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Financial Management is an appendage of the Finance function. With the creation of a complex
industrial structure, finance function has grown so much that it has which given birth to a
separate subject financial management, is today recognized as the most important branch of
business administration. One cannot think of any business activity in isolation from its financial
implications. The management may accept or reject a business proposition on the basis of its
financial viabilities. In other words, financial considerations reign supreme, particularly for line
executives who are directly involved in the decision-making process. In this connection, it is
observed that "Financial Management involves the application of general management principles
to a particular financial operation".

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On this lesson, you will be conversant with

The meaning of finance and financial management

The objectives of financial management
Advantages and criticisms on the objective of financial management
Scope and functions of the finance manager
Finance and other related subjects
The functional areas of financial management
The process of financial management
The process of financial decisions

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Financial management is that part of management which is concerned mainly with raising funds
in the most economic and suitable manner; using these funds as profitably (for a given risk level)
as possible; planning future operations; and controlling current performances and future
developments through financial accounting, cost accounting, budgeting, statistics and other
means. It guides investment where opportunity is the greatest, producing relatively uniform
yardsticks for judging most of the firm¶s operations and projects, and is continually concerned
with achieving an adequate rate of return on investment, as this is necessary for survival and
attracting new capital.

Financial management provides the best guide-ship for present and future resource allocation of
a firm. It provides relatively uniform yardsticks for judging most of the operations and projects.
Financial management implies the designing and implementation of a certain plan. Financial
plans aim at an effective utilization of funds. The term µFinancial management¶ connotes that the
fund flow is directed according to some plan. Financial management connotes responsibility for
obtaining and effectively utilizing funds necessary for the efficient operation of an enterprise.
The finance function centres round the management of funds raising and using them effectively.
But the dimensions of financial management are much broader than mere procurement of funds.
Planning is one of the most important activities of the financial manager. It makes it possible for
the financial manager to obtain funds at the best time in relation to their cost and the conditions
under which they can be obtained and their effective use by the business firm.

Financial management is dynamic, in the making of day- to-day financial decisions in a business
of any size. The old concept of finance as treasurer-ship has broadened to include the new,
meaningful concept of controllership. While the treasurer keeps track of the money, the
controller¶s duties extend to planning analysis and the improvement of every phase of the
company¶s operations, which are measured with a financial yardstick.

Financial management is important because it has an impact on all the activities of a firm. Its
primary responsibility is to discharge the finance function successfully. It touches all the other

business functions. All business decisions have financial implications, and a single decision may
financially affect different departments of an organization.

Financial management, however, should not be taken to be a profit-extracting device. No doubt

finances have to be so planned as to contribute the profit-making activities. Financial
management implies a more comprehensive concept than the simple objective of profit making
or efficiency. Its broader mission is to maximize the value of the firm so that the interests of
different sections of the community remain protected. It should be noted, therefore, that financial
management does not mean management of a business organization with a view to maximizing

Financial management applies to every organization, irrespective of its size, nature of ownership
and control - whether it is a manufacturing or service organization. It applies to any activity of an
organization which has financial implications. To say that it applies to private profit-making
organizations alone is to narrow the scope of the subject. Moreover, financial management does
not handle merely routine day-to-day matters. It has to handle more complex problems such as
mergers, reorganizations and the like. It plays two distinct roles. Firstly, it safeguards interests of
the corporation, which is a separate legal entity. Secondly, this separate legal entity has no
meaning unless the interests of owners and other sections of the community, which are directly
concerned with the corporation, are properly protected.

Financial management is thus an integrated and composite subject. It welds together much of the
material that is found in Accounting, Economics, Mathematics, Systems analysis and Behavioral
sciences, and uses other disciplines as its tool. For a long time, finance has been considered as a
rather sterile function concerned with a certain necessary recording of activities alone. financial
management makes a significant contribution to the management revolution that is taking place.

Financial management¶s central role is concerned with the same objectives as those of the
management; with the way in which the resources of the business are employed and how the
business is financed. Financial management has been divided into three main areas - decisions on
the capital structure; allocation of available funds to specific uses and analysis and appraisal of

problems. Financial management includes planning or finance, cash budgets and source of


$Financial management is the operational activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient operations". - Joseph and Massie.

"Financial management is an area of financial decision-making, harmonizing individual motives

and enterprise goals$% -Weston and Brigham.

"Financial management is the area of business management devoted to a judicious used of

capital and a careful selection of sources of capital in order to enable a business firm to move in
the direction of reaching its goals".-J.F.Bradlery.

µFinancial management is the application of the planning and control

Functions to the finance function". - Archer and Ambrosia.

"Financial management may be defined as that area or set of administrative functions in an

organization which relate with arrangement of cash and credit so that the organization may have
the means to carry out its objective as satisfactorily as possible." - Howard and ?

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Financial management evaluates how funds are procured and used. In all cases, it involves a
sound judgement, combined with a logical approach to decision-making. The core of a financial
policy is to maximize earnings in the long run and to optimize them in the short-run. This calls
for an evaluation of the conditions of alternative uses of funds and allocation of resources after
consideration of production and marketing inter-relationships. Financial management is
concerned with the efficient use of an improved resource, mainly capital funds.

Profit maximization should serve as the basic criterion for decisions arrived at by financial
managers of privately owned and controlled firms. Different alternatives are available to a

business enterprise in the process of decisions- making. Each alternative has its own
implications. Different courses of actions have to be evaluated on the basis of some analytical
framework and for this purpose, commercial strategies of an enterprise have to be taken into
consideration. The availability of funds depend upon the kind of commercial strategies adopted
by a firm during a particular period of time. Various different theories of financial management
provides an analytical framework for an evaluation of courses of action.

Maximization of profits is often considered to be a goal or an alternative goal of a firm.

However, this is somewhat narrow in concept than the goal of maximizing the value of the firm
because of the following reasons:

(a) The maximization of profits, as reflected in the earnings per share, is not an adequate goal in
the first place because it does not take into consideration time value of money.

(b) The concept of maximization of earnings per share does not include the risk of streams of
alternative earnings. A project may have an earning steam that will attain the goal of maximum
earnings per share; but when compared with the risk involved in it, it may be totally
unacceptable to a stockholder, who is generally hostile to risk-bearing activities.

(c) This concept of maximization of earnings per share does not take into account the impact of
dividend policy upon market price or value of the firm. Theoretically, a firm would never pay a
dividend if the objective is to maximize earnings per share. Rather, it would reinvest all its
earnings so as to generate greater earnings in the future.

Financial management techniques, are applicable to decisions of individuals, nonprofit

organizations and of business firms. Also, it is applicable to different situations in different

Financial managers are interested in providing answers to the following questions:

1.c aiven a firm¶s market position, the market demand for its products, its productive
capacity and investment opportunities, what specific assets should it purchase? This
Indirectly emphasizes the approach to capital budgeting.

].c aiven a firm¶s market position and investment opportunities, what is the total volume of
funds that it should commit? This indirectly emphasizes the composition of a firm¶s
3.c aiven a firm¶s market position and investment opportunities, how should it acquire the
funds which are necessary for the implementation of its investment decisions? This
underscores the approach to capital financing.

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Although in general profit maximization is the prime goal of financial management, there are
arguments against the same. The following table presents points in favour as well as against
profit maximization.

*,c -.: The goals of financial management may be such that they should be
beneficial to owners, management, employees and customers. These goals may be achieved only
by maximizing the value of the firm. The elements involved in the maximization of the wealth of
a firm is as below:

ccw#cA firm should increase its revenues in order to maximize its value. For this
purpose, the volume of sales or any other activities should be stepped up. It is a normal practice
for a firm to formulate and implement all possible plans of expansion and take every opportunity
to maximize its profits. In theory, profits are maximized when a firm is in equilibrium. At this
stage, the average cost is minimum and the marginal cost and marginal revenue are equal. A
word of caution, however, should be sounded here. An increase in sales will not necessarily
result in a rise in profits unless there is a market for increased supply of goods and unless
overhead costs are properly controlled.

/0cc Capital and equity funds are factor inputs in production. A firm has to make
every effort to reduce cost of capital and launch economy drive in all its operations.

0c #c 0/: A firm has to make a judicious choice of funds so that they maximize its
value. The sources of funds are not risk-free. A firm will have to assess risks involved in each
source of funds. While issuing equity stock, it will have to increase ownership funds into the
corporation. While issuing debentures and preferred stock, it will have to accept fixed and
recurring obligauons. The advantages of leverage, too, will have to be weighed properly.

0c 1 Different types of risks confront a firm. "No risk, no gain" - is a common
adage. However, in the world of business uncertainties, a corporate manager will have to
calculate business risks, financial risks or any other risk that may work to the disadvantage of the
firm before embarking on any particular course of action. While keeping the goal of
maximization of the value of the firm, the management will have to consider the interest of pure
or equity stockholders as the central focus of financial policies.

 0c "0 The goal of financial management should be to maximize long run value of
the firm. It may be worthwhile for a firm to maximize profits by pricing its products high, or by
pushing an inferior quality into the market, or by ignoring interests of employees, or, to be
precise, by resorting to cheap and "get-rich- quick" methods. Such tactics, however, are bound to
affect the prospects of a firm rather adversely over a period of time. For permanent progress and
sound reputation, it will have to adopt an approach which is consistent with the goals of financial
management in the long-run.


v Wealth maximization is a clear term. Here, the present value of cash flow is taken into
consideration. The net effect of investment and benefits can be measured clearly.

v It considers the concept of time value of money. The present values of cash inflows and
outflows helps the management to achieve the overall objectives of a company.

v The concept of wealth maximization is universally accepted, because, it takes care of interests
of financial institution, owners, employees and society at large.

v Wealth maximization guide the management in framing consistent strong dividend policy, to
earn maximum returns to the equity holders.

v The concept of wealth maximization considers the impact of risk factor, while calculating the
Net Present Value at a particular discount rate, adjustment is made to cover the risk that is
associated with the investments.


The concept of wealth maximization is being criticized on the following grounds:

The objective of wealth maximization is not descriptive. The concept of increasing the wealth of
the stockholders differs from one business entity to another. It also leads to confusion in, and

misinterpretation of financial policy because different yardsticks may be used by different
interests in a company.

As corporations have grown bigger and more powerful, their influence has become more
pervasive; they have created an imbalance which is widely believed to have been instrumental in
generating a movement to promote more socially conscious business behaviour. Academicians
and corporate officers alike have urged the advisability of more socially conscious business
management. Financial management will then have to rise equal to the acceptance of social
responsibility of business.

Financial management should not only maintain the financial health of a business,but should also
help to produce a rate of earning which will reward the owners adequately for the use of the
capital they have provided. To the creditors, the management must ensure administration, which
will keep the business liquid and solvent.

Moreover, financial management will have to ensure that expectations raised by the corporation
are fulfilled with a proper use of several tools at is disposal. In other words, it should ensure an
effective management of finance so that it may bear the desired fruits for the organization. If it is
properly supported and nurtured by efficient activities at all stages, it will positively ensure
desired results.

Financial management should take into account the enterprise¶s legal obligations to its
employees. It should try to have a healthy concern which can maintain regular employment
under favourable working conditions. However, a good financial management alone cannot
guarantee that a business will succeed. But it is a necessary condition for business success,
though not the only one. It may, however, be described as a pre-requisite of a successful
business. In other words, there are various other factors which may support or frustrate financial
management by supportive or non- supportive policies.

Wealth maximization is as important objective as profit maximization. The operating objective

for Financial Management is to maximize wealth or the net present worth of a firm. Wealth
maximization is an objective which has to be achieved by those who supply loan capital,
employees, society and management. The objective finds its place in these segments of the

corporate sector, although the immediate objectives of Financial Management may be to
maintain liquidity and improve profitability.

The wealth of owners of a firm is maximized by raising the price of the common stock. This is
achieved when the management of a firm operates efficiently and makes optimal decisions in
areas of capital investments, financing, dividends and current assets management. If this is done,
the aggregate value of the common stock will be maximized.

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The different dimensions of financial management are dealt below:

2c c / The financial manager has to forecast expected events in
business and note their financial implications. Financial Manager anticipates financial needs by
consulting an array of documents such as the cash budget, the pro-forma income statement, the
pro-forma balance sheet, the statement of the sources and uses of funds, etc. Financial needs can
be anticipated by forecasting expected funds in a business and their financial implications.

30c c 0 This implies knowing when, where and how to obtain the
funds which a business needs. Funds should be acquired well before the need for them is actually
felt. The financial manager should know how to tap the different sources of funds. He may
require short-term and long-term funds.

The terms and conditions of the different financial sources may vary significantly at a given
point of time. Much will also depend upon the size and strength of the borrowing firm. The
financial image of a corporation has to be improved in appropriate financial circles which are
primarily responsible for supplying finance.

c 0/cc 0 Allocating funds in a business means investing them in the best
plans of assets. Assets are balanced by weighing their profitability against their liquidity.
Profitability refers to the earning of profits and liquidity means closeness to money. The
financial manager should steer a prudent course between over-financing and under-financing. He
should preserve a proper balance among the various assets. He may adopt the famous marginal

principle which states that the last rupee invested in each kind of an asset should have the same
usefulness as the last rupee invested in any other kind of an asset. He should, moreover, allocate
funds according to their profitability, liquidity and leverage. So, while the primary financial
responsibility from the owner¶s viewpoint may be to maximize value, the financial executive¶s
primary managerial responsibility is to preserve the continuity of the flow of funds so that no
essential decision of the top management is frustrated for lack of corporate purchasing power.

/c ,c c #c 0/: Once the funds are allocated to various investment
opportunities it is the basic responsibility of the finance manager to watch the performance of
each rupee that has been invested. He has to adopt close supervision and marking of flow of
funds. This will ensure continuous flow of funds as per the requirements of the organisation.
This helps the management to increase efficiency by reducing the cost of operations & earn fair
amount of profits out of investments.

4c,c2#c#c#: Once the funds are administered, it is very comfortable

for the finance manager to take decisions. Through the budgeting, he will be able to compare the
actuals with standards. The returns on the investments must be continuous and consistent. The
cost of each financial decision and returns of each investment must be analysed. Where ever the
deviations are found, necessary steps or strategies are to be adopted to overcome such events.
This helps in achieving µLiquidity¶ of a business unit.

0c/c2cc Now, the role of the finance manager is changing.

The department of finance has gained substantial recognition. He not only acts as line executive
but also as staff. He has to advise and supply information about the performance of finance to top
management. He is also responsible for maintaining upto date records of the peformance of
financial decisions. If need arises, he has to offer his suggestion to improve the overall
functioning of the organisation. The financial manager will have to keep the assets intact, which
enable a firm to conduct its business. Asset management has assumed an important role in
Financial Management. It is also necessary for the finance manager to ensure that sufficient
funds are available for smooth conduct of the business. In this connection, it may be pointed out
that management of funds has both liquidity and profitability aspects. Financial Management is
concered with the many responsibilities which are the main thrust of a business enterprise.

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A priori definition of the scope of financial management fall into three groups. One view is that
finance is concerned with cash. At the other extreme is the relatively narrow definition that
financial management is concerned with raising and administering of funds to an enterprise. The
third approach is that it is an integral part of overall management rather than a staff specialty
concerned with fundraising operations. In this connection.

Financial Management plays two significant roles:

v To participate in the process of putting funds to work within the business and to control their
productivity; and

v To identify the need for funds and select sources from which they may be obtained.

The functions of financial management may be classified on the basis of liquidity, profitability
and management.

m5c30/4: Liquidity is ascertained on the basis of three important considerations:

(a) Forecasting cash flows, that is, matching the inflows against cash outflows;

(b) Raising funds, that is, financial management will have to ascertain the sources from which
funds may be raised and the time when these funds are needed;

(c) Managing the flow of internal funds, that is, keeping its accounts, with a number of banks to
ensure a high degree of liquidity with minimum external borrowing.

m 5cw#&4 While ascertaining profitability, the following factors are taken into account:

(a) Cost Control: Expenditure in the different operational areas of an enterprise can be analysed
with the help of an appropriate cost accounting system to enable the financial manager to bring
costs under control.

(b) Pricing: Pricing is of great significance in the company¶s marketing effort, image and sales
level. The formulation of pricing policies should lead to profitability, keeping, of course, the
image of the organization intact.

(c) Forecasting Future Profits: Expected profits are determined and evaluated. Profit levels have
to be forecasted from time to time in order to strengthen the organization.

(d) Measuring Cost of Capital: Each source of funds has a different cost of capital which must be
measured because cost of capital is linked with profitability of an enterprise.

m5c The financial manager will have to keep assets intact, for assets are resources
which enable a firm to conduct its business. Asset management has assumed an important role in
financial management. It is also necessary for the financial manager to ensure that sufficient
funds are available for smooth conduct of the business. In this connection, it may be pointed out
that management of funds has both liquidity and profitability aspects. Financial management is
concerned with the many responsibilities which are thrust on it by a business enterprise.
Although a business failure may not always be the result of financial failures, financial failures
do positively lead to business failures. The responsibility of financial management is enhanced
because of this peculiar situation.

Financial management may be divided into two broad areas of responsibilities, which are not by
any means independent of each other. Each, however, may be regarded

as a different kind of responsibility; and each necessitates very different considerations. These
two areas are:

v The management of long-term funds, which is associated with plans for development and
expansion, and which involves land, buildings, machinery, equipment, transport facilities,
research project, and so on;

v The management of short-term funds, which is associated with the overall cycle of activities of
an enterprise. These are the needs which may be described, as working capital needs.

One of the functions of financial management is co-ordination of different activities of a business
house. A business depends upon availability of funds which, in turn, depends upon the extent to
which a firm is able to effect cash sales.

Financial management must offer a solution for decisions in areas of capital structure,
investment, dividend distribution, and retention of surplus inter-alia. The investment decision
involves current cash outlay in anticipation of benefits to be realised in the future. The uncertain
nature of future benefits necessitates evaluation of investment proposals in relation to their
expected rate of return and risk. Once the investment proposals are evaluated and combined into
a capital expenditure programme or planned capital budget, the next decision involves
finalisation of sources for a given capital outlay. In other words, the financing decision involves
the determination of the ideal financing mix or capital structure. For deciding the dividend
policy, the percentage of earnings paid to shareholders becomes an important consideration. It is
obvious that the percentage of dividend policy paid affects the quantum of retained earnings. The
dividend policy is thus instrumental for changes in market price of shares in the capital market.

A prudent financial management policy calls for an optimal mix of different decisions in line
with organizational objectives. Today, financial management extends itself to the broad subject
of international money management which refers to the problem of collecting, utilising and
protecting the financial assets of internationally involved companies. This includes both ²
operating responsibilities of a multi-national corporation and providing the array of techniques
and tools available to co-ordinate that task. This task is already difficult in domestic companies.
But the task becomes more onerous on account of grated structural and environmental
impediments confronting multi-national companies. New problems in managing and
administering finances of companies have emerged following the increasing international
financing of domestic companies and the entry of foreign collaborations, problems of dealings
between parents and subsidiaries speaking in multiple languages, heavy reliance on
communication environments, following diverse legal practices, different tax umbrellas and
exchange, control system among others.

It has become imperative to have reporting systems and optimal use of financial institutions
attempting to forecast liquidity and foreign exchange risks of companies.

International cash management deals with more mechanical areas of cash collection, holding and
disbursement. International cash management involves longer distances, exchange controls
different currency units and multiple financial institutions.

A variety of instruments exist for effecting international transfer of funds. There may be payment
instructions in written or documentary form incorporating some form of credit. The standard
method of transferring funds internationally is by mail payment order, which is a lengthy
process. Cable transfers reduce remittance time appreciably. Other international modes of
payment include bank drafts, cheques and trade bills. Sight and time drafts, acceptances and
letters of credit are termed as documentary credits.

The international liquidity management is regulated by exchange control and other barriers
which usually prohibit the flow of funds in desired directions. Funds held by individual
subsidiaries in different countries cannot be considered fungible and there is little or no chance
of international pooling of funds. Even intra-country liquidity management may be affected by
weak capital markets which offer few investment media or banking systems which delay
transfers. This area is also affected by impediments in banking and mail systems.

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The financial manager performs important activities in connection with each of the general
functions of the management. He groups activities in such a way that areas of responsibility and
accountability are cleared defined. The profit centre is a technique by which activities are
decentralised for the development of strategic control points. The determination of the nature and
extent of staffing is aided by financial budget programme. Direction is based, to a considerable
extent, on instruments of financial reporting. Planning involves heavy reliance on financial tools
and analysis. Control requires the use of the techniques of financial ratios and standards. Briefly,
an informed and enlightened use of financial information is necessary for the purpose of co-
ordinating the activities of an enterprise. Every business, irrespective of its size, should,
therefore, have a financial manager who has to take key decisions on the allocation and use of
money by various departments. Specifically the financial manager should anticipate financial
needs; acquire financial resources; and allocate funds to various departments of the business. If

the financial manager handles each of these tasks well, his firm is on the road to good financial
health. The financial manager¶s concern is to:

v Determine the total amount of funds to be employed by a firm;

v Allocate these funds efficiently to various assets;

v Obtain the best mix of financing in relation to the overall evaluation of the firm.

Since the financial manager is an integral part of the top management, he should so shape his
decisions and recommendations as to contribute to the overall progress of the business, on which
depends the value of the firing. That is his primary objective is to maximise the value of the firm
to its stockholders.

Although, decisions are the end product of the financial manager¶s task, his day-to-day work
consists of more than just decision-making. A great deal of his time is spent on financial
planning, which may be described as the co-ordination of a series of inter-dependent decisions
over an extended period. Of the many environments in which the firm operates, the one closest to
the financial manager is the financial market, which ultimately determines whether a firm¶s
policies are a success or a failure. In a fundamental sense, financial management is nothing more
or less than a continuing two-way interaction between a firm and its financial environment.

It has been explained earlier that financial management is related to the environment, which is
external to a firm. This environment is the macro-economic environment, which includes the
study of the financial market. The logic here is very simple. A firm is a part of the entire business
activity, which is reflected in the financial market. The financial market is sensitive to the
reactions of firms to the supply of, and demand for, its securities. No firm can, therefore, exempt
itself from undertaking a study of the financial market. It is in this sense that financial
management makes a kind of an integrated approach to the external environment.

The financial manager should:

v Supervise the overall working of an organization instead of confining himself to technical

matters as a top management executive

v Make sure that funds have been acquired in sufficient, but not excessive amounts

v Ensure that disbursements do not create shortage of funds

v Analyse, plan and control the use of funds

v Maintain liquidity while retaining the acceptable level of profits

v Economise on the acquisition of funds and hold down their cost

v Make allowances for uncertainties that exist in the business world

v Administer effectively cash, receivables, inventory and other components of working capital

v Analyse financial aspects of external growth

v Develop the means to rejuvenate and revitalise the enterprise or to assist in liquidity and
distribution of its assets to the various claimants.

A financial manager is often up against a dilemma. He has to choose between profitability and
liquidity. Although both are desirable, sometimes one has to be sacrificed for the other. Since
cash earns no return, a firm increases its liquidity at the cost of its profitability. The financial
manager does something more than co-ordinate business activities in a mechanical way. His
central role requires that he understands the nature of problems so that he may take proper
decisions. In several situations, he faces a challenge: should he choose profitability or liquidity?
Despite the knowledge that a particular investment is quite profitable, he is forced to sacrifice
this option, if the investment is going to lock up funds for an unreasonable period; the longer the
period, the greater is the risk. Most financial managers are, therefore, tempted to compromise
between profitability and liquidity, and select projects which are reasonably profitable and, at the
same time, sound from the liquidity point of view.


Anowledge of economics is necessary for the understanding of financial environment and the
decision theories which underline contemporary financial management. Macro-economics gives

an insight into the policies of the government and private institutions through which money
flows, credit flows and general economic activity are controlled.

In recent years, a significant change has taken place in the study of financial management, as it
has in all other aspects of business and public administration. A considerable progress has been
made in the development of theoretical structures for the solution of business problems. The
model-building approach to financial management has been developed from two separate
branches of study - economics and operations research, aided by computer science. The link
between economics and financial management is close. A study of financial management is
likely to be barren if it is divorced from the study of economics. Financial management has, in
fact, evolved over the years as an autonomous branch of economics.


It is of greater managerial interest to think of financial management as something of which

accounting is a part, which is concerned mainly with the raising of funds, in the most economic
and suitable manner; using the funds as profitably as possible (for a given risk level); planning
future operations and controlling current performance and future developments through financial
accounting, cost accounting, budgeting, statistics and other means.

Effective planning and direction depends on adequate accounting information available to a

management on the financial condition of an enterprise. This includes:

Decisions which affect external, legal and financial relationships of funds; decisions on
methods of financing, fixed and working capital in general
Financial structure, credit policy, payment of dividends, creation of reserves
Decisions which are mainly internal and refer to the deployment of funds on different projects
Quasi-financial decisions which arise from marketing; personnel, production or any other
discipline and other problems which have financial aspects
Decisions for which accounting records and reports are widely used.

Accounting is a tool for handling only the financial aspects of business operations. It is geared to
the financial ends of a business only because these are measurable on the scale of money values.

The distinction between financial management and management accounting is a semantic one,
but the gap between the two is rapidly closing. Financial management, however, has the broader
meaning of planning and control of all activities by financial means, while management
accounting originally meant the internal management of finance in industry. The accountant
devotes his attention to the collection and presentation of financial data. The financial officer
evaluates the accountant¶s statements, develops additional data and arrives at decisions based on
his analysis.

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The main stream of academic writing and teaching followed the scope and pattern suggested by
the narrower and by now traditional definition of the finance function. Financial management, as
it was then more generally called, emerged as a separate branch of economics. The traditional
approach to the entire subject of finance was from the point of view of the investment banker
rather than that of the financial decision-maker in an enterprise. The traditional treatment placed
altogether too much emphasis on corporation finance and too little on the financing problems of
non-corporate enterprises.

The sequence of treatment was built too closely around the episodic phases during the life cycle
of a hypothetical corporation in which external financial relations happened to be dominant.
Matters like promotion, incorporation, merger, consolidation, recapitalization and reorganization
left too little room for problems of a normal growing company. Finally, it placed heavy emphasis
on long-term financial instruments and problems and corresponding lack of emphasis on
problems of working capital management. The basic contents of the traditional approach may
now be summarised.

The emphasis in the traditional approach is on raising of funds

The traditional approach circumscribes episodic financial function
The traditional approach places great emphasis on long-term problems
It pays hardly any attention to financing problems of non-corporate enterprises.

It is difficult to say at what stage the traditional approach was replaced by modern approach. It is
clear, however, that Ezra Solomon, Thomas L. Rein, Edward S. Meade and Arthur Stone Dewing

among others were profoundly impressed by subjects like promotion, securities, floatations,
reorganization, consolidations, liquidation, etc. Their works laid emphasis on these topics. They
did not consider routine managerial problems relating to financing of a firm, problems of profit
planning and control, budgeting, finance and cost control, and working capital management
which constitute the crux of the financial problems of modern financial management.

The central issue of financial policies is a wise use of funds and the central process involved is a
rational matching of advantages of potential uses against the caution of advantages of potential
uses against the caution of alternative potential sources so as to achieve broad financial goals
which an enterprise sets for itself. The new or modern approach is an analytical way of looking
at the financial problems of a firm. Financial problems are a vital and an integral part of overall
management. In this connection, Ezra Solomon observes: If the scope of financial management
is re-defined to cover decisions about both the use and the acquisition of funds, it is clear that the
principal content of the subject should be concerned with how financial management should
make judgements about whether an enterprise should hold, reduce, or increase its investments in
all forms of assets that require company funds.

With the advent of industrial combination the financial manager of corporation was confronted
with the complexities of budgeting and financial operations. The size and composition of the
capital structure was of particular importance. The major concern of financial management was
survival. Its attitude to long-term trade was hostile. It looked upon dividend as a residual
payment. The discipline of financial management was conditioned by changes in the socio-
economic and legal environment. Its emphasis shifted from profitability analysis to cash flow
generation; and it developed an interest in internal management procedures and control. In the
circumstances, cost, budget forecasting, aging of accounts receivable and monetary management
assured considerable importance.

With technological progress, financial management was almost forced to improve its
methodology. Such things as cost of capital, optimal capital structure, effects of capital structure
upon cost of capital and market value of a firm were incorporated in the subject. Moreover,
financial management laid emphasis on international business and finance, and showed a serious
concern for the effects of multi-nationals upon price level movements. The concern for liquidity

and profit margins was indeed tremendous throughout the several phases of financial
management. Modern financial management, however, is basically concerned with optimal
matching of uses and sources of corporate funds that lead to the maximisation of a firm¶s market

0cc#c cc

It would indeed be an extremely difficult task to delineate functions of modern financial

management. The subject management has been stretched to such a limit that a finance manager
today has to be conversant with a large variety of subjects, while the traditional finance manager
concerned him with such macroeconomic areas of finance as long-term financing, short-term
financing, study of financial institutions, capital market (more particularly, the stock exchange),
promotion, planning of corporations, underwriting of securities, and so on. A lot of literature on
the subject of Financial Management seems to be devoted to these and similar matters. These
areas, to be precise, belong to corporation finance. Modern Financial Management should hence
forward concentrate on micro- economic areas with which a business enterprise has to deal
during its day-to-day operations.

A Large number of empirical studies on the subject have already been conducted on different
portfolios of Financial Management, some of which have been tested, while others, which were
not tested, were rejected by corporate decision-makers. For example, capital structure and, more
particularly, the cost of different sources of funds, dividend policies, depreciation policies,
retention of surpluses, liquidity, profit planning and control - these are among the subjects which
have captured the attention of different schools of thoughts from time to time. The functional
areas of financial management is elaborated below.

c c/ One of the most important functions of the financial manager is
to ensure availability of adequate funds. Financial needs have to be assessed for different
purposes. Money may be required for initial promotional expenses, fixed capital and working
capital needs. Promotional expenditure includes expenditure incurred in the process of company
formation. Fixed assets needs depend upon the nature of the business enterprise - whether It is a

manufacturing, non-manufacturing or merchandising enterprise. Current asset needs depend
upon the size of the working capital required by an enterprise.

0cc 0cc#c#cc

c,c0c#c 0/: The financial manager has to choose the various sources of
funds. He may issue different types of securities. He may borrow from a number of financial
institutions and the public. When a firm is new and small and little known in financial circles, the
financial manager faces a great challenge in raising funds. Even when he has a choice in
selecting sources of funds, he should exercise it with great care and caution. A firm is committed
to the lenders of finance and has to meet various terms and conditions on which they offer credit.
To be precise, the financial manager must definitely know what he is doing.

c 4: It is the evaluation and interpretation of a firm¶s financial position and
operations, and involves the comparison and interpretation of accounting data. The financial
manager has to interpret different statements. He has to use a large number of ratios to analyse
the financial status and activities of his firm. He is required to measure its liquidity, determine its
profitability and assets and overall performance in financial terms. This is often a challenging
task, because he must understand the importance of each one of these aspects to the firm and he
should be crystal clear in his mind about the purposes for which liquidity, profitability and
performance are to be measured.

2c2c00 The financial manager has to establish an optimum capital structure

and ensure the maximum rate of return on investment. The ratio between equity and other

liabilities carrying fixed charges has to be defined. In the process, he has to consider the
operating and financial leverages of his firm. The operating leverage exists because of operating
expenses, while financial leverage exists because of the amount of debt involved in a firm¶s
capital structure. The financial manager should have adequate knowledge of different empirical
studies on the optimum capital structure and find out whether, and to what extent, he can apply
their findings to the advantage of the firm.

 "0 w#c 4: This is popularly known as the µCVP relationship¶. For this
purpose, fixed costs, variable costs and semi-variable costs have to be analysed. Fixed costs are
more or less constant for varying sales volumes. Variable costs vary according to sales volume.
Semi-variable costs are either fixed or variable in the short run. The finance manager has to
ensure that the income for the firm will cover its variable costs, for there is no point in being in
business, if this is not accomplished. Moreover, a firm will have to generate an adequate income
to cover its fixed costs as well. The finance manager has to find out the break- even-point (i.e),
the point at which total costs are matched by total sales or total revenue. He has to try to shift the
activity of the firm as far as possible from the break-ever point to ensure company¶s survival
against seasonal fluctuations.

w#cwc/c Profit planning and control have assumed great importance in the
financial activities of modern business. Economists have long before considered the importance
of profit maximization in influencing business decisions. Profit planning ensures attainment of
stability and growth. In view of the fact that earnings are the most important measure of
corporate performance, the profit test is constantly used to gauge success of a firm¶s activities.

Profit planning is an important responsibility of the finance manager. Profit is the surplus which
accrues to a firm after its total expenses are deducted from its total revenue. It is necessary to
determine profits properly, for they measure the economic viability of a business. The first
element in profit is revenue or income. This revenue may be from sales or it may be operating
revenue, investment income or income from other sources. The second element in profit
calculation is expenditure. This expenditure may include manufacturing costs, trading costs,
selling costs, general administrative costs and finance costs.

Profit planning and control is a dual function which enables management to determine costs it
has incurred, and revenues it has earned, during a particular period, and provides shareholders
and potential investors with information about the earning strength of the corporation. It should
be remembered that though the measurement of profit is not the only step in the process of
evaluating the success or failure of a company, it is nevertheless important and needs careful
assessment and recognition of its relationship to the company¶s progress. Profit planning and
control are very important. In actual practice, they are directly related to taxation. Moreover, they
lay the foundation for policies, which determine dividends, and retention of profits and surpluses
of the company. Profit planning and control are inescapable responsibilities of the management.
The break-even analysis and the CVP relationship are important tools of profit planning and

-/c c  A firm¶s fixed assets include tangibles such as land, building,
machinery and equipment, furniture and also intangibles such as patents, copyrights, goodwill,
and so on. The acquisition of fixed assets involves capital expenditure decisions and long-term
commitments of funds. These fixed assets are justified to the extent of their utility and/or their
productive capacity. Because of this long-term commitment of funds, decisions governing their
purchase, replacement, etc., should be taken with great care and caution. Often, these fixed assets
are financed by issuing stock, debentures, long-term borrowings and deposits from public. When
it is not worthwhile to purchase fixed assets, the financial manager may lease them and use
assets on a rental basis. To facilitate replacement of fixed assets, appropriate depreciation on
fixed assets has to be formulated. It is because of these facts that management decisions on the
acquisition of fixed assets are vital. If they are ill-designed, they may lead to over-capitalisation.
Moreover, in view of the fact that fixed assets are maintained over a long period of time, these
assets are exposed to changes in their value, and these changes may adversely affect the position
of a firm.

w'c wc /c 0: A substantial portion of the initial capital is sunk in long-
term assets of a firm. The error of judgment in project planning and evaluation should be
minimized. Decisions are taken on the basis of feasibility and project reports, containing analysis
of economic, commercial, technical, financial and organizational viabilities. Essentiality of a
project is ensured by technical analysis. The economic and commercial analysis study demand

position for the product. The economy of size, choice of technology and availability of factors
favouring a particular industrial site are all considerations which merit attention in technical
analysis. Financial analysis is perhaps the most important and includes forecasting of cash in-
flows and total outlay which will keep down cost of capital and maximize the rate of return on
investment. The organizational and manpower analysis ensures that a firm will have the requisite
manpower to run the project. In this connection, it should be remembered that a project is
exposed to different types of uncertainties and risks. It is, therefore, necessary for a firm to gauge
the sensitivity of the project to the world of uncertainties and risks and its capacity to withstand
them. It would be unjustifiable to accept even the most profitable project if it is likely to be the

2c 0/: Capital budgeting decisions are most crucial; for they have long-term
implications. They relate to judicious allocation of capital. Current funds have to be invested in
long-term activities in anticipation of an expected flow of future benefits spread over a long
period of time. Capital budgeting forecasts returns on proposed long-term investments and
compares profitability of different investments and their cost of capital. It results in capital
expenditure investments. The various proposal assets ranked on the basis of such criteria as
urgency, liquidity, profitability and risk sensitivity. The financial analyser should be thoroughly
familiar with such financial techniques as pay back, internal rate of return, discounted cash flow
and net present value among others because risk increases when investment is stretched over a
long period of time. The financial analyst should be able to blend risk with returns so as to get
current evaluation of potential investments.

*1c 2c : Working capital is rightly an adjunct of fixed capital

investment. It is a financial lubricant which keeps business operations going. It is the life-blood
of a firm. Cash, accounts receivable and inventory are the important components of working
capital, which is rotating in its nature. Cash is the central reservoir of a firm that ensures
liquidity. Accounts receivables and inventory form the principal of production and sales; they
also represent liquid funds in the ultimate analysis. The financial manager should weigh the
advantage of customer trade credit, such as increase in volume of sales, against limitations of
costs and risks involved therein. He should match inventory trends with level of sales. The
uncertainties of inventory planning should be dealt within a rational manner. There are several

costs and risks which are related to inventory management. The risks are there when inventory is
inadequate or in excess of requirements. The former may hold up production, while the latter
would result in an unjustified locking up of funds and increase the cost of capital. Inventory
management entails decisions about the timing and size of purchases purely on a cost basis. The
financial manager should determine the economic order quantities after considering the
relationships of different cost elements involved in purchases. Firms cannot avoid making
investments in inventory because production and deliveries involve time lags and discontinuities.
Moreover, the demand for sales may vary substantially. In the circumstances, safety levels of
stocks should be maintained. Inventory management thus includes purchase management and
material management as well as financial management. Its close association with financial
management primarily arises out of the fact that it is a simple cash asset.

//cw Dividend policies constitute a crucial area of minancial management. While

owners are interested in getting the highest dividend from a corporation, the board of directors
may be interested in maintaining its financial health by retaining the surplus to be used when
contingencies arise. A firm may try to improve its internal financing so that it may avail itself of
benefits of future expansion. However, the interests of a firm and its stockholders are
complementary, f or the ginancial management is interested in maximising the value of the firm,
and the real interest of stockholders always lies in the maximisation of this value of the firm; and
this is the ultimate goal of financial management. The dividend policy of a firm depends on a
number of financial considerations, the most critical among them being profitability. Thus, there
are different dividend policy patters which a firm may choose to adopt, depending upon their
suitability for the firm and its stockholders.

30c /c  Firms may expand externally through co-operative arrangements,
by acquiring other concerns or by entering into mergers. Acquisitions consist of either the
purchase or lease of a smaller firm by a bigger organization. Mergers may be accomplished with
a minimum cash outlay, though these involve major problems of valuation and control. The
process of valuing a firm and its securities is difficult, complex and prone to errors. The financial
manager should, therefore, go through the valuation process very carefully. The most difficult
interest to value in a corporation is that of the equity stockholder because he is the residual

2c -: Corporate taxation is an important function of the financial management,
for the former has a serious impact on the financial planning of a firm. Since the corporation is a
separate legal entity, it is subject to an income- tax structure which is distinct from that which is
applied to personal income.

The traditional notion that the finance function is simply a process of µmanaging cash and
capital¶ or planning and controlling profits, fails to cover the scope of modern financial
management. Today¶s finance manager is engaged in such activities for the construction of
models as to direct the search for new information, set performance standards, rationalise
operating rules, and establish operating control. It is, in brief, an all-encompassing function. Its
objective is first to select the items of financial information which are relevant to a particular
problem, and second, to fit these items into a coherent picture of the problem in relation to the
firm¶s aims and financial resources. The final objective of financial management is to suggest
alternative solutions to problems. However, in actual practice, the modern executive, who is
buried in a maze of seemingly endless statistics and voluminous reports, is constantly struggling
to gain real financial control, The financial controller is often behaviorally more concerned with
expenditure than with profits. He tends to become a person who wants to keep his financial
resources intact, spends nothing, and completely avoids undertaking risk. Infact, the management
of finance should have the optimal use of funds as its focal point. The auditing approach should
give place to a decision-making approach. The new demands on the finance manager call for a
basic transformation in his approach because he plays a crucial role in the future success of the
organisation. And this is a challenge which he has to face.

An analysis of financial data with the help of scientific tools and techniques to improve
performance of an undertaking (and to achieve better operating results and better quality of
products) is essential n0wdays a day. It is necessary to take a fresh look at finance management
in most Indian industries. The management of capital in Indian industries is generally anchored
to traditional legacies and practices. This is true for both private and public sectors.

The modern tools of management, including capital management, performance budgeting, cost
control, organizational development and R & D, have not yet become popular with the captains
of our industry. There is an absence of data on the marginal efficiency of capital, input-output

analysis, technical co-efficient, etc., which render current evaluation of issues somewhat
difficult. The preponderance of proprietary, partnership and private companies has made
industrial units something like closed shops. The management of these sectors is rested in family
complexes about which there is no adequate information. Moreover, social obligations, growth
potents, technical feasibility of financial planning and flow, and physical productivity - these
need a better re-orientation and gearing up of capital management practices. The vagaries of
government policy on dividend payments and tax rates and limits on share capital floatation have
resulted in a low and uncertain supply of funds to the equity market. As a consequence, business
houses are forced to look for their borrowings elsewhere as the only reliable method of finance,
even when the cost of these borrowing is relatively high. The present behaviour of financial
management is a result of government policy, in an uncertain capital market.

c c

Financial decisions are the decisions relating to financial matters of a corporate entity. Financial
requirement, Investment, Financing and Dividend Decisions are the most important areas of
financial management, which facilitate a business firm to achieve wealth maximisation.
Financial decisions have been considered as the means to achieve long-term objective of the

0/c 30c : Financial requirement decision is one of the most important
decisions of finance manager. This decision is considered with estimation of the total funds
required by a business unit. The total amount of capital and revenue expenditure of a company
facilitates the financial manager in finding the total funds requirement. Capital expenditure
consists of acquiring fixed assets. Revenue expenditure consists of maintaining the day-to-day

activities of a business unit. Hence the total of this expenditure helps the finance manager in
determining the total funds requirement.

c : Investment decision is concerned with allocation of funds to both capital
and current assets. Capital assets are financed through long-term funds and current assets are
financed through short-term funds. The financial manager has to carefully allocate the available
funds to recover not only the cost of funds but also must earn sufficient returns on the
investments. Capital budgeting, CVP analysis are the techniques generally used fir the process of
investment decisions.

c cFinancing decision is concerned with identification of various sources of

funds. Funds are available through primary market, financial institution and through the
commercial banks. Cost associated with each of the instrument or source is different. The overall
cost of that capital composition must be kept at minimum proper debt. Equity ratio should be
maintained to maximize the returns to the shareholders. This decision will be made by
considering the different factors. viz., inflation, size of the organisation, government policies,

//c : Regular and assured percentage of dividend and capital gains are the basic
desires of equity shareholders. The overall objective of a corporation is to fulfill the desires of
the shareholders and attain wealth maximization in the long run. This decision has been
considered as the barometer through which a business firm¶s performance is measured. The
suppliers of materials, bankers, creditors, shareholders and the government will measure and
understand the soundness of the company through dividend decisions. Therefore, dividend
decision has been considered as another important decision of the finance function.


1.c "Financial management is the appendage of the finance function". - Comment.

].c State the objectives of financial management.
3.c Indicate the possible areas of conflict between management and stockholders.
4.c Discuss briefly the scope and functions of financial management.
5.c State the role of the financial manager and explain his functions in an organization.

[.c Describe the evolution of financial management.
7.c Discuss briefly different functional areas of financial management.
8.c Distinguish between:
a.c Financial management and economics;
b.c Financial management and accounting.
9.c Discuss briefly the problems of international financial management.

c c



A project is an activity that involves investing a sum of money now in anticipation of benefits
spread over a period of time in the future. How do we determine whether the project is
financially viable or not? Our immediate response to this question will be to sum up the benefits
accruing over the future period and compare the total value of the benefits with the initial
investment. If the aggregate value of the benefits exceeds the initial investment, we will consider
the project to the financially viable. While this approach prima facia appears to be satisfactory,
we must be aware of an important assumption that underlies our approach. We have assumed
that irrespective of the time when money is invested or received, the value of money remains the
same. We know intuitively that this assumption is incorrect because money has time value. How
do we define this value of money and build it into the cash flow of a project? The answer to this
question forms the subject matter of this lesson.

c &'c

On reading this lesson, you will be conversant with the:

Meaning of time value of money

Future value of a single cash flow
Future value of an annuity
Present value of single cash flow

Present value of an annuity

Money has time value. A rupee today is more valuable than a rupee a year hence. Why? There
are several reasons:

Individuals, in general, prefer current consumption to future consumption.

Capital can be employed productively to generate positive returns. An investment of one rupee
today would grow to (1+r) a year hence (r is the rate of return earned on the investment).
In an inflationary period, a rupee today represents a greater real purchasing power than a rupee
a year hence.

  c  c


Many financial problems involve cash flows occurring at different points of time. For evaluating
such cash flows an explicit consideration of time value of money is required. This chapter,
discussing the methods for dealing with time value of money, is divided into four sections as

Future value of a single cash flow

Future value of an annuity
Present value of a single cash flow
Present value of an annuity


Suppose you have Rs. 1,000 today and you deposit it with a financial institution, which pays 10
per cent interest compounded annually, for a period of 3 years. The deposit would grow as



The general formula for the future value of a single cash flow is:

FVn = PV (I + k) n

FVn= future value n years hence

PV= cash flow today (present value)

k = interest rate per year

n = number of years for which compounding is done. The growth of future value is shown in the
following Table:1

&cc 00c"0c#ccc,c c

Equation (1) is a basic equation in compounding analysis. The factor (1 + k)n is referred to as the
compounding factor or the future value interest factor (FVIFk,n). It is very tedious to calculate (1
+ k)¶. To reduce the tedium, published tables are available showing the value of (1 + k) n for
various combinations of k and n. Table ] shows some typical values of (I + k) n.

&c c"0c#c " 18c#c"0c&c#c1c/cc

For example, if you deposit Rs. 1,000 today in a bank which pays 10 per interest interest
compounded annually, how much will the deposit grow to after 8 years and 1] years? The future
value, 8 years hence will be:

Rs. 1,000 (1.10) 8 = Rs. 1,000 (].144)

= Rs. ],144

The future value, 1] years hence, will be:

Rs. 1,000 (1.1W1] = Rs. 1,000 (3.138)

= Rs. 3.138


It shows graphically how one rupee would grow over time for different interest rates. Naturally,
the higher the interest rate, the faster the growth rate. We have plotted the growth curves for
three interest rates: 0 per cent, [ per cent and 1] per cent. arowth curves can be readily plotted
for other interest rates.


Investors commonly ask the question: How long would it take to double the amount at a given
rate of interest? To answer this question we may look at the future interest factor table. Looking
at the above table we find that when the interest rate is 1] percent it takes about [ years to double
the amount, when the interest rate is [ percent it takes about 1] years to double the amount, so on
and so forth. Is there a rule of thumb which dispenses with the use of the future value interest

factor table? Yes, there is one and it is called rule of 7]. According to this rule of thumb the
doubling period is obtained by dividing 7] by the interest rate. For example, if the interest rate is
8 percent, the doubling period is about 9 years (7]/8). Likewise, if the interest rate is 4 percent
the doubling period is about 18 years (7]/4). Though somewhat crude, it is a handy and useful
rule of thumb.

If you are inclined to do a slightly more involved calculation, a more accurate rule of thumb is
the rule of [9. According to this rule of thumb, the doubling period is equal to:

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


To calculate the compound rate of growth of some series, say the sales series or the profit series,
over a period of time, we may employ the future value interest factor table. The process may be
demonstrated with the help of the following sales data for Alpha Limited.

What has been the compound rate of growth in the sales of Alpha for the period 1981-87, a six-
year period? This question may be answered in two steps:

Step 1: Find the ratio of sales of 1987 to 1981. This is simply: 99/50 = 1.98.

Step ]: Consult the FVIFk, n table and look at the row for [ years, till you find a value which is
closest to 1.98 and then read the interest rate corresponding to that value.

In this case, the value closest to 1.98 is 1.974 and the interest rate corresponding to is 1] per
cent. Hence, the compound rate of growth is 1] per cent.


So far, we assumed that compounding is done annually. Now, we consider the case where
compounding is done more frequently. Suppose, you depoit Rs. 1,000 with a finance company
which advertises that it pays 1] per cent interest semi-annually² this means that interest is paid
every six months. Your deposit (if interest is not withdrawn) grows as follows:

Note that, if compounding is done annually the principal at the end of one year would be Rs.
1,000 (1.1]) = Rs. 1.1]0.0. The difference of Rs. 3.[ (between Rs.1,1]3.[0 under semi-annual
compounding and Rs. 1,1]0.0 under annual compounding represents interest on interest for the
second [ months.

The general formula value of a single cash flow when compounding is done more frequently
than annually is:

Where FVn = future value after n years

PV= cash flow today (present value)

k = nominal annual rate of interest

m = number of times compounding is done during a year

n = number of years for which compounding is done.

Example: How much does a deposit of Rs. 5,000 grow to at the end of [ years, if the nominal
rate of interest is 1] per cent and the frequency is 4 times a year?

The amount after [ years will be:

Rs. 5,000 (1 ÷0.1]) 4.[ = Rs. 5,000 (1.03) ]4

= Rs. 5,000 x ].03]8 = Rs. 10,1[4


We have seen above that Rs. 1,000 grows to Rs. 1,1]3.[ at the end of a year if the nominal rate
of interest is 1] per cent and compounding is done semi-annually. This means that Rs. 1,000
grows at the rate of 1].3[ per cent per annum. The figure of 1].3[ per cent is called the effective
rate of interest²the rate of interest under annual compounding which produces the same result
as that produced by an interest rate of 1] per cent under semi-annual compounding.

The general relationship between the effective rate of interest and the nominal rate of interest is
as follows:

Where r = effective rate of interest

k = nominal rate of interest

m = frequency of compounding per year

Example a bank offers 8 per cent nominal rate of interest with quarterly compounding.

What is the effective rate of interest?

The effective rate of interest is:

Table 5 gives the relationship between the nominal and effective rates of interest for different
compounding periods. In general, the effect of increasing the frequency of compounding is not as
dramatic as some would believe it to be²the additional gains dwindle as the frequency of
compounding increases.


An annuity is a series of periodic cash flows (payments or receipts) of equal amounts. The
premium payments of a life insurance policy, for example, are an annuity. When the cash flows
occur at the end of each period the annuity is called a regular annuity or a deferred annuity.
When the cash flows occur at the beginning of each period the annuity is called an annuity due.
Our discussion here will focus on a regular annuity²the formulae of course can be applied, with
some modification, to an annuity due. Suppose you deposit Rs. 1,000 annually in a bank for 5
years and your deposits earn a compound interest rate of 10 per cent, what will be the value of
this series of deposits (an annuity) at the end of 5 years? Assuming that each deposit occurs at
the end of the year, the future value of this annuity will be:

Rs. 1,000(1.l0) + Rs. 1,000(1.10) 3 + Rs. 1,000 (1.10) ] + Rs. 1,000 (1.10) + Rs. 1,000 = Rs.
1,000 (1.4[41) + Rs. 1.000 (1.3310) + Rs. 1,000 (1.]100) + Rs. 1,000 (1.10) + Rs. 1,000= Rs.

The time line for this annuity is shown in the following.


In general terms the future value of an annuity is given by the following formula:

FVAn = A (1+k)n + A (1+k)n-] +A

Where FVAn= future value of an annuity which has a duration of n periods

A= consant periodic flow

k= interest rate per period

n= duration of the annuity

The term is referred to as the future value interest factor for an annuity

(FVIFA k, n). The value of this factor for several combinations of k and a is in following table.

&c9c"0c#c ""c 18cc#c0c&c#c1c/c

Example: Four equal annual payments of Rs. ],000 are made into a deposit account that pays 8
per cent interest per year. What is the future value of this annuity at the end of 4 years?

The future value of this annuity is:

Rs. ],000 (FVIFA8%, 4) = Rs. ],000 (4.507)= Rs. 9,014

1c 0/c 

Equation (4) shows the relationship between FI¶A A, Ic and a. Juggling it a bit, we get:

In Eq. (5), the inverse of FVIFA ,, is called the sinking (1+ky-¶fund factor.

Equation (5) helps in answering the question: How much should be deposited periodically to
accumulate a certain sum at the end of a given period? The periodic deposit is simply A and it is
obtained by dividing FVAn by FV1FA.k,n

-2cHow much should you save annually to accumulate Rs. ]0,000 by the end of 10 years,
if the saving earns an interest of 1] per cent?


aiven the relationship between FVAn, A, k, and n, the interest rate (k) can be easily figured out if
the values of the other three²FVn, A, and. n,²are known.

Example: A finance company advertises that it will pay a lumpsum of Rs. 8,000 at the end of [
years to investors who deposit annually Rs. 1,000 for [ years. What interest rate is implicit in this

The interest rate may be calculated in two steps:

1. Find the FVIFAA[ for this contract as follows:

Rs. 8,000 = Rs. 1,000 x FV1FA,k,[

]. Look at the FVIFAk,n table and read the mw corresponding to [ years until you find a value
close to 8,000. Doing so, we find that

FVIFA1]%,[ is 8.115

So, we conclude that the interest rate is slightly below 1] per cent.


Suppose, someone promises to give you Rs. 1,000 three years hence. What is the present value of
this amount if the interest rate is 10 per cent? The present value can be calculated by discounting
Rs. 1,000, to the present point of time, as follows:


The process of discounting, used for calculating the present value, is simply the inverse of
compounding. The present value formula can be readily obtained by manipulating the
compounding formula:

Dividing both the sides of Eq. (4.1) by (l+k)n, we get,

The factor

in Eq. (4.[) is called the discounting factor or the present value interest factor (PV1F j. Table 7
gives the value of PVIFk,n for several combinations of k and n. A more detailed table of PVIF, is
given in Appendix at the end of this book.

Example: Find the present value of Rs. 1,000 receivable [ years hence if the rate of discount is
10 per cent.

The present value is:

Rs. 1,000 x PVIF10%,[ = Rs. 1,000 (0.5[45) = Rs. 5[4.5

Example: 1 Find the present value of Rs. 1,000 receivable ]0 years hence if the discount rate is 8
per cent. Since Table 7 does not have the value of PVIF we obtain the answer as follows:

&c:c"0c#cw" c 18c#c"0c&c#c1c/c

2,c"c#c 0c

The following figure shows graphically, how the present value interest factor varies in response
to changes in interest rate and time. The present value interest factor declines as the interest rate
rises and as the length of time increases.


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

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

where PVn, = present value of a cash flow stream

At = cash flow occurring at the end of year t

k = discount rate

n = duration of the cash flow stream

Table 8 shows the calculation of the present value of an uneven flow stream, using a

,c 0cw/c

Sometimes, cash flows may have to he discounted more frequently than once a year, semi-
annually, quarterly monthly, or daily. As in the case of intra-year compounding, the shorter
discounting period implies that (i) the number of periods in the analysis increases and (ii) the
discount rate applicable per period decreases. The general formula for calculating the present
value in the case of shorter discounting period is:

Where PV = present value

FVn = cash flow after n years

m = number of times per year discounting is done

k = annual discount rate

To illustrate, consider a cash flow of Rs. 10,000 to be received at the end of four years. The
present value of this cash flow when the discount rate is 1] per cent (k = 1] per cent) and
discounting is done quarterly (m = 4) and it is determined as follows:

PV = Rs. 10,000 x PVJFk/m, mxn

= Rs. 10,000 x PVIF3%, 1[

= Rs. 10,000 x 0.[]3 = Rs. [,]30


Suppose, you expect to receive Rs. 1,000 annually for 3 years, each receipt occurring at the end
of the year. What is the present value of this stream of benefits if the discount rate is 10 per cent?
The present value of this annuity is simply the sum of the present values of all the inflows of this

The time line for this problem is shown in following figure


In general terms the present value of an annuity may be expressed as follows PVAn

Where PVAn = present value of annuity which has a duration of n periods

A = constant periodic flow

k = discount rate

It is referred to as the present value interest factor for an annuity (PVIFAk,n). It is, as can be seen
clearly, simply equal to the product of the future value interest factor for an annuity (PVIFAk, n)
and the present value interest factor (PVIFAk, n). Table 9 shows the value of PVIFAL for several
combinations of k and it A more detailed table of PVIFAk, n values is found in Appendix A at the
end of this book.

&c;c"0c#cw" c 18cc#c ##c&c#c1c/c

Example: What is the present value of a 4-year annuity of Rs. 10,000 discounted at 10 percent?

The PVIFA10%, 4 is 3.170

Hence, PVAn = Rs. 10,000 (3.170) = Rs. 31,700

Example: A 10-payment annuity of Rs. 5,000 will begin 7 years hence. (The first occurs at the
end of 7 years.) What is the value of this annuity now if the discount rate is 1] per cent?

This problem may be solved in two steps.

Step 1 Determine the value of this annuity a year before the first payment begins,

i.e., [ years from now. This is equal to

Rs. 5,000 (PVJFA1]4 = Rs. 5,000 (5.[50) = Rs. ]8,]50.

Step ] Compute the present value of the amount obtained in Step 1.

Rs. ]8,]50 (PV1F1 [) = Rs. ]8,]50 (0.507) = Rs. 14,3]3.

2c4c c

Equation (4.9) shows the relationship between PVAn A, k, and n. Manipulating it a bit, we get:

In Eq. (4.10), the inverse of PVIFAk, n is called the capital recovery factor.

Example: Your father deposits Rs. 1,00,000 on retirement in a bank which pays 10 per cent
annual interest. How much can he withdraw annually for a period of 10 years?


Suppose, someone offers you the following financial contract ie., if you deposit Rs. 10,000 with
him he promises to pay Rs. ],500 annually for [ years. What interest rate do you earn on this
deposit? The interest rate may be calculated in two steps:

Step1. Find the P VIFA[ for this contract by dividing Rs. 10,000 by Rs. ],500

Step ]. Look at the PVIFA table and read the row corresponding to [ years until you find a value
close to 4,000. Doing so, you find that

Since, 4,000 lies in the middle of these values the interest rate lies (approximately) in the middle.
So, the interest rate is 13 per cent.


Perpetuity is an annuity of infinite duration. Hence, the present value of perpetuity may be
expressed as follows:

Where = present value of a perpetuity

A = constant annual payment

PVIFAk,oo = present value interest factor for a perpetuity (an annuity of infinite duration) What is
the value of PVIFAk, oo it is simply:

Putting in words, it means that the present value interest factor of a perpetuity is simply I divided
by the interest rate expressed in decimal form. Hence, the present value of perpetuity is simply

equal to the constant annual payment divided by the interest rate. For example, the present value
of a perpetuity of Rs. 10,000 if the interest rate is 10 per cent is equal to: Rs. 10,000/0.10 = Rs.
1,00,000. Intuitively, this is quite convincing because an initial sum of Rs. 1,00,000 would, if
invested at a rate of interest of 10 per cent, provide a constant annual income of Rs.10,000
forever, without any impairment of the capital value.


1.c Why does money have time value?

].c State the general formula for the future value of a single cash flow.
3.c What is the relationship between effective rate of interest and nominal rate of interest?
4.c What is an annuity?
5.c State the formula for the future value of an annuity.
[.c What is a sinking fund factor? Illustrate it with an example.
7.c State the general formula for calculating the present value of a single cash flow.
8.c What is the general formula for calculating the present value of a cash flow series?




The value of a firm is affected by two key factors: risk and return. Higher the risk, other things
being equal, lower the value; higher the return, other things being equal, higher the value.

While intuitively the meaning of risk and return is grasped by almost every person who reflects
on his experiences, the financial manager needs an explicit and quantitative understanding of
these concepts, and, more importantly, the nature of relationship between them, this chapter,
exploring these issues, is divided into three sections as follows:

Risk and return concepts

Risk in a portfolio context

Relationship between risk and return


On reading this lesson, you will he conversant with:

Ø The concepts of risk and return

Ø Risk in a portfolio context

Ø Meaning of diversifiable and non-diversifiable risks

Ø Calculation of beta

Ø Relationship between risk and return

Ø Risk and return: Implications on investment

  c  c


Risk and return may be defined in relation to a single investment or a portfolio of investments.
We will first look at risk and return of a single investment held in isolation and then discuss risk
and return of a portfolio of investments.


Risk refers to the dispersion of a probability distribution: How much do individual outcomes
deviate from the expected value? A simple measure of dispersion is the range of possible
outcomes, which is simply the difference between the highest and lowest outcomes. A more
sophisticated measure of risk, employed commonly in finance, is standard deviation¶.

How is standard deviation calculated? The standard deviation of a variable (which for our
purposes represents the rate of return) is calculated using the following formula:

Where = standard deviation

pi= probability associated with the occurrence of I th rate of return

ki= I th possible rate of return

k= excepted rate of return

n= number of possible out comes possible out comes

The calculation of the standard deviation of rates of return of Bharath Food and Oriental
Shipping is shown in Table ]. Looking at the calculation of standard deviation, we find that it
has the following features:

1. The differences between the various possible values and the expected value it squared. This
means that values which are far away from the expected value have much more effect on
standard deviation than values which are close to the expected value.

]. The squared differences are multiplied by the probabilities associated with the respective
values. This means that the smaller the probability that a particular value will occur, the lesser its
effect on standard deviation.

3. The standard deviation is obtained as the square root of the sum of squared differences
(multiplied by their probabilities). This means that the standard deviation and expected value is
measured in the same units and hence the two can be directly compared.

&c c 0c #c ,c 0c #c //c 


Most investors (individuals as well as institutions) hold portfolios of securities. Hence, a very
pertinent question is: What happens when two or more securities are combined in a portfolio? To
answer this question, let us consider an example. Suppose you have Rs. 1,00,000 to invest and
you are considering two equity stocks, Alpha Company and Beta Industries. The returns on the
equity stocks of Alpha and Beta for the preceding five years are shown in Table ] and you expect
the future returns on these stocks to be equal to their past returns. This means that on your
investment of Rs. 1,00,000 you expect to earn Rs. 1],000 per annum (because the mean return in
the preceding five years was 1] per cent) on either of the securities individually or on a portfolio
consisting of these securities.

What happens if you invest in a portfolio consisting of the equity stocks of Alpha Company and
Beta Industries in equal proportions? While the expected return remains at 1] per cent the same
as either company individually, the standard deviation is only 4.73 per cent, much less than the
standard deviation of either stock individually. As shown In Fig. 3.1 the variability in the

portfolio rate of return is much less than the variability of individual security rates of return.
Why? This happens because the rates of return on the two securities tend to move in opposite
directions. In general, if the rates of return of individual securities are not perfectly positively
correlated, diversification results in risk reduction.

&c c 0c /c 1c //0c 0c /c w#

ùWhen historical return data, rather than the probability distribution of return, is used, the
formulae used for calculating the mean return and the standard deviation are as follows:



#&c/c /#&c1c

What happens when more and more securities are added to a portfolio? In general, the portfolio
risk decreases and approaches a limit. Empirical studies have suggested that the bulk of the
benefit from diversification, in the form of risk reduction, can be achieved by forming a portfolio
of 10-15 securities - thereafter the gains from diversification are negligible or even nil. Figure
5.] represents graphically the effect of diversification on portfolio risk.

#0c% c2#c1c

Diversifiable risk (also referred to as unsystematic risk or non-market risk) of a security stems
from firm-specific factors like emergence of a new competitor, plant breakdown, lawsuit, non-
availability of raw materials, etc. Events of this kind affect primarily a specific firm and not all
firms in general. Hence, risks arising from them can be diversified away by including several
securities in a portfolio.

Non-diversifiable risk (also referred to as systematic risk or market risk) of a security stems from
the influence of certain economy-wide factors like money supply, inflation, level of government
spending, and industrial policy, which have a bearing on the fortune of almost every firm. Since,
these factors affect returns on all firms, investors cannot avoid the risk arising from them,
however, diversified their portfolios may be. Put differently such risk cannot be diversified away.
Hence, it is referred to as non-diversifiable risk or market risk (as it is applicable to all the
securities in the market place) or systematic risk (as it systematically affects all securities).

Rational investors hold diversified portfolios from which the diversifiable risk is more or less
eliminated. Hence, the relevant measure of risk of an investment is its no diversifiable risk (or
systematic risk). Do all securities have the same degree of non- diversifiable risk? All securities
do not have the same degree of non-diversifiable risk because the magnitude of influence of
economy-wide factors tends to vary from one firm to another. Different securities have differing
sensitivities to variations in market returns. This is illustrated graphically in the above figure. It
shows the returns on the market portfolio (km) over time along with the returns on two other
securities, a risky security (whose return is denoted by kr) and a conservation security (whose
return is denoted by k,). It is evident that the return on the risky security (kr) is more volatile than
the return on the market portfolio (km) whereas, the return on the conservative security (kc) is less
volatile than turn on the market portfolio (km).


The return from an investment is the realisable cash flow earned by its owner during a given
period of time. Typically, it is expressed as a percentage of the beginning of period value of the
investment. To illustrate, suppose you buy a share of the equity stock of Olympic Limited for Rs.

80 today. After a year you expect that (i) a dividend of Rs. ] per share will be received and (ii)
the price per share will rise to Rs. 90. The expected return, given this information, is simply:

In general, terms, the rate of return is defined as:

k = actual, expected, or required rate of return

Pt = price of the security at time

Pt-1= price of the security at time t-1

Dt= income receivable from the security at time t

( It may be noted that the period over which the rate of return is calculated is normally one year.
However, it can be defined as any other interval, six months, one month, one week, one day, or
any other).


When you buy an equity stock you are aware that the rate of return from it is likely to vary-and
often vary widely. For example, if you buy a share of Olympic Limited for Rs. 80 today, you
may be confronted with the following possible outcomes as far as the price after a year is

All the three outcomes may not be equally likely. The first outcome, for example, may be more
likely than the others. In more formal terms we say that the probability associated with outcome
A is greater than the probability associated with the other outcomes.

The probability of an event represents the chance of its occurrence. For example, suppose an
investor says that there is a 4 to I chance that the market price of a certain stock will rise during
the next fortnight. This implies that there is an 80 per cent chance that the price of the stock will
increase and a ]0 per cent chance that it will not increase during the next fortnight. This
judgment can be represented in the form of a probability distribution as follows:

One more example may be given to illustrate the notion of probability distribution. Consider
investment in two equity stocks. The first stock, Bharath Foods, may provide a rate of return of
15 percent, ]0 per cent, or ]5 per cent with certain probabilities associated with them based on
the state of the economy as shown in Table 3. The second stock, Oriental Shipping, being more
volatile, may earn a rate of rate return of ²]0 per cent, 10 per cent, or 40 per cent with the same
probabilities, based on the state of the economy as shown in Table 3.

&ccc#c0c/c,cw&&c#c ,,c /c/c c,22c


In defining the probability distribution, the following points should be noted:

The possible outcomes must be mutually exclusive and collectively exhaustive.

The sum of the probabilities assigned to various possible outcomes is.


When the rate of return can take several possible values because of the investment risk, it is
common to calculate the expected rate of return, a measure of central tendency. The expected
rate of return is defined as:

Where k = expected rate of return

pi = probability associated with the D possible outcome

ki = the possible outcome

n = number of possible outcomes.

From Eq. (]) it is clear that k is the weighted arithmetic average of possible outcomes²each
outcome is weighted by the probability associated with it. The expected rate of return for Bharath
Foods is:

kb= (0.30) (]5%) + (0.50) (]0%) + (0.]0) (15%) = ]0.5%

Similarly, the expected rate of return for Oriental Shipping is:

k0 = (0.30) (40%) + (0.5) (10%) + (0.]0) (-]0%) = 13.0%

= 13.0%



How is non-diversifiable risk measured? It is generally measured by beta,. Though not perfect,
beta represents the most widely accepted measure of the extent to which the return on a financial
set fluctuates with the return on the market portfolio. By definition, the beta for the market
portfolio is 1. A security which has a beta of say, 1.5, experiences greater fluctuation than the
market portfolio. More precisely, if the return on market portfolio is expected to increase by 10
per cent, the return on the security with a beta of 1.5 is expected to increase by 15 per cent (1.5 x
10 per cent). On the other hand, a security which has a beta of, say, 0.8 fluctuates lesser than the
market portfolio. If the return on the market portfolio is expected to rise by 10 per cent, the
return on the security with a beta of 0.8 is expected to rise by 8 per cent (0.8 x 10 per cent).

Individual security betas generally fall in the range 0.[0 to 1.80 and rarely, if ever, assume a
negative value.

0c#c c

For calculating the beta of a security the following market model developed by William F.
Sharpe is employed:

k1=+ where km++ej

kj= return on security j

= Intercept term alpha

= Regression coefficient, beta

km = return on market portfolio

ej = random error term

Beta reflects the slope of the above regression relationship. It is equal to:

Where Coy (kj, km) = covariance between the return on security j and the return on market

= Variance of return on the market portfolio

= Correlation coefficient between the return on jth security and the return on the market

= Standard deviation of return jth market security

= Standard deviation of return on the market portfolio

An example will help in understanding what R is and how to calculate it. The returns on security
j and the market portfolio for a 10-year period are given below:


The beta for security j, 3, is calculated in Table 5. aiven the values of (3 (0.7[) and cx, (].1]
percent) the regression relationship between the return on security j (Ic) and the return on market
portfolio (k.,) is shown graphically in Fig. 5. The graphic presentation is commonly referred to as
the characteristic line. Since security j has a beta of 0.7[ we infer that its return is less volatile
than the return on the market portfolio. If the return on the market portfolio rises/falls by 10 per
cent, the return on security j would he expected to increase/decrease by 7.[ percent (0.7[ x 10%).
The intercept term for security j (a.,) is equal to ].1] percent. It represents the expected return on
security j when the return on the market portfolio is zero.

&c=c0c#c c




What is the relationship between the risk of a security measured by its beta and its required rate
of return? According to the capital asset pricing model (CAPM) the following equation
represents the relationship between risk and return.

As per the above equation the required rate of return of a security consists of two components:
(1) the risk-free rate of return (Rf) and (ii) the risk premium (km-Rf). The risk premium, it may be
noted, is the product of the level of risk () and the compensation per unit of risk (km-Rf). Thus,
for a risky security j, if Rf is 8 per cent, is 1.4, and kM is 14 per cent, the required rate of return is:


It is evident that, ceteris paribus, the higher the beta, the greater the required rate of return, and
vice versa.


The graphical version of the CAPM is called the security market lines (SML), which shows the
relationship between beta and the required rate of return. The figure below shows the SML for
the basic data given above. In this figure, the required rate of return for three securities, A. B and
C, is shown. Security A is a defensive security with a beta of 0.5.


Its required rate of return is 11 per cent. Security B is a neutral security with a beta of 1. Its
required rate of return is equal to the rate of return on the market portfolio. Security C is an
aggressive security with a beta of 1.5. Its required rate return is 17 per cent.

(In general, if the beta of a security is less than 1 it is characterised as defensive, if the beta of a
security is equal to I it is characterised as neutral; and if the beta of a security is more than 1 it is
characterised as aggressive.)


The two parameters defining the security market line are the intercept (R1) and the slope (kM -
R1). The intercept represents the nominal rate of return on the risk-free security. It is expected to
be equal to: risk-free security real rate of return plus inflation rate. For example, if the risk-free
real rate of return is ] per cent and the inflation rate is 8 per cent the nominal rate of return on the
risk-free security is expected to be 10 per cent. The slope represents the price per unit of risk and
is a function of the risk-aversion of investors.

If the real risk-free rate of return and/or the inflation rate change, the intercept of the security
market line changes. If the risk-aversion of investors changes the slope of the security market
line changes. Figure 3.5 below shows the change in the security market line when the inflation
rate increases and Figure 3.[ shows the change in the security market line when the risk-aversion
of investors decreases



Change In the Security Market Line caused by an Increase in Inflation







The investors, after analyzing the prospects of stock A, conclude that its earnings, dividends, and
price will continue to grow at the rate of [ per cent annum. The previous dividend per share, D0,
was Rs. 1.70. The dividend per share expected a year hence is:

D1= Rs. 1.70 (1.0[) = Rs. 1.80

The market price per share happens to be Rs. ]].

What would investors, in general, do? Investors would calculate the expected return from stock
A as follows:


Finding that the expected return is less than the required rate, investors, in general, would like to
sell the stock. However, as there would be no demand for the stock at Rs. ]] per share, existing
owners will have to lower the price to such a level that it fetches a return of 15 per cent, its
required return. That price, its equilibrium price, is the value of P in the following equation:

Solving Eq., for P4, we find that the equilibrium price is Rs. ]0,00

If the market price initially had been lower than Rs. ]0.00, investors, finding its return to be
greater than its required return, seek to buy it. In this process, the price will be pushed up to Rs.
]0.00, its equilibrium price.


Stock market prices tend to change in response to changes in the underlying factors. To illustrate,
let us assume that stock A, described above, is in equilibrium and sells at a price of Rs. ]0.00 per
share. If the expectations with respect to this stock are fulfilled, its equilibrium price a year hence
will be Rs. ]1.]0,[ per cent higher than the current price. However, several factors could change
in the course of a year and alter its equilibrium price. Suppose the values of underlying factors
change as follows:



The changes in the first three factors cause kAto change from 15 per cent to 13 cent.

The change in expected growth rate, along with the change in the required rate return, causes the
equilibrium price to increase from Rs: ]0.00 to Rs. 3[.80.


1.c Why is standard deviation regarded as the most important measure of risk in financial
].c What happens to risk when we add more and more securities to a portfolio?
3.c Distinguish between non-diversifiable risk and diversifiable risk.
4.c How is the systematic risk of a security measured?
5.c What is the relationship between the risk of a security measured by its beta and its
required rate of return?
[.c What is a defensive security? Neutral security? Aggressive security?
7.c What is the effect of change in risk aversion on the security market line?
8.c "The increase in the risk-premium of all stocks, irrespective of their beta, is the - same,
when risk-aversion increases". Comment.
9.c The following information is available about two securities, A and B.


(i) Which of the two securities is more risky? Why?

10. What is the empirical evidence on CAPM?




The goal of investors and investment managers is to maximize their rate of return, or in other
words, market value of their investments. Thus, investment management is an ongoing process
that calls for continuous monitoring of information that may affect the value of securities or rate
of return of such securities. Therefore, in making valuation judgements about securities, the
analyst applies consistently a process which will achieve a true picture of a company over a
representative time span, an estimate of current normal earning power and dividend pay-out;
estimate of future profitability; growth and reliability of such expectations and the translation of
all these estimates into valuation of the company and its securities.


On learning this lesson, you will be conversant with:

Valuation concept
Valuation of bonds
The concept and calculation of YTM.
Valuation of equity under dividend capitalization approach; and

Valuation of equity under Ratio approach

This chapter, presenting such a framework, is divided into four sections as follows:

Valuation concept
Bond valuation
Equity valuation: dividend capitalization approach
Equity valuation: ratio approach

  c  c


From a financial point of view, the value of an asset is equal to the present value of the benefits
associated with it. Symbolically,

Where V0 = value of the asset at time zero

Ct = expected cash flow at the end of period r

k = discount rate applicable to the cash flows

n = expected life of the asset

For example, if an investor expects an investment to provide an annual cash inflow of Rs. 1,000
per year for the next 10 years and the appropriate discount rate is 1[ per cent, the value of the
asset can be calculated as follows:



5c 4c

A bond or debenture (hereafter referred to as only bond), akin to a promissory note, is an

instrument of debt issued by a business or governmental unit. In order to understand the
valuation of bonds, we need familiarity with certain bond-related terms. Par Value: This is the
value stated on the face of the bond. It represents the amount the firm borrows and promises to
repay at the time of maturity. Usually, the par or face value of bonds issued by business Finns is
Rs. 100. Sometimes it is Rs 1,000.

Coupon Rate and Interest A bond carries a specific interest rate which is called the coupon rate.
The interest payable to the bondholder is simply, par value of the bond x coupon rate. For
example, the annual interest payable on a bond which has a par value of Rs. 100 and a coupon
rate of 13.5 percent is Rs. 13.5 (Rs. 100 x 13.5 per cent).

04c w/cTypically corporate bonds have a maturity period of 7 to 10 years, whereas

government bonds have maturity periods extending up to ]0-]5 years. At the time of maturity the
par (face) value plus, perhaps a nominal premium, is payable to the bondholder.

&5c c /c"0c/c

As noted above. the holder of a bond receives a fixed annual interest-payment for a certain
number of years and a fixed principal repayment (equal to par value) at the time of maturity.
Hence, the value of a bond is:

Where V = value of the bond

I = annual interest payable on the bond

F = principal amount (par value) of the bond repayable at the time

of maturity

n = maturity period of the bond.

Example: A Rs. 100 par value bond, bearing a coupon rate of 1] per cent, will mature after 8
years. The required rate of return on this bond is 14 per cent. What is the value of this bond?

Since, the annual interest payment will be Rs. 1] for 8 years and the principal repayment will be
Rs. 100 at the end of 8 years, the value of the bond will be:

Example: A Rs. 1,000 par value bond, bearing a coupon rate of 14 per cent, will mature after 5
years. The required rate of return on this bond is 13 per cent. What is the value of this bond?
Since, the annual interest payment will be Rs. 140 for 5 years and the principal repayment will
be Rs. 1,000 at the end of 5 years, the value of the bond will be:

5c /c"0c ,c

Based on the bond valuation model, several bond value theorems have been derived. They state
the effect of the following factors on bond values:

1.c Relationship between the required rate of return and the coupon rate.
].c Number of years to maturity.

The following theorem show how bond values are influenced by the relationship between the
required rate of return and the coupon rate.

Ia When the required rate of return is equal to the coupon rate, the value of a bond is equal to its
par value.

lb When the required rate of return is greater than the coupon rate, the value of a bond is less
than its par value.

Ic When the required rate of return is less than the coupon rate, the value of a bond is more than
its par value.

To illustrate the above theorems let us consider a bond of Magnum Limited, which has the
following features:

What happens to the value of Magnum¶s bond when the required rate of return is 14 per cent? 1[
per cent? 1] per cent?

If the required rate of return is 14 per cent (which is the same as the coupon rate), the bond value

If the required rate of return is 1[ per cent (which is higher than the coupon rate), the bond value

If the required rate of return is 1] per cent (which is lower than the coupon rate), the bond value

The following theorems express the effect of the number of years to maturity on bond values.

IIa When the required rate of return is greater than the coupon rate, the discount on the bond
declines as maturity approaches.

IIb When the required rate of return is less than the coupon rate, the premium on the bond
declines as maturity approaches.

IIc The longer the maturity of a bond, the greater its price change in response to a given change
in the required rate of return.

To illustrate the above theorems, let us consider a bond of Sharath Limited which has the
following features:

If the required rate of return on this bond is 15 per cent, it will have a value of:

One year from now, when the matuirty period will be 7 years, the bond will have a value of:

aiven the required rate of return of 15 per cent, the bond will increase in value with the passage
of time, until it matures, as follows:

The lower curve in the following figure represents how the bond value will behave as a function
of years to maturity.

#0c<%c /c"0ccc 0c#c6cc04c

If the required rate of return on the bond of Bharath Limited is 11 percent it will have a value of:

One year from now, when the maturity period will be 7 years, the bond will have a value of:

aiven the required rate of return of II percent, the bond value will decrease with the passage of
time, until it matures, as follows:

The upper curve in Fig 4.1 above represents how the bond value will behave as a function of
years to maturity.

To show that the longer the maturity of a bond, the greater is its price change in response to a
given change in the required rate of return, we may refer to Fig. 4.1 When the required return
decreases from 15 per cent to 11 per cent, given a maturity period of 7 years, the value of the
bond increases from Rs. 91[.8 to Rs. 1,094.[, an increase of 19A percent. However, if the same
change in the required rate of return occurs with only ] years to maturity, the bond value would
rise from Rs. 9[7.4 to Rs. 1,034.7²an increase of only 7.0 per cent.

To further illustrate the theorem , consider two bonds A and B, which are alike in all respects
except their period of maturity.

What happens if the required rate of return on these two bonds rises to 14 per cent, or falls to 10
percent? The prices of these bonds will behave as follows:

From the above data, it is clear that the percentage price change in bond B (the bond with longer
maturity) is higher compared to the percentage price change in bond A (the bond with shorter
maturity) for given changes in the required rate of return.

/5c6/cc04cm6 5

Suppose the market price of a Rs. 1,000 par value bond, carrying a coupon rate of 9 percent and
maturing after 8 years, is Rs. 800. What rate of return would an investor earn if he buys this bond
and holds it till its maturity? The rate of return that he earns, called the yield to maturity (YTM
hereafter), is the value of led in the following equation:

To find the value of led which satisfies the above equation, we may have to try several values of
led till we µhit¶ on the right value. Let us begin, with a discount rate of 1] percent. Putting a
value of 1] percent for led we find that the right-hand side of the above expression becomes
equal to:

Since, this value is greater than Rs. 800, we have to try a higher value for led. Let us try led = 14
percent. This makes the right-hand side equal to:

Since, this value is less than Rs. 800, we try a lower value for k, Let us kd = 13 percent. This
makes the right-hand side equal to:

Thus, d lies between 13 percent and 14 percent. Using a linear interpolation in the range 13
percent to 14 percent, we find that Ic is equal to 13.] per cent.

In approximation if you are not inclined to follow the trial-and-error approach described above,
you can employ the following formula to find the approximate YTM n a bond:

Example: The price per bond of Zion Limited is Rs. 90. The bond has a par value of Rs. 100, a
coupon rate of 14 per cent, and a maturity period of [ years. What is he yield to maturity?

Using the approximate formula the yield to maturity on the bond of Zion works out to:

5c /c"0c,c 0cc

Most of the bonds pay interest semi-annually. To value such bonds, we have to work with a unit
period of six months, and not one year. This means that the bond valuation equation has to be
modified along the following lines:

The annual interest payment, 1, must be divided by two to obtain the semi-annual interest
The number of years to maturity must be multiplied by two to get the number of half-yearly
The discount rate has to be divided by two to get the discount rate applicable to half-yearly

With the above modifications, the basic bond valuation equation becomes:

The procedure for linear interpolation is as follows:

(a) Find the difference between the present values for the two rates, which in this case is Rs. 39.9
(Rs. 808²Rs. 7[8.1).

(b) Find the difference between the present value corresponding to the lower rate (Rs. 808 at 13
per cent) and the target value (Rs. 800). which in this case is Rs. 8.0.

(c) Divide the outcome of (b) with the outcome of (a), which is 8.0139.9 or 0.]. Add this fraction
to the lower rate, i.e., 13 percent. This gives the YTM of 13.] percent.

Where V = value of the bond

1/] = semi-annual interest payment

kd/] = discount rate applicable to a half-year period

F = par value of the bond repayable at maturity

]n = maturity period expressed in terms of half-yearly periods.

Example: A Rs. 100 par value bond carries a coupon rate of 1] per cent and a maturity period of
8 years. Interest is payable semi-annually. Compute the value of the bond if the required rate of
return is 14 per cent.

Applying Eq. ([.4), the value of the bond is:

304c"0c //c2.c22,c

According to the dividend capitalization approach, a conceptually very sound approach, the
value of an equity share is equal to the present value of dividends expected from its ownership
plus the present value of the resale price expected when the equity share is sold. For applying the
dividend capitalisation approach to equity stock valuation, we will make the following
assumptions: (i) dividends are paid annually²this seems to be a common practice for business
firms in India; and (ii) the first dividend is received one year after the equity share is bought.


Let us begin with the case where the investor expects to hold the equity share for one year. The
price of the equity share will be:

Where P0 = current price of the equity share

D1= dividend expected a year hence

P1 = price of the share expected a year hence

ks= rate of return required on the equity share.

Example: Prestige¶s equity share is expected to provide a dividend of Rs. ].00 and fetch a price
of Rs. 18.00 a year hence. What price would it sell for now if investors¶ required rate of return is
1] per cent 7

The current price will be

What happens if the price of the equity share is expected to grow at a rate of g percent annually 7
If the current price. F0, becomes P0 (1+g) a year hence, we get:

Simplifying Eq. We get,

Example: The expected dividend per share on the equity share of Road king Limited is Rs. ].00.
The dividend per share of Road king Limited has grown over the past five years at the rate of 5
percent per year. This growth rate will continue in future. Further, the market price of the equity
share of Road king Limited, too, is expected to grow at the same rate. What is a fair estimate of
the intrinsic value of the equity share of Road king Limited if the required rate is 15 percent?

Applying Eq. we get the following estimate:


In the preceding discussion we calculated the intrinsic value of an equity share, given
information about (i) the forecast values of dividend and share price, and (ii) the required rate of
return. Now, we look at a different question: What rate of return can the investor expect, given
the current market price and forecast values of dividend and sham price? The expected rate of
return is equal to:

Example: The expected dividend per share of Vaibhav Limited is Rs. 5.00. The dividend is
expected to grow at the rate of [ percent per year. If the price per share now is Rs. 50.00, what is
the expected rate of return?

Applying Eq. the expected rate of return is:

0 w/c"0c/

Having learnt the basics of equity share valuation in a single-period frame-work, we now,
discuss the more realistic, and also the most complex, case of multiperiod valuation.

Since, equity shares have no maturity period, they may be expected to bring a dividend stream of
infinite duration. Hence, the value of an equity share may be put as:

µThe steps in simplification are:

P0 =

where Po = price of the equity share today

D1= dividend expected a year hence

D]= dividend expected two years hence

Doo = dividend expected at the end of infinity.

Equation above represents the valuation model for an infinite horizon. Is it applicable to a finite
horizon? Yes. To demonstrate this consider how an equity share would be valued by an investor
who plans to hold it for n years, and sell it thereafter for a price of P. The value of the equity
share to him is:

Now, what is the value of Pn, in Eq. Applying the dividend capitalization principle, the value of
F, would be the present value of the dividend stream beyond the nth period, evaluated as at the
end of the nth year. This means:

Substituting this value of P in Eq. ([.10) we get:

We discuss below three cases:

(i) Constant dividends, (ii) constant growth of dividends, and (iii) changing growth rates of

"0c,cc //c

If we assume that the dividend per share remains constant year after year at a value of 1), the Eq.

Equation on simplification, becomes

"0c,cc,c#c //c

Most stock valuation models are based on the assumption that dividends tend to increase over
time. This is a reasonable hypothesis because business firms typically grow over time. If we
assume that dividends grow at a constant compound rate, we get:

The dividend 5 years hence will be:

Example: The current dividend (D0) for an equity share is Rs. 3.00. If the constant compound
growth rate is [ percent, what will be the dividend 5 years hence? It will be:

When the dividend increases at a constant compound rate, the share valuation equation becomes:

Eq. simplifies to:

Example: Ramesh Engineering Limited is expected to grow at the rate of [ percent per annum.
The dividend expected on Ramesh¶s equity share a year hence is Rs.].00. What price will you
put on it if your required rate of return for this share is 14 percent?

The price of Ramesh¶s equity share would be:

,c,cc#c //c

Many firms enjoy a period of super normal growth which is followed by a normal rate of growth.
Assuming that the dividends move in line with the growth rate, the price of the equity share of
such a firm is:

where P0 =price of the equity share

D1 = dividend expected a year hence

ga = super-normal growth rate of dividend.

gn = normal growth rate of dividends.

To compute the value of P0 in Eq. ([.18), the following procedure may be employed.

Step 1. Specify the dividend stream expected during the initial period of supernormal growth.
Find the present value of this dividend stream. Using the symbols presented earlier, this can be
represented as:

Step ]. Calculate the value of the share at the end of the initial growth period,

(As per the constant growth model), and discount this value to the present. In terms of our
symbols, this discounted value is:

Step 3. Add the above two present-value components to find the value of the share, P0. as given

Present value Present value of the of the dividend value of the share at stream during the end of
the initial the initial period period

To illustrate the above procedure let us consider the equity share of Vertigo Limited:

D0= current dividend per share = Rs. ].00

n = duration of the period of super-normal growth = 4 years

= growth rate during the period of super-normal growth = ]0 per cent

ga= normal growth rate after the super-normal growth period is over = 5 per cent

gn = equity investors required rate of return = 1] per cent

Step 1. The dividend stream during the supernormal growth period will be:

Step ]. The price of the share at the end of 4 years, applying the constant growth model at that
point of time, will be:

Step 3. The sum of the above components is:

P0 = Rs. 9.54 + Rs. 39.53

= Rs. 49.07

The following figure presents a graphic view, in terms of a time line diagram, of the above

#0c<% c cc/c


The expected growth rates of companies differ widely. Some companies are expected to remain
virtually stagnant; other companies are expected to show normal growth; still others are expected
to achieve super-normal growth rate.

Assuming a constant total required return, differing expected growth rates mean differing stock
prices, dividend yields, capital gains yields, and price-earnings ratios. To illustrate, consider
three cases:

The expected earnings per share and dividend per share of each of the three firms are Rs. 3.00
and Rs. ].00 respectively. Investors¶ required total return from equity investments is 15 per cent.

aiven the above information, we may calculate the stock price, dividend yield, capital gains
yield, and price-earnings ratio for the three cases as shown in Table 1.

&ccw8c //c4/8c2cc4/8c/cw cc0/c ##c


The results in Table 1 suggest the following points:

1.c As the expected growth in dividend increases, other things being equal, the expected
return¶ depends more on the capital gains yield and less on the dividend yield.
].c As the expected growth rate in dividend increases, other things being equal, the price-
earnings ratio increases.
3.c High dividend yield and low price-earnings ratio imply limited growth prospects.
4.c Low dividend yield and high price-earnings ratio imply considerable growth prospects.


While conceptually the dividend capitalization approach is unassailable, it is often not as widely
practised as it should be. Practitioners seem to prefer the ratio approach, largely because of its
simplicity. The kinds of ratios employed in the context of valuation are discussed below.


The book value per share is simply the net worth of the company (which is equal to paid up
equity capital plus reserves and surplus) divided by the number of outstanding equity shares. For
example, if the net worth of Zenith Limited is Rs. 37 million and the number of outstanding
equity shares of Zenith is ] million, the book value per share works out to Rs. 18.50 Qts. 37
mitlion divided by ] million).

How relevant and useful is the book value per share as a measure of investment value? The book
value per sham is firmly rooted in financial accounting and hence can be established relatively
easily. Due to this, its proponents argue that it represents. It may be noted that total return is the
sum of the dividend yield and capital gains yield:

Total return = Dividend yield + Capital gains yield an µobjective¶ measure of value. A closer
examination, however, quickly reveals that what is regarded as µobjective¶ is based on
accounting conventions and policies which are characterised by a great deal of subjectivity and
arbitrariness. An allied, and a more powerful, criticism against the book value measure is that the
historical balance sheet figures on which it is based are often very divergent from current
economic values. Balance sheet figures rarely reflect earnings power and hence the book value
per share cannot be regarded as a good proxy for true investment value.


The liquidation value per share is equal to

To illustrate, assume that Pioneer Industries would realise Rs. 45 million from the liquidation of
its assets and pay Rs. 18 million to its creditors and preference shareholders in full settlement of
their claims. If the number of outstanding equity shares of Pioneer is 1.5 million, the liquidation
value per share works out to:

While the liquidation value appears more realistic than the book value, there are two serious
problems in applying it. First, it is very difficult to estimate what amounts would be realised
from the liquidation of various assets. Second, the liquidation value does not reflect earnings
capacity. aiven these problems, the measure of liquidation value seems to make sense only for
firms which are µbetter dead than alive¶ ² such firms are not viable and economic values cannot
be established for them.


Traditionally, financial analysts have employed price-earnings ratio models more than dividend
capitalization models. According to the price-earnings ratio approach, the intrinsic value of a
share is expressed as:

Expected earnings per share x appropriate price-earnings ratio

The expected earnings per share is defined as:

While the preference dividend and the number of outstanding equity shares can be defined in
certain near terms, the expected profit after tax is rather difficult to estimate. To get a reasonable
handle over it the following factors, inter alia, need to be examined: sales, gross profit margin,

depreciation, interest burden, and tax rate. Some financial analysts, instead of working with the
expected earnings per share for next year, use an estimate of normal earnings per share This
represents what earnings per share would be under normal circumstances.

To establish the appropriate price-earnings ratio for a given share, one may, to begin with,
consider the price-earnings ratio for the market as a whole and also for the industrial grouping to
which the share belongs. The next step would be to judge the price-earnings ratio applicable to
the particular share under consideration. In forming this judgment the following factors may be
taken into account:

1.c arowth rate

].c Stability of earnings
3.c Size of the company
4.c Quality of management
5.c Dividend payout ratio

While it is difficult to quantify the impact of these factors on the price-earnings ratio, the
following qualitative observations may be made: the higher the growth rate, the higher the price-
earnings ratio; the greater the stability of earnings, the higher the price-earnings ratio; the larger
the size of the company, the higher the price- earnings ratio; the higher the dividend payout ratio,
the higher the price-earning ratio.

The popularity of the price-earnings ratio approach seems to stem from two main advantages: (i)
Since the price-earnings ratio reflects the price per rupee of earnings, it provides a convenient
measure for comparing the prices of shares which have different levels of earnings per share. (ii)
The estimates required for using the price-earnings ratio approach are fewer in comparison to the
estimates required for applying the dividend capitalization approach. While these advantages
make the price-earnings approach attractive to the practitioner, it must be emphasised that this
approach, as it is practised, does not have a sound conceptual basis ² the estimate of the price-
earnings ratio does not have a firm theoretical underpinning. Should an attempt be made to
develop a sound conceptual basis for this approach, it becomes identical to the dividend
capitalization approach.


1.c Discuss the basic bond valuation model.

].c When the required rate of return is equal to/greater than/less than the coupon rate, the
value of a bond is equal to/less than/more than its par value.¶ Illustrate this with a
numerical example.
3.c "When the required rate of return is greater than/less than the coupon rate the
discount/premium on the bond declines as maturity approaches." Illustrate this with a
numerical example.
4.c "The longer the maturity of a bond, the greater its price change in response to a given
change in the required rate of return." Illustrate this with a numerical example.
5.c Explain and illustrate the concept of yield to maturity.
[.c State the formula for valuing a bond which pays interest semi-annually and which is
7.c What is the expected rate of return on an equity share when dividends are expected to
grow at a constant annual rate?
8.c Discuss the valuation of an equity share with variable growth in dividends.
9.c Discuss the impact of growth on price, dividend yield, capital gains yield, and price-
earnings ratio.
10.cHow relevant and useful is the book value per share as a measure of investment value?
11.cWhat are the limitations of the liquidation value approach?
1].cWhat factors are relevant in establishing an appropriate price-earnings ratio for a given
share? What is the likely effect of these factors on the price-earnings ratio?
13.cWhat are the advantages and limitation of the price-earnings ratio approach?



ccccccccccccccccccccccccccccccccccccc "  c  c


Capital budgeting is budgeting for capital projects. The exercise involves ascertaining and
estimating cash inflows and outflows, matching the cash inflows with outflows appropriately and
evaluation of the desirability of the project, under consideration.

c &'c

after reading this lesson, you will be conversant with:

1.c The nature of investment decisions

].c Scanning and identification of investment opportunities
3.c Criteria for preliminary screening
4.c Preparation of cash flow projections for projects
5.c Assessing the financial viability of projects using the various appraisal criteria.

  c  c


Businesses investments in capital projects are of different nature. These capital projects involve
investment in physical assets, as opposed to financial assets like shares, bonds or funds. Capital
projects necessarily involve processing, manufacturing or service works. These require
investments with a longer time horizon. The initial investment is heavy in fixed assets and
investment in permanent working capital is also heavy. The benefits from the projects last for
few to many years.

Capital projects may be new ones, expansion of existing ones, diversification of existing ones,
renovation or rehabilitation of projects, R&D activities, or captive service projects. An enterprise
may put up a new subsidiary, increase stake in existing subsidiary or acquire a running firm. All
these are considered as capital projects.

Capital projects involve huge outlay and it will last for years. Hence, these are riskier than
investments in financial assets. Capital projects have technological dimensions and
environmental dimensions. So, careful analysis is needed. Decisions once taken cannot be easily
reversed in respect of capital projects and therefore thorough evaluation of costs and benefits is

#c#c2c 0/c

Every business has to commit funds in fixed assets and permanent working capital. The type of
fixed assets that a firm owns influences i) the pattern of its cost (i.e. high or low fixed cost per
unit given a certain volume of production), ii) the minimum price the firm has to charge per unit
of production iii) the break-even position of the company, iv) the operating leverage of the
business and so on. These are all very vital issues shaping the profitability and risk complexion
of the business.

Capital budgeting is significant because it deals with the right kind of evaluation of projects. A
project must be scientifically evaluated, so that no undue favor or dis-favor is shown. A good
project must not be rejected and a bad project must not be selected.

Capital investment proposals involve i) longer gestation period, ii). huge capital outlay, iii)
technological considerations needing technological forecasting, iv) environmental issues too,
which require the extension of the scope of evaluation to go beyond economic costs and benefits,
v) irreversible decision once committed, vi) considerable peep into the future which is normally
very difficult, vii) measuring of and dealing with project risks which is a daunting task in deed
and so on. All these make capital budgeting a significant task.

Capital budgeting involves capital rationing. That is, the available funds must be allocated to
competing project in the order of project potentials. Usually, the indivisibility of project poses
the problem of capital rationing because required funds and available funds may not be the same.
A slightly high return projects involving higher outlay may have to be skipped to choose one
with slightly lower return but requiring less outlay. This type of trade-off has to be skillfully

The building blocks of capital budgeting exercise are mostly estimates of price and variable cost
per unit output, quantity of output that can be sold, the tax rate, the cost of capital, the useful life
of the project, etc. over a period of years. A clear system of forecasting is also needed.

What should be the discount rate? Should it be the pre-tax overall cost of capital? Or the post-tax
overall cost of capital? The choice is very crucial in making capital budgeting exercises a
significant one.

Finally, which is the appropriate method of evaluation of projects. There are over a dozen or
more methods. The choice of method is important. And different methods might rank projects
differently leading to a complex picture of project desirability ranks. A clear thinking is needed
so that confusion is not descending on the choice of projects.


Appraisal means examination and evaluation. Capital projects need to be thoroughly appraised as
to costs and benefits.

The costs of capital projects include the initial investment at the inception of the project. Initial
investment made in land, building, machinery, plant, equipment, furniture,fixtures, etc.
generally, gives the installed capacity. Investment in these fixed assets is one time. Further, a
one-time investment in working capital is needed in the beginning, which is fully salvaged at the
end of the life of the project.

Against this committed returns in the form of net cash earnings are expected. These are
computed as follows. Let µP¶ stand for price per unit, µV¶ for variable cost per unit, µQ¶ for
quantity produced and sold, µF¶ stand for total fixed expenses exclusive of depreciation, µ0¶ stand
for depreciation on fixed assets, µI¶ for interest on borrowed capital id µT¶ for tax rate).

Then, cash earnings = [(P-V) Q-F-D-I](1-T)+D

These cash earnings have to be estimated throughout the economic life of the investment. That
is, all the variables in the equation have to be forecasted well over a period of years.

Now, that we have the benefits from the investment estimated, the same may be compared with
costs of the capital project and µnetted¶ to find out whether costs exceed benefits or benefits
exceed costs. This process of estimation of costs and benefits and comparison of the same is
called appraisal.

Payback period, accounting rate of return, net present value, rate of return, decision tree
technique, sensitivity analysis, simulation and capital asset pricing model (CAPM) are certain
methods of appraisal.


The computation of profit after tax and cash flow is relevant in evaluation of projects. Hence,
this is presented here as a prelude to the better understanding of the whole process.

Say in fixed assets at time zero, you are investing Rs.]0 lakhs. You have estimated the following
for the next 4 years.


With this information, we can estimate profit after tax for the business. For that, apart from the
given variable expenses and fixed expenses, depreciation on the fixed assets also is to be
considered. The annual depreciation is given by the cost of fixed assets divided by number of

years of economic life of the respective asset. In our case, the figure comes to Rs. ]0,00,000/4 =
Rs.5 lakhs per annum.

The calculations are given in three stages, viz. computation of profit before tax (PBT), profit
after tax (PAT) and cash flow.

The profit before tax (PBT) for a period is given by: (selling price per unit - variable cost per
unit) * (No. of units sold) - Fixed expenses - Depreciation. So, for the 1st year PBT = (]00-100)
(30000) - 1],00,000 - 5,00,000 = 30,00,000 - 47,00,000 = 13,00,000. Table gives the working
and results.


Profit after tax (PAT) for the different years is obtained by subtracting tax from the PBT.

Profit after tax = PAT = PBT (1-Tax Rate). So, for the first year PAT = 13,00,000 (1-30%) =
13,00,000 (0.7) = 9,10,000. Similarly, for the other years the profit figures can be obtained as in
table 3


Cash flow from business is equal to PAT plus depreciation. Table 3 gives cash flow from



%cw4&1cw/cmw w5c,/c

Pay back period refers to the number of years one has to wait to setback the capital invested in
fixed assets in the beginning. For this, we have to get cash flow from business.

We have invested Rs. ]0,00,000 at time zero. After one year, a sum of Rs.14, 10,000 is returned.
By next year, a sum of Rs. 19,70,000 is returned. But we have to get back only Rs. 5,90,000 (i.e.,

]0,00,000 - 14,10,000). So, in the second year we have to wait only for part of the year to get
back Rs. 5,90,000. The part of the year = 5.90,000/ 19,70,000 = 0.30 that is, pay back period is
1.30 years or 1 year, 3 months and 19 days.

In general payback period is given by µn¶ in the equation

Where µt¶ 1 to n, I = initial investment, CF = cash flow at time µt¶ and t = time measured in years.

Normally, businesses are want projects that have lower pay back period, because the invested
money is got back very soon. As future is risky, the earlier one gets back the money invested, the
better for the business. Some businesses fix a maximum limit on pay back period. This is the cut-
off pay back period, serving as the decision criterion. Accordingly, a pay back period ceiling of 3
years means, only projects with payback period equal to or less than 3 years will be accepted and
others will be rejected.


1.c It is cash flow based which is a definite concept

].c Liquidity aspect is taken care of well
3.c Risky projects are avoided by going for low gestation period projects
4.c It is simple and common sense oriented


1.c Time value of money is not considered as earnings of all years are simply added together
].c Explicit consideration for risk is not involved
3.c Post-payback period profitability is ignored totally.


Here, the accounting rate of return (ARR) on an investment is calculated. It is also called as the
average rate of return. To compute ARR, average annual profit is calculated. From the PBT for
different years, average annual PBT can be calculated.

The average annual PBT = Total PBT I No. of years

Average annual PBT = 4[,00,000/4

= Rs.11, 50,000

ARR = AAPBT / Investment

= 11,50,000/]0,00,000 = 0.574 = 57.4%

The denominator can be an average investment, i.e., (original value plus terminal value)/].Here it
is 10 lakhs. Then the ARR will be Rs.11, 50,000/ Rs.l0,00,000 = 1.15%

ARR can also be computed on the basis of Profit After Tax (PAT). The Average Annual PAT /
Original investment.

Average Annual PAT = Total PAT/ No. of years

= 31,00,000 / 4 = 7,75,000

So, ARR = 7,75,000 / ]0,00,00 = 0.3875 = 38.75%

The denominator can be the average investment, instead of actual investment, then ARR is =
Rs.7, 75,000 / Rs. 10,00,000=0.775 or 77.5%.


1.c It is simple and common sense oriented.

].c Profits of all years are taken into account.


i.c Time value of money is not considered.
ii.c Risk involved in the project is not considered.
iii.c Annual average profits might be the same for different projects but accrual of profits
might differ having significant implications on risk and liquidity.
iv.c The ARR has several variants and it lacks uniformity.

A minimum ARR is fixed as the benchmark rate or cut-off rate. The estimated ARR for an
investment must be equal to or more than this benchmark or cut-off rate so that the investment or
project is chosen.


Net present value is computed given the original investment, annual cash flows (PAT +
Depreciation) and required rate of return which is equal to cost of capital.

aiven these, NPV is calculated as follows

I = Original or initial investment

CFt = annual cash flows

A = cost of capital and

t= time measured in years.

For the problem, we have done under the pay back period method, we can get the NPV, taking k
= say 10% or 0.1,then the

NPV= -I + CF1 /(1+k) 1 + CF] /(1+k) ] + CF3 I (1+k) 3 + CF4 (l+k) 4

= -]0,00,000 + 14, l0, 000/l.l + 19,70000 / 1.1] + l 1,[0,000 / 1.13+

5,[0,000 / 1.14

= -]0,00,000 + 14,10,000 x 0 .909 + 19,70,000 x 0.8][ +

11,[0,000 x 0.751 + 5,[0,000 x 0.[83

= - ]0,00,000 + 1],81,818 + 1[,]8,099 + 8,71,5]5 + 3,79,04]

= - ]0,00,000 + 41,[0,484 = Rs. ]1,[0,484

If it is required that k= 10%, 11%, 1]% and 13% respectively, for years 1 through year 4, the
formula is written as follows.

NPV = -I+CFt/(l+kt) t

= - I + CF1 / (1+k1) 1 + CF] / (l+k]) ] + CF3 /(1+k3) 3 + CF4/(1+k4) 4

In the above example,

NPV = -]0,00,000+14,10,000/1.1+19,70,000/1.11]+1 1,[0,000/1. 1]3+ 5,[0,000/1.134

=-]0,00,000 +14,10,000 x 0.909+19,70,000 x 0.817 + 11,[0,000 x 0.71] + 5,[0,00

x 0.[35

= - ]0,00,000 + 40,49,48] = Rs. ]0,49,48]

If the NPV = 0¶ or greater than zero, the project can be taken. Incase, there are several mutually
exclusive projects with NPV >0, we will select the one with highest NPV. In the case of
mutually inclusive projects you first take up the one with the highest NPV and next the project
with next highest NPV, and so on as long as your funds for investment lasts. The factor "k" need
not be same for all projects. It can be high for projects whose cash flows suffer greater
fluctuations due to risk, and lower for projects with lower fluctuations risk.


Internal Rate of Return (IRR) is the value of µk" in the equation, I + Z CF / (l+k) t = 0. In other
words, IRR is that value of "k" for which aggregated discounted value of cash flows from the
project is equal to original investment in the project. When manually computed, "k" i.e., IRR is
got through trial and error. Suppose for a particular value of I +E CF1 I (l+k) t >0, we have to
use a higher µk¶ in our trial and if the value is <0, a lower µk¶ has to employed next time. Then,
you can interpolate k. The value of µk¶ thus got is the IRR.

c c22,c

Decision tree approach is a versatile tool used for decision-making under conditions of risk. The
features of this approach are: (1) it takes into account the results of all expected outcomes, (ii) it
is suitable where decisions are to be made in sequential parts - that is, if this has happened
already, what will happen next and what decision has to follow, (iii) every possible outcome is
weighed using joint probability model and expected outcome worked out, (iv) a tree-form
pictorial presentation of all possible outcomes is presented here and hence, the term decision-tree
is used. An example, will make understanding easier.

An entrepreneur is interested in a project, say introduction of a fashion product for which a ]

year market span is foreseen, after which the product turns fade and that within the two years all
money invested must be realised back in full. The project costs Rs. 4,00,000 at the time of

During the 1st year, three possible market outcomes are foreseen. Low penetration, moderate
penetration and high penetration are the three outcomes, whose probability values, respectively,
are 0.3, (i.e., 30% chance), 0.4 and 03 and the cash flows after tax under the three possible
outcomes are respectively estimated to be Rs. 1,[0,000, Rs. ],]0,000 and Rs. 3,00,000.

The level of penetration during the ]nd year is influenced by the level of penetration in the first
year. The probability values of different penetration levels in the ]nd year, given the level of
penetration in the 1st year and respective cash flows are estimated as follows:


If low penetration resulted in 1st year, low penetration in ]nd year with probability of 0.] and
cash flow of Rs.80, 000, moderate penetration in ] year with probability of 0.[ and cash flow of
Rs.], 00,000 and high penetration in ]" year with probability of 0.] and cash flow of Rs.3,
00,000 are possible. Similarly, you can follow for other cases.

Combining 1st and ]nd year penetration levels together, 9 outcomes are possible. These are:


At this stage, we may go for present value evaluation of these sets of outcomes. And this is done
below. For this, we require a discounting rate. Let us take a 10% discount rate. Then the present
value of Rs.1 receivable at 1st year end is Rs.0.909 (i.e. 1/1.1) and at ]nd 1 year end it Rs.0.8][
(i.e., 1/1.1]). Now, the present values of the 9

cash flow streams can be worked out. These values, the NPV relevant to each stream (i.e., the
aggregate of the present value of the two cash flows of each stream minus investment of
Rs.4,00,000), joint probability (i.e., product of probabilities of the two cash flows of each
stream) and expected value of NPV (i.e., joint probability times NPV of each stream) are given
below in table 7.

The expected NPV of the project is negative at Rs.1]][9, if low penetration prevailed both in the
1st and ]nd years and this has a probability of [ out of 100 or .0[. The expected NPV is negative
at Rs.1[085, if low penetration in 1st year and moderate penetration in ]nd year have prevailed
and the probability of this happening is 18%. Outcome 8 shows that NPV of Rs.48, 744 with

probability of ]4% is possible when high penetration in 1st year and moderate penetration in the
]nd year result. The expected NPV of the project is the aggregate of the expected NPV of the
different streams = Rs.47395. Since, it is positive, the project may be taken up.


Capital Asset Pricing Model (CAPM) is one of the premier methods of evaluation of capital
investment proposals. CAPM gives a mechanism by which the required rate of return for a
diversified portfolio of projects can be calculated given the risk. According to CAPM, the
required rate of return comprises of two parts: first, a risk-free rate of return and second a risk
premium for the amount of systematic risk of the portfolio. The formula is:

Required rate of return = Rf + (Rm -Rf) Bi, where

R1- risk free rate of return

Rm- return on market portfolio

Bi- Beta or risk coefficient of the evaluated portfolio given market portfolio beta = 1

CAPM, therefore, gives a risk-return relationship for the portfolio of various projects.


We have to calculate the required rate of return for the capital project given its beta coefficient,
risk free return and market return. Then, get the estimated return for the project. If the estimated
return for the project is greater than or equal to the required rate of return, accept the project.
Otherwise, reject the project.

The risk-free return is the rate of return obtainable on risk free investments, like investment in
any government securities.


When uncertainty haunts the estimation of variables in a capital budgeting exercise, simulation
technique may be used with respect to a few of the variables, taking the other variables at their
best estimates.

P, V, F, Q, T, A, I, D and N are the important variables. (P -Price per unit of output, V -.

Variable cost per unit of output, F - Fixed cost of operation, Q - Quantity of output, T - Tax rate,
A - Discount rate or cost of capital, I - Original investment, D - Annual depreciation and N -
Number of years of the project¶s life).

Suppose, in a project, P, V, F, Q, N and I arc fairly predictable but k and µT¶ are playing truant.
In such cases, the A and T will be dealt through simulation while others are take at given values.

Suppose, that P = Rs.300/unit, V = Rs. 150/unit, F = l5,00,000/p.a,

Q = ]O,000/p.a, N = 3 years and I = Rs.18,00,000. Then rural profit before tax = [(P-V) Q] - F -
D = [(300-I 50)*]00001 - 15,00.000 - 000 = Rs. 9,00,000/p.a.

The profit after tax and hence cash flow cannot be computed as tax rate, T is not predictable.
Further, as µk¶ is also redictable, present value cannot be computed as well. So, we use
simulation here.

Simulation process gives a probability distribution to each of the truant playing variables. Let the
probability distribution for µT¶ and µA¶ be as follows:

Next, we construct cumulative probability and assign number ranges, separately for T and A.
Two digit random n ranges are used. We start with 00 and end with 99, thus using 100 numbers.

For the different values of the variable in question, as many random numbers as are equal to the
probability values of respective values are used. Thus, for variable T, ]0% of random numbers
aggregated for its first 30% and 50% of random number for its next value 35% and 40%.

For the first value of the unpredictable variable, we assign random numbers 00 to 19. For the
second value we assign random numbers ]0²[9 and for the third value random numbers 70 - 99
are assigned. Similarly, for the variable µA¶ also random numbers are assigned as given in table

Simulation process now involves reading from random number table, random number pairs (one
for µT¶ and another for µA¶). The values of µT¶ and µA¶ corresponding to the random numbers
read are taken from the above table. Suppose the random numbers read are: 48 and 80. Then µT¶
is 35% and the random number 48 falls in the random number range ]0-[9 corresponding to 35%
and µA¶ is 1]% as the random number 80 fails in the random number range 80-99 corresponding
to 1]%. Now taking the T = 35% and A = 1]%. the NPV of the project can be worked out. We
know that the project gives a PAT of Rs.9,00,000 p/a for 3 years. So, the PAT = 9,00,000 ± Tax
ù 35% = Rs.9,00,000 - 3,15,000 Rs.5,85,000 pa. To this, we have to add depreciation of
Rs.[,00,000 (i.e. Rs.18,00,000 / 3 years) to get the cash flow. So, the cash flow= 5,85,000 +
[,00,000= Rs. 11,85,000 p.a.

= (11,85,000 /1.1] + 11,85,000/1.1]] + 11,85,000 / 1, 1]3) -18,00,000

= 11,85,000 [1/1.1] + 1/1.1]] + 1/1.1]] - 18,00,000

= 1l, 85,000 x ].4018 - 18,00,000

= ]8,5[,798 - 18,00,000 = Rs. 10,5[,798

We have just taken one pair of random numbers from the table and calculated the NPV as Rs.l0,

This process must be repeated at least ]0 times, reading ]0 pairs of random numbers and getting
the NPV for values of T and A corresponding to each pair of random numbers read. Suppose the
next pair of random numbers are ]8 and 49: Corresponding µT¶ = 35% and µA¶ = 11%. Then the
PAT = PBT - T = Rs.9, 00,000 ± Rs.3, 15,000 =Rs. 5,85,000. The cash flow = Rs 5,85,000 +
Rs.[, 00,000 = Rs. 11,85,000.

=(Rs.11, 85,000/1.11+Rs.11, 85,000/1.11]+Rs.11, 85,000/1.113)- Rs.18, 00,000

= (Rs.10, [7,598 +Rs. 9,[ 1,773 +Rs. 8,[[,4[]) ±Rs. 18,00,000

= Rs.]8, 95,803 ±Rs. 18,00,000 = Rs.10, 95,803

Similarly, the NPV for other simulations can be obtained. NPVs may be averaged if the same is


Sensitivity analysis attempts to study the level of sensitivity of the project say the NPV, for
changes in a key influencing factor, keeping the influence of all other influencing factors at
constant level.

Sensitivity analysis presumes uncertainty of the values of all or some of the influencing factors.
For such factors, the range of their values and most likely values are given. Other factors are
taken at constant values.

We know, that NPV of a project is influenced by P, V, Q, F, 1, N, T and A. Let F, 1, N, D and A

be constant at Rs.15, 00,000, Rs.18, 00,000, 3 years, Rs.[, 00,000 and 15% respectively P, V, Q
and T and let the uncertain variables. Let their range of values and most likely values be as

P: Rs.]00-Rs.350; Most Likely value is Rs.300

V Rs.100-Rs.]50; Most Likely value is Rs.150

Q: 15000-]]000; Most Likely quantity is ]0,000

T: 30%-40%; Most Likely rate is 35%

Suppose, we want to study the sensitivity of NW with respect to µT¶. then other uncertain
variables, namely, V and Q will be assigned their most likely values. Needless to say, the
variables taking constant values will take their fixed values. The variable T¶ will be taking
different values within the range of its values for each such values of T. The NPV will be worked
out and sensitivity of the NPV to that factor also be analysed. Accordingly, for our purpose: I =
Rs. 18,00,000, N = 3 years, D = Rs.[, 00,000, F = Rs.15, 00,000, k = 15%. P, V and Q at their
most likely values are Rs.300, Rs. 150 and ]0,000 units. µT¶ shall take different values within its
range; say 30%, 3].5%, 35%, 37.5% and 40%. For each of these 5 values of T, NPV will be
worked out and sensitivity of NW be analysed.

First let T be 30%. The annual cash flow is:

= [(P-V) Q - F - D] (J-T) + D

= [(Rs.300-Rs.150) ]0000units-Rs.15, 00,000±Rs.[, 00,000](1-30%) + Rs.[, 00,000

= [Rs.30, 00,000 ±Rs. ]1,00,000] (0.70) +Rs. [,00,000

= Rs.9, 00,000(0.70) +Rs. [,00,000

= Rs. 1],30,000 pa

NPV = (Rs.1],30,000 / 1.15 +Rs.1],30,000/1.15] +Rs.1],30,000 / l.153) ±Rs.18,00,000

= Rs. ]8,08,3[9 -Rs. 18,00,000= Rs. 10,08,3[9

Let T be 3].5%. The annual cash flow is:

= [(P-V) Q - F - D] (I-D) +D

= [(Rs.300-Rs.150) ]0000 units-Rs. 15,00,000 ±Rs.[, 00,000] (1-3].5%) + Rs.[, 00,000

= [Rs.30, 00,000 -Rs. ]1,00,000] (0.[75) +Rs. [,00,000

= Rs.9, 00,000(0.[75) +Rs. [,00,000

= Rs. 1],07,500 p.a

NPV = (Rs.1],07,500/1.15 + Rs.1], 07,500/1.15] + Rs.1],07,500/1.153) ± Rs.18,00,000

= Rs.]7, 5[,994 ± Rs.18,00,000 = Rs. 9,5[,994

Let T be 35% the annual cash flow is:

= [(P-V) Q - F - D] (I-D) +D

= [(300-150) ]0000² 15,00,000 ² [,00,000] (1-35%) + [,00,000

= [30,00,000 ² ]1,00,000] (0.[5) ÷ [,00,000

= 9,00,000(0.[5) + [,00,000

= Rs. 11,85,000 p.a

NPV = (Rs.11, 85,000/1.15+Rs.11, 85,000/1.15]+Rs.11, 85,000/1.15)-

Rs.18, 00,000

= Rs. ]7,05,[]] ± Rs.18, 00,000 = Rs. 9,05,[]]

Let T be 37.5%. The annual cash flow is:

= [(P-V) Q - F - D] (I-D) +D

= [(Rs.300-Rs.150) ]0000 units-Rs.15, 00,000 ±Rs. [,00,00] (1- 37.5%) +Rs. [,00,000

NPV = (Rs.l], 30,00 + Rs.1], 30,000/1.15] + Rs.1], 30,000/l.l5)-Rs.18, 00,000

= Rs. ]8,08,3[9 ±Rs. 18,00,000= Rs. 10,08,3[9

Let T be 3]%. The annual cash flow is:

= [(P-V) Q - F - D] (I-D) +D

= [(Rs.300-Rs.150) ]0000 units-Rs.15, 00,000 ±Rs.[,00,000] (1- 3].5%) +Rs. [,00,000

= [Rs.30, 00,000 ±Rs.]1, 00,000] (0.[75) + Rs.[, 00,000

= 9,00,000(0.[75) + [,00,000

= Rs. 1],07,500 p.a

NPV = (Rs.1], 07,500/1.15+Rs.1], 07,500/1.1]+Rs. 1],07,500/1.15) - Rs.18, 00,000

= Rs.]7, 5[,994 ± Rs.18, 00,000 = Rs. 9,5[,994«««.

Let T be 35% the annual cash flow is:

= [(P-V)Q - F - D] (I-D) +D

= [(300-150) ]0000² 15,00,000 ² [,00,000] (1-35%) + [,00,000

= [30,00,000 ² ]1,00,000] (0.[5) ÷ [,00,000

= 9,00,000(0.[5) + [,00,000

= Rs. 11,85,000 p.a

NPV = (11,85,000/1.15 + 11,85,000/1.15] + 11,85,000/1.15)² 18,00,000

= ]7,05,[]] - 18,00,000 = Rs. 9,05,[]]

Let T be 37.5%. The annual cash flow is:

= [(P-V)Q - F - D] (I-D) +D

= [(300-150) ]0000 ² 15,00,000 ² [,00,O0¶¶] (1-37.5%) + [,00,000

= [30,00,000²]1,00,000] (0.[]5) + [,00,000

= Rs. 11,[],500 p.a

NPV = (11,[],500/1.15 + 11,[],500/1.15] + 1 1,[],500/1.153)² 18,00,000 = ][,54,]49 -

18,00,000 = Rs. 8,54,]49

= [30,00,000 - ]1,00,000] (0.[0) + [,00,000

= 9,00,000 (0.[0) + [,00,000

= Rs. 11,40,000 p.a

NPV = (Rs.11, 40,000/1.15+Rs11, 40,000/1.15]+Rs.11,40,000/l.153)-18,00,000

= Rs.][, 0],87[ ± Rs.18,00,000 = Rs. 8,0],87[

You might have noted that as T rises, npv falls.

Rate of change in NPV for a given change in T.

When T rises to 3].5% (i.e. (0.3]5) from 30% (i.e. 0.3) NPV falls to Rs.9,5[,994 from

Rate of change =

When T rises to 35% (i.e. (0.35) from 3].5% (i.e. 0.3]5) NPV falls to

Rs.9, 05,[]] from Rs.9, 5[,994.

Rate of change =

When T rises to 37.5% from 35% NPV falls to Rs.8,54,]49 from Rs. 9,05,[]]

Rate of change =

When T rises to 40% from 37.5% NPV falls to Rs.3,0],81[ falls to Rs. 8,0],81[ from Rs.

Rate of change =

The rate of MI in NT¶V is rising with the rise in tax rate. Hence, NPV is highly negatively
sensitive with tax rate.

We can study the sensitivity of NPV to µT¶ in the form of a graph, taking NPV on the Y axis and
µT¶ on the X-axis also.

We can do the sensitivity analysis of NPV with respect to another uncertain variable, say µP,¶
keeping V, Q and T at their most likely values, other variables at their fixed values and changing
the value of P within its given range of values. Similarly, we can do the sensitivity analysis of
NPV with respect to V, keeping P. Q and T at their most likely values, other variables at their
fixed values and changing the value of V within its given range of values. So, also we can
replicate the sensitivity with respect to µQ¶.

Now, of the 4 uncertain variables, namely, P, V, Q and T, with respect to which variable the
NPV is most sensitive, can be seen. Anowledge of the same will help in monitoring the project
with respect to those variables very ably. Hence, the utility of sensitivity analysis.


A firm is currently using a machine purchased two years ago for Rs.l4,00,000. It has further 5
years of life. It is considering replacing the machine with a new one which will cost Rs.]8,
00,000 Cost of installation is Rs.], 00,000. Increase in working capital is Rs.4, 00,000. The
profits before tax and depreciation are as follows for the two machines:

The firm adopts fixed installment method of depreciation. Tax rate and capital gain tax is 10%
on inflation un-adjusted capital gain.

Is it desirable to replace the current machine by the new one, taking the resale value of old
machine at Rs. 1[,00,000 at present and using, PBP, ARR, NPV and IRR? (For NPV method
take 10% as discount rate, for ARR shod cutoff rate is 15% and for PBP method cutoff period is
3.5 years).


First, we have to calculate the size of investment needed. This includes, purchase cost of new
machine, cost of installation and working capital addition needed, reduced by net sale proceeds
(after capital gain tax) of old machine.

The old machine¶s original cost =Rs.14,00,000

Depreciation for the past ] years

Rs.], 00,000 [14,00,000 + life 7 years]

It is sold for

This gain has two components, capital gain and revenue Capital gain = Rs. Sale value - original
cost = Rs.1[,00,000 - Rs.14,00,000 = Rs.],00,000. Revenue gain Total gain-capital gain=
Rs.[,00,000 - Rs.4,00,000 = Rs.],00,000. Tax on revenue gain = Rs.4,00,000 x 40% =
Rs.1,[0,000. Tax on capital gain = ]00000 x 10% = ]0,000. Therefore, after adjustment, net
sales proceeds of old machine = Rs. 1[,00,000 - Rs.]0,00,000 - Rs.1,[0,000 = Rs. 14,]0,000.
Now, we can compute net investment at time zero, i.e., at beginning as follows:

Now, we have to calculate the change or increment in cash flow because of the firm going for
replacement of old machine by new one. For this purpose, what is the cash flow from new
machine and what would be the cash flow from old machine had the firm continued with that
must be computed. The difference of former over the latter is the change in cash flow.


A company bought a machine ] years earlier at a cost of Rs.[0, 000 and estimated its useful life
as 1] years in all. Its current market price is Rs.]5, 000. The management considers replacing
this machine with a new one with life of 10 years and price at a Rs. 1,00,000. The new machine
can produce 15 units more per hour. The annual operating hours are 1000 both for new and old
machines. Selling price per unit is Rs.3. The new machine will involve add. Material cost by
Rs.[,000 and labour by RS.[,000 p.a. But savings in cost of consumable stores of Rs.1000 and
repairs of Rs.l000 p.a. will result. The corporate tax rate is 40%. Advice on the replacement
assuming additional working capital of Rs.10000 introduced now, can be redeemed at 10 years
later, cost of capital as 10% and SLM of depreciation, using NPV method.

5c,c c20

Since, uniform cash flow is found throughout l to 9th years, the NPV formulate can be slightly
modified as:

NPV = [ACF S 1 / (I+k) t +CF10 X 1 (1+k) 10] - I

= Rs.]3000 [l / 1.1 + 1 / 1.1] + «««1 / 1.19] + 33000 x 1 / 1.110 - Rs.75000

= (Rs.]3000 x 5.759) + (Rs.33000 x 0.38[)-75000

= Rs.145195 ± Rs.75000 = Rs. 70195

The replacement is advised.


A company has 3 investment proposals. The expected PV of cash flows and the amount of
investment needed are as below:

If projects 1 and ] are jointly taken, there will be no economies or diseconomies. If projects 1
and 3 are undertaken, economies result in investment and combined investment will be Rs.4.4
lakhs. If ] and 3 are combined, combined PV of cash flow will be Rs.[.] lakhs. If all the 3
projects are combined, all the above economies will result but diseconomy in the form of
additional investment of Rs. 1.]5 lakhs will be needed. Find which projects are to be taken.


Projects 1 & 3 will be chosen as NPV is higher


Project risk refers to fluctuation in its payback period, ARR, IRR, and NPV or so higher the
fluctuation, higher is the risk and vice versa. Let us take NPV based risk.

If NPV from year to year fluctuates, there is risk. This can be measured through standard
deviation of the NPV figures. Suppose, the expected NPV of a project is Rs.18 lakhs, and
standard deviation of Rs.[ lakhs, the coefficient of variation C.V is given by sm. Deviation
divided by NPV.

C.V = Rs.[, 00,000 / Rs 18,00,000=0.33.


When multiple projects are considered together, what is the overall risk of all projects put
together? Is it the aggregate average of standard deviation of NPV of all projects? No, it is not.
Then what? Now another variable has to be brought in to the scene. That is the correlation
coefficient between NPVs of pairs of projects. When two projects are considered together, the
variation in the combined NPV is influenced by the extent of correlation between NPVs of the
projects in question. A high correlation results in high risk and vice versa. So, the risk of all
projects put together in the form of combined standard deviation is given by the formula:


sp = combined portfolio standard deviation

Pij = correlation between NPVs of pairs of projects (i and j)

si, sj = standard deviation of iin and jth projects, i.e., any pair of projects taken at a time.


Three projects have their standard deviations as follows: Rs.4000, Rs.[000 and Rs.10000. The
correlation coefficients are l&] 0.[, 1&3 0.78 and ]&3: -0.5. What is the overall standard
deviation of the portfolio of projects?

sp = [SPij si sj ] ½ = [s1]+s]]+s3]+]P1]s1s]+]P]3s]s3+]P13s1s3] ½

= [4000] + [000] + 10000] + ]x0.[x4000x[000 -i- ]x0.78x[000xl0000 +

]x(-0. 5) x 10000x4000] ½

= [1[000000+3[000000+ 100000000+]8800000+93[00000-400000000] ½

= []34400000] ½ = Rs. 15,310

What is the return from these multiple projects? This is simple. It is the aggregate NPVs.
Suppose, the three projects have NPVs of Rs.1[, 000, Rs.]0, 000 and Rs.44, 000. The combined
NPV = 1[000 + ]0000 + 44000 = Rs.80000.

The combined coefficient of variation = combined standard deviation I and combined NPV =
Rs.15340/Rs.80000 = 0.19 = 19% If we take the correlation factor, unadjusted figures of
combined standard deviations and combined NPVs, the coefficient of variation would have been:
]0000/80000 = 0.]5 = ]5%. The correlation factor has resulted in reducing overall portfolio risk
from ]5% to 19%. This results essentially when there is low degree of correlation among the
projects. More so, if there is higher negative correlation among the projects.


Three projects involve an outlay of Rs.], 00,000, Rs.3, 00,000 and Rs.5, 00,000 respectively.
The estimated return from the projects are 14%, 1[% and ]0%. The standard deviation of returns
are 5%, 10% and 10%. The correlation coefficients are 1&]: 0.4, ]&3: 0.[ and 1&3: 0.]. Find
the portfolio return and risk.


The portfolio or combined return is simply the weighted return of the projects. This is given by:
Swi Ri where wi - is the weight (0.], 0.3 and 0.5 for the three projects respectively) and Ri - is the
respective project return.

Portfolio return = (wi Ri)

= 0.]x14% + 0.3x1[% + 0.5x]0%

= ].8% + 4.8% -µ-10% = 17[%

p = Portfolio risk = [(wi wj pij (i (j]11]

= [wlwl(l (1 + w]w](](] + w3w3(3(3 + ]w1w](1] (1(] + ]w]w3(]3 (](3 + ]w1w3(13 (1(3]1/]

Putting the given values, we get that,

sp, = [0.]+0.9+].5+]A+18+]] ½

= [][] ½ = 5.099%


1.c bring out the meaning and significance of capital projects.

].c Calculate payback period, ARR, NPV (at k=10%) and given IRR.

 c>cc c

c c "  c  c


cc 2cc


Leverage has been defined as µthe action of a lever, and the mechanical advantage gained by it¶ -
A lever is a rigid item that transmits and modifies force or motion where forces are applied at
two points and it turns around a third. It is the principle that permits the magnification of force
when a lever is applied to a fulcrum. The term leverage refers to an increased means of
accomplishing some purpose. With leverage, it is possible to lift objects, which is otherwise
impossible. The term refers generally to circumstances which bring about an increase in income
volatility. In business, leverage is the means of increasing profits. It may be favourable or
unfavourable. The former reduces profit, while the latter increases it. The leverage of a firm is

essentially related to a measure, which may be a return on investment or on earnings before
taxes. It is an important tool of financial planning because it is related to profits.

c ! "c

On reading this lesson, you will be conversant with,

1.c The meaning and types of leverages

].c Steps involved in simulation procedure
3.c Advantages and limitations of financial leverage
4.c Managerial analysis of leverages

  c  c


Christy and Rodent define leverage as the tendency for profits to change at a faster rate than
sales. Leverage is an advantage or disadvantage which is derived from earning a return on total
investment (total assets) and which is different from the return on owner¶s equity. It is a
relationship between equity share capital and debt securities, and creates fixed interest and
dividend charges. It is also known as gearing. The term capital gearing is used to describe the
ratio between the ordinary share capital and the fixed interest bearing securities of a company.
Capital gearing reveals the suitability or otherwise of a company¶s capitalization. However, it is
a double-edged weapon, and emphasises the effects of deterioration as well as of improvement.


%c c  c c"c


The return on investment is a very important indicator of a firm¶s performance. It is an index of
operational efficiency. It should be remembered that the return on investment is the result of
asset turnover and profit margin. Asset turnover is the ratio of sales to total assets, while the
profit margin is the ratio of EBIT to sales. This may be expressed as follows:

0cccc?cc 0c-cw#cc

This leverage is popularly known as µROI leverage.


The asset turnover aspect of the ROI leverage is often referred to as asset leverage. A firm with a
relatively high turnover is said to have a high degree of asset leverage. There is nothing like an
absolute high or low asset leverage. In other words, it is a relative term which is used to compare
inter- firm performance. The profit margin may be increased with a careful cost control - by
reducing production costs, selling expenses, distribution expenses and administrative overheads.


The operating leverage takes place when a change in revenue produces a greater change in EBIT.
It indicates the impact of changes in sales on operating income. A firm with a high operating
leverage has a relatively greater effect on EBIT for small changes in sales. A small rise in sales
may enhance profits considerably, while a small decline in sales may reduce and even wipe out
the EBIT. Naturally, no firm likes to operate under conditions of a high operating leverage
because that creates a high-risk situation. It is always safe for a firm to operate sufficiently above
the break-even point to avoid dangerous fluctuations in sales and profits. The operating leverage
is related to fixed costs. A firm with relatively high fixed costs uses much of its marginal
contribution to cover fixed costs. It is interesting to note that beyond the break-even point, the
marginal contribution is converted into EBIT. The operating leverage is the highest near the

break-even point. After a firm reaches this point, even a small increase in sales results in a big
increase in EBIT.

The extent of the operating leverage at any single sales volume is calculated as follows:

The change in the rate of earnings is based on the operating leverage resulting from the fact that
some costs do not move proportionally with changes in production. This leverage operates both
positively and negatively, increasing profits at a rapid rate when sales are expanding and
reducing them or causing losses when operations decline. If all the costs were variable, the rate
of profit would show fewer changes at different operating levels. The operating leverage, then, is
the process by which profits are raised or lowered in greater proportion than the changes in the
volume of production because of the inflexibility of some costs. The higher the fixed costs, the
greater the leverage and the more frequent the changes in the rate of profit (or loss) with
alternations in the volume of activity.


The operating leverage decreases with an increase in sales above the break- even point. The
reason is that fixed costs become relatively smaller than the revenues and the variable costs once
the break-even point is reached. The extent of the operating leverage depends on the employment

of fixed assets in the production process. The higher the fixed costs a firm employs in the
production process, the greater is its operating leverage. This operating leverage is measured
with the help of following formula:


It is a company¶s capacity to maintain an even distribution policy in the face of difficult trading
periods, which may occur due to Dividend policies and the building up of reserves and Capital
structure management. A firm¶s capital structure is the relation between debt and equity
securities. It, therefore, shows the effects of borrowing on equity stockholders.


It is generally accepted that investors seek to maximize their return on investments, subject to
given risk constraints, and that they demand a higher return for the greater risk involved in an
investment. The proportion of debt in the capital structure of a company is limited by two

1.c Investors risk preference

].c Business risk associated with the nature of a company¶s operations.

The determination of this limit, which is known as the corporate debt capacity, is an important
aspect of the financial policy of a company to get the maximum benefit from debt financing.
While the investors¶ risk preference is difficult to assess because it varies from individual to
individual, business risk can be determined objectively.

A highly geared capital structure, or what is known as high leverage, distorts the profit earning
capacity. Frank H. Jones rightly says that the profit earning capacity of ordinary shares in a well-
financed company is not always fully appreciated. Leverage is thus the utilisation of fixed costs
to effect disproportionate changes in income. It may be defined as the employment of an asset or

funds for which a firm pays a fixed cost or fixed return. David Francis observes that a fixed cost
or return may be looked upon as the fulcrum of leverage.

Financial leverage occurs when a corporation earns a bigger return on fixed cost funds than it
pays for the use of such funds. It refers to typical situation in which a firm has fixed charges,
securities, such as preferred stock and debentures, and its return on investment must not be equal
to fixed charges. It exits in both these conditions. If these conditions are not present, financial
leverage is absent. The reason is that, if a firm earns exactly as much as it pays for the use of its
capital, there is no use making any borrowings. In other words, there is no financial leverage in
this situation. If the ROT (return on investment exceeds the rate of interest, a firm has a
favourable financial leverage) and is in a position to pass part of this advantage to its equity
stockholders by resorting to borrowings.

Charles Ellis observes that there seems to exist a general management preference for equity and
retained earnings rather than for debt and preferred capital. However, the financial leverage is
favourable when it is worthwhile for a firm to borrow. In other words, when the ROl exceeds
interest rate, the financial leverage is favourable, or the firm is said to be trading on equity. It
also means that, when there is a favourable financial leverage, the advantage is passed on to
equity stockholders. On the other hand, when the ROI is less than the interest rate, the firm loses
money by its borrowings. In other words, borrowings place it in an embarrassing position. It is
not then worthwhile for it to borrow and have an unfavourable financial leverage.

The phrase trading equity is a financial jargon which indicates the utilisation of non-equity
sources of funds in the capital structure of an enterprise. At a high debt-equity ratio, a firm may
not be able to borrow funds at a cheaper rate of interest it may not able to borrow funds at all.
This is so because creditors lose confidence in the company which has a high debt-equity ratio.
How can creditors have confidence in the company which has only creditors and no equity
stockholders? The company will, therefore, have to strive hard to regain a reasonable debt-equity
ratio so that the expectations of the market may be satisfied. In fact, equity financing by way of a
public sale of stock offers real value of a firm. Traditionally, it has served as a spearhead for
expansion of resources and productive capacity involving risk.

Merwin Waterman states that the term trading on equity is seldom heard among the practitioners
of business finance. It is, however, a term full of an academic flavour, and textbooks use it in
discussions of the financial structures. On the µstreet¶, a synonym for this academic phraseology
is financial leverage. Trading on equity is defined as the increase in profit /return resulting from
borrowing capital at a lower rate and employing it in a business yielding a higher rate. The
capital obtained from debt securities is used in a project which produces a rate of return which is
higher than its cost. This allows the difference to be distributed to holders of equity securities. In
other words, it is possible to lever the return on investment through a tighter management.

Doing business partly on borrowed capital is known as trading on equity, which, however,
includes all forms of business with funds (or properties) obtained on contracts calling for limited
payments to those who supply funds. The expectation is that these funds will produce a larger
revenue than the limited payments call for. Thus, trading on equity may be based upon bonds,
non-participating preferred stock, and/or limited rental leases. When a corporation earns more on
its borrowed capital than the interest it has to pay on bonds, trading on equity is profitable. But in
times of poor business, when the interest on bonds amounts to more than the company makes
from the use of these funds, trading on equity is unprofitable. For these reasons, it is said that
trading on equity magnifies profits and losses.

Most companies benefit from an objective review of their borrowings. In recent years,
borrowings have increased as a percentage of net tangible assets, either by force of
circumstances or as the result of the doctrine of gearing or leverage. Companies have tended to
borrow at different times in circumstances which often bear little relationship to their present size
and financial position.

-c#c c

Financial leverage depends upon the ratio of debt and preferred stock together to common stock
equity. There are three ratios which the degree of financial leverage implies.

The effect of financial leverage in a firm¶s capital structure may be analysed from the following
information given below


the firm P issued no debt, the shareholders received a [ percent after - tax return. In spite of the
firm Q issuing a debt of Rs. 30,000, it had no leverage, for the ROI (10 per cent) was equal to the

interest (10 per cent). The firm issued a similar debt and enjoyed a favourable leverage, for its
ROI (9 per cent) was higher than its interest (7 per cent). However, the firm S suffered from an
adverse or unfavourable leverage, for its ROI (7 per cent) was less than its interest rate (8 per
cent). The principle of capital structure management is then simple. It is logical for a firm to
borrow reasonable amounts; If it earns higher rate than it pays for its borrowings. Similarly,
when ROl is high, the firms with a favourable financial leverage are bound to enjoy high

/c#c cc

1. The advantage of trading on equity is that it makes it possible for a company to distribute
higher dividends per share than it would have, if it has been financed by stock alone.

]. The advantages and attractiveness of trading on equity for the owners of equity capital are all
too apparent. Some of these have already been explained while discussing the requirements for
trading on equity.

c#c c

1. It may cause dividends to disappear altogether and, indeed, may be responsible for the
insolvency and even bankruptcy of a corporation.

]. Companies enjoying a fairly regular income can employ borrowed funds more safely than
those with widely fluctuating incomes.

3. Beyond a certain point, additional capital cannot be employed to produce a return in excess of
the payments which must be made for its use or sufficiently in excess thereof to justify its

4. The bigger the amount of funds borrowed, the higher the interest rate the corporation may be
forced to pay in order to market its successive issues of bonds. Such increase in interest rates, if
carried far off, may offset all the advantages of trading on equity. But such a general principle
does not inevitably follow. A growing company which is progressively increasing its net

earnings through trading on equity may present such an earning exhibit as to make it possible for
further trading on equity at low or lower rates. Moreover, money rates may fall.


Operating and financial leverages are inter-dependent. At any given level of a firm¶s operations,
the total extent of leverage may be measured by the following formula:

Degree of Total Leverage = Degree of Operating Leverage x Degree of Financial Leverage or


It takes place when a firm has such sources of funds as preferred stock and debentures which
carry fixed charges. This leverage indicates the extent to which changes in operating income
affect the EBT. It may be calculated by the following formula:


It is evident that if a firm has fixed interest charges amounting to Rs. ]0,000, its fixed charges
leverage at a sales volume of ]0,000 units would be:

In other words, it means that any increase in EBIT would be accompanied by a 1.]9 times
increase in EBT. If the EBIT gets trebled, say Rs. ],70,000, the EBT would be Rs. ],50,000
(],70,000 - ]0,000).

The new level of fixed charges leverage would then be:

In other words, like the operating leverage, the fixed charges leverage also decreases with an
increase in EBIT.

In Financial Management, fixed charges leverage is also referred to as financial leverage.

However, as different leverage concepts are associated with the term financial leverage, it would
be better to refer to fixed charges leverage separately as the ratio of EBIT to EBT. This would
probably make it distinct from financial leverage which is more popularly associated with
trading on equity.


It is clear from the above discussion that the operating leverage, the fixed charges leverage and
the combined leverage are techniques of marginal analysis.

The fixed charges leverage isolates costs and compares changes in revenues with changes in
EBIT. The fixed charges leverage isolates interest and compares changes in EBIT with changes
in EBT. Combined leverage isolates both fixed costs and interest and compares changes in
revenues with changes in EBT. It has already been stated that operating and combined leverage
uses the marginal contribution of sales. The reason is that each additional unit of sales produces a

unit of marginal contribution. Moreover, the leverage works only when sales decrease or

If, for example, the operating leverage is a drop of 50 percent in sales may wipe off the EBIT.


Now, if sales drops by 50

percent, the same will be reduced to Rs. ],00,000.

It is clear that the EBIT has been wiped off.


1. From the following Information, you are required to compute the return on investment

Sales 1,50,000 units at Rs. 1.]0 per unit.

Total Assets = Rs. 3,00,000

Earnings before interest and taxes = Rs. 30,000


c4c ,0,cc

1. From the following information, you are required to find out the asset of a firm.

Sales Rs. 1,80,000

Total Assets Rs. 3,00,000


(Note: It should be remembered that the asset leverage is a part of the ROI Leverage).

]. From the following information, compute operating leverage of a firm.

Sales 1,50,000 units ù Ps. 1.]0 per unit.

Varilable Cost 40 paise per unit

Fixed Cost Rs. 3[,000


3. From the following Information, you are required to find out the extent of operating leuerage
in the year 1989.

EBIT (1988) Rs. 30,000

EBIT (1989) Rs. 35,000

Sales (1988) 1,50,000 units

Sales (1989) 1,80,000 units


4. A company is thinking of expansion and financing it by issuing equity stock of Rs. 50,000
shares of Rs. 100 per share or by Issuing 1]% debentures of the same amount. The tax rate is
50% and the current equity capital structure amounts to 1,00,000 shares of Rs. 100 each. The
earnings before interest and taxes are Rs. 50,00,000. You are required to explain the financial
leverage underlying the second proposition.


To find out the financial leverage, it would be necessary to prepare a table as below:

It is clear from the above table that when the debt is issued for Rs. 50,00,000 instead of equity
stock, the earnings per share has arisen from Rs. 1[.[7 to Rs.]]. This explains the financial
leverage which the equity stockholders enjoy when the proportion of equity stock to the debt is
increased in the capital structure.

5. The installed capacity of a factory is 700 units. The actual exploited capacity Is 500 units.
Selling price per unit is Rs. 10 and Variable cost Is Rs. [ per unit.

Calculate the operating leverage in each of the following situations:

I when fixed costs are Rs. 500

II when fixed costs are Rs. 1,100

III when fixed costs are Rs. 1,500




Since, there is no interest component, EBIT Itself will be treated as EBT. Operating Leverage:


1. Explain the following terms

(a) ROI Leverage

(b) Asset Leverage

(c) Operating Leverage

(d) Financial Leverage

(e) Total Leverage

(f) Fixed Charges Leverage

(g) Combined Leverage

(h) Marginal Leverage

]. As a financial analyst how would you analyze each leverage from the point of view of
financial decisions?

c c



Now that, we are familiar with the different sources of long-term finance, let us find out what it
costs the company to raise these various types of finance. The cost of capital to a company is the
minimum rate of return that it must earn on its investments in order to satisfy the various
categories of investors who have made investments in the form of shares, debentures of term
loans. Unless the company earns this minimum rate, the investors will be tempted to pull out of
the company, leave alone participate in any further capital investment in that company. For
example, equity investors expect a minimum return as dividend based on their perception of the
risk they are undertaking, on the company¶s past performance, or on the returns they are getting
risk from shares of other companies they have invested in.


On reading this lesson, you will be conversant with:

The meaning of cost of capital costs associated with the principal sources of long-term finances
concept of weighted average cost of capital method of calculating specific cost of discounts
sources of capital.

  c  c

c#c ##c0c#c c

c#c &0c


Where kd = post-tax cost of debenture capital

= annual interest payment per debenture capital

t = corporate tax rate = redemption price per debenture

F = redemption price per debenture

P = net amount realised per debenture and n = maturity, period

The interest payment (I) is multiplied by the factor (t-t) because interest on debt is a tax-
deductible expense and only post-tax costs are considered. The following example illustrates the
application of this formula.


Ajax Limited has recently made an issue of non-convertible debentures for Rs.400 lakhs. The
terms of the issue are as follows: each debenture has a face value of Rs.100 and carries a rate of
interest of 14 per cent. The interest is payable annually and the debenture is redeemable at a
premium of 5 per cent after 10 years.If Ajax Limited realises Rs.97 per debenture and the
corporate tax rate is 50 per cent, what is the cost of the debenture to the company?


aiven I = Rs.14, t = 0.5, P = Rs.97 and n = 10 years, F Ps.105. The cost per debenture (kd) will

= 7.7 percent

c#c cc

The cost of the term loans will be simply equal to the interest rate multiplied by (1- tax rate). The
interest rate to be used here will be the interest rate applicable to the new term loan. The interest
is multiplied by I (1 - tax rate) as interest on term loans is also tax deductible.


The cost of a redeemable preference share (kp) is defined as:

kp = cost of preference capital

D = preference dividend per share payable annually

F = redemption price

P = net amount realised per share and n = maturity period


The terms of the preference share issue made by Colour-Dye-Chem are as follows: Each
preference share has a face value of Rs.100 and carries a rate of dividend of 14 per cent payable

annually. The share is redeemable after 1] years at par. If the net amount realised per share is
Rs.95, what is the cost of the preference capital?


aiven that D = 14, F = 100, P = 95 and n = 1]

= 0.148 or 14.8 per cent ]


Measuring the rate of return required by the equity shareholders is a difficult and complex
exercise because the dividend stream receivable by the equity shareholders is not specified by
any legal contract (unlike in the case of debenture holders). Several approaches are adopted for
estimating this rate of return like the dividend forecast approach, capital asset pricing approach,
realised yield approach, earnings-price ratio approach, and the bond yield plus risk premium
approach. For our purposes. we shall consider only the dividend forecast approach.

According to the dividend forecast approach¶ the intrinsic value of an equity stock is equal to the
sum of the present values of the dividends associated with it,

Where a = price per equity share

= expected dividend per share at the end of year t

and ke = rate of return required by the equity shareholders.

If we know the current market price (Pe) and can forecast the future stream of dividends, we can
determine the rate of return required by the equity shareholders (k8) from equation (1), which is
nothing but the cOSI of equity capital.

In practice, the model suggested by equation (1) cannot be used in its present form because it is
not possible to forecast the dividend stream completely and accurately over the life of the
company. Therefore to apply this model in practice, the typical approach is to forecast the
dividend per share (OPS) expected at the end of the first year (D1) and assume a constant growth
rate (g) in DPS thereafter. Assuming a constant growth rate in dividends, the equation (1) can be
simplified as follows:

If the current market price of the share is given (Pe), and the values of D1 and g are known, then
the equation (]) can be. rewritten as

The following example illustrates the application of this formula:


The market price per share of Mobile alycois Limited is Rs.1]5, dividend per share expected a
year hence is Rs.1] per share and the DPS is expected to grow at a constant rate of 8 per cent per
annum. What is the cost of the equity capital to the company?


The cost of equity capital (ke) will be:


The cost of retained earnings or internal accruals is generally taken to be the same as the cost of

i.e., kr (representing cost of retained earnings) = ke

But when for raising external equity, the company has certain floatation costs (costs incurred
during public issue, like brokerage, underwriting commission, fees to managers of issue, legal
charges, advertisement and printing expenses etc.). The formula for ke in this will be as follows:

Where f = floatation costs.

For example, aamma Asbestos Limited has got Rs.100 lakhs of retained earnings and Rs.100
lakhs of external equity through a issue, in its capital structure. The equity investors expect a rate
of return of 18%. The cost of issuing external equity is 5%. The cost of retained earnings and the
cost of external equity can be determined as follows:

Cost of retained earnings

kr = ke i.e., 18%

Cost of external equity raised by the company

Now k0 = 1 - 0.05 = 18.95%


To illustrate the calculation of the weighted average cost of capital, let us consider the following


The market price per equity share is Rs.]5. The next expected dividend per share (DPS) is
Rs.].00 and the DPS is expected to grow at a rate of 8 per cent. The preference shares are
redeemable after 7 years at par and are currently quoted at IRs.75 per share in the stock
exchange. The debentures are redeemable after [ years at par and their current market quotation
is Rs.90 per share. The tax rate applicable to the firm is 50 per cent. Calculate the weighted
average cost of capital.


We will adopt a three-step procedure to solve this problem.

2c Determine the costs of the various sources of finance., We shall define the symbols ke,
kr, kp, kd and ki to denote the costs of equity, retained earnings, preference capital, debentures.
And term loans respectively.

2c % Determine the weights associated with the various sources of finance. We shall define
the symbols We, Wr, Wp, Wd and Wi to denote the weight of the various sources of finance.

2c% Multiply the costs of the various sources of finance with lh corresponding weights and
add these weighted costs to determine the weighted average cost of capital (WAC). Therefore,

WAC = Wake + Wrkr ÷ Wkp + Wdkd + Wiki

= (0.]5 x 0.1[) + (0.30 x 0.1[) + (0.0]5 x 0.1780) + (0.175 x 0.091]) +(0.]5 x 0.07)

= 0.1]59 or 1].59 per cent.


One issue to be resolved before concluding this section relates to the system of weighting that
must be adopted for determining the weighted average cost of capital.

The weights can be used on (i) book values of sources of finance included in the present capital
structure (ii) present value weights of the sources of finance included in the capital 5picture (iii)
proportions of financing planned for the capital budget to be adopted for the forthcoming period.
There are pros and cons associated with each of these systems of weighting. On the balance, we,
however, recommend the use of market value weights provided the values are available and


1.c What is cost of capital? What is the significance in capital structure planning?
].c How do you calculate cost of debenture capital?
3.c Explain the method of calculating the cost of preference capital and equity capital.
4.c How do you calculate cost of retained earnings?
5.c What is weighted average cost of capital? How do you calculate WACC?




Finance is an important input for any type of business and is needed for working capital and for
permanent investment. The total funds employed in a business are obtained from various
sources. A part of the funds are brought in by the owners and the rest is borrowed from others²
individuals and institutions. While some of the funds are permanently held in business, such as
share capital and reserves (owned funds), some others are held for a long period such as long-
term borrowings or debentures, and still some other funds are in the nature of short-term

The entire composition of these funds constitute the overall financial structure of the firm. As
such the proportion of various sources for short-term funds cannot perhaps be rigidly laid down.
The firm has to follow a flexible approach. A more definite policy is often laid down for the
composition of long-term funds, known as capital structure. More significant aspects of the
policy are the debt equity ratio and the dividend decision. The latter affects the building up of
retained earnings which is an important component of long-term owned funds. Since, the
permanent or long-term funds often occupy a large portion of total funds and involve long-term
policy decision, the term financial structure is often used to mean the capital structure of the

There are certain sources of long-term funds which are generally available to the corporate
enterprises. The main sources are: share capital (owners¶ funds) and long-term debt including
debentures (creditors¶ funds). The profits earned from operations are owners¶ funds²which may
be retained in the business or distributed to the owners (shareholders) as dividend. The portion of
profits retained in the business is a reinvestment of owners¶ funds. Hence, it is also a source of
long-term funds. All these sources together are the main constituents of the capital of the
business, that is, its capital structure.

c ! "c

After reading this chapter you would be able to understand capital structure and its features,
determinants of capital structure, cost of capital and related aspects.

  c  c


The term µcapital structure¶ represents the total long-term investment in a business firm. It
includes funds raised through ordinary and preference shares, bonds, debentures, term loans from
financial institutions, etc. Any earned revenue and capital surpluses are included:


Decision regarding what type of capital structure a company should have is of critical importance
because of its potential impact on profitability and solvency. Small companies often do not plan
their capital structure. These companies may do well in the short-run. However, sooner or later
they face considerable difficulties. The unplanned capital structure does not permit an
economical use of funds for the company. A company should therefore plan its capital structure
in such a way that it derives maximum advantage out of it and is able to adjust more easily to the
changing conditions.

Instead of following any scientific procedure to find an appropriate proportion of different types
of capital which will minimize the cost of capital and maximize the market value, a company

may just either follow what other comparable companies do regarding capital structure or may
consult some institutional leader and follow its practice.

Theoretically, a company should plan an optimum capital structure in such a way that the market
value of its shares is maximized. The value will be maximized when the marginal real cost of
each source of fund is the same.

In general, the discussion on the issue of optimum capital structure is highly theoretical. The
determination of an optimum capital structure in practice is a formidable task. That is why,
perhaps, significant variations among industries and among different companies within the same
industry regarding capital structure are found. A number of factors influence the capital structure
decision of a company. The judgement of the person or group of persons making the capital
structure decision plays a crucial role. Two similar companies can have different capital
structures if the decision makers differ in their judgement about the significance of various
factors. These factors are highly psychological, complex and qualitative and do not always
follow the accepted theory. Capital markets are not perfect and the decision has to be taken with
imperfect knowledge and consequent risk.


Capital structure is usually planned keeping in view the interests of the ordinary shareholders.
The ordinary shareholders are the ultimate owners of the company and have the right to elect the
directors. While developing an appropriate capital structure for his company, a finance manager
should aim at maximizing the long-term market price of equity shares. In practice, for most
companies within an industry, there will be a range of an appropriate capital structures within
which there are no great differences in the market values of shares. A capital structure in this
context can be determined empirically. For example, a company may be in an industry that has
an average debt to total capital ratio of [0 percent. It may be empirically found that the
shareholders in general do not mind the company operating within a 15 percent range of the
industry¶s average capital structure. Thus, the appropriate capital structure for the company
ranges between 45 percent to 75 percent debt to total capital ratio. The management of the
company should try to seek the capital structure near the top of this range in order to make

maximum use of favourable leverage, subject to other requirements such as flexibility, solvency,

A sound or appropriate capital structure should have the following features:

w#&4cThe capital structure of the company should be most advantageous. Within the
constraints, maximum use of leverage at a minimum cost should be made.

4cThe use of excessive debt threatens the solvency of the company. Debt should be used

-&4cThe capital structure should be flexible to meet the changing conditions. It should be
possible for a company to adapt its capital structure with minimum cost and delay if warranted
by a changed situation. It should also be possible for the company to provide funds whenever
needed to finance its profitable activities.

In other words, from the solvency point of view, we need to approach capital structuring with
due conservatism. The debt capacity of the company which depends on its ability to generate
future cash flows should not be exceeded. It should have enough cash to pay periodic fixed
charges to creditors and the principal sum on maturity.

The above are the general features of an appropriate capital structure. The particular
characteristics of a company may reflect some additional specific features. Further, the emphasis
given to each of these features may differ from company to company. For example, a company
may give more importance to flexibility than to retaining the control which could be another
desired feature, while another company may be more concerned about solvency than about any
other requirement. Furthermore, the relative importance of these requirements may change with
changing conditions.


Capital structure has to be determined at the time a company is promoted. The initial capital
structure should be designed very carefully. The management of the company should set a target
capital structure and the subsequent financing decisions should be made with a view to achieve

the target capital structure. Once a company has been formed and it has been in existence for
some years, the Finance Manager then has to deal with the existing capital structure. The
company may need funds to finance its activities continuously. Every time the funds have to be
procured, the Finance Manager weighs the pros and cons of various sources of finance and
selects most advantageous sources keeping in view the target capital structure. Thus, the capital
structure decision is a continuous one and has to be taken whenever a firm needs additional

aenerally, the factors to be considered whenever a capital structure decision is taken are: (i)
Leverage or Trading on equity, (ii) Cost of capital, (iii) Cash flow, (iv) Control, (v) Flexibility,
(vi) Size of the company, (vii) Marketability, and (viii) Floatation costs. Let us briefly explain
these factors.

cc /cc304c

The use of sources of finance with a fixed cost, such as debt and preference share capital, to
finance the assets of the company is known as financial leverage or trading on equity. If the
assets which are financed by debt yield a return greater than the cost of the debt, the earnings per
share will increase without an increase in the owners¶ investment. Similarly, the earnings per
share will also increase if preference share capital is used to acquire assets. But the leverage
impact is felt more in case of debt because (i) the cost of debt is usually lower than the cost of
preference share capital, and (ii) the interest paid on debt is a deductible charge from profits for
calculating the taxable income while dividend on preference shares is not.

Because of its effect on the earnings per share, financial leverage is one of the important
considerations in planning the capital structure of a company. The companies with high level of
the Earnings Before Interest and Taxes (EBIT) can make profitable use of the high degree of
leverage to increase return on the shareholders¶ equity. One common method of examining the
impact of leverage is to analyse the relationship between Earnings Per Share (EPS) at various
possible levels of EBIT under alternative methods of financing. The EBIT-EPS analysis is one
important tool in the hands of the Finance Manager to get an insight into the firm¶s capital

structure management. He can consider the possible fluctuations in EBIT and examine their
impact on EPS under different financing plans.


Plan A No debt, all equity shares

Plan B 50% debt (10%), 30% preference shares (1]%), ]00/c equity shares

Plan C 80% debt (10%), ]00/c equity shares

The face value of equity shares is Rs. 10. The rates in parentheses indicate the fixed return on
debt and preference shares.

The total amount of capital required to be raised is Rs. ],00,000. The company estimates its
earnings before interest and taxes (EBIT) at Rs. 50,000 annually.

The effect of financial leverage (trading on equity) is presented in Table1. It will be seen that
Plan C is the most attractive, from shareholders¶ point of view as the EPS of Rs. 4.]5 is the
highest under this plan. The lowest EPs are when the company does not use any debt or fixed
return securities. You will note that the proportion of fixed return securities under plans B and C

is the same (80%). However, plan C gives a higher EPS for the reason that dividend on
preference share is not deductible for income tax purposes while interest is a deductible charge.

Assuming that the estimates about EBIT turn out to be correct, the shareholders would be
benefited to the maximum if plan C is adopted. The shares of the company will command a high
premium in the market and would be greatly in demand. The managements of companies
sometimes intentionally want to make their equity shares very attractive and prized possessions.
This they can achieve by the practice of trading on equity. The secret of the advantage in
financial leverage lies in the fact that whereas the overall return (before tax) on capital employed
is ]5% the return on preference share and debt is only 1]% and 10% respectively. The savings
resulting from this difference enable the management to enhance the return on equity shares.

Although leverage increases BPS under favourable conditions, it can also increase financial risk
to the shareholders. Financial risk increases with the use of debt because of (a) the increased
variability in the shareholder¶s earnings and (b) the threat of insolvency. A firm can avoid
financial risk altogether if it does not employ any debt in its capital structure. But when no debt
is employed in the capital structure, the shareholders will be deprived of the benefit of increases
in BPS arising from financial leverage.

Therefore, a firm should employ debt to the extent the financial risk perceived by the
shareholders does not exceed the benefit of increased BPS.


Measuring the costs of various sources of funds is a complex subject and needs a separate
treatment. Needless to say that it is desirable to minimize the cost of capital. Hence, cheaper
sources should be preferred, other things remaining the same.

The cost of a source of finance is the minimum return expected by its suppliers. The expected
return depends on the degree of risk assumed by investors. A high degree of risk is assumed by
equity shareholders than debt-holders. In the case of debt-holders, the rate of interest is fixed and
the company is legally bound to pay interest, whether it makes profits or not. For equity
shareholders the rate of dividend is not fixed and the Board of Directors has no legal obligation

to pay dividends even if the profits have been made by the company. The loan of debt-holders is
returned within prescribed period, while shareholders can get back their capital only when the
company is wound up. This leads one to conclude that debt is a cheaper source of funds than
equity. The tax deductibility of interest charges further reduces the cost of debt. The preference
share capital is cheaper than equity capital, but is not as cheap as debt is. Thus, in order to
minimise the overall cost of capital, a company should employ a large amount of debt.

However, it should be realised that a company cannot go on minimising its overall cost of capital
by employing debt. A point is reached beyond which debt becomes more expensive because of
the increased risk of excessive debt to creditors as well as to shareholders. When the degree of
leverage increases, the risk to creditors also increases. They may demand a higher interest rate
and may not further provide funds loan to the company once the debt has reached a particular
level. Furthermore, the excessive amount of debt makes the shareholders¶ position very risky.
This has the -effect of increasing the cost of equity. Thus, up to a point the overall cost of capital
decreases with debt, but beyond that point the cost of capital would start increasing and,
therefore, it would not be advantageous to employ debt further. So, there is a combination of
debt and equity which minimizes that firm¶s average cost of capital and maximizes the market
value per share.

The cost of equity includes the cast of new issue of shares and the cost of retained earnings. The
cost of debt is cheaper than the cost of both these sources of equity funds. Between the cost of
new issue and retained earnings, the latter is cheap. The cost of retained earnings is less than the
cost of new issue because the company does not have to pay personal taxes which have to be
paid by shareholders on distributed earnings, and also because, unlike new issues, no floatation
costs are incurred if the earnings are retained. As a result, between these two sources, retained
earnings are preferable.

Thus, when we consider the leverage and the cost of capital factors, it appears reasonable that a
firm should employ a large amount of debt provided its earnings do not fluctuate very widely. In
fact, debt can be used to the point where the average cost of capital is minimum. These two
factors taken together set the maximum limit to the use of debt. However, other factors should
also be evaluated to determine the appropriate capital structure for a company.

Theoretically, a company should have such a mix of debt and equity that its overall cost of
capital is minimum. Let us understand this concept by taking an illustration.


A company is considering a most desirable capital structure. The cost of debt (after tax) and of
equity capital at various levels of debt equity mix are estimated as follows:

Determine the optimal mix of debt and equity for the company by calculating composite cost of

For determining the optimal debt equity mix, we have to calculate the composite cost of capital
i.e., Ao which is equal to Aipl+Aep]

Where Ai = Cost of debt

P1 = Relative proportion of debt in the total capital of the firm

Ae = Cost of equity

P] = Relative proportion of equity in the total capital of the firm

Before we arrive at any conclusion, it would be desirable to prepare a table showing all
necessary information and calculations.


The optimal debt equity mix for the company is at a point where the composite cost of capital is
minimum. From the table, it is evident that a mix of ]0% debt and 80% equity gives the
minimum composite cost of capital of 14%. Any other mix of debt and equity gives a higher
overall cost of capital. The closest to the minimum cost of capital is a mix of 40% debt and [0%
equity where Ao is 14.4%. It can therefore be concluded that a mix of ]0% debt and 80% equity
will make the capital structure optimal.

,c c

One of the features of a sound capital structure is conservatism. Conservatism does not mean
employing no debt or a small amount of debt. Conservatism is related to the assessment of the
liability for fixed charges, created by the use of debt or preference capital in the capital structure
in the context of the firm¶s ability to generate cash to meet these fixed chares.

The fixed charges of a company include payment of interest, preference dividend and principal.
The amount of fixed charges will be high if the company employs a large amount of debt or
preference capital. Whenever, a company thinks of raising additional debt, it should analyze its
expected future cash flows to meet the fixed charges. It is obligatory to pay interest and return
the principal amount of debt. If a company is not able to generate enough cash to meet its fixed
obligations, it may have to face financial insolvency. The companies which expect large and
stable cash inflows can employ a large amount of debt in their capital structure. It is somewhat
risky to employ sources of capital with fixed charges for companies whose cash inflows are
unstable or unpredictable.


In designing the capital structure, sometimes the existing management is governed by its desire
to continue control over the company. The existing management team may not only want to be
elected to the Board of Directors but may also dispute to manage the company without any
outside interference.

The ordinary shareholders have the legal right to elect the directors of the company. If the
company issues new shares, there is a risk of loss of control. This is not a very important
consideration in case of a widely held company. The shares of such a company are widely
scattered. Most of the shareholders are not interested in taking active part in the company¶s
management. They do not have the time and urge to attend the meetings. They are simply
interested in dividends and appreciation in the price of shares. The risk of loss of control can
almost be avoided by distributing shares widely and in small lots.

Maintaining control however, could be a significant question in the case of a closely held
company. A shareholder or a group of shareholders could purchase all or most of the new shares
and thus control the company. Fear of having to share control and thus being interfered by others
often delays the decision of the closely held companies to go public. To avoid the risk of loss of
control the companies may issue preference shares or raise debt capital.

Since, holders of debt do not have voting right, it is often suggested that a company should use
debt to avoid the loss of control. However, when a company uses large amounts of debt, lot of
restrictions are imposed on it by the debt-holders to protect their interests. These restrictions
curtail the freedom of the management to run the business. An excessive amount of debt may
also cause bankruptcy, which means a complete loss of control.


Flexibility means the firm¶s ability to adapt its capital structure to the needs of the changing
conditions. The capital structure of a firm is flexible if it has no difficulty in changing its
capitalization or sources of funds. Whenever needed, the company should be able to raise funds
without undue delay and cost to finance the profitable investments. The company should also be

in a position to redeem its preference capital or debt whenever warranted by future conditions.
The financial plan of the company should be flexible enough to change the composition of the
capital structure. It should keep itself in a position to substitute one form of financing for another
to economies on the use of funds.


The size of a company greatly influences the availability of funds from different sources. A small
company may often find it difficult to raise long-term loans. If somehow it manages to obtain a
long-term loan, it is available at a high rate of interest and on inconvenient terms. The highly
restrictive covenants in loan agreements of small companies make their capital structure quite
inflexible. The management thus cannot run business freely. Small companies, therefore, have to
depend on owned capital and retained earnings for their long-term funds.

A large company has a greater degree of flexibility in designing its capital structure. It can obtain
loans at easy terms and can also issue ordinary shares, preference shares and debentures to the
public. A company should make the best use of its size in planning the capital structure.


Marketability here means the ability of the company to sell or market a particular type of security
in a particular period of time which in turn depends upon the readiness of the investors to buy
that security. Marketability may not influence the initial capital structure very much but it is an
important consideration in deciding the appropriate timing of security issues. At one time, the
market favours debenture issues and at another time, it may readily accept ordinary share issues.
Due to the changing market sentiments, the company has to decide whether to raise funds
through common shares or debt.

If the share market is depressed, the company should not issue ordinary shares but issue debt and
wait to issue ordinary shares till the share market revives. During boom period in the share
market, it may not be possible for the company to issue debentures successfully. Therefore, it
should keep its debt capacity unutilised and issue ordinary shares to raise finances.


Floatation costs are incurred when the funds are raised. aenerally, the cost of floating a debt is
less than the cost of floating an equity issue. This may encourage a company to use debt rather
than issue ordinary shares. If the owner¶s capital is increased by retaining the earnings, no
floatation costs are incurred. Floatation cost generally is not a very important factor influencing
the capital structure of a company except in the case of small companies.


1.c What are the factors effecting capital structure of the company?
].c Explain the features of an optimal capital structure?




A business organization always aims at earning profits. The utilisation of profits earned is a
significant financial decision. The main issue here is whether the profits should be used by the
owner(s) or be retained and reinvested in the business itself. This decision does not involve any
problem is so far as the sole proprietory business is concerned. In case of a partnership the
agreement often provides for the basis of distribution of profits among partners. The decision-
making is somewhat complex in the case of joint stock companies.

Since a company is an artificial person, the decision regarding utilisation of profits rests with a
group of people, namely the board of directors. As in any other type of organization, the disposal
of net earnings of a company involves either their retention in the business or their distribution to
the owners (i.e., shareholders) in the form of dividend, or both.

The decision regarding distribution of disposable earnings to the shareholders is a significant

one. The decision may mean a higher income, lower income or no income at all to the
shareholders. Besides affecting the mood of the present shareholders, dividend may also

influence the mood, behavior and responses of prospective investors, stock exchanges and
financial institutions because of its relationship with the worth of the company which in turn
affects the market value of its shares.

The decision regarding dividend is taken by the Board of Directors and is then recommended to
the shareholders for their formal approval in the annual general body meeting of the company.
Disposal of profits in the form of dividends can become a controversial issue because of
conflicting interests of various parties like the directors, employees, shareholders, debenture
holders, lending institutions, etc. Even among the shareholders there may be conflicts as they
may belong to different income groups. While some may be interested in regular income, others
may be interested in capital appreciation and capital gains. Hence, formulation of dividend
policy is a complex decision. It needs careful consideration of various factors.

c &'c

The objectives of this unit are:

To acquaint with the meaning, types and purpose of dividend

To highlight the various factors, which influence the determination of dividend policy.

  c  c

c#c //c

Dividend ordinarily is a distribution of profits earned by a joint stock company among its
shareholders. Mostly dividends are paid in cash, but there are also other forms of dividends such
as Scrip dividends, Debenture dividends, Stock dividends, and, in unusual circumstances,
Property dividends. These are briefly described below:

2c //c

Dividends can be paid only out of profits earned in the particular year or in the past reflected in
the company¶s accumulated reserves. Profits do not necessarily mean adequate cash to enable
payment of cash dividends. In case the company does not have a comfortable cash position it

may issue promissory notes payable in a few months. It may also issue convertible dividend
warrants redeemable in a few years.

&0c //c

Companies may also issue debentures in lieu of dividends to their shareholders. These
debentures bare interest and are payable after a prescribed period. It is just like creating a long-
term debt. Such a practice is not common.

0c,cc1c //c

Instead of paying dividends out of accumulated reserves, the latter may be capitalized by issue of
bonus shares to the shareholders. Thus, while the funds continue to remain with the company, the
shareholders acquire the right and this way their marketable equity increases. They can either
retain their bonus shares and thus be entitled to increase total dividend or can sell their bonus
shares and realise cash. Ordinarily, bonus shares are not issued in lieu of dividends. They are
periodically issued by prosperous companies in addition to usual dividends. Certain guidelines,
as laid down by the government, are applicable for issue of bonus shares in India.

w24c //c

This form of dividend is unusual. Such dividend may be in the form of inventory or securities in
lieu of cash payment. A company sometimes may hold shares of other companies, eg., its
subsidiaries which it may like to distribute among its own shareholders, instead of paying
dividend in cash. In case the company sells these shares it may have to pay capital gains which
may be subject to taxation. If these shares are transferred to its shareholders, there is no tax


The objective of corporate management usually is the maximization of the market value of the
enterprise i.e., its wealth. The market value of common stock of a company is influenced by its
policy regarding allocation of net earnings into µplough back¶ and µpayout¶. While maximizing
the market value of shares, the dividend policy should be so oriented as to satisfy the interests of

the existing shareholders as well as to attract the potential investors. Thus, the aim should be to
maximize the present value of future dividends and the appreciation in the market price of

w4c 2c

Dividend policy options refer to the policy options that the management formulates in regard to
earnings for distribution as dividend among shareholders. It is not merely concerned with
dividends to be paid in one year, but is concerned with the continuous course of action to be
followed over a period of several years. Dividend decision involves dealing with several
questions, such as:

Whether dividend should be paid right from the initial year of operation i.e., regular dividends.
Whether equal amount or a fixed percentage of dividend be paid every year,
Irrespective of the quantum of earnings as in case of preference shares, i.e., stable dividends.
Whether a fixed percentage of total earnings be paid as dividend which would mean varying
amount of dividend per share every year, depending on the quantum of earnings and number
of ordinary shares in that year, i.e., a fixed payout ratio.
Whether the dividend be paid in cash or in the form of shares of other companies held by it or
by converting (accumulated) retained earnings into bonus shares, i.e., property dividend or
bonus dividend.


There are several factors which influence the determination of the dividend policy. As such no
two companies may follow exactly similar dividend policies. The dividend policy has to be
tailored to the particular circumstances of the company. However, the following aspects have
general applicability:

Dividend policy should be analysed in terms of its effect on the value of the company.
Investment by the company in new profitable opportunities creates value and when a company
foregoes an attractive investment, shareholders opportunity loss.
Dividend, investment and financing decisions are interdependent and a trade off.

Dividend decision should not be treated, as a short run residual decision because variability of
annual earnings may cause even a zero dividend in a particular year. This may have serious
repercussions for the company and may exult in the delisting of its shares for the purpose of
dealings on any approved stock exchange.
A workable compromise is to treat dividends as a long-term residual to avoid undesirable
variations in payout. This needs financial planning over a tawny long time horizon.
Whatever dividend policy is adopted by the company, the general principles guiding the
dividend policy should, as far as possible, be communicated clearly to investors who may then
take their decisions in terms of their own preferences and needs.
Erratic and frequent changes in dividends should be avoided. Reduction in the rate of dividend
is a painful thing for the shareholders to bear. The management will find it hard to convince
the shareholders of the desirability of a lower dividend for the sake of preserving their future

c#c,c cc

The disposal of the earnings, retention in business or distribution among shareholders, is an issue
of fundamental importance in financial management. The Finance Manager plays an important
role in advising the management i.e., Board of Directors regarding the decision. It is the latter
whose privilege it is to take the decision. The retention of profits in business helps the company
in mobilizing funds for expansion. Economists, however, believe that the entire earnings of a
business should be paid to its owners who should then decide where to reinvest them. That, all of
them may decide to reinvest the distributed earnings in the same company is another thing.

In case the company has more favorable reinvestment opportunities within it as compared to
those offered outside, it would be more profitable for the company to retain earnings than to pay
them out as dividends. The shareholders can later be compensated by issue of bonus shares. Let
us illustrate this point by taking an example. Suppose the net profit after taxes of a company is
Rs. 1 lakh and is totally distributed as dividend to shareholders. The relevant figures would then
appears as follows:


It is clear from the above example that if dividends are not paid, Rs. 1 lakh of income is available
to the company for reinvestment in business. In case dividends are paid, it is likely that not more
than Rs. 54,000would be available for reinvestment (in the same or any other business),
assuming that the stockholders are willing to reinvest their entire dividend income. lf better
outside investment opportunities are available to the shareholders, depending upon the
environment prevalent in the capital market, they may not appreciate the recommendation (or
action) of the Board of Directors for retention of larger amounts in the business, as they might
perceive it to their detriment. As such they would be interested in receiving larger dividends. The
dividend policy, particularly the timing of the declaration of dividend, influences the market
value of a company¶s shares. The Finance Manager, therefore, should be well-informed about the
capital market trends and the tax policies of the government, besides the rationale behind the
investment programme of the company.

c#c,c /c#c c

The Board of Directors has the power to determine whether and at what rate dividend shall be
paid to the shareholders. The payment of dividend is not obligatory.

Even a majority of shareholders have no right to interfere with the authority of the Board. So
long as the Board acts in good faith, acts on the basis of a reasonable policy, and it does not
flagrantly abuse its fiduciary responsibility, its decision cannot be challenged and there is no way
to force a dividend by direct legal action.

However, there are some restrictions, dictated by law or prudence, on the discretion of the Board
of Directors which are as follows:

Dividends may be declared out of any inappropriate surplus.
If there is a loss, it should be absorbed first before dividends can be declared.
Dividend declarations which impair the capital strength of a corporation must be discouraged.
Dividend declarations which might lead to insolvency should be discouraged.
A due provision for depreciation, depletion, etc. should be made prior to dividend declaration.
Directors can be used by shareholders, if they have declared any unlawful dividends or have
grossly neglected their interests.
The rights of creditors should be taken care of while taking a decision on dividend.

The corporate management is an elective management. The power of recommending a dividend

is delegated by the shareholders to the Board of Directors. The Board declares a dividend in its
duly convened meeting by a resolution which sets forth the rate of dividend, the class of
stockholders to whom dividend is payable, and the date and mode of dividend payment.

At times, the interest of the shareholders may come into conflict with those of the company. The
Board is expected to act judiciously in taking a decision on dividends. The decision has two
dimensions. First, the corporate management must satisfy the shareholders by offering them a
fair return on their investment by way of dividends. Second, the management has a commitment
to ensure the financial stability of the corporation by withholding dividends (i.e., by not
declaring dividends), if it feels this course is necessary, in order to enable the company to stand
on a firm ground.

The dividend decision thus is a difficult one because of conflicting objectives and also because
of lack of specific decision-making techniques. It is not easy to lay down an optimum dividend
policy which would maximize the long-run wealth of the shareholders.

There are certain factors that impinge upon the dividend decision and, therefore, should be taken
into consideration while deciding a policy in this respect.

c##c //c c

It is possible to group the factors affecting dividend policy into two broad categories:

Ownership considerations
Firm-oriented considerations.

Ownership Considerations: Where ownership is concentrated in few people, there are no

problems in identifying ownership interests. Where, however, ownership is decentralized on a
wide spectrum the identification of their interests becomes difficult. Further, the influence of
stockholders¶ interests on dividend decision becomes uncertain because: (a) the status or
preferences of stockholders relating to their position, capital gains, current income, etc. cannot be
precisely ascertained; (b) a conflict in shareholders¶ interests may arise. Inspite of these
difficulties, efforts should be made to ascertain the following interests of shareholders to
encourage market acceptance of the stock:

Current income requirements of stockholders

Alternative uses of funds in the hands of stockholders -
Tax matters affecting stockholders.

Since, various groups of shareholders may have different desires¶ and objectives,
understandably, investors gravitate to those companies, which combine the mix of growth and
desired dividends. Since companies generally do not have a singular group of shareholders, the
objective of the maximization of the market value of shares requires that the dividend policy be
geared to investors in general.


Ownership interests alone may not determine the dividend policy. A firm¶s needs are also an
important consideration, which include the following:

Contractual and legal restrictions

Liquidity, credit-standing and working capital
Needs of funds for immediate or future expansion
Availability of external capital
Risk of losing control of organization
Relative cost of external funds

Business cycles
Post dividend policies and stockholder relationships.

The following factors affect the shaping of a dividend policy.

0c#c 0c

This is an important determinant of the dividend policy of a company. Companies with unstable
earnings adopt dividend policies which are different from those which have steady earnings.
Consumer goods industries usually suffer less from uncertainties of income and, therefore, pay
dividends with greater regularity than the capital goods industries. Industries with stable income
are in a position to formulate consistent dividend policies. Thus, public utilities may be able to
establish a relatively fixed dividend rate. Mining companies, on the other hand, with long
gestation period and multiplicity of hazards, may not be able to declare dividends for years. But
once they get established, they might afford to make liberal dividend payments. If earnings
fluctuate and losses are caused during depression, the continued payment of dividends may
become a risky proposition.

A company with µwasting¶ assets²such as timber, oil or mines²which get depleted over time,
may well pursue a policy of gradually returning capital to its owners because its resources are
going to be exhausted. Such a company may offer dividends, which include, in part, a return of
the owner¶s investment.

aenerally speaking, large and mature companies pay a reasonably good but not an excessive rate
of dividend. Excessive dividends may be paid only by µmushroom¶ companies; a healthy
company with an eye on future follows a somewhat cautious policy and builds up reserves. A
company which believes in publicity gimmicks may follow a more liberal dividend policy to its
future detriment. A firm with a head programme of investment in research and development
would see to it-that adequate reserves are built up for the purpose.

0/c/c &'c#cc

While some organizations may be niggardly in dividend payments,¶ some others may be liberal.
A large number of firms may be found within these two extremes.

Niggardly organizations prefer to conserve cash. Though such an approach may easily meet their
future needs for funds, it deprives the stockholders of a legitimate return on their investment.
Liberal organizations, on the other hand, feel that stockholders are entitled to an established rate
of dividend as long as their financial condition is reasonably sound. Within these two extremes, a
number of corporations adopt several venations.

The attitude of the management affects the dividend policies of a corporation in another way.
The stockholders who control the management of the company may be interested in µempire-
building¶ They may consider ploughing back of earnings as the most effective technique for
achieving their objective of building up the corporate as perhaps the largest in the field.


There may be marked variations in dividend policies on account of the variations in the
composition of the shareholding. In the case of a closely held company, the personal objectives
of the directors and of a majority of shareholders may govern the decision. Widely held
companies have scattered shareholders. Such companies may take the dividend decision with a
greater sense of responsibility by adopting a more formal and scientific approach.

The tax burden on business corporations is a determining factor in formulation of their dividend
policies. The directors of a closely held company may take into consideration the effect of
dividends upon the tax position of their important shareholders. Those in the high-income
brackets may be willing to sacrifice additional income in the form of dividends in favour of
appreciation in the value of shares and capital gains. However, when the stock is widely held,
stockholders are enthusiastic about collecting their dividends regularly, and do not attach much
importance to tax considerations.

Thus, a company which is closely held by a few shareholders in the high income-tax brackets, is
likely to payout a relatively low dividend. The shareholders in such a company are interested in
taking their income in the form of capital gains rather than in the form of dividends which arc

subject to higher personal income taxes. On the other hand, the shareholders of a large and
widely held company may be interested in high dividend payout.

c 220c

Many companies retain the earnings to facilitate planned expansion. Companies with low credit
ratings may feel that they may not be able to sell their securities for raising necessary finance
they would need for future expansion. So, they may adopt a policy for retaining larger portion of

In the context of opportunities for expansion and growth, it is wise to adopt a conservative
dividend policy if the cost of capital involved in external financing is greater than the cost of
internally generated funds.

Similarly, if a company has lucrative opportunities for investing its funds and can earn a rate
which is higher than its cost of capital, it may adopt a conservative dividend policy.

c#c c4c/c30/4c

Companies may desire to build up reserves by retaining their earnings which would enable them
to weather deficit years or the down-swings of a business cycle. They may, therefore, consider it
necessary to conserve their cash resources to face future emergencies, Cash credit limits, and
working capital needs, capital expenditure commitments, repayment of long-term debt, etc.
influence the dividend decision. Companies sometimes prune dividends when their liquidity


A company may decide about dividends on the basis of its current earnings which according to
its thinking may provide the best index of what a company can pay, even though large variations
in earnings and consequently in dividends may be observed from year to year. Other companies
may consider regularity in payment of dividends as more important than anything else. They
may use past profits to pay dividends regularly, irrespective of whether they have enough current
profits or not. The past record of a company in payment of dividends regularly builds up the

morale of the stockholders who may adopt a helpful attitude towards it in periods of emergency
or financial crisis. Regularity in dividends cultivates an investment attitude rather than a
speculative one towards the shares of the company.

c&4c c0c

Sometimes, financial institutions which grant, long-term loans to corporations put a clause
restricting dividend payment till the loan or a substantial part of it is repaid.


Inflation is also a factor which may affect a firm¶s dividend decision. In the period of inflation,
funds generated from depreciation may not be adequate to replace worn out equipment¶. Under
these circumstances, the firm has to depend upon retained earnings as a source of funds to make
up for the shortfall. This is of particular relevance if the assets have to be replaced in near future.
Consequently, the dividend payout ratio will tend to be low.

On account of inflation often the profits of most of the companies are inflated. A higher payout
ratio based on overstated profits may eventually lead to the liquidation of the company.

Inflation has another dimension. In an inflationary situation, current income becomes more
important and shareholders in general attach more value to current yield than to distant capital
appreciation. They would thus expect a higher payout ratio.

,c c

Age of the company has some effect on the dividend decision. Established companies often find
it easier to distribute higher earnings without causing an adverse effect on the financial position
of the company than a comparatively younger corporation which has yet to establish itself.

The demand for capital expenditure, money supply, etc. undergo great oscillations during the
different stages of a business cycle. As a result, dividend policies may fluctuate from time to


1.c What is dividend and why is dividend decision important?

].c "While formulating a dividend policy the management has to reconcile its own needs for
funds with the expectations of shareholders". Explain the statement. What policy goals
might be considered by management in taking a decision on dividends?
3.c Discuss the role of a Finance Manager in the matter of dividend policy. What alternatives
he might consider and what factors should he take into consideration before finalising his
views on dividend policy?
4.c "Dividend can be paid only out of profits". Explain the statement. Will a company be
justified in paying dividends when it has unwritten-of accumulated losses of the past?
5.c What factors a company would in general consider before it takes a decision on


cccccccccccccccccccccccccccccccccc* @cw c c




Effective Financial Management is the outcome, among other things, of proper management of
investment of funds in business. Funds can be invested for permanent or long-term purposes
such as acquisition of fixed assets, diversification and expansion of business, renovation or
modernization of plant and machinery, and research and development.

Funds are also needed for short-tem purposes, that is, for current operations of the business. For
example, if you are managing a manufacturing unit you will have to arrange for procurement of
raw material, payment of wages to your workmen and for meeting routine expenses. All the
goods which are manufactured in a given time period may not be sold in that period. Hence,
some goods remain in stock, eg., raw material, semi-finished (manufacturing-in-process) goods
and finished marketable goods. Funds are thus blocked in different types of inventory. Again, the
whole of the stock of finished goods may not be sold against ready cash, some of it may be sold
on credit. The credit sales also involve blocking of funds with debtors till cash is received or the
bills are cleared.

Working Capital refers to a firm¶s investment in short-term assets: viz., cash, short-term
securities, amount receivables (debtors) and inventories of raw materials, work-in-process and
finished goods. It can also be regarded as that portion of the firm¶s total capital which is
employed in short-term operations. It refers to all aspects of current assets and current liabilities.
In simple words, we can say that working capital is the investment needed for carrying out day-
to-day operations of the business smoothly. The management of working capital is no less
important than the management of long-term financial investment.

c &'c

The objectives of this unit are to familiarize you with the:

Concepts and components of working capital

Significance of and need for working capital
Determinants of the size of working capital
Criteria for efficiency in managing working capital

  c  c


One will hardly find an operating business firm which does not require some amount of working
capital. Even a fully equipped manufacturing firm is sure to collapse without (a) an adequate
supply of raw materials to process, (b) cash to meet the wage bill, (c) the capacity to wait for the
market for its finished products, and (d) the ability to grant credit to its customers. Similarly, a
commercial enterprise is virtually good for nothing without merchandise to sell. Working capital,
thus, is the life-blood of a business. As a matter of fact, any organization, whether profit-oriented
or otherwise, will not be able to carry on day-to-day activities without adequate working capital.


The time between purchase of inventory items (raw material or merchandise) and their
conversion into cash is known as operating cycle or working capital cycle. The successive events
which are typically involved in an operating cycle are depicted in Figure I. A perusal of the
operating¶ cycle would reveal that the funds invested in operations are re-cycled back into cash.
The cycle, of course, takes some time to complete. The longer the period of this conversion the
longer is the operating cycle. A standard operating cycle may be for any time period but does not
generally exceed a financial year. Obviously, the shorter the operating cycle, the larger will be
the turnover of funds invested for various purposes. The channels of the investment are called
current assets. Sometimes the available funds may be in excess of the needs for investment in
these assets, eg., inventory, receivables and minimum essential cash balance. Any surplus may
be invested in government securities rather than being retained as idle cash balance.


There are two types of working capital, namely aross and Net working capital.


According to this concept, working capital refers to the firm¶s investment in current assets. The
amount of current liabilities is not deducted from the total of current assets. This concept views
Working Capital and aggregate of Current Assets as two interchangeable terms. This concept is
also referred to as µCurrent Capital¶ or µCirculating Capital¶.

The proponents of the gross working capital concept advocate this for the following reasons:

1.c Profits are earned with the help of assets which are partly fixed and partly current. To a
certain degree, similarity can be observed in fixed and current assets so far as both are
partly financed by borrowed funds, and are expected to yield earnings over and above the

interest costs. Logic then demands that the aggregate of current assets should be taken to
mean the working capital.
].c Management is more concerned with the total current assets as they constitute the total
funds available for operating purposes than with the sources from which the funds come.
3.c An increase in the overall investment in the enterprise also brings about an increase in the
working capital.


The net working capital refers to the difference between current assets and current liabilities.
Current liabilities are those claims of outsiders which are expected to mature for payment within
an accounting year and include creditors¶ dues, bills payable, bank overdraft and outstanding
expenses. Net working capital can be positive or negative. A positive net working capital will
arise when current assets exceed current liabilities. A negative net working capital occurs when
current liabilities are in excess of current assets.

"Whenever working capital is mentioned it brings to mind, current assets and current liabilities
with a general understanding that working capital is the difference between the two".

µNet working capital¶ is a qualitative concept which indicates the liquidity position of the firm
and indicates the extent to which working capital needs may be financed by permanent sources
of funds. This needs some explanation.

Current assets should be sufficiently in excess of current liabilities to constitute a margin or

buffer for obligations maturing within the ordinary operating cycle of a business. A weak
liquidity position poses a threat to the solvency of the company and makes it unsafe. Excessive
liquidity is also bad. It may be due to mismanagement of current assets. Therefore, prompt and
timely action should be taken by management to improve and correct the imbalance in the
liquidity position of the firm.

The net working capital concept also covers the question of a judicious mix of long-term and
short-term funds for financing current assets. Every firm has a minimum amount of net working
capital which is permanent. Therefore, this portion of the working capital should be financed

with permanent sources of funds such as owners¶ capital, debentures, long-term debt, preference
capital and retained earnings. Management must decide the extent to which current assets should
be financed with equity capital and/or borrowed capital.

Several economists uphold the net working capital concept. In support of their stand, they state

In the long run what matters is the surplus of current assets over current liabilities.
It is this concept which helps creditors and investors to judge the financial soundness of the
It is the excess of current assets over current liabilities which can be relied upon to meet
contingencies since this amount is not liable to be returned.
It helps to ascertain the correct comparative financial position of companies having the same
amount of current assets.

It may be stated that gross and net concepts of working capital are two important facets of
working capital management. Both the concepts have operational significance for the
management and therefore neither can be ignored. While the net concept of working capital
emphasizes the qualitative aspect, the gross concept underscores the quantitative.


Ordinarily, working capital is classified into two categories:

Fixed, Regular or Permanent Working Capital; and Variable, Fluctuating, Seasonal,

Temporary or Special Working Capital.


The need for current assets is associated with the operating cycle is a continuous process. As
such, the need for current assets is felt constantly. The magnitude of investment in current assets
however may not always be the same. The need for investment in current assets may increase or
decrease over a period of time according to the level of production. Nevertheless, there is always
a certain minimum level of current assets which is essential for the firm to carry on its business

irrespective of the level of operations. This is the irreducible minimum amount necessary for
maintaining the circulation of the current assets. This minimum level of investment in current
assets is permanently locked up in business and is therefore referred to as permanent or fixed or
regular working capital. It is permanent in the same way as investment in the firm¶s fixed assets


Depending upon the changes in production and sales, the need for working capital, over and
above the permanent working capital, will fluctuate. The need for working capital may also vary
on account of seasonal changes or abnormal or unanticipated conditions. For example, a rise in
the price level may lead to an increase in the amount of funds invested in stock of raw materials
as well as finished goods. Additional doses of working capital may be required to face cutthroat
competition in the market or other contingencies like strikes and lockouts. Any special
advertising campaigns organized for increasing sales or other promotional activities may have to
be financed by additional working capital. The extra working capital needed to support the
changing business activities is called as fluctuating (variable, seasonal, temporary or special)
working capital.

Figures II and III give an idea about fixed and fluctuating working capital.


It is shown in Figure II that fixed working capital is stable overtime, while variable Working
capital is fluctuating²sometimes increasing and sometimes decreasing. The permanent working
capital line, however, may not always be horizontal. For a growing firm, permanent working
capital may also keep on increasing over time as has been shown in Figure III.

Both these kinds of working capital²permanent and temporary²are required to facilitate

production and sales through the operating cycle, but temporary working capital is arranged by
the firm to meet liquidity requirements that are expected to be temporary.


It is already noted that working capital has two components: Current assets and Current
liabilities. Current assets comprise several items. The typical items are:

Cash to meet expenses as and when they occur.

Accounts receivables or sundry trade debtors.
Inventory of raw materials, stores, supplies and spares, work-in-process, and finished goods.
Advance payments towards expenses or purchases, and other short-term advances, which are
Temporary investment of surplus funds which could be converted into cash whenever needed.

Apart from these, the need for funds to finance the current assets may be met from supply of
goods on credit, and deferment, on account of custom, usage or arrangement, of payment for
expenses. The remaining part of the need for working capital may be met from short-term
borrowing from financiers like banks. These items arc collectively called current liabilities.
Typical items of current liabilities are:

aoods purchased on credit

Expenses incurred in the course of the business of the organization (eg., wages or salaries,
rent, electricity bills, interest etc.) which are not yet paid for.
Temporary or short-term borrowings from banks, financial institutions or other parties.
Advances received from parties against goods to be sold or delivered, or as short-term
Other current liabilities such as tax and dividends payable.


Because of its close relationship with day-to-day operations of a business, a study of working
capital and its management is of major importance to internal, as well as external analysts. It is
being increasingly realised that inadequacy or mismanagement of working capital is the leading
cause of business failures. We must not lose sight of the fact that management of working capital
is an integral part of the overall Financial Management and, ultimately, of the overall corporate
management. Working capital management thus throws a challenge and should be a welcome
opportunity for a finance manager who is ready to play a pivotal role in his organization.

Neglect of management of working capital may result in technical insolvency and even
liquidation of a business unit. With receivables and inventories tending to grow and with
increasing demand for bank credit in the wake of strict regulation of credit in India by the

Central Bank, managers need to develop a long-term perspective for managing working capital.
Inefficient working capital management may cause either inadequate or excessive working
capital which is dangerous.

A firm may have to face the following adverse consequences from inadequate working capital:

4.c arowth may be stunted. It may become difficult for the firm to undertake profitable
projects due to non-availability of funds.
5.c Implementation of operating plans may become difficult and consequently the firm¶s
profit goals may not be achieved.
[.c Operating inefficiencies may creep in due to difficulties in meeting even day-to-day
7.c Fixed assets may not be efficiently utilised due to lack of working funds, thus lowering
the rate of return on investments in the process.
8.c Attractive credit opportunities may have to be lost due to paucity of working capital.
9.c The firm loses its reputation when it is not in a position to honour its short-term
obligations. As a result, the firm is likely to face tight credit terms.

On the other hand, excessive working capital may pose the following dangers:

10.cExcess of working capital may result in unnecessary accumulation of inventories,

increasing the chances of inventory mishandling, waste, and theft.
11.cIt may provide an undue incentive for adopting too liberal a credit policy and slackening
of collection of receivables, causing a higher incidence of bad debts. This has an adverse
effect on profits.
1].cExcessive working capital may make management complacent, leading eventually to
managerial inefficiency.
13.cIt may encourage the tendency to accumulate inventories for making speculative profits,
causing a liberal dividend policy which becomes difficult to maintain when the firm is
unable to make speculative profits.

An enlightened management, therefore, should maintain the right amount of working capital on a
continuous basis. Financial and statistical techniques can be helpful in predicting the quantum of
working capital needed at different points of time.


There are no set rules or formulas to determine the working capital requirements of a firm. The
corporate management has to consider a number of factors to determine the level of working
capital. The amount of working capital that a firm would need is affected not only by the factors
associated when the firm itself but is also affected with economic, monetary and general business
environment. Among the various factors the following are important ones.

0c/c.c#c 0c

The working capital needs of a firm are basically influenced by the nature of its business.
Trading and financial firms generally have a low investment in fixed assets, but require a large
investment in working capital. Retail stores, for example, must carry large stocks of a variety of
merchandise to satisfy the varied demand of their customers. Some manufacturing businesses
like tobacco, and construction firms also have to invest substantially in working capital but only
a nominal amount in fixed assets. In contrast, public utilities have a limited need for working
capital and have to invest abundantly in fixed assets. Their working capital requirements are
nominal because they have cash sales only and they supply services, not products. Thus, the
amount of funds tied up with debtors or in stocks is either nil or very small. The working capital
needs of most of the manufacturing concerns fall between the two extreme requirements of
trading firms and public utilities.

The size of business also has an important impact on its working capital needs. Size may be
measured in terms of the scale of operations. A firm with larger scale of operations will need
more working capital than a small firm. The hazards and contingencies inherent in a particular
type of business also have an influence in deciding the magnitude of working capital in terms of
keeping liquid resources.


The manufacturing cycle starts with the purchase of raw materials and is completed with the
production of finished goods. If the manufacturing cycle involves a longer period the need for
working capital will be more, because an extended manufacturing time span means a larger tie-
up of funds in inventories. Any delay at any stage of manufacturing process will result in
accumulation of work-in-process and will enhance the requirement of working capital. You may
have observed that firms making heavy machinery or other such products, involving long
manufacturing cycle, attempt to minimise their investment in inventories (and thereby in
working capital) by seeking advance or periodic payments from customers.

0c 00c

Seasonal and cyclical fluctuations in demand for a product affect the working capital
requirement considerably, especially temporary working capital requirements of the firm. An
upward swing in the economy leads to increased sales, resulting in an increase in the firm¶s
investment in inventory and receivables or book debts. On the other hand, a decline in the
economy may register a fall in sales and, consequently, a fall in the levels of stocks and book

Seasonal fluctuations may also create production problems. Increase in production level may be
expensive during peak periods. A firm may follow a policy of steady production in all seasons to
utilise its resources to the fullest extent. This will mean accumulation of inventories in off-season
and their quick disposal in peak season. Therefore, financial arrangements for seasonal working
capital requirement should be made in advance. The financial plan should be flexible enough to
take care of any seasonal fluctuations.


If a firm follows steady production policy, even when the demand is seasonal, inventory will
accumulate during off-season periods and there will be higher inventory costs and risks. If the
costs and risks of maintaining a constant production schedule are high, the firm may adopt the
policy of varying its production schedule in accordance with the changes in demand. Firms
whose physical facilities can be utilised for manufacturing a variety of products can have the
advantage of diversified activities. Such firms manufacture their main products during the season

and other products during off-season. Thus, production policies may differ from firm to firm,
depending upon the circumstances. Accordingly, the need for working capital will also vary.


The speed with which the operating cycle completes its round raw materials finished product
accounts receivables cash plays a decisive role in influencing the working capital needs. (Refer
to Figure 1 on operating cycle).

/c c

The credit policy of the firm affects the size of working capital by influencing the level of book
debts. Though the credit terms granted to customers in a large measure depend upon the norms
and practices of the industry or trade to which the firm belongs, yet it may endeavour to shape its
credit policy within such constrains. A long collection period will generally mean tying of larger
funds in book debts. Slave collection procedures may even increase the chances of bad debts.

The working capital requirements of a firm are also affected by credit terms granted by its
creditors. A firm enjoying liberal credit terms will need less working capital.


As a company grows, logically, larger amount of working capital will be needed, Though it is
difficult to state any firm rules regarding the relationship between growth in the volume-of a
firm¶s business and its working capital needs. The fact to be recognised is that the need for
increased working capital funds may precede the growth in business activities, rather than
following it. The shift in composition of working capital in a company may be observed with
changes in economic circumstances and corporate practices. arowing industries require more
working capital than those that are static.


Operating efficiency means optimum utilisation of resources. The firm can minimise its need for
working capital by efficiently controlling its operating costs. With increased operating efficiency
application use of working capital is improved


aenerally, rising price level requires a higher investment in working capital. Increasing prices
for the same levels of current assets need enhanced investment. However, firms which can
immediately revise prices of their products upwards may not face a severe working capital
problem in periods of rising price levels. The effects of increasing price level may, however, be
felt differently by different firms. It is possible that some companies may not be affected by the
rising prices, whereas others may be badly hit by it.

,c c

There are some other factors which affect the determination of the need for working capital. A
high net profit margin contributes towards the working capital. The net profit is a source of
working capital to the extent it has been earned. The cash inflow can be calculated by adjusting
non-cash items such as depreciation. Outstanding expenses, losses written off, etc. from the net

The firm¶s appropriation policy, that is, the policy to retain or distribute profit has a bearing on
working capital. Payment of dividend consumes cash resourse and reduces the firm¶s working
capital to that extent. If the profits are retained in the business, the firm¶s working capital
position will be strengthened.


Two approaches are generally followed for the management of working carpet (i) the
conventional approach and (ii) the operating cycle approach.


This approach implies managing the individual components of working capital (ii) the inventory,
receivables, payables, etc. efficiently and economically so that there are neither idle funds nor
paucity of funds. Techniques have been evolved for the management of each of these
components. In India, more emphasis is given to the management of debtors because they
generally constitute the largest share of the investment in working capital. On the other hand,
inventory control has not yet been practiced on a wide scale perhaps due to scarcity of goods (or
commodities) and ever rising prices.

,c 2c4c22,c

This approach views working capital as a function of the volume of operating expenses. Under
this approach the working capital is determined by the duration of the operating cycle and the
operating expenses needed for completing the cycle. The duration of the operating cycle is the
number of days involved in the various stages, commencing with acquisition of raw materials to
the realisation of proceeds from debtors. The credit period allowed by creditors will have to be
set off in the process. The optimum level of working capital will be the requirement of operating
expenses for an operating cycle, calculated on the basis of operating expenses required for a

In India, most of the organizations used to follow the conventional approach earlier, but now the
practice is shifting in favour of the operating cycle approach. The banks - usually apply this
approach while granting credit facilities to their clients.


Measurement of working capital is dealt in the following illustration.


Determine the magnitude of working capital (with the help of the following particulars) for
aujarat Tricycles Limited, a newly set up enterprise:

a) The proforma cost sheet shows that the various elements of cost bear the undermentioned
relationship to the selling price:

Materials, parts and components 40%

Labour 30%

Overhead 10%

b) Production in 19x 8 is estimated to be [,000 tricycles.

c) Raw material, parts and components are expected to remain in the stores for an average period
of one month before issue to production.

d) Finished goods are likely to stay in the warehouse for two months on an average before being
sold and delivered to customers.

e) Each unit of production will be in process for half a month on an average:

f) Half of the sales are likely to be on credit. The debtors will be allowed two months credit from
the date of sale.

g) Credit period allowed by suppliers of raw material, parts and components is one month.

h) The lag of payment to labor is one month.50% of the overhead consists of salaries of non-
production staff.

i) Selling price will be Rs ]00 per tricycle -

j) Assume that sales and production follow a consistent pattern.

k) Allow ]0% to computed figure for buffer cash and contingencies.

Before attempting to calculate the working capital, it will be helpful to work out the following
basic data

a) The yearly production is [,000 tricycles. Hence, monthly production will be 500 tricycles.

b) The selling price per tricycle is Rs. ]00. The various elements of cost (i.e., raw material, parts
and components, labour and overheads) comprise 80% (40%+30%+ 10%) of the selling price.
Hence, cost of production is Rs. 1[0 i.e., (]00x).


It is desirable to check the increasing demand for capital for maintaining the existing level of
activity. Such a control acquires even more significance in times of inflation. In order to control
working capital needs in periods of inflation, the following measures may be applied.

areater disciplines in all segments of the production front may be attempted as under:

14.cThe possibility of using substitute raw materials without affecting quality must be
explored in all seriousness. Research activities in this regard may be undertaken, with
financial assistance provided by the aovernment and the corporate sector, if any.
15.cAttempts must be made to increase the productivity of the work force by proper
motivational strategies. Before going in for any incentive scheme, the cost involved must

be weighed against the benefit to be derived. Though wages in accounting are considered
a variable cost, they have tended to become partly fixed in nature due to the influence of
various legislative measures adopted by the Central or State aovernments in recent times.
Increased productivity results in an increase in value added and this has the effect of
reducing labour cost per unit.

The managed costs should be properly scrutinised in terms of their costs and benefits. Such costs
include office decorating expenses, advertising, managerial salaries and payments, etc. Managed
costs are more or less fixed costs and once committed they are difficult to retreat. In order to
minimise the cost impact of such items, the maximum possible use of facilities already created
must be ensured. Further, the management should be vigilant in sanctioning any new expenditure
belonging to this cost area.

The increasing pressure to augment working capital will, to some extent, be neutralised if the
span of the operating cycle can be i-educed. areater turnover with shorter intervals and quicker
realisation of debtors will go a long way in easing the situation.

Only when there is a pressure on working capital does the management become conscious of the
existence of slow-moving and obsolete stock. The management tends to adopt ad hoc measures
which are grossly inadequate. . Therefore, a clear-cut policy regarding the disposal of slow-
moving and obsolete stocks must be formulated and adhered to. In addition to this, there should
be an efficient management information system reflecting the stock position from various

The payment to creditors in time leads to building up of good reputation and consequently it
increases the bargaining power of the firm regarding period of credit for payment and other
conditions. Projections of cash flows should be made to see that cash inflows and outflows match
with each other. If they do not, either some payments have to be postponed or purchase of some
avoidable items has to be deferred.


Improved profitability of firm, to a great extent, depends on its efficiency in managing working
capital. A single criterion would not be sufficient to judge or evaluate the efficiency in a dynamic
area like working capital.


p.c Whether there is enough assurance for the creditors about the ability of the company to
meet its short-term commitments on time. Hence, a reliable index is whether a company
can settle the bills on due dates. The finance department has to plan in advance to
maintain sufficient liquidity to meet maturing liabilities.
q.c Whether maximum possible inventory turnover is achieved. The adverse effect of
ineffective inventory management may not be offset even by the most efficient
management of other components of working capital.
r.c Whether reasonable credit is extended to customers. This powerful instrument to promote
sales should not be misused. The other side of the same coin is receiving credit. Both
depend upon a company¶s strength as a seller and as a buyer.
s.c Whether adequate credit is obtained from suppliers. It depends upon the company¶s
position in relation to its suppliers and the nature of supply market i.e. whether there is a
single supplier or an oligarchy or a large number of suppliers. With coordination of
efforts buyers can be in a position to negotiate competitive credit terms even if there is a
single supplier and his ability to control the market. At times the supplier imposes the
credit terms as 100% advance i.e., negative trade credit.
t.c Whether there are adequate safeguards to ensure that neither overtrading nor -
undertrading takes place.

The following indices can be used for measuring the efficiency in managing working capital:


CR =Current Assets/Current Liabilities

It indicates the ability of a company to manage the current affairs of business. It is useful to
study the trend of working capital over a period of time.

Though the current ratio of ]:1 is considered ideal, this may have to be modified depending on
the peculiar conditions prevailing in a particular trade or industry. It is not only the quantum of
current ratio that is important but also its quality. i.e., extent to which assets and liabilities are
really current.


QR=Liquid Assets/Current Liabilities

Liquid assets mean current assets minus those which are not quickly realisable. Inventory and
sticky debts are generally treated as non-quick assets.

The relationship of 1:1 between quick assets and current liabilities is considered ideal, but, like
current ratio, it also varies from industry to industry, depending on the peculiar conditions of a
particular industry.


If cash alone is a major item of current assets then it may be a good indicator of the profitability
of the organization, as cash by itself does not earn any profit, the proportion should usually be
kept low.


Sales to Cash Ratio=Sales/Average cash balance during the period.

Cash should be turned over as many times as possible, in order to achieve maximum sales with
minimum cash on hand.


(Debtors/Credit Sales) X 3[5

This ratio explains how many days of credit a company is allowing to its customers to settle their


Average payment period=(Creditors/Credit purchases) x 3[5

It indicates how many days of credit is being enjoyed by the company from its suppliers.

4c 0ccm 5c

ITR=Sales/Average Inventory

It shows how many times inventory has turned over to achieve the sales. Inventory should be
maintained at a level which balances production facilities and sales needs.


Usually expressed in terms of percentage, it signifies that for any amount of sales a relative
amount of working capital is needed. If any increase in sales is contemplated it has to be seen
that working capital is adequate. Therefore, this ratio helps management in maintaining working
capital which is adequate for the planned growth in sales.


This ratio shows the relationship between working capital and the funds belonging to the owners.
When this ratio is not carefully watched, it may lead to:

a) Over trading when the conditions are in the upswing. Its symptoms being (I) High Inventory
Turnover Ratio (ii) Low Current Ratio; or

b) Undertrading when the conditions of market are not good. Its major symptoms are:

i) Low Inventory Turnover Ratio

ii) High Current Ratio.

Efficient working capital management should, therefore, avoid both over-trading and under-


Sources of working capital are many. There are both external or internal sources. The external
sources are both short-term and long-term. Trade credit, commercial banks, finance companies,
indigenous bankers, public deposits, advances from customers, accrual accounts, loans and
advances from directors are external short-term sources. Companies can also issue debentures
and invite public deposits for working capital which are external long-term sources. Equity funds
may also be used for working capital.


Trade credit is a short-term credit facility extended by suppliers of raw materials and other
suppliers. It is a common source. It is an important source. Either open account credit or
acceptance credit may be adopted. In the former as per business custom credit is extended to the
buyer. The buyer is not giving any debt instrument as such. The invoice is the basic document. In
the credit system a bill of exchange is drawn on the buyer who accepts and returns the same. The
bill of exchange evidences the debt. Trade credit is an informal and readily available credit
facility. It is unsecured. It is flexible too; that is advance retirement or extension of credit period
can be negotiated. Trade credit might be costlier as the supplier may inflate the price to account
for the loss of interest for delayed payment.

c &1care the next important source of working capital finance. Commercial
banking system in the country is broad based and fairly developed. Straight loans, cash credits,
hypothecation loans, pledge loans, overdrafts and bill purchase and discounting are the principal
forms of working capital finance provided by commercial banks. Straight loans are given with or
without security. A onetime lump-sum payment is made, while repayments may be periodical or
one time. Cash credit is an arrangement by which the customers (business concerns) are given
borrowing facility upto a certain limit, the limit being subjected to examination and revision year
after year. Interest is charged on actual borrowings, though a commitment charge for utilization
may be charged. Hypothecation advance is granted on the hypothecation of stock or other asset.
It is a secured loan. The borrower can deal with the goods. Pledge loans are made against
physical deposit of security in the bank¶s custody. Here the borrower cannot deal with the goods

until the loan is settled. Overdraft facility is given to current account holding customers to
overdraw the account upto certain limit. It is a very common form of extending working capital
assistance. Bill financing by purchasing or discounting bills of exchange is another common
form of financing. Here, the seller of goods on credit draws a bill on the buyer and the latter
accepts the same. The bill is discounted for cash with the banker. This is a popular form.

c 2c c ,c 04cAbout 50000 companies exist at present. They provide
services almost similar to banks. They provide need-based loans and sometimes arrange loans
from others for customers. Interest rate is higher. But timely assistance may be obtained.

/0c&1 also provide financial assistance to small business and trades. They charge
exorbitant rates of interest by very much understanding.

w0&c/2 are unsecured deposits raised by businesses for periods exceeding a year but not
more than 3 years by manufacturing concerns and not more than 5 years by non-banking finance
companies. The RBI is regulating deposit taking by these companies in order to protect the
depositors. Quantity restriction is placed at ]5% of paid up capital + free services for deposits
solicited from public is prescribed for non-banking manufacturing concerns. The rate of interest
ceiling is also fixed. This form of working capital financing is resorted to by well-established

/c#c0 are normally demanded by producers of costly goods at the time of

accepting orders for supply of goods. Contractors might also demand advance from customers.
Where sellers market prevails, advances from customers may be insisted. In certain cases, to
ensure performance of contract an advance may be insisted.

0c0care simply outstanding suppliers of overhead service requirements.

c #c /, loans from group companies etc. constitute another source of working
capital. Cash rich companies lend to liquidity companies under liquidity crunch.

c22 are usance promissory notes negotiable by endorsement and delivery. Since
1990 CPs came into existence. There are restrictive conditions as to the issue of commercial

paper. CPs are privately placed after RBI¶s approval with any firm, incorporated or not, any bank
or financial institution. Big and sound companies generally float CPs.

&0c /c 304c #0/ can be issued to finance working capital so that the permanent
working capital can be matchingly financed through long term funds.


Tandon committee was appointed by RBI in July 1974 under the Chairpersonship of Shri.
P.LTandon who was the Chairman of Punjab National Bank then. The terms of references of the
committee were:

]1.cTo suggest guidelines for commercial banks to follow up and supervise credit from the
point of view of ensuring proper use of funds and keeping a watch on the safety of
]].cTo suggest the type of operational data and other information that may be obtained by
banks periodically from the borrowers and by the Reserve bank from the lending banks.
]3.cTo make suggestions for prescribing inventory norms for different industries both in the
private and public sectors and indicate the broad criteria for deviating from these norms.
]4.cTo suggest criteria regarding satisfactory capital structure and sound financial basis in
relation to borrowing.
]5.cTo make recommendations regarding resources for financing the minimum working
capital requirements.
][.cTo suggest whether the existing pattern of financing working capital requirements by
cash credit overdraft requires to be modified. If so, Suggest suitable modification.

Findings of the committee: The committee studied the existing system of extending working
capital finance to industry and identified the following as its major weaknesses:

]7.cIt is the borrower who decides how much he would borrow. The banker cannot do any
credit planning since he does not decide how much he would lend.
]8.cBank credit, instead of being taken as a supplementary to other sources of finance, is
treated as the first source of finance.

]9.cBank credit is extended on the account of security available and not according to the level
of operations of the borrower,
30.cThere is a wrong notion that security by itself ensures the safety of bank funds. As a
matter of fact, safety essentially lies in efficient follow-up of the industrial operations of
the borrower.

c / The report submitted by the Tandon committee introduced

major changes in the financing of working capital by commercial banks in India. The report was
submitted on 9th August 1975.

-c#c% An important feature of the Tandon Committee¶s recommendations relate to

fixation of norms for bank lending to industry.


31.cIn order to reduce the dependence of businesses on banks for working capital, ceiling on
bank credit to individual firms has been prescribed. Accordingly, businesses have to
compute the current assets requirement on the basis of stipulations as to size. So, flabby
inventory, speculative inventory cannot be carried on with bank finance. Normal current
liabilities, other than bank finance, are also worked out considering industry and
geographical features and factors. Working capital gap is the excess of current assets as
per stipulations over normal current liabilities (other than bank assistance). Bank
assistance for working capital shall be based on the working capital gap, instead of the
current assets need of a business. This type of financing assistance by banks was
introduced on the basis of recommendations of Tandon Committee.
3].c4c /c &c  The committee has suggested norms for 15 major

The norms proposed represent the maximum level for holding ventures and receivables. They
pertain to the following:

gg.cRaw materials including stores and other items used in the process of manufacture
hh.cStock in process

ii.c Finished goods
jj.c Receivables and bills discounted and purchased.

Raw materials are expressed as so many months¶ cost of production. Stock in process is
expressed as so many months¶ cost of production. Finished goods and receivables are expressed
as so many months cost of sales and sales respectively.

5c/c: The lending norms have been suggested in view of the realization that the
banker¶s role as a lender is only to supplement the borrower¶s resources. The committee has
suggested three alternative methods for working out the maximum permissible level of bank
borrowings. Each successive method reduces the involvement of short-term credit to finance the
current assets, and increases the use of long-term funds.

The first method provided for a maximum 75% of bank funding of the working capital gap. That
is, at least ]5% of working capital gap must be financed through long-term funds. The second
method provided for full bank financing of working capital gap based on 75% of current assets
only. That is,]5% of current assets should be financed through long-term funds. ]5% of current
assets are greater than ]5% of working capital gap. Hence ]nd method meant more non-bank
finance for working capital. The third method provided for long-term fund financing of whole
permanent current assets and ]5% of varying current assets. That is bank financing will be
limited to working capital gap computed taking 75% of varying current assets only.

The three methods are discussed below to show permitted bank funding of working capital:

Today, Tandon committee recommendations are not relevant. Now, banks are flush with funds.
But good borrowers aren¶t many. Tandon committee recommendations were relevant when
controlled economy prepared. Today, it opens economy. Besides, these recommendations were
relevant in those years when money market was tight and capital rationing was needed. Today,
the whole environment has changed. Now banks want to provide long-term loans well. Actually
from April 15, 1997, all instructions relating to maximum permissible bank finance (MPBF)
were withdrawn.


Following the Tandon Committee the Chore Committee under the Chairmanship of Shri.
IC.B.Chore, of RBI, was constituted in April 1979. The terms of reference were:

37.cTo review the working of cash credit system

38.cTo study the gap between sanctioned and utilized cash credit levels
39.cTo suggest measures to ensure better credit discipline
40.cTo suggest measures to enable banks to relate credit limits with output levels.

The recommendations of the committee were:

41.cTo continue the present system of working capital financing, viz., credit, bill finance and
4].cIf possible supplement cash credit system by bill and loan financing
43.cTo periodically review cash credit levels
44.cNo need to bifurcate cash credit accounts into demand loan and cash credit components.
45.cTo fix peak level and non-peak level limits of bank assistance wherever, seasonal factors
significantly affect level of business activity.
4[.cBorrowers to indicate before commencement requirement of bank credit within peak and
sanctioned. A variation of 10% is to be tolerated.
47.cExcess or under utilization beyond 10% tolerance level is to be considered as irregularity
and corrective actions are to be taken up.
48.cQuarterly statements of budget and performance be submitted by all borrowers having
Rs.50 lakh working capital limit from the whole of banking system.
49.cTo discourage borrowers depending on adhoc assistances over and above sanctioned
50.cThe second method of financing of working capital as suggested by the Tandon
committee be uniformly adopted by banks.
51.cTo treat as working capital term loan the excess of bank funding when the switch over to
the second method bank financing is adopted and the borrower is not able to repay the
excess loan.


Later Marathe Committee was appointed to suggest meaningful credit management function of
the RBI. The recommendations of the committee include:

5].cThe second method of financing Tandon committee should be followed.

53.cFast-track system of advance releasing upto 50% of additional credit required by
borrowers pending RBI¶s approval of such enhanced credit authorization.
54.cThe bank should ensure the reasonableness of projections as to sales, current assets,
current liability, net working capital by looking into past performance and assumptions of
the future trend.
55.cThe current assets and liabilities to be classified in conformity with the guidelines issued
by the RBI. For instance current liability should include any liability that needs to be
retired within 1] months from the date of previous balance sheet.
5[.cA minimum of 1.33 current ratio should be maintained. That is, ]5% current assets
should be financed from long-term funds.
57.cA quarterly information system (QIS) giving details as to projected level of current assets
and current liabilities be evolved such that the information is given to the banker in the
week preceding the commencement of the quarter to which the data is related and
58.cA quarterly performance reporting system giving data on performance within [ weeks
following the end of the quarter to which the data is related and adopted.
59.cA half yearly operating and fund flow statement to be submitted with in ] months from
the close of the half-year
[0.cThe banker should review the borrower¶s accounts at least once a year


[1.cDiscuss the concept of working capital. Are the gross and net concepts of working capital
exclusive? Explain.
[].cDistinguish between fixed and fluctuating working capitals. What is the significance of
such distinction in financing working needs of an enterprise?

[3.cDiscuss the significance of working capital management in a business enterprise. What
shall be the repercussions if a firm has (a) shortage of working capital and (b) excess
working capital?
[4.cA firm desires to finance its current assets entirely with short-term loans. Do you think
this pattern of financing would be in the interest of the firm? Support your answer with a
cogent argument.
[5.cWhat factors a Finance Manager would ordinarily take into consideration while
estimating working capital needs of his firm?
[[.cWhat is an operating cycle and how a close study of the operating cycle is helpful?
[7.cHow would you as a Finance Manager control the need of increased working capital on
account of inflationary pressures? Narrate some real-life examples you might have come
[8.cHow would you judge the efficiency of the management of working capital in a business
enterprise? Explain with the help of hypothetical data.
[9.cDefine working capital and describe its components
70.cBring out the kinds and concepts of working capital and the nature and significance of
each type of working capital
71.cWhat do you mean by working capital management? What approaches would you adopt
to ensure effectiveness?
7].cDiscuss clearly the factors affecting the size and composition of working capital.
73.cHow would you plan the working capital requirements of a manufacturing undertaking.
74.cWhat is operating cycle? Explain its significance in the context of estimation of working
capital and ensuring efficient management of working capital.
75.cExplain the different sources of working capital finance.
7[.cDiscuss the terms of reference and recommendations of the Tandon Committee. aive the
impact on financing of working capital.
77.cWhat are the recommendations of Chore Committee? Explain them.

c c



When the finished goods are sold on credit, the entire sales (both on cash and credit bases) are
recorded as sales in the profit and loss account. But, while the cash sales get represented in terms
of cash in hand or in bank or some assets purchased on cash basis, etc, the credit sales are
reflected in the value of sundry debtors (SDs) (as referred to in India),are also known as Trade
Debtors (TDs). Accounts Receivable (ARs), Bills Receivable (BRs) on the assets side of the
balance sheet. This is what happens in the books of the seller. But, in the books of the buyer, the
purchases made on credit basis are accounted for as sundry creditors (SCs) also known as Trade
Creditors (TCs), Accounts Payables (APs) and Bills Payable (BPs).

Further, with a view to fully understand and appreciate the high need for effective monitoring
and follow-up of sundry debtors, it may be very pertinent to mention here that generally
speaking, after the company¶s investment in plant and machinery, and stocks of inventory
(mostly in that order), the sundry debtors constitute the third largest and most important item of
assets of the company.

Therefore, the imperative need of effective monitoring and control of all the items of Sundry
Debtors assume a highly important and strategic position in the area of Corporate Financial


After reading this lesson, you will be conversant with:

Meaning and computation of receivables

Credit policy of organization
Purpose and cost of maintaining receivables
Causes for high sundry debtors
Caridecations for formulation credit policy
Education of credit worthiness of customers
Decision tree for credit granting
Monitoring of receivables

  c  c


While formulating credit policies, we should vary the quantum and period of credit, party-wise.
For this purpose, we may broadly classify our parties (customers, clilentele) under four different
categories, on the basis of their integrity and ability (both intention and strength) to pay in full
and in due time. Accordingly, these may be classified as under:

4c c#c1c

A No risk

B Little risk

C Some risk

D High risk

But, such an exercise should not be taken as just a onetime exercise. Such classifications must,
instead, be reviewed periodically, and revised upward or downward, as the case may be. That is,
if the performance of a particular party in category A seems to be declining, in terms of
promptness in payment, it could well be brought down from Category A to say, Category B.
And, similarly, based upon the past performance, as per the company¶s records, if some
perceptible improvement is observed in some category B, or even category C parties, these could
as well be promoted to Category A and B respectively, as the case be.

I am saying so, such that all the sundry debtors of the company may remain under continuous
observation and scrutiny, and some urgent remedial measures (of applying some restrictions or
liberalization) could be affected, before it becomes too late.

We would now discuss, in detail, about the various ways and means, steps and strategies that can
be adopted to achieve the desired goal of keeping the sundry debtors at the minimal level.




The very first step towards effective supervision and follow-up of sundry debtors is that the
goods must be despatched promptly, as also the relative invoice. Because, the 15th day or [0th,
whatever, can be counted only after the day one begins, i.e., when the goods invoice have been
despatched. Thus, a slight delay of even a day or two delays the payment of the sundry debtors at
least by so many day(s).

2c c


It is of crucial importance that the order number, particulars (quality and quantity) of goods, and
such other details are incorporated in the invoice correctly, so as to facilitate the buyer company
to connect the matter appropriately. Any error in these particulars, howsoever all, may result in a
significant financial loss, sometimes, due to the avoidable correspondence and the resultant delay
in payment.



Extra care and due precaution must be taken by and at all times, in despatching the goods of the
agreed quality only, (not even a shade less or more), so that may keep all the possible disputes
avoided, ways.


//cm2/5cc2#c,cc ##c2:

With a view to ensuring that all the relevant particulars have been incorporated in the invoice, (of
course, meticulously and correctly), it would augur well if the company takes care to evolve an
all - comprehensive proforma of its invoices, such that no relevant particulars may be lost sight

of. Besides, with a view to ensuring that the invoice, along with the relative bill of exchange and
such other documents, have been duly received by the party, an acknowledgement slip could also
be provided as a tear off portion of the relative forwarding letter itself, wherein all the relevant
particulars details of the various documents, etc., as also the full and correct postal address of the
seller company, are computer-printed at the appropriate place. This way, the buyer company, at
the receiving end, would have to just put its rubber stamp (not even signature) on the
acknowledgement slip, and to slip the (acknowledgement) slip in the window envelop and post
it. And, that is it. A specimen proforma of the suggested forwarding letter along with the tear off
portion containing the acknowledgement slip, is placed in Annexure 5.1 at the end of the

When the efforts of typing acknowledgement letter are involved, mostly the buyer companies are
found to be adopting the easiest course of action. That is, they just do not send any
acknowledgement, whatsoever.


c c ,c m5c c c mc 2,5c /c m5c /c 0c m24

With a view to exercising effective control on all the Working Capital Management sales
effected, on a day-to-day basis, the companies may maintain a Master Register; wherein all the
particulars of all the sales effected on a particular day may be entered, in serial order.

To facilitate calculation of the due dates of payment, separate sections in the register (or separate
files in the computer) should be maintained for parties enjoying the credit for different periods,
viz. 15 days, 30 days, 45 days, [0 days, 75 days, 90 days, 180 days, and so on.It will be better
still, if separate sub-sections are also maintained for parties falling under different categories like
A, B and C (presuming that the parties falling under the category "D" being the high risk will not
be given any credit, whatsoever). So, because this may facilitate the company¶s effective follow-
up programme in a scientific and systematic manner, on the basis of the ABC analysis, whereby
the quantum of pressure and frequency and rigour of monitoring could be gradually increased in
the cases of B (as compared to A) and C (as compared to B) categories of sundry debtors.

That is, in case of category A, too much of close follow-up may not be required until their
payment pattern calls for their degradation from category A to category B, and so on. Similarly,
the parties under category B may require somewhat closer follow-up, while those under category
C may require a still closer and more frequent follow-up measures as also a constant watch and
vigil over the payment pattern, so as to decide whether some restrictions are required to be
imposed on their credit terms, such that the situation may not get worsened and go out of control,
beyond any remedy.

ccwc#c  02c0c

A general pattern of follow-up of sundry debtors are discussed hereafter, followed by some
special strategies to be evolved for some special and specific cases, desiring special attention and
specific treatment.

The idea behind having different sections or registers (or different folios in the computer) is that
the actual due date can easily be calculated from the date of sale, as the same section / file will
have the same due date for the same date of sale. That is, in a section / file of 30 days credit
period, the due date will be 30 days after the date of sale and so on.


By way of a general follow-up, usually a week before the due date of payment, a routine type of
computer printed reminder could be sent.

2c c

Further, if the bill does not appear to have been paid even after a week or a fortnight, of the
stipulated due date, a second reminder may be sent with a slightly firm language used, and a
copy thereof may be endorsed to the Sales Officer/Sales Representative for necessary follow-up


If, even such reminder does not evoke the desired results, a third strict reminder may have to be
sent, with a copy thereof endorsed to the Sales Officer/Sales Manager concerned, to personally
follow-up the matter with the party concerned, during their immediately next visit to the area, so
as to obtain the payment, at the earliest. And, in the mean time, the goods despatch section may
be instructed to suspend the supply of goods to such party , till further fuctions, so as to avoid the
situation of accumulation of some huge over- amounts.


And, if even such strict and firm dealings do not bestir (activate) the parties, legal notice(s) may
have to be served on some of them, just as test cases, so that they (and even other buyers) may
not get an impression that they may go scot free so easily.


Similarly, in some cases, just by way of setting an example, and creating some sense of fear,
even civil suits may be filed, though not with the intention of bringing it to its logical conclusion,
but only as a demonstration of strong will that mean business.

As has already been stated earlier, along with the master register, the companies must also
maintain a separate ledger account for each party, wherein the date of sale, particulars of sale,
date of payment or return of the bills, etc. would be incorporated. This way, you will be able to
form an opinion regarding each party which may, in turn, facilitate the review and revision of the
categorization of each party periodically, and adopting specific strategies for the continuation of
the terms of the credit sales or otherwise, depending upon the review data, revealed by the ledger
account of the party concerned.


Due care must be taken by the companies to identify one specific official to attend to all the
enquiries pertaining to sundry debtors, and all the other officials of the company, including the
telephone operators, must know it and know it well. Thus, any call coming for such enquiries
may invariably be put through to the right person, and even if, by chance, it gets connected to

some wrong number, the person concerned would be able to transfer the call to the right person,
in one go, instead of the call being tossed over from one person to the other. Now, in almost all
the companies, all the relevant particulars will be available to the person, with the press of a
button on the computer, for clarification of any doubt or for replying to any query pertaining to
the bills with great ease.

Further, the official concerend would do well if he could note down all the queries made by
various sundry debtors so that when all these are listed category-wise, the study and analysis may
throw-up some light on how to streamline the proforma invoice or such other systems, so that
much of the queries could be eliminated.

Incidentally, it may be mentioned here that such enlisting of various complaints received on
different counts, may also be used to enable us to take some suitable remedial measures
pertaining to after-sales service, quality control, delayed despatch, etc. We should, therefore,
treat all the complaints as a free and frank feed back, an opportunity to introspect and improve

Besides, this will also enable the official of the company to raise some of his own queries or else
to seek some clarification or even to remind of some long over-due payments, etc. But, care must
be taken that you praise your query only after all the queries of the caller have been answered to
his entire satisfaction.

c0c+,c0/4c &c


IC-l Ambiguous/Incorrect invoicing regarding quantity, price, etc.

IC-] Delay in the despatch of the documents / goods.

IC-3 Lack of effective monitoring of Sundry Debtors like, Age-wise/Party-wise analysis and
vigorous follow-up, etc.

IC-4 Lacunae in the Monitoring Mechanism! Credit Policy, (regarding credit period/cash
discount, etc.).

IC-5 aoods despatched with insufficient documents, e.g. valid purchase Order, etc.

IC-[ Defective supplies, e.g. sub-standard quality/quantity, insufficient after-sales services, etc.

IC-7 Relevant documents and/or information not readily available for vigorous follow-up,

IC-8 Ambiguity/deficiency in the terms and conditions, fixation/re-fixation of prices, and such
unresolved issues, causing further delays.

IC-9 Overbilling regarding excise duty/sales tax etc., due to the changes in the Acts, non-
compliance of the terms and conditions of the purchase order, especially regarding excise
duty/sales tax, etc.

IC-10 Holding back of 5 to 10 per cent of the amount of the bill, pending installation and
commissioning, completion of the project, expiry of the warranty period and such other mutually
agreed terms and conditions.

IC.11 Any other internal cause (s); please specify).

A Bc-c0cm5c

(S); (please specify)

EC- 1 Damage/Loss during transit

EC-] Lack of co-ordination in the buyers¶ organizations

EC-3 Lack of liquidity with the buyers

EC-4 Buyer¶s insolvency/liquidation

EC-5 Buyers¶ reluctance- to take delivery of the documents from the bank

EC-[ Instalments due but not collected by the collecting agent

EC- 7 Instalments collected but not remitted by the collecting agent forcredit of the company¶s

EC-8 Any other external cause (s); (please specify).

ABc 20c c,c0cm 5c

DC-1 Buyers¶ unreasonable rejections on untenable grounds of deficiency in the quality/quantity

of goods supplied

DC-] Buyers unduly delaying the inspection of finished goods, before despatch

DC-3 Charges like freight, insurance, postage, demmurages, bank charges, etc.
disallowed/deducted by the buyers, and are being contested by

DC-4 Litigation

A Bccc

Sundry Debtors may be dividend into four categories.

78.cInternal causes (IC 1 to 11) where the reasons could be the negligence or slackness on the
part of some in-house staff
79.cExternal causes (EC 1 to 8) where the reasons lie somewhere outside the company and its
80.cDispute being the cause (DC 1 to 5) where the dispute regarding quality and/or quantity
or such other factors may be the main causes.
81.cMiscellaneous causes (MC 1 to 3) where the causes are such which do not fall under any
of the aforesaid three categories.

The added advantage of the listing of the causes, with code numbers given in the parentheses,
would be, to facilitate all the different departments to submit the periodical performance reports

in regard to the sundry debtors, with the specific reasons, quoted at the appropriate places, by
way of the code numbers only, like 1C3, EC5, DC] etc. or MC1.

Besides, such list may force the departmental heads concerned to identify the specific reasons to
be quoted in their periodical reports, instead of the usual practice of giving some causes or the
other, mostly in general terms, which did not convey much sense. But, this practice may
facilitate the analyses of the various causes of high sundry debtors, which, in turn, may go a long
way in evolving some appropriate remedial measures, promptly and well in time.


Credit policies need to be formulated by the top management, of course, in consultation with the
lower levels of management, as they are expected to have the real feel and first-hand experience
and information about the market trends as also about the traders and the competitors.

,c 0c

Cash discount is a very common mechanism of effecting and encouraging speedy payments but
of course, at a price. Therefore, before taking a decision about the period and quantum of giving
cash discount, we must first try to understand and appreciate the financial implications of such a
stand taken, mainly in terms of the quantum of interest gained or lost. This can be best
understood by taking some illustrative examples.

4Ccc 0/cm  5c

There is yet another method of monitoring and follow-up of sundry debtors, commonly known as
"Day¶s Sales Outstanding" (DSO).

The µday¶s sales outstanding¶ at a given time "t" may be said to be the ratio of sundry debtors
outstanding at the material time to the average daily (credit) sales [not total sales] during the
preceding month or two months period or quarter, or say 30 days, [0 days and 90 days, or such
other suitable period. It may be represented as under:

DSOt = Sundry Debtors at time "t" I Average daily (Credit) Sales. Let us try to understand this
method / tool better with the help of an illustrative example.

 c c@c

Sundry debtors management requires a lot of decision-making exercises, in several areas, by the
personnel at different levels: top level, middle level and junior level.


Formulation of credit policy comes within the purview of the top management. It comprises
various aspects of credit policy, which are discussed hereafter, one by one.

%cc#c/ ,c#c,c0/4c/&c

This decision is the most crucial one to make, as it is the starting point of the whole chain of
events, right from the point of sales on credit to the point of final realization of the proceeds of
the credit sales.

Here, also the main problem area is to take a decision while selecting a new party for dealings
for the first time. This may involve various facets of enquiries and studies, with a view to
assessing and evaluating the credit-worthiness and financial stability and strength of each
company under consideration. While assessing the extent and quantum of credit risks involved,
which differ from case to case, one must guard against some usual types of errors of judgement
that may take place sometimes.

They are:

(i) Either a class A category of customer may be classified as category B or even C.

(i) Or vice versa, i.e., a category B (or even category C) customer may be erroneously classified
as A category one.

And, both these errors may prove a little costly in that either a good business may be lost, (and
the financial gains therewith), or the company may accumulate some more bad debts, eating into
its profitability.

Such errors may take place but only in some cases, and not in general, provided due care is taken
at the time of the evaluation of the credit-worthiness of the parties. In such cases, the periodical
review of the payment pattern of the respective parties may be helpful in reclassification of some
parties, and thereby rectifying the error, if any, hopefully well in time.


Different dimensions of the credit policy may vary in different degrees and shades. It may be
categorised under three broad types:

m5c &c /c w4 A credit policy may be termed as liberal wherein some other
concessions and facilities are granted to the buyers, with the expectation that this way the sales
may pick up, and thereby, the cost of extra concessions granted can well be taken care of, by the
additional yield, resulting from the extra sales achieved therewith. But then, such liberalization
may as well lead to some additional quantum of bad debts, related with the extra sales effected,
as also the resultant higher blockage of funds in sundry debtors, and a higher cost of collection,
too. Therefore, all such inter-related facts and factors must be duly considered while taking a
decision regarding adoption and execution of a specific credit policy, most suited under the given

m5c c /c w4 Under such credit policy, as against the liberal one, the minimum
possible concessions and relaxations are granted to the customers. And, as a result thereof, the
sales may get somewhat adversely affected. But, at the same time, the risk of bad debts may as
well be minirnized, and so will be the extent of blockage of funds in sundry debtors and the
collection efforts and expenses, too. Thus, the decision should be based on the trade-off position
of the positive and negative factors.

m5c /0c m/5c /c w4 Such credit policy adopts the middle of the road
approach whereby a balance is tried to be struck in such a way that both the quantum of

additional sales and the resultant risk of bad debts may be kept at the optimal levels, i.e., neither
too high nor too low, but in about just the right measure.


The various dimensions on the basis of which a company may be said to be adopting a rather
liberal, strict or medium (moderate) credit policy may broadly be classified under four different
parameters. They are:

(i) Standard of credit,

(ii) Period of credit,

(iii) Cash discount, and

(iv) Effective monitoring and follow-up {i.e., Collection Efforts}.

Let us discuss all these four different parameters of credit policy one after the other.


The main and most important question that may arise, while arriving at the credit policy
decision, is what standard could be considered as the most appropriate and optimal one, with a
view to accepting or rejecting a customer for credit sales. Here, the company has a variety of
choices, of offering credit sales, ranging from µnone¶ to µall¶ and to "some only". The first two
options, obviously, do not seem to be right, as these may either adversely affect the volume and
value of the sales, or else may run the high risk of the quantum of bad debts. Thus, both these
steps are generally not advisable unless either the company enjoys the envious privilege of being
in the sellers¶ market or else it is in such a disparate situation that its sales may drastically drop
down unless a very liberal credit policy is adopted.

m 5cw/c#c/c

The duration of time (say 30 days, 45 days. [0 days, etc.) allowed to the customers, to make the
payment of the bill, representing the cost of the goods, supplied on credit, is referred to as the

credit period. It has generally been seen that the credit period ranges from 15 days to [0 days or
even more. And, in the case of government departments, it may be even 90 days, 180 days, or
even more. The credit period, however, varies mainly on two considerations:

(i) The trade practices in the particular line of business, and

(ii) The degree of trust and credit-worthiness on the part of the customers concerned

m5c,c 0c

Cash discount is given by some companies with a view to giving some financial incentive to the
customers so as to reduce them to pay the bills well before the usual credit period granted. Under
such arrangement, the term of payment will be such that the buyer will get a cash discount at a
certain percentage (say ]%), if he makes the payment well before the usual credit period granted,
(eg., if he pays within 10 days, while the usual credit period granted is say, 30 days). If such
would be the stipulation, it is usually represented, as per the prevailing practice, as "]/10 net 30."

To say it again, it means that the buyer will get a discount of ] per cent, if he makes the payment
within 10 days from the date of the bill, or else he will have to pay the full amount of the bill, if
the payment is made after 10 days but within 30 days. We must, therefore, appreciate that to
obtain an early payment of the bill, some discount is being given, which means that there is a
price to be paid to obtain an early payment.

Now, let us compute the price, (or the rate of interest, as it, in effect, is the interest only), that is
being paid by the seller, to the buyer, for making an early payment. We are here, presuming that
all the buyers are prudent enough to pay the bill, only on the 10th day (and not earlier) so as to
reap the maximum benefit out of the cash discount offered. And, if they were to decide, not to
avail of the cash discount, they would, invariably, pay the bill on the very last day, i.e., on the
30th day only.


m5c c,c2c#cc#c,cc

(i) ]/10 Net 30

In effect, it means that a discount of ] per cent is to be given if the bill is paid earlier, just by ]0
days only (i.e., 30 less 10 = ]0 days). That is, the loss, by way of interest, to the seller (on Rs.
100) for ]0 days is ] per cent. Thus, the rate of interest per annum (presuming 3[0 days to a
year) would come to:

(] x 3[0) / [100 (30-10)1 = 7]0/]000 = 0.3[ or 3[ %

(ii) Similarly, in the case of "1/15 net 45", the cost, (to the seller) by way of interest, will be:

(1 x 3[0) / [100 x (45-15)1 = 3[0/3000 = 0.1] or 1] %

(iii) And, in the case of "]/9 net 45", the cost, (to the seller) by way of interest, would be:

(] x 3[0) / [100 (45-9)] = 7]0/3[00 = 0.]0 or ]0%

(iv) And, "1.5/15 net [0" would mean:

(1.5 x 3[0) / [100 ([0-15)] = 540/4500 = 0.1] or 1] %

m 5c c,c2c#cc#c,c&04c

But, does it mean that the percentage of savings made by the buyer is also the same (as the
percentage of the cost incurred by the seller), or else it is a little more or less? Let us, find it out,
based upon the very first illustrative example, given above. That is, "]/10 net 30".

Here, from the point of view of the buyer, he stands to gain Rs. ] when he has to actually pay
(Rs. 100 - Rs. ]/-) = Rs. 98/- only (instead of Rs. 100). That is, on an investment or payment of
Rs. 98/- only, he stands to gain Rs. ]/- in ]0 days period. So, on an annualized basis, he stands to
gain(] x 3[0) / 98 x ]0 = 3[.[[[ percent or say, 3[.[7 percent.

Thus, we see that the buyer is a gainer by a slightly higher percentage, as compared to the seller,
because, the buyer gains the same amount by investing or paying a little lesser amount than Rs.

100)- (i.e. Rs. 981- only). But, the loss of the seller is on the full Rs. 100/- i.e., instead of getting
Rs. 100/-, he gets a little less, i.e., Rs. 98/-, in the example under consideration.

c#c0/4c &cm c&cc0c&5cc/c

We have so far discussed about the various principles of management and control of sundry
debtors. Now, we would like to critically examine as to what are the actual practices and policies
that are, generally being followed by the various companies in India. For the purpose of the study
we shall take up the issues under three broad categories:

(A) Credit Policy

(B) Assessment of Credit-worthiness of the customers (present and prospective), and

(C) Monitoring and Control of Sundry Debtors.


(i) Very few companies have been found to have systematically formulated and documented
their credit policies. In most of the cases these are made on an ad hoc basis and mostly remain as
unwritten conventions and practices.

(ii) In some of the companies, the credit policy and philosophy have been stated, in too general
terms, which do not signify any specific stand or standard, to be followed by the operating staff.
For example, if a company states its credit policy, in general terms, like "Our credit policy aims
at maximising the growth of sales with the minimal bad debt risks", it does not convey much as a
guideline or guiding principle of any practical use and utility.

(iii) The credit period offered by various companies differs to a very great extent, ranging from 0
day to [0 days or even 90 days. For example, a company, which is privileged to be in the seller¶s
market, may not give a single day¶s credit, i.e., may insist on cash down payments, while the
companies like Premier Motors or Daewoo Motors may offer a much longer credit period, to
boost up the sales. Further, while some of the companies, manufacturing consumer products
(with the exception of textile and garment manufacturing companies) may give nil or a limited

credit period, other companies may have to give a much longer credit period, to be able to sell
their products.

(iv) Besides, the practice of offering cash discount (with a view to ensuring early payments) does
not seem to be very popular in Indian business scenario.

m 5cc#c/ *,c#c0c

8].cThere does not seem to be any systematic and scientific study made, by using different
tools and techhiques, to determine the creditworthiness or financial strength and stability
of the customers - both present and prospective. In fact, the financial position of the
present customers should also be reviewed and revised on a regular basis, based upon
out: own experiences of their past performance and dealings with us. But this seldom
seems to have been resorted to, in most of the companies.
83.cNo serious and sincere effort seems to have been made to meticulously analyse the
balance sheet and profit and loss account of the companies, with a view to making a
realistic assessment and appraisal of their financial position. It has hardly been observed
that some companies have asked for some break-ups of certain items (say, of inventories
or bad debts), to see through the elements of window dressing, if any.
84.cProspective customers are required to give, at least, two or three references, but no
serious attempt seems to have been made by most of the companies to verify the position
from such references.
85.cIndependent credit rating agencies have, of late, appeared on the scene like CRISIL,
ICRA, etc., but the credibility and dependability of their credit ratings may be a little
doubtful. The credit rating agencies had given satisfactory credit rating to µMS Shoes¶
and µCRB Finance Company¶, but their assessment had proved to be totally wrong and
contrary to facts. Besides, the practice of seeking professional help from such credit
rating companies to ascertain and assess the financial position of the prospective
customers does not seem to be very common, as opposed to the conditions prevailing in
the USA, and other developed countries.
8[.cSome companies attempt to get the opinion of the bankers on the prospective customers
from the letters¶ bank, but, as has already been observed earlier, their opinions, though

given in strict confidence and without any obligation, are written in such general and
vague terms that these do not seem to be of much help and practical utility.

m5c##cc/cc#c0/4c &c

Though the various tools and techniques, systems and strategies, of effective monitoring of
sundry debtors, are very well known to the executives of most of the companies, very few
companies have been found to have evolved some systematic mechanism of effective monitoring
and follow-up of sundry debtors on some sound, systematic and scientific lines. A lot seems to
have been left to be desired. Some companies have been found to be working out the average
collection period, but not party-wise. They may do the ageing analysis but only in absolute terms
and not in terms of percentage, etc.


Factoring is a unique financial innovation. It is both a financial as well as a management support

to a client. It is a method of converting a non-productive, inactive asset (i.e., hook debts) into a
productive asset (viz., cash) by selling book debts (receivables) to a company that specialises in
their collection and administration.¶ For a number of companies, cash may become a scarce
resource if it takes a long time to receive payment for goods and services supplied by them. Such
a current asset in the balance sheet is, in fact, illiquid and serves no business purpose; it is much
better to sell that asset for cash which can be immediately employed in the business. A "facto?¶
makes the conversion of receivables into cash possible.

The term factor has its origin in the Latin word µfacere¶, meaning to make or do, or to get things
done. Originally, factors acted as selling agents. They facilitated the flow of merchandise from
the manufacturers to customers. The functions of a factor included finding out customers for the
manufacturer¶s products, stock his goods, sell them and finally collect sales proceeds and remit
them to the manufacturer. Thus, the function of factors in olden days included stocking,
marketing and distribution as well as administration and financing of credit. The modem factor
has specialized in credit collection and financial services, leaving the marketing and distribution
functions to the manufacturer.


While purchase of book debts is fundamental to the functioning of factoring, the factor provides
the following three basic services to clients:

87.cSales ledger administration and credit management.

88.cCredit collection and protection against default and bad-debt losses.
89.cFinancial accommodation against the assigned book debts.


A factor provides full credit administration services to his clients. He helps and advises them
from the stage of deciding credit extension to customers to the final stage of book debt
collection. The factor maintains an account for all customers of all items owing to them, so that
collections could be made on due date or before. He helps clients to decide whether or not and
how much credits to extend to customers. He provides clients with information about market
trends, competition and customers and helps them to determine the credit worthiness of
customers. He makes a systematic analysis of the information regarding credit for its proper
monitoring and management. He prepares a number of reports regarding credit and collection,
and supplies them to clients for their perusal and action.


When individual book debts become due from the customer, the factor undertakes all collection
activity that is necessary. He also provides full or partial protection against bad debts. Because of
his dealings with the variety of customers and defaults with different paying habits, he is better
position to develop appropriate strategy to guard against possible defaults.


Often factors provide financial assistance to the client by extending advance cash against book
debts. Customers of "clients" become debtors of a factor and have to pay to him directly in order
to settle their obligations. Factoring thus involves an outright purchase of debts, allowing full
credit protection against any bad debts and providing financial accommodation against the firm¶s

book debts. In the U.S.A., the maximum advance a factor provides is equal to the amount of
factored receivables less the sum of (i) the factoring commission, (ii) interest on advance, and
(iii) reserve that the factor requires covering bad-debts losses. The amount of reserve depends on
the quality of factored receivables and usually ranges between 5 to ]0 per cent in the U.S.A.

In view of the services provided by a factor, factoring involved the purchase of a client¶s book
debts with the purpose of facilitating credit administration, collection and protection. It is also a
means of short-term financing. It provides protection against the default in -paying for book
debts. For these services, the factor, however, charges a fee from the client. Thus factoring has a


In developed countries like the U.S.A factors provide many other services. They include: (i)
providing information on prospective buyers; (ii) providing financial counselling; (iii) assisting
the client in managing its liquidity and preventing sickness; (iv) financing acquisition of
inventories; (v) providing facilities for opening letters of credit by the client etc.

c/c, c c

Although, factoring provides short-term financial accommodation to the client, it differs from
other types of short-term credit in the following manner:

Factoring involves sale of book debts. Thus the client obtains advance cash against the
expected debt collection and does not incur a debt.
Factoring provides flexibility as regards credit facility to the client. He can obtain cash either
immediately or on due date or from time to time, as and when he needs cash such flexibility is
not available from formal sources of credit.
Factoring is a unique mechanism, which not only provides credit to the client but also
undertakes the total management of client¶s book debts.

c/c c 0c

Factoring should be distinguished from bill discounting. Bill discounting or invoice discounting
consists of the client discounting bills of exchange for goods and services on buyers, and then
discounted it with bank for a charge. Thus, like factoring, bill discounting is a method of
financing. However, it falls short of factoring in many respects. Factoring is of bills discounting
plus much more. Bills discounting has the following limitations in comparison with factoring:

Bills discounting is a sort of borrowing while factoring is the efficient and specialized
management of book debts along with enhancement of the client¶s liquidity.
The client has to undertake the collection of book debts. Bill discounting is always µwith
recourse, and as such the client is not protected from bad debts.
Bills discounting is not a convenient method for companies having large number of buyers
with small amounts since it is quite inconvenient to draw a large number of bills.

42c#c c

The factoring facilities available worldwide can be broadly classified into four main groups

90.cFull service non-recourse (old line)

91.cFull service recourse factoring
9].cBulk/agency factoring
93.cNon-notification factoring


94.cThere are several terms of payment prevalent in the business world. Name the major
terms of payment in practice and briefly describe each of them separately.
95.cWhat are the ramifications of enhancing and reducing the credit period? Explain, by
citing some illustrative examples.
9[.cDistinguish between (i) liberal and (ii) strict credit standards by citing suitable examples
in each case. Explain the effects of liberal and strict credit terms, in each of the cases
97.cWhat do you mean by (i) liberalizing and (ii) restricting the credit policies, in terms of the
following: -

a.c Period of credit
b.c Cash discount
c.c Credit standards, and
d.c Collection efforts.
98.cProper assessment of credit risks is considered to be one of the most crucial factors in the
area of management of credit. Do you agree? aive reasons for your answer.
99.cWhat are the two main types of error that may creep in, while assessing the credit risks?
Explain each of them by citing suitable illustrative examples.
a.c Bank reference is considered to be one of the major factors for assessing the
credit-worthiness of a prospective customer. Do you agree? aive reasons for your
b.c What are the main shortcomings and limitations connected with obtaining bank
references and what are the pragmatic approaches for overcoming them?
a.c Credit management practices, in Indian Companies, suffer from several
deficiencies. What are these and what are the adverse effects of each of them in
actual practice?
b.c What are the specific suggestions that you would like to make with a view to
streamlining and strengthening the present practices of management of credit
(Sundry Debtors) by the industries in India?
10].c "Ageing Analysis" is an effective tool for monitoring and follow-up of sundry
debtors. However, for better results, it is desirable to do the ageing analysis:
i.c Not only "Period-wise", but also "Party-wise", and
ii.c Not only in "absolute terms" (of Rs.) but also in "percentage terms".

Explain and illustrate, by using suitable examples.

103.c Explain the objective of credit policy? µWhat is an optimum credit policy?
104.c Is the credit policy that maximizes expected operating profit an optimum credit
policy? Explain.

105.c What benefits and costs are associated with the extension of credit?
10[.c How should they be combined to obtain an appropriate credit policy?
107.c What is the role of credit terms and credit standards in the credit policy of a firm?
108.c What are the objectives of the collection policy? How should it be established?
109.c What shall be the effect of the following changes on the level of the finn¶s
.c Interest rate increases.
a.c The general economic conditions slacken.
b.c Production and selling costs increase.
c.c The firm changes its credit terms from "]/10, net 30" to "3/10, net 30."
110.c µThe credit policy of a company is criticised because the bad debt losses have
increased considerably and the collection period has also increased.¶ Discuss under what
conditions thiscriticism may not be justified.
111.c What credit and collection procedures should be adopted in case of individual
accounts? Discuss.
11].c How would you monitor book debts? Explain the pros and cons of various
113.c What is factoring? What functions does it perform?
114.c Explain the features of various types of factoring.
115.c Define factoring. How does it differ from bills discounting and short-term




The importance and imperative need for effectively managing and controlling all the items of
inventory in a company can be judged from the fact that generally these comprise the largest
component of the total assets of a company, second only to the items of plant and machinery. In
terms of percentage of the total assets of a manufacturing company, all the three components of

inventory, taken together, generally account for around ]5 to 30 per cent of the total assets of the
company. Thus, the importance of effectively managing and controlling the inventory of a
company can hardly be over-emphasised.


After reading this lesson, you will be conversant with:

The nature of inventory and its role in working capital management

Purpose and compenents of inventories
Types of inventories and costs associated with it.
Determination of EOQ and Economic production quantity.
Inventory planning
Various methods of pricing inventories
Special techniques like ABC analysis and VED analysis

c c


The term µinventory¶ comprises three components. They are:

11[.c Raw materials (also consumable stores and spares),

117.c Work-in-process (also known as stock-in-process, process), and
118.c Finished goods.

Let us now discuss all these three items, one by one.

119.c Raw Materials are those basic inputs, which are used to manufacture the finished
1]0.c Work-in-process, however, is the intermediary stage that comes after the stage of
raw materials, but just before the stage of finished goods.
1]1.c The finished goods, in turn, comprise the end products, that is, the goods at their
final stage of production, ready for sale in the market.

Supposing, a company is in the business of production of breads. In this case, the wheat flour,
baking powder, etc., would comprise the raw materials. And, when the flour is put in the relative
moulds, which in turn, are placed in the furnace, this stage is known as the work-in-process
stage. And, when the bread is fully baked and is ready for sale, of course, after being wrapped in
the packing paper, it comprises the finished goods of the company.

It may be noted that in the case of manufacturing companies, inventory comprises raw materials,
work-in-process and finished goods, while in the case of trading concerns or trade merchants or
retail traders, the inventory comprises only the finished goods. Thus, while all the three
components, as aforesaid, comprise the items of inventory for the manufacturing concerns, only
the finished goods, like the breads alone, comprise the inventory for a retail trader, selling

Here, it may be pertinent to mention that the task of inventory management and control is the
joint responsibility of the purchase department, materials department, production department and
marketing department. Further, while the policy pertaining to the raw materials is to be
formulated by the purchase department, in coordination with the materials and production
departments, the policy in regard to the inventory of finished goods is to be formulated by the
production department in coordination with the marketing department. The policy in regard to
the work-in-process, however, is finalised by the production department alone.

And, as we have already seen earlier, keeping in view the vital importance of inventory
management and control, in financial terms, the role of finance manager can be said to be the
central coordinating role, among all the aforesaid four different departments, with a view to
ensuring that the inventory management and control are being exercised effectively at the
various stages and departments, on the desired lines. Here, the main responsibility of the finance
manager comprises apprising the non-finance executives so as to, at least, understand the basis of
the mechanism and its overall implication in regard to the control of various items of inventory,
as these have direct effect on the financial gains of the company. That is why it is said that the
management of inventory, and for that matter, the management of working capital as a whole, is
not the responsibility of the finance manager alone, but also of the purchase department,
materials department, production department, and marketing department.


These inventories comprise the various items of raw materials, lying at the various stages of
production, till these reach the final stage, to become the finished goods. Supposing, a company
is manufacturing iron nails, and its basic raw material is iron rods. In the drawing machine, these
rods may be drawn total time required for completing all the involved processes (stretched) and,
thus, these may become thinner and thinner in three to four processes, when these may come to
the required diameter. Then, these thinner n rods will be cut into pieces of the required length of
the nails. And then, while one end may be made pointed, the other end may be flattened to
become the head of the nail. And, after all these required processes are completed in full, the
stocks of finished goods are ready for transportation (movement) to the godown(s) or to the
company¶s sales outlets.

Thus, as the production process involves several stages of production, the aggregate quantum
and value of the raw materials, lying at the different stages of production, all taken together,
comprise the stocks of process inventory.

And, thus, if the entire process (from the raw material stage till the stage immediately preceding
the finished goods stage) takes say, ten days, and the average production of the item is 1000 units
per day, the average quantity of such process inventories would be equal to:

Average stocks-in-process, multiplied by the time days required to complete all the processes,
i.e., 1000 x 10 days = 10,000 units.


Movement inventories are usually referred to the inventories of finished goods, to be transferred
from the factory to the company¶s godowns, warehouses, or sales depots. Thus, if the average
daily sales at the company¶s sales depot are ]50 units and the transit time (for transporting the
finished goods from the factory to the sales depots) is 10 days, the average movement
inventories, as per the aforesaid formula, would be:

]50 units x 10 days = ]500 units, or

]50 units x Rs. 5/- x 10 days = Rs. 1],500/-


Organization inventories, on the other hand, comprise the items of raw materials and finished
goods stored and stocked in the company¶s godowns, to be supplied to the factory or to the sales
depots, as and when they would requisition for the required number, weight, volume, etc., of the
specific items of raw materials and finished goods, respectively.

Here, it may be mentioned that the moment the stocks of raw materials and finished goods are
issued from the company¶s godown(s), these items are excluded from the organisation
inventories and these, in turn, are included in the Working Capital process inventories (though
these raw materials may actually be put into the production process a little later), or in the
movement inventories (even if the stocks of the finished goods may be lying in the company¶s
show-rooms, unsold).

Now, a natural question, that may arise, could be that if the inventory carrying cost is so huge
and material to affect the profitability of the company, favourably or unfavourably, why should
the companies, at all, have organization inventories, too, inaddition to the process inventories
and movement inventories. And, the answer, too, is very simple and logical. That is, to make the
decision-making process of planning (of purchases of raw materials and level of stocking of
various items of finished goods) and scheduling of successive operations of production, even
more free and flexible. This also facilitates bifurcation of the functions of purchase of raw
materials and production plan into two separate departments, to be managed by the respective
experts in each department.

Thus, while the production department may just give its production schedule to the purchase
department, it would be the sole responsibility of the purchase department to decide about the
quantum of such purchases and the stockists to purchase them from. That is, if the stocks
sometimes are available at a cheaper price during the harvesting seasons of the respective
agricultural products, etc., the purchase department may even purchase the materials in much
larger quantity than required by the production department (just for a fortnight or a month).
Decision could as well be taken by the purchase department whether to go in for such purchases

to avail of the bulk discount, or to avail of the cash discount, etc., whenever offered. Similarly,
the purchase department may make purchases for a week only locally, to meet the immediate
demands of production, if, by that time, bulk purchases may be made available at a much
cheaper rate. Similarly, in an inflationary condition, the purchase people may exercise their
prudence and expertise to make the purchases of a larger quantity than required, if such
purchases are going to be sufficiently cheaper today, taking into account the quantum of
inflation, etc. That is, it would augur well if the purchase people could as well know the
fundamentals of cost-benefit analysis, to be made in this regard, as also as to what factors should
be taken into consideration (like time-value of money, rate of inflation and the total inventory
carrying costs, etc.).

This much about the rationale behind keeping the organisation inventory of stocks of raw
materials, and delinking the purchase functions and the production functions.

Now, let us discuss about the rationale behind keeping organization inventories of finished
goods. It is a well known fact that, in order to have some edge over the competitors, companies
have to keep some items in ready stock so as to be able to supply these to the customers from the
shelf, at least to meet their immediate requirements, and the balance to be supplied in a week¶s
time or so. This is important because keeping huge numbers of items in ready stock is fraught
with grave risks of obsolescence, expiry of shelf life, etc. Further, by virtue of having some
organisation inventory of finished foods, the companies are able to delink the production
schedule from marketing activities.

Thus, we can very well appreciate that by delinking the purchase activities and production
activities, as also production activities from marketing activities, companies may be able to
optimise their profitability, by enabling the experts different departments, to plan things in such a
way that the profitability of the company could be optimized and each departmental experts can
concentrate on their respective work, of course, keeping the overall interests and requirements if
the other departments, too, in the fore front, inasmuch as all the departments inter-dependent
with each other.

At this stage, it may be quite pertinent to examine the rationale behind keeping the in-process
inventory, too, (though these do not constitute a part of organization inventory, as such).

Let us, at the very outset, clarify that though the in-process inventory refers to work-in-process
inventory only, it is different from the process or movement inventory, discussed earlier, even
though a part of the work-in-process inventory may represent process or movement inventory,

Now, as regards the rationale behind keeping the in-process inventory, it may be mentioned here
that it provides some flexibility and latitude in the scheduling of production, so as to ensure
efficient production schedule and higher capacity utilisation of plant and machinery. Further, in
case there is no stock of in-process inventory, some bottlenecks may be caused sometime
somewhere in the production process, which may ultimately result in delay in production and
non utilisation of the installed capacity at the optimum possible level. These factors, naturally,
will culminate in adversely affecting the financial gains of the company.

c /cÎ04cm Î5c

In regard to the management of inventories (specially the inventories of raw materials) two
primary questions naturally arise. They are:

(a) Order size, i.e., what should be the ideal size of the order?

(b) Order Level, i.e., at what level of the stocks should the next order be placed?

But, before deliberating to find out the answers to the above questions, let us first try to
understand the distinguishing features of the three types of costs involved in the management of

(i) Ordering costs,

(ii) (Inventory) carrying costs, and

(iii) Shortage costs.

Let us now discuss these costs, in detail, one by one.

These include the expenses in respect of the following items:

(i) Cost of requisitioning items(s)

% /cc

Ordering costs pertain to placing an order for the purchase of certain items of raw. These include
the expenses in respect of the following items:

(i) Cost of requisitioning the items(s)

(ii) Cost of preparation of purchase order (i.e. drafting, typing, despatch, postage, etc)

(iii) Cost of sending reminders to get the dispatch of the items(s) expedited

(iv) Cost of transportation of goods

(v) Cost of receiving and verifying the goods

(vi) Cost of unloading of the item(s) of goods

(vii) Storage and stacking charges, etc.

However, in case of items manufactured in-house (i.e., by the same company), the ordering costs
would comprise the following costs:

(i) Requisitioning cost

(ii) Set-up cost

(iii) Cost of receiving and verifying the items

(iv) Cost of placing and arranging/stacking of the items in the store, etc.


Inventory carrying costs include the expenses incurred on the following items:

(i) Capital cost (i.e., interest on capital locked up in inventories)

(ii) Storage cost

(iii) Cost of insurance (fire and theft insurance of stocks)

(iv) Obsolescence cost

(v) Taxes, etc.

It may, however, be mentioned here that the carrying costs usually constitute around ]5 per cent
of the value of inventories held.


Shortage costs or costs of stock out are such costs which the company would incur in case of
shortage of certain items of raw materials required for production, or the shortage of certain
items of finished goods to meet the immediate demands of the customers.

Shortage of inventories of raw materials may affect the company in one or more of the following

(i) The company may have to pay somewhat higher price, connected with immediate (crash)

(ii) The company may have to compulsorily resort to some different production schedules, which
may not be as efficient and economical.

Stock out of finished goods, however, may result in the dissatisfaction of the customers and the
resultant loss of sales.

It, however, is relatively very difficult to actually measure the shortage cost when it results due
to the failure to meet the demands of the customers instantaneously, out of the existing stocks.

This is so because such costs may have ramifications, both in the short-term as also in the long
term. Besides, these costs are somewhat intangible in nature, and consequently difficult to assess

It has also been observed that some of the companies, with a view to reducing total ordering
costs, prefer to order larger quantities. But, this way the level of inventory becomes higher, and
thereby the inventory carrying costs also go up. Further, if the company decides to carry a safety
stock of inventory so as to mitigate or reduce the stock out costs, or shortage costs, its carrying
costs, in turn, would go up further.

Thus, with a view to keeping the total costs, pertaining to management of inventory, at the
minimum level, we may have to arrive at the optimal level where the total costs, i.e., total
ordering costs plus total inventory carrying costs, are minimal. To achieve this end result, we
may have to work out the Economic Order Quantity (EOQ).

cc /cÎ04cm Î5c/c

At the very outset, it is to clarify here that we are going to discuss only the basic EOQ model,
one of the simplest inventory models. There are, in fact, a large number of other inventory
models, depending upon various variables and assumptions.

02c#c,c c Îc/c

It may further be clarified here that the basic EOQ model is based on various assumptions, which
are given hereunder:

1]].c The estimate of usage (demand or consumption) of the item of inventory for a
given period (usually one year) is known accurately.
1]3.c The usage (demand or consumption of the various items of inventory) is equal
(even), throughout the period.
1]4.c There is no lead time involved. That is, the item of inventory can be supplied
immediately on the receipt of the order itself; there being virtually no time lag between
placing of an order and the receipt of the goods. Consequently, there is no likelihood of

stock out, at any stage. Therefore, the shortage cost (or stock out cost) is not being taken
into account, as if it is nil.
1]5.c Thus, there remain only two distinct costs involved in computing the total costs,
pertaining to inventory, viz., a) Ordering cost, and (b) Inventory carrying cost.
1][.c Further, the cost of every order remains uniformly the same, irrespective of the
size of the order.
1]7.c And, finally, that the inventory carrying cost is a fixed percentage of the average
value of inventory.

3c 0cc c/cc,/c

It may be observed that the EOQ can be ascertained in two distinct ways:

(i) By trial and error method (discussed immediately hereafter), and

(ii) By use of a definite formula (discussed thereafter).


Let us understand the "trial and error" method with the help of an illustrative example.

c /cÎ04cm Î5c/c 20c /cÎ04cm Î5c

The standard EOQ analysis is based on the assumption that no discount is given, howsoever
large the order size be. But, in most of the cases, some discount is given by way of an incentive
to the buyers to order for a larger quantity so as to avail of some bulk discount. Thus, we should
try to modify the standard EOQ formula so as to find out the EOQ as also to assess whether it
would be economical to avail of the bulk discount or not.

c /cÎ04cm Î5/c#c

The EOQ analysis presumes that the cost price per unit is constant. This implies that the
incidence of inflation has not been taken into account. In order to account for inflation, what we
have to do is, to first substract the rate of inflation from C (the annual inventory carrying cost,

expressed as a percentage) and apply the standard EOQ formula with this simple modification

But, you may ask, and rightly so, that why at all do we substract the rate of inflation from C? The
reason is simple enough. In an inflationary condition, the purchase price of inventory will also go
up and this will, to some extent, offset the inventory carrying cost.


Inventory carrying costs comprise various items, some of which are given hereunder:


That is, the rental payable will be proportionately higher as more space would be required to
store higher level of inventory.


That is, when higher stocks will be stored, handling charges like unloading and stacking charges,
at the time of receipt of the goods, etc., involving man power, may also go up.


Similarly, the amount of insurance premium payable, for fire insurance, theft insurance, flood
and such other natural calamity insurance, etc., will also be higher.


It has generally been observed that if more than sufficient stocks of inventory are stored, there is
a usual tendency to consume more than what is actually required, resulting in extra avoidable

To bring home the point, let us take a common place example. Supposing there is a huge stock of
medical bills proforma, these may, at times, be used even as paper plates, etc. But, if these
proforma were in short supply, people may take care not to waste a single form.

m5c c/c c

In the event of storing more than required level of stocks of raw materials and finished goods,
there is every chance that the goods may deteriorate in quality, like the whiteness of papers gets
diminished (it turns yellowish) with the passage of time. Some chemicals or medicines also have
limited shelf-life, where after these may turn useless. Stocks of cement, in rainy season, are
fraught with grave risk of turning into stones, and, thus, becoming useless.

m5c , &

In the modern age of technological advancements, the pace of goods and commodities becoming
obsolete has become fast enough. Thus, more than necessary stocks run the risk of becoming
obsolete and consequently of much lesser value and use.

m5c 1c#c 0/c

And, above all, more than necessary funds, blocked in inventory, may pose liquidity problems to
the companies. It may as well involve some loss by way of payment of interest as also
opportunity costs.


But, at the same time, it may be argued that there are several reasons which may justify stocking
of higher level of inventories of raw materials and finished goods.


For example, you may get bulk discount, making the average costs of the stocks much cheaper.
But then, one should not lose sight of the fact that, in such a case, there are several inventory
carrying costs involved (like wastages, damages and deterioration, loss of interest and
opportunity cost, etc.) which may offset the advantages of bulk purchases.

/c c

*,ccc&4c/ 7c

Lead-time is the time lag that takes place between the placement of an order and the actual
supply/delivery made in the company¶s godown. Supposing, an order is processed at our end and
is placed to the supplier today. The supplier¶s office will also take its own time in processing the
order plus loading, transportation and unloading, etc. And, supposing it takes say, around 15
days in completing all these processes and the goods are delivered and stored in our godown(s)
on the 1[th day. Thus, in the instant case, the lead-time would be said to be 1[ days.

But, as seen earlier, the standard EOQ model presumes as if there is no lead-time involved. And
thus, the order can well be placed when the inventory level comes to zero. But, the factual
position is otherwise. Therefore, we should decidedly take into account the lead-time, too, while
computing EOQ. This can well be done by introducing a slight modification in the standard EOQ
analysis to arrive at a realistic ordering point, so as to take care of the lead time involved and
thereby to mitigate the risk of shortage of stocks, involving stock out costs.


This can well be done by ensuring that the order is placed when sufficient balance of stock is still
left to take care of the lead-time. But, for doing so accurately, we may have to know the rate of
usage of materials as also the lead-time, exactly and in definite terms. In that case the ordering
level would simply be as under:

Lead time (in number of days for procurement) multiplied by average usage per day. i.e. Order
Point = Lead time (in days) x Daily Usage.


But then, in actual practice, one can neither estimate the lead time nor the daily usage so
accurately and exactly. We can, at best, make some reasonable estimates. But, in that case, the
possibility of some error, howsoever small, can hardly be eliminated completely.

And, therefore, we should, to be on the safer side, take into account the element of such
uncertainty, too. Accordingly, we should always keep some safety stock with us to meet such

And, as such, the order point should be computed by adding the quantum of sufficient safety
stocks, too.

Thus, the order point can well be computed as:

EOQ + [lead time (in days) x daily usage] + safety stock

But, how to compute the safety stock? In fact, it is a managerial decision and, therefore, it largely
depends upon the inventory policy as also the organisational culture of the company. It may,
accordingly, be high or low, or even medium.

This, however, does not mean that we should try to cut it too fine, either. Otherwise, a lot of the
valuable time of the Materials Manager and the Purchase Department would get wasted in the
fire-fighting operations in procuring the materials, in the nick of time, and incur the avoidable
expenses relating to such crash purchases.

The best policy, in regard to keeping the safety stock, would ideally be - neither "too much", nor
"too little", but "just right". But, it is easy said than done. However, the considered opinion that,
by some trial and error method, we may be able to arrive at a nearly optimal level of safety
stocks, in due course of time.

,c"&c c##c Îc

In finding out the EOQ or order level or safety stock, etc., we have, in the preceding pages, made
certain assumptions that some other factors do not vary, though in the real world they do.
Therefore, it would always be prudent enough to consider the following variable factors, too,
while taking a particular decision. They are:

%c c 2/c &4c ,c c 1c #c /c m 5c /c ,c  The
Reserve Bank of India (RBI), and the aovernment of India, with a view to arresting inflation or
steep rise in the prices of certain essential commodities, like food grains (rice, wheat, maize,
etc.), onion, etc., may resort to some changes in their Selective Credit Control Policies,
instructing the banks to retain higher percentage as margin on the stocks advanced against, as
also by fixing some ceiling on the maximum amount that could be advanced against the security

of some commodities specified, to a single borrower, as also to fix a lower ceiling on the holding
of such stocks by a single party, so as to restrict hoarding, and consequently the steep rise in the
price. Such statutory restrictions exercise limitation on the companies in formulating their
inventory policy.

%c -2/c 4 In case certain material is expected to be in short supply in the near
future, it would be a prudent policy to stock a larger quantity of such material so as to avoid the
stock-out risk, as far as possible.

%c 00cw Sometimes the price of certain commodity is expected to rise or fall, in
the near future. And, accordingly, the stocks of inventory of such items should be kept flexible,
and adjusted accordingly, i.e., retaining higher or lower levels of such inventory, respectively.

<%c1c#c & Certain items of raw materials may become obsolete with the passage
of time. For example, jute packing has since been replaced by polythene matting in the carpet
industries. The risk of obsolescence may be even higher and costlier in the cases of the finished
goods, in the modern age of technological advancements and stiff global competition. Such
stocks should naturally be kept at the minimal possible level.

Here, it may be emphasised that even if the policy of meeting the customers¶ demand
immediately is taken to be the company¶s marketing strategy, instead of having a huge ready
stocks of such finished goods, it would augur well if only a percentage of the market
requirements could be kept in the ready stock, to be supplied to the customers immediately, and
the balance quantity could be produced on an emergency basis and supplied in a week¶s time or
so. This way, the company may meet the competitive challenges, as also avoid the risk of


ABC analysis is a very effective and useful tool for monitoring and control of inventories. As
you must have observed, generally speaking, a very small percentage of the total number of
items of inventory (say 10%) may account for a much larger percentage (say [5%) in terms of
value. As against this, in cases of certain other items of inventory, a very large percentage of the

total number of items of inventory (say 70%) may account for a much smaller percentage (say
10%) in terms of their total value. And, likewise, a medium percentage of some items (say ]0%)
may account for a medium percentage (say ]5%) in terms of their total value. These are
classified as category A, B and C respectively. ABC analysis is also referred to as VED (Vital,
Essential and Desirable) analysis.

We may put the aforesaid statements in a tabular form as under:

The main (or even sole) purpose of classifying the inventories into these three categories, A, B,
and C, is to vary the pressure and intensity of control, in terms of the value of the items of

To put it differently, while the entire stocks (say 100%), of the items in category "A" must be
very closely monitored and controlled, the monitoring and control of say, 10% of the items of
category "C", could be considered enough to serve the purpose. And, in the case of "B" category
of items, the monitoring and control of say ]5% of the item alone may be taken as sufficient.


Now, let us see how do we usually proceed to classify the various items of inventories into the
three categories viz., A, B, and C. The procedure involves the following steps, in a sequential


Rank all the items of inventory, in a descending order, based upon their annual usage value, and
serially number them, from I to n.

2c c

Record the totals of annual consumption values of all the items separately and store them as a
percentage of the total value of consumption.


a) Observe the percentage column and find out the cut off point where the difference between the
two successive percentages is rather significant and marked.

b) At the same time, please do bear in mind that the cut off point so arrived at, comprises a
reasonable number of items of inventory, too.


We may finalise the classification of the items of inventory into A, B, and C categories, giving
the number of units of inventory and their values in percentage terms, under all the three
categories, with the laid down principles and objectives of the ABC analysis (or VED analysis),
in the desired manner.

c Îc/

It is based on the following assumptions:

(i) The quantum of the usual annual usage of the items of inventories is known, in accurate term.

(ii) The usage is usually uniform throughout the year.

(ii) The lead-time (i.e, time gap between ordering and receiving) is NIL.

(iv) Therefore, there is no risk of stock-out, either. That is, the stock-out cost is NIL.

(v) Thus, only two costs are involved:

(a) Ordering Cost, and

(b) Inventory Carrying Cost.

(vi) Further,

(a) Ordering Cost is uniform, irrespective of the order size, and

(b) The Inventory Carrying Cost is a fixed percentage of the average value of Inventories.

 Îc 0c%c c/cc,/c

Trial and Error Method is a very cumbersome and time-consuming process. The formula,
however, makes the procedure rather simple enough.


There is no single Economic Order Point (EOP). There is, instead, an Economic Order Range

 Îc"%cDDDcm 2c /cÎ045c

[That is, when bulk (quantity) discount is available].

(a) When the quantity discount is available at a lower level than the EOQ, then EOQ itself will
be the 000, too.

(b) But, if it is higher than EOQ, 000 will be the EOQ or the quantity eligible for bulk discount,
depending upon which one of these two will be beneficial [i.e., when the resultant difference will
be a positive (+ve) figure].

cc0cc Îc

That is, after finding out the EOQ in terms of the nearest integer figure, we should find out the
number of orders. And, this again, should be converted into the nearest integer number. Based on
this figure as the number of orders, we should calculate the EOQ, which will be the EOQ in real
terms. Besides, we should bear in mind the concepts of EOP and EOR, too, at this stage.


(i) Storage Cost

(ii) Handling Charges

(iii) Insurance Charges

(iv) Wastages

(v) Damage/Deterioration

(vi) Technical Obsolescence, Blockage of funds and cost of capital, and opportunity cost
connected therewith.


(a) High Stocks of Raw Materials

(i) Bulk purchase at cheaper rate with quantity discount. [Better, if bulk annual purchase is
ordered, but the delivery and payments are to be made in phases, to the mutual advantages of
both the parties. It is an optimal strategy).

(ii) Seasonal purchases, being cheaper and sure.

(iii) No Stock-out cost and risk.

(iv) In inflationary economy, it may be gainful.

(v) Savings of ordering cost and the connected hazels of loading and unloading, etc.

m&5c+,c1c#c ,/c/c

(i) It may facilitate instant delivery, out of the shelf, and, thus, to have an edge over the
competitors. [But, better to have only a small ready stock and the rest to be produced on receipt
of the order, on priority basis].

(ii) Thus, the "aolden Mean" is the most basic management mantra, pertaining to the
management of inventory, too.

=%c/c c

It represents the time lag between placement of order and the actual receipt of goods. This could
as well be taken into account by modifying the EOQ formula, just slightly.

9%c /cwcc

Thus, as a prudent manager, we should place the next order well in advance, at the point in time,
when there is some stock left, being sufficient enough to take care of the lead time.


And, it would be a better business sense to have some safety stock, too, so as to take care of
some possible fluctuations in both (i) the lead-time, and accordingly; (ii) the order point.

Thus, Order Point will be = EOQ + [Lead-time (in days) x Daily Usage] + Safety Stock.

Estimating and ascertaining the safety stock is a managerial judgement² decision & discretion.
But, the safety stock should not be too high, nor too low. It should be sufficient enough, just
about right.


1. (a) Name the three main components of inventory.

(b) Whether bond papers, ceiling fans, woollen suit lengths and Maruti 800 cars are raw
materials or finished goods? aive specific reasons for your answer, citing illustrative examples
to bring home your points of view.

]. Why, at all, are we required to keep stocks of inventories of

(a) Raw materials, and (b) finished goods?

3. (a) Distinguish between, "process or movement" inventories, and "organization" inventories.

(b) What is the rationale behind keeping stocks of "organization" inventories of both raw
materials and finished goods?

4. The basic EOQ model is based on several assumptions. What are they?

5. Write down the formula for EOQ. Explain, how the formula has been derived?

[. The basic EOQ model does not take into account the elements of inflation. What adjustments
of modifications, in your considered view, need to be made in the basic EOQ model to take care
of the elements of inflation?

7. What do you understand by the terms?

(a) Ordering cost.

(b) Inventory carrying costs.

(c) Shortage costs or stock-out costs?

Clarify your points, by citing suitable illustrative examples, in each case.

8. What are the various factors) elements involved in the inventory carrying costs? Explain with
the help of some illustrative examples.

9. (a) Explain the following terms with the help of some illustrative examples:

(i) Lead time, (ii) order point, and (iii) safety stock.

(b) How is the reorder level ascertained? Explain with the help of an illustrative example.

10. (a) What do you understand by the term "ABC Analysis"? Explain with the help of
illustrative examples, the procedure adopted for doing the ABC analysis.

(b) What purpose does ABC Analysis serve in the context of inventory policy, monitoring,
management and control? Explain, with the help of some suitable illustrative examples.

(c) In what other two areas (other than the area of inventory management) can the ABC Analysis
be used with immense advantage? Name them and explain each of them with the help of some
illustrative examples.

11. The state of affairs in the area of management of inventory in most of the Indian companies
leaves a lot to be desired.

(a) What are the various factors responsible for such dismal state of affairs?

(b) What corrective steps would you suggest to streamline and improve the system of inventory
management and control in India?

1]. Distinguish between EOQ and OOQ (Optimum Order Quantity) when quantity discount is
available. Elucidate your point by citing suitable illustrative examples.

13. Distinguish between JIT (Just In Time) and JIC (Just In Case) approaches towards inventory
management and control.

(i) Cite suitable illustrative examples to clarify your point.

(ii) Which one of the above noted two approaches, in your considered opinion, should be
adopted by any company? aive reasons for your answer.

14. (a) What are the comparative advantages and disadvantages of carrying too high or too low
stocks of inventories of:

(i) Raw materials, and (ii) finished goods?

Explain, with the help of some illustrative examples.

(b) What, in your considered view, would be the right approach in this area? aive convincing
reasons for your answer.




In the previous unit, various issues regarding management of working capital were discussed. It
was explained that current assets form an important aspect of working capital management. In
fact, each current asset requires a detailed treatment to understand the issues related to the need
and method of its management. In this unit we shall discuss the planning and managing of cash.
Cash to business is like blood stream in human body. Cash denotes the liquidity of a business
enterprise and plays an important role in nurturing and improving the profitability of an
organization. It is, therefore, essential to make a proper estimate of the cash needs and plan for it
so as to avoid technical or legal insolvency. Hence, effective management ensuring adequate
cash is necessary. The cash available with the organization should neither be short nor too

c &'c

The objectives of this unit are to acquaint you with the:

Importance of maintaining adequate liquidity

Concept of optimum cash balance
Importance of cash management and the usefulness of cash budgeting as a technique of
liquidity planning

  c  c


The demand for liquid assets like cash, whether by individuals or firms, is normally attributed to
three behavioral motives, viz., the transaction motive, the precautionary motive and the
speculative motive.

The transaction motive for holding cash is helpful in the conduct of everyday ordinary business
such as making of purchases and sales. The amount of cash needed, however, differs from
business to business and from firm to firm depending on the frequency of cash transactions.
Retail trade, for example, requires a higher ratio of cash to sales and of cash to total assets. Firms
having seasonal business will need greater amount of cash during the season.

The precautionary motive is concerned with predictability of cash inflows and outflows. Higher
the predictability of cash, lower is the amount needed against emergencies or contingencies. This
motive for holding cash is also influenced by the ability of the firm to obtain additional cash on
short notice through short-term borrowings. A minimum reservoir of cash must always be kept in
hand to meet the unexpected payments and other contingencies.

The speculative motive for holding cash is concerned with availing the opportunities arising
from unexpected developments, e.g. an abnormal increase in prices. However, keeping additional
cash for speculative purpose is not common in business.

c 2c,c c

Holding of excessive cash is a non-profitable proposition, as idle cash does not earn any income.
Similarly shortage of cash may deprive the business unit of availing the benefits of cash
discounts, and of taking advantage of other favorable opportunities. It may even lead to loss of
credit-worthiness on account of default in paying liabilities when the same becomes due. Hence,
every organization, irrespective of its size and nature, has to determine the appropriate or
optimum cash balance that it would need.

A firm¶s cash balance, generally, may not be constant overtime. It would therefore be
worthwhile to investigate the maximum, minimum and average cash needs over a designated
period of time.

You are aware that cash is needed for various transactions of the organization. Maintenance of a
cash balance however has an opportunity cost in the following ways:

a) Cash can be invested in acquiring assets such as inventory, or for purchasing securities.
Opportunities for such investments may be lost if a certain minimum cash balance is held.

b) Holding of cash means that it cannot be used to offset financial risks from the short-term

c) Excessive reliance on internally generated liquidity can isolate the firm from the short-term
financial market.

Now the Finance Manager should understand the benefits and the opportunity costs for holding
cash. Thereafter, he must proceed to work out a model for determining the optimal amount of
cash. First of all, Critical minimum cash balance should be conceived below which the firm
would incur definite and measurable costs. Apart from risk aversion, the existence of the
minimum balance is justified by institutional requirements such as credit ratings, checking
accounts and lines of credit.

The violation of maintaining a minimum cash balance will create shortage costs, which will be
determined by the actions of creditors on account of postponing their payments or non-availing
of cash discounts.

At any point of time a firm¶s (ending) cash balance can be represented as follows:

Ending balance=Beginning Balance + Receipts ² Disbursements

If receipts and disbursements are equal for any unit of time, no problem is involved. Ordinarily,
however, receipts may be more than disbursements or vice versa. Hence, the ending balance will

keep on fluctuating. In actual practice, receipts and disbursements do vary, particularly in case of
firms having seasonal activities.

Suppose, the receipts and disbursements are not synchronized but the variation is predictable,
then the main problem will be that of minimizing total costs.


Cash, being a sensitive asset, has to be regulated according to needs. Any deficits (or
inadequacies) should be rectified and any excess amount be gainfully invested. Cash
management involves two main questions

1]8.c How should the collection and disbursement of cash balances be managed?
1]9.c How should the appropriate cash balance be determined, and how should any
temporary idle cash be invested in interest earning assets?

cc/c &0c


In order to deal with the problem of cash management, we must have an idea about the flow of
cash through a firm¶s account. The entire process of this cash flow is known as Cash Cycle. This
has been illustrated in Figures III and IV. Cash is used to purchase materials from which goods
are produced. Production of these goods involves use of funds for paying wages and meeting
other expenses. aoods produced are sold either on cash or credit. In the latter case the pending
bills are received at a later date. The firm thus receives cash immediately or later for the goods
sold by it. The cycle continues repeating itself.





The diagram in above figure only gives a general idea about the channels of flow of cash
Managing Cash in a business. The magnitude of the flow in terms of time is depicted in the
diagram given in Figure IV. The following information is reflected by Figure IV:

zzzzz.c Raw material for production is received 10 days after placement of order.
aaaaaa.c The material is converted into goods for sale in 37 days (15+]+]0) from point B
to E.
bbbbbb.c The payment for material purchased can be deferred to 17 days (15+]) after it is
received (i.e. the distance of time between points B to D), assuming that it takes ] days
for collection of payment of the cheque.
cccccc.c The amount of the bill for goods sold is received 3[ days (3]+]+]) after the sale
of goods as is depicted by duration of time between point F to H.
dddddd.c The recovery of cash spent till point D is made after 5[ days (]0+30+]+]+]) as
shown between points D to H.


In order to minimize the size of cash holding, the time gap between sale of goods and their cash
collection should be reduced and the flow be controlled. Normally, certain factors creating time
lags are beyond the control of management. Yet, in order to improve the efficiency, attention
should be paid to the following.

All cash collected should be directly deposited in one account. If there are more than one
collection centers, all cash receipts should be remitted to the main account with, top speed.
Compared to a single collection center, the aggregate requirement for cash will be more when

there are several centers. Concentration of collections at one place will thus permit the firm to
store its cash more efficiently.

The time lag between the dispatch of cheque by the customer and its credit to our account with
the bank should be reduced. Some firms with large collection transactions introduce lock box
system. In this system the post boxes are hired at different centers where cash/cheques can be
dropped in. The local banker can daily collect the same from the lockers. The collecting bank is
paid service charges. In order to minimize time front banks may be asked to devise methods for
speeding up the collection of cash.

c 0c

After sale of goods on credit, either on account of convention or for promoting sales, receivables
are created. It may however be useful to reduce the amount blocked in receivables by seeing to it
that they do not become overdue accounts. Incentive in the form of discounts for early payment
may be given. More important than anything else, is a constant follow-up action for the recovery
of dues. This will improve position of cash balance.

c &0c

Needless to assert that speeding up of collections helps conversion of receivables into cash and
thus reduces the financing requirements of the firm. Similar kind of benefit can be derived by
delaying disbursements. Trade credit is a costless source of funds for it allows us to pay the
creditors only after the period of credit agreed upon. The dues can be withheld till the last date.
This will reduce the requirement for holding large cash balances. Some firms may like to take
advantage of cheque book float which is the time gap between the date of issue of a cheque and
the actual date when it is presented for payment directly or through the bank.

c#c/c,c cc

Two other important aspects in cash management are how to determine appropriate cash balance
and how to invest temporarily idle cash in interest earning assets or securities. The first part
relating to the theory of determining appropriate cash balance has already been discussed earlier.

Now we shall discuss the investment of idle cash balances on temporary basis. Cash by itself
yields no income. If we know that some cash will be in excess of our need for a short period of
time, we must invest it for earning income without depriving ourselves of the benefit of liquidity
of funds. While doing this, we must weigh the advantages of carrying extra cash (i.e. more than
the normal requirement) and the disadvantages of not carrying it. The carrying of extra cash may
be necessitated due to its requirement in future, whether predictable or unpredictable. The
experience indicates that cash flows cannot be predicted with complete accuracy. Competition,
technological changes, unexpected failure of products, strikes and variations in economic
conditions make it difficult to predict cash needs accurately.


When it is realized that the excess cash will remain idle, it should be invested in such a way that
it would generate income and at the same time ensure quick re-conversion of investment in cash.
While choosing the channels for investment of any idle cash balance for a short period, it should
be seen that (i) the investment is free from default risk, that is, the risk involved due to the
possibility of default in timely payment of interest and repayment of principal amount; (ii) the
investment shall mature in a short span of time; and (iii) the investment has adequate
marketability. Marketability refers to the ease with which an asset can be converted back into
cash. Marketability has two dimensions price and time-which are inter-related. If an asset can be
sold quickly in large amounts at a price determinable in advance, the asset will be regarded as
highly marketable and highly liquid. The assets, which largely satisfy the aforesaid criteria, are:
aovernment Securities, Bankers¶ Acceptances and Commercial Paper.

,c 0/c

Planning cash and controlling its use are very important tasks. If the future cash flows are not
properly anticipated, it is likely that idle cash balances may be created which may result in
unnecessary losses. It may also result in cash deficits and consequent problems. The Finance
Manager should therefore, plan the cash needs and uses. Cash budget is a useful device for this

Cash budget basically incorporates estimates of future inflows and outflows of cash over a
projected short period of time which may usually be a year, a quarter or a half-year. Effective
cash management is facilitated if the cash budget is further broken down into monthly, weekly or
even daily basis.

w2cc,c 0/c

There are two components of a cash budget²cash inflows and cash outflows. In both these
components there are two types of flows, viz. operating cash flows and financial cash flows.
Some common elements of each are as follows:

Cash Inflows - (a) Operating: cash sales, receivable collections. (b) Financial: interest receipts,
sale of marketable securities, issue of new securities.

Cash Outflows -(a) Operating: wage payments, payments of bills and accounts payable, and
capital expenditure (b) Financial: dividend payments, interest payments, redemption of
securities, loan repayments, purchase of marketable securities and tax payments.


Sales bring in a major part of cash inflows. All sales may not be against cash; credit sales are
quite common. Each business establishment has its own credit policy for promoting sales. Even
when care is taken to ensure that credit sales do not exceed the permitted percentage of total
sales and that debtors do not default in paying bills in time, it is a common experience that the
total amount of sales is recovered over a period of time.


135.c What are the three motivations behind holding cash? Explain briefly.
13[.c "In managing cash, the Finance Manager faces the problem of compromising the
conflicting goals of liquidity and profitability". Comment. What strategy should the
Finance Managers develop to solve this problem?
137.c What is optimum cash balance and how can it be arrived at?
138.c What is cash cycle and how can it be reduced?

139.c If a firm estimates that it will have some idle cash balances from time to time,
what advice would you render to the firm?
140.c What is a cash budget and in what way can it be helpful in liquidity planning?
141.c How would you judge the efficiency of cash management of a company?


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Capital markets are a sub-part of the financial system. Conceptually, the financial system
includes a complex of institutions and mechanisms which affects the generation of savings and
their transfer to those who will invest. It may be said to be made of all those channels through
which savings become available for investments. The main elements of the financial system are a
variety of (i) financial instruments/assets/securities, (ii) financial intermediaries/institutions and
(iii) financial markets.

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on going through this lesson, you will be conversant with:

The nature of financial assets.

The rate of financial intermediaries.
The functioning of financial market.

The relationship between new issue markets and stock exchange.
The functions of stock exchange.
The issue mechanism followed in Indian markets.

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A financial asset/Instrument/security is a claim against another economic unit and is held as a

store of value and for the return that is expected. While the value of a tangible/physical asset
depends on its physical properties such as buildings, machines, furniture vehicles and so on, a
financial asset represents a claim to future cash flows in the form of interest, dividends and so
on. They are a claim on a stream of income and/or particular assets. The entity/economic unit
that offers the future cash flows is the issuer of the financial instrument¶ and the owner of the
security is the investor¶.

Depending upon the nature of claim/return, an instrument may be (i) debt (security) such as
bonds, debentures, term loans, (ii) equity (security) shares and (iii) hybrid security such as
preference shares and convertibles, Based on the type of issuer, the security may be (1) direct (])
indirect and (3) derivative. The securities issued by manufacturing companies are direct assets
(e.g. shares/debentures). Indirect assets are claims against financial intermediaries (e.g. units of
mutual funds). The derivative instruments include options and futures. The prevalence of a
variety of securities to suit the investment requirements of heterogeneous investors, offers
differentiated investment choice to them and is an important element in the maturity and
sophistication of the financial system.


Financial Intermediaries are institutions that channelise the savings of investors into
investments/loans. As institutional source of finance, they act as a link between the savers and
the investors, which results in institutionalisation of personal savings. Their main function is to
convert direct financial assets into indirect securities. The indirect securities offer to the
individual investor better investment alternative than the direct/primary security by pooling

which it is created, for example, units of mutual funds. The main consideration underlying the
attractiveness of indirect securities is that the pooling of funds by the financial intermediary leads
to a number of benefits to the investors. The services/benefits that tailor indirect financial assets
to the requirements of the investors are (i) convenience, (ii) lower risk, (iii) expert management
and (iv) lower cost.

Financial intermediaries convert direct/primary securities into a more convenient vehicle of

investment. They divide primary securities of higher denomination into indirect securities of
lower denomination. They also transform a primary security of certain maturity into an, indirect
security of a different maturity. For instance, as a result of the redemption/repurchase facility
available to unitholders of mutual funds, maturities on units would conform more with the
desires of the investors than those on primary securities.


The lower risk associated with indirect securities results from the benefits of diversification of
investments. In effect, the financial intermediaries transform the small investors in matters of
diversification into large institutional investors as the former shares proportionate beneficiary
interest in the total portfolio of the latter.


Indirect securities give to the investors the benefits of trained, experienced and specialised
management together with continuous supervision. In effect, financial intermediaries place the
individual investors in the same position in the matter of expert management as large
institutional investors.


Low cost iscthe benefits of investment through financial intermediaries are available to the
individual investors at relatively lower cost due to the economies of scale.

The major financial intermediaries are banks, insurance organisations, both life and non-life/
general, mutual funds, non-banking financial companies and so on.


Financial markets perform a crucial function in the financial system as facilitating organisations.
Unlike financial intermediaries, they are not a source of funds but are a link and provide a forum
in which suppliers of funds and demanders of loans/investments can transact business directly.
While the loans and investments of financial intermediaries are made without the direct
knowledge of the suppliers of funds (i.e. investors), suppliers in the financial market know where
their funds are being lent/invested. The two key financial markets are the money market and the
capital market.


The money market is created by a financial relationship between suppliers and demanders of
short-term funds which have maturities of one year or less. It exists because investors (i.e.
individuals, business entities, government and financial institutions) have temporarily idle funds
that they wish to place in some type of liquid asset or short-term interest-earning instrument. At
the same time, other entities/ organisations find themselves in need of seasonal/ temporary
financing. The money market brings together these suppliers and demanders of short- term liquid
funds. The broad objectives of money market are three-fold:

An equilibrating mechanism for evening out short-term surplus and deficiencies in the
financial system;
A focal point of intervention by the central bank (e.g. Reserve Bank of India) intervention for
influencing liquidity in the economy; and
A reasonable access to the users of short-term funds to meet their requirements at realistic/
reasonable cost and temporary deployment of funds for earning returns to the suppliers of


The capital market is a financial relationship created by a number of institutions and
arrangements that allows suppliers and demanders of long-term funds (i.e. funds with maturities
exceeding one year) to make transactions. It is a market for long-term funds. Included among
long-term funds are securities issues of business and aovernment. The backbone of the capital
market is formed by the various securities exchanges that provide a forum for equity (equity
market) and debt (debt market) transactions. Mechanisms for efficiently offering and trading
securities contribute to the functioning of capital markets which is important to the long-term
growth of business. Thus, the capital market comprises of (I) stock/security exchanges/markets
(secondary markets) and (]) new issue/primary market [initial public offering (IPO) market].

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The industrial securities market is divided into two parts, namely, NIM and stock market. The
relationship between these parts of the market provides an insight into its organisation. One
aspect of their relationship is that they differ from each other organisationally as well as in the
nature of functions performed by them. They have some similarities also.


The differences between NIM and stock exchanges pertain to (i) Types of securities dealt, (ii)
Nature of financing and (iii) Organisation.

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The NIM deals with new securities, that is, securities which were not previously available and
are, therefore, offered to the investing public for the first time. The market, therefore, derives its
name from the fact that it makes available a new block of securities for public subscription. The
stock market, on the other hand, is a market for old securities which may be defined as securities
which have been issued already and granted stock exchange quotation. The stock exchanges,
therefore, provide a regular and continuous market for buying and selling of securities. The usual
procedure is that when an enterprise is in need of funds, it approaches the investing public, both
individuals and institutions, to subscribe to its issue of capital. The securities thus floated are
subsequently purchased and sold among the individual and institutional investors. There are, in

other words, two stages involved in the purchase and sale of securities. In the first stage, the
securities are acquired from the issuing companies themselves and these are, in the second stage,
purchased and sold continuously among the investors without any involvement of the companies
whose securities constitute the stock-intrude except in the strictly limited sense of registering the
transfer of ownership of the securities. The section of the industrial securities market dealing
with the first stage is referred to as the NIM, while secondary market covers the second stage of
the dealings in securities.

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Another aspect related to the separate functions of these two parts of the securities market is the
nature of their contribution to industrial financing. Since the primary market is concerned with
new securities, it provides additional funds to the issuing companies either for starting a new
enterprise or for the expansion or diversification of the existing one and, therefore, its
contribution to company financing is direct. In contrast, the secondary markets can in no
circumstance supply additional funds since the company is not involved in the transaction. This,
however, does not mean that the stock markets have no relevance in the process of transfer of
resources from savers to investors. Their role regarding the supply of capital is indirect. The
usual course in the development of industrial enterprise seems to be that those who bar the initial
burden of financing a new enterprise, pass it on to others when the enterprise becomes well
established. The existence of secondary markets which provide, institutional facilities for the
continuous purchase and sale of securities and, to that extent, lend liquidity and marketability,
play an important part in the process.

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The two parts of the market have organisational differences also. The stock exchanges have,
organisationally speaking, physical existence and are located in a particular geographical area.
The NIM is not rooted in any particular spot and has no geographical existence. The NIM has
neither any tangible form any administrative organisational set up like that of stock exchanges,
nor is it subjected to any centralised control and administration for the consummation of its
business. It is recognised only by the services that it renders to the lenders and borrowers of

capital funds at the time of any particular operation. The precise nature of the specialised
institutional facilities provided by the NIM is described in a subsequent section.


Nevertheless, in spite of organisational and functional differences, the NIM and the stock
exchanges are inseparably connected.


One aspect of this inseparable connection between them is that the securities issued in the NIM
are invariably listed on a recognised stock exchange for dealings in them. In India, for instance,
one of the conditions to which a prospectus is to conform is that it should contain a stipulation
that the application has been made, or will be made in due course for admitting the securities to
dealings on the stock exchange. The practice of listing of new issues on the stock market is of
immense utility to the potential investors who can be sure that should they receive an allotment
of new issues, they will subsequently be able to dispose them off any time. The absence of such
facilities would act as some sort of psychological barrier to investments in new securities. The
facilities provided by the secondary markets, therefore, encourage holdings of new securities
and, thus, widen the initial/primary market for them.


The stock exchanges exercise considerable control over the organisation of new issues. In terms
of regulatory framework related to dealings in securities, the new issues of securities which seek
stock quotation/listing have to comply with statutory rules as well as regulations framed by the
stock exchanges with the object of ensuring fair dealings in them. If the new issues do not
conform to the prescribed stipulations, the stock exchanges would refuse listing facilities to
them. This requirement obviously enables the stock exchange to exercise considerable control
over the new issues market and is indicative of close relationship between the two.


The markets for new and old securities are, economically, an integral part of a single market²
the industrial securities market. Their mutual interdependence from the economic point of view
has two dimensions. One, the behavior of the stock exchanges has a significant bearing on the
level of activity in the NIM and, therefore, its responses to capital issues: Activity in the new
issues market and the movement in the prices of stock exchange securities are broadly related:
new Issues increase when share values are rising and vice versa.1 This is because the two parts
of the industrial securities market are susceptible to common influences and they act and react
upon each other. The stock exchanges are usually the first to feel a change in the economic
outlook and the effect is quickly transmitted to the new issue section of the market.

The second dimension of the mutual interdependence of the two parts of the market is that the
prices of new issues are influenced by the price movements on the stock market. The securities
market represents an important case where the stock-demand-and-supply curves, as distinguished
from flow-demand-and-supply curves, exert a dominant influence on price determination. The
quantitative predominance of old securities in the market usually ensures that it is these which
set the tone of the market as a whole and govern the prices and acceptability of the new issues.
Thus, the flow of new savings into new securities is profoundly influenced by the conditions
prevailing in the old securities market²the stock exchange.


Stock exchanges discharge three vital functions in the orderly growth of capital formation:

(i) Nexus between savings and investments, (ii) Market place and (iii) Continuous price


First and foremost, they are the nexus between the savings and the investments of the
community. The savings of the community are mobilised and channelled by stock exchanges for
investment into those sectors and units which are favoured by the community at large, on the
basis of such criteria as good return, appreciation of capital, and so on. It is the preference of
investors for individual units as well as industry groups, which is reflected in the share price, that

decides the mode of investment. Stock exchanges render this service by arranging for the
preliminary distribution of new issues of capital, offered through prospectus, as also offers for
sale of existing securities, in an orderly and systematic manner. They themselves administer the
same, by ensuring that the various requisites of listing (such as offering at least the prescribed
minimum percentage of capital to the public, keeping the subscription list open for a minimum
period of days, making provision for receiving applications at least at the prescribed centres,
allotting the shares against applications on a fair and unconditional basis) are duly complied with
Members of stock.

Exchanges also assist in the flotation of new issues by acting (i) as brokers, in which capacity
they, inter alia, try to procure subscription from investors spread all over the country, and (ii) as
underwriters. This quite often results in their being required to nurse new issues till a time when
the new ventures start making profits and reward their shareholders by declaring reasonable
dividends when their shares command premiums in the market. Stock companies also provide a
forum for trading in rights shares of companies already listed, thereby enabling a new class of
investors to take up a part of the rights in the place of existing shareholders who renounce their
rights for monetary considerations.


The second important function discharged by stock markets/exchanges is that they provide a
marker place for the purchase and sale of securities, thereby enabling their free transferability
through several successive stages from the original subscriber to the neverending stream of
buyers, who may be buying them today to sell them at a later date for a variety of considerations
like meeting their own needs of liquidity, shuffling their investment portfolios to gear up for the
ever changing market situations, and so on. Since the point of aggregate sale and purchase is
centralised, with a multiplicity of buyers and sellers at any point of time, by and large, a seller
has a ready purchaser and a purchaser has a ready seller at a price which can he said to be
competitive. This guarantees saleability to one who has already invested and surety of purchase
to the other who desires to invest.

00cwc c

The third major function, closely related to the second, discharged by the stock exchanges is the
process of continuous price formation. The collective judgement of many people operating
simultaneously in the market, resulting in the emergence of a large number of buyers and sellers
at any point of time, has the effect of bringing about changes in the levels of security prices in
small graduations, thereby evening out wide swings in prices. The ever changing demand and
supply conditions result in a continuous revaluation of assets, with today¶s prices being
yesterday¶s prices, altered, corrected, and adjusted, and tomorrow¶s values being again today¶s
values altered, corrected and adjusted. The process is an unending one. Stock exchanges thus act
as a barometer of µthe state of health of the nations economy, by constantly measuring its
progress or otherwise. An investor can always have his eyes turned towards the stock exchanges
to know, at any point of time, the value of the investments and plan his personal needs


The main function of NIM is to facilitate the transfer of resources from savers to entrepreneurs
seeking to establish new enterprise or to expand/diversify existing ones. Such facilities are of
crucial importance in the context of the dichotomy of funds available for capital uses from those
in whose hands they accumulate, and those by whom they are applied to productive uses.
Conceptually, the NIM should not, however, be conceived as exclusively serving the purpose of
raising finance for new capital expenditure. In fact, the organisation and facilities of the market
are also utilised for selling concerns to the public as going concerns through the conversion of
existing proprietary enterprises or private companies into public companies. The NIM is a
complex of institutions through which funds can be obtained directly or indirectly by those who
require them from investors who have savings.

New issues can be classified in various ways. The first of new issues are by new companies and
old companies. This classification was first suggested by R.F. Henderson. The distinction
between new also called initial and old also known as further, does not bear any relation to the
age of the company. The securities issued by companies for the first time either after the
incorporation or conversion from private to public companies are designated as initial issues,

while those issued by companies which already have stock exchange quotation, either by public
issue or by rights to existing shareholders, are referred to as further or old.

The new issues by corporate enterprise can also be classified on the basis of companies seeking
quotation, namely, new money issues and no new money issues. The term new money issues
refers to the issues of capital involving newly created shares; no new money issues represent the
sale of securities already in existence and sold by their holders. The new money issues provide
funds to enterprises for additional capital investment. According to Merrett and others,5 new
money refers to the sum of money equivalent to the number of newly created shares multiplied
by the price per share minus all the administrative cost associated with the issue. This money
may not be used for additional capital investment; it may be used wholly or partly to repay debt.
Henderson uses the term in a rather limited sense so that it is the net of repayment of long-term
debt and sums paid to vendors of existing securities. The differences in the approaches by
Merrett and others, on the one hand, and Henderson, on the other, arise because of the fact that
while the concern of the former is with both flow of funds into the market as well as flow of
money, Henderson was interested only in the latter.

However, two types of issues are excluded from the category of new issues. First, bonus/
capitalisation issues which represent only book-keeping entries, and, second, exchange issues by
which shares in one company are exchanged for securities of another.

The general function of the NIM, namely, the channelling of investible funds into industrial
enterprises, can be split from the operational stand-point, into three services (i) Origination,(ii)
Underwriting, and (iii) Distribution. The institutional set-up dealing with these can be said to
constitute the NIM organisation. In other words, the NIM facilitates the transfer of resources by
providing specialist institutional facilities to perform the triple-service function.


The term origination refers to the work of investigation and analysis and processing of new
proposals. These two functions8 are performed by the specialist agencies which act as the
sponsors of issues. One aspect is the preliminary investigation which entails a careful study of
technical, economic, financial, and legal aspects of the issuing companies. This is to ensure that

it warrants the backing of the issue houses in the sense of lending their name to the company
and, thus, give the issue the stamp of respectability, to satisfy themselves that the company is
strongly based, has good market prospects, is well-managed and is worthy of stock exchange
quotation. In the process of origination, the sponsoring institutions render, as a second function,
some services of an advisory nature that go to improve the quality of capital issues. These
services include advice on such aspects of capital issues as: (i) determination of the class of
security to be issued and price of the issues in the light of market conditions, (ii) the timing and
magnitude of issues, (iii) methods of Rotation, and (iv) technique of selling, and so on. The
importance of the specialised services provided by the NIM organisation in this respect can
hardly be overstressed in view of its pivotal position in the process of flotation of capital in the
NIM. On the thoroughness of investigation and soundness of judgement of the sponsoring
institutions depends, to a large extent, the allocative efficiency of the market.


The origination howsoever thoroughly done, will not, by itself, guarantee the success of an issue.
To ensure success of an issue, therefore, the second specialist service²underwriting²provided
by the institutional setup of the NIM takes the form of a guarantee that the issues would be sold
by eliminating the risk arising from uncertainty of public response. That adequate institutional
arrangement for the provision of underwriting is of crucial significance both to the issuing
companies as well as the investing public cannot be overstressed.


Underwriting, however, is only a stopgap arrangement to guarantee the success of an issue, in the
ultimate analysis, depends on the issues being acquired by the investing public. The sale of
securities to the ultimate investors is referred to as distribution. It is a specialist job, which can
best be performed by brokers and dealers in securities, who maintain regular and direct contact
with the ultimate investors.

Thus, the NIM is a complex of institutions through which funds can be obtained by those who
require them from investors who have savings. The ability of the NIM to cope with the growing
requirements of the expanding corporate sector would depend on the presence of specialist

agencies to perform the triple-service-function of origination, underwriting and distribution.
While the nature of the services provided by an organised NIM is the same in all developed
countries,the degree of development and specialisation of market organisation, the type of
institutions found and the actual procedures followed differ from country to country, as they are
determined partly by history and partly by the particular legal, social, political, and economic


The success of an issue depends, partly, on the issue mechanism. The methods by which new
issues are made are: (i) Public issue through prospectus, (ii) Tender/Book building, (iii) Offer for
sale (iv) Placement and (v) Rights issue.


A common method followed by corporate enterprises to raise capital through the issue of
securities is by means of a prospectus inviting subscription from the investing public. Under this
method, the issuing companies themselves offer directly to the general public a fixed number of
shares at a stated price, which in the case of new companies is invariably the face value of the
securities, and in the case of existing companies, it may sometimes include a premium amount, if
any. Another feature of public issue method is that generally the issues are underwritten to
ensure success arising out of unsatisfactory public response.

The foundation of the public issue method is a prospectus, the minimum contents of which are
prescribed by the Companies Act, 195[. It also provides both civil and criminal liability for any
misstatement in the prospectus. Additional disclosure requirements are also mandated by the
SEBI. The contents of the prospectus, inter alia, include: (i) Name and registered office of the
issuing company; (ii) Existing and proposed activities; (iii) Board of directors; (iv) Location of
the industry; (v) Authorised, subscribed and proposed issue of capital to public; (vi) Dates of
opening and closing of subscription list; (vii) Name of broker, underwriters, and others, from
whom application forms along with copies of prospectus can be obtained; (viii) Minimum
subscription; (ix) Names of underwriters, if any, along with a statement that in the opinion of the
directors, the resources of the underwriters are sufficient to meet the underwriting obligations;

and (x) A statement that the company will make an application to stock exchange(s) for the
permission to deal in or for a quotation of its shares and so on.

The public issue method through prospectus has the advantage that the transaction is carried on
in the full light of publicity coupled with approach to the entire investing public. Moreover, a
fixed quantity of stock has to be allotted among applicants on a non-discriminatory basis. The
issues are, thus, widely distributed and the danger of an artificial restriction on the quantity of
shares available is avoided. It would ensure that the share ownership is widely diffused, thereby
contributing to the prevention of concentration of wealth and economic power.

A serious drawback of public issue, as a method to raise capital through the sale of securities, is
that it is a highly expensive method. The cost of flotation involves underwriting expenses,
brokerage, and other administrative expenses. The administrative cost includes printing charges
of prospectus, advertisement/publicity charges, accountancy charges, legal charges, bank
charges, stamp duty, listing fee, registration charges, travelling expenses, filling of document
charges, mortgage deed registration fee and postage and so on). In view of the high cost involved
in raising capital, the public issue method is suitable for large issues and it cannot he availed of
in case of small issues.

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The essence of the tender/book building method is that the pricing of the issues is left to the
investors. The issuing company incorporates all the details of the issue proposal in the offer
document on the lines of the public issue method including the reserve/minimum price. The
investors are required to quote the number of securities and the price at which they wish to


Another method by which securities can be issued is by means of an offer for sale. Under this
method, instead of the issuing company itself offering its shares directly to the public, it offers
through the intermediary of issue houses/merchant banks/investment banks or firms of
stockbrokers. The modus operandi of the offer of sale is akin to the public issue method in that

the prospectus with strictly prescribed minimum contents which constitutes the foundation for
the sale of securities, and a known quantity of shares are distributed to the applicants in a
nondiscriminatory manner. Moreover, the issues are underwritten to avoid the possibility of the
issue being left largely in the hands of the issuing houses. But the mechanism adopted is
different. The sale of securities with an offer for sale method is done in two stages.

In the first stage, the issuing company sells the securities to the issuing houses or stockbrokers at
an agreed fixed price and the securities, thus acquired by the sponsoring institutions, are resold,
in the second stage, by the issuing houses to the ultimate investors. The securities are offered to
the public at a price higher than the price at which they were acquired from the company. The
difference between the sale and the purchase price, technically called as turn, represents the
remuneration of the issuing houses. In the case of public method, the issuing houses receive a fee
based upon the size and the complications involved in supervision as they act as agents of the
issuing companies. Although this is theoretically possible, but usually the issuing houses¶
remuneration in offer for sale is the turn¶ out of which they also meet subsidiary expenses such
as underwriting commission, the cost of advertisement and prospectus, and so on, whereas these
are borne by the companies themselves in the case of public issue method.

The offer for sale method shares the advantage available to public issue method. One additional
advantage of this method is that the issuing company is saved from the cost and trouble of selling
the shares to the public. Apart from being expensive, like the public issue method, it suffers from
another serious shortcoming. The securities are sold to the investing public usually at a premium.
The margin between the amount received by the company and the price paid by the public does
not become additional funds, but it is pocketed by the issuing houses or the existing


Yet another method to float new issues of capital is the placing method defined by London Stock
Exchange as "sale by an issue house or broker to their own clients of securities which have been
previously purchased or subscribed". Under this method, securities are acquired by the issue
houses, as in offer for sale method, but instead of being subsequently offered to the public, they

are placed with the clients of the issue houses, both individual and institutional investors. Each
issue house has a list of large private and institutional investors who are always prepared to
subscribe to any securities which are issued in this manner. Thus, the flotation of the securities
involves two stages: In the first stage, shares are acquired by the issuing houses and in the second
stage, they are made available to their investor-clients. The issue houses usually place the
securities at a higher price than the price they pay and the difference, that is, the turn is their
remuneration. Alternatively, though rarely, they may arrange the placing in return for a fee and
act merely as an agent and not principal.

Another feature of placing is that, the placing letter and the other documents, when taken
together, constitute a prospectus/offer document and the information concerning the issue has to
be published. In this method, no formal underwriting of the issue is required as the placement
itself amounts to underwriting since the issue houses agree to place the issue with their clients.
They endeavour to ensure the success of the issue by carefully vetting the issuing company
concerned and offering generous subscription terms.


Securities that are unquoted is known as private placing. The securities are usually in small
companies but these may occasionally be in large companies. When the securities to be placed
are newly quoted, the method is officially known as stock exchange placing.

The main advantage of placing, as a method of issuing new securities, is its relative cheapness.
This is partly because, many of the items of expenses in public issue and offer for sale methods
like underwriting commission, expense relating to applications and allotment of shares, and so
on are avoided. Moreover, the stock exchange requirements relating to contents of the prospectus
and its advertisement are less onerous in the case of placing.

Its weakness arises from the point of view of distribution of securities. As the securities are
offered only to a select group of investors, it may lead to the concentration of shares into a few
hands who may create artificial scarcity of scrips in times of hectic dealings in such shares in the

The placement method is advantageous to the issuing companies but it is not favorably received
by the investing public. The method is suitable in case of small issues which cannot bear the high
expenses entailed in a public issue, and also in such issues which are unlikely to arouse much
interest among the general investing public. Thus, with the placement method, new issues can be
floated by small companies which suffer from a financial disadvantage in the form of
prohibitively high cost of capital in the case of other methods of flotation as well as at times
when conditions in the market may not be favorable as it does not depend for its success on
public response. This underscores the relevance of this method from the viewpoint of the market.


The methods discussed above can be used both by new companies as well as by established
companies. In the case of companies whose shares are already listed and widely held, shares can
be offered to the existing shareholders. This is called rights issue. Under this method, the existing
shareholders are offered the right to subscribe to new shares in proportion to the number of
shares they already hold. This offer is made by circular to µexisting shareholders¶ only.

In India, Section 81 of the Companies Act, 195[ provides that where a company increases its
subscribed capital by the issue of new shares, either after two years of its formation or after one
year of first issue of shares whichever is earlier, these have to be first offered to the existing
shareholders with a right to renounce them in favour of a nominee. A company can, however,
dispense with this requirement by passing a special resolution to the same effect.

Rights issues are not normally underwritten but to ensure full subscription and as a measure of
abundant precaution, a few companies have resorted to underwriting of rights shares. The
experience of these companies has been that underwriters were not called upon to take up shares
in terms of their obligations. It is, therefore, observed that such underwriting serves little
economically useful purpose in that "it represents insurance against a risk which is (i) readily
avoidable and (ii) of extremely rare occurrence even where no special steps are taken to avoid it.
The chief merit of rights issue is that it is an inexpensive method. The usual expenses like
underwriting commission, brokerage and other administrative expenses are either non-existent or
are very small. Advertising expenses have to be incurred only for sending a letter of rights to

shareholders. The management of applications and allotment is less cumbersome because the
number is limited. As already mentioned, this method can be used only by existing companies
and the general investing public has no opportunity to participate in the new companies. The pre-
emptive right of existing shareholders may conflict with the broader objective of wider diffusion
of share-ownership.

The above discussion shows that the available methods of flotation of new issues are suitable in
different circumstances and for different types of enterprises. The issue mechanism would vary
from market to market.


1.c Discuss the main elements of the financial system.

].c Explain briefly financial assets/instruments.
3.c Describe briefly the functions of financial intermediaries.
4.c Explain briefly the two key financial markets.
5.c Write a brief note on the differences between the new issue market and the stock
[.c What are the similarities between the NIM and the stock market?
7.c What are the functions of the stock exchanges?
8.c Briefly discuss the functions of the NIM.
9.c What are the different methods of flotation of issues in the primary market?

c c

c c c0c#c c



Long-term capital is capital with maturity exceeding one year. Long-term capital is used to fund
the acquisition of fixed assets and part of current assets. Public limited companies meet their
long-term financial requirements by issuing shares and debentures and through borrowing and

public deposits. The required fund is to be mobilized and utilized systematically by the

c &'c

On going through this lesson, you will be conversant with:

The various sources of long term capital

The different types for long term capital instruments
Merits and demerits of equity and preference share capital
Different types of debentures and their merits and demerits.
Different modes of capital issues
SEBI auidelines on public issues.

  c  c


Broadly speaking, a company can have two main sources of funds. Internal and external, Internal
sources refer to sources from within the company External sources refer to outside sources.

Internal sources consist of depreciation provision, general reserve fund or free reserve ²
retained earnings or the saving of the company. External sources consists of share capital,
debenture capital, loans and advances (short term loans from commercial banks and other
creditors, long term loans from finance corporations and other creditors). Share capital is
considered as ownership or equity capital whereas debentures and loans constitute borrowed or
debt capital. Raising capital through issue of shares, debentures or bonds is known as primary
capital sourcing. Otherwise it is called new issues market.

Long-term sources of finance consist of ownership securities y shares and preference shares) and
creditor-ship securities (debentures, towing from the financing institutions and lease finance).
Short-term sources of finance consists of trade credit, short-term loans from banks and financial
institutions and public deposits.


Corporate securities also known as company securities are said to be the documentary media of
raising capital by the joint stock companies. These are of two classes: Ownership securities; and
Creditor-ship securities.


Ownership securities consist of shares issued to the intending investors with the right to
participate in the profit and management of the company. The capital raised in this way is called
µowned capital¶. Equity shares and securities like the irredeemable preference shares are called
ownership securities. Retained earnings also constitute owned capital.

/ ,2c0c

Creditor-ship securities consist of various types of debentures which are acknowledgements of

corporate debts to the respective holders with a right to receive interest at specified rate and
refund of the principal sum at the expiry of the agreed term. Capital raised through creditor-ship
securities is known as µborrowed capital¶. Debentures, bonds, notes, commercial papers etc. are
instruments of debt or borrowed capital.


Equity shares are instruments to raise equity capital. The equity share capital is the backbone of
any company¶s financial structure. Equity capital represents ownership capital. Equity
shareholders collectively own the company. They enjoy the reward of ownership and bear the
risk of ownership. The equity share capital is also termed as the venture capital on account of the
risk involved in it. The equity shareholders¶ liability, unlike the liability of the owner in a
proprietary concern and the partners in a partnership concern, is limited to their capital
subscription and contribution.


1.c Equity share capital constitutes the µcorpus¶ of the company. It is the µheart¶ to the
].c It represents permanent capital. Hence, there is no problem of refunding the capital. It is
repayable only in the event of company¶s winding up and that too only after the claims of
preference shareholders have been met in full.
3.c Equity share capital does not involve any fixed obligation for payment of dividend.
Payment of dividend to equity shareholders depends on the availability of profit and the
discretion of the Board of Directors.
4.c Equity shares do not create any charge on the assets of the company and the assets may
be used as security for further financing.
5.c Equity capital is the risk-bearing capital, unlike debt capital which is risk-burdening.
[.c Equity share capital strengthens the credit worthiness and borrowing or debt capacity of
the company. In general, other things being equal, the larger the equity base, the higher
the ability of the company to secure debt capital.
7.c Equity capital market is now expanding and the global capital market can be accessed.


1.c Cost of issue of equity shares is high, as the limited group of risk- seeking investors need
to be attracted and targeted. Equity shares attract only those classes of investors who can
take risk. Conservative and cautious investors do not subscribe for equity issues,
underwriting commission, brokerage costs and other issue expense¶ are high for equity
capital, rising up issue cost.
].c The cost of servicing equity capital is generally higher than the cost of issuing preference
shares or debenture since on account of higher rise, the expectation of the equity
shareholders is also high as compared preference shares or debentures.
3.c Equity dividend is payable from post-tax earnings. Unlike interest" paid on debt capital,
dividend is not deductible as an expense from the profit for taxation purposes. Hence cost
of equity is high Sometimes, dividend tax is paid, further rising cost of equity share

4.c The issuing of equity capital causes dilution of control of the equity holders.In times of
depression, dividends on equity shares reach low be which leads to drastic fall in their
market values.
5.c Excessive reliance on financing through equity shares reduces the capacity of the
company to trade on equity. The excessive use of equity shares is likely to result in over
capitalization of the company.


Preference shares are those which catty priority rights in regard to the payment of dividend and
return of capital and at the same time are subject to certain limitations with regard to voting

The preference shareholders are entitled to receive the fixed rate of dividend out of the net profit
of the company. Only after the payment of dividend at a fixed rate is made to the preference
shareholders, the balance of it will be used for paying dividend to ordinary shares. The rate of
dividend preference shares is mentioned in the prospectus. Similarly in the event of liquidation
the assets remaining after payment of all debts of the company are first used for returning the
capital contributed by the preference shareholders.


There are many forms of preference shares. These are:

1.c Cumulative preference shares

].c Non-Cumulative preference shares
3.c Participating preference shares
4.c Non-participating preference shares
5.c Convertible preference shares
[.c Non-convertible preference shares
7.c Redeemable preference shares
8.c Ir-redeemable preference shares
9.c Cumulative convertible preference shares


1.c The preference shares have the merits of equity shares without their limitations.
].c Issue of preference shares does not create any charge against the assets of the company.
3.c The promoters of the company can retain control over the company by issuing preference
shares, since the preference shareholders have only limited voting rights.
4.c In the case of redeemable preference shares, there is the advantage that the amount can be
repaid as soon as the company is in possession of funds flowing out of profits.
5.c Preference shares are entitled to a fixed rate of dividend and the company may declare
higher rates of dividend for the equity shareholders by trading on equity and enhance
market value.
[.c If the assets of the company are not of high value, debenture holders will not accept them
as collateral securities. Hence the company prefers to tap market with preference shares.
7.c The public deposit of companies in excess of the maximum limit stipulated by the
Reserve Bank can be liquidated by issuing preference shares.
8.c Preference shares are particularly useful for those investors who want higher rate of
return with comparatively lower risk.
9.c Preference shares add to the equity base of the company and they strengthen the financial
position of it. Additional equity base increases the ability of the company to borrow in
10.cPreference shares have variety and diversity, unlike equity shares; Companies thus have
flexibility in choice.


1.c Usually preference shares carry higher rate of dividend than the rate of interest on
].c Compared to debt capital, preference share capital is a very expensive source of financing
because the dividend paid to preference shareholders is not, unlike debt interest, a tax-
deductible expense.
3.c In the case of cumulative preference shares, arrears of dividend accumulate. It is a
permanent burden on the profits of the company.

4.c From the investor¶s point of view, preference shares may be disadvantageous because
they do not carry voting rights. Their interest may be damaged by equity shareholders in
whose hands the control is vested.
5.c Preference shares have to attraction. Not even 1% of total corporate capital is raised in
this form.
[.c Instead of combining the benefits of equity and debt, preference share capital, perhaps
combines the benefits of equity and debt.


A debenture is a document issued by a company as an evidence of a debt due from the company
with or without a charge on the assets of the company. It is an acknowledgement of the
company¶s indebtedness to its debenture-holders. Debentures are instruments for raising long-
term debt capital. Debenture holders are the creditors of the company.

In India, according to the Companies Act, 195[, the term debenture includes "debenture stock,
bonds and any other securities of company whether constituting a charge on the assets of the
company or not"

Debenture-holders are entitled to periodical payment of interest agreed rate. They are also
entitled to redemption of their capital as per the terms. No voting rights are given to debenture-
holders. Under section 117 of the companies Act, 195[, debentures with voting rights cannot be
issued. Usually debentures are secured by charge on or mortgage of the assets of the company.


Debentures can be various types. They are:

1.c Registered debentures

].c Bearer debentures or unregistered debentures
3.c Secured debentures
4.c Unsecured debentures
5.c Redeemable debentures

[.c Irredeemable debentures
7.c Fully convertible debentures
8.c Non-convertible debentures
9.c Partly convertible debentures
10.cEquitable debentures
11.cLegal debentures
1].cPreferred debentures
13.cFixed rate debentures
14.cFloating rate debentures
15.cZero coupon debentures
1[.cForeign currency convertible debentures

/c /&0: Registered debentures are recorded in a register of debenture-holders

with full details about the number, value and types of debentures held by the debenture-holders.
The payment of interest and repayment of capital is made to the debenture-holders whose names
are entered duly in the register of debenture-holders. Registered debentures are not negotiable.
Transfer of ownership of these types of debentures cannot be valid unless the regular instrument
of transfer is sanctioned by the Directors. Registered debentures are not transferable by mere

/c/&0: The debentures which are payable to the bearer are called
bearer debentures. The names of the debenture-holders are not recorded in the register of
debenture-holders. Bearer debentures are negotiable. They are transferable by mere delivery and
registration of transfer is not necessary.

0/c/&0: The debentures which are secured by a mortgage or change on the whole
or a part of the assets of the company are called secure debentures.

0/c/&0: Unsecured debentures are those, which do not have charge on the assets
of the company.

/&c/&0: The debentures which are repayable after a certain period are called
redeemable debentures. Redeemable debentures may be bullet repayment debentures (i.e. one
time be payment) or periodic repayment debentures.

/&c /&0: The debentures which are not repayable during lifetime of the
company are called irredeemable debentures. They are al known as perpetual debentures.
Irredeemable debentures can be redeemed in the event of the company¶s winding up.

04c&c/&0: Convertible debentures can be converted into equity shares of the

company as per the terms of their issue. Convertible debenture-holders get an opportunity to
become shareholders and to take part the company management at a later stage. Convertibility
adds a µsweetner¶ to debentures and enhances their appeal to risk seeking investors.

>&c /&0 Non-convertible debentures are not convertible They remain as

debt capital instruments.

w4c&c/&0: Partly convertible debentures appeal to investors who want the

benefits of convertibility and non-convertibility in one instrument.

30&c /&0: Equitable debentures are those which are secured by deposit of title
deeds of the property with a memorandum in writing to create a charge.

c &0: Legal debentures are those in which the legal ownership of property of the
corporation is transferred by a deed to the debenture holders, security for the loans.

w#/c /&0: Preferred debentures are those which are paid first in the L time of
winding up of the company. The debentures have priority over other debentures

-/cc/&0: Fixed rate debentures carry a fixed rate of interest Now a days this class
is not desired by both investors and issuing institutions.

c c /&0: Floating rate debentures carry floating interest rate coupons. The
rates float over some benchmark rates like bank rate, LIBOR etc.

) 02c/&0: Zero-coupon debentures are merest coupons. Interest on these is paid
on maturity called as deep-discount debentures.

c04c&c/&0: Foreign currency convertible debentures are issued

in overseas market in the currency of the country where the flotation takes place. Later these are
converted into equity, either aDR. ADR or plain equity.


1.c Debentures provide funds to the company for a long period without diluting its control,
since debenture holders are not entitled to vote.
].c Interest paid to debenture-holders is a charge on income of the company and is deductible
from computable income for income tax purpose whereas dividends paid on shares are
regarded as income and are liable to corporate income tax. The post-tax cost of debt is
thus lowered.
3.c Debentures provide funds to the company for a specific period. Hence, the company can
appropriately adjust its financial plan to suit its requirements.
4.c Since debentures are generally issued on redeemable basis, the company can avoid over-
capitalisation by refunding the debt when the financial needs are no longer felt.
5.c In a period of rising prices, debenture issue is advantageous. The burden of servicing
debentures, which entail a fixed monetary commitment for interest and principal
repayment, decreases in real terms as the price level increases.
[.c Debentures enable company to take advantage of trading on equity and thus pay to the
equity shareholders a dividend at a rate higher than overall return on investment.
7.c Debentures are suitable to the investors who are cautious and who particularly prefer a
stable rate of return with no risk. Even institutional investors prefer debentures for this

c#c &0c

1.c Debenture interest and capital repayment are obligatory payments. Failure to meet these
payment jeopardizes the solvency of the firm.

].c In the case of debentures, interest has to be paid to the debenture holders irrespective of
the fact whether the company earns profit or not. It becomes a great burden on the
finances of the company.
3.c Debenture financing enhances the financial risk associated with the firm. This may
increase the cost of equity capital.
4.c When assets of the company get tagged to the debenture holders the result is that the
credit rating of the company in the market comes down and financial institutions and
banks refuse loans to that company.
5.c Debentures are particularly not suitable for companies whose earnings fluctuate
considerably. In case of such company raising funds through debentures, may lead to
considerable fluctuations in the rate of dividend payable to the equity shareholders.

c ,0,c304c,c/c &0c2c

A company may prefer equity finance (i) if long gestation period is involved, (ii) if equity is
preferred by the market forces, (iii) if financial risk perception is high, (iv) if debt capacity is low
and (v) dilution of control isn¶t a problem or does not rise.

A company may prefer debenture financing compared to equity shares financing for the
following reasons:

i.c aenerally the debenture-holders cannot interfere in the management of the company,
since they do not have voting rights.
ii.c Interest on debentures is allowed as a business expense and it is tax- deductible.
iii.c Debenture financing is cheaper since the rate of interest payable on it is lower than the
dividend rate of preference shares.
iv.c Debentures can be redeemed in case the company does not need the funds raised through
this source. This is done by placing call option in the debentures.
v.c aenerally a company cannot buy its own shares but it can buy its own debentures.
vi.c Debentures offer variety and in dull market conditions only debentures help gaining
access to capital market.


A convertible issue is a bond or a share of preferred stock that can be converted at the option of
the holder into common stock of the same company. Once converted into common stock, the
stock cannot be estranged again for bonds or preferred stock. Issue of convertible preference
shares and convertible debentures are called convertible issues. The convertible preference
shares and convertible debentures are converted into equity shares. The ratio of exchange
between the convertible issues and the equity shares can be stated in terms of either a conversion
price or a conversion ratio.


The convertible security provides the investor with a fixed return from a bond (debenture) or
with a specified dividend from preferred stock (preference shares). In addition, the investor gets
an option to convert the security (convertible debentures or preference shares) into equity shares
and thereby participates in the possibility of capital gains associated with, being a residual
claimant of the company. At the time of issue, the convertible security will be priced higher than
its conversion value. The difference between the issue price and the conversion value is known
as conversion premium. The convertible facility provides a measure of flexibility to the capital
structure of the company to company which wants a debt capital to start with, but market wants
equity. So, convertible issues add sweeteners to sell debt securities to the market which want
equity issues.

&c2#c, The preference shares which carry the right of conversion into
equity shares within a specified period, are called convertible preference shares. The issue of
convertible preference shares must be duly authorized by the articles of association of the

&c /&0cConvertible debentures provide an option to their holders to convert

them into equity shares during a specified period at a particular price. The convertible debentures
are not likely to have a good investment appeal, as the rate of interest for convertible debentures
is lesser than the non-convertible debentures. Convertible debentures help a company to sell
future issue of equity shares at a price higher than the price at which the company¶s equity shares
may be selling when the convertible, debentures are issue. By convertible debentures, a company

gets relatively cheaper financial resource for business growth. Debenture interest constitutes tax
deductible expenses. So, till the debentures are converted, the company gets a tax advantage.
From the investors¶ point of view, convertible debentures prove an ideal combination of high
yield, low risk and potential capital appreciation.


Capital instruments, namely, shares and debentures can be issued to the market by adopting any
of the four modes: Public issues, Private placement, Rights issues and Bonus issues. Let us
briefly explain these different modes of issues.


Only public limited companies can adopt this issue when it wants to raise capital from the
general public. The company has to issue a prospectus as per requirements of the corporate laws
in force inviting the public to subscribe to the securities issued, may be equity shares, preference
shares or debentures/bonds. A private company cannot adopt this route to raise capital. The
prospectus shall give an account of the prospects of investment in the company. Convinced
public apply to the company for specified number of shares/debentures paying the application
money, i.e., money payable at the time of application for the shares/debentures usually ]0 to
30% of the issue price of the shares/debentures. A company must receive subscription for at least
95% of the shares/bonds offered within the specified days. Otherwise, the issue has to be
scrapped. If the public applies for more than the number of shares/debentures offered, the
situation is called over subscription. In under subscription public subscribes for less number of
shares/debentures offered by the company. For good companies coupled with better market
conditions, over ²subscription results. Prior to issue of shares/debentures and until the
subscription list is open, the company goes on promoting the issue. In the western countries such
kind of promoting the issue is called µroad-show¶. When there is over-subscription a part of the
excess subscription, usually upto 15% of the offer, can be retained and allotment proceeded with.
This is called as green-shoe option.

When there is over-subscription, pro-rata allotment (proportionate basis allotment, i.e., say when
there is ]00% subscription, for every ]00 share applied 100 shares allotted) may be adopted.

Alternatively, pro-rata allotment for some applicants, fill scale allotment for some applicants and
nil allotment for rest of applicants can also be followed. Usually the company co-opts authorities
from stock-exchange where listing is done, from securities regulatory bodies (SEI3J in Indian,
SEC in USA and so on) etc. in finalizing mode of allotment.

Public issues enable broad-based share-holding. aeneral public¶s savings directed into corporate
investment. Economy, company and individual investors benefit. The company management
does not face the challenge of dilution of control over the affairs of the company. And good price
for the share¶ and competitive interest rate on debentures are quite possible.


Whenever an existing company wants to issue new equity shares, the existing shareholders will
be potential buyers of these shares. aentrally the Articles or Memorandum of Association of the
Company gives the right to existing shareholders to participate in the new equity issues of the

This right is known as µpre-emptive right¶ and such offered shares are called µRight shares¶ or
µRight issue¶.

A right issue involves selling securities in the primary market by issuing rights to the existing
shareholders. When a company issues additional share capital, it has to be offered in the first
instance to the existing shareholders on a pro-rata basis. This is required in India under section
81 of the Companies Act, 195[. However, the shareholders may by a special resolution forfeit
this right, partially or fully, to enable the company to issue additional capital to public.

Under section 81 of the Companies Act 195[, where at any time after the expiry of two years
from the formation of a company, or at any time after the expiry of one year from the allotment
of shares being made for the first lime after its formation, whichever is earlier, it is proposed to
increase the subscribed capital of the company by allotment of further shares, then such further
shares shall be offered to the persons who, at the date of the offer, are holders of the equity
shares of the company, in proportion as nearly as circumstances admit, to the capital paid on
those shares at that date. Thus the existing shareholders have a pre-emptive right to subscribe to

the new issues made by a company. This right has at its root in the doctrine that each shareholder
is entitled to participate in any further issue of capital by the company equally, so that his interest
in the company is not diluted.


1.c The number of rights that a shareholder gets is equal to the number of shares held by him.
].c The number rights required to subscribe to an additional share is determined by the
issuing company.
3.c Rights are negotiable. The holder of rights can sell them fully or partially.
4.c Rights can be exercised only during a fixed period which is usually less than thirty days.
5.c The price of rights issues is generally quite lower than market price and that a capital gain
is quite certain for the share holders.
[.c Rights issue gives the existing shareholders an opportunity for the protection of their pro-
rata share in the earning and surplus of the company.
7.c There is more certainty of the shares being sold to the existing shareholders. If a rights
issue is successful it is equal to favourable image and evaluation of the company¶s
goodwill in the minds of the existing shareholders.


Bonus issues are capital issues by companies to existing shareholders whereby no fresh capital is
raised but capitalization of accumulated earnings is done. The shares capital increases, but
accumulated earnings fall. A company shall, while issuing bonus shares, ensure the following:

1.c The bonus issue is made out of free reserves built out of the genuine profits and shares
premium collected in cash only.
].c Reserves created by revaluation of fixed assets are not capitalized
3.c The development rebate reserves or the investment allowance reserve is considered as
free reserve for the purpose of calculation of residual reserves only.
4.c All contingent liabilities disclosed in the audited accounts which have bearing on the net
profits, shall be taken into account in the calculation of the residual reserve.

5.c The residual reserves after the proposed capitalisation shall be at least 40 per cent of the
increased paid up capital.
[.c 30 percent of the average profits before tax of the company for the previous three years
should yield a rate of dividend on the exp capital base of the company at 10 percent.
7.c The capital reserves appearing in the balance sheet of the company as a result of
revaluation of assets or without accrual of cash resources are capitalized nor taken into
account in the computation of the residual reserves of 40 percent for the purpose of bonus
8.c The declaration of bonus issue, in lieu of dividend is not made.
9.c The bonus issue is not made unless the partly paid shares, if any existing, are made fully
10.cThe company ² a) has not defaulted in payment of interest or principal in respect of
fixed deposits and interest on existing debentures or principal on redemption thereof and
(b) has sufficient reason to believe that it has not defaulted in respect of the payment of
statutory dues of the employees such as contribution to provident fund, gratuity or bonus.
11.cA company which announces its bonus issue after the approval of the board of directors
must implement the proposals within a period of six months from the date of such
approval and shall not have the option of changing the decision.
1].cThere should be a provision in the Articles of Association of the Company for
capitalisation of reserves, etc. and if not the company shall pass a resolution at its general
body meeting making decisions in the Articles of Association for capitalisation.
13.cConsequent to the issue of bonus shares if the subscribed and paid-up capital exceed the
authorized share capital, a resolution shall be passed by the company at its general body
meeting for increasing the authorized capital.
14.cThe company shall get a resolution passed at its generating for bonus issue and in the said
resolution the management¶s intention regarding the rate of dividend to be declared in the
year immediately after the bonus issue should be indicated.
15.cNo bonus shall be made which will dilute the value or rights of the holders of debentures,
convertible fully or partly.


1.c Subscription list for public issues should be kept open for at least 3 working days and
disclosed in the prospectus.
].c Rights issues shall not be kept open for more than [0 days.
3.c The quantum of issue, whether through a right or public issue, shall not exceed the
amount specified in the prospectus/letter of offer. No retention of over subscription is
permissible under any circumstances, except the special case of exercise of green-shoe
4.c Within 45 days of the closures of an issue a report in a prescribed form with certificate
from the chartered accountant should be forwarded to SEBI to the lead managers.
5.c The gap between the closure dates of various issues eg., Rights and Indian public should
not exceed 30 days.
[.c SEBI will have right to prescribe further guidelines for modifying the existing norms to
bring about adequate investor protection, enhance the quality of disclosures and to bring
about transparency in the primary market.
7.c SEBI shall have right to issue necessary clarification to these guidelines to remove any
difficulty in its implementation.
8.c Any violation of the guidelines by the issuers/intermediaries will be punishable by
prosecution by SEBI under the SEBI Act
9.c The provisions in the Companies Act, 195[ and other applicable laws shall be complied
in connection with the issue of shares and debentures.


1.c Discuss the sources of long-term finance of a company.

].c Critically evaluate equity shares a source of finance both the point of (i) the company and
(ii) investing public.
3.c Discuss the features of preference shares and evaluate preference share capital from the
company¶s point of view.
4.c What are right shares? Explain the significance of the same from the company¶s and
investors¶ view point.
5.c Define µdebenture¶ and bring out its salient features as an instrument of corporate

[.c Explain the different types of debentures that may be issued by a company.
7.c What are the advantages and disadvantages of debenture finance to a company?
8.c List out the SEBI guidelines for issuing bonus shares.


/cw/0c#c,c c/c c0c


Under this head we shall see the lending procedure practiced by long-term finance

c &'c

After reading this lesson, you will be conversant with:

The different types of appraisal used by term lending institution for financing
The conditions for financial assistance
The various schemes of assistance of financial institutions
The concept, merits and demerits of public deposits
The regulations of RBI regarding public deposits.

  c  c


The essential requirements insisted upon by the financial institutions before taking up a request
for financial assistance for consideration are:

1.c The applicant concerned include the following should have obtained industrial license or
should have made some kind of commitment, where necessary
].c The applicant should have obtained/applied for permission of the Securities and
Exchange Board of India to issue capital, wherever necessary
3.c The applicant should have obtained the approval of the aovernment regarding the terms
of technical and/or financial collaboration agreement, if any.

4.c The applicant should have a clearance from the Capital aoods Committee in respect of
the machinery proposed to be imported
5.c The applicant should have selected a site for the location of the factory and has prepared
a detailed µproject report¶.

After the receipt of the filled up application in triplicate in the case of non-corporate units and
quadruplicate in the case of corporate bodies, the project is appraised by a team of technical,
financial and economic officers of the Corporation from several angles ² technical, financial,
economic, managerial and social.

22c&4c c0c

% ,c22c

The technical appraisal of the project involves a critical analysis of the following:

1.c Feasibility of the selected technical project and its suitability in Indian conditions.
].c Location of the project in relation to the sources and availability of inputs ² raw
materials, water, power, transport, skilled and unskilled labour and in relation to the
market to be served by the product/service.
3.c Adequacy of the plant and machinery and their specifications
4.c Adequacy of the plant layout
5.c Arrangements for securing technical know-how, if necessary
[.c Availability of skilled and unskilled labour and arrangements for training for the
7.c Provision for the disposal of factory effluents and utilisation of byproducts if any.
8.c Whether the process proposed for selection is technically sound up-to-date etc.

Another important feature of technical appraisal relates to the technology to be adopted for the
project. In case of new technical processes adopted from abroad, attention is to be paid to the
terms and conditions.


The economic appraisal of a project involves:

1.c Consideration of natural and industrial property of the project and contribution to the
national economy of the country in terms of contribution to aDP, down stream and
upstream projects.
].c Savings in foreign exchange or prospects of exports.
3.c Employment potential, direct and indirect
4.c A critical study of the existing and future demand for the products proposed to be
manufactured, the licensed and installed capacity, the level of competition etc.
5.c Scrutiny of the project in relation to the import and export policies of the aovernment
and various other factors like regulatory controls, if any, in regard to production, prices
and raw materials.

% c22c

Financial appraisal of the existing concern deals with an analysis of its working results, balance
sheets and cash flow for the past years/projected future years and an examination of the
following aspects in all cases.

1.c Estimated cost of the project

].c Financial plan with reference to capital structure, promoter¶s contribution, debt-equity
ratio and the availability of other resources.
3.c Crucial examination of the investments made outside the business and justification
4.c Projections of cash flow, both during the construction and the operation periods.
5.c Projects break-even level of operation and time required to reach that level of operation.
[.c Estimation of future profitability in the light of competition and product service
7.c Internal rate of return, debt-service coverage and projected dividends on share capital,
payback period, abandonment value at the end of different levels of milestones or years
of operation.


The confidence of the lending institution in the repayment prospects of a loan is largely
conditioned by its opinion of the borrowing unit¶s management. Therefore, it has been remarked
that appraisal of management is the touch stone of term credit analysis. Where the technical
competence, administrative ability, integrity and resourcefulness of the management are well
established, the loan application gets the most favourable consideration. The expertise,
experience and earnestness of the management tells in the efficiency, effectiveness and
excellence of the project.


The social objectives of the project are considered keeping in view the interest of the general
public. The projects, which provide large employment opportunities and canalize the income of
the agricultural sector for productive use, projects located in totally less developed areas and
projects that stimulated small scale industries are considered to serve the society well. The social
benefits are more. The social cost of pollution consumption of scarce resources, etc. is also to be

/c#cc#c c0c

Different financial institutions stipulate different kinds of conditions depending on the nature of
the project, the borrower etc. The main conditions of a term loan are as follows:

1.c The borrower (applicant) has to obtain all relevant aovernment clearances such as
licensing, capital goods clearance for imported machines, import license, clearance from
pollution control board, etc.
].c For consortium loan, the borrower has to satisfy all the institutions participating in
3.c Concurrence of the financial institution is necessary for repayment of any existing loan or
long-term liabilities.
4.c The term loan agreement may stipulate the debt-equity ratio to be followed by the
5.c As long as the loan is outstanding, the declaration of dividend is made subject to the
institution¶s approval.

[.c The term lending institution reserves the right to nominate one or more directors in the
management of the company.
7.c Once the loan agreement is signed, any major commercial agreements such as orders for
equipment, consultancy, collaboration agreement, selling agency agreement etc. and
further expansion need the concurrence of the term lending institution.
8.c The borrower is not permitted to create any additional charge on the assets without the
knowledge of the financial institutions.
9.c The financial institutions may appoint suitable personnel in the areas of marketing,
research and development, depending upon the nature of the project.
10.cThe promoters cannot dispose their shareholders without the consent of the lending
institutions. This is stipulated for keeping the promoters involved as long as the
institutions are involved in the business.

w02c 2c

Deposits with companies have come into prominence in r cent years. Of these the more
important one are the deposits accepted by trading and manufacturing companies. The Indian
Central Banking Enquiry Committee in 1931 recognized the importance of public deposits in the
financing of cotton textile industry in India in general and at Ahmedabad in particular. The
growth of public deposits has been considerable. From the company¶s point of view, public
deposits are a major source of finance to meet the working capital needs. Due to the credit
squeeze imposed by the Research Bank of India on bank loans the corporate sector during 1970s
1980s and also due to the recommendations of the Tandon Committee, restricting credit, many
companies were not getting as much money in the 1980s as they are used to getting in the past,
from the banks. So, public deposits came handy as working capital funds for the businesses.
While to the depositor the rate offered is higher than that offered by banks, the cost of deposits to
the company is less than the cost of borrowings from bank. Moreover, the availability and
volume of bank credit are restricted by considerations of margin, security offered, periodical
submission of statements etc. The credit available to companies through public deposits is not
affected by such consideration. There is no problem of margin or security. Since, the fixed
deposits from the public are unsecured, the borrowing company need not mortgage or

hypothecate any of its assets to raise loans in this form. These deposits are available for
comparatively longer terms than bank credit.

c#cw0&c 2c

The merits of public deposits are as follows:

1.c There is no need of creation of any charge against any of the assets of the company for
raising funds through public deposits.
].c The company can get advantage of trading on equity since the rate of interest and the
period for which the public deposits have been accepted are fixed.
3.c Public deposit is a less costly method for raising short-term as well as medium term funds
required by the companies, because of less restrictive covenants governing this as against
bank credits.
4.c No questions are asked about the uses of public deposits.
5.c Tax leverage is available as interest on public deposits is a charge on revenue.

c#cw0&c 2c

The main demerits of the public deposits are as follows:

i.c This mode of financing, sometimes, puts the company into serious financial difficulties.
Even a slight rumour about the inefficiency of the company may result in a rush of the
public to the company for getting premature payments of the deposits made by them.
ii.c Easy availability of fund encourages lavish spending.
iii.c Public deposits are unsecured deposits and in the event of a failure of the company,
depositors have no assurance of getting their money back.

 c0c#cw0&c 2c

The RBI regulation of public deposits has six main aspects:

i.c There is a ceiling on the quantum of deposits in terms of paid-up capital and reserves by
the company because undue accumulation of short-term liabilities in the form of deposits

can lead a company into financial difficulties. In the beginning the definition of deposits
was quite narrow and excluded unsecured loans accepted from the public and guaranteed
by the directors. Now the term deposit covers "an money received by a non-banking
company by way of deposit or loan or in any other form but excludes money raised by
way of share capital or contributed as capital by proprietors".
ii.c The second aspect of the Reserve Bank¶s regulation is the limit on the period of such
deposit. Formerly, in order to avoid direct competition with short-term public deposits,
companies were prohibited from accepting deposits for a period of less than 1] months.
But the 1973 amendment reduced the period to less than [ months. The short-term
deposit is now pegged down to 10 per cent of the garagate of the paid-up capital and free
reserves of the company while secured and unsecured deposits shall not exceed 15 per
cent and ]5 per cent, respectively, of the paid-up capital and free reserves.
iii.c The Reserve Bank has made obligatory on the part of the companies accepting deposits to
regularly file the returns, giving detailed information about them, their repayment, etc. so
that the Reserve Bank can verify whether the companies adhere to the restrictions.
However such statements are not filed and the Reserve Bank¶s action to prevent a
defaulting company from accepting any deposit fails to afford any protection to the
existing depositors.
iv.c The Reserve Bank has stipulated that while issuing newspaper advertisements (or even
the application forms) soliciting such deposits, certain specified information regarding
the financial position and the working of the company must accompany. This clause is
often mis-ued as much advertisement often carried words like "as per Reserve Bank
directive", thereby giving a wrong impression that these deposits are actually governed
by the Reserve Bank. Now such advertisements would be illegal and attract penal
provision prescribed in this behalf. Similarly, the catalogues and handouts issued by
brokers stating that the companies mentioned therein had complied with Reserve Bank
directives would also attract the penal provision.
v.c The Reserve Bank has entrusted the auditors of the companies with additional
responsibilities of reporting to it that the provision under the Act has been strictly
followed by the company.

vi.c The Reserve Bank has issued a broad "RBI Directives on Company Deposit in order to
clarify its role in protecting the depositors. The bank has reiterated that the deposits or
loans are fully protected or are absolutely safe merely because the companies claimed to
have complied with the RBI directives and that they should not presume that the Reserve
Bank can come to their rescue in the event of failure of a company to meet its obligations.


1.c What do you mean by Public Deposits? Explain their merits and demerits.
].c Explain the types of appraisal to be made in sanctioning project finance.


"0c2c c


In present day economy, finance is defined as the provision of money at the time when it is
required. Finance is required for all types of project and non-profit organizations, to carry out
their regular activities to achieve their objectives. Hence, it is considered as lifeblood of
economic activities. The success of any organization mainly depends on how well financial
resources are being used.

The financial services in India have undergone drastic changes in the last 50 years. In the early
[0s both primary and secondary market were functioning on traditional basis and were inactive
and unorganised. Later FERA Act, 1973, Nationalization of commercial bank, establishment of
IDBI have contributed greatly to the growth of primary and secondary markets. From 1970 on
wards an uninterrupted rise in the industrial, agricultural and service sector growth was found.
The same trend continued even in the 80s. This led to the introduction of different types of
financial instruments in the market. But during the 90s the country faced severe balance of
payments crisis, high inflationary pressures and set back in industrial and finance sector. In the
year 1991, Sri P.V. Narasimha Rao¶s government with a view to bring inflation under control
and to restore normalcy. In the economy introduced the new industrial policy was introduced.

Liberalization in industrial licensing, foreign investment, foreign technology agreements,
disinvestment of public sector units and MRTP Act amendments were introduced. The new
import and export policy brought series of changes in the economic environment. All these
attracted the financial sector. Both primary and secondary markets started functioning as per the
requirements of the market. New financial products were introduced. Technology in banks and
customer service have improved. Competitive financial market was created focusing on needs of
customers. This resulted in the witnessing of new financial instruments in the market Viz.,
Leasing, Hire-purchase Factoring, Forfeiting, alobal Depository Receipts, Venture capital etc.,


On going through this lesson, you will be conversant with

Definition and meaning of venture capital

Characteristic features of venture fund
Venture capital investment process
Stages of financing
Types of organizations
Venture capital financing in India
auidelines on venture funds capital
Present scenario of venture capital financing

The new financial instrument µVenture Capital¶ is discussed in detail.

  c  c



It is defined as long-term funds in equity or semi-equity form to finance hi-tech projects

involving high risk and yet having strong potential of high profitability.

The term µVenture Capital¶ refers to capital investment made in a business or industrial
enterprise, which carries elements of risk and insecurity and the probability of business hazards.
Capital investment may assume the form of either equity or debt or both as a derivative
instrument, The risk associated with the enterprise could be so high as to entail total loss or be so
insignificant as to lead high gains. aenerally, the investment is made in the form of equity with
the prime objective being capital gains as the business prospers. Equity investment enables the
investor to the investment into cash when required.


Venture Capital means many things to many people Jane Aoloski Morris, editor of the well
known industry publication, Venture Economics, defines Venture capital as µproviding seed,
start-up and first stage financing¶ and also funding the expansion of companies that have already
demonstrated their business potential but do not yet have access to the public securities market or
to credit oriented institutional funding sources Venture capital also provides management in
leveraged buy out financing".

The European venture capital association describes it as risk finance for entrepreneurial growth
oriented companies. It is investment for the medium or long-term seeking to maximize medium
or long-term return for both parties. It is a partnership with the entrepreneur in which the investor
can add value to the company because of his knowledge experience and contract base.

Steven James Lee, defines it as actual or potential equity investments in companies through the
purchase of stock, warrants, options or convertible securities. Venture capital is a long-term
investment discipline that often requires the venture capitalist to wait five or more years before
realising a significant return on the capital resource.

The 1995 Finance Bill, defines Venture capital as long-term equity investment in novel
technology, based projects which display potential for significant growth and financial returns.
Hence, venture capital implies an investment in the form of equity for high risk projects with the
expectation of higher returns. The investment is made through the private placement with the
expectation of risk of total loss or huge returris. Risk is associated with such capital investment
and as such it is termed as venture capital. High technology industry is more attractive to venture

capital because of high returns. The main object of investing equity is to get high capital profits
at saturation stage.

,c 0c

· Investments are made in equity in high tech. Industry and wait for 5- 7 years to reap the
benefit of capital gains.
· Investments are made in innovative projects with new technology with a view to
commercialise the know how through new products\services
· The claim over the management is decided on the basis of proportion to investments.
· Venture capital investor does not interfere in the day-to-day business affairs but closely
watch the performance of the business unit.
· Venture capital funds need not be repaid in the course of business units, but they are realised
through exist route, (stock exchange).


Financing of a High tech., project under venture capital has following steps. They are:

%c &,c #c c &c ,c 20c /c ,c 0c 2 The
Prospective entrepreneur, with his know how prepares a project report establishing there in the
possibility of marketing a commercial product. This can be done with the help of auditor,
professional or a merchant banker. The business consists of five important feasibility reports
namely, Technical, Financial, Managerial, Marketing and Socio-economic feasibility. The formal
application in duplicate will be submitted to venture capital investor.

%cw4c0cAfter the preliminary evaluation of the report is completed, venture

capital investor normally discusses the investment plan for the project with the banker. During
this stage close net work is expected from the management team, to implement the project.

%c /c22: In addition to the close discussion with the management team, a detailed
appraléal of project is undertaken. Techno-economic feasibility will be examined by involving

the executives of the Venture capital Investor and the management professional. If required they
may even consult the experts In the similar field to take a decision.

<%c4c4 The Forecasted results of sales and profits are tested and analysed. The
risks and threats will be evaluated by using sensitivity analysis. Sensitivity analysis helps the
evaluators to predict the probable risks and returns associated with the project. This formally
clears the project for investment.

=%c c c ,c 2' The terms and conditions of venture capital assistance will be
finalised according to the requirement of the project. The amount of funds required, profile of the
business, the life time technology and the possible competition in the business will be looked
into. A formal agreement is entered between the technocrat and investor stating therein the role
of and share of management in the new project.

9%c c ,c w'c /c 2c c 022cThe venture capitalist role begins
with financing the project. It is a general practice of the Investor to appoint an executive director
to have closer look in to the project. The executive director assists the project in developing
strategies, decision-making and planning. The process of interaction with the technocrat
increases the healthy environment in carrying the day-to-day business affairs.

c#c"0c2c c

The financing of high-tech., project in the form of venture capital financing is done in several

They may µbe in the form of:

1.c Early-stage financing

].c Later stage financing

m5c4 c#c

This stage of financing is done to the new project or to the new technocrat who wishes to
commercialize his research talents. As the technocrat is well versed only with know how and not

with capital, going for debt at this stage increases the risk of entrepreneur and affect the health of
the business unit. In, other means of financing, the obligation to repay the loans along with
interest starts immediately with lending. Hence, it is not advisable for young entrepreneurs to go
in for such loans. They have depend mainly on equity stoke so that the risk of repayment does
not arise equity financing permits the young entrepreneurs to commercialize and earns profits out
of the investment. The main instruments used for such financial assistance would be in the form
of equity contribution, unsecured loans and optionally convertible securities. Once the financing
is done, venture capitalists assists the firm in general administrative activities and allow the
technocrat to concentrate on production and marketing. This stage of venture capital financing
consists of seed capital, start-ups and second round financing.

m5c/c2 Seed capital financing includes the implementation of research project, starting
from all initial conceptual stage. This stage requires more time to complete the process. Because
the entrepreneur made an effort to the maximum to meet the market potentiality. Therefore
external equity in preferred. The key factors that influence equity financing at this stage are:

The technology used in the project, possible threats of new technology in the near future.
Different aspects of the product life cycle.
The total investment required commercializing the product and time required to get suitable
returns etc.,

m&5c  02c c #: At this stage innovator requires finance to commercialize the
product. This stage is not simple to execute, it requires more time in getting different elements
ie., (patent rights, trade marks, design and copy rights) which are very essential to bring the
product in the market. All these components are very essentially needed to launch the product
effectively. Hence, time and finance is needed. On the other hand, the research must also be done
to evaluate the probable opportunities to exploit the market. Therefore, venture capital investor
evaluates the projects carefully and negotiate the terms and conditions with the entrepreneur with
regard to sharing the management.

m5c/c0/c#c# This type of financing is required when the project incurs loss
or inability to yield sufficient profits. The reasons could be due to internal or external factors. At

this stage, if the venture capitalists is fully aware of the genuine reasons for the loss, he should
decide on second round financing, or he may seek the support of new investor. This is a complex
process as the original investor may express his inability to further finance the project or
entrepreneur must have lost the confidence with the original investor or he may wishes to broad
base the investment pattern. Lot of bargaining has be done to coordinate the financing with
original investor and with the technocrat or promoter.

m 5ccc c

Later stage financing is considered to be the easy means of assistance. The reason being, the
product launched has not only reached the boom period but also indicator further expansion and
growth. Hence it is a easy means of financing with low risk profile. The real problem associated
at this stage is entrepreneur not be willing to give majority of his stake to the venture capitalists
but may accept for more number of executive directors in the board. This means of is also known
as expansion finance, replacement capital, management buy out and turn around capital.

m5c-2c#: Later stage financing is executed to expand the market, production or to

establish warehouses etc., Export trade activities may also be considered for financing the

m&5c 2c 25 Under this stage, the promoter may prefer to buy the entire equity
stake of the project by approaching some other financiers. He may also wish to increase his
holding by buying more number of equity shares. Replacement capital) is normally preferred at
the time of public issues. If the company is unlisted, getting capital gains on the fresh issues
needs more time, tilt then replacement capital can be obtained in the form of convertible
preference shares from the second financier.

m5cc 04c0cm 5 This may be offered in two ways namely. µManagement buy
out¶ or µManagement buy int. In management buy out, venture capitalist help the management of
a company to buy or take over the ownership of the business. This would help the management
to reshuffle or reengineer the entire project.

In management buy in strategies, outsides prefers to buy the existing business. This means of
financing is less risky, it is not considered as venture capital and has wide criticism.

m/5c0c2: Rescue capital is also known as turnaround capital offered with a view to
help the technocrat or the business unit to come out of difficulties. This means of financing is
risky in nature and the investor may ask for major changes in the management. In India, venture
capital financing for MBO and turnout are rarely seen, as the majority of the investor prefers to
invest only in later stages.

42c#c"0c2c .c

On the basis of ownership, management and rising of funds, venture capital organization are
categorised on the following groups:

2c "0c 2c 0/ These organizations are wholly owned by financial
institutions and are operated as subsidiaries. The parental institutions supply funds for venture
capital assistance e.g.. 1DBI used captive funds to assist venture capital, TDIC uses the funds for
venture capital which is supplied by UTI and ICICI. RCTC used the funds of UTI and IFCI. All
these venture capital investors perform their activities independently.
/2/c"0c2c 0/ All these funds are raised by group individuals venture
capitalists. These funds are close-ended with minimum capital base and equity oriented
instruments. The investor in such contribution expects huge capital gains, rather than regular
income of dividends. The amount invested in the project will be realised through the exist route.
(Promoter and venture capitalists prefers to go for primary market to sell the shares and
distributes the realised amount as per the terms and conditions of the agreement.)

c 0/ These venture capital organizations are wholly owned by the government.
The assistance will be given to promoter at the initial stages to complete research and
developmental activities. To avail such benefits the product innovated should be of national
importance. aovernment of Aarnataka through the Central aovernment scheme, provides Rs.
]5,000 for the technocrat who commercializes his know how by obtaining a patent right, the
Commissioner of industrial development is authorised to release this fund through Aarnataka
Council of Technological upgradation scheme.


The main aim of venture capitalist is to realise the investment with huge profit after the
completion of successful efforts with the promoter in launching or commercialising the product.
The exit route will be well thought by the investor at the stage of marking investments. Exit
means realization of investment through the issue of equity shares to the public. The main motto
of venture capitalist is find exit at µmaximum profit or if it is unavoidable with µminimum loss¶.
There are alternative routes of disinvestment practiced in a real life situation. They are:

aoing public
Sale of shares to entrepreneurs
Sale of the company to another company
Finding a new investor

m5ccw0& Most of the venture capital assisted firms prefers to go in for public issue to
recover their investments with profits. This process not only help the entrepreneur but also the
investor in different ways. The main benefit of going public increases the liquidity of the
business firm. This liquidity will increase the percentage returns over the private placements. (If
it were sold through private placements). The public issues provides another opportunity for the
business firm to list its shares in the stock market. Once the shares are listed, it increases the
image of the organization. In addition to this, it increases and attracts efficient persons to work in
the organization. In addition to this, the commercial banks and financial institutors will forward
to offer different types of loans. If the firm wishes to raise additional capital for expansion and
growth, it could be done easily through the public issue.

However, going public is not an easy route to exit or venture capital assisted units because, it has
to observes several legal for¶ of stock exchange. The company must also disclose part a
considerable ar1t of information at the time of issuing the shares; this could be a sales threat with
the global competition. Employees may ask for better comfort with huge hike in the salaries and
perks. The expenditure incurred during the course of the issue in also substantially high, which
may affect the profitability. As the company is going for public issue, its social responsibility

increases and they have to be accountable to all the organs of the society, which burdens the
financial affairs of the company. With all these demerits or bottlenecks going public for exit
route is widely used in seal life situations.

m&5c c #c ,c c 20 Some times, promoter may prefers to have exit route
through, Over The Counter Exchange by entering into bought out deals with the member of
O.T.C. He may purchase the shares with a view of entering in to the primary market at the later

In certain circumstances, an entrepreneur himself prefers to buy the entire shares. He may even
buy the shares with the help of his own group-even the employees are allowed to do so at an
agreed price for buying such shares. If necessary, the entrepreneur may approach financial
institutions for loans. The price at which the stake of the V. C. assisted may be done as several
methods. Viz.,

m5c 1c0c,/ According to this method, the price is fixed on the basis of book value
method or a predetermined multiple applied to determine the book value

(5cw c This method is widely in practice. The price of the share is determined
as the basis of multiplying the price earning ratio to earning per share.

m5cwc#cc,/ Pricing under P/E ratio is popular only when the earnings are
low or the company anticipated losses in the coming years PIE ratio is not suitable. On such
circumstance, percentage of sale method is used. If the sales figures are highly volatile, the total
average sale of the industry is taken into consideration.

m5c 02c #c ,c #c ,/ According to this method, the value of the business is
determined by multiplying the cash flow of the business by a multiplies which is similar to the
industry. Hence it is considered to be a better method when compared to PIE ratio and
percentage on sales method.

(5c /2/c "0 Sometimes, the task of determining the value of business is
assigned to professionals like CAs or Merchant Bankers. They may use either p/eratio method or
a traditional method for assessing the value of the assets. (Realisable value)

m5c /c c ,c ,/ Venture capitalist and the entrepreneur follow the price that was
determined mutually at the time of launching business. This is a traditional and simple method.

(5c c #c c 24c c ,c 24: On many occasions, venture capitalist and the
entrepreneur may agree together to sell the business unit to some other company. The reasons
could be many viz., the entrepreneurs may prefer to undertake some other new company. He may
find it difficult to operate the business profitably. At the time of managerial difficulties he may
search for a new company which is having similar line of business. The modalities of such a sale
will be made on the basis of level of operations and, the nature of venture, which may be
acceptable to both the parties.

m/5c /c c c  Under this method, the venture capitalists and the investor may
decide to sell the unit to another new investor who may be a venture capitalist or a corporate who
is having similar line of business. But buying venture from others and buying company may
increase their operation and profitability. This provides an opportunity to exploit and can have
economies of large scale operations

m5c30/: This is a lender of last resort, when a firm performs very badly, in other words
if it incurs continuous cash loss over the years, venture capitalist and the entrepreneur decides to
close down the operations. Hence, it takes the firm to liquidation. The reason for such a exercises
would be many viz., stiff competition, technological failure, poor management by the
entrepreneur etc.,


1.c Define the term µVenture Capital¶

].c Explain the process Venture Capital investment.
3.c Mention the different characteristic features of Venture Capital
4.c What is early stage financing? Explain.

5.c What is later stage financing? Explain.