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Masters of Arts in Management: Financial Management

Module I: Financial Management Function
Contents
1. The nature and purpose of financial management
2. Importance of Financial Planning
3. Functions of financial Management
4. Ethics & Social Responsibility of Entrepreneurs
5. Financial Statement Analysis

Instruction: All students’ Activities should be answered in a different sheet of paper and should be emailed to:
badocp2019@gmail.com. Please do not attach it in our Financial Management Summer 2020 Chat Group. However
you may inform me via the Chat group once you have emailed your answers.

The nature and purpose of financial management Modern Approach

Since 1950s, the approach and utility of financial management has started changing in a revolutionary manner.
Financial management is considered as vital and an integral part of overall management. The emphasis of
Financial Management has been shifted from raising of funds to the effective and judicious utilization of
funds. The modern approach is analytical way of looking into the financial problems of the firm.

Advice of finance manager is required at every moment, whenever any decision with involvement of funds is taken.
Hardly, there is an activity that does not involve funds. In the words of Solomon “The central issue of financial
policy is the use of funds. It is helpful in achieving the broad financial goals which an enterprise sets for
itself”. Nowadays, the finance manger is required to look into the financial implications of every decision to be
taken by the firm. His Involvement of finance manager has been before taking the decision, during its review
and, finally, when the final outcome is judged. In other words, his association has been continuous in every
decision-making process from the inception till its end.

AIMS OF FINANCE FUNCTION

The following are the aims of finance function:
1. Acquiring Sufficient and Suitable Funds: The primary aim of finance function is to assess the needs of the
enterprise, properly, and procure funds, in time. Time is also an important element in meeting the needs of the
business. If the funds are not available as and when required, the firm may become sick or, at least, the profitability
of the firm would be, definitely, affected.
It is necessary that the funds should be, reasonably, adequate to the demands of the firm. The funds should be raised
from different sources, commensurate to the nature of business and risk profile of the business. When the nature of
business is such that the production does not commence, immediately, and requires long gestation (conception,
development, growth) period, it is necessary to have the long-term sources like share capital, debentures and long
term loan etc. A concern with longer gestation period does not have profits for some years. So, the firm should rely
more on the permanent capital like share capital to avoid interest burden on the borrowing component.

2. Proper Utilization of Funds: Raising funds is important, more than that is its proper utilization. If proper
utilization of funds were not made, there would be no revenue generation. Benefits should always exceed cost of
funds so that the organization can be profitable. Beneficial projects only are to be undertaken. So, it is all the more
necessary that careful planning and cost-benefit analysis should be made before the actual commencement of
projects.

3. Increasing Profitability: Profitability is necessary for every organization. The planning and control functions of
finance aim at increasing profitability of the firm. To achieve profitability, the cost of funds should be low. Idle
funds do not yield any return, but incur cost. So, the organization should avoid idle funds. Finance function also
requires matching of cost and returns of funds. If funds are used efficiently, profitability gets a boost.
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4. Maximizing Firm’s Value: The ultimate aim of finance function is maximizing the value of the firm, which is
reflected in wealth maximization of shareholders. The market value of the equity shares is an indicator of the wealth
maximization.

IMPORTANCE OF FINANCIAL PLANNING

Source:https://www.blueshorefinancial.com/ToolsAdvice/Articles/FinancialPlanning/TenReasonsWhyFinancialPlanningIsImportant/

Financial planning helps you determine your short and long-term financial goals and create a balanced plan to meet
those goals.

Here are reasons why financial planning will get you where you want to be.

1. Income: It's possible to manage income more effectively through planning. Managing income helps you
understand how much money you'll need for tax payments, other monthly expenditures and savings.
2. Cash Flow: Increase cash flows by carefully monitoring your spending patterns and expenses. Tax planning,
prudent spending and careful budgeting will help you keep more of your hard earned cash.
3. Capital: An increase in cash flow, can lead to an increase in capital. Allowing you to consider investments
to improve your overall financial well-being.
4. Family Security: Providing for your family's financial security is an important part of the financial planning
process. Having the proper insurance coverage and policies in place can provide peace of mind for you and
your loved ones.
5. Investment: A proper financial plan considers your personal circumstances, objectives and risk tolerance. It
acts as a guide in helping choose the right types of investments to fit your needs, personality, and goals.
6. Standard of Living: The savings created from good planning can prove beneficial in difficult times. For
example, you can make sure there is enough insurance coverage to replace any lost income should a family
bread winner become unable to work.
7. Financial Understanding: Better financial understanding can be achieved when measurable financial goals
are set, the effects of decisions understood, and results reviewed. Giving you a whole new approach to your
budget and improving control over your financial lifestyle.
8. Assets: A nice 'cushion' in the form of assets is desirable. But many assets come with liabilities attached. So,
it becomes important to determine the real value of an asset. The knowledge of settling or canceling the
liabilities, comes with the understanding of your finances. The overall process helps build assets that don't
become a burden in the future.
9. Savings: It used to be called saving for a rainy day. But sudden financial changes can still throw you off
track. It is good to have some investments with high liquidity. These investments can be utilized in times of
emergency or for educational purposes.

Goals http://en.wikipedia.org/wiki/Financial_analysis
Financial analysts often assess the following elements of a firm:
1. Profitability - its ability to earn income and sustain growth in both the short- and long-term. A company's degree
of profitability is usually based on the income statement, which reports on the company's results of operations;
2. Solvency - its ability to pay its obligation to creditors and other third parties in the long-term;
3. Liquidity - its ability to maintain positive cash flow, while satisfying immediate obligations;
Both 2 and 3 are based on the company's balance sheet, which indicates the financial condition of a business as of a
given point in time.
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4. Stability - the firm's ability to remain in business in the long run, without having to sustain significant losses in
the conduct of its business. Assessing a company's stability requires the use of both the income statement and the
balance sheet, as well as other financial and non-financial indicators. etc.

Student Activity 1
Multiple Choice : Instruction: Encircle the letter, which you think will conform to the best and correct answer.
Please justify your choices
1. Select the letter that represents the internal environment of a business firm.
a. Management
b. Customers
c. Suppliers
d. Financial institutions
2. What is the most important goal of a business firm?
a. Gain income
b. Maximize company profits
c. Customer satisfaction
d. Corporate social responsibility
3. Which of the following statements is true?
a. For a firm to realize its goals, it must consider the needs of its environment.
b. Only the needs of the investors are considered in undertaking the company’s goals
c. The management’s goals are considered the most in undertaking company’s goals
d. Nothing is considered at all
4. Who decides on the financial policy and strategy of a firm?
a. Middle management
b. Top management
c. Staff
d. None of the above
5. Financial management is mainly concerned with
(A) Efficient management of every activity of business
(B) Arrangement of funds required to the firm
(C) Obtaining required funds in the appropriate mix and utilising them, efficiently
6. Financial management helps in
(A) Short-term planning of company’s activities
(B) Estimating the total funds’ requirement and their proper utilisation in fixed assets and
working capital
(C) Profit planning of the firm

Ethics & Social Responsibility of Entrepreneurs by Anil Agarval

http://courseblog-entrepreneurship.blogspot.com/2013/03/notes-ethics-and-social-responsibility.htm

Business Ethics: A Brief Definition

Ethics is the branch of philosophy concerned with the meaning of all aspects of human behavior.. Theoretical ethics
is the rational reflection on what is right, what is wrong, what is just, what is unjust, what is good, and what is bad in
terms of human behavior. How we see 'ethical behavior' - in terms of what is right and wrong - is guided by these
definitions.
Business ethics (also corporate ethics) is a form of applied ethics or professional ethics that examines ethical
principles and moral or ethical problems that arise in a business environment. It applies to all aspects of business
conduct and is relevant to the conduct of individuals and entire organizations.
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Business ethics can be defined as written and unwritten codes of principles and values that govern decisions and
actions within a company. In the business world, the organization’s culture sets standards for determining the
difference between good and bad decision making and behavior. In the most basic terms, a definition for business
ethics boils down to knowing the difference between right and wrong and choosing to do what is right. The phrase
'business ethics' can be used to describe the actions of individuals within an organization, as well as the organization
as a whole.
There are three parts to the discipline of business ethics: personal, professional, and corporate.
Personal ethics is a category of philosophy that determines what an individual believes aboutmorality and right
and wrong.
Example:

Personal Code of Ethics

 Integrity – I will be honest in everything I do – always forthright – always sincere – always reliable – always
dependable
 Caring – I will care about others – always considerate – always fair – always willing to help those in need – never
ridicule or intentionally hurt others
 Excellence – I will do the best at everything I do – always strive for excellence – never accept mediocrity – never
procrastinate
 Attitude – I will maintain a positive attitude – always respectful – always loyal – always humble – never arrogant
 Courage – I will stand up for what is right – never give in to negative peer pressure – never allow fear of failure to
prevent trying

Professional ethics
http://www.businessdictionary.com/definition/professional-ethics.html#ixzz3LaINRhxs
Professional accepted standards of personal and business behavior, values and guiding
principles. Codes of professional ethics are often established by professional organizations to
help guide members in performing their job functions according to sound and consistent
ethical principles.
For example, a lay member of the public should not be held responsible for failing to act to save a car crash victim
because they could not give an appropriate emergency treatment. This is because they do not have the relevant
knowledge and experience. In contrast, a fully trained doctor (with the correct equipment) would be capable of making
the correct diagnosis and carrying out appropriate procedures. Failure of a doctor to help in such a situation would
generally be regarded as negligent and unethical. An untrained person would not be considered to be negligent for
failing to act in such circumstances and might indeed be considered to be negligent for acting and potentially causing
more damage and possible loss of life.
A business may approach a professional engineer to certify the safety of a project which is not safe. Whilst one engineer
may refuse to certify the project on moral grounds, the business may find a less scrupulous engineer who will be
prepared to certify the project for a bribe, thus saving the business the expense of redesigning.

All three are intricately related. It is helpful to distinguish between them because each rests on slightly different
assumptions and requires a slightly different focus in order to be understood. We are looking at business ethics
through a trifocal lens: close up and personal, intermediate and professional, and on the grand scale (utilizing both
farsighted and peripheral vision) of the corporation. In spite of some recent bad press, business executives are first
and foremost human beings. Like all persons, they seek meaning for their lives through relationships and enterprise,
and they want their lives to amount to something. Since ethics is chiefly the discipline of meaning, the business
executive, like all other human beings, is engaged in this discipline all the time, whether cognizant of it or not.
Social responsibility: A Brief Note
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Social responsibility is an ethical ideology or theory that an entity, be it an organization or individual, has an
obligation to act to benefit society at large. Social responsibility is a duty every individual or organization has to
perform so as to maintain a balance between the economy and the ecosystem. A trade-off always exists between
economic development, in the material sense, and the welfare of society and the environment. Social responsibility
means sustaining the equilibrium between the two. It pertains not only to business organizations but also to anyone
whose action impacts the environment. This responsibility can be passive, by avoiding engaging in socially harmful
acts, or active, by performing activities that directly advance social goals. This shows the various ways that
companies can invest in being socially responsible and the value those actions can bring to the company.
A report suggests that social responsibility is a way of conducting business through balancing the long-term
objectives, decision-making, and behavior of a company with the values, norms, and expectations of society. Social
responsibility can be a normative principle and a soft law principle engaged in promoting universal ethical standards
in relationship to private and public corporations.
Companies can demonstrate social responsibility in a myriad of ways. They can donate funds to education, arts and
culture, underprivileged children, animal welfare, or they can make commitments to reduce their environmental
footprint, implement fair hiring practices, sponsor events, and work only with suppliers with similar values.
Social responsibility in business is also known as corporate social responsibility, corporate responsibility, corporate
citizenship, responsible business, sustainable responsible business, or corporate social performance. This term refers
to a form of self-regulation that is integrated into different disciplines, such as business, politics, economy, media,
and communications studies.
Entrepreneurship v/s Ethics and social responsibility
Ethics and social responsibility are very important values in entrepreneurship ventures. This is particularly essential
in decision making process. Ethical conscience reminds entrepreneurs to make trustworthy and profitable
entrepreneurship decisions. Likewise, the social responsibility component sought entrepreneurs to make
entrepreneurial decisions that can enhance benefits and repelling harms to the stakeholders.
The entrepreneur must establish a balance between ethical exigencies, economic expediency, and social
responsibility. A managers attitudes concerning corporate responsibility tend to be supportive of laws and
professional codes of ethics. Entrepreneurs have few reference persons, role models, and developed internal ethics
codes. Entrepreneurs are sensitive to peers pressure and social norms in the community as well as pressures from
their companies.
While ethics refers to the “study of whatever is right and good for humans,” business ethics concerns itself with the
investigation of business practices in light of human values. The word “ethics” stems from the Greek ethos, meaning
custom and usage. Development of Our Ethical Concepts Socrates, Plato, and Aristotle provide the earliest writings
dealing with ethical conceptions; earlier writings involving moral codes can be found in both Judaism and
Hinduism.
Ethics and social responsibilities of an entrepreneur is certainly an important issue considering the role of social
responsibility in society and ethics in business. Social responsibility is beneficial for business community and at the
same time for global community. Social responsibility is significant owing to the realism of globalization. The
people of the universe are becoming interconnected more owing to the advancement of technology, transportation
and communication. The world market economy is affecting not only services and goods but values and ideas as
well. Expansion on the global front, enhancing regulatory omission and the factors which is responsible for creating
awareness regarding the significance of making for sectored, macro and operational hazards to both an
organization’s and entrepreneur’s competitive position and reputation. As small business owners and entrepreneurs,
activities which harm the people and the planet, will spoil the scope for your profits. For this reason there is great
significance for “triple bottom line” which is profits, planet and people.
The world economy requires innovators and entrepreneurs to both advance and sustain global community. While
ethics and social responsibilities of an entrepreneur and businesses undertake the plan and consider social
responsibility a vital event in their activities, everybody benefits. The effect could be noticed within local
communities and ultimate profit making from their business. With the extension of cooperation for businesses,
governments and NGOs, they encourage in the matter of corporate social responsibility and entrepreneurship and
take steps to improve the mechanism for its potential growth. Therefore, in regards ethics and social responsibilities,
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an entrepreneur has to become aware about his role and strive to obey them in perfect manner which would be
beneficial to him as well as the community as a whole
An entrepreneur is actually running his own business and being a businessman he has some obligation of a business
to meet his economic and legal responsibilities. Social responsibility is basically a business intention, beyond its
legal and economic obligation to do the right things and act in ways that are good for society.
While we are talking about the business ethics, there are three things that need consideration:
(1)    Avoid breaking criminal law in one’s work related activity
(2)    Avoid action that may result in civil law suits against the company
(3)    Avoid actions that are bad for the company image.
For example, an entrepreneur made a chemical that looks like a pesticide and he started selling it like a pesticide in
the market and earns the profit, this act is against the law.
Link between Ethics and Social Responsibility
You will probably note the link between business ethics and corporate social responsibility (CSR).  The two
concepts are closely linked:
· A socially responsible firm should be an ethical firm
· An ethical firm should be socially responsible
However there is also a distinction between the two:
·         CSR is about responsibility to all stakeholders and not just shareholders
·         Ethics is about morally correct behavior
How do businesses ensure that its directors, managers and employees act ethically?
A common approach is to implement a code of practice. Ethical codes are increasingly popular – particularly with
larger businesses and cover areas such as:
    * Corporate social responsibility
    * Dealings with customers and supply chain
    * Environmental policy & actions
    * Rules for personal and corporate integrity
Here is Darrin's 10-Point Ethics Checklist:
1. The Golden Rule: Would I want people to do this to me?
2. The Fairness Test: Who might be affected and how? Is this fair to everyone?
3. The „What if everybody did this?‟ Test: Would I want everyone to do this? Would I want to live in that kind of
world?
4. The Truth Test: Does this action represent the whole truth and nothing but the truth?
5. The Parents Test: How would my parents feel if they found out about this? What advice would they give me?
6. The Children Test: Would I be willing to explain everything about this to my kids and expect them to act in the
same way?
7. The Religion Test: Does this go against my religion?
8. The Conscience Test: Does this go against my conscience? Will I feel guilty?
9. The Consequences Test: Are there possible consequences of this action that would be bad? Would I regret doing
this?
10. The Front Page Test: How would I feel if my action were reported on the front page of my hometown paper?

Student Activity 2 : Answers should be backed -up by ethical concepts and standards presented above.
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1. Returning unspent money

DevAnand is running an NGO to help street children. He receives government grant of Rs.2 lakh rupees
for a project to teach the “out of school” children, who work at tea-stalls, do boot-polishing etc. A year
passes, but Dev managed to utilize only 50,000 rupees from the grant. Despite his best efforts, he
couldn’t convince many poor children or their families to join his NGO’s program.

As per the grant rules, Dev has to return all the unspent money back to government by the end of March
31st. But his colleague Pran suggests following:

1. If we honestly return Rs.1.5 lakh back, then government officials will think we are amateur,
ineffective NGOs and they’ll substantially reduce our grant for next year or even worse- they’ll not give
us any project next time!
2. We should take help of CA Prem Chopra to manipulate our account books and show majority of
the grant was utilized for education.
3. Many other NGOs do the same thing- there is no problem – nobody will raise any objection, as
long as we give 20% of the grant to SDM in charge of this project.
4. Although it sounds unethical but we won’t use this money for personal needs, we’ll use it on street
children only. Hence our act is fully ethical and moral.

What should DevAnand do with the money?

In anycase, If Dev keeps the unspent grant, government will continue pumping more money- other NGOs
and the SDM will keep amassing wealth.

2. Misleading for good purpose

DevAnand is the inspector in charge of Rampur Police station. The police station building is in dire need
of repairs, but hasn’t received any grants for years. One day, a cyclone hits a nearby area, damaging
most of the houses and shops. Although Dev’s police station gets partially damaged, but most of the
building remain intact . Government sends a disaster assessment team to ascertain the level of damage
and pay relief money. The DSP Mr. Pran, orders DevAnand to do following:

1. Hire some laborers and destroy the remaining parts of your police station building.
2. When disaster assessment team comes, you tell them building collapsed by the cyclone, and ask
them to give priority in funding after all police station is one the most important public offices in a town.

Should DevAnand obey his boss’s order?

4. Private matter of Public employee?

1. DevAnand is working as an under Secretary in the pension department. One day, his friend
GuruDutt, an SBI PO, narrates

DevAnand visits Mr.Ashok Kumar’s house but he is suffering from Alzheimer’s disease, unable to give
coherent answers. Frustrated DevAnand directly confronts Prem Chopra. But Prem says “Mr.Ashok
Kumar was a friend of my father. He has no relatives or children and my wife Bindu has been taking care
of him like daughter since a long time. Therefore, Mr.Ashok Kumar gives us money out of good will, so
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we can send our son to an expensive IIT coaching class @Kota, Rajasthan. Besides this is a personal
family matter and none of your damn business.”

Do you think DevAnand made a blunder or was he merely performing an ethical duty?

FUNCTIONS OF FINANCE
Finance function is the most important function of a business. Finance is, closely, connected with production,
marketing and other activities. In the absence of finance, all these activities come to a halt. In fact, only with finance,
a business activity can be commenced, continued and expanded.
Finance exists everywhere, be it production, marketing, human resource development or undertaking research
activity. Understanding the universality and importance of finance, finance manager is associated, in modern
business, in all activities as no activity can exist without funds. Financial Decisions or Finance Functions are
closely inter-connected. All decisions mostly involve finance. When a decision involves finance, it is a financial
decision in a business firm. In all the following financial areas of decision-making, the role of finance manager is
vital. We can classify the finance functions or financial decisions into four major groups:
(A) Investment Decision or Long-term Asset mix decision
(B) Finance Decision or Capital mix decision
(C) Liquidity Decision or Short-term asset mix decision
(D) Dividend Decision or Profit allocation decision

(A) Investment Decision

Investment decisions relate to selection of assets in which funds are to be invested by the firm. Investment
alternatives are numerous. Resources are scarce and limited. They have to be rationed and discretely used.
Investment decisions allocate and ration the resources among the competing investment alternatives or
opportunities. The effort is to find out the projects, which are acceptable.

Investment decisions relate to the total amount of assets to be held and their composition
in the form of fixed and current assets. Both the factors influence the risk the organization is exposed to. The
more important aspect is how the investors perceive the risk.
The investment decisions result in purchase of assets. Assets can be classified, under two
broad categories:
(i) Long-term investment decisions – Long-term assets
(ii) Short-term investment decisions – Short-term assets

Long-term Investment Decisions: The long-term capital decisions are referred to as Capital Budgeting Decisions,
which relate to fixed assets. The fixed assets are long term, in nature. Basically, fixed assets create earnings to the
firm. They give benefit in future. It is difficult to measure the benefits as future is uncertain. The investment
decision is important not only for setting up new units but also for expansion of existing units. Decisions related to
them are, generally, irreversible. Often, reversal of decisions results in substantial loss. When a brand new car is
sold, even after a day of its purchase, still, buyer treats the vehicle as a second-hand car. The transaction, invariably,
results in heavy loss for a short period of owning. So, the finance manager has to evaluate profitability of every
investment proposal, carefully, before funds are committed to them.

Following are the two aspects of investment decision

a. Evaluation of new investment in terms of profitability

b. Comparison of cut off rate against new investment and prevailing investment.
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Since the future is uncertain therefore there are difficulties in calculation of expected return. Along with uncertainty
comes the risk factor which has to be taken into consideration. This risk factor plays a very significant role in
calculating the expected return of the prospective investment. Therefore while considering investment proposal it is
important to take into consideration both expected return and the risk involved.

Investment decision not only involves allocating capital to long term assets but also involves decisions of using
funds which are obtained by selling those assets which become less profitable and less productive. It wise decisions
to decompose depreciated assets which are not adding value and utilize those funds in securing other beneficial
assets. An opportunity cost of capital needs to be calculating while dissolving such assets. The correct cut off rate is
calculated by using this opportunity cost of the required rate of return (RRR)

Investment Decisions and Capital Budgeting

http://people.duke.edu/~charvey/Classes/ba350_1997/vcf2/vcf2.htm

Overview:

This lesson provides an overview of capital budgeting - determining which investments a firm should undertake.
The net present value (NPV) rule, which is widely used in practice, is developed and illustrated with several
examples. A number of alternative evaluation techniques including internal rate of return and payback period are
also illustrated, highlighting potential problems with their use. The NPV technique is illustrated in the context of
choosing between mutually exclusive projects and projects with different lives.

Objectives:

After completing this lesson, you should be able to:

 Compute the net present value of an investment proposal.

 Compute the internal rate of return of an investment proposal.
 Compute the payback period of an investment proposal.
 Determine whether a particular investment proposal should be undertaken.
 Determine which (if either) of two mutually exclusive investment proposals should be undertaken.
 Determine which (if any) of a set of investment proposals should be undertaken when the firm is capital
constrained.
 Determine which (if either) of two mutually exclusive investment proposals with different lives should be
undertaken.

Present Value (NPV)

The net present value (NPV) of a project is defined as the present value of all future cash flows produced by an
investment, less the initial cost of the investment:

where n is the number of cash flows generated by the investment and rp is the required return on the investment
project.

The NPV Decision rule

In determining whether to accept or reject a particular projected, the NPV decision rule is
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 Accept a project if its NPV > 0;

 Reject a project if its NPV < 0;
 Indifferent where NPV = 0.

 NPV Computations

In order to illustrate the computation of Net Present Values, we consider a series of examples.

Example 1

Consider the following investment proposal:

Year 0 1 2 ... 25
Cash Flow -100 11 11 11 11
Assuming that the required rate of return for this project is rp =10%, is this a worthwhile investment?
Applying the NPV rule here requires the calculation of the present value of the future cash flows followed by
a comparison with the investment cost of $100 million.

Since NPV < 0 we reject this proposal.

Example 2

Consider now the example from the previous section on the determination of cash flows:

Year 0 1 2 3 4 5 6 7
Cash Flow -62,000 39,020 39,020 39,020 39,020 39,020 39,020 45,020
Assuming that the required rate of return for this project is rp= 10%, is this a worthwhile investment? Once
again, to apply the NPV rule we must find the present value of the future cash flows and compare them with
the investment cost in period zero.

Since NPV>0, we must accept this proposal.

NPV analysis relies upon an evaluation of cash flows resulting from a project. There are four basic rules for
calculating net cash flows:

 Use inflows and outflows of cash when the occur--do not use accounting variables
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 Use after-tax net cash flows

 Discount after-tax cash flows at the after-tax interest rate.
 Identify all real options and include in project evaluation

Mutually Exclusive Projects

In many cases, a firm will be faced with a choice of between mutually exclusive investment projects. These are
cases in which the firm can undertake only one of the potential projects. For example, a firm may be considering
whether to construct an office building or a shopping mall on a parcel of land, or deciding whether to refurbish an
old apartment building or turn it into a parking garage. In this case, the NPV rule is to undertake the project with the
largest NPV, so long as it is positive.

Example 3

A manufacturer is considering purchasing one of two machines, A and B. The cash flows of each of the
projects are presented below on a time line. The projects required rate of return is 10 percent. Since these
projects are mutually exclusive, which proposal (if any) should the manufacturer choose?

Project A

Year 0 1 2 3 4 5
Cash Flow -3,000 1,000 1,000 1,000 1,000 1,000
Project B

Year 0 1 2 3 4 5
Cash Flow -2,000 700 700 700 700 700
The NPV computations are:

Since these are mutually exclusive projects and both have NPV > 0, we take the project with the highest NPV.
Project A is thus the preferred alternative.

 Alternative Evaluation Techniques

This section outlines several alternatives to the NPV rule. These evaluation techniques include:

 Internal Rate of Return (IRR)

 Payback Period
 Profitability Index
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Internal Rate of Return (IRR)

The internal rate of return, IRR, of a project is the rate of return which equates the net present value of the projects
cash flows to zero; or equivalently the rate of return which equates the present value of inflows to the present value
of cash outflows. The internal rate of return (IRR) solves the following equation:

In determining whether to accept or reject a particular project, the IRR decision rule is

 Accept a project if IRR > rp

 Reject a project if IRR< rp
 Indifferent if IRR = rp
 For Mutually exclusive projects accept the project with highest IRR if IRR > rp

where rp is the required return on the project. We illustrate the use of the IRR rule, and some of the pitfalls of this
approach via a series of examples.

Example 4

Suppose a firm whose required rate of return is 10% is considering a project with the following cash flows:

Year 0 1 2 3 4
Cash Flow -1,000 400 400 400 400
Is this a worthwhile investment?

The internal rate of return of this project is the rate of return which solves

Note that we have to interpolate or use an iterative technique such as Excel's Solver to find the IRR in this
case. The internal rate of return of this project turns out to be 21.86%. Applying the decision rules above, we
would accept the project since 
IRR > rp (i.e., 21.86%>10%). The graph below shows the NPV of this project using various discount rates.
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Problems with IRR

However, the IRR method has a number of potential difficulties which are outlined below:

Example 5 -- Timing of Inflows and Outflows

Consider the desirability of the following 2 investment proposals for a firm whose required rate of return is
10%.

Project A Project B
Year 0 Flow -1,000 1,000
Year 1 Flow 1,500 -1,500
IRR 50% 50%
NPV 363.64 -363.64
Both projects have an IRR of 50%, yet clearly project A is preferred to project B. Notice that the NPV rule
correctly identifies the profitable alternative. The IRR rule fails in this case because it ignores the ordering of
the inflows and outflows. Project A is a situation in which we are investing 1000 now and it accumulates to
1500 in 1 period. This is a very good return on our investment. In project B we are borrowing 1000 and
having to repay 1500 in 1 period. This is an extremely high interest rate which we have to pay. However, the
IRR does not take account of whether we are borrowing or lending and reports the same rate for both projects.
If we followed the IRR rule and accepted project B, the firm would be worse of by $363.64. That is, the value
of the firm would immediately fall by $363.64. Thus, we see that the IRR rule can yield results inconsistent
with the objective of maximizing shareholder wealth.
Example 6 -- Ambiguous Results

Another problem with the IRR rule is that there can be multiple internal rates of return. Suppose a firm whose
required rate of return is 10% is contemplating an investment project whose incremental cash flows are as
follows:

Year 0 1 2
Cash Flow -1,000 3,200 -2,400
 14

The internal rate of return is the value of IRR that solves the following equation:

Dividing both sides by 1,000, we get:

Now, multiply both sides by (1+IRR)2 to get:

3.2(1+IRR) - 2.4 - (1+IRR)2 = 0

Rearranging the terms, and letting x = (1+IRR) and we have:

x2 - 3.2x - 2.4 = 0

which is a quadratic equation with a well-known solution:

Recall that x = (1+IRR). Hence, the project has two possible internal rates of return, 100% or 20%. Assuming
the marginal cost of capital is 10%, the project appears to be acceptable no matter which value of IRR we use.
The NPV of the project, however, indicates that project acceptance will cause shareholders to be worse off:

The inconsistency revealed through this illustration is referred to as the multiple root problem. For every
change in sign of the cash flows through time, there can exist an additional internal rate of return. In this
example, there were two changes in sign, from -1,000 to +3,200 and from +3,200 to -2,400, and there are two
internal rates of return. Both of these IRRs exceed the required return of the firm, but acceptance of the
project will cause share price to fall (the project has a negative NPV). Note that this example is not extreme
by any means. Many investments (e.g., the clean up stage in mining operations) require large negative cash
flows in the final period of the projects life. The graph below depicts the projects NPV at various discount
rates. Note that the parabola intersects the x-axis at both of its roots.
 15

Example 7 -- Scale of Investment

A manufacturer is considering the purchase of one of two machines, A and B. The machine will be installed
in the manufacturers factory and will produce items for sale. Both machines take exactly the same input and
produce exactly the same final product. The only difference between the machines is that one is more efficient
and therefore has lower operating costs, resulting in higher net cash flows. Assume that the required rate of
return is 10% and that the firm has excess debt capacity (i.e., it can borrow as much as it likes to finance any
profitable investment). The cash flows of each of the projects are as follows:

Project A Project B
Year 0 Flow -3,000 -2,000
Year 1 Flow 1,000 700
Year 2 Flow 1,000 700
Year 3 Flow 1,000 700
Year 4 Flow 1,000 700
Year 5 Flow 1,000 700
IRR 19.86% 22.11%
NPV 790.80 653.55
The internal rates of return of projects A and B are 19.86% and 22.11%, respectively. Thus, it appears that
project B should be chosen. However,

NPVA = 790.79 and NPVB = 653.55,

so project A is actually superior to project B from a shareholder wealth maximization standpoint. The
inconsistency arises from a scale of investment problem. The IRR method gives only a measure of the
profitability of the project per dollar invested and does not measure absolute profitability.

 Non-Uniform Term Structure

Now we consider the possibility of a non-uniform term structure. Suppose we are faced with the following cash
flows and one period interest rates:

Period Interest Rate Cash Flow Discount Present Value

0 -1,000 1 -1,000
1 20% 80 1.2 66.67
2 10% 80 (1.2)(1.1) 60.61
 16

3 4% 80 (1.2)(1.1)(1.04) 58.28
2
4 4% 80 (1.2)(1.1)(1.04) 56.03
3
5 4% 1,080 (1.2)(1.1)(1.04) 727.36

This example just replicates the cash flows from purchasing a five year bond that pays an 8% annual coupon.
The internal rate of return is 8%. The final two rows of the table calculate the present value of each cash flow.
These results are shown below. Although the IRR of this investment is 8%, the NPV of the investment is clearly
negative. In the case of a non-uniform term structure, the IRR is not that meaningful a measure.

Present Value of Inflows 968.94

Investment 1,000
Net Present Value -31.03

 Undefined IRR

Consider the following cash flows:

Period 0 1 2
Cash Flow 100 -200 150

To solve for the IRR, use the quadratic equation as above. The result comes out to:

We cannot solve the square foot of a negative number with a real number. The solutions to the IRR involve
using imaginary numbers. This does not help us evaluate the worth of the project. We cannot provide a graphical
representation of the differences between NPV and IRR here unless we use the complex plane. Note in this
particular case that the NPV is greater than zero for all discount rates.

What use is the IRR?

The IRR has one strong attraction: it provides a rate of return which is easier to interpret than the NPV. Hence, are
there any applications where we would be able to use it? The answer is: very few. Essentially, we have to be careful
that none of the above problems occurs.

An example would be a mortgage. A mortgage is a financing, where one cash inflow is followed by a sequence of
cash outflows. Hence, the cash flow pattern has only one sign change, so the IRR is unique (avoids problem 2).
Moreover, you need to compare mortgages with the same repayment horizon in order to avoid problem 1, and for
the same amount in order avoid problem 3. Then you can use the rule that the mortgage with the lower rate (i. e. the
lower IRR) is better. Hence, the moral is that you can use the IRR for some stylized situations, but not for the
general capital budgeting problem, where the NPV is the dominant criterion that is robust to the problems listed
above.

Another place where IRR is frequently used is in the pricing of bonds. The yield of a bond is just its IRR. Like the
mortgage, there is a unique solution when calculating a yield. Investors can run into trouble when they compare the
 17

yields of two bonds, if the bonds are very different. But if two bonds have similar characteristics, then comparing
the yield is a good way to compare the values.

Payback Period (PP)

The payback period, PP, is the length of time it takes to recover the initial investment of the project. To apply the
payback period criterion, it is necessary for management to establish a maximum acceptable payback value PP*. In
practice, PP* is usually between 2 and 4 years. In determining whether to accept or reject a particular project, the
payback period decision rule is:

 Accept if PP < PP*

 Reject if PP > PP*
 Indifferent where PP = PP*
 For mutually exclusive alternatives accept the project with the lowest PP if PP<PP*

Example 8

Suppose a firm is considering two mutually exclusive projects, C and D, where the firm�s required rate of
return is 10% and the projects� cash flows are:

Project C Project D
Year 0 Flow -1,000 -1,000
Year 1 Flow 200 600
Year 2 Flow 800 300
Year 3 Flow 25 1,000
PP 2 3
NPV -$138 $548
The payback method dictates that project C should be accepted, however the NPV indicates that if C is
accepted, the share price will fall. It appears that the payback method is not consistent with the goal of
shareholder wealth maximization. The problems with the payback method are that:

 It ignores the time value of money;

 It ignores the cash flows that occur after the payback period; and,
 It ignores the scale of investment.

 Payback Period: accounting for money at risk

One of the attractions of the payback period is that it provides some measure of the "money at risk". At the start of
the project we are presented with a lot of uncertainty about future cash flows, and the economic environment and
our cash flows may turn out more or less favorable than we initially anticipated, with uncertainty being larger for
those cash flows in the more distant future. However, the payback criterion is the wrong method to account for that.
There are two tools for analyzing the risk associated with more distant cash flows. The first concerns the setting of
discount rates. We shall see later (lectures 9 and 10) that discount rates can be decomposed into a risk-free rate,
which is a compensation for the time value of money, and a risk premium, which rewards investors for risk. Hence,
the discount rate is:
 18

Discount rate = Risk free rate + Risk premium

Suppose the risk free rate is 10% and the required risk premium is 5% (we will discuss how to determine risk
premiums later in the course). Then we obtain the following relationship between the discount rates and the time
horizon:

Period 1 Period 2 Period 3 Period 4

Discount factor at 10% 0.91 0.83 0.75 0.68
Discount factor at 15% 0.87 0.76 0.66 0.57
Difference 0.0395 0.0703 0.0938 0.1113
% Difference 4.35 8.51 12.48 16.29

The picture emerges quite clearly: the risk premium reduces the value of one dollar at the end of period 1 from $0.91
to $0.87, or by 3.95 cents or 4.35%. However, dollars at the end of period 2 are reduced much more substantially by
7.03 cents or 8.51%, and the reduction increases with the time horizon. Hence, our NPV criterion, with appropriately
set discount rates already accounts for the fact that risk increases with the time horizon.

In addition to this, we know much less about the more distant future than the immediate future, and we would
typically change the design of a project if circumstances change in the future. Hence, we need to reflect the fact that
one project commits our money for a short period of time and another one for a long period of time in our analysis,
because projects with longer time horizons give us somewhat less flexibility. We shall see later in the course that
this argument has also some merit, because flexibility has economic value. However, the appropriate tool for
analyzing flexibility is decision tree analysis or option analysis (so-called "real options"). We shall discuss these
tools in lecture 11 and see that they extend NPV analysis and allow us to quantify the value of flexibility and of
"money at risk". Using payback period is an illegitimate shortcut.

Profitability Index

Another capital budgeting technique, the profitability index, is used when firms have only a limited supply of capital
with which to invest in positive NPV projects. This type of problem is referred to as acapital rationing problem.
Given that the objective is to maximize shareholder wealth, the objective in the capital rationing problem is to
identify that subset of projects that collectively have the highestaggregate net present value. To assist in that
evaluation, this method requires that we compute each projects profitability index  PI.

We then rank the projects PI from highest to lowest, and then select from the top of the list until the capital budget is
exhausted. The idea behind the profitability index method is that this will provide the subset of projects that
maximize the aggregate net present value. However, this is not always the case (as the examples below show).

Example 9

Suppose a firm is considering the following investment projects and only has $12,000 available to invest.

Investment Cost NPV PI

Project
 19

A 1,000 600 0.6

B 4,000 2,000 0.5
C 6,000 2,400 0.4
D 2,000 400 0.2
E 5,000 500 0.1
In this case, the profitability index is successful since the combination of projects A, B, and C provides the
highest aggregate net present value of $5,000. The second best alternative is projects B, C and D with an
aggregate net present value of $4,800. Note, however, that if the firm had invested in all of the projects it
would have an aggregate net present value of $5,900.

Suppose a firm is considering the following investment projects and only has $12,000 available to invest

Investment Cost NPV PI

Project
A 1,000 600 0.6
B 4,000 2,000 0.5
C 6,000 2,400 0.4
D 2,000 700 0.35
E 5,000 500 0.1
In this case, the profitability index does not work. The best alternative is BCD with an aggregate net present
value of $5,100. The project ranked most highly by the PI (i.e., Project A) is not even included in the final set.
Once again, note that if the firm had not imposed the capital rationing constraint of $12,000 it could have
taken all of the projects and thus achieved an aggregate net present value of $6,200.

Obviously the profitability index gives results inconsistent with the maximization of shareholder wealth and it
should not be used. Indeed, the concept of capital rationing gives results inconsistent with the maximization of
shareholder wealth. It is hard to believe that a firm with positive NPV projects can not go out to the capital
market and borrow the required funds to finance these projects.

 Comparing Projects with Different Lives

The Annual Equivalent

Suppose a firm with a required rate of return of 10% is considering the acquisition of a new machine to produce its
product. It is deciding between Machine A and Machine B. Machine A has a useful life of the 3 years and machine
B has a useful life of 5 years. The net present values of the machines are as follows:

Machine NPV Machine Life

A 2000 3 Years
B 3000 5 Years

Should the firm choose Machine A or Machine B? Machine B has a higher NPV, but it also has a useful life of 5
years versus the 3 year life of Machine A. Since the machine is going to be used to produce the output of the firm, it
is reasonable to assume that Machine A will be replaced at the end of year 3 and thus its NPV above is understated.
That is, assume that the machine will be used by the firm indefinitely. Hence, at the end of the machines useful life it
 20

will be replaced by another identical machine. Machines of type A are replaced on a 3-year cycle and machines of
type B will be replaced on a 5-year cycle.

We need to restate the NPVs of the two alternatives in a way that will allow direct comparison. One way to do this is
to compare the annual equivalent cash flows of the two alternative projects. Machine A has a NPV of $2,000, but at
the required return of 10% we would be indifferent between $2,000 at the beginning of period zero and the annual
equivalent (AE) of:

at the end of each of the 3 years. This is because

so that

Since we assume that the machine is going to be used indefinitely, this implies that we will receive the annual
equivalent cash flow of AEA=$804.25 indefinitely.

In general, the annual equivalent cash flow is given by:

The annual equivalent cash flow of machine B is thus given by:

Therefore, we can now compare the annual equivalent cash flows of the two proposals and the decision rule is to
accept the proposal with the highest annual equivalent cash flow. Here AEA > AEB so the firm should accept project
A.

 The Decision Rule

The rule is that for mutually exclusive projects with different lives it is not appropriate to compare the NPVs
directly. We should, instead, convert these NPVs to annual equivalent cash flows (AE) where:
 21

and take the project with the highest AE. This applies to cases where the firm is considering one type of machine
which is to be replaced indefinitely or an alternative type of machine that is to be replaced indefinitely.

Examples illustrating these concepts

Example 10

A corporation is considering replacing an existing machine with a new machine. The new machine costs
$60,000 plus installation costs of $2,000. It will generate revenues of $155,000 annually and cash expenses
annually of $100,000. It will be depreciated to a salvage of $6,000 over a seven-year life using the straight-
line method. The old machine has a book value of $40,000 and a remaining useful life of 5 years. It can be
sold immediately for $15,000. If retained, the machine will generate revenues of $150,000 and cash expenses
annually of $110,000. Assuming the firm has a marginal cost of capital of 12% and is in the 34% marginal tax
bracket, should it replace the existing machine? Assume that this is a one-off decision - the choice is either
keep the existing machine for five years or buy the new machine and run it for seven years.

Step 1 - Determine the Cash Flows

Old Machine -- First compute the tax expense.

Taxable
Revenues Expenses Depreciation Tax Paid
Year Income
0
1 150,000 -110,000 8,000 32,000 -10,880
2 150,000 -110,000 8,000 32,000 -10,880
3 150,000 -110,000 8,000 32,000 -10,880
4 150,000 -110,000 8,000 32,000 -10,880
5 150,000 -110,000 8,000 32,000 -10,880
Now, compute net cash flow:

Revenues Expenses Tax Paid Net Cash Flow

Year
0
1 150,000 -110,000 10,880 29,120
2 150,000 -110,000 10,880 29,120
3 150,000 -110,000 10,880 29,120
4 150,000 -110,000 10,880 29,120
5 150,000 -110,000 10,880 29,120
New Machine -- First, compute the tax expense
 22

Taxable
Revenues Expenses Depreciation Tax Paid
Year Income
0 -25,000b 8,500
a
1 155,000 -100,000 -8,000 47,000 -15,980
2 155,000 -100,000 -8,000 47,000 -15,980
3 155,000 -100,000 -8,000 47,000 -15,980
4 155,000 -100,000 -8,000 47,000 -15,980
5 155,000 -100,000 -8,000 47,000 -15,980
6 155,000 -100,000 -8,000 47,000 -15,980
7 155,000 -100,000 -8,000 47,000 -15,980
Notes:

a. (60,000+2,000-6,000)/7
b. Book loss on sale of old machine (40,000-15,000) generates a tax credit of $8,500

Now, compute the net cash flows:

Revenues Expenses Salvage Cost Tax Paid Net Flows

Year
0 15,000a -62,000 8,500 -38,500
1 155,000 -100,000 -15,980 39,020
2 155,000 -100,000 -15,980 39,020
3 155,000 -100,000 -15,980 39,020
4 155,000 -100,000 -15,980 39,020
5 155,000 -100,000 -15,980 39,020
6 155,000 -100,000 -15,980 39,020
b
7 155,000 -100,000 6,000 -15,980 45,020
Notes:

a. Old Machine
b. New Machine

Step 2 - Determine Net Present Value

Old Machine

New Machine
 23

Step 3 - Make the decision

Since NPVn > NPV0 we replace the machine

Summary of Important Formulas

 Net Present Value 

 Internal Rate of Return 

 Profitability Index 

Student Activity 3:
1. If you have a cool 2 Million Dollars which of the 10 Examples above will you invest in? Please allocate your
2M.
2. Briefly discuss the methods/formulas used in making important investment decision.

Short-term Investment Decisions: The short-term investment decisions are, generally, referred as working capital
management. The finance manager has to allocate among cash and cash equivalents, receivables and inventories.
Though these current assets do not, directly, contribute to the earnings, their existence is necessary for proper,
efficient and optimum utilization of fixed assets.

(B) Finance Decision

Once investment decision is made, the next step is how to raise finance for the concerned investment. Finance
decision is concerned with the mix or composition of the sources of raising the funds required by the firm. In
other words, it is related to the pattern of financing. In finance decision, the finance manager is required to
determine the proportion of equity and debt, which is known as capital structure. There are two main sources of
funds, shareholders’ funds (variable in the form of dividend) and borrowed funds (fixed interest bearing). These
sources have their own peculiar characteristics. The key distinction lies in the fixed commitment. Borrowed funds
are to be paid interest, irrespective of the profitability of the firm. Interest has to be paid, even if the firm incurs loss
and this permanent obligation is not there with the funds raised from the shareholders. The borrowed funds are
relatively cheaper compared to shareholders’ funds, however they carry risk. This risk is known as financial
risk i.e. Risk of insolvency due to non-payment of interest or non-repayment of borrowed capital.
 24

On the other hand, the shareholders’ funds are permanent source to the firm. The shareholders’ funds could be from
equity shareholders or preference shareholders. Equity share capital is not repayable and does not have fixed
commitment in the form of dividend. However, preference share capital has a fixed commitment, in the form of
dividend and is redeemable, if they are redeemable preference shares. Barring a few exceptions, every firm tries to
employ both borrowed funds and shareholders’ funds to finance its activities. The employment of these funds, in
combination, is known as financial leverage. Financial leverage provides profitability, but carries risk. Without
risk, there is no return. This is the case in every walk of life!

Financial leverage. The degree to which an investor or business is utilizing borrowed money. Companies that

are highly leveraged may be at risk of bankruptcy if they are unable to make payments on their debt; they may also
be unable to find new lenders in the future. Financial leverage is not always bad, however; it
can increase the shareholders' return on investmentand often there are tax advantages associated
with borrowing. also called leverage.

When the return on capital employed (equity and borrowed funds) is greater than the rate of interest paid on the
debt, shareholders’ return get magnified or increased. In period of inflation, this would be advantageous while it is a
disadvantage or curse in times of recession.
Example:
Total investment: Php100,000
Return 15%.

Composition of investment:
Equity Php 60,000
Debt @ 7% interest 40,000

Return on investment
@ 15% Php 15,000
Interest on Debt 2,800
(7% on Php 40,000)
Earnings available to
Equity shareholders Php 12,200

Return on equity (ignoring tax) is 20%, (12,200/60,000) which is at the expense of debt as they get 7% interest only.
In the normal course, equity would get a return of 15%. But they are enjoying 20% due to financing by a
combination of debt and equity.
The finance manager follows that combination of raising funds which is optimal mix of debt and equity. The optimal
mix minimizes the risk and maximizes the wealth of shareholders.

A firm tends to benefit most when the market value of a company’s share maximizes this not only is a sign of
growth for the firm but also maximizes shareholders wealth. On the other hand the use of debt affects the risk and
return of a shareholder. It is more risky though it may increase the return on equity funds. A sound financial
structure is said to be one which aims at maximizing shareholders return with minimum risk. In such a scenario the
market value of the firm will maximize and hence an optimum capital structure would be achieved. Other than
equity and debt there are several other tools which are used in deciding a firm capital structure.

Financial Leverage And Capital Structure Policy - Capital Structure

http://www.investopedia.com/walkthrough/corporate-finance/5/capital-structure/capital-structure.aspx
For stock investors that favor companies with good fundamentals, a strong balance sheet is an important
consideration for investing in a company's stock. The strength of a company' balance sheet can be evaluated by three
broad categories of investment-quality measurements: working capital adequacy, asset performance and capital
 25

structure. In this section, we'll consider the importance of capital structure.

A company's capitalization  describes its composition of permanent or long-term capital, which consists of a

combination of debt and equity. A company's reasonable, proportional use of debt and equity to support its assets is
a key indicator of balance sheet strength. A healthy capital structure that reflects a low level of debt and a
corresponding high level of equity is a very positive sign of financial fitness.

Clarifying Capital Structure-Related Terminology

The equity part of the debt-equity relationship is the easiest to define. In a company's capital structure, equity
consists of a company's common and preferred stock plus retained earnings, which are summed up in the
shareholders' equity account on a balance sheet. This invested capital and debt, generally of the long-term variety,
comprises a company's capitalization and acts as a permanent type of funding to support a company's growth and
related assets.

A discussion of debt is less straightforward. Investment literature often equates a company's debt with its liabilities.
Investors should understand that there is a difference between operational and debt liabilities - it is the latter that
forms the debt component of a company's capitalization. That's not the end of the debt story, however.

Among financial analysts and investment research services, there is no universal agreement as to what constitutes a
debt liability. For many analysts, the debt component in a company's capitalization is simply a balance sheet's long-
term debt. However, this definition is too simplistic. Investors should stick to a stricter interpretation of debt where
the debt component of a company's capitalization should consist of the following: short-term borrowings (notes
payable), the current portion of long-term debt, long-term debt, and two-thirds (rule of thumb) of the principal
amount of operating leases and redeemable preferred stock. Using a comprehensive total debt figure is a prudent
analytical tool for stock investors.

Capital Ratios and Indicators

In general, analysts use three different ratios to assess the financial strength of a company's capitalization structure.
The first two, the debt and debt/equity ratios, are popular measurements; however, it's the capitalization ratio that
delivers the key insights to evaluating a company's capital position.

A measure of a company's financial leverage calculated by dividing its total liabilities by stockholders' equity. It
indicates what proportion of equity and debt the company is using to finance its assets.

Note: Sometimes only interest-bearing, long-term debt is used instead of total liabilities in the calculation.

Also known as the Personal Debt/Equity Ratio, this ratio can be applied to personal financial statements as well as
corporate ones.
A high debt/equity ratio generally means that a company has been aggressive in financing its growth with debt. This
can result in volatile earnings as a result of the additional interest expense.

If a lot of debt is used to finance increased operations (high debt to equity), the company could potentially generate
more earnings than it would have without this outside financing. If this were to increase earnings by a greater
amount than the debt cost (interest), then the shareholders benefit as more earnings are being spread among the same
 26

amount of shareholders. However, the cost of this debt financing may outweigh the return that the company
generates on the debt through investment and business activities and become too much for the company to handle.
This can lead to bankruptcy, which would leave shareholders with nothing.

The debt/equity ratio also depends on the industry in which the company operates. For example, capital-intensive
industries such as auto manufacturing tend to have a debt/equity ratio above 2, while personal computer companies
have a debt/equity of under 0.5.

The debt ratio compares total liabilities to total assets. Obviously, more of the former means less equity and,
therefore, indicates a more leveraged position. The problem with this measurement is that it is too broad in scope,
which, as a consequence, gives equal weight to operational and debt liabilities. The same criticism can be applied to
the debt/equity ratio, which compares total liabilities to total shareholders' equity. Current and non-current
operational liabilities, particularly the latter, represent obligations that will be with the company forever. Also,
unlike debt, there are no fixed payments of principal or interest attached to operational liabilities.

The capitalization ratio (total debt/total capitalization) compares the debt component of a company's capital structure
(the sum of obligations categorized as debt plus the total shareholders' equity) to the equity component. Expressed as
a percentage, a low number is indicative of a healthy equity cushion, which is always more desirable than a high
percentage of debt. (To continue reading about ratios, see Debt Reckoning.)

Corporate Capital Structure

By Troy Adkins on November 18, 2013
A company needs financial capital in order to operate its business. For most companies, financial capital is raised by
issuing debt securities and/or by selling common stock. The amount of debt and equity that makes up a company’s
capital structure has many risk and return implications. Therefore, corporate management has an obligation to use a
thorough and prudent process for establishing a company’s target capital structure. The capital structure is how a
firm finances its operations and growth by using different sources of funds.

Empirical Use of Financial Leverage

Financial leverage is defined as the extent to which fixed-income securities and preferred stock are used in a
company’s capital structure. Financial leverage has value due to the interest tax shield that is afforded by the U.S.
corporate income tax law. The use of financial leverage also has value when the assets that are purchased with the
debt capital earn more than the cost of the debt that was used to finance them. Under both of these circumstances,
the use of financial leverage increases the company’s profits. With that said, if the company does not have sufficient
taxable income to shield, or if its operating profitsare below a critical value, financial leverage will reduce equity
value and thus reduce the value of the company. 

Given the importance of a company’s capital structure, the first step in the capital decision making process is for the
management of a company to decide how much external capital it will need to raise to operate its business. Once this
amount is determined, management needs to examine the financial markets to determine the terms in which the
company can raise capital. This step is crucial to the process, because the market environment may curtail the ability
of the company to issue debt securities or common stock at an attractive level or cost. With that said, once these
questions have been answered, the management of a company can design the appropriate capital structure policy,
and construct a package of financial instruments that need to be sold to investors. By following this systematic
process, management’s financing decision should be implemented according to its long-run strategic plan, and the
manner in which it wants to grow the company over time.
 27

The use of financial leverage varies greatly by industry and by business sector. There are many industry sectors in
which companies operate with a high degree of financial leverage. Retail stores, airlines, grocery stores, utility
companies, and banking institutions are classic examples. Unfortunately, the excessive use of financial leverage by
many companies in these sectors has played a paramount role in forcing a lot of them to file for Chapter
11bankruptcy. Examples include R.H. Macy (1992), Trans World Airlines (2001), Great Atlantic & Pacific Tea Co
(A&P) (2010), and Midwest Generation (2012). Moreover, excessive use of financial leverage was the primary
culprit that led to the U.S. financial crisis between 2007 and 2009. The demise of Lehman Brothers (2008) and a
host of other highly levered financial institutions are prime examples of the negative ramifications that are
associated with the use of highly levered capital structures.

Overview of the Modigliani and Miller Theorem on Corporate Capital Structure

The study of a company’s optimal capital structure dates back to 1958 when Franco Modigliani and Merton Miller
published their Nobel Prize winning work “The Cost of Capital, Corporation Finance, and the Theory of
Investment.” As an important premise of their work, Modigliani and Miller illustrated that under conditions where
corporate income taxes and distress costs are not present in the business environment, the use of financial leverage
has no effect on the value of the company. This view, known as the Irrelevance Proposition theorem, is one of the
most important pieces of academic theory that has ever been published. 

Unfortunately, the Irrelevance Theorem, like most Nobel Prize winning works in economics, require a number of
impractical assumptions that need to be accepted to apply the theory in a real world environment. In recognition of
this problem, Modigliani and Miller expanded their Irrelevance Proposition theorem to include the impact of
corporate income taxes, and the potential impact of distress cost, for purposes of determining the optimal capital
structure for a company. Their revised work, universally known as the Trade-off Theory of capital structure, makes
the case that a company’s optimal capital structure should be the prudent balance between the tax benefits that are
associated with the use of debt capital, and the costs associated with the potential for bankruptcy for the company.
Today, the premise of the Trade-off Theory is the foundation that corporate management should be using to
determine the optimal capital structure for a company.

Impact of Financial Leverage on Performance 

Perhaps the best way to illustrate the positive impact of financial leverage on a company’s financial performance is
by providing a simple example. The Return on Equity (ROE) is a popular fundamental used in measuring the
profitability of a business as it compares the profit that a company generates in a fiscal year with the money
shareholders have invested. After all, the goal of every business is to maximize shareholder wealth, and the ROE is
the metric of return on shareholder's investment.

In the table below, an income statement for Company ABC has been generated assuming a capital structure that
consists of 100% equity capital. Capital raised was $50 million dollars. Since only equity was issued to raise this
amount, total value of equity is also $50 million. Under this type of structure, the company’s ROE is projected to fall
between the range of 15.6 and 23.4%, depending on the level of the company’s pre-tax earnings.
 28

In comparison, when Company ABC’s capital structure is re-engineered to consist of 50% debt capital and 50%
equity capital, the company’s ROE increases dramatically to a range that falls between 27.3 and 42.9%.

As you can see from the table below, financial leverage can be used to make the performance of a company look
dramatically better than what can be achieved by solely relying on the use of equity capital financing.

Since the management of most companies relies heavily on ROE to measure performance, it is vital to understand
the components of ROE to better understand what the metric conveys.

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 29

A popular methodology for calculating ROE is the utilization of the DuPont Model. In its most simplistic form, the
DuPont Model establishes a quantitative relationship between net income and equity, where a higher multiple
reflects stronger performance. However, the DuPont Model also expands upon the general ROE calculation to
include three of its component parts. These parts include the company’s profit margin, its asset turnover, and
its equity multiplier. Accordingly, this expanded DuPont formula for ROE is as follows:

Based on this equation, the DuPont Model illustrates that a company’s ROE can only be improved by increasing the
company’s profitability, by increasing its operating efficiency, or by increasing its financial leverage.

Measurement of Financial Leverage Risk

Corporate management tends to measure financial leverage by using short-term solvency ratios. Like the name
implies, these ratios are used to measure the ability of the company to meet its short-term obligations. Two of the
most utilized short-term solvency ratios are the current ratio and acid-test ratio. Both of these ratios compare the
company’s current assets to its current liabilities. However, while the current ratio provides an aggregated risk
metric, the acid-test ratio provides a better assessment of the composition of the company’s current assets for
purposes of meeting its current liability obligations since it excludes inventory from current assets. 

Capitalization ratios are also used to measure financial leverage. While there are many capitalization ratios that are
used in the industry, two of the most popular metrics are thelong-term-debt-to-capitalization ratio and the total-debt-
to-capitalization ratio. The use of these ratios is also very important for measuring financial leverage. However,
these ratios can be easily distorted if management leases the company’s assets without capitalizing the assets' value
on the company’s balance sheet. Moreover, in a market environment where short-term lending rates are low,
management may elect to use short-term debt to fund both its short- and long-term capital needs. Therefore, short-
term capitalization metrics also need to be used to conduct a thorough risk analysis.

Coverage ratios are also used to measure financial leverage. The interest coverage ratio, also known as the times-
interest-earned ratio, is perhaps the most well-known risk metric. The interest coverage ratio is very important
because it provides an indication of a company’s ability to have enough pre-tax operating income to cover the cost
of its financial burden. The funds-from-operations-to-total-debt ratio, and the free-operating-cash-flow-to-total-debt
ratio are also important risk metrics that are used by corporate management. 

Factors Considered in the Capital Structure Decision-Making Process

There are many quantitative and qualitative factors that need to be taken into account when establishing the
company’s capital structure. First, from the standpoint of sales, a company that exhibits high and relatively stable
sales activity is in a better position to utilize financial leverage, as compared to a company that has lower and more
volatile sales.

Second, in terms of business risk, a company with less operating leverage tends to be able to take on more financial
leverage than a company with a high degree of operating leverage.

Third, in terms of growth, faster growing companies are likely to rely more heavily on the use of financial leverage,
 30

because these types of companies tend to need more capital at their disposal than their slow growth counterparts.

Fourth, from the standpoint of taxes, a company that is in a higher tax bracket tends to utilize more debt to take
advantage of the interest tax shield benefits.

Fifth, a company that is less profitable tends to use more financial leverage, because a less profitable company is
typically not in a strong enough position to finance its business operations from internally generated funds. 

The capital structure decision can also be addressed by looking at a host of internal and external factors. First, from
the standpoint of management, companies that are run by aggressive leaders tend to use more financial leverage. In
this respect, their purpose for using financial leverage is not only to increase the performance of the company, but to
also help ensure their control of the company.

Second, when times are good, capital can be raised by issuing either stocks or bonds. However, when times are bad,
suppliers of capital typically prefer a secured position, which in turn puts more emphasis on the use of debt capital.
With this in mind, management tends to structure the capital makeup of the company in a manner that will provide
flexibility in raising future capital in an ever-changing market environment.

The Bottom Line

In essence, corporate management utilizes financial leverage primarily to increase the company’s earnings per
share and to increase its return-on-equity. However, with these advantages come increased earnings variability and
the potential for an increase in the cost of financial distress, perhaps even bankruptcy. With this in mind, the
management of a company should take into account the business risk of the company, the company’s tax position,
the financial flexibility of the company’s capital structure, and the company’s degree of managerial aggressiveness
when determining the optimal capital structure.

Additional Evaluative Debt-Equity Considerations

Funded debt is the technical term applied to the portion of a company's long-term debt that is made up of bonds and
other similar long-term, fixed-maturity types of borrowings. No matter how problematic a company's financial
condition may be, the holders of these obligations cannot demand immediate and full repayment as long the
company pays the interest on its funded debt. In contrast, bank debt is usually subject to acceleration clauses and/or
covenants that allow the lender to call its loan. From the investor's perspective, the greater the percentage of funded
debt to total debt, the better. Funded debt gives a company more wiggle room.

Factors That Influence a Company's Capital-Structure Decision

The primary factors that influence a company's capital-structure decision are as follows:

1. Business Risk 
Excluding debt, business risk is the basic risk of the company's operations. The greater the business risk, the lower
the optimal debt ratio. 

As an example, let's compare a utility company with a retail apparel company. A utility company generally has more
stability in earnings. The company has less risk in its business given its stable revenue stream. However, a retail
apparel company has the potential for a bit more variability in its earnings. Since the sales of a retail apparel
 31

company are driven primarily by trends in the fashion industry, the business risk of a retail apparel company is much
higher. Thus, a retail apparel company would have a lower optimal debt ratio so that investors feel comfortable with
the company's ability to meet its responsibilities with the capital structure in both good times and bad.

2. Company's Tax Exposure 

Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a
project is attractive because the tax deductibility of the debt payments protects some income from taxes.

3. Financial Flexibility
Financial flexibility is essentially the firm's ability to raise capital in bad times. It should come as no surprise that
companies typically have no problem raising capital when sales are growing and earnings are strong. However,
given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an
effort to be prudent when raising capital in the good times and avoid stretching their capabilities too far. The lower a
company's debt level, the more financial flexibility a company has.

Let's take the airline industry as an example. In good times, the industry generates significant amounts of sales and
thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to
borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these
bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded
on top. (Learn more about this industry in Dead Airlines And What Killed Them and 4 Reasons Why Airlines Are
Always Struggling.)

4. Management Style
Management styles range from aggressive to conservative. The more conservative a management's approach is, the
less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using
significant amounts of debt to ramp up the growth of the company's earnings per share (EPS).

5. Growth Rate
Firms that are in the growth stage of their cycle typically finance that growth through debt by borrowing money to
grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and
unproven. As such, a high debt load is usually not appropriate.

More stable and mature firms typically need less debt to finance growth as their revenues are stable and proven.
These firms also generate cash flow, which can be used to finance projects when they arise.

6. Market Conditions
Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to
borrow funds for a new plant. If the market is struggling, meaning that investors are limiting companies' access to
capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In
that situation, it may be prudent for a company to wait until market conditions return to a more normal state before
the company tries to access funds for the plant. (Read more about market conditions in The Cost Of Unemployment
To The Economy and Betting On The Economy: What Are The Odds?)

(C) Liquidity Decision

 32

Liquidity decision is concerned with the management of current assets. Basically, this is Working Capital
Management. Working Capital Management is concerned with the management of current assets. It is concerned
with short-term survival. Short term-survival is a prerequisite for long-term survival.
When more funds are tied up in current assets, the firm would enjoy greater liquidity. In consequence, the firm
would not experience any difficulty in making payment of debts, as and when they fall due. With excess liquidity,
there would be no default in payments. So, there would be no threat of insolvency for failure of payments. However,
funds have economic cost. Idle current assets do not earn anything. Higher liquidity is at the cost of profitability.
Profitability would suffer with more idle funds. Investment in current assets affects the profitability, liquidity and
risk. A proper balance must be maintained between liquidity and profitability of the firm. This is the key area
where finance manager has to play significant role. The strategy is in ensuring a trade-off between liquidity
and profitability. This is, indeed, a balancing act and continuous process. It is a continuous process as the
conditions and requirements of business change, time to time. In accordance with the requirements of the firm, the
liquidity has to vary and in consequence, the profitability changes. This is the major dimension of liquidity decision
working capital management. Working capital management is day to day problem to the finance manager. His skills
of financial management are put to test, daily.

Liquidity measures: By Richard Loth 

1. Liquidity Measurement Ratios: Current Ratio

The current ratio is a popular financial ratio used to test a company's liquidity (also referred to as its current
or working capital position) by deriving the proportion of current assets available to cover current liabilities.

The concept behind this ratio is to ascertain whether a company's short-term assets (cash, cash equivalents,
marketable securities, receivables and inventory) are readily available to pay off its short-term liabilities
(notes payable, current portion of term debt, payables, accrued expenses and taxes). In theory, the higher the
current ratio, the better.

Formula:

Components: 

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings' current assets amounted to
$1,575.60 (balance sheet), which is the numerator; while current liabilities amounted to $606.90 (balance
sheet), which is the denominator. By dividing, the equation gives us a current ratio of 2.6.

Commentary:
The current ratio is used extensively in financial reporting. However, while easy to understand, it can be
misleading in both a positive and negative sense - i.e., a high current ratio is not necessarily good, and a low
current ratio is not necessarily bad (see chart below).

Here's why: Contrary to popular perception, the ubiquitous current ratio, as an indicator of liquidity, is
flawed because it's conceptually based on the liquidation of all of a company's current assets to meet all of its
current liabilities. In reality, this is not likely to occur. Investors have to look at a company as a going
concern. It's the time it takes to convert a company's working capital assets into cash to pay its current
 33

obligations that is the key to its liquidity. In a word, the current ratio can be "misleading."

A simplistic, but accurate, comparison of two companies' current position will illustrate the weakness of
relying on the current ratio or a working capital number (current assets minus current liabilities) as a sole
indicator of liquidity:

Company Company
--
ABC XYZ
Current Assets $600 $300
Current
$300 $300
Liabilities
Working
$300 $0
Capital
Current Ratio 2.0 1.0

Company ABC looks like an easy winner in a liquidity contest. It has an ample margin of current assets over
current liabilities, a seemingly good current ratio, and working capital of $300. Company XYZ has no
current asset/liability margin of safety, a weak current ratio, and no working capital.

However, to prove the point, what if: (1) both companies' current liabilities have an average payment period
of 30 days; (2) Company ABC needs six months (180 days) to collect its account receivables, and its
inventory turns over just once a year (365 days); and (3) Company XYZ is paid cash by its customers, and its
inventory turns over 24 times a year (every 15 days). 

In this contrived example, Company ABC is very illiquid and would not be able to operate under the
conditions described. Its bills are coming due faster than its generation of cash. You can't pay bills with
working capital; you pay bills with cash! Company's XYZ's seemingly tight current position is, in effect,
much more liquid because of its quicker cash conversion. 

When looking at the current ratio, it is important that a company's current assets can cover its current
liabilities; however, investors should be aware that this is not the whole story on company liquidity. Try to
understand the types of current assets the company has and how quickly these can be converted into cash to
meet current liabilities. This important perspective can be seen through the cash conversion cycle. By
digging deeper into the current assets, you will gain a greater understanding of a company's true liquidity.

2. Liquidity Measurement Ratios: Quick Ratio

The quick ratio - aka the quick assets ratio or the acid-test ratio - is a liquidity indicator that further refines
the current ratio by measuring the amount of the most liquid current assets there are to cover current
liabilities. The quick ratio is more conservative than the current ratio because it excludes inventory and other
current assets, which are more difficult to turn into cash. Therefore, a higher ratio means a more liquid
current position.

Formula:
 34

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings' quick assets amounted to
$756.40 (balance sheet); while current liabilities amounted to $606.90 (balance sheet). By dividing, the
equation gives us a quick ratio of 1.3.

Variations:
Some presentations of the quick ratio calculate quick assets (the formula's numerator) by simply subtracting
the inventory figure from the total current assets figure. The assumption is that by excluding relatively less-
liquid (harder to turn into cash) inventory, the remaining current assets are all of the more-liquid variety.
Generally, this is close to the truth, but not always.

Zimmer Holdings is a good example of what can happen if you take the aforementioned "inventory shortcut"
to calculating the quick ratio:

Standard Approach: $233.2 plus $524.2 = $756 ÷ $606.9 =1.3

Shortcut Approach: $1,575.6 minus $583.7 = $991.9 ÷ $606.9 = 1.6

Restricted cash, prepaid expenses and deferred income taxes do not pass the test of truly liquid assets. Thus,
using the shortcut approach artificially overstates Zimmer Holdings' more liquid assets and inflates its quick
ratio.

Commentary:
As previously mentioned, the quick ratio is a more conservative measure of liquidity than the current ratio as
it removes inventory from the current assets used in the ratio's formula. By excluding inventory, the quick
ratio focuses on the more-liquid assets of a company. 

The basics and use of this ratio are similar to the current ratio in that it gives users an idea of the ability of a
company to meet its short-term liabilities with its short-term assets. Another beneficial use is to compare the
quick ratio with the current ratio. If the current ratio is significantly higher, it is a clear indication that the
company's current assets are dependent on inventory.

While considered more stringent than the current ratio, the quick ratio, because of its accounts receivable
component, suffers from the same deficiencies as the current ratio - albeit somewhat less. To understand
these "deficiencies", readers should refer to the commentary section of the Current Ratio chapter. In brief,
both the quick and the current ratios assume a liquidation of accounts receivable and inventory as the basis
for measuring liquidity. 

While theoretically feasible, as a going concern a company must focus on the time it takes to convert its
working capital assets to cash - that is the true measure of liquidity. Thus, if accounts receivable, as a
component of the quick ratio, have, let's say, a conversion time of several months rather than several days,
the "quickness" attribute of this ratio is questionable.

Investors need to be aware that the conventional wisdom regarding both the current and quick ratios as
indicators of a company's liquidity can be misleading.
 35

3. Liquidity Measurement Ratios: Cash Ratio

The cash ratio is an indicator of a company's liquidity that further refines both the current ratio and the quick
ratio by measuring the amount of cash, cash equivalents or invested funds there are in current assets to cover
current liabilities. 

Formula:

Components:

As of December 31, 2005, with amounts expressed in millions, Zimmer Holdings' cash assets amounted to
$233.20 (balance sheet); while current liabilities amounted to $606.90 (balance sheet). By dividing, the
equation gives us a cash ratio of 0.4

Commentary:
The cash ratio is the most stringent and conservative of the three short-term liquidity ratios (current, quick
and cash). It only looks at the most liquid short-term assets of the company, which are those that can be most
easily used to pay off current obligations. It also ignores inventory and receivables, as there are no
assurances that these two accounts can be converted to cash in a timely matter to meet current liabilities.

Very few companies will have enough cash and cash equivalents to fully cover current liabilities, which isn't
necessarily a bad thing, so don't focus on this ratio being above 1:1.

The cash ratio is seldom used in financial reporting or by analysts in the fundamental analysis of a company.
It is not realistic for a company to purposefully maintain high levels of cash assets to cover current liabilities.
The reason being that it's often seen as poor asset utilization for a company to hold large amounts of cash on
its balance sheet, as this money could be returned to shareholders or used elsewhere to generate higher
returns. While providing an interesting liquidity perspective, the usefulness of this ratio is limited. 

4. Liquidity Measurement Ratios: Cash Conversion Cycle

This liquidity metric expresses the length of time (in days) that a company uses to sell inventory, collect receivables
and pay its accounts payable. The cash conversion cycle(CCC) measures the number of days a company's cash is
tied up in the the production and sales process of its operations and the benefit it gets from payment terms from its
creditors. The shorter this cycle, the more liquid the company's working capital position is. The CCC is also known
as the "cash" or "operating" cycle.

Formula:

Components:
 36

DIO is computed by:

1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
2. Calculating the average inventory figure by adding the year's beginning (previous yearend amount) and
ending inventory figure (both are in the balance sheet) and dividing by 2 to obtain an average amount of
inventory for any given year; and
3. Dividing the average inventory figure by the cost of sales per day figure.

For Zimmer's FY 2005 (in $ millions), its DIO would be computed with these figures:

(1) cost of sales per

739.4 ÷ 365 = 2.0
day
(2) average inventory 536.0 + 583.7 =
2005 1,119.7 ÷ 2 = 559.9
(3) days inventory
559.9 ÷ 2.0 = 279.9
outstanding

DIO gives a measure of the number of days it takes for the company's inventory to turn over, i.e., to be converted to
sales, either as cash or accounts receivable.

DSO is computed by:

1. Dividing net sales (income statement) by 365 to get a net sales per day figure;
2. Calculating the average accounts receivable figure by adding the year's beginning (previous yearend amount)
and ending accounts receivable amount (both figures are in the balance sheet) and dividing by 2 to obtain an
average amount of accounts receivable for any given year; and
3. Dividing the average accounts receivable figure by the net sales per day figure.

For Zimmer's FY 2005 (in $ millions), its DSO would be computed with these figures:

(1) net sales per day 3,286.1 ÷ 365 = 9.0

(2) average accounts 524.8 + 524.2 = 1,049
receivable ÷ 2 = 524.5
(3) days sales
524.5 ÷ 9.0 = 58.3
outstanding

DSO gives a measure of the number of days it takes a company to collect on sales that go into accounts receivables
(credit purchases).

DPO is computed by:

1. Dividing the cost of sales (income statement) by 365 to get a cost of sales per day figure;
 37

2. Calculating the average accounts payable figure by adding the year's beginning (previous yearend amount)
and ending accounts payable amount (both figures are in the balance sheet), and dividing by 2 to get an
average accounts payable amount for any given year; and
3. Dividing the average accounts payable figure by the cost of sales per day figure.

For Zimmer's FY 2005 (in $ millions), its DPO would be computed with these figures:

(1) cost of sales per

739.4 ÷ 365 = 2.0
day
(2) average accounts 131.6 + 123.6 = 255.2
payable ÷ 125.6
(3) days payable
125.6 ÷ 2.0 = 63
outstanding

DPO gives a measure of how long it takes the company to pay its obligations to suppliers.

CCC computed:
Zimmer's cash conversion cycle for FY 2005 would be computed with these numbers (rounded):

DIO 280 days

DSO +58 days
DPO -63 days
CCC 275 days
Variations:
Often the components of the cash conversion cycle - DIO, DSO and DPO - are expressed in terms of turnover as a
times (x) factor. For example, in the case of Zimmer, its days inventory outstanding of 280 days would be expressed
as turning over 1.3x annually (365 days ÷ 280 days = 1.3 times). However, actually counting days is more literal and
easier to understand when considering how fast assets turn into cash. 

Commentary:
An often-overlooked metric, the cash conversion cycle is vital for two reasons. First, it's an indicator of the
company's efficiency in managing its important working capital assets; second, it provides a clear view of a
company's ability to pay off its current liabilities. 

It does this by looking at how quickly the company turns its inventory into sales, and its sales into cash, which is
then used to pay its suppliers for goods and services. Again, while the quick and current ratios are more often
mentioned in financial reporting, investors would be well advised to measure true liquidity by paying attention to a
company's cash conversion cycle. 

The longer the duration of inventory on hand and of the collection of receivables, coupled with a shorter duration for
payments to a company's suppliers, means that cash is being tied up in inventory and receivables and used more
quickly in paying off trade payables. If this circumstance becomes a trend, it will reduce, or squeeze, a company's
cash availabilities. Conversely, a positive trend in the cash conversion cycle will add to a company's liquidity.

By tracking the individual components of the CCC (as well as the CCC as a whole), an investor is able to discern
 38

positive and negative trends in a company's all-important working capital assets and liabilities. 

For example, an increasing trend in DIO could mean decreasing demand for a company's products. Decreasing DSO
could indicate an increasingly competitive product, which allows a company to tighten its buyers' payment terms. 

As a whole, a shorter CCC means greater liquidity, which translates into less of a need to borrow, more opportunity
to realize price discounts with cash purchases for raw materials, and an increased capacity to fund the expansion of
the business into new product lines and markets. Conversely, a longer CCC increases a company's cash needs and
negates all the positive liquidity qualities just mentioned.

Note: In the realm of free or low-cost investment research websites, the only one we've found that provides complete
CCC data for stocks is Morningstar, which also requires a paid premier membership subscription. 

Current Ratio Vs. The CCC

The obvious limitations of the current ratio as an indicator of true liquidity clearly establish a strong case for greater
recognition, and use, of the cash conversion cycle in any analysis of a company's working capital position.

Nevertheless, corporate financial reporting, investment literature and investment research services seem to be stuck
on using the current ratio as an indicator of liquidity. This circumstance is similar to the financial media's and the
general public's attachment to the Dow Jones Industrial Average. Most investment professionals see this index as
unrepresentative of the stock market or the national economy. And yet, the popular Dow marches on as the market
indicator of choice.

The current ratio seems to occupy a similar position with the investment community regarding financial ratios that
measure liquidity. However, it will probably work better for investors to pay more attention to the cash-cycle
concept as a more accurate and meaningful measurement of a company's liquidity.

(D) Dividend Decision

Dividend decision is concerned with the amount of profits to be distributed and retained in the firm. Dividend: The
term ‘dividend’ relates to the portion of profit, which is distributed to shareholders of the company. It is a reward or
compensation to them for their investment made in the firm. The dividend can be declared from the current profits
or accumulated profits. Which course should be followed – dividend or retention? Normally, companies distribute
certain amount in the form of dividend, in a stable manner, to meet the expectations of shareholders and balance is
retained within the organization for expansion. If dividend is not distributed, there would be great dissatisfaction to
the shareholders. Non-declaration of dividend affects the market price of equity shares, severely. One significant
element in the dividend decision is, therefore, the dividend payout ratio i.e. what proportion of dividend is to be paid
to the shareholders. The dividend decision depends on the preference of the equity shareholders and investment
opportunities, available within the firm. A higher rate of dividend, beyond the market expectations, increases
the market price of shares. However, it leaves a small amount in the form of retained earnings for expansion.
The business that reinvests less will tend to grow slower. The other alternative is to raise funds in the market
for expansion. It is not a desirable decision to retain all the profits for expansion, without distributing any amount in
the form of dividend. There is no ready-made answer, how much is to be distributed and what portion is to be
retained. Retention of profit is related to
• Reinvestment opportunities available to the firm.
• Alternative rate of return available to equity shareholders, if they invest themselves.

Earning profit or a positive return is a common aim of all the businesses. But the key function a financial manager
performs in case of profitability is to decide whether to distribute all the profits to the shareholder or retain all the
profits or distribute part of the profits to the shareholder and retain the other half in the business. It’s the financial
manager’s responsibility to decide a optimum dividend policy which maximizes the market value of the firm.
 39

Hence an optimum dividend payout ratio is calculated. It is a common practice to pay regular dividends in case
of profitability Another way is to issue bonus shares to existing shareholders.
Dividend policy ratios measure how much a company pays out in dividends relative to its earnings and market
value of its shares. These ratios provide insights into the dividend policy of a company. They compare the dividends
to the earnings to measure how much of its earnings a company is paying out in dividends. They also compare the
dividends to share prices to see how much cash flow the investors get for their investments in the company’s shares.
Dividend payout ratio and dividend yield are two most common examples of dividend policy ratios. Dividend cover
is another example of such ratios. Dividend payout ratio gives an idea how well the earnings support the dividends
paid out. Dividend yield measures how much a company pays out in dividends relative to the market value of its
shares.

Definition of 'Dividend Payout Ratio'

The percentage of earnings paid to shareholders in dividends.
Calculated as:

Remember:
- A reduction in dividends paid is looked poorly upon by investors, and the stock price usually depreciates as
2005 2006 Horizontal
investors seek other dividend-paying stocks. Analysis
$000 $000 $000 $000
Current Assets
- A stable dividend payoutBank
ratio indicates
Accounts receivable
33.5
a solid240.8
dividend 41.0
policy by210.2
the company's board of directors.
Inventory 300.0 370.8
'FINANCIAL STATEMENT ANALYSIS' 574.3 622.0 108
Non-current assets
http://www.investopedia.com/terms/f/financial-statement-analysis.asp
Fixtures & fittings (net) 64.6 63.2
The process of reviewingLand and&evaluating
buildings (net)a company's
financial statements,
381.2 376.2 thereby gaining an understanding of the
financial health of the company and enabling more effective 445.8 decision making.439.4Financial99statements record financial
data; however, this information must be evaluated through
Total assets 1,020.1 financial statement
1,061.4 analysis
104 to become more useful to
investors, shareholders, managers and other interested parties. There are three financial statements to be analyzed
Current Liabilities
namely: Balance Sheet, Income Statement and 261.6
Accounts payable Cash Flow Statement. 288.8 Balance sheet walk demonstrates financial
statement analysis usingIncome
the tax
relationship of the60.2key financial statements,
76.0 the income statement, cash flow and
321.8 364.8 113
balance sheet. Non-current liabilities
Loan 200.0 60.0 30
Balance sheet as illustrated in the example below for Company B shows the assets and liabilities for the business.
On the balance sheet
Shareholders we can see the cash balance at the start as reflected in the Cash in Bank.
Funds
Paid-up ordinary capital 300.0 334.1
However, Retained
the details
profit
of all the cash
198.3
flows cannot be gleaned from the balance sheet. The balance
302.5
sheet shows the accounting equation: Assets = Liabilities + Capital.
498.3 636.6 128
Total liabilities & equity 1,020.1 1,061.4 104
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Income statement : The income statement (or profit and loss) shows revenue, cost of sales, expenses, interest and
tax, but does not show the cash flow for a business.
2005 2006 Horizontal
Analysis
$000 $000 $000 $000
Sales 2,240.8 2,681.2 120
Less Cost of goods sold 1,745.4 2,072.0 119
Gross profit 495.4 609.2 123
Wages & salaries 185.8 275.6
Rates 12.2 12.4
Heat & light 8.4 13.6
Insurance 4.6 7.0
Interest expense 24.0 6.2
Postage & telephone 9.0 16.4
Depreciation -
Buildings 5.0 5.0
Fixtures & fittings 27.0 276.0 32.8 369.0 134

Net profit before tax 219.4 240.2 109

Less Income tax 60.2 76.0 126
Net profit after tax 159.2 164.2 103

Cash flow statement shows the cash flows for the business. Here we see the operating cash
flows, financing cash flows and investing cash flows.
2005 2006
$000 $000 $000 $000
Cash flow from operations
Receipts from customers 2,281 2,711.8
Payments to suppliers & employees (2,050) (2,460.4)
Interest paid (24) (6.2)
Tax paid (46.4) (60.2)
Net cash flow from operating activities 160.6 185
Investing activities
Purchase of non-current assets (121.2) (31.4)
Net cash used in investing activities (121.2) (31.4)
Financing activities
Dividends paid (32.0) (40.2)
Issue of ordinary shares 20.0 34.1
Repayment of loan capital -__ (140.0)
Net cash outflow from financing activities (12) (146.1)
Increase in cash & cash equivalents 27.4 7.5
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Financial statement links: The income statement shows the potential cash flows. The cash flow statement shows
the real cash flows. The balance sheet shows the cash owing or payable.

Financial Analysis Types (http://www.finanalys.com/financial-analysis/)

Almost all literature points out three major types of financial analysis used:
1. Horizontal Analysis;
2. Vertical analysis;
3. Ratio analysis.
Horizontal Analysis: shows figure changes in two or more periods or their dynamics. Figure change can be
calculated in percentage or numbers, how much have they changed at evaluated period compared with previous
period.
Vertical Analysis: shows figure part or percentage compared to its basic figure. what portion does it makes. Basic
figure is always 100%.
In short horizontal analysis shows figure change while vertical analysis its portion as showed below. As can be
seen visually this is were its names come from since different figures are
layed vertically and different periods horizontally.

Ratio Analysis:  Shows two financial statement figures ratio that are logically linked. This analysis methods
is widely used to compare companies. Many ratios are calculated, some of them even don’t even have united name.
There is no united grouping of these ratios, many analysts link them differently, but most common are these:
1. Profitability;
2. Solvency;
3. Market ratios.
Profitability ratios  are calculated using different types of profit which basic income statement has 4 (gross profit,
operating profit, income before tax, net income), also there is EBITDA and Net income before depreciation. Many
more profit types can be created by including or excluding different types of expenses.
The most simple profitability ratios are calculated by dividing different type of profit from revenue. These are
also called margins. These are the mostly used:
 Gross profit margin
 Operating margin
 Net income margin
Also another very important figure to add would be EBIDA margin or Net income before depreciation margin which
would show how much real earning are generated from one $ of revenue. This ratios are calculated from income
statement figures, so they should be used when analyzing income statement data.
Other part of profitability ratios are calculated from dividing different type of profit with different balance sheet
figures. Mostly common are these:
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 Asset profitability;
 Equity profitability.
They are also called ROA – return on asset and ROE – return on equity and calculated mostly by dividing Net
income with total asset and Net income with total equity. These figures show how effective companies asset and
equity in generating Net income. There is also ROE subratio called ROEC – return on capital employed which is
calculated by adding financial debts to equity a and shows how much one $ of borrowed and stockholders owned
money generates profit. Reverse ratio would show how many years it would take for companies asset or equity
would be earned.
Solvency ratios shows companies ability to cover various type of liabilities. Solvency is sometimes mixed with
liquidity, but liquidity is mainly means how fast can some type of asset be converted into cash.
Solvency ratios can be grouped into long term solvency and short term solvency ratios which are linked to
companies ability to pay its short term and long term debts.
One of main short term solvency ratio is Liquidity ratio which is calculated by dividing Total current asset from
Total current liabilities. This ratio is very important because it shows companies ability to cover its short term debts.
Even very profitable companies can run into trouble if to much short term debts matures at once. When this ratio is
lower then 1 that shows that company has more short term debts to pay then it has short term asset and thus there is
a risk that company can face solvency problems. When ratio is over 2 it can be called a very good and safe one. So
here are its evaluations:
 >1,0 bad
 1,0 – 1,5 weak
 1,5 – 2,0 good
 >2,0 very good
Also other ratios are calculated by using different type of liquidity asset dividing by current liabilities. There is also
quick liquidity ratio which takes only cash and alike asset.
In short term solvency group there are also working capital ratios. Most important is Net working capital (NWC) -
which is sometimes called as asset that is left after you exclude current liabilities from current asset. This ratio is
linked to current as this type of asset is participating in companies activity and often called working. As can seen
below this ratio is nothing more but equity part that participates in short term of working asset.

Another ratio at this group is called Working investments (WI) – and is capital or asset that is participating in
companies activity, there are Inventories and Account receivables. These are companies temporary “frozen” cash
that are used in its performance until they are paid by its customers and becomes cash again.
A very important ratio is Net working investments (NWI) – calculated as Inventories + account receivables -
account payable. This ratio shows how much companies own funds are “frozen” in working investments.
Another important ratio is Working investment financing sources. The more Net working investments in it the
better. Good ratio is considered to be over 50% of Net working investments.
Main long term solvency ratio is Equity level which is calculated by dividing equity from total asset. Its bets to be
presented in percentage. Low equity level means that companies liabilities compared to equity are high, because all
remaining asset is covered by liabilities. This ratio is very important, because at most times if this ratio is good
mainly all other ratios are good also. Rate where this ratio would be considered as good is 50%. Lower rate is not
 43

deadly as it allows company to maximize its return on equity, but lower then 30% should be considered as
dangerous, in contrary above 70% can be considered as very good. So it can be rated accordingly:
 0% – 30% bad
 30% – 50% low
 50% – 70% good
 70% – 100% very good
But equity ratio is different for certain sectors for example financial sector good capital ratio is 10% consumer goods
and services 40% would be also good ratio, while technologies or energy which needs a lot of investments even 50%
would be a bit low equity ratio or a bottom line. So preferable equity ratio would be:
 10% Financial
 30% –50% Consumer goods, Healthcare and Services.
 50% – 70% Energy an Technology.
Market ratios are mostly used for investors and shareholders. All of them one way or another are linked to
companies share market price. Most popular are these:
 Market capitalization.
 P/E ratio.
 Dividend yield
Market capitalization represents total value of the company calculated by it market share price multiplied by
companies share number. In theory this ratio could represent how much company is worth according to market
prices.
P/E ratio or Price per earning shows what is the ratio of companies share price divided by amount of money earned
to one of its share. This is no other then reversed companies share profitability ratio. As this is often used
ratio, better understood ratio would be Share profitability calculated as  Share price divided by Net Income
generated for one companies share as Net Income is the best figure that shows how much money company is earning
for its shareholders  Companies generated profitability should be much higher then bank of Government bonds paid
interest and should be at least more then 4%, good profitability could be considered above 7% and very good one
which is over 10% so it could be grouped accordingly:
 >4% low profitability
 4-7% average profitability
 7-10% good profitability
 >10% very good profitability
One important ratio is Share value. There are many ways and methods to calculate share price but to chose the right
one the understanding of companies share price must be clarified. Share price market value is decided by the market,
companies share price is the one that you can sell it for, but companies real share value can be calculated also from
its financial statements, because its is mostly twisted by Market Expectations, so it is very advisable to know what
is the financial companies value. The simplest way to know companies financial or book value is simply dividing
companies Equity by its share number.
At most cases companies share market price is much higher then its basic value due to mentioned expectations, but
it is normal as some companies has good results.
Share value:
Equity / share 10,0 bn.$ 2,0 bn. 5,0 $/sh.
Market value 30,0 $ +20,0$ 10 years
Year Net income before 3,0 bn.$ +1,5$/sh. 5,0%
Depreciation
Best way to measure the difference between share Market price and Basic financial value is by Years of generated
Net income .
 Up to 5 year could be considered as share is not valuated enough.
 Over 5 year and up to 15 years could be the level when companies share evaluation is normal.
 44

 Over 15-25 years is the level where it should be considered as highly evaluated and should be looked
very closely if it is worth of paying that much in front, maybe companies rapid growth is predicted of is a very
stable company like coca-cola.
 Over 25 years is the level where it can be said that companies share is over-valuated.
Another thing that must be mentioned in companies share evaluation is Dividends. Dividends is the main and only
real earnings for its shareholders as share value increase is depended on market value and once again on
expectations. If expectations goes down with it your investment value. Two most important factors are:
 Dividend yield
 Dividend payout ratio.
Dividend yield is percentage of how much dividend you are getting compared to its share market value so
is calculated as Annual dividends/share market value. Bad dividends yield can be considered as 2%, then it is better
to invest in government bonds or bank deposits, while 5% can be considered as a good dividend yield.
 <2% bad profitability
 2-3% low profitability
 3-5% average profitability
 >5% good profitability
Dividend payout ratio is a figure that shows how much companies earned Net income is spent on dividend payout.
Stable companies can pay even up to 100% of its earnings which does not need any additional investments, but that
is not good as this eliminated possibilities for company to grow, earn more and in final results increase its dividends,
which is called dividend growth stock. For a long time investor such stable and growing companies is a
key investments as some companies managed to increase their dividend payouts for 20 or even 50 years in a row.
When company pays 1/2 of its earnings to shareholders that can be considered as a normal payout ratio. Range can
be set from 30% up to 70% as normal. While <30% is a low payout ratio. Such companies mainly have a very low
dividend yields which is also not good for investors. 
 >100% bad payout ratio.
 70-100% high payout ratio.
 30-70% normal payout ratio.
 <30% low payout ratio.
On the other hand when more earnings are left in companies equity companies book value increases, but never the
less companies with very low payout ratio but with dividend yield >2% can be treated as bad investment unless at
that time bank deposit and government bonds yields are even lower.
Student Activity 4
1. Supply the missing part of the Financial Statements of the KLEEN SWEEP, Inc.

Cash flow statement

Cash flows from operating activities
Cash receipts from revenues $ 1,500
Cash payments for expenses (300)
Net cash flow from operating activities $ 1,200

Cash flows from investing activities

Cash payment for Land $(500)
Net cash flow from investing activities $ (500)

Cash flows from financing activities

Cash receipts from stock issue $ 2,000
Cash receipts from bank loan 1,000
Cash payments for dividends (50)
 45

Net cash flow from financing activities $ 2,950

Net increase in cash $ ______

Income Statement
Revenue 1,500
- Expenses
Rent 100
Utility Exp 200 ____
Net income ____

BALANCE SHEET
Assets
Cash $ 3,650
Land 500
Total Assets $ 4,150

Liabilities
Note payable $ 1,000
Stockholders’ Equity
Common Stock $ 2,000
Retained Earnings 1,150
Total Stockholders’ Equity 3,150
Total Liabilities and Stockholders’ Equity $_______

2. Assess the financial health of the business in terms of profitability, liquidity & solvency by using the
ratios. Justify your answers

Prepared by:
Pricilla P. Badoc, D.M.
Assistant Prof. IV
46