Theories of capital structure

1. Net income approach:

According to this approach, a firm can minimise the weighted average, cost of capital and increase the value of
the firm as well as market price of equity shares by using debt financing to the maximum possible extent. The
theory propounds that a company can increase its value and reduces the overall cost of capital by increasing the
proportion of debt in its capital structure. This approach is based upon the following assumptions:

(i) The cost of debt is less than the cost of equity

(ii) There are no taxes.

(iii) The risk perception of investors is not changed by the use of debt.

V=S+D
V= value of the firm

S= market value of equity

D= market value of debt

Also: V= EBIT/KO
2. Net Operating Income Approach:
According to this approach, change in the capital structure of a company does not affect the market value of the
firm and the overall cost of capital remains constant irrespective of the method of financing. It implies that the
overall cost of capital remains the same whether the debt-equity mix is 50:50 or 20:80 or 0:100. Thus, there is
nothing as an optimal capital structure and every capital structure is the optimum capital structure. This theory
presumes that:

a) there are no taxes

b) risk is same at all the levels of debt equity mix.

c) ko remains constant.

V= EBIT/KO

This theory has been criticized on the grounds that ko and kd cannot remains constant at all the levels.

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3. Traditional approach (intermediate approach): it is a balance between two above discussed approaches.
As per this theory of capital structure, initially the value of the firm can be increased as well as cost of capital can
be decreased by using more debt as debt is a cheaper source of funds than equity. But after a particular point of
time, the cost of equity start increasing. Thus, overall cost of capital, according to this theory, decreases upto
certain point, remains more or less unchanged for moderate increase in debt thereafter; and increases or rises
beyond a certain point. Even the cost of debt may increase at this state due to increased financial risk.
4. Modigliani and Miller Approach:

a) In the absence of taxes: The theory proves that the cost of capital is not affected by changes in the capital
structure or says that the debt-equity mix is irrelevant in the determination of the total value of a firm. This theory
of capital structure assumes:

a) there are no taxes

b) there is a perfect market

c) investors act rationally

d) no transaction cost

e) all earning goes to the shareholders

b) In the presence of taxes (net income approach): according to this approach cost of capital will decrease
and value of the firm increase with the use of debt due to taxes. Thus, the optimum capital structure can be
achieved by maximising the debt mix in the equity of a firm.

V= EBIT/KO

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 Working capital
Meaning: the capital of a business which is used in its day-to-day trading operations of the business. working
capital is the difference between current assets and current liabilities. Current assets is the money you have in the
bank as well as any assets you can quickly convert to cash if you needed it. Current liabilities are debts that you
will repay within the year. Working Capital indicates the liquidity levels of companies for managing day-to-day
expenses and covers inventory, cash, accounts payable, accounts receivable and short-term debt that is due.

1. Need for managing working capital

Proper management of working capital is essential to a company’s fundamental financial health and
operational success as a business.

2. Strengthen the Solvency

Working capital helps to operate the business smoothly without any financial problem for making the
payment of short-term liabilities. Purchase of raw materials and payment of salary, wages and overhead
can be made without any delay. Adequate working capital helps in maintaining solvency of the business
by providing uninterrupted flow of production.

3. Regular Supply of Raw Material

Quick payment of credit purchase of raw materials ensures the regular supply of raw materials fro
suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and
continuous production.

4. Smooth Business Operation

Working capital is really a life blood of any business organization which maintains the firm in well
condition. Any day to day financial requirement can be met without any shortage of fund. All expenses
and current liabilities are paid on time.

5. Ability To Face Crisis

Adequate working capital enables a firm to face business crisis in emergencies such as depression.

6. Enhance Goodwill
Sufficient working capital enables a business concern to make prompt payments and hence helps in
creating and maintaining goodwill. Goodwill is enhanced because all current liabilities and operating
expenses are paid on time.

7. Maintaining proper liquidity Position

8. Meeting day-to-day requirements of business

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9. Maximising the return on current asset investments: Maximising the return on
current investments is another objective of working capital management. The ROI on currently invested
assets should be greater than the weighted average cost of the capital so that wealth maximization is
ensured.

10. Management of payables and receivable

Determinants of Working Capital

1. Nature of business
The trading or manufacturing concerns will require more amount of working capital along-
with their fixed investment of stock, raw materials and finished products. Public utilities and
railway companies with huge fixed investment usually have the lowest needs for current
assets

2. Length of period of manufacture

The average length of the period of manufacture, i.e., the time which elapses between the
commencement and end of the manufacturing process is an important factor in determining
the amount of the working capital. If it takes less time to make the finished product, the
working capital required will be less.

3. Volume of business
Generally, the size of the company has a direct relation with the working capital needs. Big
concerns have to keep higher working capital for investment in current assets and for paying
current liabilities.

4. Turnover of working capital

Turnover means the speed with which the working capital is recovered by the sale of goods.
In certain businesses, sales are made quickly and the stocks are soon exhausted and new
purchases have to be made. In this manner, a small amount of money invested in stocks will
result in sales of much larger amount.

5. Terms of Credit:
A company purchasing all raw-materials for cash and selling on credit will be requiring more
amount of working capital. Contrary to this, if the enterprise is in a position to buy on credit
and sell it for cash, it will need less amount of working capital.

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 6. Requirements of Cash:
The need to have cash in hand to meet various requirements e.g., payment of salaries, rents,
rates etc., has an effect on the working capital. The more the cash requirements the higher
will be working capital needs of the company and vice versa.

7. Growth and expansion of business:

As a company grows, it is logical to expect that larger amount of working capital will be
required though It Is difficult to draw up firm rules for the relationship between the growth in
the volume of a company’s business and the growth of its working capital.

8. Seasonal fluctuations

9. Dividend Policy
The dividend policy of the firm is an important determinant of working capital. The need for
working capital can be met with the retained earning. If a firm retains more profit and
distributes lower amount of dividend, it needs less working capital.

10. Price level changes: The price level changes require the firm to keep more amount of
working capital to go hand in hand with the price changes which normally affect the firm's
liquidity position.

Operating cycle of working capital

The Working Capital Cycle for a business is the length of time it takes to convert net working
capital (current assets less current liabilities) all into cash. Businesses typically try to manage
this cycle by selling inventory quickly, collecting revenue from customers quickly, and paying bills
slowly, to optimize cash flow.

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Stages of operating cycle
Stage 1: Cash to Inventory : In this stage, cash first gets converted into raw materials, then work-in-progress and
then finished goods in a typical manufacturing concern. As regards non-manufacturing concerns, when the goods
are purchased, cash gets converted into inventory.

Stage 2: Inventory to Debtors : The inventory thus produced or purchased, gets converted into debtors or
receivables upon credit sales.

Stage 3: The debtors or accounts receivables get in turn converted back into cash when they make payment.

periods of each stage of operating cycle are ascertained as follows:

(a) Raw Material Holding Period:

(b) Work-In-Process Period:

(c) Finished Goods Holding Period:

(d) Receivables Collection Period:

(e) Creditors Payment Period:

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 Estimation of working capital
Estimating working capital means calculating future working capital.

Methods for estimation of working capital

Percentage of Sales Method

This method of estimating working capital requirements is based on the assumption that the level of working
capital for any firm is directly related to its sales value. If past experience indicates a stable relationship between
the amount of sales and working capital, then this basis may be used to determine the requirements of working
capital for future period. Thus, if sales for the year 2007 amounted to Rs 30,00,000 and working capital required
was Rs 6,00,000; the requirement of working capital for the year 2008 on an estimated sales of Rs 40,00,000 shall
be Rs 8,00,000; i.e. 20% of Rs 40,00,000.

Regression Analysis Method

This method of forecasting working capital requirements is based upon the statistical technique of estimating or
predicting the unknown value of a dependent variable from the known value of an independent variable. It is the
measure of the average relationship between two or more variables, i.e.; sales and working capital, in terms of the
original units of the data.

The relationships between sales and working capital are represented by the
equation:

Cash Forecasting Method

This method of estimating working capital requirements involves forecasting of cash receipts and disbursements
during a future period of time. Cash forecast will include all possible sources from which cash will be received
and the channels in which payments are to be made so that a consolidated cash position is determined.

operating Cycle Method:

This method of estimating working capital requirements is based upon the operating cycle concept of working
capital. The cycle starts with the purchase of raw material and other resources and ends with the realization of
cash from the sale of finished goods.

It involves purchase of raw materials and stores, its conversion into stock of finished goods through work-in-
process with progressive increment of labour and service costs, conversion of finished stock into sales, debtors

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and receivables, realization of cash and this cycle continues again from cash to purchase of raw material and so
on. The speed/time duration required to complete one cycle determines the requirement of working capital –
longer the period of cycle, larger is the requirement of working capital and vice-versa.

Projected Balance Sheet Method

Under this method, projected balance sheet for future date is prepared by forecasting of assets and liabilities by
following any of the methods stated above. The excess of estimated total current assets over estimated current
liabilities, as shown in the projected balance sheet, is computed to indicate the estimated amount of working
capital required.

Leverage analysis

Meaning: the term leverage refers to the relationship between tow interdependent variables. In
financial analysis it refers to the influence of one financial variable over the other related
financial variable. These financial variables may be cost, revenue, output, contribution, profit,
EPS, EBIT, EBT, etc. Leverage is an investment strategy of using borrowed money —
specifically, the use of various financial instruments or borrowed capital — to increase the
potential return of an investment. Leverage can also refer to the amount of debt a firm uses to
finance assets. When one refers to a company, property or investment as "highly leveraged," it
means that item has more debt than equity. Leverage occurs in varying degrees. The higher the
degree of leverage, the higher is the risk involved.

Definition: According to J. C. Van Home: “Leverage is the employment of an asset or funds

for which the firm pays a fixed cost of fixed return.”

Types of Leverage
1. Operating leverage: is the leverage concerned with investment activities of the firm. It
refers to the ability of the firm to use its fixed cost and variable cost to influence sales in
order to increase its operating profit or EBIT. When a company spends more on
employment of fixed assets and less on employment of variable assets, it is said to have
higher degree of OL and vice versa.

Operating leverage (OL) = contribution/EBIT

 Contribution= sales-variable cost

 EBIT=sales-variable cost-fixed cost

Degree of operating leverage= %change in profit/%change in sales

Higher the fixed expense, higher is the OL. OL directly impacts the operating profits
(Profits before Interest and Taxes (PBIT)). Under good economic conditions, an increase
of 1% in sales will have more than 1% change in operating profits. Operating leverage

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measures the impact of changes in sales of the company which leads to change in EBIT
or returns of shareholders.
Example of operating leverage: Airline companies: fixed cost of airline companies
involve Aircraft, insurance etc. variable cost of airline companies includes fuel, runway
charges etc. these companies have higher fixed cost as compare to variable cost. If the
DOL is 2. Suppose if their sales increase by 20%, their operating profit will increase by
40% and vice versa. In conclusion we can say that these companies do well in boom but
they are in much trouble in recession.

Financial leverage: it is the leverage associated with the financial activities of a firm. It
is a leverage created with the help of debt component in the capital structure of a
company. Higher the debt, higher would be the FL because with higher debt comes the
higher amount of interest that needs to be paid. It can be both good and bad for a business
depending on the situation. If a firm is able to generate a higher return on
investment (ROI) than the interest rate it is paying, leverage will have its positive effect
shareholder’s return. The darker side is that . If a firm is not able to generate a
higher return on investment (ROI) than the interest rate it is paying,, higher leverage can
take a business to a worst situation like bankruptcy.

Example of financial leverage: we take the example of real estate company who use
highest % of debt and low % of equity in their capital structure.
If ROI>interest paid, company can grow very fast and vice versa. For example a
company’s ROI is 20% from real estate and pay 12% interest to bank on loan taken,
company earns 8% extra by utilizing bank’s money which is very favorable condition and
company can grow very fast. But if a company’s ROI is 6% and they pay 12% to bank, it
is very unfavorable situation for the company.
Conclusion: High FL companies Do well in boom and do worse in recession.

Formula for financial leverage:

FL=operating profit before interest and tax/operating profit before tax
Or
FL=EBIT/EBT
Degree of financial leverage=%change in EPS/%change in EBIT

Combined leverage: is the combination of operating and financial leverage. When a

company makes use of both OL and FL to influence sales in order to increase profit or
EPS, the use combined leverage.
CL=Operating leverage x financial leverage
Or

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 Contribution/EBT
Degree of combined leverage= % change in EPS/% change in sales
EPS=profit after tax/no of shares

Difference between operating leverage and financial leverage

Operating leverage
It is associated with investment activities of the
company
It measures the effect of fixed operating cost
It influences sales and EBIT
OL arises due to company’s cost structure
Formula of OL=contribution/EBIT
OL is used to measure business risk
OL depends upon fixed cost and variable cost
Tax rate and interest rate will not affect OL
Financial leverage
It is associated with financial activities of the
company
It measures the effect of interest expenses
It influences EPS and EBIT
FL arises due to capital structure
Formula of FL=EBIT/EBT
FL is used to measure financial risk
FL depends upon the operating profit
Financial leverage will change due to Tax rate
and interest rate

1st : Impact of Operating Leverage on Risk and Return

To check this impact, we have to calculate operating leverage. Operating leverage is %

change of earning before interest and tax divided by % change in sales. If it is 2/1 it means it
is low, we have increased 1% of our sale but our earning has increased 2%. But if there is
situation of 5/1. It is high operating but more from this may be risky because at that time our
current ratio will not be according to rule of thumb.

2nd : Impact of Financial Leverage on Risk and Return

We will also see the impact of financial leverage on risk and return. High financial leverage
means we got high loan at low rate of interest and low financial leverage means we has taken
loan at high rate of interest. We can calculate financial leverage by taking percentage of
changing in earning per share and changing in earning before interest and tax. Low and very
high financial leverage is not good.

3rd : Impact of the Combined Leverage on Risk and Return

When we see the impact of the combined leverage on risk and return, we can better insight.

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High operating and high financial leverage are very risk for business. But low operating and
high financial leverage is good combination.

Inventory Management

Meaning of inventory: Inventory refers to the Stocks of manufactured products available

for sale and the material that are used to make the product. It includes raw materials, work-
in-process, finished goods and stores and spares (supplies).

Need to hold Inventory:

There are three general motives for holding inventories

(i) The Transactions motive: It expresses the need to maintain inventories to facilitate
production and sales operation smoothly.

(ii) The Precautionary motive: It necessitates holding of inventories to guard against the
risk of unpredictable change in demand and supply forces.

(iii) The Speculative motive: companies hold inventory to take advantage of future price
fluctuations.

Other reasons for holding inventories:

 To supply the required materials continuously

 To meet future demand
 To ensure right quantity of product at the right time and right place
 To satisfy customer needs.
 To avoid shortage
 To Reduce Order Costs
 If a firm's ordering cost is relatively higher for order placed each time, frequent
purchasing in small quantity is not economical. Therefore, placing lessor number of
orders in relatively large quantity each time could reduce the variable costs associated
to ordering of material.
Types of inventory:

1. Raw material 2. Work in progress 3. Finished goods 4. Spares

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Inventory management: Inventory Management is a business process which is responsible for
managing, storing, moving, sorting, arranging, counting and maintaining the inventory. Inventory
management is all about having the right inventory at the right quantity, in the right place, at the right time,
and at the right cost.

Objective of inventory management

1. To supply the required materials continuously

2. To minimize the risk of under and over stocking of material

3. To maintain systematic record of inventory

4. To reduce losses, damages and misappropriation of materials

5. To minimize the cost associated with inventory

6. To Control inventory investment by maintaining optimum inventory.

Factors affecting inventory investment

 Lead Time: Lead time is the time it takes from the moment an item is ordered to the moment it
arrives.
 The rate of inventory turnover: The rate of inventory turnover is the time period
within which inventory completes the cycle of production and sales. When the
turnover rate is high, investment in inventories tends to be low.
 Product Type: Inventory management must take into consideration the different
types of products in stock. For example, some products may be perishable and
therefore have a shorter shelf life than others. In this case inventory must be managed
to ensure that these items are rotated in line with expiration dates.
 Financial position of the firm: A financially sound company may buy materials in
bulk and hold them for future use. A firm starved of funds cannot maintain large
stocks.
 Cost of Holding Inventory
 Material Costs
 Ordering Costs
 Carrying Costs
 Suppliers
 Stock Levels: Reorder Level, Maximum Level, Minimum Level, Safety Level / Danger Level

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Techniques of inventory management:
1. Economic order quality –EOQ: Economic order quality is defined as the quantity of inventories to be
ordered each time that minimizes the total inventory cost. Inventory cost comprise the ordering or set-
up cost and carrying or holding cost less discount if any.

Assumptions of this model:

 The firm knows with certainty the annual usage or consumption of a particular item of inventory.
 The rate of the usage of inventory is stable over time
 Annual cost of carrying of inventory is constant
 Total inventory cost = ordering cost + carrying cost

EOQ=√2AB/C

 A= Annual usage of inventory (units)

 Buying cost per order
 Carrying cost per unit

2. Last-In First-Out (LIFO)

3. JUST IN TIME (JIT) METHOD

4. ABC ANALYSIS: ABC stands for Always Better Control technique. ABC analysis is an inventory
management technique where inventory items are classified into three categories namely: A, B, and C.
The items in A category of inventory are closely controlled as it consists of high-priced inventory which
may be less in number but are very expensive. The items in B category are relatively lesser expensive
inventory as compared to A category and the number of items in B category is moderate so control level
is also moderate. The C category consists of a high number of inventory items which require lesser
investments so the control level is minimum.

5. MATERIAL REQUIREMENTS PLANNING (MRP) METHOD: Material Requirements Planning is an

inventory control method in which the manufacturers order the inventory after considering the sales
forecast. MRP system integrates data from various areas of the business where inventory is utilized.
Based on the data and demand in the market, order for new inventory is placed with the material
suppliers.

6. VED ANALYSIS: VED stands for Vital essential and desirable. Organizations mainly use this
technique for controlling spare parts of inventory. Like, high level of inventory is required for vital parts
that are very costly and essential for production. Others are essential spare parts, whose absence may slow
down the production process, hence it is necessary to maintain such inventory. Similarly, an organization
can maintain a low level of inventory for desirable parts, which are not often required for production.

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7. First-In First-Out (FIFO)

8. FAST, SLOW & NON-MOVING (FSN) METHOD: This method of inventory control is very useful for
controlling obsolescence. All the items of inventory are not used in the same order; some are required
frequently, while some are not required at all. So this method classifies inventory into three categories,
fast moving inventory, slow-moving inventory and non-moving inventory. The order for new inventory is
placed based on the utilization of inventory.

9. Setting up of various stock levels: To avoid over-stocking and under stocking of materials, the management
has to decide about the maximum level, minimum level, re-order level, danger level and average level of
materials to be kept in the store.

10. VED ANALYSIS: VED stands for Vital Essential and Desirable. Organizations mainly use this technique
for controlling spare parts of inventory. Like, a higher level of inventory is required for vital parts that are
very costly and essential for production. Others are essential spare parts, whose absence may slow down
the production process, hence it is necessary to maintain such inventory. Similarly, an organization can
maintain a low level of inventory for desirable parts, which are not often required for production.

11. Reorder Point level: A reorder point formula tells you approximately when you should order more stock –
that is, when you’ve reached the lowest amount of inventory you can sustain before you need more.
Here’s the reorder point formula you can use today:
(Average Daily Unit Sales x Average Lead Time in Days) + Safety Stock = Reorder Point

Setting up of various stock levels

 Minimum Level: This represents the minimum quantity which must be maintained in hand at all
times. If stocks are less than the minimum level, then the work will stop due to shortage of
materials.

Minimum level= reorder level – (average consumption * average re-order period)

 Maximum Level: It is the maximum quantity of materials beyond which a firm should not
exceed its stocks. If the quantity exceeds maximum level limit then it will be termed as
overstocking. A firm avoids overstocking because it will result in high material costs.
Overstocking will lead to the requirement of more capital, more space for storing the materials,
capital blockage etc.

Maximum level = re-order level + re-order quantity- (minimum consumption * minimum re-
order period)

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  Re-order level: It is that level of stock where new order should be placed considering re-order
period and rate of consumption. The order is sent before the materials reach minimum stock
level. this level is fixed somewhere Between the minimum level & the maximum level. If the
inventory falls below the re-order level, store keeper start purchasing of fresh goods.

Reorder level = maximum consumption * maximum re-order period

 Re-order quantity: it is that quantity of material that is purchased each time.

 Average stock level: it is the normal level of stock between maximum and minimum level.

Average level = minimum level+ ½ re-order quantity

Average level = (max level+ min level)/2

 Danger Level: It is the level below which stocks should not fall in any case. If danger level
approaches then immediate steps should taken to replenish the stocks even if more cost is
incurred in arranging the materials. Danger level can be determined with the following formula:

Danger Level = Average Consumption x Maximum reorder period for emergency purchases.

Safety stock level: Safety stock is an additional quantity of an item held in inventory in order to reduce
the risk that the item will be out of stock due to uncertainties in supply and demand.

Cash Management
Definition: Cash management is the efficient collection, disbursement, and investment of cash in an
organization while maintaining the company’s liquidity.

In other words, it is concerned with managing the cash flows within and outside the firm and making
decisions with respect to the investment of surplus cash or raising the cash from outside for financing
the deficit.

Facets of Cash Management

In order to resolve the uncertainty about cash flow the firm should develop appropriate strategies
for cash management regarding the following four facets of cash management:

1. Cash planning: cash inflows and outflows should be planned to project cash surplus or deficit
for each period of the planning period. Cash budget should be prepared for this purpose.

2. Managing the cash flows: the flow of cash should be properly managed. The cash inflows
should be accelerated while, as far as possible, the cash outflows should be decelerated.

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3. Optimum cash level: the firm should decide about the appropriate level of cash balances. The
cost of excess cash and danger of cash deficiency should be matched to determine the optimum
level of cash balances.
4. Investing surplus cash: the surplus cash balances should be properly invested to earn profits.
The firm should decide about the division of such cash balance between alternative short-term
investment opportunities such as bank deposits, marketable securities, or inter- corporate
lending.

Motives for Holding Cash

1. Transaction Motive: The transaction motive refers to the cash required by a firm to meet the
day to day needs of its business operations. In an ordinary course of business, the firm requires
cash to make the payments in the form of salaries, wages, interests, dividends, goods purchased,
etc. Likewise, it also receives cash from its sales, debtors, investments. Often the firm’s cash
inflows and outflows do not match, and hence, the cash is held up to meet its routine
commitments.

2. Precautionary Motive: The precautionary motive refers to the tendency of a firm to hold cash,
to meet the contingencies or unforeseen circumstances arising in the course of business. Since
the future is uncertain, a firm may have to face contingencies such as an increase in the price of
raw materials, labor strike, lockouts, change in the demand, etc. Thus, in order to meet with these
uncertainties, the cash is held by the firms to have uninterrupted business operations.

3. The Speculative Motives: The speculative motive relates to the holding of cash for investing in
profit making opportunities as and when they arise. The opportunity to make profit may arise
when the security prices changes. The firm will hold cash, when it is expected that interest rates
will fall. Securities can be purchased when the interest rate is expected to fall. The firm will
benefit by the subsequent fall in interest rates and increase in security prices. The firm may also
speculate on materials prices. If it is expected that materials price will fall, the firm can postpone
materials purchasing and make purchases in future when price actually falls. Some firms may
hold cash for speculative purposes. By and large, business firms do not engage in speculations.

16
 Thus, the primary motives to hold cash and marketable securities are the transactions motive and
the precautionary motive.

Optimal Cash Balance

The ideal level of cash that a company wishes to hold in reserve at any given point in time. Companies
with excess cash on hand may be missing out on investment opportunities, while companies that are in
shortage of cash may be not able to meet its day to day requirements.

Baumols model: This model developed by William Baumol. This model enables companies to find out
their desirable level of cash balance under certainty. This is similar to the EOQ model used in inventory
management. As such, the firm attempts to minimise the sum of the cost of holding cash (inventory of
cash) and the cost of converting marketable securities to cash.

The objective is to minimize the sum of the fixed costs of transactions and the opportunity cost of
holding cash balances.

Assumptions of the model:

1. The firm is able to forecast its cash need with certainty.

2. The firm’s cash payments occur uniformly over a period of time.

3. The opportunity cost of holding cash is known and it does not change over time.
4. The firm will incur the same transaction cost whenever it converts securities to cash.

The optimal level of cash is determined using the following formula:

Optimal level of cash = √(2FT / I)

F = fixed cost of transaction

T = total cash required for specific time period

I = interest rate on marketable securities

Example:

A Company estimates a cash requirement of $2,000,000 for a 1 month period. The opportunity interest
rate is 6% per annum, which works out to 0.5 percent per month. The transaction cost for borrowing or
withdrawing funds is $150.

Optimal level of cash = √(2 x $150 x $2,000,000) / 0.005 => $346,410.16

With the above optimal transaction size, we can now find the number of transactions required.

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Number of transactions required = $2,000,000 / $346,410.16 => 5.77 or 6 transactions during the
month.

Limitations of the Baumol model:

1.It does not allow cash flows to fluctuate.

2. Overdraft is not considered.
3. There are uncertainties in the pattern of future cash flows.

Miller-Orr Model

The Miller-Orr model of cash management is developed for businesses with uncertain cash inflows and
outflows.

The limitation of the baumol model is that it does not allow the cash flows to fluctuate. Firms in
practice do not use their cash balance uniformly nor are they able to predict daily cash inflows and
outflows. The Miller-Orr (MO) model overcomes this shortcoming and allows for daily cash flow
variation. The model works in terms of upper and lower control limits, and a target cash balance. As
per the Miller and Orr model of cash management the companies let their cash balance move within
two limits – the upper limit and the lower limit.

When the cash balances of a company touches the upper limit it purchases a certain number of salable
securities that helps them to come back to the desired level.

If the cash balance of the company reaches the lower level then the company trades its salable
securities and gathers enough cash to fix the problem.

Assumptions

1. The cash inflows and cash outflows are uncertain or not constant. In other words, each day a
business may have both different cash payments and different cash receipts.

2. There is a transaction fee when marketable securities are bought or sold.

3. A business maintains the minimum acceptable cash balance, which is called the lower limit.

To use the Miller-Orr model, the manager must do 4 things

1. Set the lower control limits for the cash balance.

2. Estimate Standard deviation of daily cash flows

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3. Determine Interest Rate

4. Estimate the trading costs of buying and selling marketable securities.

Formula:

Z = 3√(3F σ2)/ 4I

F = fixed cost of transaction

I = Daily interest rate

σ2 = variance of daily cash flow

Z = optimal cash balance

In this model we need to calculate few things:

Spread: it is the difference between upper limit and lower limit.

Spread = 3Z or 3 x 3√(3F σ2)/ 4I

Return point: it is the extent to which cash can be exchange to securities when cash touch upper limit
and the extent to which securities can be exchanged to cash in case when cash touch lower limit.

Return Point = Lower Limit + 1/3 × Spread

Upper Limit = Lower Limit + Spread

Graph:

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Illustration

If a company must maintain a minimum cash balance of £8,000, and the variance of its daily cash flows
is £4m (ie std deviation £2,000). The cost of buying/ selling securities is £50 & the daily interest rate is
0.025%.

Solution

Lower limit = 8,000 (per question)

Spread = 3(3/4 x 50 x 4,000,000 / 0.00025) power of 1/3 = 25,303
Upper limit = 8,000 + 25,303 = 33,303
Return point = 8,000 + (1/3 x 25,303) = 16,434

Optimum cash balance (Z) = 8434.33

Short-Term and Long-Term Cash Forecasting

Section – D
Receivable Management
Meaning of receivables: Receivables, also referred to as accounts receivable, are debts owed to
a company by its customers for goods or services that have been delivered or used but not yet
paid for. Receivables are the current assets of a company.

Receivable management: Receivables Management refers to the set of policies, procedures, and
practices employed by a company with respect to managing sales offered on credit. Receivable
management includes various decisions such as credit policies, credit terms and credit
collection.

Objectives of receivables management:

 To minimize the possible bad debt losses.

 To promote sales
 To minimize cost of credit
 Collection of credits
 Establishment of credit policies
 Setting the Credit & Payment terms
 Maintaining up to date record of receivable

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 Factors affecting receivables

 Size of Credit Sales: The volume of credit sales is the first factor which increases or
decreases the size of receivables. If a concern sells only on cash basis as in the case of
Bata Shoe Company, then there will be no receivables.
 Type/Nature of Business: Food business on cash basis whilst manufacturing business
has more accounts receivable
 Volume of business: large businesses may have large amount of receivables.
 Availability of funds: if a firm has sufficient funds, it may give large amount of credit
 Credit period: Higher the credit period will lead to more volume of receivables
 Credit Policies: A firm with conservative credit policy will have a low size of
receivables while a firm with liberal credit policy will be increasing this figure.
 Expansion Plans: When a concern wants to expand its activities, it will have to enter
new markets. To attract customers, it will give incentives in the form of credit facilities.
 Habits of Customers: The paying habits of customers also have bearing on the size of
receivables. The customers may be in the habit of delaying payments even though they
are financially sound.

Variables of credit policy

Meaning of credit policy: credit policy is certain principles and guidelines that provide a
framework for extension and collection of credit. It includes whether or not to extend credit,
how much to extend and how to collect it etc.

Variables of credit policy:

 Credit standards: credit standards represents the basic criteria for the extension of credit to
customers. A firm may have liberal credit standards or tight credit standards. In liberal
standards a firm may decide to grand credit to all customers irrespective of their credit rating.
On the other hand it may decide not to extend credit to any customer or extend credit to
customer based on certain conditions. In general, liberal credit standards tend to push sales
up by attracting more customers. This is, however, accompanied by a higher incidence of
bad debt loss, a larger investment in receivables, and a higher cost of collection. In case of
tight credit standards the above case may be opposite.

 Credit period: The credit period refers to the length of time customers are allowed to pay
for their purchases. Long credit period pushes sales up by inducing existing customers to
purchase more and attracting additional customers. This is, however, accompanied by a
larger investment in receivables and a higher incidence of bad debt loss. Shortening of the
credit period would have opposite influences: It tends to lower sales, decrease investment in

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 receivables, and reduce the incidence of bad debt loss. Credit period generally varies from 15
days to 60 days.

 Cash discount: Firms generally offer cash discounts to induce customers to make prompt
payments. The percentage discount and the period during which it is available depend upon
the credit terms of the firm. For example, credit terms of 2/10, net 30 mean that a discount of
2 per cent is offered if the payment is made by the tenth day; otherwise the full payment is
due by the thirtieth day.

 Collection Effort: it refers to the procedure followed to collect the receivables after the
expiry of the credit period. Steps in collection effort includes:

 Letters, including reminders

 Telephone call for personal contact
 Personal visit
 Help of collection agencies
 Legal action

Credit Evaluation

Meaning: it is the process of determining the credit worthiness of customer or borrower.

A. Traditional credit analysis: under this method customer is evaluated based on 5 C’s.

5 C’s for credit evaluation:

 Character: Character refers to the willingness of the customer towards fulfillment of

his obligations. This information appears on the borrower's credit reports. credit
reports contain detailed information about how much an applicant has borrowed in the
past and whether they have repaid loans on time. For example, FICO, (formerly
known as the Fair Isaac Corporation), a leading credit evaluation firm, uses the
information found on a consumer's credit report to create a credit score, a tool lenders
use for a quick snapshot of creditworthiness before looking at credit reports. FICO
scores range from 300-850

 Capacity: Capacity refers to the ability of the customer to pay on time. Capacity
measures the borrower's ability to repay a loan by comparing income against recurring
debts Lenders calculate DTI by adding together a borrower's total monthly debt
payments and dividing that by the borrower's gross monthly income. The lower an
applicant's DTI, the better the chance of qualifying for a new loan. Every lender is

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 different, but many lenders prefer an applicant's DTI to be around 35% or less before
approving an application for new financing.

 Capital: Lenders also consider any capital the borrower puts toward a potential
investment.

 Collateral: Collateral represents the security offered by the borrower to the lender. It
gives the lender the assurance that if the borrower defaults on the loan, the lender can
repossess the collateral. Car loans, for instance, are secured by cars. Generally loans
that are secured by some form of collateral are commonly offered with lower interest
rates.

 Conditions: Conditions can refer to how a borrower intends to use the money.
Consider a borrower who applies for a car loan or a home improvement loan. A lender
may be more likely to approve those loans because of their specific purpose, rather
than a loan which could be used for anything. Additionally, lenders may consider
conditions that are outside of the borrower's control, such as the state of the economy,
industry trends or legal conditions etc.

To get information on the five C’s, following sources can be used:

1. Financial statement: it provides information about financial position of the company

such as current ratio, liquid ratio, debt-equity ratio, return on equity etc.
2. Bank reference
3. Experience of the firm: how prompt was the customer in making payment in the past?

B. Numerical credit scoring: under this method a consumer is evaluated based on credit
based on certain factors. This system involves following steps:
 Identifying factors relevant for credit evaluation.
 Assigning weights to these factors.
 Rating consumer based on various factors, using 5 or 7 rating scale.
 For each factor, multiply the factor rating with factor rating to get the factor score
 Add all the factor scores.
 Based on score, classify the customers.

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 Example: construction of credit rating index based on 5 point rating scale:

S.N Factor Weight Rating Score

5 4 3 2 1
1 Past payment 3 √ 12
2 Current ratio 2 √ 8
3 Debt-equity ratio 1 √ 3
4 Net profit 2 √ 8
5 Rating index 31

Dividend Decisions
Meaning of dividend: dividend is a share of the after-tax profit of a company, distributed to its
shareholders according to the number and class of shares held by them.

in other words it is a sum of money paid regularly (typically annually) by a company to its
shareholders out of its profits. Dividends can be issued as cash payments, as shares of stock, or
other property, though cash dividends are the most common.

Dividend decisions: The Dividend Decision, in corporate finance, is a decision made by the
board of directors of a company about the payment of dividend made to the company’s
stockholders. Dividend decision determines the division of earnings between payments to
shareholders and retained earnings.

Types of dividend

 Cash dividend– this is the payment of actual cash from the company directly to the
shareholders and is the most common type of dividend. The payment is usually made
electronically (wire transfer), but may also be paid by check or cash.

Example of Cash Dividend: Midterm international Ltd on January 1, 2019, held the meeting
on which board of directors of the company declared the cash dividend of $1 per share on
outstanding shares of the company which is to be paid to all the shareholders on June 1 who
were there on record on April 1.

 Stock Dividend/ Bonus Shares: These types of dividend are issued when a company lacks
operating cash, but still issues, the common stock to the shareholders to keep them happy.The
shareholders get the additional shares in proportion to the shares already held by them and

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 don’t have to pay extra for these bonus shares. Example of Stock Dividend: Midterm
international Ltd on January 1, 2019, declares the stock dividend of 20,000 shares to the
shareholders when the par value of the shares is $2 and the fair market value is $3.00.

 Property Dividend: These dividends are paid in the form of a property rather than in cash. In
case, a company lacks the operating cash; then non-monetary dividends are paid to the
investors.The property dividends can be in any form: inventory, asset, vehicle, real estate, etc.

Example of Property Dividend: The board of directors of New Sports International Ltd elects
to declare the issuance of 1000 identical artwork which was stored by the company from last
many years. The fair market value of the artwork on the date of declaration of the dividend is $
6,000,000 which originally the company acquired $ 80,000.

 Scrip Dividend: Under this form, a company issues the transferable promissory note to the
shareholders, wherein it confirms the payment of dividend on the future date.A scrip dividend
has shorter maturity periods and may or may not bear any interest. These types of dividend are
issued when a company does not have enough liquidity and require some time to convert its
current assets into cash. Example of Scrip Dividend: The Mid Term International declares to its
shareholders a $ 150,000 scrip dividend with the interest rate of 10 percent.
 Liquidating Dividend: When the board of directors decides to pay back the original capital
contributed by the equity shareholders as dividends, is called as a liquidating dividend. These
are usually paid at the time of winding up of the operations of the firm or at the time of final
closure.

Issues in Dividend Policy

 Dividend payout ratio

 Stability of dividend
 Legal constraints
 Inflation

Theories of dividend

Traditional Model: It is given by B Graham and DL Dodd. This model says that there is a direct
relationship between the dividends and market price of the shares. According to this model, the
stock increase due to higher dividends and decrease when there are low dividends. This model
establishes the relationship between market price and dividends using a multiplier.

P/E ratios are directly related to the dividend payout ratios i.e a higher dividend payout ratio will
increase the P/E ratio and vice-versa.

According to this model the market price of share is calculated as follows:

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 P = m(D+E/3)

• Where; P = market price, M = multiplier, D = Dividend per share, E = Earnings per

share

Li Limitation of the Traditional Approach:

• P/E ratios are directly related to the dividend payout ratios is not true for a firm’s whose
payout is low but its earnings are increasing.
• This approach does not hold good for those firm whose payout is high but have slow growth
rate.

Walter Model

Definition: According to the Walter’s Model, given by prof. James E. Walter, the dividends are
relevant and have a bearing on the firm’s share prices. Also, the investment policy cannot be
separated from the dividend policy since both are interlinked. Walter’s Model shows the clear
relationship between the return on investments and the cost of capital (K). According to him
investment policy and dividend policy are inter related and the choice of a appropriate dividend
policy affects the value of an enterprise. According to this model, the companies who pays
higher dividends have more value as compare to the companies who pay lower dividend or do
not pay dividend at all.

Assumptions:

 Internal financing: Retained earnings are the only source of finance. This means that the
company does not rely upon external funds like debt or new equity capital.

 Constant IRR and cost of capital: he rate of return (r) and the cost of capital (K) remain
constant irrespective of any changes in the investments.

 The earnings per share (EPS) and Dividend per share (DPS) remains constant.

 The firm has a perpetual life.

 100% Retention or Pay-out: All the earnings are either retained or distributed completely
among the shareholders.

FoFormula for determination of expected market price of a share is as follows:

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Where,

P = Market price of equity share ,

D = Dividend per share,

E = Earnings per share

(E-D) = Retained earnings per share,

r = Internal rate of return on investment,

k = cost of capital

 Example: A company has the following facts:

Cost of capital (ke) = 0.10
Earnings per share (E) = $10
Rate of return on investments ( r) = 8%
Dividend payout ratio: Case A: 50% Case B: 25%
Show the effect of the dividend policy on the market price of the shares.

Solution:

Case A:
D/P ratio = 50%
When EPS = $10 and D/P ratio is 50%, D = 10 x 50% = $5

5 + [0.08 / 0.10] [10 - 5]

P = => $90
0.10

Case B:
D/P ratio = 25%
When EPS = $10 and D/P ratio is 25%, D = 10 x 25% = $2.5

2.5 + [0.08 / 0.10] [10 -

2.5]
P = => $85
0.10

Conclusion:

 If r>K, the firm should retain the earnings because it possesses better investment
opportunities and can gain more than what the shareholder can by re-investing. These
firms are called growth firms and they retain all their earnings.

 If r<K, the firm should pay all its earnings to the shareholders in the form of

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 dividends, because they have better investment opportunities than a firm. Here the
payout ratio is 100%.
 If r=K, the firm’s dividend policy has no effect on the firm’s value. Here the firm is
indifferent towards how much is to be retained and how much is to be distributed
among the shareholders. The payout ratio can vary from zero to 100%.
Criticism:

 No external Financing
 Constant Rate of Return
 It is assumed that the cost of capital (K) remains constant

Gordon Model

Myron Gordon developed the dividend capitalization approach to study the effect of the
firms dividend policy on the stock price. Gordon's theory contends that dividends are
relevant. This model is of the view that dividend policy of a firm affects its value. He
Showed how dividend policy can be used to maximize the wealth of the shareholders.
Gordon model assumes that the investors are rational and risk averse. They prefer certain
returns to uncertain returns and thus put a premium to the certain returns and discount the
uncertain returns. Investor would prefer to pay a higher price for the stocks, which earn
them current dividends income and would discount those stocks, which either postpones/
reduce the current income.
Assumptions:

 All Equity Firm

 No External Financing
 Constant Return and Cost of Capital
 Perpetual Earnings
 No Taxes
 Constant Retention
 Cost of Capital greater than Growth Rate

Acc to Gordon Market Price Per share is given by:

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 Where,
P = Price
E = Earning per Share
b = Retention Ratio
k = Cost of Capital
br = g = Growth Rate

Acc to Gordon; –
 The firms with rate of return greater than the cost of capital should have a higher
retention ratio. –
 Firms which have rate of return less than the cost of capital, should have a lower
retention ratio. –
 The firms which have a rate of return equal to the cost of capital will however not
have any impact on its share value, it can adopt any retention policy.

Miller and Modigliani Model

According to M-M, under a perfect market situation, the dividend policy of a firm is
irrelevant as it does not affect the value of the firm. According to Miller and Modigliani
Hypothesis or MM Approach, dividend policy has no effect on the price of the shares of
the firm and believes that it is the investment policy that increases the firm’s share value.
They argue that the value of the firm depends on firm earnings which results from its
investment policy.
According to them the price of a share of a firm is determined by its earnings and
investment policy and not by the dividend distribution. in short, this model says if you pay
dividend or you don’t pay, the value of the firm will not change.

Assumptions:
1. The firm operates in perfect capital market
2. Taxes do not exist
3. The firm has a fixed investment policy
4. Risk of uncertainty does not exist. That is, investors are able to forecast future prices and
dividends

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The market price of a share in the beginning of the period is equal to the present value of
dividends paid at the end of the period plus the market price of shares at the end of the
period. Symbolically,

Where: P0 = Prevailing market price of a share

ke = cost of equity capital
D1 = Dividend to be received at the end of period 1 and
P1 = Market price of a share at the end of period 1.

Value of the firm will be calculated by the following formula:

n= the No of shares
outstanding at the beginning of the period

np0= value of the firm

Example:
A company whose capitalization rate is 10% has outstanding shares of 25,000 selling at $100
each. The firm is expecting to pay a dividend of $5 per share at the end of the current financial
year. Prove that using MM model, the payment of dividend does not affect the value of the firm.

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 Corporate Restructuring

Meaning: Any change in a company’s operations or change in the capital structure / ownership of
the corporate body s called corporate restructuring. Idea and Vodafone is the recent example of
corporate restructuring.

Need of corporate restructuring:

 To improve competitive advantage
 Expansion of business
 To eliminate the competition between the co-companies.
 To overcome significant problems in a company
 To have better market share
 To have access to better technology
 Cost reduction by deriving the benefit of economies of scale
 To merge with another company

Financial and Operational restructuring

Financial restructuring: Any change in a company’s capital structure / ownership of the

corporate body s called financial restructuring. Financial restructuring involves change in equity
capital and equity capital. Financial restructuring can be done because of either compulsion or as
part of the financial strategy of the company.

There are two components of financial restructuring are;

 Debt Restructuring
 Equity Restructuring

Debt Restructuring: Debt restructuring is the process of reorganizing the whole debt capital of the
company. Debt restructuring is more commonly used as a financial tool than compared to equity
restructuring because debt is the cheaper source of finance.

Components of debt restructuring

 Restructuring of secured long-term borrowings

 Restructuring of unsecured long-term borrowings
 Restructuring of secured working capital borrowings

Equity Restructuring: Equity restructuring is the process of reorganizing the equity capital.
Restructuring of equity and preference capital becomes a complex process involving a process of
law and is a highly regulated area. One way of equity restructuring is making a public company
private through the repurchase of stock by current management and/or outside private investors.

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Operational restructuring: Any change in a company’s operations of the corporate body s called
operational restructuring. It may be through the following:

• Liquidation -- The sale of assets of a firm, either voluntarily or in bankruptcy.

• Sell-off -- The sale of a division of a company, known as a partial sell-off, or the company as
a whole, known as a voluntary liquidation.
• Spin off: A spinoff is the creation of an independent company through the sale or
distribution of new shares of an existing business or division of a parent company.

Merger and amalgamation

Meaning of merger: A merger refers to an agreement in which two companies join together
to form one company. In other words, a merger is the combination of two companies into a
single legal entity. Example of recent merger is Vodafone-Idea.
Types of merger:

• Horizontal merger: A merger between companies that are in direct competition with
each other and perform at the same industry. Ex. Vodafone and idea, Bank of Madura and
ICICI Bank
• Vertical merger: A merger between companies In which a company merge with its
supplier or its distributer. A vertical merger can happen in two ways. One is when a firm
acquires another firm which produces raw materials used by it. For e.g., a tyre
manufacturer acquires a rubber manufacturer, a car manufacturer acquires a steel
company, a textile company acquires a cotton yarn manufacturer etc. Another form of
vertical merger happens when a firm acquires another firm which would help it get closer
to the customer. For e.g., a consumer durable manufacturer acquiring a consumer durable
dealer.
Example: merger of Tata motors and Trilix srl. Tata motors is a car manufacturing
company and Trilix srl is a design and engineering services company. These both
companies merged in 2010.
• Market-extension merger: A merger between companies in different markets that sell
similar products or services
• Product-extension merger: A merger between companies in the same markets that sell
different but related products or services
• Conglomerate merger: A merger between companies in unrelated business activities
(e.g., a clothing company buys a software company)
• Cross border merger: combination of two companies in 2 different countries.

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Motives behind merger:
• Synergy
• Diversification of risk: A commonly stated motive for mergers and acquisitions is to
achieve risk reduction through diversification.
• Diversification of products: Diversification into new areas and new products can
also be a motive for a firm to merge an other with it. A firm operating in North India,
if merges with another firm operating primarily in South India, can definitely cover
broader economic areas. Individually these firms could serve only a limited area.
• Growth
• Increased Market Power
• Increase Supply-chain Pricing Power: By buying out one of its suppliers or one of
the distributors, a business can eliminate a level of costs. If a company buys out one of
its suppliers, it is able to save on the margins that the supplier was previously adding
to its costs; this is known as a vertical merger. If a company buys out a distributor, it
may be able to ship its products at a lower cost.
• Competition
• Tax
Amalgamation
• Meaning: Amalgamation is defined as the combination of one or more companies
into a new entity. Amalgamation is distinct from a merger because none of the
companies remains as a legal entity. Instead, a completely new entity is formed to
house the combined assets and liabilities of both companies. There are two terms
related to amalgamation.
• Amalgamating companies are those two or more companies which willingly unite
(combine) to carry on their business activities jointly.
• Amalgamated company is a newly formed union (alliance) of two or more
amalgamating companies. It has a separate legal existence with a new unique name.
Types of amalgamation:
 In the nature of merger
 In the nature of purchase

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