Financial Management

PALVIELA PG COLLEGE, PALIVELA , KOTHAPETA -533229, PHONE NO:08855-244771/774
FINANCIAL MANAGEMENT
Unit- I: Nature , Scope and Objectives of Financial Management, Goals of FM-Profit

Maximization Vs. Wealth Maximization – Finance Functions – Financial Planning and
Forecasting - Role of Financial Manager – Funds Flow Analysis – Cash Flow Analysis.-
Ratio Analysis (theory no exercises on Ratio analysis).
Unit-II: Financing Decision: Financial Leverage – EPS-EBIT Analysis –Cost of Capital

– Weighted Average Cost Capital – Capital Structure – Factors Affecting Capital
Structure Theories of Capital Structure.
Unit – III: Investment Decision: Nature and Significance of Investment Decision-

Estimation of Cash Flows – Capital Budgeting Process – Techniques of Investment
Appraisal: Pay Back Period; Accounting Rate of Return, Time Value of Money- DCF
Techniques –Net Present Value, Profitability Index and Internal Rate of Return.
Unit-IV: Dividend Decision: Meaning and Significance – Theories of Dividend –

Determinants of Dividend – Dividend policy – Bonus Shares – Stock Splits.
Unit – V: Working Capital Decision: Meaning – Classification and Significance of

Working Capital – Component of Working Capital –operating and cash conversion
cycle – Calculation of working capital. (Case Study is compulsory in all Units)
1|Page : PALIVELA PG COLLEGE (ICET CODE : SSSK)

Preparation Plan :
Important concepts
UNIT: 1
ESSAY QUESTIONS:
1. Nature and scope of the financial management? *****
2. Role of financial manager? *****
3. Financial functions? *****
4. Goals (OR) objectives of the financial management?
5. Ratio analysis?
SHORT QUESTIONS:
1. Funds flow analysis? ****
2. Cash flow analysis? ****
3. Financial planning and forecasting?
4. Profit maximization?
5. Wealth maximization?
UNIT: 2
ESSAY QUESTIONS:
1. Meaning and definition of financial decision and types of financial decision? *****
2. Meaning and definition of leverage? And types of leverages?
3. Importance of cost of capital and types of cost of capital?
4. Factors effecting Capital structure. And theories of capital structure? *****
SHORT QUESTIONS:
1. EBIT – EPS Analysis
2. Financial leverage
3. WACC (weighted average cost of capital) ****
UNIT: 3
ESSAY QUESTIONS:
1. Nature and significance of investment decision?
2. Process of capital budgeting and techniques of capital budgeting? *****
SHORT QUESTIONS:
1. Time value of money?
2. Capital budgeting 5 methods? *****
UNIT: 4
ESSAY QUESTIONS:
1. Dividend –Significance, determinants and types? ****
2. Theories of dividend?
SHORT QUESTIONS:

1. 5 dividend policies? ****

2. Bonus shares vs. stock splits?
UNIT: 5
ESSAY QUESTIONS:
1. Define working capital? Significance and components of working capital?
2. Classification (or) types of working capital?
SHORT QUESTIONS:
1. Operating cycle?
2. Classification of working capita?
CASE STUDIES :( PROBLEMATIC)
1. Capital budgeting ( V.IMP) ******
2. Cost of capital
3. EBIT-EPS ****
4. Leverage
5. Operating /working capital cycle
6. Working capital calculation
7. Funds flow statement
8. Cash flow statement

Unit- I: Nature , Scope and Objectives of Financial Management, Goals of

FM-Profit Maximization Vs. Wealth Maximization – Finance Functions –
Financial Planning and Forecasting - Role of Financial Manager – Funds
Flow Analysis – Cash Flow Analysis.- Ratio Analysis (theory no exercises
on Ratio analysis).
Q 1: Explain the nature, scope and objectives of financial management:
1.1 INTRODUCTION TO FINANCIAL MANAGEMENT
Meaning of Financial Management: Financial management refers to that part of

the management activity, which is concerned with the planning, & controlling of
firm’s financial resources. It deals with finding out various sources for raising funds
for the firm. Financial management is practiced by many corporate firms and can be
called Corporation finance or Business Finance.
According to Guthmann and Doug all: “Business finance can be broadly

defined as the activity concerned with the planning, raising controlling and
administrating the funds used in the business.”
According to Joseph & Massie: “Financial Management is the operational

activity of a business that is responsible for obtaining and effectively utilizing the
funds necessary for efficient operations”
Financial Management is the application of the general management principles in

the area of financial decision-making, namely in the areas of investment of funds,
financing various activities, and disposal of profits.
Financial management is the art of planning; organizing, directing and

controlling of the procurement and utilization of the funds and safe disposal of
profits to the end that individual, organizational and social objectives are
accomplished.

Nature of the financial management
(i) Financial management is a specialized branch of general management, in

the present-day-times. Long back, in traditional times, the finance function
was coupled, with production or with marketing; without being assigned a
separate status.
(ii) Financial management is growing as a profession. Young educated
persons, aspiring for a career in management, undergo specialized courses
in Financial Management, offered by universities, management institutes
etc.; and take up the profession of financial management.
(iii) Despite a separate status financial management, is intermingled with
other aspects of management.
(iv) Likewise, the Advertising Manager thinking, in terms of launching an
aggressive advertising programmer, is too, considering a financial

decision; and so on for other functional managers. This intermingling
nature of financial management calls for efforts in producing a coordinated
financial system for the whole enterprise.

(v) Financial management is multi-disciplinary in approach. It depends on
other disciplines, like Economics, Accounting etc., for a better procurement
and utilization of finances.
(vi) Financial management is multi-disciplinary in approach. It depends on
other disciplines, like Economics, Accounting etc., for a better procurement
and utilization of finances.
(vii) The central focus of finance function is valuation of the firm
(viii) Finance functions comprise control functions also
Scope of the financial management
Scope of financial management is divided for the purpose of exposition into two
broad categories
Traditional Approach
Traditional approach is the initial stage of financial management, which was

followed, in
the early part of during the year 1920 to 1950. This approach is based on the
past experience
and the traditionally accepted methods. Main part of the traditional approach is
rising of
funds for the business concern. Traditional approach consists of the following
important area.
1. Arrangement of funds from lending body

2. Arrangement of funds through various financial instruments.
3. Finding out the various sources of funds

Modern approach
The modern approach is an analytical way of looking into financial problems of

the firm. According to this approach, the finance function covers both acquisitions of
funds as well as the allocation of funds to various uses. Financial management is
concerned with the issues in involved in rising of funds and efficient and wise
allocation of funds.
Objectives of financial management
Effective procurement and efficient use of finance lead to proper utilization of the
finance
by the business concern. It is the essential part of the financial manager. Hence, the
financial
manager must determine the basic objectives of the financial management.
Objectives of
Financial Management may be broadly divided into two parts such as:
1. Profit maximization
2. Wealth maximization.
Profit Maximization:
Main aim of any kind of economic activity is earning profit. A business

concern is also functioning mainly for the purpose of earning profit. Profit is the
measuring techniques to understand the business efficiency of the concern. Profit
maximization is also the traditional and narrow approach, which aims at, maximizes
the profit of the concern. Profit maximization consists of the following important
features.

1. Profit maximization is also called as cashing per share maximization. It leads

to
maximize the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence, it considers all
the
possible ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business concern.
So it shows the entire position of the business concern
4. Profit maximization objectives help to reduce the risk of the business.
Favorable Arguments for Profit Maximization

The following important points are in support of the profit maximization objectives
of the
business concern:
(i) Main aim is earning profit.

(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also
Drawbacks of Profit Maximization
(i) It is vague: In this objective, profit is not defined precisely or correctly. It

creates some unnecessary opinion regarding earning habits of the
business concern.
(ii) It ignores the time value of money: Profit maximization does not
consider the time value of money or the net present value of the cash
inflow. It leads certain differences between the actual cash inflow and net
present cash flow during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the
business concern. Risks may be internal or external which will affect the
overall operation of the business concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which

involves latest innovations and improvements in the field of the business concern.
The term wealth means shareholder wealth or the wealth of the persons those who
are involved in the business concern Wealth maximization is also known as value
maximization or net present worth maximization. This objective is a universally

accepted concept in the field of business.
Favorable Arguments for Wealth Maximization
(i) Wealth maximization is superior to the profit maximization because

the main aim of the business concern under this concept is to
improve the value or wealth of the shareholders.
(ii) Wealth maximization considers the comparison of the value to cost
associated with the business concern. Total value detected from the
total cost incurred for the business operation. It provides extract
value of the business concern.
(iii) Wealth maximization considers both time and risk of the business
concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.
Unfavorable Arguments for Wealth Maximization
(i) Wealth maximization leads to prescriptive idea of the business concern

but it may not be suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the
indirect name of the profit maximization
(iii) Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoy certain benefits
(v) The ultimate aim of the wealth maximization objectives is to maximize
the profit.
(vi) Wealth maximization can be activated only with the help of the
profitable position of the business concern.
2Q: Functions of Financial Management?
The following explanation will help in understanding each finance function in detail
1. Investment decision
2. Financial decision
3. Dividend decision
4. Liquidity decision

1. Investment Decision
One of the most important finance functions is to intelligently allocate
capital to long term assets. This activity is also known as capital budgeting. It is
important to allocate capital in those long term assets so as to get maximum yield in
future. 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.
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.
2. Financial Decision
Financial decision is yet another important function which a financial manger must
perform. It is important to make wise decisions about when, where and how should
a business acquire funds. Funds can be acquired through many ways and channels.
Broadly speaking a correct ratio of an equity and debt has to be maintained. This
mix of equity capital and debt is known as a firm’s capital structure.
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.
3. Dividend Decision
Earning profit or a positive return is a common aim of all the businesses. But
the key function a financial manger 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.
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It’s the financial manager’s responsibility to decide a optimum dividend policy

which maximizes the market value of the firm. 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.
4. Liquidity Decision
It is very important to maintain a liquidity position of a firm to avoid

insolvency. Firm’s profitability, liquidity and risk all are associated with the
investment in current assets. In order to maintain a tradeoff between profitability
and liquidity it is important to invest sufficient funds in current assets. But since
current assets do not earn anything for business therefore a proper calculation must
be done before investing in current assets.
Current assets should properly be valued and disposed of from time to time once
they become non profitable. Currents assets must be used in times of liquidity
problems and times of insolvency.
Financial Planning and Forecasting
Definition of Financial Planning
Financial Planning is the process of estimating the capital required and

determining it’s competition. It is the process of framing financial policies in relation
to procurement, investment and administration of funds of an enterprise.
Objectives of Financial Planning
a. Determining capital requirements- This will depend upon factors like

cost of current and fixed assets, promotional expenses and long- range
planning. Capital requirements have to be looked with both aspects: short-
term and long- term requirements.
b. Determining capital structure- The capital structure is the composition
of capital, i.e., the relative kind and proportion of capital required in the

business. This includes decisions of debt- equity ratio- both short-term and
long- term.
c. Framing financial policies with regards to cash control, lending,
borrowings, etc.
d. A finance manager ensures that the scarce financial resources are
maximally utilized in the best possible manner at least cost in order
to get maximum returns on investment.
Importance of Financial Planning
Financial Planning is process of framing objectives, policies, procedures,

programmers and budgets regarding the financial activities of a concern. This
ensures effective and adequate financial and investment policies. The importance
can be outlined as-
1. In concern adequate funds have to be ensured.

2. Financial Planning helps in ensuring a reasonable balance between outflow
and inflow of funds so that stability is maintained.
3. Financial Planning ensures that the suppliers of funds are easily investing in
companies which exercise financial planning.
4. Financial Planning helps in making growth and expansion programmes which
helps in long-run survival of the company.
5. Financial Planning reduces uncertainties with regards to changing market
trends which can be faced easily through enough funds.
6. Financial Planning helps in reducing the uncertainties which can be a
hindrance to growth of the company. This helps in ensuring stability and
profitability in concern.
Financial Forecasting
Financial forecasts estimate future income and expenses for a business over a

period of time, generally the next year. They are used to develop projections for
profit and loss statements, balance sheets, burn rate, and other cash flow forecasts.

A financial forecast is an estimate of future financial outcomes for a company. It is

part of planning process
There are four main types of forecasting methods that financial analysts use to

predict future revenues, expenses, and capital costs for a business. While there is a
wide range of frequently used quantitative budget forecasting tools, in this article we
focus on the top four methods:
(1) Straight-line,
(2) Moving average
(3) Simple linear regression, and
(4) Multiple linear regressions
Forecasting is the process of making predictions of the future based on past and
present data and most commonly by analysis of trends. A commonplace example
might be estimation of some variable of interest at some specified future
date. Prediction is a similar, but more general term.
Role of a Financial Manager
A financial manager is a person who takes care of all the important financial
functions of an organization. The person in charge should maintain a far sightedness
in order to ensure that the
funds are utilized in the most
efficient manner. His actions
directly affect the Profitability,
growth and goodwill of the firm.
Following are the main

functions of a Financial
Manager:
1. Raising of Funds

In order to meet the obligation of the business it is important to have enough cash
and liquidity. A firm can raise funds by the way of equity and debt. It is the
responsibility of a financial
Manager to decide the ratio between debt and equity. It is important to maintain a
good balance between equity and debt.
2. Allocation of Funds
Once the funds are raised through different channels the next important function is
to allocate the funds. The funds should be allocated in such a manner that they are
optimally used. In order to allocate funds in the best possible manner the following
point must be considered
 The size of the firm and its growth capability
 Status of assets whether they are long-term or short-term
 Mode by which the funds are raised
These financial decisions directly and indirectly influence other managerial activities.
Hence formation of a good asset mix and proper allocation of funds is one of the
most important activities
3. Profit Planning
Profit earning is one of the prime functions of any business organization. Profit
earning is important for survival and sustenance of any organization. Profit
planning refers to proper usage of the profit generated by the firm.
Profit arises due to many factors such as pricing, industry competition, state of the
economy, mechanism of demand and supply, cost and output. A healthy mix of
variable and fixed factors of production can lead to an increase in the profitability of
the firm.
4. Understanding Capital Markets

Shares of a company are traded on stock exchange and there is a continuous sale
and purchase of securities. Hence a clear understanding of capital market is an
important function of a financial manager. When securities are traded on stock
market there involves a huge amount of risk involved. Therefore a financial manger
understands and calculates the risk involved in this trading of shares and
debentures.
****
Funds Flow Analysis
Fund flow statement is one of the important management tools for decision
making. The statement is prepared taking into account revenue statement and
position statement of the organization.
Definitions
"The fund statement is an important device for bringing to light the underlying
financial movements the ebb and flow of funds." - Patton and Patton
"Funds Flow Statement is prepared to indicate in summary form, changes

occurring in items of financial position between two different balance sheet dates."
- Smith and Brown
Significance of Fund Flow Statement
• Analytical Tool
• Design Policies
• Control Device
• Reflect Financial Position
• Uses for Working Capital
• Help to Lenders
• Direction for Business
Limitations of Fund Flow Statement

 It ignores non-fund items.
 It ignores to project future operations.
 It also ignores transactions when they occur between current accounts and
non-current accounts.

 This is not ideal tool for financial analysis.

 It does not provide any additional information to the management because
financial statements are simply rearranged and presented.
Objectives of the funds flow statement
The utility of this statement can be measured on the basis of its contribution to the
financial management. It generally serves the following purpose:
1. Analysis of Financial Position: The basic purpose of preparing the statement is

to have a rich insight into where the funds were obtained and used in the
past.
2. Evaluation of the Financing Capacity: One important use of the statement is
that it evaluates the firms financing capacity.
3. Instrument for Allocation of Resources: In modern large scale business,
available funds are always short for expansion programs and there is always a
problem of allocation of resources.
4. Tool of communication to outside world: Funds flow statement helps in
gathering the financial states of business.
5. Future guide: The management can formulate its financial policies based on
information gathered from the analysis of such statement.
Cash Flow Analysis
Definition:
Cash Flow Analysis is the evaluation of a company's cash inflows and outflows

from operations, financing activities, and investing activities. In other words, this is
an examination of how the company is generating its money, where it is coming
from, and what it means about the value of the overall company.
Cash flows are often transformed into measures that give information e.g. on a
company's value and situation:
 To determine a project's rate of return or value. The time of cash flows into

and out of projects are used as inputs in financial models such as internal rate
of return and net present value.
 To determine problems with a business's liquidity. Being profitable does not
necessarily mean being liquid. A company can fail because of a shortage of
cash even while profitable.

 As an alternative measure of a business's profits when it is believed

that accrual accounting concepts do not represent economic realities. For
instance, a company may be notionally profitable but generating little
operational cash (as may be the case for a company that barters its products
rather than selling for cash).
 Cash flow can be used to evaluate the 'quality' of income generated
by accrual accounting. When net income is composed of large non-cash items
it is considered low quality
 To evaluate the risks within a financial product, e.g., matching cash
requirements, evaluating default risk, re-investment requirements, etc.
COMPONENTS OF A CASH FLOW STATEMENT
 [Operating cash flow] - a measure of the cash generated by a company's

regular business operations. Operating cash flow indicates whether a
company can produce sufficient cash flow to cover current expenses and pay
debts.
 Cash flow from investing activities - the amount of cash generated from
investing activities such as purchasing physical assets, investments in
securities, or the sale of securities or assets

 Cash flow from financing activities (CFF) - the net flows of cash that are used
to fund the company. This includes transactions involving dividends, equity,
and debt.
RATIO ANALYSIS
Is a method or process by which the relationships of items or groups of

items in the financial statements are computed and presented .Is an important tool
of financial analysis.
Ratio analysis is a quantitative method of gaining insight into a company's

liquidity, operational efficiency, and profitability by comparing information contained
in its financial statements. Ratio analysis is a cornerstone of fundamental analysis.
Ratio Analysis – Categories of Financial Ratios
There are numerous financial ratios that are used for ratio analysis, and they are
grouped into the following categories:
1. Liquidity ratios

Liquidity ratios measure a company's ability to pay off its short-term debts

as they come due using the company's current or quick assets. Liquidity ratios
include the current ratio, quick ratio, and working capital ratio.
Current Ratio = Current Assets ÷ Current Liabilities
Evaluates the ability of a company to pay short-term obligations using

current assets (cash, marketable securities, current receivables, inventory,
and prepayments).
Acid Test Ratio = Quick Assets ÷ Current Liabilities
Also known as "quick ratio", it measures the ability of a company to

pay short-term obligations using the more liquid types of current assets or
"quick assets" (cash, marketable securities, and current receivables).
Net Working Capital = Current Assets - Current Liabilities
Determines if a company can meet its current obligations with its current
assets; and how much excess or deficiency there is.
2. Solvency ratios
Also called financial leverage ratios, solvency ratios compare
a company's debt levels with its assets, equity, and earnings to evaluate whether a
company can stay afloat in the long-term by paying its long-term debt and interest
on the debt. Examples of solvency ratios include debt-equity ratio, debt-assets ratio,
and interest coverage ratio.

3. Profitability Ratios
Profitability ratios measure a business’ ability to earn profits, relative to

their associated expenses. Recording a higher profitability ratio than in
the previous financial reporting period shows that the business is
improving financially
1. Gross Profit Rate = Gross Profit ÷ Net Sales

Evaluates how much gross profit is generated from sales. Gross profit is equal to
net sales (sales minus sales returns, discounts, and allowances) minus cost of
sales.
2. Return on Sales = Net Income ÷ Net Sales

Also known as "net profit margin" or "net profit rate", it measures the percentage
of income derived from dollar sales. Generally, the higher the ROS the better.
3. Return on Assets = Net Income ÷ Average Total Assets

In financial analysis, it is the measure of the return on investment. ROA is used in
evaluating management's efficiency in using assets to generate income.
4. Return on Stockholders' Equity = Net Income ÷ Average

Stockholders' Equity
Measures the percentage of income derived for every dollar of owners' equity.

4. Efficiency ratios
Efficiency ratios measure how well the business is using its assets and liabilities to
generate sales and earn profits. They calculate the use of inventory, machinery
utilization, turnover of liabilities, as well as the usage of equity.
Receivable Turnover = Net Credit Sales ÷ Average Accounts Receivable

Measures the efficiency of extending credit and collecting the same. It indicates the
average number of times in a year a company collects its open accounts. A high
ratio implies efficient credit and collection process.
Days Sales Outstanding = 360 Days ÷ Receivable Turnover
Also known as "receivable turnover in days", "collection period". It measures the

average number of days it takes a company to collect a receivable. The shorter the
DSO, the better. Take note that some use 365 days instead of 360.
Inventory Turnover = Cost of Sales ÷ Average Inventory
Represents the number of times inventory is sold and replaced. Take note that some
authors use Sales in lieu of Cost of Sales in the above formula. A high ratio indicates
that the company is efficient in managing its inventories.
Days Inventory Outstanding = 360 Days ÷ Inventory Turnover
Also known as "inventory turnover in days". It represents the number of days

inventory sits in the warehouse. In other words, it measures the number of days
from purchase of inventory to the sale of the same. Like DSO, the shorter the DIO
the better.
Accounts Payable Turnover = Net Credit Purchases ÷ Ave. Accounts

Payable

Represents the number of times a company pays its accounts payable during a
period. A low ratio is favored because it is better to delay payments as much as
possible so that the money can be used for more productive purposes.
Total Asset Turnover = Net Sales ÷ Average Total Assets

Measures overall efficiency of a company in generating sales using its assets. The
formula is similar to ROA, except that net sales are used instead of net income.
5. Operating performance ratio
Operating performance ratios are intended to measure different aspects of

an organization's core operations. This ratio compares revenues to net fixed
assets. A high ratio indicates that a business is generating a large amount of sales
from a relatively small fixed asset base.
6. Risk analysis
Risk analysis is the process of identifying and analyzing potential issues that
could negatively impact key business initiatives or critical projects in order to help
organizations avoid or mitigate those risks.
7. Turnover ratio
A measure of the number of times a company's inventory is replaced during a given

time period. Turnover ratio is calculated as cost of goods sold divided by average
inventory during the time period. A high turnover ratio is a sign that the company
is producing and selling its goods or services very quickly
The inventory turnover ratio is calculated by dividing the cost of goods sold
for a period by the average inventory for that period.

Growth Ratios
1. Earnings per Share = ( Net Income - Preferred Dividends ) ÷

Average Common Shares Outstanding
EPS shows the rate of earnings per share of common stock. Preferred dividends
are deducted from net income to get the earnings available to common
stockholders.
2. Price-Earnings Ratio = Market Price per Share ÷ Earnings per Share

Used to evaluate if a stock is over- or under-priced. A relatively low P/E
ratio could indicate that the company is under-priced. Conversely, investors
expect high growth rate from companies with high P/E ratio.
3. Dividend Pay-out Ratio = Dividend per Share ÷ Earnings per Share
Determines the portion of net income that is distributed to owners. Not all
income is distributed since a significant portion is retained for the next year's
operations.
4. Dividend Yield Ratio = Dividend per Share ÷ Market Price per Share
Measures the percentage of return through dividends when compared to the price
paid for the stock. A high yield is attractive to investors who are after dividends
rather than long-term capital appreciation.
Advantages of Ratio Analysis
 Ratio analysis will help validate or disprove the financing, investment and

operating decisions of the firm.
 It simplifies complex accounting statements and financial data into simple
ratios of operating efficiency, financial efficiency, solvency, long-term positions
etc.

 Ratio analysis helps identify problem areas and bring the attention of the
management to such areas. Some of the information is lost in the complex
accounting statements, and ratios will help pinpoint such problems.
 Allows the company to conduct comparisons with other firms, industry
standards, intra-firm comparisons etc.
Unit-II: Financing Decision: Financial Leverage – EPS-EBIT Analysis –Cost

of Capital – Weighted Average Cost Capital – Capital Structure – Factors
effecting Capital Structure Theories of Capital Structure.
Financing Decision:
Definition: The Financing Decision is yet another crucial decision made by the

financial manager relating to the financing-mix of an organization. It is concerned
with the borrowing and allocation of funds required for the investment decisions.
The financing decision involves two sources from where the funds can be
raised: using a company’s own money, such as share capital, retained earnings or
borrowing funds from the outside in the form debenture, loan, bond, etc. The
objective of financial decision is to maintain an optimum capital structure, i.e. a
proper mix of debt and equity, to ensure the trade-off between the risk and return
to the shareholders.
The Debt-Equity Ratio helps in determining the effectiveness of the financing

decision made by the company. While taking the financial decisions, the finance
manager has to take the following points into consideration:
Every company is required to take three main financial decisions, they are:
 Investment Decision
 Financing Decision
 Dividend Decision

1. Investment Decision:
A financial decision which is concerned with how the firm’s funds are invested in
different assets is known as investment decision. Investment decision can be long-
term or short-term.
A long term investment decision is called capital budgeting decisions which involve
huge amounts of long term investments and are irreversible except at a huge cost.
Short-term investment decisions are called working capital decisions, which affect
day to day working of a business. It includes the decisions about the levels of cash,
inventory and receivables.
Factors Affecting Investment Decisions / Capital Budgeting Decisions:
 Cash flows of the project- The series of cash receipts and payments over the
life of an investment proposal should be considered and analyzed for selecting
the best proposal.
 Rate of return- The expected returns from each proposal and risk involved in
them should be taken into account to select the best proposal.
 Investment criteria involved- The various investment proposals are evaluated
on the basis of capital budgeting techniques
2. Financing Decision:

A financial decision which is concerned with the amount of finance to be raised from
various long term sources of funds like, equity shares, preference shares,
debentures, bank loans etc. Is called financing decision.
Capital Structure Owner’s Fund + Borrowed Fund
Factors Affecting Financing Decision:
 Cost- The cost of raising funds from different sources is different. The cost of
equity is more than the cost of debts.
 Risk- The risk associated with different sources is different. More risk is
associated with borrowed funds as compared to owner’s fund as interest is
paid on it and it is also repaid after a fixed period of time or on expiry of its
tenure.
 Flotation cost- The cost involved in issuing securities such as broker’s
commission, underwriter’s fees, expenses on prospectus etc.
 Cash flow position of the business- In case the cash flow position of a
company is good enough then it can easily use borrowed funds.
3.Dividend Decision:
A financial decision which is concerned with deciding how much of the profit earned
by the company should be distributed among shareholders (dividend) and how much
should be retained for the future contingencies (retained earnings) is called dividend
decision.
Factors affecting Dividend Decision:
 Earnings- Company having high and stable earning could declare high rate of
dividends as dividends are paid out of current and past earnings.
 Stability of dividends- Companies generally follow the policy of stable
dividend.
 Growth prospects- In case there are growth prospects for the company in the
near future then, it will retain its earnings and thus, no or less dividend will be
declared.
 Cash flow positions- Dividends involve an outflow of cash and thus,
availability of adequate cash is foremost requirement for declaration of
dividends.
 Preference of shareholders- While deciding about dividend the preference of
shareholders is also taken into account.
 Taxation policy- A company is required to pay tax on dividend declared by it.
Financial Leverage
introduction

Financial decision is one of the integral and important parts of financial management
in any kind of business concern.
Financial leverage may be favorable or unfavorable depends upon the use of fixed
cost funds. Favorable financial leverage occurs when the company earns more on
the assets purchased with the funds, then the fixed cost of their use. Hence, it is
also called as positive financial leverage.
Unfavorable financial leverage occurs when the company does not earn as much as
the funds cost. Hence, it is also called as negative financial leverage.
Definition of Financial Leverage
Financial leverage which is also known as leverage or trading on equity, refers to
the use of debt to acquire additional assets. Financial leverage arises from the firms
fixed financing costs such as interest on debt.
According to Gitmar , financial leverage is the ability of a firm to use fixed financial
changes to magnify the effects of change in EBIT and EPS
Where,
FL = Financial leverage
EBIT = Earnings before interest and tax
EPS = Earnings per share
Meaning of Leverage
The term leverage refers to an increased means of accomplishing some purpose.
Leverage is used to lifting heavy objects, which may not be otherwise possible. In
the financial point of view, leverage refers to furnish the ability to use fixed cost
assets or funds to increase the return to its shareholders.
Definition of leverage:
“Leverage is the ratio of the net rate of return on
shareholders’ equity and the net rate of return on total capitalization ’’
James Horne has defined leverage as, “the employment of an asset or fund for
which the firm pays a fixed cost or fixed return.
Types of leverage
There are three types of leverages
 Financial leverage

 Operating leverage
 Composite leverage
Financial leverage
Leverage activities with financing activities are called financial leverage. Financial
leverage represents the relationship between the company’s earnings before interest
and taxes (EBIT) or operating profit and the earning available to equity
shareholders. Financial leverage is defined as “the ability of a firm to use fixed
financial charges to magnify the effects of changes in EBIT on the earnings per
share”. It involves the use of funds obtained at a fixed cost in the hope of increasing
the return to the shareholders. “The use of long-term fixed interest bearing debt and
preference share capital along with share capital is called financial leverage or
trading on equity”.
Degree of Financial Leverage
Degree of financial leverage may be defined as the percentage change in taxable

profit as a result of percentage change in earnings before interest and tax (EBIT).
This can be calculated by the following formula
DFL= Percentage change in taxable Income/ Percentage change in EBIT
Uses of Financial Leverage
 Financial leverage helps to examine the relationship between EBIT and EPS
 Financial leverage measures the percentage of change in taxable income to

the percentage change in EBIT.
 Financial leverage locates the correct profitable financial decision regarding
capital
Structure of the company.
 Financial leverage is one of the important devices which is used to measure
the fixed

Cost proportion with the total capital of the company.

 If the firm acquires fixed cost funds at a higher cost, then the earnings from
those
Assets, the earning per share and return on equity capital will decrease.
OPERATING LEVERAGE
The leverage associated with investment activities is called as operating

leverage. It is caused due to fixed operating expenses in the company. Operating
leverage may be defined as the company’s ability to use fixed operating costs to
magnify the effects of changes in sales on its earnings before interest and taxes.
Operating leverage consists of two important costs viz., fixed cost and variable cost.
When the company is said to have a high degree of operating leverage if it
employs a great amount of fixed cost and smaller amount of variable cost. Thus, the
degree of operating leverage depends upon the amount of various cost structure.
Operating leverage can be determined with the help of a break even analysis.
Operating leverage can be calculated with the help of the following formula:
Where,
OL = Operating Leverage
C = Contribution
OP = Operating Profits
OL = COP
Degree of Operating Leverage
The degree of operating leverage may be defined as percentage change in the

profits resulting from a percentage change in the sales. It can be calculated with the
help of the following

Formula:
DOL = Percentage change in profits/ Percentage change in sales
Uses of Operating Leverage
 Operating leverage is one of the techniques to measure the impact of

changes in sales
 Which lead for change in the profits of the company?
 If any change in the sales, it will lead to corresponding changes in profit.
 Operating leverage helps to identify the position of fixed cost and variable
cost.
 Operating leverage measures the relationship between the sales and revenue
of the company during a particular period.
 Operating leverage helps to understand the level of fixed cost which is
invested in the operating expenses of business activities.
 Operating leverage describes the overall position of the fixed operating cost.

Comment
Operating leverage for B Company is higher than that of A Company; B Company

has a
Higher degree of operating risk. The tendency of operating profit may vary
portionately with sales, is higher for B Company as compared to A Company.
Composite leverage OR combined leverage
When the company uses both financial and operating leverage to magnification of
any change in sales into a larger relative changes in earning per share. Combined
leverage is also called as composite leverage or total leverage. Combined leverage

expresses the relationship between the revenue in the account of Sales and the
taxable income.
The composite leverage focuses attention on the entire income of the concern. The
risk factor should be properly assessed by the management before using the
composite leverage.
Degree of Composite Leverage (DCL) = Percentage Change in EPS/percentage
Change in Sales
Or, Composite Leverage = Operating Leverage * Financial Leverage
EPS-EBIT Analysis
The EBIT-EBT analysis is the method that studies the leverage, i.e. comparing
alternative methods of financing at different levels of EBIT. Simply put, EBIT-EPS
analysis examines the effect of financial leverage on the EPS with varying levels of
EBIT or under alternative financial plans.
EBIT-EPS analysis gives a scientific basis for comparison among various financial
plans and shows ways to maximize EPS. Hence EBIT-EPS analysis may be defined as
‘a tool of financial planning that evaluates various alternatives of financing a project
under varying levels of EBIT and suggests the best alternative having highest EPS
and determines the most profitable level of EBIT’.
Limitations of EBIT-EPS Analysis
 The EBIT-EPS approach may not be the best and correct tool for making
decisions about capital structuring.

 The EBIT-EPS approach focuses on maximizing EPS rather than controlling
costs and limiting risk.
Advantages of EBIT-EPS analysis

 EBIT-EPS analysis evaluates the alternatives and finds the level of EBIT which
maximizes EPS.
 EBIT-EPS analysis is useful in evaluating the relative efficiency of

departments, product lines and markets. It identifies the EBIT earned by
these different departments, product lines and from various markets, which
helps financial planners to rank them according to profitability and also assess
the risk associated with each.
 This analysis is useful in making a comparative evaluation of performances of

various sources of funds. It also evaluates whether a fund obtained from a
source is used in a project that produces a rate of return higher than its cost.
 It helps determining the alternative that gives the highest value of EPS as the
most profitable financing plan or the most profitable level of EBIT.
Cost of Capital
Cost of capital is the required return necessary to make a capital budgeting project,

such as building a new factory, worthwhile. When analysts and investors discuss the
cost of capital, they typically mean the weighted average of a firm's cost of debt and
cost of equity blended together.
Cost of capital refers to the opportunity cost of making a specific investment. It is

the rate of return that could have been earned by putting the same money into a
different investment with equal risk. Thus, the cost of capital is the rate of return
required to persuade the investor to make a given investment.
Definition:
As it is evident from the name, cost of capital refers to the weighted average cost of
various capital components, i.e. sources of finance, employed by the firm such as
equity, preference or debt. In finer terms, it is the rate of return that must be
received by the firm on its investment projects, to attract investors for investing
capital in the firm and to maintain its market value.

Cost of capital = cost of dept. + cost of equity
Importance of Cost of Capital
 It helps in evaluating the investment options, by converting the future

cash flows of the investment avenues into present value by discounting it.
 It is helpful in capital budgeting decisions regarding the sources of

finance used by the company.
 It is vital in designing the optimal capital structure of the firm, wherein

the firm’s value is maximum, and the cost of capital is minimum.
 It can also be used to appraise the performance of specific projects by

comparing the performance against the cost of capital.
 It is useful in framing optimum credit policy, i.e. at the time of deciding

credit period to be allowed to the customers or debtors, it should be
compared with the cost of allowing credit period.
Types of cost of capital
1. Explicit Cost of Capital:
The explicit cost of any sources of capital may be defined as the discount rate that
equates the present value of the cash inflows that are incremental to the taking of
the financing opportunity with the present value of its incremental cash outflow.
2. Future Cost and Historical Cost
Future Costs are the expected costs of funds for financing a particular project. They
are very significant while making financial decisions. For instance, at the time of
taking financial decisions about the capital expenditure, a comparison is to be made
between the expected IRR and the expected cost of funds for financing the same,
i.e. the relevant costs here are future costs.

3. Specific Cost:
The cost of each component of capital, viz., equity shares, preference shares,
debentures, loans etc. are termed specific or component cost of capital which is the
most appealing concept. While determining the average cost of capital, it requires
consideration about the cost of specific methods for financing the projects.
4. Average Cost and Marginal Cost

Average Cost:
The average cost of capital is the weighted average cost of each component of the
funds invested by the firm for a particular project, i.e. percentage or proportionate
cost of each element in the total investment. The weights are in proportion to the
shares of each component of capital in the total capital structure or investment.
Marginal Cost:
According to the Terminology of Cost Accountancy (ICMA, Para 3.603), Marginal
Cost is the amount at any given volume of output by which aggregate costs are
changed if the volume of output is increased or decreased by one unit. Same
principle is being followed in cost of capital. That is, marginal cost of capital may be
defined as the cost of obtaining another rupee of new capital.
5.Composite or Combined Cost
It may be recalled that the term ‘cost of capital’ has been used to denote the overall
composite cost of capital or weighted average of the cost of each specific type of
fund, i.e., weighted average cost. In other words, when specific costs are combined
in order to find out the overall cost of capital, it may be defined as the composite or
weighted average cost of capital.
Weighted Average Cost Capital
Definition: As it is evident from the name, cost of capital refers to the weighted

average cost of various capital components, i.e. sources of finance, employed by the
firm such as equity, preference or debt. In finer terms, it is the rate of return that

must be received by the firm on its investment projects, to attract investors for
investing capital in the firm and to maintain its market value.
The weighted average cost of capital (WACC) is a calculation of a

firm's cost of capital in which each category of capital is proportionately weighted.
All sources of capital, including common stock, preferred stock, bonds, and any
other long-term debt, are included in a WACC calculation.
A firm’s Weighted Average Cost of Capital (WACC) represents its

blended cost of capital across all sources, including common shares, preferred
shares, and debt. The cost of each type of capital is weighted by its percentage of
total capital and they are added together.
Factors that affect the WACC:
1. Economic conditions
When banks can easily give loans at low rate of interest to increase their stability,
then the company’s debt will decrease, and the cost of equity will increase. Well, it is
not just limited to bank, it can be said that any economic conditions can be
applicable for the same.

2.Capital structure
Debt equity ratio will always affect cost of capital because if the debt is greater than
share capital, then cost of capital would become more. But if the stock capital
exceeds the debt, the pay cost of equity has to be paid.
3. Dividend policy
Every company has its dividend policy. The amount of total earning is the company’s
interest to be paid as dividend.
4. Receiving new fund
If any business requires a certain amount immediately for certain purposes, then the
company will need paying a real high rate of interest, and with it, the risk of financial
institution will also increase. Therefore the company is bound to follow the new rate
of cost of capital that might affect business’s cost of capital rate.
5. Financial and investment decisions
When any business gets a new share capital, they have to mention the causes to
fund provider for using their capital. If they find it’s too risky, then both of creditors
and shareholders will receive high rewards.
6. Income tax rates
Any business after earning money, they deduct interest charges, tax charges.
Therefore, for higher tax rates it will affect the cost of share capital and vice versa.
7.Breakpoints of the marginal cost of capital Break points equal to amount of

money at which sources of cost of capital changes or proportion of new capital will
be raised from this source.
Following are the main points of breakpoints:
 Debt
 Preference share
 Equity share capital
Advantages of WACC
 Straight – forward and logical

 Builds on individual debt and equity components
 Accurate in periods of normal profits
 Accurate when the debt level is reasonable
Disadvantages of WACC

 Determining the weights

 Choice of capital structure
 Other limitations
Capital Structure
Capital structure represents the relationship among different kinds of long term
capital. Normally, a firm raises long term capital through the issue of shares-
common shares, sometimes accompanied by preference shares. The share capital is
often supplemented by debenture capital and others long-term borrowed capital.
Capital structure is the mix of the long-term sources of funds used by a firm. It is
made up of debt and equity securities and refers to permanent financing of a firm. It
is composed of long-term debt, preference share capital and shareholders’ funds.
According to James C.V an Horne,
“The mix of a firm’s permanent long-term financing represented by debt, preferred

stock and common stock equity”.
According to prasanna Chandra,
“The composition of a firm’s financing consists of equity, preference, and debt.
According to gerstenbeg
“Capital structure of a company refers to the composition or make-up of its

capitalization and it includes all long –term capital resources viz: loans, reserves,
shares, and bonds.

Importance of Capital Structure:
1. Increase in value of the firm:
A sound capital structure of a company helps to increase the market price of shares
and securities which, in turn, lead to increase in the value of the firm.
2. Utilization of available funds:
A good capital structure enables a business enterprise to utilize the available
funds fully. A properly designed capital structure ensures the determination of the
financial requirements of the firm and raise the funds in such proportions from
various sources for their best possible utilization. A sound capital structure protects
the business enterprise from over-capitalization and under-capitalization.
3. Maximization of return:
A sound capital structure enables management to increase the profits of a company
in the form of higher return to the equity shareholders i.e., increase in earnings per
share. This can be done by the mechanism of trading on equity i.e., it refers to
increase in the proportion of debt capital in the capital structure which is the
cheapest source of capital.
4. Minimization of cost of capital:
A sound capital structure of any business enterprise maximizes shareholders’ wealth
through minimization of the overall cost of capital. This can also be done by
incorporating long-term debt capital in the capital structure as the cost of debt
capital is lower than the cost of equity or preference share capital since the interest
on debt is tax deductible.
5. Solvency or liquidity position:
A sound capital structure never allows a business enterprise to go for too much
raising of debt capital because, at the time of poor earning, the solvency is disturbed
for compulsory payment of interest to .the debt-supplier.

6. Flexibility:
A sound capital structure provides a room for expansion or reduction of debt capital
so that, according to changing conditions, adjustment of capital can be made.
7. Undisturbed controlling:
A good capital structure does not allow the equity shareholders control on business
to be diluted.
8. Minimization of financial risk: If debt component increases in the capital
structure of a company, the financial risk (i.e., payment of fixed interest charges and
repayment of principal amount of debt in time) will also increase. A sound capital
structure protects a business enterprise from such financial risk through a judicious
mix of debt and equity in the capital structure.
Factors of capital structure
1. Risk of cash insolvency: Risk of cash insolvency arises due to failure to pay
fixed interest liabilities. Generally, the higher proportion of debt in capital structure
compels the company to pay higher rate of interest on debt irrespective of the fact
that the fund is available or not. The non-payment of interest charges and principal
amount in time call for liquidation of the company.
2. Risk in variation of earnings:
The higher the debt content in the capital structure of a company, the higher will be
the risk of variation in the expected earnings available to equity shareholders. If
return on investment on total capital employed (i.e., shareholders’ fund plus long-
term debt) exceeds the interest rate, the shareholders get a higher return.
3. Cost of capital:
Cost of capital means cost of raising the capital from different sources of funds. It is
the price paid for using the capital. A business enterprise should generate enough

revenue to meet its cost of capital and finance its future growth. The finance
manager should consider the cost of each source of fund while designing the capital
structure of a company.
4. Control: The consideration of retaining control of the business is an important
factor in capital structure decisions. If the existing equity shareholders do not like to
dilute the control, they may prefer debt capital to equity capital, as former has no
voting rights.
5. Trading on equity:
The use of fixed interest bearing securities along with owner’s equity as sources of
finance is known as trading on equity. It is an arrangement by which the company
aims at increasing the return on equity shares by the use of fixed interest bearing
securities (i.e., debenture, preference shares etc.).
6. Government policies:
Capital structure is influenced by Government policies, rules and regulations of SEBI
and lending policies of financial institutions which change the financial pattern of the
company totally. Monetary and fiscal policies of the Government will also affect the
capital structure decisions.
7. Size of the company:
Availability of funds is greatly influenced by the size of company. A small company
finds it difficult to raise debt capital. The terms of debentures and long-term loans
are less favourable to such enterprises. Small companies have to depend more on
the equity shares and retained earnings. On the other hand, large companies issue
various types of securities despite the fact that they pay less interest because
investors consider large companies less risky.
8. Needs of the investors:

While deciding capital structure the financial conditions and psychology of different
types of investors will have to be kept in mind. For example, a poor or middle class
investor may only be able to invest in equity or preference shares which are usually
of small denominations, only a financially sound investor can afford to invest in
debentures of higher denominations.
9. Flexibility:
The capital structures of a company should be such that it can raise funds as and
when required. Flexibility provides room for expansion, both in terms of lower
impact on cost and with no significant rise in risk profile.
10. Period of finance:
The period for which finance is needed also influences the capital structure. When
funds are needed for long-term (say 10 years), it should be raised by issuing
debentures or preference shares. Funds should be raised by the issue of equity
shares when it is needed permanently.
11. Nature of business:
It has great influence in the capital structure of the business, companies having
stable and certain earnings prefer debentures or preference shares and companies
having no assured income depends on internal resources.
12. Legal requirements:
The finance manager should comply with the legal provisions while designing the
capital structure of a company.
13. Purpose of financing:
Capital structure of a company is also affected by the purpose of financing. If the
funds are required for manufacturing purposes, the company may procure it from
the issue of long- term sources. When the funds are required for non-manufacturing

purposes i.e., welfare facilities to workers, like school, hospital etc. the company
may procure it from internal sources.
14. Corporate taxation:
When corporate income is subject to taxes, debt financing is favorable. This is so
because the dividend payable on equity share capital and preference share capital
are not deductible for tax purposes, whereas interest paid on debt is deductible from
income and reduces a firm’s tax liabilities. The tax saving on interest charges
reduces the cost of debt funds.
15. Cash inflows:
The selection of capital structure is also affected by the capacity of the business to
generate cash inflows. It analyses solvency position and the ability of the company
to meet its charges.
16. Provision for future:
The provision for future requirement of capital is also to be considered while
planning the capital structure of a company.
17. EBIT-EPS analysis:

If the level of EBIT is low from HPS point of view, equity is preferable to debt. If the
EBIT is high from EPS point of view, debt financing is preferable to equity. If ROI is
less than the interest on debt, debt financing decreases ROE. When the ROI is more
than the interest on debt, debt financing increases ROE.
Theories of Capital Structure
 Net income ( NI) theory

 Net operating income ( NOI ) theory
 Traditional theory
 Modigliani – miller ( M-M) theory

1.NET INCOME ( NI ) THEORY
This theory was propounded by “David Durand” and is also known as “fixed ‘ke’
theory”
According to NI approach a firm may increase the total value of the firm by lowering
its cost of capital. When cost of capital is lowest and the value of the firm is
greatest, we call it the optimum capital structure for the firm and, at this point, the
market price per share is maximized.
2. Net operating income (NOI) theory

Now we want to highlight the Net Operating Income (NOI) Approach which was
advocated by David Durand based on certain assumptions.
They are:
(i) The overall capitalization rate of the firm K w is constant for all degree of
leverages;
(ii) Net operating income is capitalized at an overall capitalization rate in order to
have the total market value of the firm.
This approach is also provided by Durand. It is opposite of the Net Income Approach
if there are no taxes. This approach says that the weighted average cost of capital

remains constant. It believes in the fact that the market analyses a firm as a whole
and discounts at a particular rate which has no relation to debt-equity ratio. If tax
information is given, it recommends that with an increase in debt financing WACC
reduces and value of the firm will start increasing. For more – Net Operating Income
Approach.
3.Traditional theory
t is accepted by all that the judicious use of debt will increase the value of the firm
and reduce the cost of capital. So, the optimum capital structure is the point at
which the value of the firm is highest and the cost of capital is at its lowest point.
Practically, this approach encompasses all the ground between the Net Income
Approach and the Net Operating Income Approach, i.e., it may be called
Intermediate Approach
4.Modigliani – miller ( M-M) theory
It is a capital structure theory named after Franco Modigliani and Merton Miller. MM
theory proposed two propositions.
 Proposition I: It says that the capital structure is irrelevant to the value of a

firm. The value of two identical firms would remain the same and value would
not affect by the choice of finance adopted to finance the assets. The value of
a firm is dependent on the expected future earnings. It is when there are no
taxes.
 Proposition II: It says that the financial leverage boosts the value of a firm
and reduces WACC. It is when tax information is available
Unit – III: Investment Decision: Nature and Significance of Investment

Decision- Estimation of Cash Flows – Capital Budgeting Process –
Techniques of Investment Appraisal: Pay Back Period; Accounting Rate of
Return, Time Value of Money- DCF Techniques –Net Present Value,
Profitability Index and Internal Rate of Return.

Investment Decision
Meaning of Investment Decisions:

In the terminology of financial management, the investment decision means capital
budgeting. Investment decision and capital budgeting are not considered different
acts in business world. In investment decision, the word ‘Capital’ is exclusively
understood to refer to real assets which may assume any shape viz. building, plant
and machinery, raw material and so on and so forth, whereas investment refers to
any such real assets.
Definition: The Investment Decision relates to the decision made by the

investors or the top level management with respect to the amount of funds to be
deployed in the investment opportunities.
Simply, selecting the type of assets in which the funds will be invested by the firm is
termed as the investment decision. These assets fall into two categories:
1. Long- Term Assets
2. Short-Term Assets
Nature and Significance of Investment Decision
Investment decision taken by individual concern is of national importance because it

determines employment, economic activities and economic growth.

(1) Large investment
 Involve large investment of funds

 Fund available is limited and the demand for funds exceeds the existing
resources
 Important for firm to plan and control capital expenditure
(2) Long term commitment of funds
 Involves not only large amount of fund but also long term on permanent
basis.
 It increases financial risk involved in investment decision.
 Greater the risk greater the need for planning capital expenditure.
(3) Irreversible Nature
 Capital expenditure decision are irreversible
 Once decision for acquiring permanent asset is taken, it become very difficult
to dispose of these assets without heavy losses.
(4) Long-term effect on profitability
 Capital expenditure decision are long-term and have effect on profitability of a

concern
 Not only present earning but also the future growth and profitability of the
firm depends on investment decision taken today
 Capital budgeting is needed to avoid over investment or under investment in
fixed assets.
(5) Difficulties of investment decision
 Long term investment decision are difficult to take because (i) decision
extends to a series of year beyond the current accounting period
 uncertainties of future
 higher degree of risk
(6) National importance

Investment decision taken by individual concern is of national importance because it
determines employment, economic activities and economic growth.
Estimation of Cash Flows

Cash flow estimates are used to determine the economic viability of long-term

investments. The cash flows of a project are estimated using discounted and
nondiscounted cash flow methods.
Cash flow estimation is an integral part of the valuation and capital

budgeting process. Cash flow estimation is a necessary step for assessing
investment decisions of any kind. Project cash flows consider all kinds of inflows of
cash. The estimation of cash flows is done through the coordination of wide range of
professionals involved in the project. The engineering department is responsible for
forecasting of capital outlays. The production team is responsible for forecasting
operational costs. The marketing team is basically involved in forecasting revenues.
The finance manager has the responsibility to collect data and set norms for better
estimation. Forecasting cash flows is one of the major challenges faced by valuation
professionals. Cash flow estimation is based on a number of principles
Importance of estimate the cash flow statement
Cash flow estimate is very important document and has a legal value. It is
mandatory for a Contractor to submit a Cash Flow Estimate to the Client or Sponsor
according to his planned schedule of works. The Contractor cannot proceed with the
works unless he has submitted and approved the Cash Flow Estimate from the Client
or Sponsor. Below is the snapshot of one such contract requirement taken from
‘Conditions of Contract for Works of Civil Engineering Construction – FIDIC’, which is
an international standard contract.
Principles of Cash Flow Estimation
 Cash flows should be measured on an incremental basis.

 Cash flows should be measured on an after -tax basis.
 All the indirect effects of a project should be included in the cash flow
calculations.
 Standed costs should not be considered when evaluating a project.
Capital Budgeting Process

Definition: The Capital Budgeting is one of the crucial decisions of the financial

management that relates to the selection of investments and course of actions that
will yield returns in the future over the lifetime of the project.
1. Identification of Potential Investment Opportunities:
An organization needs to first identify an investment opportunity. An investment

opportunity can be anything from a new business line to product expansion to
purchasing a new asset. For example, a company finds two new products that they
can add to their product line.
2. Assembling of Investment Proposals:
Once an investment opportunity has been recognized an organization needs to

evaluate its options for investment. That is to say, once it is decided that new
product/products should be added to the product line, the next step would be
deciding on how to acquire these products. There might be multiple ways of
acquiring them. Some of these products could be:
 Manufactured In-house
 Manufactured by Outsourcing manufacturing the process, or

 Purchased from the market.
3. Decision Making:
At this stage, the executives decide on the investment opportunity on the basis of
the monetary power, each has with respect to the sanction of an investment
proposal. For example, in a company, a plant superintendent, work manager, and
the managing director may okay the investment outlays up to the limit of 15,
00,000, and if the outlay exceeds beyond the limits of the lower level management,
then the approval of the board of directors is required.
4. Preparation of Capital Budget and Appropriations:
The next step in the capital budgeting process is to classify the investment outlays
into the smaller value and the higher value. The smaller value investments okayed
by, the lower level management, are covered by the blanket appropriations for the
speedy actions.
5. Implementation:
Finally, the investment proposal is put into a concrete project. This may be time-
consuming and may encounter several problems at the time of implementation. For
expeditious processing, the capital budgeting process committee must ensure that
the project has been formulated and the homework in terms of preliminary studies
and comprehensive formulation of the project is done beforehand.
6. Performance Review:
Once the project has been implemented the next step is to compare the actual
performance against the projected performance. The ideal time to compare the
performance of the project is when its operations are stabilized.

Objectives of Capital budgeting
Capital expenditures are huge and have a long-term effect. Therefore, while
performing a capital budgeting analysis an organization must keep the following
objectives in mind:
1. Selecting profitable projects
An organization comes across various profitable projects frequently. But due to

capital restrictions, an organization needs to select the right mix of profitable
projects that will increase its shareholders’ wealth.
2. Capital expenditure control
Selecting the most profitable investment is the main objective of capital budgeting.
However, controlling capital costs is also an important objective. Forecasting capital
expenditure requirements and budgeting for it, and ensuring no investment
opportunities are lost is the crux of budgeting.
3. Finding the right sources for funds
Determining the quantum of funds and the sources for procuring them is another
important objective of capital budgeting. Finding the balance between the cost of
borrowing and returns on investment is an important goal of Capital Budgeting.
Capital Budgeting Techniques
To assist the organization in selecting the best investment there are various
techniques available based on the comparison of cash inflows and outflows.
These techniques are:

1. Payback period method
In this technique, the entity calculates the time period required to earn the initial
investment of the project or investment. The project or investment with the shortest
duration is opted for.
Payback period is the time required to recover the initial cost of an investment. It is
the number of years it would take to get back the initial investment made for a
project. Therefore, as a technique of capital budgeting, the payback period will be
used to compare projects and derive the number of years it takes to get back the
initial investment. The project with the least number of years usually is selected.
Features of Payback period method
 Payback period is a simple calculation of time for the initial investment to

return.
 It ignores the time value of money. All other techniques of capital budgeting
consider the concept of time value of money. Time value of money means
that a rupee today is more valuable than a rupee tomorrow. So other
techniques discount the future inflows and arrive at discounted flows.

 It is used in combination with other techniques of capital budgeting. Owing to

its simplicity the payback period cannot be the only technique used for
deciding the project to be selected.
2.Net Present value (NPV )
The net present value is calculated by taking the difference between the present

value of cash inflows and the present value of cash outflows over a period of time.
The investment with a positive NPV will be considered. In case there are multiple
projects, the project with a higher NPV is more likely to be selected.
This is one of the widely used methods for evaluating capital investment proposals.
In this technique the cash inflow that is expected at different periods of time is
discounted at a particular rate. The present values of the cash inflow are compared
to the original investment. If the difference between them is positive (+) then it is
accepted or otherwise rejected. This method considers the time value of money and
is consistent with the objective of maximizing profits for the owners. However,
understanding the concept of cost of capital is not an easy task.
Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost
of the investment proposal and n is the expected life of the proposal. It should be
noted that the cost of capital, K, is assumed to be known, otherwise the net present,
value cannot be known.
NPV = PVB – PVC
where,
PVB = Present value of benefits
PVC = Present value of Costs

3. Accounting Rate of Return
In this technique, the total net income of the investment is divided by the initial or
average investment to derive at the most profitable investment.
This method helps to overcome the disadvantages of the payback period method.
The rate of return is expressed as a percentage of the earnings of the investment in
a particular project. It works on the criteria that any project having ARR higher than
the minimum rate established by the management will be considered and those
below the predetermined rate are rejected.
This method takes into account the entire economic life of a project providing a
better means of comparison. It also ensures compensation of expected profitability
of projects through the concept of net earnings. However, this method also ignores
time value of money and doesn’t consider the length of life of the projects. Also it is
not consistent with the firm’s objective of maximizing the market value of shares.
ARR= Average income/Average Investment
4. Internal Rate of Return (IRR)
For NPV computation a discount rate is used. IRR is the rate at which the NPV
becomes zero. The project with higher IRR is usually selected.
This is defined as the rate at which the net present value of the investment is zero.
The discounted cash inflow is equal to the discounted cash outflow. This method
also considers time value of money. It tries to arrive to a rate of interest at which
funds invested in the project could be repaid out of the cash inflows. However,
computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay and proceeds
associated with the project and not any rate determined outside the investment.
It can be determined by solving the following equation:
IRR = X + P x – I / P x –P y (Y – X)

Where IRR = internal rate of return
Y = Higher discount rate
X = Lower discount rate
P x = present value of cash inflows at X
P y = present value of cash inflows at Y
I = Initial investment
Accept – reject decision: The use of IRR, as a criterion to accept capital investment
decision, involves a comparison of the actual IRR with required rate of return also
known as the cut – off rate or hurdle rate. The project would qualify to be accepted
if the IRR (r) exceeds the cut off rate.
Advantages of internal rate of return method
1. Recognition of time value

2. Easy to understand
3. Indicate profitability
4. Consistent with overall objectives
Dis advantages of internal rate of return method
1. Tedious calculations
2. Confusion in multiple rates
3. In consistent in maximizing shareholders wealth
4. Reinvestment of cash flows
5. Ignores the rupee of NPV
5. Profitability Index
Profitability Index is the ratio of the present value of future cash flows of the project
to the initial investment required for the project.
Each technique comes with inherent advantages and disadvantages. An organization

needs to use the best-suited technique to assist it in budgeting. It can also select

different techniques and compare the results to derive at the best profitable
projects.
It is the ratio of the present value of future cash benefits, at the required rate of
return to the initial cash outflow of the investment. It may be gross or net, net being
simply gross minus one. The formula to calculate profitability index (PI) or benefit
cost (BC) ratio is as follows.
PI = NPV (benefits) / NPV (Costs)
Profitability index = P.V of cash inflows / P.V of cash out flows .
Time Value of Money
The time value of money (TVM) is the concept that money available at the present
time is worth more than the identical sum in the future due to its potential earning
capacity. This core principle of finance holds that provided money can earn interest,
any amount of money is worth more the sooner it is received. TVM is also
sometimes referred to as present discounted value.
Time Value of Money Formula
Depending on the exact situation in question, the time value of money formula may
change slightly. For example, in the case of annuity or perpetuity payments, the
generalized formula has additional or less factors. But in general, the most
fundamental TVM formula takes into account the following variables:
Based on these variables, the formula for TVM is:
FV = PV x [1 + (i / n) ] (n x t)
 FV = Future value of money

 PV = Present value of money

 I = interest rate
 n = number of compounding periods per year
 t = number of years
****END OF 3RD UNIT****

Unit-IV: Dividend Decision: Meaning and Significance – Theories of

Dividend – Determinants of Dividend – Dividend policy – Bonus Shares –
Stock Splits.
Dividend Decision
The term dividend refers to that part of profits of a company which is distributed by
the company among its shareholders after execution of retained earnings. It is the
reward of the shareholders for investment made by them in the shares for the
company.
Definition: The Dividend Decision is one of the crucial decisions made by the

finance manager relating to the payouts to the shareholders. The payout is the
proportion of Earning per Share given to the shareholders in the form of dividends.
The companies can pay either dividend to the shareholders or retain the earnings
within the firm. The amount to be disbursed depends on the preference of the
shareholders and the investment opportunities prevailing within the firm.
Significance of Dividend Decision
 The firm has to balance between the growth of the company and the
distribution to the share holders
 It plays an important in determining the value of the firm
 Stakeholders visualize dividends as signals of the firm’s ability to generate

income.
 The decision to pay dividend is independent of investment decision, dividends

can influence the external financing plans of finance managers.
 It has a critical influence on the value of the firm.
 It has also to strike a balance between the long term financing decision and
the wealth maximization.
 The market price gets affected if dividends paid are less.
Theories of Dividend
Some of the major different theories of dividend in financial management are as

follows:
1. Walter’s model

2. Gordon’s model
3. Modigliani and Miller’s hypothesis.
1. Walter’s model:
Professor James E. Walter argues that the choice of dividend policies almost always
affects the value of the enterprise. His model shows clearly the importance of the
relationship between the firm’s internal rate of return (r) and its cost of capital (k) in
determining the dividend policy that will maximize the wealth of shareholders.
Walter’s model is based on the following assumptions:
1. The firm finances all investment through retained earnings; that is debt or new
equity is not issued;
2. The firm’s internal rate of return (r), and its cost of capital (k) are constant;
3. All earnings are either distributed as dividend or reinvested internally immediately.
4. Beginning earnings and dividends never change. The values of the earnings per
share (E), and the divided per share (D) may be changed in the model to determine
results, but any given values of E and D are assumed to remain constant forever in
determining a given value.
5. The firm has a very long or infinite life.
Valuation formula: Based on above assumptions, Walter put forward the following
valuation formula:
D+ (E-D) r/k
P= ___________________
Where P is the price per equity share, D is the dividend per share; E is the earnings
per share

(E – D) is the retained earnings per share, ‘r’ is the rate of return on investment and
the K is the cost of capital.
2. Gordon’s Model:
Gordon proposed a model of stock valuation using the dividend capitalization

approach. His model is based on the following assumptions.
One very popular model explicitly relating the market value of the firm to dividend
policy is developed by Myron Gordon.
Assumptions:
Gordon’s model is based on the following assumptions.
1. The firm is an all Equity firm
2. No external financing is available
3. The internal rate of return (r) of the firm is constant.
4. Retained earnings represent the only source of financing for the firm Thus, like
the Walter model the Gordon model ties investment decision to dividend decision
5. The rate of return on the firm’s investment is constant.
6. The cost of capital for the firm remains constant and it is greater than growth
rate.
Valuation formula: Gordon’s valuation formula is:
E (1 – b)
P= ____________________
K - br

Where P is the price of the share at the end of year, E is the earnings per
share, (1-b) is the fraction of earnings the firm distributes by way of dividends, b is
the fraction of earnings the firm retains, k is the rate of return required by the
shareholders r is the rate of return earned on investments.
3. Modigliani and Miller’s hypothesis
According to Modigliani and Miller (M-M), dividend policy of a firm is irrelevant as it
does not affect the wealth of the shareholders. They argue that the value of the firm
depends on the firm’s earnings which result from its investment policy.
Thus, when investment decision of the firm is given, dividend decision the split of
earnings between dividends and retained earnings is of no significance in
determining the value of the firm. M – M’s hypothesis of irrelevance is based on the
following assumptions.
 Capital markets are perfect and the investors are rational.

 Floatation costs are nil.
 There are no taxes.
 Investment opportunities and future profits of firm are known with certainty.
 Investment and dividend decisions are independent.
 The firm has a fixed investment policy.

The division of earnings between dividends and retained earnings is irrelevant from
the point of view of the shareholders
To prove their argument MM begin with simple valuation model
P1=P0 (1+Ke)-D1
The number shares to be issued can be computed with help of equation.
No of shares (m)= proposed investment (I) +Dividend paid --- Earnings of the firm
Price of share (P1)
Further, the valuation of the firm can be ascertained with the help of the following

(n+ m) P1 ---- ( I----E)
n P= _____________________
1+ke
Determinants of Dividend
 Legal restrictions
 Magnitude and trend of earnings
 Desire and type of shareholders
 Nature of industry
 Age of the company
 Future financial requirements
 Taxation policy
 Policy of control
 Requirements of institutional investors.
Legal restrictions
The Companies (Transfer of Profits to Reserves) Rules, 1975 require a company
providing more than ten per cent dividend to transfer certain percentage of the
current year’s profits to reserves. Companies Act, further, provides that dividends
cannot be paid out of capital, because it will amount to reduction of capital adversely
affecting the security of its creditors.
Magnitude and trend of earnings
The amount and trend of earnings is an important aspect of dividend policy. It is
rather the starting point of the dividend policy. As dividends can be paid only out of
present or past year’s profits, earnings of a company fix the upper limits on
dividends.
Desire and type of shareholders

Although, legally, the discretion as to whether to declare dividend or not has been
left with the Board of Directors, the directors should give the importance to the
desires of shareholders in the declaration of dividends as they are the
representatives of shareholders. Desires of shareholders for dividends depend upon
their economic status.
Nature of industry
Nature of industry to which the company is engaged also considerably affects the
dividend policy. Certain industries have a comparatively steady and stable demand
irrespective of the prevailing economic conditions. For instance, people used to drink
liquor both in boom as well as in recession. Such firms expect regular earnings and
hence can follow a consistent dividend policy.
Age of the company
The age of the company also influences the dividend decision of a company. A newly
established concern has to limit payment of dividend and retain substantial part of
earnings for financing its future growth and development, while older companies
which have established sufficient reserves can afford to pay liberal dividends.
Future financial requirements
If a company has highly profitable investment opportunities it can convince the

shareholders of the need for limitation of dividend to increase the future earnings
and stabilize its financial position.
Taxation policy
The taxation policy of the Government also affects the dividend decision of a firm. A
high or low rate of business taxation affects the net earnings of company (after tax)
and thereby its dividend policy. Similarly, a firm’s dividend policy may be dictated by
the income-tax status of its shareholders.
Policy of control

When a company pays high dividends out of its earnings, it may result in the dilution
of both control and earnings for the existing shareholders. As in case of a high
dividend pay-out ratio, the retained earnings are insignificant and the company will
have to issue new shares to raise funds to finance its future requirements.
Requirements of institutional investors.
Dividend policy of a company can be affected by the requirements of institutional

investors such as financial institutions, banks insurance corporations, etc. These
investors usually favor a policy of regular payment of cash dividends and stipulate
their own terms with regard to payment of dividend on equity shares.
Dividend policy
Meaning and definition of dividend policy
The term dividend policy refers to the policy concerning quantum of profit to be
distributed as dividend. The concept of dividend policies implies that companies
through their board of directors evolve a pattern of dividend payment which has a
bearing on future action.
According to “Weston and Brigham” “dividend policy determines the division of

earnings between payments to shareholders and retained earnings”.
Dimensions of dividend policy: There are two important dimensions of a
dividend policy
1. What should be the average pay-out ratio?
2. How stable should the dividends be over time?
Types of dividend policy

1) Regular dividend policy: in this type of dividend policy the investors get
dividend at usual rate. Here the investors are generally retired persons or weaker
section of the society who want to get regular income. This type of dividend
payment can be maintained only if the company has regular earning.
Merits of Regular dividend policy:
 It helps in creating confidence among the shareholders.

 It stabilizes the market value of shares.
 It helps in marinating the goodwill of the company.
 It helps in giving regular income to the shareholders.
2) Stable dividend policy: here the payment of certain sum of money is regularly

paid to the shareholders. It is of three types:
a) Constant dividend per share: here reserve fund is created to pay fixed

amount of dividend in the year when the earning of the company is not enough. It is
suitable for the firms having stable earning.
b) Constant payout ratio: it means the payment of fixed percentage of earning as

dividend every year.

c) Stable rupee dividend + extra dividend: it means the payment of low

dividend per share constantly + extra dividend in the year when the company earns
high profit.
Merits of stable dividend policy:
 It helps in creating confidence among the shareholders.

 It stabilizes the market value of shares.
 It helps in marinating the goodwill of the company.
 It helps in giving regular income to the shareholders.
3) Irregular dividend policy: as the name suggests here the company does not
pay regular dividend to the shareholders. The company uses this practice due to
following reasons:
 Due to uncertain earning of the company.

 Due to lack of liquid resources.
 The company sometime afraid of giving regular dividend.
 Due to not so much successful business.
4) No dividend policy: the company may use this type of dividend policy due to
requirement of funds for the growth of the company or for the working capital
requirement.
Types of dividend: Dividends can be classified in various forms. Dividends paid in

the ordinary course of business are known as profit dividends while dividends paid
out of capital are known as liquidation dividends.

1. Cash Dividend:
Generally, many companies pay dividends in the form of cash. But payment of
dividend in the form of cash requires enough cash in its bank or in hand. In other
words, there should not be any shortage of cash for payment of dividends. Sufficient
cash is available only when a company prepares cash budget to estimate the
required amount for the period for which the budget is prepared.
2. Scrip Dividend:
In this form of dividends, the equity shareholders are issued transferable promissory
notes for a shorter maturity period that may or may not be interest bearing. Stated
simply it means payment of dividends in the form of promissory notes. Payment of
dividend in this form takes place only when the firm is suffering from shortage of
cash or weak liquidity position.
3. Bond Dividend:
Both scrip dividend and bond dividend are same, but they differ in terms of maturity.
Bond dividends carry longer maturity whereas scrip dividend carries shorter
maturity. Effect of both forms of dividends on the company is the same. Bond
dividend bears interest.

4. Property Dividend:
The name itself suggests that payment of dividend takes place in the form of
property. This form of dividends takes place only when a firm has assets that are no
longer necessary in the operation of business and shareholders are ready to accept
dividend in the form of assets. This form of dividend payment is not popular in India.
5. Stock Dividend:
Stock dividend is the payment of additional shares of common stocks to the ordinary
shareholders. It is known as stock dividend in the USA to the existing shareholder.
Bonus shares are shares issued to the existing shareholders as a result of
capitalization of resources.
6. Liquidating dividend:
A liquidating dividend is a type of payment that a corporation makes to its

shareholders during a partial or full liquidation. For the most part, this form of
distribution is made from the company's capital base. As a return of capital, this
distribution is typically not taxable for shareholders. A liquidating dividend is
distinguished from regular dividends that are issued from the company's operating
profits or retained earnings.
Bonus Shares and stock split
In the bonus shares and stock splits the number of shares of a company increases.
But what are bonus shares and what are stock splits and more importantly what’s
the difference between them?
Definition: Bonus shares are additional shares given to the current shareholders

without any additional cost, based upon the number of shares that a shareholder
owns. These are company's accumulated earnings which are not given out in the
form of dividends, but are converted into free shares.
Points of similarity

1. Both are accounting gimmick that actually adds nothing to a company’s

fundamentals.
2. They increase the number of shares available for trade.
3. Both keep shareholders happy.
4. Shareholders equity does not change in either case.
5. Under both cases net assets remain the same.
Advantages of bonus shares
 There is no need for investors to pay any tax on receiving bonus shares.
 It is beneficial for the long-term shareholders of the company who want to

increase their investment.
 Bonus shares enhance the faith of the investors in the operations of the
company because the cash is used by the company for business growth.
 When the company declares a dividend in the future, the investor will receive
higher dividend because now he holds larger number of shares in the
company due to bonus shares.
 Bonus shares give positive sign to the market that the company is committed
towards long term growth story.
 Bonus shares increase the outstanding shares which in turn enhances the
liquidity of the stock.
 The perception of the company's size increases with the increase in the issued
share capital.
 Since there are many advantages of bonus shares, let us now learn the
conditions for the issue of bonus shares.
Bonus shares
 The face value of the shares does not change.

 Bonus shares are declared by transferring reserves.

 The dividend pay-out of the company is likely to increase.

 Issue of bonus shares increases the total paid-up capital of the company.
 Bonus shares are issued when the company has large accumulated reserves.
Stock split
 The face value of the shares is reduced.

 There is no such transfer in a stock split.
 The dividend pay-out is not affected by a stock split.
 The total paid-up remains unaffected by a stock split.
 A share is generally split that has a high price.

Unit – V: Working Capital Decision: Meaning – Classification and

Significance of Working Capital – Component of Working Capital -
operating and cash conversion cycle – Calculation of working capital.
(Case Study is compulsory in all Units)
Working Capital:
Meaning:
Working capital management is an act of planning, organizing and controlling
the components of working capital like cash, bank balance inventory, receivables,
payables, overdraft and short-term loans. In an ordinary sense, working capital
denotes the amount of funds needed for meeting day-to-day operations of a
concern.
This is related to short-term assets and short-term sources of financing.

Hence it deals with both, assets and liabilities—in the sense of managing working
capital it is the excess of current assets over current liabilities. In this article we will
discuss about the various aspects of working capital.
According to shubin, “working capital, the amount of funds necessary to cover the
cost of operating the enterprise.
According to gerestenberg, “circulating capital means current assets. Of a

company that is changed in the ordinary course of business from one form to
another, as for examples, from cash to inventories, inventories to receivables into
cash.
According to Smith K.V, “Working capital management is concerned with the

problems that arise in attempting to manage the current asset, current liabilities
and the interrelationship that exist between them”.
According to Weston and Brigham, “Working capital generally stands for excess of
current assets over current liabilities. Working capital management therefore refers
to all aspects of the administration of both current assets and current liabilities”
There are two concepts in respect of working capital:
(i) Gross working capital and

(ii) Networking capital.
(i) Gross working capital and
(ii) Networking capital.
Classification of Working Capital
1.Gross Working Capital:

The sum total of all current assets of a business concern is termed as gross working
capital. So,
Gross working capital = Total current assets
In the broad sense, the term working capital refers to the gross working capital and
represents the amount of funds invested in current assets. Thus, the gross-working
capital is the capital invested in total current assets of the enterprise. Current assets
are those assets which in the ordinary course of business can be converted into cash
within a short period of normally one accounting year examples of current assets are
Constituents of current assets
1. Cash in hand and bank balances.

2. Bills receivables
3. Sundry debtors ( less provision for bad debts)
4. Short –term loans and advances
5. Inventories of stocks as;
 Raw materials
 Work-in-process
 Stores and spares
 Finished goods
6. Temporary investment of surplus funds
7. Prepaid expenses
8. Accrued incomes
2.Net Working Capital:
In a narrow sense, the term working capital refers to the net working capital. Net
working capital is the excess of current assets over current liabilities, or say:
Net working capital = current assets – current liabilities
Net working capital may be positive or negative. When the current assets exceed the
current liabilities the working capital is positive and the negative working capital
results when the current liabilities are more than the current assets.
Current liabilities are those liabilities which are intended to be paid in the ordinary
course of business within a short period of normally one accounting year out of the
current assets or the income of the business. Examples of current liabilities are:
Constituents of current liabilities
1. Bills payables.

2. Sundry creditors or accounts payables.

3. Accrued or outstanding expenses.
4. Short-term loans, advances and deposits.
5. Dividends payables.
6. Bank OD
Characteristics of Working Capital
 Needs that are Short Term: Working capital is being utilized in acquiring
current assets which will be converted to cash for a short period only.
 Circular Movement: Working capital is being converted to cash constantly

which will just be turned as a working capital all over again.
 Permanency: Although it is just a kind of short term capital, working capital

is needed by a business forever and always.
 Fluctuation: Working still fluctuates every now and then even it is

something permanent.
 Liquidity: It is very liquid for it can be converted as cash any time without
losing anything.
 Less Risky: Investments in current assets such as working capital comes

with less risk for it is just for short term.
 No Need for Special Accounting System: since working capital is a short

term asset that will last for a year only, there will be any need for adoption of
a special accounting system.
Operating / working capital /cash conversion cycle:
The operating cycle of a company can be said to cover distinct stages, each stage
requiring a level of supporting investment. The time gap between the firm’s paying
cash for materials, entering into work in process, making finished goods, selling
finished goods to the debtors and the inflow of cash from debtors is known as
working capital or operating cycle.
According to the nature of business the duration of working capital cycle varies. It is
the responsibility of the finance manager to shorten the length of working capital
cycle.
1. Firstly the working capital cycle may be longer if the availability of raw materials is
not easy. As a result the organization will have to hold large amount of raw
materials in stores.
2. Secondly the processing period may be longer. The nature of the product is such
that the product passes through various departments to get finished.
3. Thirdly the product may be slow moving. In that case the time taken to deplete
the finished goods stock will be longer.
4. Finally the credit policy and the inefficiency of the organization in debt collection
also increase the length of operating cycle.
The above operating cycle is repeated again and again over the period depending
upon the nature of the business and type of product etc. The duration of the

operation cycle for the purpose of estimating working capital is equal to the sum of
the durations allowed by the suppliers.
Working capital cycle can be calculated by the following formula:
O =R+W+F+D–C
Where, R = Raw material storage period = Average stock of raw material /Average
Cost of production per day
W = Work -in -progress Holding period = Average work-in-progress inventory /
Average cost of production per day
F = Finished goods storage periods = average stock finished goods / average
Cost of goods sold per day
D = Debtor collection period = Average book debts / Average credit sales per day
C = Credit period available = Average trade creditors /Average credit purchases
Per day

CLASSIFICATION OR TYPES OF WORKING CAPITAL
On the basis of concept
On the basis of concept working capital is divided into two categories as under:
(A) Gross Working Capital:
Gross working capital refers to total investment in current assets. The current
assets employed in business give the idea about the utilization of working capital
and idea about the economic position of the company. Thus, gross working capital
the amount of funds invested in different current assets. Gross working capital
concepts are popular and acceptable concept in the field of finance.
(B) Net Working Capital:

Net working capital means current assets minus current liabilities. The difference
between current assets and current liabilities is called the net working capital. If the
net working capital is positive business is able to meet its current liabilities. Net
working capital concept provides the measurement for determining the
creditworthiness of company.
On the basis of periodicity:
The requirements of working capital are continuous. More working capital is
required in a particular season or the peck period of business activity. On the basis
of periodicity working capital can be divided under two categories as under:
 Permanent working capital
 Variable working capital
Permanent working capital:
This type of working capital is known as Fixed Working
Capital. Permanent working capital means the part of working capital which is
permanently locked up in the current assets to carry out the business smoothly.
Regular Working capital:
Minimum amount of working capital required to keep the primary circulation. Some
amount of cash is necessary for the payment of wages, salaries etc.
Reserve Margin Working capital:

Additional working capital may also be required for contingencies that may arise
any time. The reserve working capital is the excess of capital over the needs of the
regular working capital is kept aside as reserve for contingencies, such as strike,
business depression etc.
· Variable or Temporary Working Capital:

The term variable working capital refers that the level of working capital is
temporary and fluctuating. Variable working capital may change from one assets to
another and changes with the increase or decrease in the volume of business.
The variable working capital may also be subdivided into following two sub-groups.
·
Seasonal Variable Working capital:
Seasonal working capital is the additional amount which is required during the
active business seasons of the year. Raw materials like raw-cotton or jute or
sugarcane are purchased in particular season. The industry has to borrow funds for

short period.It is particularly suited to a business of a seasonal nature. In short,

seasonal working capital is required to meet the seasonal liquidity of the business.
· Special variable working capital:

Additional working capital may also be needed to provide additional current assets
to meet the unexpected events or special operations such as extensive marketing
campaigns or carrying of special job etc.
The –End
Prepared by M. RATNA KUMARI

Financial Management

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Financial Management

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PALVIELA PG COLLEGE, PALIVELA , KOTHAPETA -533229, PHONE NO:08855-244771/774

Unit- I: Nature , Scope and Objectives of Financial Management, Goals of FM-Profit

Unit-II: Financing Decision: Financial Leverage – EPS-EBIT Analysis –Cost of Capital

Unit – III: Investment Decision: Nature and Significance of Investment Decision-

Unit-IV: Dividend Decision: Meaning and Significance – Theories of Dividend –

Unit – V: Working Capital Decision: Meaning – Classification and Significance of

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1. 5 dividend policies? ****

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Unit- I: Nature , Scope and Objectives of Financial Management, Goals of

Q 1: Explain the nature, scope and objectives of financial management:

1.1 INTRODUCTION TO FINANCIAL MANAGEMENT

Meaning of Financial Management: Financial management refers to that part of

According to Guthmann and Doug all: “Business finance can be broadly

According to Joseph & Massie: “Financial Management is the operational

Financial Management is the application of the general management principles in

Financial management is the art of planning; organizing, directing and

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Nature of the financial management

(i) Financial management is a specialized branch of general management, in

(iv) Likewise, the Advertising Manager thinking, in terms of launching an

aggressive advertising programmer, is too, considering a financial

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decision; and so on for other functional managers. This intermingling

nature of financial management calls for efforts in producing a coordinated

financial system for the whole enterprise.

Scope of the financial management

Traditional approach is the initial stage of financial management, which was

1. Arrangement of funds from lending body

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The modern approach is an analytical way of looking into financial problems of

Objectives of financial management

Main aim of any kind of economic activity is earning profit. A business

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1. Profit maximization is also called as cashing per share maximization. It leads

Favorable Arguments for Profit Maximization

(i) Main aim is earning profit.

Drawbacks of Profit Maximization

(i) It is vague: In this objective, profit is not defined precisely or correctly. It

Wealth maximization is one of the modern approaches, which

maximization or net present worth maximization. This objective is a universally

Favorable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because

Unfavorable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business concern

2Q: Functions of Financial Management?

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It’s the financial manager’s responsibility to decide a optimum dividend policy

It is very important to maintain a liquidity position of a firm to avoid

Financial Planning and Forecasting

Definition of Financial Planning

Financial Planning is the process of estimating the capital required and

Objectives of Financial Planning

a. Determining capital requirements- This will depend upon factors like

11 | P a g e : PALIVELA PG COLLEGE (ICET CODE : SSSK)

Importance of Financial Planning

Financial Planning is process of framing objectives, policies, procedures,

1. In concern adequate funds have to be ensured.

Financial forecasts estimate future income and expenses for a business over a

12 | P a g e : PALIVELA PG COLLEGE (ICET CODE : SSSK)

A financial forecast is an estimate of future financial outcomes for a company. It is