a
fixed amount of, say, Rs. 5 as dividend per share having a face value of Rs. 50.
The fixed amount would be paid regularly year after year irrespective of the
actual earnings, i.e., the firm will pay dividend even if there is a loss. In short,
fluctuation in earnings will not affect the payment of dividend. It does not
necessarily mean that the amount of dividend will remain fixed for all times in
future. When the earnings of the company will increase the rate of dividend
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will also increase provided the new level can be maintained in future. If there
is a temporary increase in earnings, there will not be any change in the payment
of dividends. The relationship between the EPS (Earning per share) and DPS
(Dividend per share) can better be represented with the help of the following
diagram :
DPS and EPS (Rs.)

EPS

DPS

Time (years)
Fig. 1 : Showing stable dividend policy per Share
From the above, it becomes clear that earnings per share many
fluctuate from year to year but the dividend per share is constant. In order to
formulate this policy, a firm whose earnings are not stable may have to make
provisions to those years when there is higher earnings. i.e., a Dividend
Equalization Reserve' fund may be created for the purpose.
(b) Constant Percentage of Net Earnings : According to this policy, a
certain percentage of the net earnings/profits is paid by way of dividend to
shareholders year after year, i.e., when a constant pay out ratio is followed by
a firm. In other words, it implies that the percentage of earnings paid out each
year is fixed and as such, dividends would fluctuate proportionately with
earnings. This is particularly very useful in cases where there is wide
fluctuations in the earnings of a firm. This policy suggests that when the
earnings of a firm decline, the dividend would naturally be low. For instance,

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if a firm adopts a 40% dividend payout ratio and earns Rs. 5 per share then it
will pay Rs. 2 to the shareholder by way of dividend.
The relationship under this policy between the EPS an DPS is
presented below with the help of a diagram that shows.

DPS and EPS (Rs.)

EPS

DPS

Time (years)
Fig. 2: Showing stable dividend policy under constant payout ratio
(c) Constant Dividend Per Share Plus Extra Dividend : Under this policy,
a firm usually pays a fixed dividend per share to the shareholders. At the time
of market prosperity, additional or extra dividend is paid over and above the
regular dividend. This extra dividend is waived as soon as the normal conditions
return.
Now, the questions that arise us are which policy is the most
appropriate one and what is their relative suitability or which one is most
favourable to the investors or what are the implications to the shareholders.
The most appropriate policy may be considered as the first one,
viz., Constant Dividend Per Share. Because, most of the investors desire a fixed
rate of return from their investment which will gradually increase over a period
of time. This is satisfied by the said policy. But in case of constant percentage
of net earnings the return actually fluctuates with the amount of earnings and
it also involves uncertainties and that is why it is not preferred by the
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shareholders although the same is favoured by the management since it
correlates the amount of dividends to the ability of the company to pay its
dividend. At the same time, in case of constant dividend per share plus extra
dividend, there is always an uncertainty about the extra dividend and as a result
it is not generally preferred by the shareholders.
A stable dividend policy is advantageous due to the following :
(i) Desire for Current Income : There are investors like, old and retired
persons, widows etc., who desire to have a stable income in order to meet
their current living expenses since such expenses are almost fixed in nature.
Such a stable dividend policy will help them.
(ii) Resolution of Investors' Uncertainty : If a firm adopts a stable dividend
policy, it must have to declare and pay dividend even if the earnings are
temporarily reduced. It actually conveys to the investors that the future is
bright. On the contrary, if it follows a policy of changing dividend with cyclical
changes in the rate of earnings, the investors will not be confined about their
return which may induce them to require a higher discount factor. The same is
not desired in case of a stable dividend policy.
( i i i ) Raising additional finance : If stable dividend policy is adopted by a
firm, raising additional funds from external sources become advantageous on
the part of the company since it will make the shares of a firm an investment.
The shareholders/investors will hold the shares for a long time as it will create
some confidence in the company and as such, for further issue of shares, they
would be more receptive to the offer by the company. This dividend policy
also helps the company to sale preference shares and debentures. Because,
past trend regarding the payment of dividend informs them that the company
has been regularly paying the dividends and their interest/dividend naturally
will be paid by the company when it will mature for repayment together with
the principal.
(iv) Requirement of Institutional Investors : Sometimes the shares of a
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company are purchased by financial institutions, like, IFC, IDB, LIC, UTI etc.,
educational and social institutions in addition to the individuals. These financial
institutions are the largest purchasers of shares in corporate securities in our
country and every firm is intended to sell their shares to these institutions.
These financial institutions are interested to buy the shares of those companies
who have a stable dividend policy.
Danger of Stability of Dividends
Once this policy is being adopted by a firm it cannot be changed
with an immediate affect which will adversely affect the investors' attitude
towards the financial stability of the company. Because, if a company, with
stable dividend policy, fails to pay the dividend in any year, there will be a
severe effect on the investors than the failure to pay dividend under unstable
dividend policy. That is why, in order to maintain that rate, sometimes the
directors pay dividend, even if there is insufficient earning, i.e., declaring
dividend out of capital which ultimately invites the liquidation of a firm.
From the foregoing discussions it becomes clear that the rate of
dividend should be fixed at a conservative figure which is possible to pay even
in a lean period for several years. Extra dividend can be declared out of extra
earnings which, in other words, will not create any adverse effect in future.
15.5 FORMS OF DIVIDEND
Dividends can be distributed by a company in various forms. These
forms are cash dividends, stock dividends, scrip dividends and bond dividends.
These forms of dividends are briefly explained as under :
(i) Cash Dividends : It is the common practice to pay dividends in cash.
These dividends are paid when profits are earned by an enterprise. In the event
of a company following a policy of stable dividends, it has to pay the same
even though the profits of the enterprise are small. If this is so the company
may even have to borrow to meet the fund requirement for dividend payment.
The payment of cash dividend results in the reduction of reserves
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of the company. Consequently both the net worth and the assets of the company
get reduced. Such a reduction may be the cause of reduction of the share prices
of the enterprise. At the same time cash dividends are desirable especially in
case of those shareholders who supplement their income with the dividend
receipts.
(ii) Stock Dividend : Such dividend payment in India is know as bonus
shares. This is an alternative form of dividend payment. In this case the current
shareholders get their share of dividends by way of share distribution. Such a
distribution may be either in lieu of cash dividend or it may be in addition to
the cash dividend.
Stock dividends are distributed in the proportion of shareholding
with the result there is no change in the ownership proportion of the
shareholders. The payment by way of stock dividends does not change the net
worth of the company.
With the help of distribution of dividend through stock dividend
method, the company is in a position to conserve its cash. There are two conflict
ends that are met by stock dividends. Firstly, the retention of earnings and
secondly the payment of dividends. With single action of stock dividends both
the two conflicting ends of an enterprise are satisfied. A company can declare
stock dividends even when it is put in a stringent financial position. Again,
such a dividend arrangement helps when the creditors put restriction on cash
dividend payment. Thus, the stock dividends are beneficial on this account as
well.
The stock dividends do not affect the wealth of shareholders and
so they are beneficial to them as well. With this the shareholders are exempt
from the payment of tax as otherwise they would be subject to if dividends
were paid in cash. In the event of their selling of the stock dividends, they
would be subject to capital gains tax which is charged comparatively at a lower
rate as against rate applicable to cash dividends. In addition, when the company
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pays cash dividend in future, the shareholders shall receive higher dividend as
they are holding increased number of shares now. This will be so when there is
constancy in earnings per share of the company. From creditors point of view
also, the stock dividends are preferable. With stock dividends the creditors
realise that the liquidity position of the company becomes strong and with this
their interests are more protected.
On the other hand, payment of dividends through proportionate
stock issues increases administrative costs. Also the earnings per share tend
to drop, if there is no proportionate increase in the earnings. This is turn affects
adversely the credit worthiness of the company. As such, while formulating a
policy regarding stock dividend payment, these factors need thorough
consideration on the part of the management of the company.
( i i i ) Scrip Dividend : This is another form of dividend whereby the dividend
is paid by a company in the shape of a scrip or a promissory note. The document
bears a maturity date and when it reaches this date the stated payment is made
in cash. However, there are instances wherein no maturity date is given on the
promissory note. The payment in that case is made as per the direction of the
Board of Directors. The amount of scrip dividend carries interest, though in
most of the cases it is interest-free. This form of dividend payment is resorted
by a company when despite high earnings it faces a temporarily tight financial
position. With scrip dividend the company maintains an established record of
dividend payments, of course not making any cash payment, though for a short
period. Scrip dividend form is not in practice in India.
(iv) Bond Dividend : This form of dividend payment also is not popular in
India. This is just like a scrip dividend wherein bonds are issued by a company
when despite sufficient earnings the financial position of the company is tight.
The bonds are issued in lieu of dividend payments. But, as against scrip dividends
bonds carry a long maturity period. With bond dividends issued, the shareholders
have a stronger claim against the enterprise. Alongwith this the company has
another liability of interest payment. Therefore, before deciding about the
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payment of dividends through issue of bonds, the company is advised to weigh
properly the benefits of each conservation against the cost involved by way of
interest liability of the bonds desired to the issued in lieu of dividends.
15.6 LEGAL AND PROCEDURAL OF DIVIDEND
Legal Aspects
The amount of dividend that can be legally distributed is governed
by company law, judicial pronouncements in leading cases, and contractual
restrictions. The important provisions of company law pertaining to dividends
are described below :
1. Companies can pay only cash dividends (with the exception of bonus
shares).
2. Dividends can be paid only out of the profits earned during the financial
year after providing for depreciation and after transferring to reserves
such percentage of profits as prescribed by law. The companies (Transfer
to Reserve) Rules, 1975, provide that before dividend declaration, a
percentage of profit as specified below should be transferred to the
reserves of the company :
(a) Where the dividend proposed exceeds 10 per cent but not 12.5
per cent of the paid-up capital, the amount to be transferred to
the reserve should not be less than 2.5 per cent of the current
profits.
(b) Where the dividend proposed exceeds 12.5 per cent but not 15
per cent, the amount to be transferred to reserves should not be
less than 5 per cent of the current profits.
(c) Where the dividend proposed exceeds 15 per cent but not 20 per
cent, the amount to be transferred to reserves should not be less
than 7.5 per cent of the current profits.
(d) Where the dividend proposed exceeds 20 per cent, the amount to
be transferred to reserve should not be less 10 per cent.
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3. Due to inadequacy or absence of profits in any year, dividend may be
paid out of the accumulated profits of previous years. In this context,
the following conditions, as stipulated by the Companies (Declaration
of Dividend out of Reserves) Rules, 1975 have to be satisfied :
(a) The rate of the declared dividend should not exceed the average of the
rates at which dividend was declared by the company in 5 years
immediately preceding that year or 10 per cent of its paid-up capital,
whichever is less.
(b) The total amount to be drawn from the accumulated profits earned in
previous years and transferred to the reserves should not exceed an
amount equal to one-tenth of the sum of its paid-up capital and free
reserves and the amount so drawn should first be utilised to set off the
losses incurred in the financial year before any dividend in respect of
preference or equity shares is declared.
(c) The balance of reserves after such drawal should not fall below 15 per
cent of its paid-up capital
4. Dividends cannot be declared for past years for which accounts have
been closed.
Procedural Aspects
The important events and dates in the dividend payment procedure are :
1. Board resolution : The dividend decision is the prerogative of the board
of directors. Hence, the board of directors should in a formal meeting
resolve to pay the dividend.
2. Shareholders approval : The resolution of the board of directors to pay
the dividend has to be approved by the shareholders in the annual general
meeting.
3. Record date : The dividend is payable to shareholders whose names
appear in the register of members as on the record date.
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4. Dividend payment : Once a dividend declaration has been made, dividend
warrant must be posted within 42 days. Within a period of 7 days, after
the expiry of 42 days, unpaid dividends must be transferred to a special
account opened with a scheduled bank.
SUMMARY
A dividend decision of the firm is another crucial area of financial
management. The important aspect of dividend policy is to determine the
amount of earnings to distributed to shareholders and the amount to be retained
by the firm. Retained earnings are the most significant internal sources of
financing the growth of the firm. On the other hand dividends may be considered
desirable from shareholders' point of view as they tend to increase their return.
Dividends, however, constitute the use of the firm's funds. The determinants
of the dividend policy of a firm are dividend payout ratio, stability of dividends,
capital market considerations, general state of economy, legal, contractual and
internal constraints and restrictions, owners' considerations, capital market
considerations and inflation.
A stable dividend policy refers to the consistency or lack of
variability in the stream of dividends, that is, a certain minimum amount of dividend
is paid out regularly. Of the three forms of stability of dividend, namely, constant
dividend per share, constant percentage of net earnings and constant dividend per
share plus extra dividend, the first one is the most appropriate. The investors prefer
a stable dividend policy for a number of reasons, such as, desire for current income,
information contents, institutional requirement, and so on.
The legal restrictions on payment of dividends stipulate conditions
pertaining to capital impairment, net profits, insolvency and illegal
accumulation of excess profits. The contractual restrictions on payment of
dividends are imposed by loan agreements. The internal constraints impinging
on the dividend restrictions relate to growth prospects, availability of funds,
earnings stability and control. The dividend policy is also likely to be affected
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by the owners' consideration of (a) tax status of the shareholders, (b) their
opportunities for investment and (c) dilution of ownership.
15.8 SELF ASSESSMENT QUESTIONS
1. What is meant by internal financing? Discuss the factors determining
the magnitude of internal funds.
2. Explain the various factors which influence the dividend decision of a
firm.
3. "A firm should follow a policy of very high dividend pay-out". Do you
agree? Why or why not?
4. What do you understand by a stable dividend policy? Why should it be
followed?
5. Discuss the various forms of dividends.
15.9 FURTHER READINGS
1. Financial Decision Making by John J. Hampton
2. Corporation Finance by S.C. Kuchhal
3. Financial Management by S.N. Maheshwari
4. Financial Management by Ravi M. Kishore

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 LESSON – 16

APPROACHES TO DIVIDEND DECISION

Objective : This lesson will make you familiar with the models explaining
the relevance or irrelevance of the dividend policy.
Structure
16.1 Introduction
16.2 Relevance of Dividend Policy
16.3 Irrelevance of Dividend Policy
16.4 Summary
16.5 Self Assessment Questions
16.6 Further Readings
16.1 INTRODUCTION
Dividend policy is primarily concerned with deciding whether to
pay dividend in cash now, or to pay increased dividends at a later stage or
distribution of profits in the form of bonus shares. The current dividend
provides liquidity to the investors but the bonus share will bring capital gains
to the shareholders. The investor's preferences between the current cash
dividend and the future capital gain have been viewed differently. Some are of
the opinion that the future capital gain are more risky than the current dividends
while others argue that the investors are indifferent between the current
dividend and the future capital gains.
The basic question to be resolved while framing the dividend policy
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may be stated simply : What is sound rationale for dividend payments? In the
light of the objective of maximizing the value of the share, the question may
be restated as follows : Given the firms investments and financing decisions,
what is the effect of the firm's dividend policies on the share price? Does a
high dividend payment decrease, increase or does not affect at all the share
price. However, the dividend policy has been a controversial issue among the
financial managers and is often refer to as a dividend puzzle.
Various models have been proposed to evaluate the dividend policy
decision in relation to value of firm. While agreement is not found among the
models as to the precise relationship, it is still worth while to examine some
of these models to gain insight into the effect which the dividend policy might
have on the market price of the share and hence on the wealth of the
shareholders. Two schools of thoughts have emerged on the relationship
between the dividend policy and value of the firm.
One school associated with Walter, Gordon etc. holds that the
future capital gains (expected to result from lower current dividend payout)
are more risky and the investors have preference for current dividends. The
investors do have a tilt towards those firms which pay regular dividend. So, the
dividend payment affects the market value of the share and as a result the
dividend policy is relevant for the overall value of the firm. On the other hand,
the other school of thought associated with Modigliani and Miller holds that
the investors are basically indifferent between current cash dividends and future
capital gains. Both these schools of thought on the relationship between
dividend policy and value of the firm have been discussed as follows :
1. Relevance of Dividend Policy
2. Irrelevance of Dividend Policy
16.2 RELEVANCE OF DIVIDEND POLICY
Generally, the firm pay dividends and view such dividend payments
positively. The investors also expect and like to receive dividend income on
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their investments. The firms not paying dividends may be adversely rated by
the investors affecting the market value of the share. The basic argument of
those supporting the dividend relevance is that because current cash dividends
reduce investors uncertainty, the investors will discount the firm's earnings at
a lower rate, k e , thereby placing a higher value on the share. If dividends are
not paid then the uncertainty of shareholders/investors will increase, raising
the required rate of return, k e, resulting in relatively lower market price of the
share. So, it may be argued that the dividend policy has an effect on the market
value of the share and the value of the firm. The market price of the share will
increase if the firm pays dividends, otherwise it may decrease. A firm therefore,
must pay a dividend to shareholders to fulfill the expectations of the
shareholders in order to maintain or increase the market price of the share.
Two models representing this argument may be discussed here :
1 Walter Model
The dividend policy given by James E Walter considers that
dividends are relevant and they do affect the share price. In this model he studied
the relationship between the internal rate of return (r) and the cost of capital
of the firm (k), to give a dividend policy that maximizes the shareholders'
wealth.
The model studies the relevance of the dividend policy in three
situations : (i) r > k e (ii) r < k e (iii) r = k e. According to the Walter Model,
when the return on investment (r) is more than the cost of equity capital (ke ),
the earnings can be retained by the firm since it has better and more profitable
investment opportunities than the investors. It implies that the returns the
investor gets when the company re-invests the earnings will be greater than
what they earn by investing the dividend income. Firms which have their r > k e
are the growth firms and the dividend policy that suits such firms is the one
which has a zero pay-out ratio. This policy will enhance the value of the firm.
In the second case the return on investment is less than the cost
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of equity capital and in such situation the investor will have a better investment
opportunity than the firm. This suggests a dividend policy of 100% pay-out.
This policy of a full pay-out ratio will maximise the value of the firm.
Finally, when the firm has rate of return that is equal to the cost
of equity capital, the firms' dividend policy will not affect the value of the
firm. The optimum dividend policy for such normal firms will range between
zero to a 100% pay-out ratio, since the value of the firm will remain constant
in all cases.
In nutshell, a firm can maximize the market value of its share and
the value of the firm by adopting a dividend policy as follows :
(i) If r > k e, the payout ratio should be zero (i.e., retention of 100% profit).
(ii) If r < k e , the payout ratio should be 100% and the firm should not retain
any profit, and
(iii) If r = ke , the dividend is irrelevant and the dividend policy is not expected
to affect the market value of the share.
Assumptions : The relevance of the dividend policy as explained by the
Walter's Model is based on a few assumptions, which are as follows :
(i) Retained earnings is the only source of finance available to the firm,
with no outside debt or additional equity used.
(ii) r and k are assumed to be constant and thus additional investments made
by the firm will not change its risk and return profiles.
(iii) Firm has an infinite life.
(iv) For a given value of the firm, the dividend per share and the earnings per
share remain constant.
In order to testify, Walter has suggested a mathematical valuation
model i.e.
D (r/k e) (E-D)
P= +
ke ke

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Where
P = Market price of Equity share
D = Dividend per share paid by the Firm
r = Rate of return on Investment of the Firm
ke = Cost of Equity share capital, and
E = Earnings per share of the firm
As per the above formula, the market price of a share is the sum of two
components i.e.,
(i) The present value of an infinite stream of dividends, and
(ii) The present value of an infinite stream of return from retained earnings.
Thus, the Walter's formula shows that the market value of a share
is the present value of the expected stream of dividends and capital gains. The
effect of varying payout ratio on the market price of the share under different
rate of returns, r, have been shown in Example
Example 1 : Given the following information about ABC Ltd., show the effect
of the dividend policy on the market price of its shares, using the Walter's
model :
Equity capitalization rate (k e) = 12%
Earnings per share (E) = Rs. 8
Assumed return on investments (r) as follows :
(i) r = 15%
(ii) r = 10%
(iii) r = 12%
Solution :
To show the effect of the different dividend policies on the share value of the
firm for the three levels of r let us consider the dividend pay-out (D/P) ratios
of zero, 25%, 50%, 75% and 100%.

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(i) r > k e ( r= 15%, k e = 12%)
a. D/P ratio = 0 ; dividend per share = zero
0 + (0.15/0.12) (8-0)
P =
0.12
= Rs. 83
b. D/P ratio = 25%; dividend per share : Rs. 2.00

P = 2.0 + (0.15/0.12) (8-2)

0.12
= Rs. 79

c. D/P ratio = 50%; dividend per share = Rs. 4

4.0 + (0.15/0.12) (8-4)
P =
0.12
= Rs. 75
d. D/P ratio = 75%; dividend per share = Rs. 6
6 + (0.15/0.12) (8-6)
P =
0.12
= Rs. 71

e. D/P ratio = 100%; dividend per share = Rs. 8

8.0 + (0.15/0.12) (8-8)
P =
0.12
= Rs. 67
Interpretation : From the above calculations it can be observed that when the
return on investment is greater than the cost of capital, there is an inverse
relation between the value of the share and the pay-out ratio. Thus, the value of
ABC Ltd. is the highest when the D/P ratio is zero (P=Rs.83) and this goes on
declining as the D/P ratio increases. Hence the optimum dividend policy for a
growth firm is a zero dividend pay-out ratio.
(ii) r < k e (r=10%, k e = 12%)
a. D/P ratio = 0 ; dividend per share = zero

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 0 + (0.10/0.12) (8-0)
P =
0.12
= Rs. 56

b. D/P ratio = 25%; dividend per share : Rs. 2

2.0 + (0.10/0.12) (8-2)
P =
0.12
= Rs. 58
c. D/P ratio = 50%; dividend per share = Rs. 4
4.0 + (0.10/0.12) (8-4)
P =
0.12
= Rs. 61
d. D/P ratio = 75%; dividend per share = Rs. 6
6 + (0.10/0.12) (8-6)
P =
0.12
= Rs. 64
e. D/P ratio = 100%; dividend per share = Rs. 8

P = 8.0 + (0.10/0.12) (8-8)

0.12
= Rs. 67

Interpretation : When the return on investment is less than the cost of equity
capital, the calculations reveal that the firm's value will enhance as the D/P
ratio increase. Due to this positive correlation between the share price and the
dividend pay-out ratio, firms which have their return on investment less than
the cost of equity capital should prefer a higher dividend pay-out ratio in order
to maximize the share value.
(iii) r = k e (r=12%, k e = 12%)
a. D/P ratio = 0 ; dividend per share = zero
0 + (0.12/0.12) (8-0)
P =
0.12
= Rs. 67

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 b. D/P ratio = 25%; dividend per share : Rs. 2
2 + (0.12/0.12) (8-2)
P =
0.12
= Rs. 67
c. D/P ratio = 50%; dividend per share = Rs. 4
4 + (0.12/0.12) (8-4)
P =
0.12
= Rs. 67
d. D/P ratio = 75%; dividend per share = Rs. 6
6 + (0.12/0.12) (8-6)
P =
0.12
= Rs. 67
e. D/P ratio = 100%; dividend per share = Rs. 8
8 + (0.12/0.12) (8-8)
P =
0.12
= Rs. 67
Interpretation : In the final case where the firm has its' return on investment
equal to the cost of equity capital, the dividend policy does not effect the
share price of the firm. The price of the firm remains Rs. 67 for all the given
levels of the D/P ratio. However, in actual practice r and k will not be the same
and it can only be hypothetical case. Excepting the hypothetical cases of r = ke
in other cases where r<ke or r>k e, according to Walter model the dividend policy
of a firm, as shown above is relevant for maximizing the share price of the
firm.
Limitations of the Walter's Model
Most of the limitations for this model arise due to the assumptions
made. The first assumption of exclusive financing by retained earnings make
the model suitable only for all-equity firms. Secondly, Walter assumes the
return on investments to be constant. This again will not be true for firms
making high investments. Finally, Walter's model on dividend policy ignores

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the business risk of the firm which has a direct impact on the value of the firm.
Thus, k cannot be assumed to be constant.
2. Gordon's Dividend Capitalization Model
Yet another model that has given importance to the dividend policy
of the firm is the Gordon Model. Myron Gordon used the dividend capitalization
approach to study the effect of the firm's dividend policy on the stock price.
The model is however, based on the following assumptions :
Assumptions : The following are the assumptions based on which Gordon
gave the dividend policy for firms :
(i) The firm will be an all-equity firm with the new investment proposals
being financed solely by the retained earnings.
(ii) Return on investment (r) and the cost of equity capital (k e) remain
constant.
(iii) Firm has an infinite life
(iv) The retention ratio remains constant and hence the growth rate also is
constant (g=br).
(v) k > br i.e. cost of equity capital is greater than the growth rate.
Gordon's Model assumes that the investors are rational and risk-
averse. They prefer certain returns to uncertain returns and thus put a premium
to the certain returns and discount the uncertain returns. Thus, investors would
prefer current dividends and avoid risk. Retained earnings involve risk and so
the investor discounts the future dividends. This risk will also affect the stock
value of the firm. Gordon explains this preference for current income by bird-
in-hand argument. Since a bird-in-hand is better than two in the bush, the
investors would prefer the income that they earn currently to that income in
future which may or may not be available. Thus, investors would prefer to pay
a higher price for the stocks which earn them current dividend income and
would discount those stocks which either postpone/reduce the current income.
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The discounting will differ depending on the retention rate (percentage of
retained) and the time.
Gordon's dividend capitalization model gives the value of the stock
as follows :
E (1-b)
P =
k e - br
where,
P = Share price
E = Earnings per share
b = Retention ratio
(1-b) = Dividend pay-out ratio
ke = Cost of equity capital (or cost capital of firm)
br = Growth rate (g) in the rate of return on investment
This mode shows that there is a relationship between payout ratio
(i.e., 1-b), cost of capital ke , rate of return, r, and the market value of the share.
This can be explained with the help of Example 2.
Example 2 : The following information is available in respect of XYZ Ltd :
Earning per share = Rs. 10 (Constant)
Cost of Capital, k e, = .10 (Constant)
Find out the market price of the share under as per Gordon Model
different rate of return, r, of 8%, 10% and 15% for different payout ratios of
0%, 40%, 80% and 100%.
Solution : The market price of the share as per Gordon's model may be
calculated as follows :
If r =15% and payout ratio is 40%, then the retention ratio b is .6
(i.e. 1-.4) and the growth rate, g=br=.09 (i.e., 6×.15) and the market price of
the share is
E (1-b)
P =
k e - br
10 (1-.6)
P =
.10 - .09
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 = Rs. 400
If r = 8% and payout ratio is 80%, then the retention ratio b is .2
(i.e., 1-.8) and the growth rate, g=br=.016 (i.e., .2×.08) and the market price
of the share is
10 (1-.2)
P =
.10 - .016
= Rs. 95
Similarly, the expected market price under different combinations
of 'r' and dividend payout ratio have been calculated and placed in Table 16.1
Table-16.1 : Market Price under Gordon's Model for Different Combinations of
'r' and Payout Ratio.
D/P Ratio = r=15% r=10% r=8%
0% 0 0 0
40% Rs. 400 Rs. 100 Rs. 77
80% Rs.114.3 Rs. 100 Rs. 95
100% Rs.100 Rs. 100 Rs. 100

On the basis of figures given in Table 16.1, it an be seen that if

the firm adopts a zero payout then the investor may not be willing to offer any
price. For a growth firm (i.e., r>k e >br), the market price decreases when the
payout ratio is increased. For a firm having r<k e, the market price increases
when the payout ratio is increased.
If r = k e, the dividend policy is irrelevant and the market price
remains constant at Rs. 100 only. However, in his revised model, Gordon has
argued that even if r = k e, the dividend payout ratio matters and the investors
being risk averse prefer current dividends which are certain to future capital
gains which are uncertain. The investors will apply a higher capitalization rate
i.e., k e to discount the future capital gains. This will compensate them for the
future uncertain capital gain and thus, the market price of the share of a firm
which retains profit will be adversely affected.
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 Thus, Gordon's conclusion about the relationship between the
dividend policy and the value of the firm are similar to that of Walter's model.
The similarity is due to the reason that the underlying assumptions of both the
models are same.
16.3 IRRELEVANCE OF DIVIDEND POLICY
The other school of thought on dividend policy and valuation of
the firm argues that what a firm pay as dividends to shareholders is irrelevant
and the shareholders are indifferent about receiving current dividends or
receiving capital gains in future. The advocates of this school of thought argue
that the dividend policy has no effect on the market price of a share. The
shareholders do not differentiate between the present dividend or future capital
gains. They are basically interested in higher returns either earned by the firm
by reinvesting profits in profitable investment opportunity or earned by
themselves by making investment of dividend income. The underlying intuition
for the dividend irrelevance proposition is simple : Firms that pay more
dividends offer less price appreciation but provide the same total return to
shareholders, given the risk characteristics of the firm. The investors should
be indifferent of receiving their returns in the form of current dividends or in
the form of price increase in the market. Modigliani- Miller model
comprehensively argues in favour of irrelevance of dividends which is as
follows :
1. Modiglilani -Miller Model
Modigliani-Miller have propounded the MM hypothesis to explain
the irrelevance of the firm's dividend policy. This model which is based on a
few assumptions, sidelined the importance of the dividend policy and its effect
thereof on the share price of the firm. According to the model, it is only the
firms' investment policy that will have an impact on the share value of the firm
and hence should be given more importance.
Assumptions : Before discussing the details of the model let us first look
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into the assumptions upon which the model is based :
(i) The first assumption is the existence of a perfect market in which all
investors are rational. In perfect market condition there is easy access
to information and the floatation and the transaction costs do not exist.
The securities are infinitely divisible and hence no single investor is
large enough to influence the share value.
(ii) Secondly, it is assumed that there are no taxes implying that there is no
differential tax rates for the dividend income and the capital gain.
(iii) Thirdly, a firm has a given investment policy which does not change.
The operational implication of this assumption is that financing of new
investments out of retained earnings will not change the business risk
complexion of the firm and, therefore, there would not be no change in
the required rate of return.
(iv) Finally, it was also assumed that the investors are able to forecast the
future earnings, the dividends and the share value of the firm with
certainty. This assumption was however, dropped out of the model.
Based on these assumption and using the process of arbitrage
Modigliani and Miller have explained the irrelevance of the dividend policy.
The process of arbitrage balances completely offsets two transactions which
are entered into simultaneously. The two transactions here are the acts of paying
out dividends and raising external funds–either through the sale of new shares
or raising additional loans–to finance investment programmes. Assume that a
firm has some investment opportunity. Given its investment decision, the firm
has two alternatives : (i) it can retain its earnings to finance the investment
programme; (ii) or distribute the earnings to the shareholders as dividend and
raise an equal amount externally through the sale of new shares/bonds for the
purpose. If the firm selects the second alternative, arbitrage process is involved,
in that payment of dividends is associated with raising funds through other
means of financing. The effect of dividend payment on shareholder's wealth
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will be exactly offset by the effect of raising additional share capital.
Further, that the increase in market price of the share (resulting
as a consequence of dividend payment) will be completely off set by the decline
in terminal value of the share (as more shares would have already been issued
at the time of dividend payment). The benefit of increase in market value as a
result of dividend payment will be offset completely by the decrease in terminal
value of the share. The market price before and after the payment of dividend
would be indentical. The investors, according to Modigliani and Miller, would,
therefore, be indifferent between dividend and retention of earnings. Since
the shareholders are indifferent, the wealth would not be affected by current
and future dividend decisions of the firm. It would depend entirely upon the
expected future earnings of the firm.
There would be no difference to the validity of the MM premise,
if external funds are raised in the form of debt instead of equity capital. This
is because of their indifference between debt and equity with respect to
leverage. The cost of capital is independent of leverage and the real cost of
debt is the same as the real cost of equity.
That investors are indifferent between dividend and retained
earnings implies that the dividend decision is irrelevant. The arbitrage process
also implies that the total market value plus current dividends of two firms
which are alike in all respects except D/P ratio will be identical. The individual
shareholder can retain and invest his own earnings as well as the firm would.
With dividends being irrelevant, a firm's cost of capital would be independent
of its D/P ratio.
Finally, the arbitrage process will ensure that under conditions of
uncertainty also the dividend policy would be irrelevant. When two firms are
similar in respect of business risk, prospective future earnings and investment
policies, the market price of their shares must be the same. This, MM argue, is
because of the rational behaviour of investors who are assumed to prefer more
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wealth to less wealth. Differences in current and future dividend policies cannot
affect the market value of the two firms as the present value of prospective
dividends plus terminal value is the same.
In order to testify their model, MM have started with the following
valuation model :
Step I : The market price of a share in the beginning of the period is equal to
the present value of dividends paid at the end of the period plus the market
price of share at the end of the period. Symbolically,
1
P0 = (D 1 + P 1) (1)
(1+k e)
where P0 = Prevailing market price of a share
K e = Cost of equity capital
D 1 = Dividend to be received at the end of period 1
P1 = Market price of a share at the end of period 1
Step 2 : Assuming no external financing, the total capitalised value of the
firm would be simply the number of shares (n) times the price of each share
(P0). Thus.
1
nP 0 = (nD 1 + nP 1) (2)
(1+k e)

Step 3 : If the firm's internal sources of financing its investment opportunities

fall short of the funds required, and ∆n is the number of new shares issued at
the end of year 1 at price of P 1, Eq. 2 can be written as :
1
nP 0 = [nD 1 + (n+ ∆n) P 1 - ∆nP 1)] (3)
(1+k e)
where n = Number of shares outstanding at the beginning of the period
∆n = Change in the number of shares outstanding during the period/
Additional shares issued
Equation 3 implies that the total value of the firm is the capitalised
value of the dividends to be received during the period plus the value of the
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number of shares outstanding at the end of the period, considering new shares,
less the value of the new shares. Thus, in effect, Eq. 3 is equivalent to Eq. 2.
Step 4 : If the firm were to finance all investment proposals, the total amount
raised through new shares issued would be given in Eq. 4
∆nP 1 = I – (E – nD 1)
or ∆nP 1 = I – E + nD 1 (4)
Where ∆nP 1 = Amount obtained from the sale of new shares
I = Total amount/requirement of capital budget
E = Earnings of the firm during the period
nD1 = Total dividends paid
(E-nD 1) = Retained earnings
According to Equation 4, whatever investment needs (I) are not
financed by retained earnings, must be financed through the sale of additional
equity shares.
Step 5 : If we substitute Eq. 4 into Eq. 3 we derive Eq. 5
1
nP0 = (nD 1 + (n + ∆n) P 1 – (I – E + nD 1)] (5)
(1+k e)
Solving Eq. 5 we have
nD1 + (n + ∆n) P 1 – I + E – nD 1
nP 0 =
(1 + k e )
There is a positive nD1 and negative nD 1. Therefore, nD1 cancels. We then have
(n + ∆n) P 1 – I + E
nP 0 = (6)
(1 + k e)

Step -6 : Since dividends (D) are not found in Eq. 6, Modigliani and Miller
conclude that dividends do not count and that dividend policy has no effect on
the share price.
MM's approach to irrelevance of dividend to valuation is illustrated
in Example 3.

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Example 3 : A company belongs to a risk class for which the approximate
capitalisation rate is 10 per cent. It currently has outstanding 25,000 shares
selling at Rs. 100 each. The firm is contemplating the declaration of a dividend
of Rs. 5 per cent share at the end of the current financial year. It expects to
have a net income of Rs. 2,50,000 and has a proposal for making new
investments of Rs. 5,00,000. Show that under the MM assumption, the payment
of dividend does not affect the value of the firm.
Solution
(a) Value of the firm, when dividends are paid :
1
(i) Price per share at the end of year 1, P 0 = (D + P 1) 1
(1+k e) 1
1
Rs. 100 = (Rs. 5 + P 1)
1.10
100 = Rs. 5 + P 1
105 = P 1
(ii) Amount required to be raised from the issue of new shares,
∆nP 1 =1-(E – nD 1)
= Rs. 5,00,000 - (Rs. 2,50,000 - Rs. 1,25,000) = Rs. 3,75,000
Rs.3,75,000 75,000
(iii) Number of additional shares to be issued, ∆n = =
Rs. 105 21
shares
(iv) Value of the firm,
(n+∆n) P 1-I+E
nP 0 = =
1+k e

[ 25,000 + 75,000
1 21 ] (Rs.105) - Rs.5,00,000 + Rs. 2,50,000

Rs. 27,50,000
= = Rs. 25,00,000
1.10
(b) Value of the firm when dividends are not paid :
P1
(i) Price per share at the end of the year 1, Rs. 100 = , or 110 = P1
1.10
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(ii) Amount required to be raised from the issue of new shares,
∆nP 1 = (Rs. 5,00,000 - Rs. 2,50,000) = Rs. 2,50,000
(iii) Number of additional shares to be issued
Rs. 2,50,000 25,000
= = shares
Rs. 110 11

(iv) Value of the firm = [ 25,000 25,000

1
+
21 ]
(Rs110)-Rs. 5,00,000+Rs.2,50,000

Rs. 27,50,000 = Rs. 25,00,000

=
1.1
Thus, whether dividends are paid or not, value of the firm remains
the same.
The above example clearly demonstrates that the shareholders are
indifferent between the retention of profits and the payment of dividend.
Criticism of M M Hypothesis
It has already been stated M M hypothesis is actually based on
some assumptions. Under these assumptions, no doubt, the conclusion which
is derived is logically sound and consistent although they are not well-based.
For instance, the assumption of perfect capital market does not usually hold
good in many countries. Since the assumptions are unrealistic in real world
situation, it lacks practical relevance which indicates that internal and external
financing are not equivalent. The shareholders/investors cannot be indifferent
between dividends and capital gains as dividend policy itself affects their
perceptions, which, in other words, proves that dividend policy is relevant. As
a result, M M hypothesis, is criticised on the following grounds :
(i) Tax Differential : M M hypothesis assumes that taxes do not exist, in
reality, it is impossible. On the contrary, the shareholders have to pay taxes on
the dividend so received. We know that different tax rates are applicable to
dividend and capital gains and tax rate on capital gains is comparatively low
than the tax rate on dividend. That is why, an investor should prefer the capital
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gains as against the dividend due to the fact that capital gains tax is comparatively
less and such capital gains tax is payable only when the shares are actually sold
in the market at a profit. In short, the cost of internal financing is cheaper as
compared to cost of external financing. Thus, on account of tax advantages/
differential, an investor will prefer a dividend policy with retention of earnings
as compared to cash dividend.
(ii) Existence of Floatation Costs : M M also assumes that both internal
and external financing are equivalent. It indicates that if dividend is paid in
cash, a firm is to raise external funds for its own investment opportunities.
There will not be any difference in shareholders' wealth whether the firm retains
its earnings or issues fresh shares provided there will not be any floatation
cost. But, in reality, floatation cost exists for issuing fresh shares, and there
is no such cost if earnings are retained. As a result of the floatation cost, the
external financing becomes costlier than internal financing. Therefore, if
floatation costs are considered, fresh issue and retained earnings will never
be equivalent.
( i i i ) Existence of Transaction Costs : M M also assumes that whether the
dividends are paid or not, the shareholders' wealth will be the same. When the
dividends are not paid in cash to the shareholder, he may desire current income
and as such, he can sell his shares. When a shareholder sells his shares for the
desire of his current income, there remains the transaction costs which are
not considered by MM approach. Because, at the time of sale, a shareholder
must have to incur some expenses by way of brokerage, commission, etc., which
is again more for small sales. A shareholder will prefer dividends to capital
gains in order to avoid the said difficulties and inconvenience.
(iv) Diversification : M M hypothesis considers that the discount rate should
be the same whether a firm uses internal or external financing. But, practically,
it does not so happen. If the shareholders desire to diversify their portfolios
they would like to distribute earnings which they may be able to invest in such

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dividends in other firms. In such a case, shareholders/investors will be inclined
to have a higher value of discount rate if internal financing is being used and
vice-versa.
(v) Uncertainty : According to M M hypothesis, dividend policy of a firm
will be irrelevant even if uncertainty is considered. M M reveal that if the two
firms have identical investment policies, business risks and expected future
earnings, the market price of the two firms will be the same. This view is actually
not accepted by some other authorities. According to them, under conditions
of uncertainty, dividends are relevant because, investors are risk-averters and
as such, they prefer near dividends than future dividends since future dividends
are discounted at a higher rate as dividends involve uncertainty. Thus, the value
of the firm will be higher if dividend is paid earlier than when the firm follows
a retention policy.
16.4 SUMMARY
The discussions on the dividend policies of the firms consider
the two different schools of thought. According to one school of thought in a
perfect market situation investment and financing decisions are independent
and thus, the dividend decisions become irrelevant. The model given by
Modigliani and Miller belongs to this school of thought. They also consider
that the share value of the firm is based on the investment opportunities of the
firm. However, the imperfect market conditions and the uncertainty prevailing
in the future earnings do not provide enough support to this model. The second
school of thought explains the relevance of the dividend policy and the impact
of the same on the share value. However, inspite of these dividend models, it
should be noted that investors are risk-averse and prefer current dividend to
future earnings. Further, with maximization of shareholder wealth being the
most important issue, the dividend policies will vary for the firms, depending
on the operational environment.

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16.5 SELF ASSESSMENT QUESTIONS
1. What are the essentials of Walter's dividend model? Explain its
shortcomings?
2. What are the assumptions which underline Gordon's model of dividend
effect? Does dividend policy affect the value of the firm under Gordon's
model?
3. "Walter's and Gordon's models are based on the same assumptions. Thus,
there is no basic difference between the two models". Do you agree or
not? Why?
4. "The assumptions underlying the irrelevance hypothesis of Modigliani
and Miller are unrealistic". Explain.
5. Explain the Modigliani-Miller hypothesis of dividend irrelevance. Does
this hypothesis suffer from deficiencies?
6. The earnings per share of a company are Rs. 10. It has rate of return of
15% and the capitalization rate of risk class is 12.5%. If Walter's model
is used: (i) What should be the optimum payout ratio of the firm? (ii)
What would be the price of the share at this payout? (iii) How shall the
price of the share be affected if a different payout was employed?
7. The ABC Ltd., currently has outstanding 1,00,000 shares selling at Rs.
100 each. The firm is considering to declare a dividend of Rs. 5 per
share at the end of the current fiscal year. The firm's opportunity cost
of capital is 10%. What will be the price of the share at the end of the
year if (i) a dividend is not declared, (ii) a dividend is declared?
Assuming that the firm pays the dividend, has net profits of Rs. 10,00,000
and makes new investments of Rs. 20,00,000 during the period, how
many new shares must be issued? Use the MM model to answer these
questions.

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16.6 FURTHER READINGS
1. Financial Decision Making by John J. Hampton
2. Corporation Finance by S.C. Kuchhal
3. Financial Management by Ravi M. Kishore
4. Financial Management by I.M. Pandey

✪✪✪

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 LESSON – 17

FINANCIAL MODELING

Objective : The objective of this lesson is to discuss the concept of Financial

Modeling.
Structure
17.1 Introduction
17.2 The Concept of Financial Model
17.3 Recent Breakthroughs in Financial Modeling
17.4 Financial Models as a Business Tool
17.5 Abuses of Financial Modeling
17.6 Use and Benefits of Financial Models
17.7 Summary
17.8 Self Assessment Questions
17.9 Further Readings
17.1 INTRODUCTION
Finance has always been an important segment of the aggregate
organisational structure; the art of financial management continues to assume
added significance with decision making as the main thrust and sophistication
as a necessary ingredient. The financial manager's tasks could be separated
into several distinct areas. First, it is essential that the financial manager
analyse the past and present financial positions of the company in question to

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ascertain strengths and weaknesses. Second, given that analysis, the financial
manager must plan the need for funds in order to fortify the strengths,
ameliorate the weaknesses, and sustain the presumed course and direction of
future business activities. Third, management must take the funds information
which has been gathered in the planning process and set forth procedures to
acquire those funds. Essentially, funds acquisition is the determination of the
composition of funds sources. Once the funds have been raised, the fourth
task is their proper investment. Funds are invested in assets, because they are
the sources of revenue generation within the firm. In effect this fourth step is
the determination of the asset composition (mix) of the firm. This sequence
of steps provides the foundation from which management performance may be
evaluated implicity or explicity by current and prospective stockholders and
by the board of directors via the return on investment (ROI) criterion.
Planning is perhaps best conceived as the ex ante recognition and
identification segment, which is such an integral part of composite financial
management performance. Among the principal tools of the financial manager
are financial statement analysis, operating and financial leverage, cost-volume-
profit relationships, fund statements, budgeting and pro forma statements, and
financial modeling. The very nature of the financial management position lends
itself to the availability and receipt of voluminous amounts of data input.
Consequently, the requirement that the financial manager become increasingly
analytical, decision-oriented, and sophisticated has never been more in
evidence. There is need of familiarity with operations research (e.g., linear
programming and related techniques), management information systems, the
computer and its applications, the management science concepts, and the ability
to construct viable financial models.
Financial modeling, fancy buzz word, is a meaningful concept that
has gradually, over time, absorbed into the body of business knowledge and
become an integral part of the financial planning and control function. Most

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new techniques are initially oversold to create interest and to overcome the
natural forces that resist change. Financial modeling has not been an exception.
However, the important question is : Will it withstand the test of exposure to
real life problems and the executives who must deal with these problems as
decision makers?
Any new technique must have gestation period during which it will
be critically evaluated by business and the profession in term of meaningful
results. If results are forthcoming within a reasonable time, the technique
becomes part of standard business practice. At present, financial modeling is
in its gestation period. There have been many well publicised success stores
concerning its benefits; there are also a number of disappointments and failures.
17.2 THE CONCEPT OF FINANCIAL MODEL
The term, financial modeling, has been defined in many different
ways. Actually, financial modeling is not a complex concept. It is simply the
process of developing financial statements and ratios which deal typically with
future projections based upon a defined set of assumptions and logical
relationships.
When an accountant develops a set of assumptions and historical
ratios, and then applies normal accounting logic in the preparation and
summarisation of spread sheets, we refer to the end product as financial
projections or pro forma statements. If the same process is followed, except
that, instead of pencil, paper and a ten-key adding machine, a computer time-
sharing terminal is utilised, the process becomes financial modeling.
As the term is frequently used today, a financial model is a
mechanised way of preparing financial projections. The advantages of
mechanisation in this case are basically threefold : the time required to prepare
and revise the projections, the cost of preparation, and the accuracy of the
projections.
In terms of mathematical-statistical sophistication, most financial
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models use the same algebra found in accounting : add, multiply, divide and, of
course, debits equal credits. In addition, logic routines normally found in the
models relate to depreciation calculations, interest rates, discounting of cash
flow, return on investment calculations, and growth rates. The output of a
financial model is typically such a financial statement while evaluating alternate
assumptions, only selected lines of different statements will be printed so as
to reduce printing time.
For purpose of decision-making, financial variables may be
classified into exogenous and endogenous variables. The exogenous variables
are those variables whose values are taken by the decision-maker as given,
whereas the endogenous variables are those variables whose value are
determined by the model itself. The exogenous variables may in turn be divided
into those variables subject to management control and those beyond
management control. Given the values assigned to the exogenous variables,
the corresponding values of the endogenous variables are determined by the
system of relationship within the mathematical model.
The relationships defined by the model also determine how and
to what extent endogenous variables are affected by changes in the exogenous
variables brought about by new financial decisions. In terms of the model, new
financial decisions cause exogenous variables to take on a corresponding set
of new values, which in turn causes the endogenous variables to seek their new
equilibrium values. If, in addition, there exists an objective function that defines
how changes in each variable affect the welfare of the firm, then the financial
manager is able to make value judgements among different policies and select
that course of action which produces the best results.
Another useful distinction between variables in the mathematical
model is the distinction between random variables and deterministic variables.
Random variables may be thought of as those variables whose values cannot be
predicted with certainty at the time a decision is made. Deterministic variables

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are simply variables that are not random, that is, variables whose values can be
predicted with certainty at the time a decision is made. Since financial
decisions are frequently made under conditions of uncertainty, a number of
the mathematical models contain random as well as deterministic variables.
Until a few years ago, mechanisation of projections was not
particularly attractive because the programmes required for an in-house
computer were expensive to write. Once the programmes were completed, the
computer could prepare the projections in minutes with a very high degree of
accuracy. However, there were frequently substantial delays, often in terms of
days, in key-punching the data and then scheduling the programme on the
computer.
17.3 RECENT BREAKTHROUGHS IN FINANCIAL MODELING
By far the most important technological innovation affecting
financial analysis and providing the opportunity to greatly expand the use of
financial models in recent years has been the advent of inexpensive and readily
available computing capacity. A microcomputer is on the desk of virtually every
financial analyst at progressive and innovative firms. The primary impact of
this cheap computing capacity and user-friendly software has been the case
with which previously laborious financial analysis can now be performed in
seconds. Previously, if the firm was going to perform a particularly tedious
procedure, such as a forecast for the next year's cash flows for each month, it
was quite time consuming and costly. Thus, analysis was often limited to one
pass through the algorithm, utilising the best estimates of the input variables.
Sensitivity and simulation analysis procedures could be justified only for the
most critical decisions. But the microcomputer revolution has changed all that.
Now, the changing of input variables and the observation of the effects on output
variables takes seconds, not hours. Procedures to assess risk, which in the
past were too expensive, can now be performed routinely.
Three types of microcomputer software are currently available
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and are useful for the analysis of financial decisions : the spreadsheet, the
mathematical programming package, and the simulation package. Spreadsheets
are now a commodity item. Spreadsheets consist of rows and columns and are
useful in the analysis of many types of financial problems. The power of the
spreadsheet stems from its copying feature and its quick execution of
recalculations. The former is useful if the financial analysis procedure requires
more than a few similar calculations; it makes model building in such
circumstances much easier and faster than manual methods. If the analyst wants
to see the effect of a deviation from the original estimate on important
outcome variables, the quick recalculation feature of the spreadsheet makes
substantial analysis feasible; the analyst merely changes the data or formula,
and the spreadsheet automatically recalculates all the other cells. However,
one note of warning is appropriate. Spreadsheets are a financial modeling tool,
not an end in themselves. The data outputs they provide are only as good as the
estimated input data and the financial algorithms used.
While spreadsheets are very useful in a number of respects, they
are tools of analysis, not optimisation. Some of the problems we study in
management are such that an optimum solution can be found by the proper
application of mathematical programming techniques, among them importance
are linear programming (where all the variables may assume noninteger values)
and integer programming (where only one or several variables may assume
integer values). While it is always desirable to accomplish something for less
cost, the real value of increased efficiency in programming a financial model
is in the end product. The new languages have permitted the development of
models that are more comprehensive in nature and more adaptable to needs of
the executives and planners who use the models. Revisions in the models can
be made easily and quickly. The models are no longer cast in stone but are
adaptable to revisions and refinements.

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17.4 FINANCIAL MODELS AS A BUSINESS TOOL
The description of a new technique, such as financial modeling,
is frequently of intellectual interest. But, for the technique to be of value, it
must serve a function. The complexity and sophistication of a technique may
intrigue the mind and imagination but in the end it must be evaluated in a
practical sense. This seems to have been the problem with many of the earlier
attempts at financial modeling. In effect, the models tended to become ends
unto themselves rather than useful tools for others to use. They did not meet
the critical test in terms of contributing to the achievement of corporate goals.
Financial modeling should be viewed in a functional sense rather
than as a technical achievement. How and where can it be used? Some
proponents of the techniques envision huge corporate models with video-tube
displays whereby a captain of industry could plot future courses of action.
Eventually such modeling systems way exist. They do not appear to be practical
today.
What approaches can a finance manager follow in gaining initial
exposure to the actual operations of a financial model? There are several :
through special analysis problems, financial planning models, and corporate
models.
1. Special Analysis
Recent experience indicates financial modeling is very successful
when it is initially used in a limited area to solve specific problems. Some
examples of such areas are portfolio construction, foreign exchange rates,
income tax planning, merger and acquisition analysis, capital equipment
evaluation, and analysis of capital structure and bank financing. Real benefits
have resulted from financial models applied in these areas. This route also
enables financial manager to test the water before deciding whether to jump in
– or how deep they should get into it.

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2. Financial Modeling and Planning
Another approach to financial modeling is to view it as a part of
the planning function in an organisation. While this approach has been
successful in a number of cases, the chances of success are highly dependent
on how well the planning function is organised and accepted by executive
management. A finance manager cannot use financial modeling as a substitute
for planning, but can use financial modeling to improve planning in an
organisation.
It is difficult to generalise about how financial modeling may be
used in planning activities because these activities vary so much from company
to company and industry to industry. When the emphasis is primarily on the
annual plan, the model is usually set up in monthly increments and may be
adjusted to reflect monthly operating results and budget revisions. This
capability has been particularly useful in industries where prices vary
substantially for raw materials. Another important use is in multi-division
companies where the clerical-mechanical problems of consolidation limit the
use of revised budgets and current outlooks. With a model, consolidations of
the budgets of the individual divisions can be accomplished within minutes.
With current pressures from investors for earnings projections, a financial
model related to the budget may be of considerable value in preparing
statement. In addition to the annual planning cycle, most companies today are
preparing long-range plans extending over a number of years. In this connection,
financial models are useful in evaluating alternate plans and strategies.
An example of such a question is : What would be the annual
earnings per share if Division A's sales grew at 5 per cent instead of 3 per cent
and Division B's sales at 1 per cent instead of 7 per cent? Of curse, such a
question could be answered without a model. But, because of short response
time and low cost of analysis with a model, more questions are asked, and
management tends to get a more comprehensive understanding of the financial

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implications of different strategies and economic conditions.
3. Corporate Models
Financial modeling has also been used in operating management
systems. In these situations, the financial model becomes a part (often referred
to as a module) of a corporate model which encompasses a number of modules.
The nonfinancially oriented modules in a corporate model typically relate to
the physical characteristics of production and marketing. For example, the
production modules may relate to raw material requirements in tonnes,
production capacities in units, and manpower requirements in man-hours. The
marketing modules typically deal with factors such as market segments,
advertising and promotion programmes, market penetration, price-volume
relationships, discounts and allowances, and channels of distribution.
Just as accounting systems eventually tie together the results of
the many operating segments of a company in developing financial statements,
the financial portion of a corporate model integrates the various modules
relating to operations.
17.5 ABUSES OF FINANCIAL MODELING
Before discussing the benefits of financial modeling, it would be
more useful to evaluate some reasons why the techniques has not been
successful in a number of practical business situations.
1. Don't meander into financial modeling : A number of companies have
launched financial modeling projects without adequate knowledge or a sense
of direction. When this happens, the bureaucratic elements inherent in all
organisations slowly grab hold of the project. Before, one realises it, adhoc
committees may have blurred the objectives of the project and extended the
completion dates indefinitely.
2. Problems of excessive evaluation of computer software : While it is
important to learn about computer software used in financial modeling, this
can be overdone. Because of the number of competing software systems
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available and the rapid technological change in this area, it is easy to lose
sight of the forest (the use of the models) because of the trees (the software
systems).
3. Beware of sophisticated statistical models : A financial model typically
is built upon the logic of accounting statements. Some people outside the
accounting profession may not be impressed with the complexity of accounting
logic. But they usually find it is considerably more difficult to understand
than they expect when they are charged with developing financial models.
Statistical probability distributions are technically interesting and potentially
useful. However, they should not be incorporated into the financial models
until the models have been in operation for some time. Generally speaking,
these techniques are like candles on a birthday cake. They improve the looks
of the cake but not its ultimate use.
4. Recognise the "future shock" syndrome : A number of well-conceived
financial models have failed because of the reactions of the people who run
and use them. The "future shock" or rate at which an organisation can change,
must be carefully evaluated and considered in both the design of the models
and in the way they are introduced into the organisation. The spread sheet
approach to projections may be laborious and ineffective. However, it is a
known element to the finance manager who has been working with it during his
whole career. The financial model may be a superior technique. But, to many,
it may seem to be a threat both to their technical knowledge and their
relationship to the organisation.
5. Financial models are not for everyone : There are many situations
where financial modeling would be of very limited use. Before a model can be
applied, some form of logical structure must exist and be accepted by the
decision-making group. In addition to structure, there must be a means of
developing input data and assumptions. The structure of the model may take
into account both fixed and variable elements of cost. However, the model

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will be of little value if there is not a similar breakdown of cost data available
for input into the model.
6. Financial models, budgets, and general ledgers are different : The
potential use of computerised general ledger systems as a financial model has
been stressed by some financial managers. While the theory is good, the
approach usually is not practical. The level of detail required in a general ledger
and the volume of data in the files make it a complex data processing system –
even on a monthly closing cycle. Typically, budget data is included in a
computer-based general ledger system. However, this is normally at a summary
level above the lowest level transaction code. A financial model normally is at
a summary level above the budget, but it should be integrated to the budget
level. The financial model must operate at an aggregate level in order to keep
the number of input elements within reason and to keep the processing time
under control.
17.6 USE AND BENEFITS OF FINANCIAL MODELS
The advent of cost-benefit analysis, which is another new and only
partially proven financial tool, means that management must evaluate new
systems in a rational manner that compares related costs and benefits. Applying
this to financial modelling is difficult, because the most important benefits
are those that improve the quality of executive decisions. The problem is to
determine how much the quality of executive decisions has been improved and
how much of this improvement is due to the financial model and how much to
the executives themselves. There are a number of explicit benefits related to
financial modeling, but the really important benefits are implicit and embedded
within the executive decision-making process. Most of these benefits can only
be evaluated by an executive through first-hand experience. Yet, it can be useful
to explore some of them which are as follows :
1. Increase the breadth of analysis leading to decision making : In
evaluating capital expenditure decisions or a profit plan, it has been fairly
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common to consider only a few alternate strategies or economic assumptions
before reaching a decision. Cost has been one factor limiting the number of
contingency plans reviewed, but time to prepare the alternatives has usually
been the primary limiting factor.
With a financial model, both the cost and time limitations are
greatly reduced. As a result, a decision that might have been based on three or
four cycles of analysis might now be predicated on 30 or 40 cycles of analysis.
In a similar manner, budget outlooks can be adjusted more frequently to reflect
new data and changes in assumptions and forecasts. In effect, the financial
model shifts the effort of the financial analyst away from pencil pushing and
toward the evaluation of alternate conditions and decisions.
2. Provide a framework for long-range planning : The primary problem
of long-range planning in industry is that everybody talks about it but few
people do anything about it. One reason for this is the lack of structure within
the planning process. A financial model may provide a focal point for structuring
the planning process. In some cases the financial model and its implications
for planning have been used as a vehicle for improving communications
between individuals of varied backgrounds within the organisation.
3. Evaluating new forms and uses of financial information : In some
companies financial modeling has been used to evaluate alternate forms and
uses of financial information. Because of the flexibility inherent in modeling
and the ability to evaluate the impact of various financial factors on profits,
the financial model is used as an experimental lab for testing and evaluating
new accounting approaches.
4. Tool for special problems : More and more attention is being devoted
by management to one-time or temporary problem situations. Because they
are not of a continuing nature, it is not practical to develop typical data-
processing systems for these problems. Financial models can frequently fill
this gap. Some recent applications in this area relate to wage-price controls,
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changes in tax law, exchange rates, and mergers and acquisitions.
5. Understanding the inherent logic of the financial system : As a by
product of financial modeling, some executives have found that the experience
of defining the logic and interaction of the financial system in developing the
model was, in itself, a very important and revealing activity. In effect, it forces
a soul-searing in terms of "Why do we do it that way?" For the first time, many
relationships are recognised a more explicit basis.
It may be observed from experience that financial modeling
techniques can be applied effectively in a number of business situations,
especially those in which there is a logical structure and where a degree of
uncertainty is inherent in the assumptions involved. With business facing the
conflicting forces of the energy crisis, environmental constraints, etc.,
executive management must look for new ways to evaluate alternate courses
of action and their impact on profitability. Financial modeling may provide
management with important tools for dealing with the increasing complexities
and uncertainties facing industry today and tomorrow.
17.7 SUMMARY
The art of developing financial modeling is intended to capture
the essential features of a complex business situation and to eliminate irrelevant
detail. The use of financial models is thus an aid to simplification in business
planning, especially in representing alternative situations. Although it is true
that models are built to simplify reality the use of financial modelling is
developing fast and the developments whilst they are geared to the creation of
more useful and hence more realistic models inevitably lead to more complex
models. The use of computers and computer spreadsheets provides the tools
for the construction of more comprehensive and more detailed models. In large
organisation, computer models which encompass the whole organisation will
be very complex and specialist staff are required to operate them.

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17.8 SELF ASSESSMENT QUESTIONS
1. What is financial modeling? Discuss the recent breakthroughs in
financial modeling.
2. Discus the importance of the microcomputer er to modern financial
management.
3. "Financial modeling should be viewed a functional sense rather than as a
technical achievement." Do you agree? How and where can it be used?
4. What are the abuses of financial modeling?
5. Discuss the uses and benefits of financial models.
17.9 FURTHER READINGS
1. Financial Modelling : A Practical Guide by D. Sherwood.
2. Building Financial Models : A Simulation Approach by K. Bhaskar
3. Financial Management by Prasana Chandra.

✪✪✪

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 LESSON – 18

INSTRUMENTS OF SHORT-TERM FINANCE

Objectives : This lesson will enable the students to understand the nature,
features, merits and demerits of the various instruments of working capital/
short-term finance.
Structure :
18.1 Introduction
18.2 Trade Credit
18.3 Accruals
18.4 Bank Finance
18.5 Public Deposits
18.6 Short-term loans from Financial Institutions
18.7 Commercial Paper
18.8 Factoring
18.9 Summary
18.10 Self Test Questions
18.11 Suggested Readings
18.1 INTRODUCTION
Funds available for a period of one year or less are called short-term finance. In India,
short-term funds are used to finance working capital. The financial manager generally
spends a good chunk of his time in finding money to finance current assets. Typically,
current assets are supported by a combination of long term and short term sources of
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finance. Long-term sources of finance, discussed in lesson 11, which include equity
share capital, preference share capital, debentures, long term borrowings, retained
earnings etc. primarily support fixed assets and secondarily provide the margin money
for working capital. Short-term sources of finance, the subject matter of this lesson,
more or less exclusively support the current assets. The most significant short-term
sources of finance are : trade credit and bank borrowing. The use of trade credit has
been increasing over years in India. Trade credit as a ratio of current assets is about 40
per cent. It is indicated by the Reserve Bank of India data that trade credit has grown
faster than the growth in sales.
Bank borrowing is the next important source of working capital finance. Before
seventies, bank credit was liberally available to firms. It became a scarce
resource after eighties because of the change in the government policy.
The other short-term sources of working capital finance becoming popular in
India are : (i) accruals, (ii) public deposits, (iii) short-term loans from financial
institutions, (iv) factoring of receivables and (v) commercial paper.
18.2 TRADE CREDIT
Trade credit refers to the credit extended by the supplier of goods and services
in the normal course business/sale of the firm. According to trade practices,
cash is not paid immediately for purchases but after an agreed period of time.
Thus, deferral of payment (trade credit) represents a source of finance for
credit purchases.
There is, however, no formal/specific negotiation for trade credit. It is an
informal arrangement between the buyer and the seller. There are no legal
instruments/acknowledgements of debt which are granted on an open account
basis. Such credit appears in the records of the buyer of goods as sundry
creditors/accounts payable.
A variant of accounts payable is bills/notes payable. Unlike the open account
nature of accounts payable, bills/notes payable represent documentary evidence
of credit purchases and a formal acknowledgement of obligation to pay for
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credit purchases on a specified (maturity) date failing which legal/penal action
for recovery will follow. A notable feature of bills/notes payable is that they
can be rediscounted and the seller does not necessarily have to hold till maturity
to receive payment. However, it creates a legally enforceable obligation on
the buyer of goods to pay on maturity whereas the accounts payable have more
flexible payment obligations. Although most of the trade credit is on open
account as accounts payable, the suppliers of goods do not extend credit
indiscriminately. Their decision as well as the quantum is based on a
consideration of factors such as earnings record over a period of time, liquidity
position of the firm and past record of payment.
Advantages
Trade credit, as a source of short-term/working capital finance, has certain
advantages. It is easily, almost automatically, available. Moreover, it is a flexible
and spontaneous source of finance. The availability and magnitude of trade
credit is related to the size of operations of the firm in terms of sales/
purchases. For instance, the requirement of credit purchases to support the
existing sales is Rs. 5 lakh per day. If the purchases are made on a credit of 30
days, the average outstanding accounts payable/trade credit (finance) will
amount to Rs. 1.5 crore (Rs. 5 lakh × 30 days). The increase in purchases of
goods to support higher sales level to Rs. 6 lakh will imply a trade credit finance
of Rs. 1.8 crore (Rs. 6 lakh × 30 days). If the credit purchases of goods decline,
the availability of trade credit will correspondingly decline. Trade credit is
also an informal, spontaneous source of finance. Not requiring negotiation
and formal agreement, trade credit is free from the restrictions associated
with formal/negotiated source of finance/credit.
Cost of Trade Credit
The cost of trade credit depends on the terms of credit offered by the supplier.
If the terms are, say, 30 days net, then trade credit is cost-free because the
amount payable is the same whether the payment is made on purchase or on the
30th day. However, if the supplier offers discount for prompt payment and the
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terms are, say, 2/10, net 30, there is a cost associated with trade credit availed
beyond the discount period. In such a case, we may divide the 30-day period
into two parts as follows :
10 days 20 days
;
Discount period Non-discount period
The cost of trade credit during the discount period is nil, whereas the cost of
trade credit during the non-discount period is :
Discount % 360
×
1–Discount % Credit period – Discount period
In our example, this works out to :
0.02 360
× = 36.7 per cent
1–0.02 30 – 10
The cost of trade credit for several credit terms is shown below :
Credit Terms Cost of Trade Credit
1/10, net 20 36.4 per cent
2/10, net 45 21.0 per cent
3/10, net 60 22.3 per cent
2/15, net 45 24.5 per cent
In general, the cost of additional trade credit is very high and unless the firm
is hard pressed financially, it should not forego the discount for prompt
payment.
The above calculation is based on the assumption that once a firm foregoes
discount, it would make payment only at the end of the net period. What happens
if the firm fails to pay within the discount period but pays before the end of
the net period? Naturally, the annual interest cost of trade credit is higher, the
longer the difference between the day of payment and the end of the discount
period.
From the foregoing discussion two things are clear.
1. In general the cost of trade credit is very high beyond the discount period
and unless the firm is hard pressed financially it should not forego the
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 discount for prompt payment.
2. If the firm is unable to avail of the discount for prompt payment, it should
delay the payment till the last day of the net period, and even beyond if
such an action does not impair the credit worthiness of the firm.
18.3 ACCRUALS
The major accrual items are wages and taxes. These are simply what the firm
owes to its employees and to the government. Wages are usually paid on a
weekly, fortnightly, or monthly basis – between payments, the amounts owned
but not yet paid is shown as accrued wages on the balance sheet. Income tax is
payable quarterly and other taxes may be payable half-yearly or annually. In
the interim, taxes owed but not paid may be shown as accrued taxes on the
balance sheet.
Accruals vary with the level of activity of the firm. When the activity level
expands, accruals increase and when the activity level contracts accruals
decrease. As they respond more or less automatically to changes in the level
of activity, accruals are treated as part of spontaneous financing.
Since no interest is paid by the firm on its accruals, they are often regarded as
a 'free' source of financing. However, a closer examination would reveal that
this may not be so. When the payment cycle is longer, wages may be higher.
For example, an employee earning Rs. 600 per week and receiving weekly
payment may ask for a slightly higher compensation if the payment is made
monthly. Likewise when the payment period is longer, tax authorities may raise
the tax rates to some extent. Even when such adjustments are made, the fact
remains that between established payment dates accruals do not carry any
explicit interest burden.
While accruals are a welcome source of financing, they are typically not amenable
to control by management. The payment period for employees is determined by the
practice in industry and provisions of law. Similarly, tax payment dates are given by
law and postponement of payment normally results in penalties.
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18.4 BANK FINANCE FOR WORKING CAPITAL
Advance by commercial banks is another very important source of short term
finance in India. A bank considers a firm's sales and production plans and the
desirable levels of current assets in determining its working capital
requirements. The amount approved by the bank for the firm's working capital
is called credit limit. Credit limit is the maximum funds which a firm can obtain
from the banking system. In the case of firms with seasonal business, banks
may fix separate limits for the 'peak level' credit requirements and 'normal
non-peak level' credit requirement indicating the periods during which the
separate limits will be utilised by the borrower. In practice, banks do not lend
100 per cent of the credit limit; they deduct margin money. Margin requirement
is based on the principle of conservatism and is meant to ensure security. If
the margin requirement is 30 per cent, bank will lend only upto 70 per cent of
the value of the asset. This implies that the security of bank's lending should
be maintained even if the asset's value falls by 30 per cent.
Application and Processing
A customer seeking an advance is required to submit an appropriate application
form – there are different types of application forms for different categories
of advances. The information furnished in the application covers, inter alia,
the following : the name and address of the borrower and his establishment;
the details of the borrower's business; the nature and amount of security offered.
The application form has to be supported by various ancillary statements like
the financial statements and financial projections of the firm.
The application is processed by the branch manager or his field staff. This
primarily involves an examination of the following factors : (i) ability, integrity,
and experience of the borrower in the particular business, (ii) general prospects
of the borrower's business, (iii) purpose of advance, (iv) requirement of the
borrower and its reasonableness, (v) adequacy of the margin, (vi) provision of
security, and (vii) period of repayment.
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Sanction and Terms and Conditions
Once the application is duly processed, it is put up for sanction to the
appropriate authority. If the sanction is given by the appropriate authority, along
with the sanction of advance the bank specifies the terms and conditions
applicable to the advance. These usually cover the following : (i) the amount
of loan or the maximum limit of the advance, (ii) the nature of the advance,
(iii)the period for which the advance will be valid, (iv) the rate of interest
applicable to the advance, (v) the primary security to be charged, (vi) the
insurance of the security, (vii) the details of collateral security, if any, to be
provided, (viii) the margin to be maintained, and (ix) other restrictions or
obligations on the part of the borrower. It is a common banking practice to
incorporate important terms and conditions on a stamped security document
to be executed by the borrower. This helps the bank to create the required
charge on the security offered and also obligates the borrower to observe the
stipulated terms and conditions.
Forms of Bank Finance
Short-term fiance is provided by commercial banks in three primary ways : (i)
cash credits/overdrafts, (ii) loans, and (iii) purchase/discount of bills. In
addition to these forms of direct finance, commercial banks help their
customers in obtaining credit from other sources through the letter of credit
arrangement.
Cash Credits/Overdrafts : Under a cash credit or overdraft arrangement, a
pre-determined limit for borrowing is specified by the bank. The borrower
can draw as often as required provided the outstandings do not exceed the cash
credit/overdraft limit. The borrower also enjoys the facility of repaying the
amount, partially or fully, as and when he desires. Interest is charged only on
the running balance, not on the limit sanctioned. A minimum charge may be
payable, irrespective of the level of borrowing, for availabling this facility.
This form of advance is highly attractive from the borrower's point of view
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because while the borrower has the freedom of drawing the amount in
instalments as and when required, interest is payable only on the amount actually
outstanding.
Loans : These are advances of fixed amounts which are credited to the current
account of the borrower or released to him in cash. The borrower is charged
with interest on the entire loan amount, irrespective of how much he draws. In
this respect this system differs markedly from the overdraft or cash credit
arrangement wherein interest is payable only on the amount actually utilised.
Loans are payable either on demand or in periodical instalments. When payable
on demand, loans are supported by a demand promissory note executed by the
borrower. There is often a possibility of renewing the loan.
Bills Purchased/Discounted : This arrangement is of relatively recent origin
in India. With the introduction of the New Bill Market Scheme in 1970 by the
Reserve Bank of India (RBI), bank credit is being made available through
discounting of usance bills by banks. The RBI envisaged the progressive use of
bills as an instrument of credit as against the prevailing practice of using the
widely-prevalent cash credit arrangement for financing working capital. The
cash credit arrangement gave rise to unhealthy practices. As the availability of
bank credit was unrelated to production needs, borrowers enjoyed facilities in
excess of their legitimate needs. Moreover, it led to double financing. This
was possible because credit was taken from different agencies for financing
the same activity. This was done, for example, by buying goods on credit from
suppliers and raising cash credit by hypothecating the same goods. The bill
financing is intended to link credit with the sale and purchase of goods and,
thus, eliminate the scope for misuse or diversion of credit to other purpose.
The amount made available under this arrangement is covered by the cash credit
and overdraft limit. Before discounting the bill, the bank satisfies itself about
the credit-worthiness of the drawer and the genuineness of the bill. To popularise
the scheme, the discount rates are fixed at lower rates than those of cash credit,

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the difference being about 1-1.5 per cent. The discounting banker asks the
drawer of the bills (i.e. seller of goods) to have his bill accepted by the drawee
(buyers) bank before discounting it. The latter grants acceptance against the
cash credit limit, earlier fixed by it, on the basis of the borrowing value of
stocks. Therefore, the buyer who buys goods on credit cannot use the same
goods as a source of obtaining additional bank credit.
The modus operandi of bill finance as a source of working capital financing is
that a bill arises out of a trade sale-purchase transaction on credit. The seller
of goods draws the bill on the purchaser of goods, payable on demand or after
a usance period not exceeding 90 days. On acceptance of the bill by the
purchaser, the seller offers it to the bank for discount/purchase. On discounting
the bill, the bank releases the funds to the seller. The bill is presented by the
bank to the purchaser/acceptor of the bill on due date for payment. The bills
can also be rediscounted with the other banks/RBI. However, this form of
financing is not popular in the country.
Letter of Credit : While the other forms of bank credit are direct forms of
financing in which banks provide funds as well as bear risk, letter of credit is
an indirect form of working capital financing and banks assume only the risk,
the credit being provided by the supplier himself.
The purchaser of goods on credit obtains a letter of credit from a bank. The
bank undertakes the responsibility to make payment to the supplier in case the
buyer fails to meet his obligations. Thus, the modus oprandi of letter of credit
is that the supplier sells goods on credit/extends credit (finance) to the
purchaser, the bank gives a guarantee and bears risk only in case of default by
the purchaser.
Mode of Security
Banks provide credit on the following modes of security :
Hypothecation : Under this mode of security, the banks provide credit to
borrowers against the security of movable property, usually inventory of goods.
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The goods hypothecated, however, continue to be in the possession of the owner
of these goods (i.e., the borrower). The rights of the lending bank
(hypothecatee) depend upon the terms of the contract between the borrower
and the lender. Although the bank does not have physical possession of the
goods, it has the legal right to sell the goods to realise the outstanding loan.
Hypothecation facility is normally not available to new borrowers.
Pledge : Pledge, as a mode of security, is different from hypothecation in that
in former the goods which are offered as security are transferred to the physical
possession of the lender. An essential prerequisite of pledge, therefore, is
that the goods are in the custody of the bank. The borrower who offers the
security is, called a 'pawnor' (pledg), while the bank is called the 'pawnee'
(pledgee). The lodging of the goods by the pledgor to the pledgee is a kind of
bailment. Therefore, pledge creates some liabilities for the bank. It must take
reasonable care of goods pledged with it. The term 'reasonable care' means
care which a prudent person would take to protect his property. He would be
responsible for any loss or damage if he uses the pledged goods for his own
purposes. In case of non-payment of the loans, the bank enjoys the right to sell
the goods.
Lien : The term 'lien' refers to the right of a party to retain goods belonging to
another party until a debt due to him is paid. Lien can be of two types : (i)
particular lien, and (ii) general lien. Particular lien is a right to retain goods
until a claim pertaining to these goods is fully paid. On the other hand, general
lien can be applied till all dues of the claimant are paid. Banks usually enjoy
general lien.
Mortgage : It is the transfer of a legal interest in specific immovable property
for securing the payment of debt. The person who parts with the interest in the
property is called 'mortgagor' and the bank in whose favour the transfer takes
place is the 'mortgagee'. The instrument of transfer is called the 'mortgage
deed'. Mortgage is, thus, conveyance of interest in the mortgaged property.

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The mortgage interest in the property is terminated as soon as the debt is paid.
Mortgages are taken as an additional security for working capital credit by
banks.
Charge : Where immovable property of one person is, by the act of parties or
by the operation of law, made security for the payment of money to another
and the transaction does not amount to mortgage, the latter person is said to
have a charge on the property and all the provisions of simple mortgage will
apply to such a charge. The provisions are as follows :
• A charge is not the transfer of interest in the property though it is security
for payment. But mortgage is a transfer of interest in the property.
• A charge may be created by the act of parties or by the operation of law.
But a mortgage can be created only by the act of parties.
• A charge need not be made in writing but a mortgage deed must be
attested.
• Generally, a charge cannot be enforced against the transferee for
consideration without notice. In a mortgage, the transferee of the
mortgaged property can acquire the remaining interest in the property
if any is left.
Regulation of Bank Finance
Traditionally, industrial borrowers enjoyed a relatively easy access to bank
fiance for meeting their working capital needs. Further, the cash credit
arrangement, the principal device through which such finance has been provided,
is quite advantageous from the point of view of borrowers. Ready availability
of finance in a fairly convenient form led to, in the opinion of many informed
observers of the Indian banking scene, over-borrowing by industry and
deprivation of other sectors.
Concerned about such a distortion in credit allocation, the Reserve bank of
India (RBI) has been trying, particularly from the mid-sixties onwards, to bring
a measure of discipline among industrial borrowers and to redirect credit to
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the priority sectors of the economy. From time to time, the RBI has been
issuing guidelines and directives to the banking sector towards this end.
Important guidelines and directives have stemmed from the recommendations
of certain specially constituted groups entrusted with the task of examining
various aspects of bank finance to industry. In particular, the following
committees have significantly shaped the regulation of bank finance for working
capital in India : the Dhejia Committee, the Tandon Committee, the Chore
Committee, and the Marathe Committee. The key elements of regulation are
discussed below :
Norms for Inventory and Receivables
In the mid-seventies, the RBI accepted the norms for raw materials, stock-in-
progress, finished goods, and receivables that were suggested by the Tandon
Committee for fifteen major industries. These norms were based, on company
finance studies made by the Reserve Bank of India, process periods in different
industries, discussions with industry experts, and feedback received on the
interim reports. These norms represented the maximum levels for holding
inventory and receivables in each period.
From the mid-1980s onwards, special committees were set up by the RBI to
prescribe norms for several other industries and revise norms for some
industries covered by the Tandon Committee. Banks have a discretion to deviate
from the norms. Still banks often look at them.
Maximum Permissible Bank Finance
The Tandon Committee had suggested three methods for determining the
maximum permissible bank finance (MPBF). To describe these methods, the
following notation is used :
CA = current assets as per the norms laid down
CL = non-bank current liabilities like trade credit and provisions
CCA = core current assets – this represents the permanent component
of working capital
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The methods for determining the maximum permissible bank finance (MPBF)
are described below:
Method 1 0.75 (CA-CL)
Method 2 0.75 (CA) - CL
Method 3 0.75 (CA - CCA) - CL
To illustrate the calculation of the MPBF under the three methods, consider
the data for Omni Company :
Current Assets Rs. (in million)
Raw material 18
Work-in-process 5
Finished goods 10
Receivables (including bills discounted) 15
Other current assets 2
Total 50

Current Liabilities
Trade creditors 12
Other current liabilities 3
Bank borrowings (including bills discounted) 25
Total 40
The MPBF for Omni Company as per the three methods is as follows :
Method 1 0.75 (CA-CL) = 0.75 (50-15)
= Rs. 26.25 million
Method 2 0.75 (CA)-CL = 0.75(50) - 15
= Rs 22.5 million
Method 3 0.75(CA-CCA)-CL = 0.75 (50-20) - 15
= Rs 7.5 million
The CCA are assumed to be Rs. 20 million.
The second method has been adopte d. Note that under this method the minimum
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current ratio works out to be 1.33. An example will illustrate this point. Suppose
the current assets and current liabilities (excluding bank finance) for a firm
are 100 and 50 respectively. The MPBF will be :
0.75 (CL) - CA = 0.75 (100) - 50 = 25
This means that the current liabilities including MPBF will be : 50+25 =75.
Hence, the current ratio works out to 100/75 = 1.33
Forms of Assistance
Traditionally, bank credit to industry has been mainly in the form of cash credit
which was introduced by the Scottish bankers. Under the cash credit system,
the bank bears the responsibility of cash management because the borrowers
have the freedom to determine their drawals within the cash credit limit
provided by the bank.
With a view to bringing about a better desicipline in the utilisation of bank
credit, in 1995 a "Loan" system for delivery of bank credit was introduced.
Under the new dispensation, within the MPBF so arrived at in terms of the
extant guidelines, banks/consortia/syndicates are required to restrict sanction
of cash credit limits to borrowers up to a certain portion (which is currently
25 percent) of the MPBF. Where borrowers desire to avail of bank credit for
the balance portion (which is currently 75 percent) of the MPBF, or any part
thereof, this will be considered on merit by banks/consortia/syndicates in the
form of a short-term loan (or loans) repayable on demand for working capital
propose for a stipulated period. Banks/consortia/syndicates will have the
discretion to stipulate repayment of the short-term loan for working capital
purpose by a borrower in instalments or by way of a "bullet" or "balloon"
payment. In case the loan is repaid before the due date, it will be credited to
the cash credit account.
Information and Reporting System
While banks can devise their own information and reporting system they largely follow
the system recommended by the Chore Committee. Its key components are as follow:
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1. Quarterly Information System-Form I : This gives (i) the estimates of
production and sales for the current year and the ensuing quarter, and (ii) the
estimates of current assets and liabilities for the ensuing quarter.
2. Quarterly Information System-Form II : This gives (i) the actual
production and sales during the current year and for the latest completed year,
and (ii) the actual current assets and liabilities for the latest completed quarter.
3. Half-yearly Operating statements-Form III : This gives the actual
operating performance for the half-year ended against the estimates for the
same.
4. Half-yearly Funds Flow Statements-FormIIIB : This give the sources
and use of funds for the half-year ended against the estimates for the same.
The thrust of the information and reporting system is (i) to strengthen the
partnership between the borrowers and the banker, (ii) to give the banker a
deeper insight into the operations and funds requirements of the performance
and efficiency of the borrower.
18.5 PUBLIC DEPOSITS
Many firms, large and small, have solicited unsecured deposit from the public
in recent years, mainly to finance their working capital requirements.
Cost
The interest rate payable on public deposits was subject to a ceiling of till
mid-1996. Just before the ceiling was withdrawn, it was 15 per cent. When the
ceiling was withdrawn in 1996, companies started offering higher returns. Some
of the NBFCs offered about 20 per cent. Due to unhealthy competition, RBI
has re-imposed the ceiling of 15 per cent.
Regulation
The Companies (Acceptance of Deposits) Amendment Rules 1978 governs fixed
deposits. The important features of this regulation are :
• Public deposits cannot exceed 25 per cent of share capital and free
(577)
 reserves.
• The maximum maturity period permitted for public deposits is 6 months
and the maximum maturity period allowed is 3 years. For non-banking
financial corporations (NBFCs) however, the maximum maturity period
is 5 years. A minimum maturity period of 3 months, however, is allowed
for deposits amounting to 10 per cent of share capital and free reserves.
• A company which has public deposits is required to set aside, as deposit
or investment, by 30th April of each year, an amount equal to 10 per
cent of the deposits maturing by 31st March of the following year. The
amount so set aside can be used only for repaying such deposits.
• A company inviting deposits from the public is required to disclose
certain facts about its financial performance and position.
Evaluation
Public deposits offer the following advantages to the company :
• The procedure for obtaining public deposits is fairly simple.
• The restrictive covenants are involved.
• No security is offered against public deposits. Hence the mortgageable
assets of the firm are conserved.
• The post-tax cost is fairly reasonable.
The demerits of public deposits are :
• The quantum of funds that can be raised by way of public deposits is
limited.
• The maturity period is relatively short.
18.6 SHORT TERM LOANS FROM FINANCIAL INSTITUTIONS
The Life Insurance Corporation of India, the General Insurance Corporation
of India, and the Unit Trust of India provide short-term loans to manufacturing
companies with an excellent track record.

(578)
Eligibility
A company to be eligible for such loans should satisfy the following conditions:
• It should have declared an annual dividend of not less than 6 per cent for
the past five years (In certain cases, however, this condition is relaxed
provided the company has paid an annual dividend of at lest 10 per cent
over the last years).
• The debt-equity ratio of the company should not exceed 1.5:1.
• The current ratio of the company should be at least 1.33.
• The average of the interest cover ratios for the past three years should
be at least 2:1.
Features
The short-term loan provided by financial institutions have the following
features:
• They are totally unsecured and are given on the strength of a demand
promissory note.
• The loan is given for a period of 1 year and can be renewed for two
consecutive years, provided the original eligibility criteria are satisfied.
• After a loan repaid, the company will have to wait for at least 6 months
before availing of a fresh loan.
• The loans carry an interest rate of 18 per cent per annum with a quarterly
rest, which works out to an effective rate of 19.29 per cent per annum.
However, there is a rebate of 1 per cent for prompt payment, in which
case the effective rate comes down accordingly
18.7 COMMERCIAL PAPERS
Commercial Paper (CP) is a short-term unsecured negotiable instrument,
consisting of usance promissory note with a fixed maturity. It is issued on a
discount on face value basis but it can also be issued in interest bearing form.
A CP when issued by a company directly to the investor is called a direct paper.
(579)
The companies announce current rates of CPs of various maturities, and
investors can select those maturities which closely approximate their holding
period. When CPs are issued by security dealers/dealers on behalf of their
corporate customers, they are called dealer paper. They buy at a price less
than the commission and sell at the highest possible level. The maturities of
CPs can be tailored within the range to specific investments.
Advantages
A CP has several advantages for both the issuers and the investors. It is a simple
instrument and hardly involves any documentation. It is additionally flexible
in terms of maturities which can be tailored to match the cash flow of the
issuer. A well-rated company can diversify its short-term sources of finance
from banks to money market at cheaper cost. The investors can get higher
returns than what they can get from the banking system. Companies which are
able to raise funds through CPs have better financial standing. The CPs are
unsecured and there are no limitations on the end-use of funds raised through
them. As negotiable/transferable instruments, they are highly liquid. The
creation of the CP market can result in a part of intercorporate funds flowing
into this market which would come under the control of monetary authorities
in India.
Framework of Indian CP Market
The CPs emerged as sources of short-term financing in the yearly nineties.
They are regulated by the RBI. The main elements of the present framework
are given below :
• CPS can be issued for periods ranging between 15 days and one year.
Renewal of CPs is treated as fresh issue.
• The minimum size of an issue is Rs. 25 lakh and the minimum unit of
subscription is Rs. 5 lakh.
• The maximum amount that a company can raise by way of CPs is 100 per
cent of the working capital limit.
(580)
• A company can issue CPs only if it has a minimum tangible net worth of
Rs. 4 crore, a fund-based working limit of Rs. 4 crore or more, at least
a credit rating of P2 (Crisil), A2 (Icra), PR-2 (Care ) and D-2 (Duff &
Phelps) and its borrowal account is classified as standard asset.
• The CPs should be issued in the form of usance promissory notes,
negotiable by endorsement and delivery at a discount rate freely
determined by the issuer. The rate of discount also includes the cost of
stamp duty (0.25 to 0.5 per cent), rating charges (0.1 to 0.2 per cent),
dealing bank fee (0.25 per cent) and stand by facility (0.25 per cent).
• The participants/investors in CPs can be corporate bodies, banks, mutual
funds, UTI, LIC, GIC, NRIs on non-repatriation basis. The Discount and
Finance House of India (DFHI) also participates by quoting its bid and
offer prices.
• The holder of the CPs would present them for payment to the issuer on
maturity.
Effective Cost/Interest Yield
As the CPs are issued at discount and redeemed at its face value, their effective
pre-tax cost/interest yield

=
( Face value – Net amount realised
Net amount realised )(
× 360
Maturity period )
where net amount realised = Face value–discount–issuing and paying agent
(IPA) charges, that is, stamp duty, rating charges, dealing bank fee and fee for
stand by facility.
Assuming face value of a CP, Rs. 5,00,000, maturity period, 90 days, net amount
realised/discount, Rs. 4,80,000 and other charges associated with the issue of
CP, 1.5 per cent, the pre-tax effective cost of CP
Rs 5,00,000 - (Rs 4,80,000 - Rs 7,500) 360
= × = 23.3 per cent
(Rs 4,80,000 - Rs 7,500) 90

(581)
18.8 FACTORING
A factor is a financial institution which offers services relating to management
and financing of debts arising from credit sales. While factoring is well-
established in Western countries, only two factors, the SBI Factoring and
Commercial Services Limited and Canbank Factoring Limited, which have been
mandated by the Reserve Bank of India to operate in the western region and the
southern region respectively, have been set up recently in India. The Punjab
National Bank and the Bank of Allahabad are expected to set up factoring
agencies to serve the northern region and the eastern region, respectively.
Features of a Factoring Arrangement
The key features of a factoring arrangement are as follows :
• The factor selects the accounts of the client that would be handled by it
and establishes, along with the client, the credit limits applicable to the
selected accounts.
• The factor assumes responsibility for collecting the debt of accounts
handled by it. For each account, the factor pays to the client at the end
of credit period or when the account is collected, whichever comes
earlier.
• The factor advances money to the client against not-yet-collected and
not-yet-due debts. Typically, the amount advanced is 70 to 80 per cent
of the face value of the debt and carries an interest rate which may be
equal to or marginally higher than the lending rate of commercial banks.
• Factoring may be on a recourse basis (this means that the credit risk is
borne by the client) or on a non-recourse basis (this means that the credit
risk is borne by the factor). Presently, factoring in India is done on a
recourse basis.
• Besides the interest on advances against debt, the factor charges a
commission which may be 1 to 2 per cent of the face value of the debt
factored.
(582)
The mechanics of factoring are illustrated in Exhibit 1.
Exhibit 1 : Mechanics of Factoring

1
CLIENT Places order CUSTOMER
SELLER 3 (BUYER)
Deliveries goods and
invoice with notice
to pay the factor
4 8 6
Sends Pays Follows
invoice balance up
copy amount
2 5 7
Fixes Prepays Pays
customers up to
limit 80%

FACTOR

Evaluation
Factoring offer the following advantages which makes it quite attractive : (i)
Factoring ensures a definite pattern of cash inflows from credit sales. (ii)
Continuous factoring may virtually eliminate the need for the credit and
collection department. As against these advantages, the limitations of factoring
are : (i) The cost of factoring tends to be higher than the cost of other forms
of short-term borrowing : (ii) Factoring of debt may be perceived as a sign of
financial weakness.
18.9 SUMMARY
The more important short-term sources of financing current assets are : (a)
trade credit, (b) accruals (c) bank finance. The first two sources are available
(583)
in the normal course of business, and therefore, they are called spontaneous
sources of working capital finance. They do not involve any explicit costs.
Bank finances have to be negotiated and involve explicit costs. They are called
non-spontaneous or negotiated sources of working capital finance. Two
alternative ways of raising short-term finances in India are : factoring and
commercial paper.
Trade credit refers to the credit that a buyer obtains from the suppliers of
goods and services. Payment is required to be made within a specified period.
Suppliers sometimes offer cash discount to buyers for making prompt payment.
Buyer should calculate the cost of foregoing cash discount to decide whether
or not cash discount should be availed.
Accruals also provide some funds for financing working capital. However, it is
a limited source as payment of accrued expenses cannot be postponed for a
long period. Similarly, advance income will be received only when there is a
demand-supply gap or the firm is a monopoly.
Bank finance is the most commonly negotiated source of the working capital
finance. It can be availed in the forms of overdraft, cash credit, purchase/
discount of bills and loans. Each company's working capital need is determined
as per the norms. These norms are based on the recommendation of the Tandon
Committee and later on, the Chore Committee. The policy is to require firms
to finance more and more of their capital needs from sources other than bank.
Banks are the largest providers of working capital finance to firms.
Commercial paper is an important money market instrument for raising short-
term finances. Firms, banks, insurance companies, individuals etc. with short-
term surplus funds invest in commercial papers. Investors would generally
invest in commercial paper of a financially sound and credit worthy firm. In
India, commercial papers of 91 to 180 days maturity are being floated. The
interest rate will be determined in the market. Factoring involves sale of
accounts receivables to a factor who charges a commission, bears the credit
risk associated with the accounts receivable purchased by it and provides funds
(584)
in advance of collection and, thus, finances receivables.
18.10 SELF TEST QUESTIONS
1. What are the features of trade credit as a short-term source of working
capital finance?
2. How can the cost of trade credit be calculated?
3. Discuss the main forms of working capital advance by banks. What is
the kind of security required by them?
4. Discuss briefly commercial papers as source of working capital finance.
How would you compute the cost of commercial papers?
5. What is factoring? Give a brief account of the major functions of a
factor.
6. "Accruals are a 'free source of finance". Comment.
7. What is the kind of security required by banks for working capital
advance?
8. Evaluate public deposits from the point of view of the company and the
investor.
9. What is the annual percentage interest cost associated with the following
credit terms?
(i) 2/10 net 50 (ii) 2/15 net 40
(iii) 1/15 net 30 (iv) 1/10 net 30
Assume that the firm does not avail of the cash discount but pays on the
last day of the net period. Assume 360 days to a year.
18.11 SUGGESTED READINGS
1. Prasanna Chandra : Financial Management, Tata McGraw Hill
2. I.M. Pandey : Financial Management, Vikas Publishing House
3. John J. Hampton : Financial Decision Making, PHI
4. Khan and Jain : Financial Management, Tata McGraw Hill
✪✪✪
(585)
APPENDICES
A to G

(587)
Table-A : The Compound Sum of One Rupee
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.010 1.020 1.030 1.040 1.050 1.060 10.70 1.080 1.090 1.110
2 1.020 1.040 1.061 1.082 1.102 1.124 1.145 1.166 1.188 1.210
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.1260 1.295 1.331
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 1.412 1.464
5 1.031 1.104 1.159 1.217 1.276 1.338 1.403 1.469 1.539 1.611
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 1.677 1.772
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 1.828 1.949
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 1.993 2.144
9 1.094 1.195 1.305 1.423 1.551 1.689 1.838 1.999 2.172 2.358
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 2.367 2.594
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 2.580 2.853
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 2.813 3.138
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 3.066 3.452
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 3.342 3.797
15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172 3.642 4.177
16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426 3.970 4.595
17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.70 4.328 5.054
18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996 4.717 5.560
19 1.208 1.457 1.753 2.107 2.527 3.026 3.616 4.316 5.142 6.116
20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661 5.604 6.727
21 1.232 1.516 1.860 2.279 2.786 3.399 4.140 5.034 6.109 7.400
22 1.245 1.546 1.916 2.370 2.925 3.603 4.430 5.436 6.658 8.140
23 1.257 1.577 1.974 2.465 3.071 3.820 4.740 5.871 7.258 8.954
24 1.270 1.608 2.033 2.563 3.225 4.049 5.072 6.341 7.911 9.850
25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848 8.623 10.834
30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.062 13.267 17.449
35 1.417 2.000 2.814 3.946 5.516 7.686 10.676 14.785 20.413 28.102
40 1.489 2.208 3.262 4.801 7.040 10.285 14.974 21.724 31.408 45.258
45 1.565 2.438 3.781 5.841 8.985 13.764 21.002 31.920 48.325 72.888
50 1.645 2.691 4.384 7.106 11.467 18.419 29.456 46.900 74.354 117.386
(589)
Table-A : The Compound of an Annuity of One Rupee
Year 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1. 1.110 1.120 1.130 1.140 1.150 1.160 1.170 1.180 1.190 1.200
2 1.232 1.254 1.277 1.300 1.322 1.346 1.369 1.392 1.416 1.440
3 1.368 1.405 1.443 1.482 1521 1.561 1.602 1.643 1.685 1.728
4 1.518 1.574 1.630 1.689 1.749 1.811 1.874 1.939 2.005 2.074
5 1.685 1.762 1.842 1.925 2.011 2.100 2.192 2.288 2.386 2.488
6 1.870 1.974 2.082 2.195 2.313 2.436 2.565 2.700 2.840 2.986
7 2.076 2.211 2.353 2.502 2.660 2.826 3.001 3.185 3.379 3.583
8 2.305 2.476 2.658 2.853 3.059 3.278 3.511 3.759 4.021 4.300
9 2.558 2.773 3.004 3.252 3.518 3.803 4.108 4.435 4.785 5.160
10 2.839 3.106 3.395 3.707 4.046 4.411 4.807 5.234 5.695 6.192
11 3.152 3.479 3.836 4.226 4.652 5.117 5.624 6.176 6.777 7.430
12 3.498 3.896 4.334 4.818 5.350 5.936 6.580 7.288 8.064 8.916
13 3.883 4.363 4.898 5.492 6.153 6.886 7.699 8.599 9.596 10.699
14 4.310 4.887 5.535 6.261 7.076 7.987 9.007 10.147 11.420 12.839
15 4.785 5.474 6.254 7.138 81.37 9.265 10.539 11.974 13.589 15.407
16 5.311 6.130 7.067 8.137 9.358 10.748 12.330 14.129 16.171 18.488
17 5.895 6.866 7.986 9.276 10.761 12.468 14.426 16.672 19.244 22.186
18 6.543 7.690 9.024 10.575 12.375 14.462 16.879 19.673 22.900 26.623
19 7.263 8.613 10.197 12.055 14.232 16.776 19.748 23.214 27.251 31.948
20 8.062 9.646 11.523 13.743 16.366 19.461 23.105 27.393 32.429 38.337
21 8.949 10.804 13.021 15.667 18.821 22.574 27.033 32.323 38.591 237.373
22 9.933 12.100 14.713 17.861 21.644 26.186 31.629 38.141 45.923 55.205
23 11.026 12.552 16.626 20.361 24.891 30.376 37.005 45.007 54.648 66.247
24 12.239 15.178 18.788 23.212 28.625 35.236 43.296 53.108 65.031 79.496
25 13.585 17.000 21.230 26.461 32.918 40.874 50.656 62.667 77.387 95.395
30 22.892 29.960 39.115 50.949 66.210 85.849 111.061 143.367 184.672 237.373
35 38.574 52.799 72.066 98.097 133.172 180.311 243.495 327.988 440.691 590.657
40 64.999 93.049 132.776 188.876 267.856 378.715 533.846 750.353 1051.642 1469.740
45 109.527 163.985 244.629 363.662 538.752 795.429 1170.425 1716.619 2509.583 3657.176
50 184.559 288.996 450.711 700.197 1083.619 1670.669 2566.080 3927.189 5988.730 9100.191
(590)
Table-A : The Compound Sum of One Rupee
Year 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 1.210 1.220 1.230 1.240 1.250 1.260 1.270 1.280 1.290 1.300
2 1.464 1.488 1.513 1.538 1.562 1.588 1.613 1.638 1.664 1.690
3 1.772 1.816 1.861 1.907 1.953 2.000 2.048 2.097 2.147 2.197
4 2.144 2.215 2.289 2.364 2.441 2.520 2.601 2.684 2.769 2.856
5 2.594 2.703 2.815 2.932 3.052 3.176 3.304 3.436 3.572 3.713
6 3.138 3.297 3.463 3.635 3.815 4.001 4.196 4.398 4.608 4.827
7 3.797 4.023 4.259 4.508 4.768 5.042 5.329 5.629 5.945 6.275
8 4.595 4.908 5.239 5.589 5.960 6.353 6.767 7.206 7.669 8.157
9 5.560 5.987 6.444 6.931 7.451 8.004 8.595 9.223 9.893 10.604
10 6.727 7.305 7.926 8.594 9.313 10.086 10.915 11.806 12.761 13.786
11 8.140 8.912 9.749 10.657 11.642 12.708 13.862 15.112 16.462 17.921
12 9.850 10.872 11.991 13.215 14.552 16.012 17.605 19.343 21.236 23.298
13 11.918 13.264 14.749 16.386 18.190 20.175 22.359 24.759 27.395 30.287
14 14.421 16.182 18.141 20.319 22.737 25.420 28.395 31.691 35.339 39.373
15 17.449 19.742 22.314 25.195 28.422 32.030 36.062 40.565 45.587 51.185
16 21.113 24.085 27.446 31.242 35.527 40.357 45.799 51.923 58.808 66.541
17 25.547 29.384 33.758 38.740 44.409 50.850 58.165 66.461 75.862 86.503
18 30.912 35.848 41.523 48.038 55.511 64.071 73.869 85.070 97.862 112.454
19 37.404 43.735 51.073 59.567 69.389 80.730 93.813 108.890 126.242 146.190
20 45.258 53.357 62.820 73.863 86.736 101.720 119.143 139.379 162.852 190.047
21 54.762 65.095 77.268 91.591 108.420 128.167 151.312 178.405 210.079 247.061
22 66.262 79.416 95.040 113.572 135.525 161.490 192.165 228.358 271.002 321.178
23 80.178 96.887 116.899 140829 169.407 203.477 244.050 292.298 349.592 417.531
24 97.015 118.203 143.786 174.628 211.758 256.381 309.943 374.141 450.974 542.791
25 117.388 144.207 176.857 261.539 264.698 323.040 393.628 478.901 581.756 705.627
30 304.471 389.748 497.904 634.810 807.793 1025.904 1300.477 1645.488 2078.208 2619.936
35 789.716 1053.370 1401.749 1861.020 2465.189 3258.053 4296.547 5653.840 7423.988 9727.598
40 2048.309 2846.941 3946.340 5455.797 5723.156 10346.879 14195.051 19426.418 26520.723 36117.754
45 5312.758 7694.418 11110.121 15994.316 22958.844 32859.457 46897.973 66748.500 94739.937 134102.187
50 13779.844 20795.680 31278.301 46889.207 70064.812 104354.562 154942.687 229345.875 338440.000 497910.125
(591)
Table-A : The Compound Sum of One Rupee
Year 31% 32% 33% 34% 35% 36% 37% 38% 39% 40%
1 1.310 1.320 1.330 1.340 1.350 1.360 1.370 1.380 1.390 1.400
2 1.716 1.742 1.769 1.796 1.822 1.850 1.877 1.904 1.932 1.960
3 2.248 2.300 2.353 2.406 2.460 2.515 2.571 2.628 2.686 2.744
4 2.945 3.036 3.129 3.224 3.312 3.421 3.523 3.627 3.733 3.842
5 3.858 4.007 4.162 4.320 4.484 4.653 4.826 5.005 5.189 5.378
6 5.054 5.290 5.535 5.789 6.053 6.328 6.612 6.907 7.213 7.530
7 6.621 6.983 7.361 7.758 8.172 8.605 9.058 9.531 10.025 10.541
8 8.673 9.217 9.791 10.395 11.032 11.703 12.410 13.153 13.935 14.758
9 11.362 12.166 13.022 13.930 14.894 15.917 17.001 18.151 19.370 20.661
10 14.884 16.060 17.319 18.666 20.106 21.646 23.292 25.049 26.924 28.925
11 19.498 21.199 23.034 25.012 27.144 29.439 31.910 34.567 37.425 40.495
12 25.542 27.982 30.635 33.516 36.644 40.037 43.716 47.703 52.020 56.694
13 33.460 36.937 40.745 44.912 49.469 54.451 59.892 65.830 72.308 79.371
14 43.832 48.756 54.190 60.181 66.784 74.053 82.051 90.845 100.509 111.119
15 57.420 64.358 72.073 80.643 90.158 100.712 112.410 125.366 139.707 155.567
16 75.220 84.953 95.857 108.061 121.713 136.968 154.002 173.005 194.192 217.793
17 98.539 112.138 127.490 144.802 164.312 186.277 210.983 238.747 269.927 304.911
18 129.086 148.022 169.561 194.035 221.822 253.337 289.046 329.471 375.198 426.875
19 169.102 195.389 225.517 260.006 299.459 344.537 395.993 454.669 521.525 597.625
20 221.523 257.913 299.937 348.408 404.270 468.571 542.511 627.443 724.919 836.674
21 290.196 340.446 398.916 466.867 545.764 637.256 743.240 865.871 1007.637 1171.343
22 380.156 449.388 530.558 625.601 736.781 866.668 1018.238 1194.900 1400.615 1639.878
23 498.004 593.192 705.642 838.305 994.653 1178.668 1394.986 1648.961 1946.854 2295.829
24 652.385 783.013 938.504 1123.328 1342.781 1602.988 1911.129 2275.564 2706.125 3214.158
25 854.623 1033.577 1248.210 1505.528 1812.754 2180.063 2618.245 3140.275 3761.511 3499.816
30 3297.081 4142.008 5194.516 6503.285 8128.426 10142.914 12636.086 15716.703 19517.969 24201.043
35 12719.918 16598.906 21617.363 28096.695 36448.051 47190.727 60983.836 78660.188 101276.125 130158.687
40 49072.621 66519.313 89962.188 121388.437 163433.875 219558.625 294317.937 393684.687 525508.312 700022.688
(592)
Table-B : The Compound Sum of One Rupee
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100
3 3.030 3.060 3.091 3.122 3.152 3.184 3.215 3.246 3.278 3.310
4 4.060 4.122 41.84 4.246 4.310 4.375 4.440 4.506 4.573 4.641
5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105
6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716
7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487
8 8.286 8.583 8.892 9.214 9.549 9.897 10.260 10.637 11.028 11.436
9 9.368 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579
10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937
11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531
12 12.682 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384
13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523
14 14.947 15.974 17.086 18.292 19.598 21.015 22.550 24.215 26.019 27.975
15 16.097 17.293 18.599 20.023 21.578 23.276 25.129 27.152 29.361 31.772
16 17.258 18.639 20.157 21.824 23.657 25.672 27.888 30.324 33.003 35.949
17 18.430 20.012 21.761 23.697 25.840 28.213 30.840 33.750 36.973 40.544
18 19.614 21.412 23.414 25.645 28.132 30.905 33.999 37.540 41.301 45.599
19 20.811 21.840 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.158
20 22.019 24.297 26.870 29.778 33.066 36.785 40.995 45.672 51.169 57.274
21 23.239 25.783 28.676 31.969 35.719 39.992 44.865 50.422 56.754 65.002
22 24.471 27.299 30.536 34.248 38.505 43.392 49.005 55.456 62.872 71.402
23 25.716 28.845 32.452 36.618 41.340 46.995 53.435 60.893 6.531 79.542
24 26.973 30.421 34.426 39.082 44.501 50.815 58.176 66.764 76.789 88.496
25 28.243 32.30 36.459 41.645 47.726 54.864 63.248 73.105 84.699 98.346
30 34.784 40.567 47.575 56.084 66.438 79.057 95.459 113.282 136.305 164.491
35 41.659 49.994 50.461 73.651 90.318 11.432 138.234 172.314 215.705 271.018
40 48.885 60.401 75.400 95.024 120.797 154.758 199.630 259.052 337.872 442.580
45 56.479 71.891 92.718 121.027 159.695 212.737 285.741 386.497 525.840 718.881
50 64.461 84.577 112.794 152.664 209.341 290.325 406.516 573.756 815.051 1163.865
(593)
Table-B : The Compound Sum of One Rupee
Year 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.110 2.120 2.130 2.140 2.150 2.160 2.170 2.180 2.190 2.200
3 3.342 3.374 3.407 3.440 3.472 3.506 3.539 3.572 3.606 3.640
4 4.710 4.779 4.850 4.921 4.993 5.066 5.141 5.215 5.291 5.338
5 6.228 6.353 6.480 6.610 6.742 6.877 7.014 7.154 7.297 7.442
6 7.913 8.115 8.323 8.535 8.754 9.897 9.207 9.442 9.683 9.930
7 9.783 10.089 10.405 10.730 11.067 11.414 11.772 12.141 12.523 12.916
8 11.859 12.300 12.757 13.233 13.727 14.240 14.773 15.327 15.902 16.499
9 14.164 14.776 15.416 16.085 16.786 17.518 18.285 19.086 19.923 20.799
10 16.722 17.549 18.420 19.337 20.304 21.321 22.393 23.521 24.709 25.959
11 19.561 20.655 21.814 23.044 24.349 25.733 27.200 28.755 30.403 32.150
12 22.713 24.133 25.650 27.271 29.001 30.850 32.824 34.931 37.180 39.580
13 26.211 28.029 29.984 32.088 34.352 36.786 39.404 42.218 45.244 48.496
14 30.095 32.392 34.882 37.581 40.504 43.672 47.102 50.818 54.841 59.196
15 34.405 37.280 40.417 43.842 47.580 51.659 56.109 60.965 66.260 72.035
16 39.190 42.753 46.671 50.980 55.717 60.925 66.648 72.938 79.850 87.442
17 44.500 48.883 53.738 59.117 65.075 71.673 78.978 87.067 96.021 105.930
18 50.396 55.749 61.724 68.393 75.836 84.140 93.404 103.739 115.265 128.116
19 56.939 63.439 70.748 78.968 88.211 98.603 110.283 123.412 138.165 154.739
20 64.202 72.052 80.946 91.024 102.443 115.379 130.031 146.626 165.417 186.687
21 72.264 81.968 92.468 104.767 118.809 134.840 153.136 174.019 197.846 225.024
22 81.213 92.502 105.489 120.434 137.630 157.414 180.169 206.342 236.436 217.028
23 91.147 104.602 120.203 138.295 159.274 183.600 211.798 244.483 282.359 326.234
24 102.173 118.154 136.829 158.656 184.166 213.976 248.803 289.490 337.007 392.480
25 114.412 133.333 155.616 181.867 212.790 249.212 292.099 342.598 402.038 471.976
30 199.018 241.330 293.192 356.778 434.738 530.306 647.423 790.932 966.698 1181.865
35 341.583 431.658 546.663 693.552 881.152 1120.699 1426.448 1816.607 2314.173 2948.294
40 581.812 767.080 1013.667 1341.979 1779.048 2360.724 3134.412 4163.094 5529.711 7343.715
45 986.613 1358.208 1874.086 2590.464 3585.031 4965.191 6879.008 9531.258 13203.105 18280.914
50 1668.732 2399.975 3459.975 4994.301 7217.488 10435.449 15088.805 21812.273 31514.492 45496.094
(594)
Table-B : The Compound Sum of One Rupee
Year 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.210 2.220 2.230 2.240 2.250 2.260 2.270 2.280 2.290 2.300
3 3.674 3.708 3.743 3.778 3.813 3.848 3.883 3.918 3.954 3.990
4 5.446 5.524 5.604 5.684 5.766 5.848 5.931 6.016 6.101 6.187
5 7.589 7.740 7.893 8.048 8.207 8.368 8.533 8.700 8.870 9.043
6 10.183 10.442 10.708 10.980 11.259 11.544 11.837 12.136 12.442 12.756
7 13.321 13.740 14.171 14.615 15.073 15.546 16.032 16.534 17.051 17.583
8 17.119 17.762 18.430 19.123 19.842 20.588 21.361 22.163 22.995 23.858
9 21.714 22.670 23.669 24.712 25.802 26.940 28.129 29.369 30.664 32.015
10 27.274 28.657 30.113 31.643 33.253 34.945 36.723 38.592 40.556 42.619
11 34.001 35.962 38.039 40.238 42.566 45.030 47.639 50.398 53.318 56.405
12 42.141 44.873 47.787 50.895 54.208 57.738 61.501 65.510 69.780 74.326
13 51.991 55.745 59.778 64.109 68.760 73.750 79.106 84.853 91.016 97.624
14 63.909 69.009 74.528 80.496 86.949 93.925 101.465 109.611 118.411 127.912
15 78.330 85.191 92.669 100.815 109.687 119.346 129.860 141.302 153.750 167.285
16 95.779 104.933 114.983 126.010 138.109 151.375 165.922 181.867 199.337 218.470
17 116.982 129.019 142.428 157.252 173.636 191.733 211.721 233.790 258.145 285.011
18 142.439 158.403 176.187 195.993 218.045 242.583 269.885 300.250 334.006 371.514
19 173.351 194.251 217.710 244.031 273.556 306.654 343.754 385.321 431.868 483.968
20 210.755 237.986 268.783 303.598 342.945 387.384 437.568 494.210 558.110 630.157
21 256.013 291.343 331.603 337.461 429.681 489.104 556.710 633.589 720.962 820.204
22 310.775 356.438 408.871 469.052 538.101 617.270 708.022 811.993 931.040 1067.265
23 377.038 435.854 503.911 582.624 673.626 778.760 900.187 1040.351 1202.042 1388.443
24 457.215 523.741 620.810 732.453 843.032 982.237 1144.237 1332.649 1551.634 1805.975
25 554.230 650.944 764.596 898.082 1054.791 1238.617 1454.180 1706.790 2002.608 2348.765
30 1445.110 1767.044 2160.459 2640.881 3227.172 3941.953 4812.891 5873.172 7162.785 8729.805
35 3755.314 4783.520 6090.227 7750.094 9856.746 12527.160 15909.480 20188.742 25596.512 32422.090
40 9749.141 12936.141 17153.691 22728.167 30088.621 39791.957 52570.707 69376.562 91447.375 120389.375
45 25294.223 34970.230 48300.660 66638.937 91813.312 126378.937 173692.875 238384.312 326686.375 447005.062
(595)
Table-B : The Compound Sum of One Rupee
Year 31% 32% 33% 34% 35% 36% 37% 38% 39% 40%
1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2 2.310 2.320 2.330 2.340 2.350 2.360 2.370 2.380 2.3900 2.400
3 4.026 4.062 4.099 4.136 4.172 4.210 4.247 4.284 4.322 4.360
4 6.274 6.362 6.452 6.542 6.633 6.725 6.818 6.912 7.008 7.104
5 9.219 9.398 9.581 9.766 9.954 10.146 10.341 10.539 10.741 10.946
6 13.077 13.406 13.742 14.086 14.438 14.799 15.167 15.544 15.930 16.324
7 18.131 18.696 19.277 19.876 20.492 21.126 21.779 22.451 23.142 23.853
8 24.752 25.678 26.638 27.633 28.664 29.732 30.837 31.982 33.167 34.395
9 33.425 34.895 36.429 38.028 39.629 41.435 43.247 45.135 47.103 4.152
10 44.786 47.062 49.451 51.958 54.590 57.351 60.248 63.287 66.473 69.813
11 59.670 63.121 66.769 70.624 74.696 78.998 83.540 88.335 98.397 98.739
12 79.167 84.320 89.803 95.636 101.840 108.437 115.450 122.903 130.882 139.234
13 10.709 112.302 120.438 129.152 138.484 148.474 159.166 170.606 182.842 195.928
14 138.169 149.239 161.183 174063 187.953 202.925 219.058 236.435 255.151 275.299
15 182.001 197.996 215.373 234.245 254.737 276.978 301.109 327.281 355.659 386.418
16 239.421 262.354 287.446 314.888 344.895 377.690 413.520 452.647 495.366 541.985
17 314.642 347.307 383.303 422.949 466.608 514.658 567.521 625.652 689.558 759.778
18 413.180 459.445 510.792 567.751 630.920 700.935 778.504 864.399 959.485 1064.689
19 542.266 607.467 680.354 761.786 852.741 954.271 1067.551 1193.870 1334.683 1491.563
20 711.368 802.856 905.870 1021.792 1152.220 1298.809 1463.544 1648.539 1856.208 2089.188
21 932.891 1060.769 1205.807 1370.201 1556.470 1767.380 2006.055 2275.982 2581.128 2925.862
22 1223.087 1401.215 1604.724 1837.068 2102.234 2404.636 2749.294 3141.852 3588.765 4097.203
23 1603.243 1850.603 2135.282 2462.669 2839.014 3271.304 3767.532 4336.750 4989.379 5737.078
24 2101.247 2443.795 2840.924 33900.974 3833.667 4449.969 5162.516 5985.711 6936.230 8032.906
25 2753.631 3226.808 3779.428 4424.301 51767.445 6052.957 7073.645 8261.273 9642.352 11247.062
30 10632.543 12940.672 15737.945 19124.434 23221.258 28172.016 34148.906 41357.227 50043.625 60500.207
(596)
Table-C : The Present Value of One Rupee
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 .990 .980 .971 .962 .952 .943 .935 .926 .917 .909
2 .980 .961 .943 .925 .907 .890 .873 .857 .842 .826
3 .971 .942 .915 .889 .864 .840 .816 .794 .772 .751
4 .961 .924 .888 .855 .823 .792 .763 .735 .708 .683
5 .951 .906 .863 .822 .784 .747 .713 .681 .650 .621
6 .942 .888 .837 .790 .746 .705 .666 .630 .596 .564
7 .933 .871 .813 .760 .711 .665 .623 .583 .547 .513
8 .923 .853 .789 .731 .677 .627 .582 .540 .502 .467
9 .914 .837 .766 .703 .645 .592 .544 .500 .460 .424
10 .905 .820 .744 .676 .614 .558 .508 .463 .422 .386
11 .896 .804 .722 .650 .585 .527 .475 .429 .388 .350
12 .887 .789 .701 .625 .557 .497 .444 .397 .356 .319
13 .879 .773 .681 .601 .530 .469 .415 .368 .326 .290
14 .870 .758 .661 .577 .505 .442 .388 .340 .299 .263
15 .861 .743 .642 .555 .481 .417 .362 .315 .275 .239
16 .853 .728 .623 .534 .458 .394 .339 .292 .252 .218
17 .844 .714 .605 .513 .436 .371 .317 .270 .231 .198
18 .836 .700 .587 .494 .416 .350 .296 .250 .212 .180
19 .828 .686 .570 .475 .396 .331 .227 .232 .194 .164
20 .820 .673 .554 .456 .377 .312 .258 .215 .178 .149
21 .811 .660 .538 .439 .359 .294 .242 .199 .164 .135
22 .803 .647 .522 .422 .342 .278 .226 .184 .150 .123
23 .795 .634 .507 .406 .326 .262 .211 .170 .138 .112
24 .788 .622 .492 .390 .310 .247 .197 .158 .126 .102
25 .780 .610 .478 .375 .295 .233 .184 .146 .116 .092
30 .742 .552 .412 .308 .231 .174 .131 .099 .075 .057
35 .706 .500 .355 .253 .181 .130 .094 .068 .049 .036
40 .672 .453 .307 .208 .142 .097 .067 .046 .032 .022
45 .639 .410 .264 .171 .111 .073 .048 .031 .021 .014
50 .806 .372 .228 .141 .087 .054 .034 .021 .013 .009
(597)
Table-C : The Present Value of One Rupee
Year 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 .901 .893 d.885 .877 .870 .862 .855 .847 .840 .833
2 .812 .797 .783 .769 .756 .743 .731 .718 .706 .694
3 .731 .712 .693 .675 .658 .641 .624 .609 .593 .579
4 .659 .636 .613 .592 .572 .552 .534 .516 .499 .482
5 .593 .567 .543 .519 .497 .476 .456 .437 .419 .402
6 .535 .507 .480 .456 .432 .410 .390 .370 .352 .335
7 .482 .452 .425 .400 .376 .354 .333 .314 .296 .279
8 .434 .404 .376 .351 .327 .305 .285 .266 .249 .233
9 .391 .361 .333 .308 .284 .263 .243 .225 .209 .194
10 .352 .322 .295 .270 .247 .227 .208 .191 .176 .162
11 .317 .287 .261 .237 .215 .195 .178 .162 .148 .135
12 .286 .257 .231 .208 .187 .168 .152 .137 .124 .112
13 .258 .229 .204 .182 .163 .145 .130 .116 .104 .093
14 .232 .205 .181 .160 .141 .125 .111 .099 .88 .078
15 .209 .183 .160 .140 .123 .108 .095 0.84 .074 0.65
16 .188 .163 .141 .123 .107 .093 .081 .071 .062 .054
17 .170 .146 .125 .108 .093 .080 .069 .060 .052 .045
18 .153 .130 .111 .095 .081 .069 .059 .051 .044 0.38
19 .138 .116 .098 .083 .070 .060 .051 .043 0.37 .031
20 .124 .104 .087 .073 .061 .051 .043 .037 .031 .026
21 .112 .093 .077 .064 .053 .044 .037 .031 .026 .022
21 .101 .083 .068 .056 .046 .038 .032 .026 .022 .018
23 .091 .074 .060 .049 .040 .033 .027 .022 .018 .015
24 .082 .066 .053 .043 .035 .028 .023 .019 .015 .013
25 .074 .059 .047 .038 .030 .024 .020 .016 .013 .010
30 .044 .033 .026 .020 .015 .012 .009 .007 .005 .004
35 .026 .019 .014 .010 .008 .006 .004 .003 .002 .002
40 .015 .011 .008 .005 .004 .003 .002 .001 .001 .001
45 .009 .006 .004 .003 .002 .001 .001 .001 .000 .000
50 .005 .003 .002 .001 .001 .001 .000 .000 .000 .000
(598)
Table-C : The Present Value of One Rupee
Year 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 .826 .820 .813 .806 .800 .794 .787 .781 .775 .769
2 .683 .672 .661 .650 .640 .630 .620 .610 .601 .592
3 .564 .551 .537 .524 .512 .500 .488 .477 .466 .455
4 .467 .451 .437 .423 .410 .397 .384 .373 .361 .350
5 .386 .370 .355 .341 .328 .315 .303 .291 .280 .269
6 .319 .303 .289 .275 .262 .250 .238 .227 .217 .207
7 .263 .249 .235 .222 .210 .198 .188 .178 .168 .159
8 .218 .204 .191 .179 .168 .157 .148 .139 .130 .123
9 .180 .167 .155 .144 .134 .125 .116 .108 .101 .094
10 .149 .137 .126 .116 .107 .099 .092 .085 0.78 .073
11 .123 .112 .103 .904 .086 .079 .072 .066 .061 .056
12 .102 .092 .083 .076 .069 .062 .057 .052 .047 .043
13 .084 .075 .068 .061 .055 .050 .045 .040 .037 .033
14 .069 .062 .055 .049 .044 .039 .035 .032 .028 .025
15 .057 .051 .045 .040 .035 .031 .028 .025 .022 .020
16 .047 .042 .036 .032 .028 .025 .022 .019 .017 .015
17 .039 .034 .030 .026 .023 .020 .017 .015 .013 .012
18 .032 .028 .024 .021 .018 .016 .014 .012 .010 .009
19 .027 .023 .020 .017 .014 .012 .011 .009 .008 .007
20 .022 .019 .016 .014 0.012 .010 .008 .007 .006 .005
21 .018 .015 .013 .011 .009 .008 .007 .006 .005 .004
22 .015 .013 .011 .009 .007 .006 .005 .004 .004 .003
23 .012 .010 .009 .007 .006 .005 .004 .003 .003 .002
24 .010 .008 .007 .006 .005 .004 .003 .003 .002 .002
25 .009 .007 .006 .005 .004 .003 .003 .002 .002 .001
30 .003 .003 .002 .002 .001 .001 .001 .001 .000 .000
35 .001 .001 .001 .001 .000 .000 .000 .000 .000 .000
40 .000 .000 .000 .000 .000 .000 .000 .000 .000 .000
45 .000 .000 .000 .000 .000 .000 .000 .000 .000 .000
50 .000 .000 .000 .000 .000 .000 .000 .000 .000 .000
(599)
Table-C : The Present Value of One Rupee
Year 31% 32% 33% 34% 35% 36% 37% 38% 39% 40%
1 .763 .758 .752 .746 .741 .735 .730 .725 .0719 .714
2 .583 .574 .565 .557 .549 .541 .533 .525 .518 .510
3 .445 .435 .425 .416 .406 .398 .389 .381 .372 .364
4 .340 .329 .320 .310 .301 .292 .284 .276 .268 .260
5 .259 .250 .240 .231 .223 .215 .207 .200 .193 .186
6 .198 .189 .181 .173 .165 .158 .151 .145 .139 .133
7 .151 .143 .136 .129 .122 .116 .110 .105 .100 .095
8 .115 .108 .102 .096 .091 .085 0.081 .076 .072 .068
9 .088 .082 .077 .072 .067 .063 .059 .055 .052 .048
10 .067 .062 .058 .054 .050 .046 .043 .040 .037 .035
11 .051 .047 .043 .040 .037 .034 .031 .029 .027 .025
12 .039 .036 .033 .030 .027 .025 .023 .021 .019 .018
13 .030 .027 .025 .022 .020 .018 .017 .015 .014 .013
14 .023 .021 .018 .017 .015 .014 .012 .011 .010 .009
15 .017 .016 .014 .012 .011 .010 .009 .008 .007 .006
16 .013 .012 .010 .009 .008 .007 .006 .006 .005 .005
17 .010 .009 .008 .007 .006 .005 .005 .004 .004 .003
18 .008 .007 .006 .005 .005 .004 .003 .003 .003 .002
19 .006 .005 .004 .004 .003 .003 .003 .002 .002 .002
20 .005 .004 .003 .003 .002 .002 .002 .002 .001 .001
21 .003 .003 .003 .002 .002 .002 .001 .001 .001 .001
22 .003 .002 .002 .002 .001 .001 .001 .001 .001 .001
23 .002 .002 .001 .001 .001 .001 .001 .001 .001 .000
24 .002 .001 .001 .001 .001 .001 .001 .000 .000 .000
25 .001 .001 .001 .001 .001 .000 .000 .000 .000 .000
30 .000 .000 .000 .000 .000 .000 .000 .000 .000 .000
35 .000 .000 .000 .000 .000 .000 .000 .000 .000 .000
40 .000 .000 .000 .000 .000 .000 .000 .000 .000 .000
45 .000 .000 .000 .000 .000 .000 .000 .000 .000 .000
50 .000 .000 .000 .000 .000 .000 .000 .000 .000 .000
(600)
Table-D : The Present Value of an Annutiy of One Rupee
Year 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1 .990 .980 .971 .962 .952 .943 .935 .926 .917 .909
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868
8 7.652 7.326 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145
11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103
14 13.004 12.106 11.296 10.563 9.899 9.295 8.746 8.244 7.786 7.367
15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.560 8.061 7.606
16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824
17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022
18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201
19 17.226 15.679 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365
20 18.046 16.352 14.878 13.590 12.462 11.470 10.594 9.818 9.129 8.514
21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.292 8.649
22 19.661 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.442 8.772
23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.580 8.883
24 21.244 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.707 8.985
25 22.023 19.524 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077
30 25.808 22.397 19.601 17.292 15.373 13.765 12.409 11.258 10.274 9.427
35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.644
40 32.835 27.356 23.115 19.793 17.159 15.046 12.332 11.925 10.757 9.779
45 36.095 29.490 24.519 20.720 17.774 15.456 13.606 12.108 10.881 9863
50 39.197 31.424 25.730 21.482 18.256 15.762 13.801 12.234 10.962 9.915
(601)
Table-D : The Present Value of an Annutiy of One Rupee
Year 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
1 .901 .893 .885 .877 .870 .862 .855 .847 .850 .833
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.487 4.327
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533
14 6.982 6.628 5.303 6.002 5.724 5.468 5.229 5.008 4.802 4.611
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675
16 7.379 6.974 6.604 6.265 5.954 5.669 5.405 5.162 4.938 4.730
17 7.549 7.120 6.729 6.373 6.047 5.749 5.475 5.222 4.990 4.775
18 7.702 7.250 6.840 6.467 6.128 5.818 5.534 5.273 5.033 4.812
19 7.839 7.366 6.938 6.550 6.198 5.877 5.585 5.316 5.070 4.843
20 7.963 7.469 7.024 6.623 6.259 5.929 5.628 5.353 5.101 4.870
21 8.075 7.562 7.102 6.687 6.312 5.973 5.665 5.384 5.127 4.891
22 8.176 7.645 7.170 6.743 6.359 6.011 5.696 5.410 5.149 4.909
23 8.266 7.718 7.230 6.792 6.399 6.044 6.723 5.432 5.167 4.925
24 8.348 7.784 7.283 6.835 6.434 6.073 5.747 5.451 5.182 4.937
25 8.422 7.843 7.330 6.873 6.464 6.097 5.766 5.467 5.195 4.948
30 8.694 8.055 7.496 7.003 6.566 6.177 5.829 5.517 5.235 4.979
35 8.855 8.176 7.586 7.070 6.617 6.215 5.858 5.539 5.251 4.992
40 8.951 8.244 7.634 7.105 6.642 6.233 5.871 5.548 5.258 4.997
45 9.008 8.283 7.661 7.123 6.654 6.242 5.877 5.552 5.261 4.999
50 9.042 8.305 7.675 7.133 6.661 6.246 5.880 5.554 5.262 4.999
(602)
Table-D : The Present Value of an Annutiy of One Rupee
Year 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
1 8.26 .820 8.13 .806 .800 .794 .787 .781 .775 .769
2 1.509 1.492 1.474 1.457 1.440 1.424 1.407 1.392 1.376 1.361
3 2.074 2.042 2.011 1.981 1.952 1.923 1.896 1.868 1.842 1.816
4 2.540 2.494 2.448 2.404 2.362 2.320 2.280 2.241 2.203 2.166
5 2.926 2.864 2.803 2.745 2.689 2.635 2.583 2.532 2.483 2.436
6 3.245 3.167 3.092 3.020 2.951 2.885 2.821 2.759 2.700 2.643
7 3.508 3.416 3.327 3.242 3.161 3.083 3.009 2.937 2.868 2.802
8 3.726 3.619 3.518 3.421 3.329 3.241 3.156 3.076 2.999 3.925
9 3.905 3.786 3.673 3.566 3.463 3.366 3.273 3.184 3.100 3.019
10 4.054 3.923 3.799 3.682 3.570 3.465 3.364 3.269 3.178 3.092
11 4.177 4.035 4.902 3.776 3.656 3.544 3.437 3.335 3.239 3.147
12 4.278 4.127 3.985 3.851 3.752 3.606 3.493 3.387 3.286 3.190
13 4.362 4.203 4.053 3.912 3.780 3.656 3.538 3.427 3.322 3.223
14 4.432 4.265 4.108 3.962 3.824 3.695 3.573 3.459 3.351 3.249
15 4.489 4.315 4.153 4.001 3.859 3.726 3.601 3.483 3.373 3.268
16 4.536 4.357 4.189 4.033 3.887 3.751 3.623 3.503 3.390 3.283
17 4.576 4.391 4.219 4.059 3.910 3.771 3.640 3.518 3.403 3.295
18 4.608 4.419 4.243 4.080 3.928 3.786 3.654 3.529 3.413 3.304
19 4.635 4.442 4.263 4.097 3.942 3.799 3.664 3.539 3.421 3.311
20 4.657 4.460 4.279 4.110 3.954 3.808 3.673 3.546 3.427 3.316
21 4.675 4.476 4.292 4.121 3.963 3.816 3.679 3.551 3.432 3.320
22 4.690 4.488 4.302 4.130 3.970 3.822 3.684 3.556 3.436 3.323
23 4.703 4.499 4.311 4.137 3.976 3.827 3.689 3.559 3.438 3.325
24 4.713 4.507 4.318 4.143 3.981 3.831 3.692 3.562 3.441 3.327
25 4.721 4.514 4.323 4.147 3.985 3.834 3.694 3.564 3.442 3.329
30 4.746 4.534 4.339 4.160 3.995 3.842 3.701 3.569 3.447 3.332
35 4.756 4.541 4.345 4.164 3.998 3.845 3.703 3.571 3.448 3.333
40 4.760 4.544 4.347 4.166 3.999 3.846 3.703 3.571 3.448 3.333
45 4.761 4.545 4.347 4.166 4.000 3.846 3.704 3.571 3.448 3.333
50 4.762 4.545 4.348 4.167 4.000 3.846 3.704 3.571 3.448 3.333
(603)
Table-D : The Present Value of an Annutiy of One Rupee
Year 31% 32% 33% 34% 35% 36% 37% 38% 39% 40%
1 .763 .758 .752 .746 .741 .735 .730 .725 .719 .714
2 1.346 1.331 1.317 1.303 1.289 1.276 1.263 1.250 1.237 1.224
3 1.791 1.766 1.742 1.719 1.696 1.673 1.652 1.630 1.609 1.589
4 2.130 2.096 2.062 2.029 1.997 1.966 1.935 1.906 1.877 1.849
5 2.390 2.345 2.302 2.260 2.220 2.181 2.143 2.106 2.070 2.035
6 2.588 2.534 2.483 2.433 2.385 2.339 2.294 2.251 2.209 2.168
7 2.739 2.677 2.619 2.562 2.508 2.455 2.404 2.355 2.308 2.263
8 2.854 2.786 2.721 2.658 2.598 2.540 2.485 2.432 2.380 2.331
9 2.942 2.868 2.798 2.730 2.665 2.603 2.544 2.487 2.432 2.379
10 3.009 2.930 2.855 2.784 2.715 2.649 2.587 2.527 2.469 2.414
11 3.060 2.978 2.899 2.824 2.752 2.683 2.618 2.555 2.496 2.438
12 3.100 3.013 2.931 2.853 2.779 2.708 2.641 2.576 2.515 2.456
13 3.129 3.040 2.956 2.876 2.799 2.727 2.658 2.592 2.529 2.469
14 3.152 3.061 2.974 2.892 2.814 2.740 2.670 2.603 2.539 2.477
15 3.170 3.076 2.988 2.905 2.825 2.750 2.679 2.611 2.546 2.484
16 3.183 3.088 2.999 2.914 2.834 2.757 2.685 2.616 2.551 2.489
17 3.193 3.097 3.007 2.921 2.840 2.763 2.690 2.621 2.555 2.492
18 3.201 3.104 3.012 2.926 2.844 2.767 2.693 2.624 2.557 2.494
19 3.207 3.109 3.017 2.930 2.848 2.770 2.696 2.626 2.559 2.496
20 3.211 3.113 3.020 2.933 2.850 2.772 2.698 2.627 2.561 2.497
21 3.215 3.116 3.023 2.935 2.852 2.773 2.699 2.629 2.562 2.498
22 3.217 3.118 3.025 2.936 2.853 2.775 2.700 2.629 2.562 2.498
23 3.219 3.120 3.026 2.938 2.854 2.775 2.701 2.630 2.563 2.499
24 3.221 3.121 3.027 2.939 2.855 2.776 2.701 2.630 2.563 2.499
25 3.222 3.122 3.028 2.939 2.856 2.776 2.702 2.631 2.563 2.499
30 3.225 3.124 3.030 2.941 .857 2.777 2.702 2.631 2.564 2.500
35 3.226 3.125 3.030 2.941 2.857 2.778 2.703 2.632 2.564 2.500
40 3.226 3.125 3.030 2.941 2.857 2.778 2.703 2.632 2.564 2.500
45 3.226 3.125 3.030 2.941 2.857 2.778 2.703 2.632 2.564 2.500
50 3.226 3.125 3.030 2.941 2.857 2.778 2.703 2.632 2.564 2.500
(604)
Table-E : Z-Table Values of the Standard Normal Distribution Function
σ
x/σ .001 .01 .02 .03 .04 .05 .06 .07 .08 .09
0.0 .0000 .0040 .0080 .0120 .0160 .1099 .0239 .0279 .0319 .0359
0.1 .0398 .0438 .0478 .0517 .0557 .0596 .0636 .0675 .0714 .0753
0.2 .0793 .0832 .0871 .0910 .0948 .0987 .1020 .1064 .1103 .1133
0.3 .1179 .1217 .1255 .1293 .1331 .1363 .1406 .1443 .1480 .1515
0.4 .1554 .1591 .1682 .1664 .1700 .1736 .1772 .1808 .1844 .1570
0.5 .1915 .1950 .1935 .2019 .2054 .2088 .2123 .2157 .2190 .2324
0.6 .2257 .2291 .2324 .2357 .2389 .2422 .2454 .2486 .2518 .2549
0.7 .2580 .2612 .2642 .2673 .2704 .2734 .2764 .2794 .2823 .2892
0.8 .2881 .2910 .2939 .2967 .2995 .3023 .3051 .3078 .3106 .3185
0.9 .3159 .3186 .3212 .3238 .3264 .3289 .3315 .3340 .3365 .3389
1.0 .3413 .3438 .3461 .3485 .3508 .3531 .3554 .3577 .3599 .3621
1.1 .3648 .3665 .3686 .3708 .3729 .3749 .3770 .3790 .3810 .3830
1.2 .3849 .3869 .3888 .3907 .3925 .3944 .3962 .3980 .3997 .4015
1.3 .4032 .4049 .4066 .4082 .4099 .4115 .4131 .4147 .4162 .4177
1.4 .4192 .4207 .4222 .4236 .4251 .4265 .4279 .4292 .4305 .4319
1.5 .4332 .4345 .4357 .4370 .4382 .4394 .4406 .4418 .4429 .4441
1.6 .4452 .4463 .4474 .4484 .4495 .4505 .4515 .4525 .4535 .4545
1.7 .4554 .4564 .4573 .4582 .4591 .4599 .4608 .4616 .4625 .4633
1.8 .4641 .4649 .4656 .4664 .4671 .4678 .4686 .4693 .4699 .4706
1.9 .4713 .4719 .4726 .4732 .4738 .4744 .4750 .4750 .4761 .4767
(605)
Table-F : Z-Table Values of the Standard Normal Distribution Function
σ
x/σ .001 .01 .02 .03 .04 .05 .06 .07 .08 .09
2.0 .4772 .4778 .4783 .4788 .4793 .4798 .4803 .4803 .4812 .4817
2.1 .4821 .4826 .4830 .4834 .4838 .4842 .4846 .4850 .4854 .4857
2.2 .4861 .4864 .4868 .4871 .4875 .4878 .4881 .4884 .4887 .4890
2.3 .4893 .4896 .4898 .4901 .4904 .4906 .4909 .4911 .4913 .4916
2.4 .4918 .4920 .4922 .4925 .4927 .4929 .4931 .4932 .4934 .4936
2.5 .4938 .4940 .4941 .4943 .4945 .4946 .4948 .4949 .4951 .4952
2.6 .4953 .4955 .4956 .4957 .4959 .4960 .4961 .4962 .4963 .4964
2.7 .4965 .4966 .4967 .4968 .4969 .4970 .4971 .4972 .4973 .4974
2.8 .4974 .4975 .4976 .4977 .4977 .4978 .4979 .4979 .4980 4.981
2.9 .4981 .4982 .4982 .4983 .4984 .4984 .4985 .4985 .4986 .4986
3.0 .4986 .4987 .4987 .4988 .4988 .4989 .4989 .4989 .4990 .4990
3.1 .4990 .4991 .4991 .4991 .4992 .4992 .4992 .4992 .4993 4.993
3.2 .4993 .4993 .4994 .4994 .4994 .4994 .4994 .4995 .4995 .4995
3.3 .4995 .4995 .4996 .4996 .4996 .4996 .4996 .4996 .4996 .4997
3.4 .4996 .4997 .4997 .4997 .4997 .4997 .4997 .4997 .4998 .4998
3.5 .4997 .4998 .4998 .4998 .4998 .4998 .4998 .4998 .4998 .4998
3.6 .4998 .4998 .4999 .4999 .4999 .4999 .4999 .4999 .4999 .4999
3.7 .3998 .4999 .4999 .4999 .4999 .4999 .4999 .4999 .4999 .4999
3.8 .49992 .4999 .4999 .4999 .4999 .4999 .4999 .5000 .5000 .5000
3.9 .49995 .5000 .5000 .5000 .5000 .5000 .5000 .5000 .5000 .5000
4.0 .49996
4.5 .49999
5.0 .4999997

(606)
Table-F : Relationship Between Nominal and Effective Rate of Interest and Discount
Effective j(2) j(4) j(12) d d(2) d(4) d(12)
rate
Intrest
0.01 0.0100 0.0100 0.0100 0.0099 0.0099 0.0099 0.0099
0.02 0.0199 0.0199 0.0198 0.0196 0.0197 0.0198 0.0198
0.03 0.0298 0.0297 0.0296 0.0291 0.0293 0.0294 0.0295
0.04 0.0396 0.0394 0.0393 0.0385 0.0388 0.0390 0.0392
0.05 0.0494 0.0491 0.0489 0.0476 0.0482 0.0485 00487
0.06 0.0591 0.0587 0.0584 0.0566 0.0574 0.0578 0.0581
0.07 0.0688 0.0682 0.0678 0.0654 0.0665 0.0671 0.0675
0.08 0.0785 0.0777 0.0772 0.0741 0.0755 0.0762 0.0859
0.09 0.0881 0.0871 0.0865 0.0826 0.0843 0.0853 0.0859
0.10 0.0976 0.0965 0.0957 0.0909 0.0931 0.042 0.0949
0.11 0.1071 0.1057 0.1048 0.0991 0.1017 0.1030 0.1039
0.12 0.1166 0.1149 0.1139 0.1071 0.1102 0.1117 0.1128
0.13 0.1260 0.1241 0.1228 0.1150 0.1186 0.1204 0.1216
0.14 0.1354 0.1332 0.1317 0.1228 0.1268 0.1289 0.1303
0.15 0.1448 0.1422 0.1406 0.1304 0.1350 0.1373 0.1390
0.16 0.1541 0.1512 0.1493 0.1379 0.1430 0.1457 0.1475
0.17 0.1633 0.1601 0.1580 0.14534 0.1510 0.1540 0.1560
0.18 0.1726 0.1690 0.1667 0.1525 0.1589 0.1621 0.1644
0.19 0.1817 0.1778 0.1752 0.1597 0.1666 0.1702 0.1727
0.20 0.1909 0.1865 0.1837 0.1667 0.1743 0.1782 0.1809
0.21 0.2000 0.1952 0.1921 0.1736 0.1818 0.1861 0.1891
0.22 0.2091 0.2039 0.2005 0.1803 0.1893 0.1940 0.1972
0.23 0.2181 0.2125 0.2088 0.1870 0.1967 0.2017 0.2052
0.24 0.2271 0.2210 0.2171 0.1935 0.2039 0.2094 0.2132
0.26 0.2450 0.2379 0.2334 0.2063 0.2183 0.2246 0.2289
0.28 0.2627 0.2546 0.2494 0.2188 0.2322 0.2394 0.2443
0.30 0.2804 0.2712 0.2653 0.2308 0.2459 0.2539 0.2595
0.32 0.2978 0.2875 0.2809 0.2424 0.2592 0.2682 0.2744
0.34 0.3152 0.3036 0.2963 0.2537 0.2723 0.2822 0.2891
0.36 0.3324 0.3196 0.3115 0.2647 0.2850 0.2960 0.3036
0.38 0.3495 0.3354 0.3264 0.2754 0.2975 0.3095 0.3178
0.40 0.3664 0.3510 0.3412 0.2857 0.3097 0.3227 0.3318

(607)
Table-G : Relationship Between Nominal and Effective Rate of Interest and Discount
Effective j(2) j(4) j(12) d(2) d(4) d(12)
rate
Intrest
0.01 1.0025 1.0037 1.0046 1.0075 1.0062 1.0054
0.02 1.0050 1.0075 1.0091 1.0150 1.0125 1.0108
0.03 1.0074 1.0112 1.0137 1.0224 1.0187 1.0162
0.04 1.0099 1.0149 1.0182 1.0299 1.0249 1.0215
0.05 1.0123 1.0816 1.0227 1.0373 1.0311 1.0269
0.06 1.0148 1.0222 1.0272 1.0448 1.0372 1.0322
0.07 1.0172 1.0259 1.0317 1.0522 1.0434 1.0375
0.08 1.0196 1.0295 1.0362 1.0596 1.0495 1.0428
0.09 1.0220 1.0331 1.0406 1.0670 1.0556 1.0481
0.10 1.0244 1.0368 1.0450 1.0744 1.0618 1.0534
0.11 1.0268 1.0404 1.0495 1.0818 1.0679 1.0586
0.12 1.0292 1.0439 1.0539 1.0892 1.0739 1.0639
0.13 1.0315 1.0475 1.0583 1.0965 1.0800 1.0691
0.14 1.0339 1.0511 1.0626 1.1039 1.0861 1.0743
0.15 1.0362 1.0546 1.0670 1.1112 1.0921 1.0795
0.16 1.0385 1.0581 1.0714 1.1185 1.0981 1.0847
0.17 1.0409 1.0617 1.0757 1.1258 1.1042 1.0899
0.18 1.0431 1.0652 1.0800 1.1331 1.1102 1.0950
0.19 1.0454 1.0687 1.0843 1.1404 1.1162 1.1002
0.20 1.0477 1.0722 1.0887 1.1477 1.1222 1.1053
0.21 1.0500 1.0756 1.0929 1.1550 1.1281 1.1104
0.22 1.0523 1.0791 1.0972 1.1623 1.1341 1.1155
0.23 1.0545 1.0825 1.1015 1.1695 1.1400 1.1206
0.24 1.0568 1.0860 1.1057 1.1768 1.1460 1.1257
0.26 1.0612 1.0928 1.1142 1.1912 1.1578 1.1359
0.28 1.0657 1.0996 1.1226 1.2057 1.1696 1.1460
0.30 1.0701 1.1064 1.1310 1.2201 1.1814 1.1560
0.32 1.0745 1.1131 1.1393 1.2345 1.1931 1.1660
0.34 1.0788 1.1197 1.1476 1.2488 .2047 1.1759
0.36 1.0831 1.1264 1.1559 1.2631 1.2164 1.1859
0.38 1.0874 1.1330 1.1641 1.2774 1.2280 1.1957
0.40 1.0916 1.1395 1.1722 1.2916 1.2395 1.2055

✪✪✪
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